2024 Market Outlook: Investors Are In For A Few Surprises

Investors have to be ready for many surprises in 2024.  While the US economy was able to escape a recession in 2023, if anything, it has increased the chances of either a recession or a market pullback in the first half of 2024.  While many investors remember how bad the Great Recession was back in 2008 and 2009, very few remember what the market conditions were like prior to the recession beginning.  As an investment firm, we archive a lot of that data, so we reference it at any time to determine where the market may be headed today, and the historical data is alarming.

Rewind the clock to January 2008

In January 2008, the US economy was already in a recession, but it had not officially been declared yet that's because a recession, by textbook definition, is two consecutive quarters of negative GDP, but you don't get the quarterly GDP readings until after each calendar quarter end, so while the recession in the US officially began December 2007, investors didn't realize recession had been declared until mid-way through 2008.  So what were the forecasts for the S&P 500 in January 2008? 

The broker-dealer that we were with at the time was forecasting in January 2008 that the S&P 500 Index would be up 16% in 2008.  We now know that 2008 was the first year of the Great Recession, and the S&P 500 ended up posting a loss of 36% for the year.  Many investors don't realize that historically, the consensus is very bad at predicting a coming recession because they failed to recognize the patterns in the economy and monetary policy that tend to be very good predictors of recessions.  Investors are often more worried about missing out on the next 20% rally in the markets, which is why they get caught when the market begins its steep sell-off.

What were some of these economists looking at in January 2008 that made them so wrong?  Towards the end of 2007, we had already begun to see the cracks within the US housing market, the economy had already started to slow, but in September 2007, the Federal Reserve began to lower interest rates which stock forecasters saw as a bullish signal that the monetary stimulus of lower interest rates would mean growth for the stock market in 2008.  This echoes much of the same rhetoric that I heard in the fourth quarter of 2023 as the Fed decided to go on pause and then built in rate cuts to their 2024 forecast. 

If you look back at history, there's a pattern between the US economy and the Fed funds rate, and it's fairly consistent over time.  Here is a chart of the Fed funds rate going back to 1993.  You will see the same pattern in the chart, The Fed raises rates to fight inflation, they pause (which is the tabletop portion at each of the mountain peaks), and then rates drop rapidly when the economy slows by too much, and the economy enters a recession.  The Fed is historically very bad at delivering soft landings, which is a reduction in inflation without a recession. 

Why is that?  I think largely it's because we have the largest economy in the world, so picture a battleship in a bathtub, it takes a long time to turn, and because it's so large, once you've begun the turn you can't just stop the turn on a dime, so our turns tend to overshoot their mark, creating prolonged bull market rallies past what the consensus expects, but also an inability to stop the economy from slowing too much in an effort to fight inflation before it dips into a recession. 

Here is the pattern

This chart shows our current rate hike cycle as well as the five rate hike cycles before us.  For the five rate hike cycles preceding our current cycle, four of the five resulted in a recession.  But that means one of the five created a soft landing, which one was it?

The 1994/1995 rate hike cycle was one of the very few soft landings that the Fed has engineered in history, so could that be done again?  What was different about the mid-90s compared to the other four rate hike cycles that led us into a recession?

Leading Economic Index

The leading economic index is comprised of multiple economic indicators such as manufacturing hours worked, consumer sediment, building permits, and more.  Its parts are considered by many to be forward-looking measurements of economic activity, which is why it's called the leading index.  Below is a historical chart of the LEI index going back to 1960.  The way you read the chart, when it's blue the leading indicators in aggregate are positive, when it's red, the leading indicators in aggregate are contracting.

If you look at the four rate hike cycles that led to a recession, the leading indicators index was contracting in all four prior to the recession beginning, serving as a warning sign.  But if you look at 1995 in the chart, the leading indicators index never contracted, which means the Fed was able to bring down inflation without slowing the economy.

But on the far right-hand side of the chart, look at where we are now.  Not only has the leading indicators index contracted similar to the four rate hike cycles that caused the recession, but it's contracted at a level so deep that we've never been at this level without already being in a recession. If we avoid a recession over the next 12 months, it will be the first time that the LEI index has been this low without a recession preceding it.

Inverted yield curve

There is a technical indicator in the bond market called the yield curve, which tracks both short-term and long-term interest rates.  Without getting into the technical details of how it works, when the yield curve inverts, which means short-term interest rates are higher than long-term interest rates, historically, it's a bearish signal, and it increases the likelihood of a recession occurring.  In the past, an inverted yield curve has been a very good predictor of a coming recession.  See the chart below. 

Anytime The blue line drops below the red line the yield curve is inverted, the gray bars on the chart are the recessions, so when all of the previous 5 recessions the yield curve gave us an advance warning before the recession actually occurred.  On the far right-hand side of the chart, that is where we are now, not just slightly inverted, but far more heavily inverted than the previous four recessions.  Similar to the leading indicators index historical behavior, if we were to avoid a recession in the next 12 months, that would be the exception to the rule.

Returning to our original question of why was the 1994/1995 soft landing different, notice on the inverted yield curve chart during 1995, the yield curve never inverted, making it much different than the situation we're in now.

 Magnitude and pace of rate hikes

After going through this exercise and understanding the patterns of the leading indicators index as well as the yield curve, let's return to our first chart, which showed the six rate hike cycles, including the one we're in now. 

The gold line is the rate hike cycle that we're in now, the others are the five previous rate hike cycles. Again four of those five caused the recession, and the reason why the gold line on the chart is higher than the rest the Fed raised rates higher and faster than they had in the previous five rate hike cycles which begs the question, if the catalyst that caused the recessions is stronger, wouldn't the occurance of a recession be more likely? 

Said another way, think of the Fed as a bully that likes to push kids at school, the kids represent the US economy, and the force that the bully uses to push the kids is measured by the magnitude of the interest rate increase.  There are six kids standing in the hallway as the bully approaches, the first four he pushes with half of his strength, and the kids fall over on the floor, the fifth child gets nudged but does not fall over, but the bully is now running full speed at the sixth child and we're trying to figure out how it's going to end. 

With history as a guide, I have a difficult time envisioning a situation where that sixth student remains on their feet.

No Recession

So what if we're wrong? What if, by some miracle, in the face of all these historic trends, the US economy avoids a recession?  I would then add that while it is, of course, possible that we could avoid a recession because it's happened before, that does not necessarily mean we are going avoid a 10% plus market correction at some point in 2024 because the stock market looks to be priced for perfection.   You can see this in the future earnings expectations for the S&P 500.   Blue bars on the chart are the earnings expectations going into 2024 that are already baked into the S&P 500 stock prices. 

 It seems that not only is the consensus expecting no recession, but they are also expecting significant earnings growth.  Again, with the leading economic indicators being so negative right now and the Fed not expected to lower rates until mid-2024, how do the companies in the S&P 500 meet those aggressive earnings expectations when it seems like the consumer is softening?  I completely understand that the stock market is a forward-looking animal, but it seems more likely that we're repeating the mistakes of the past because the stock market can only go so far without the economy and the stock market is already way ahead even as we head into 2024.  That was the most puzzling aspect of 2023,  the stock market continued to rally throughout all of 2023, while the U.S. economy continued to slow throughout 2023. 

The Consumer Is Not As Strong As They Seem

I continue to hear the phrase, “consumer spending remains strong”, and I agree that the consumer has been more resilient that even I expected in 2023. However, much of that spending is being done on credit.  Take a look at how much credit card debt has risen in the U.S. post COVID, quickly breaking through over $1 Trillon dollars.  

Not only has the level of credit card debt risen to record levels but the interest rates being charged on that debt is significantly higher than it was just a year ago, resulting in less discretionary income for consumers with credit card debt.

Buffet & Munger

Many people know the famous investor Warren Buffet and his famous quote: “Be fearful when others are greedy, and be greedy when others are fearful.”  But many people don’t know that Warren had a fellow billionaire partner in Berkshire Hathaway named Charlie Munger.  Charlie just passed away in 2023 at the age of 99, and Charlie had a famous quote of his own:

“The world is full of foolish gamblers, and they will not do as well as the patient investors.”

Living in a world of FOMO (Fear Of Missing Out), patience is probably the most difficult investment discipline to master, but I personally have found it to be the most rewarding discipline during my 20+ year career in the investment industry.   The year 2024 may be lining up to be another history lesson as FOMO investors fail to recognize the historical pattern between interest rates and the economy dating back 50 years.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

So Where Is The Recession?

Toward the end of 2022 and for the first half of this year, many economists and market analysts were warning investors of a recession starting within the first 6 months of 2023.  Despite those widespread warnings, the S&P 500 Index is up 16% YTD as of July 3, 2023, notching one of the strongest 6-month starts to a year in history.  So why have so many people been wrong about their prediction and off by so much? 

The primary reason is that the U.S. economy and the U.S. stock market are telling us two different stories. The U.S. stock market seems to be telling the story that the worst is behind us, inflation is coming down, and we are at the beginning of a renewed economic growth cycle fueled by the new A.I. technology.  But the U.S. economy is telling a very different story.  The economic data suggests that the economy is slowing down quickly, higher interest rates are taking their toll on bank lending, the consumer, commercial real estate, and many of the economic indicators that have successfully forecasted a recession in the past are not only flashing red but have become progressively more negative over the past 6 months despite the rally in the stock market.

So are the economists that predicted a recession this year wrong or just early? In this article, we will review both sides of the argument to determine where the stock market may be heading in the second half of 2023. 

The Bull Case

Let’s start off by looking at the bull case making the argument that the worst is behind us and the stock market will continue to rally from here.

Strong Labor Markets

The bulls will point to the strength of the U.S. labor market. Due to the shortage of workers in the labor market, companies are still desperate to find employees to hire, and even companies that have experienced a slowdown within the last 6 months are reluctant to layoff employees for fear that they will not be able to hire them back if either a recession is avoided or if it’s just a mild recession. 

I agree that the labor market environment is different than previous market cycles, as a business owner myself, I cannot remember the last time it was this difficult to find qualified employees to hire.  From the research that we have completed, the main catalyst of this issue stems from a demographic issue within the U.S. labor force.  It’s the simple fact that there are a lot more people in the U.S. ages 50 to 70 than there are people ages 20 – 40.  You have people retiring in droves, dropping out of the workforce, and there are just not enough people to replace them. 

The bulls are making the case that because of this labor shortage, the unemployment rate will remain low, the consumer will retain their spending power, and a recession will be avoided.

Inflation is Dropping Fast

The main risk to the economy over the past 18 months has been the rapid rise in inflation.  The bulls will highlight that not only has the inflation dropped but it has dropped quickly.  Inflation peaked in June 2022 at around 9% and as of May 2023, the inflation rate has dropped all of the way down to 4% with the Fed’s target at 2% - 3%.  The inflation battle is close to being won.  As a result of the rapid drop in inflation, the Fed made the decision to pause as opposed to raising the Fed Fund Rate at their last meeting, which is also welcomed news for bullish investors since avoiding additional interest rate hikes and shifting the discussion to Fed Fund rate cuts could eliminate some of the risks of a Fed-induced recession.

The Market Has Already Priced In The Recession

Some bulls will argue that the stock market has already priced in a mild recession which is the reason why the S&P 500 Index was down 19% in 2022, so even if we end up in a recession, the October 2022 market lows will not be retested.  Also, since the market was down in 2022, historically it’s a rare occurrence that the market is down two years in a row. 

The Bear Case

Now let’s shift gears over to the bear case that would argue that while a recession has not surfaced yet, there are numerous economic indicators that would suggest that there is a very high probability that the U.S. economy will enter a recession within the next 12 months.  Full disclosure, we are in this camp and we have been in this camp since December 2021.  Admittedly, I am surprised at the “magnitude” of the rally this year but not necessarily surprised at the rally itself.

Bear Market Rallies Are Common

Rarely does the stock market fire a warning shot and then proceed to enter a recession.  Historically, it is more common that the stock market experiences what we call a “false rally”, right before the stock market wakes up to the fact that the economy is headed for a recession, followed by a steep selloff but there is always a bull market case that exists that investors want to believe.

The last real recession that we had was the 2008 housing crisis and while investors remember how painful that recession was for their investment accounts, they typically don’t remember what was happening prior to the recession beginning.  Leading into the 2008/2009 recession, the S&P 500 Index had rallied 12%, the housing market issues were beginning to surface, but there was still a strong case for a soft landing as the Fed paused interest rate hikes, and began decreasing the Fed Funds Rate at the beginning of 2008, but as we know today the Great Recession occurred anyways.

The Fed Has Never Delivered A Soft Landing

While there is talk of a soft landing with no recession, if you look back in history, anytime the Fed has had to reduce the inflation rate by more than 2%, the Fed rate hike cycle has been followed by a recession every single time.  As I mentioned above, the inflation rate peaked at 9% and their target is 2% - 3% so they have to bring down the inflation rate by much more than 2%.    If they pull off a soft landing with no recession, it would be the first time that has ever happened.

The Market Bottom

For the bulls that argue that the market is expecting a mild recession and has already priced that in, that would also be the first time that has ever happened. If you look back at the past 9 recessions, how many times in the past 9 recessions did the market bottom PRIOR to the recession beginning?  Answer: Zero.  In each of the past 9 recessions, the market bottomed at some point during the recession but not before it.

Also, the historical P/E ratio of the S&P 500 Index is a 17.  P/E ratios are a wildly used metric to determine whether an investment or index is undervalued, fairly valued, or overvalued.   As I write this article on July 3, 2023, the forward P/E of the S&P 500 Index is 22 so the stock market is already arguably overvalued or as others might describe it as “priced to perfection”.   So not only is the stock market priced for no recession, it’s priced for significant earnings growth from the companies that are represented within the S&P 500 Index.

A Rally Fueled by 6 Tech Companies

The S&P 500 Index, the stock market, is comprised of 500 of the largest publicly traded companies in the U.S.  The S&P Index is a “cap-weighted index” which means the larger the company, the larger the impact on the direction of the index.  Why does this matter?  In 2023, many of the big tech companies in the U.S. have rallied substantially on the back of the artificial intelligence boom.

As of June 2, 2023, the S&P 500 Index was up 11.4% YTD, and at that time Nvidia one of the top ten largest companies in the S&P 500 was up 171%, Amazon up 49%, Google up 41%.  If instead you ignored the size of the companies in the S&P 500 Index and gave equal weight to each of the 500 companies that make up the stock index, the S&P 500 Index would have only been up 1.2% YTD as of June 2, 2023.  So this has not been what we consider a broad rally where most of the companies are moving higher. (Data Source for this section: Reuters)

Why is this important?  In a truly sustainable growth environment, we tend to see a broad market rally where a large number of companies within the index see a meaningful amount of appreciation and just doesn’t seem to be the case with the stock market rally this year.   

2 Predictors of Coming Recessions

There are two economic indicators that have historically been very good at predicting recessions; the yield curve and the Leading Economic Indicators Index.  Both started the year flashing red warning signals and despite the stock market rally so far this year, both indicators have moved even more negative within the first 6 months of 2023.

Inverted Yield Curve

The yield curve right now is inverted which historically is a very accurate predictor of a coming recession.  Below is a chart of the yield curve going back to 1977, anytime the grey line moved below the red line in the chart, the yield curve is inverted.  As you can see, each time the yield curve inverts it’s followed by a recession which are the grey shaded areas within the graph.  On the far right side of the chart is where we are now, heavily inverted.  If we don’t get a recession within the next 12 months, it would be the first time ever that the yield curve was this inverted and a recession did not occur.

The duration of the inversion is also something to take note of.  As of July 2, 2023 the yield curve has been inverted for 159 trading days, since 1962 the longest streak that the yield curve was inverted was 209 trading days ending May 2008 (the beginning of the Great Recession).  If the current yield curve stays inverted until mid-September, which is likely, it will break that record.

Leading Economic Indicators Index (LEI Index)

The Leading Economic Indicators index is the second very accurate predictor of a coming recession because as the name suggests the index is comprised of forward-looking economic data including but not limited to manufacturing hours works, building permits, yield curve, consumer confidence, and weekly unemployment claims.  The yield curve is a warning from the bond market and the LEI index is a warning from the U.S. economy.

In the chart below, when the blue drops below the red line (where the red arrows are) the LEI index has turned negative, indicating that the forward-looking economic indicators in the U.S. economy are slowing down.  The light grey areas are the recessions. As you can see in the chart, shortly after the LEI index goes negative, historically a recession appears shortly after. If you look at where are now on the righthand side of the chart, not only are we negative on the LEI, but we have never been this negative without already being in a recession.  Again, if we don’t get a recession within the next 12 months, it would be the first time ever that this indicator did not accurately predict a recession at its current level. 

“Well…..This Time It’s Different”

A common phrase that you will hear from the bulls right now is “well…..this time is different” followed by a list of all the reasons why the yield curve, LEI index, and other indicators that are flashing red are no longer a creditable predictor of a coming recession.  After being in the investment industry for over 20 years and experiencing the tech bubble bust, housing crisis, Eurozone crisis, and Covid, from my experience, it’s rarely different which is why these predictors of recessions have been so accurate over time. Yes, the market environment is not exactly the same in each time period, sometimes there is a house crisis, other times an energy crisis, or maybe a pandemic, but the impact that monetary policy and fiscal policy have on the economy tend to remain constant over longer periods of time.

Market Timing

It’s very difficult to time the market.  I would love to be able to know exactly when the market was peaking and bottoming in each market cycle but the stock market itself throws off so many false readings that become traps for investors.  While we rely more heavily on the economic indicators because they have a better track record of predicting market outcomes over the long term, the timing is never spot on but what I have learned over time is that if you are able to sidestep the recessions, and avoid the big 25%+ downturns in an investment portfolio, it often leads to greater outperformance over the long term.  Remember, mathematically, if your portfolio drops by 50%, you have to earn a 100% rate of return to get back to breakeven.  But it takes discipline to watch these market rallies happen and not feel like you are missing out.

The Consumer’s Uphill Battle

Consumer spending is the number one driver of the U.S. economy and the consumer is going to face multiple headwinds in the second half of 2023.  First, student loan payments are set to restart in October. Due to the Covid relief, many individuals with student loans have not been required to make a payment for the past three years and the $10,000 student loan debt cancellation that many people were banking on was recently struck down by the Supreme Court.  

Second, while inflation has dropped, the interest rates on mortgages, car loans, and credit cards have not.  The inflation rate dropped from 9% in June 2022 to 4% in May 2023 but the 30-year fixed mortgage rate peaked in November at around 7% and as of July 2023 still remains around 6.8%, virtually unchanged, so not a lot of relief for individuals that are trying to buy a house. 

This is largely attributed to the third headwind for consumers which is that banks are tightening their lending practices.  The banks see the same charts of the economy that we do and when the economy begins slowing down banks begin to tighten their lending standards making it more difficult for consumers and businesses to obtain loans.  Even though the stock market has rallied in 2023, banks have continued to tighten their lending standards over the past 6 months and with more limited access to credit, that could put pressure on the economy in the second half of 2023.

Consumer spending has been stronger than expected in 2023 which has helped fuel the stock market rally this year but we can see in the data that a lot of this spending has been done using credit cards and default rates on credit cards and auto loans are rising quickly.  So now many consumers have not only spent through their savings but by the end of the year they could have large credit card payments, car payments, higher mortgage/rent payments, and student loan payments.  

Reasons for Recession Delay

With all of these clear headwinds for the market, why has the recession not begun yet as so many economists had forecasted at the beginning of 2023?  In my opinion, the primary reason for the delay is that it typically takes 9 to 12 months for each Fed rate hike to impact the economy.  When the Fed is raising rates, they are intentionally trying to slow down the economy to curb inflation.  The Fed just paused for the first time in June 2023 but all of the rate hikes that were implemented in the first half of 2023 have yet to work their way into the economy.  This is why you see yet another very consist historically pattern with the Fed Funds Rate.  A pattern that I call the “Fed Table Top”.   Here is a chart showing the last three Fed rate hike cycles going back to 2000:

You will see the same pattern over time, the Fed raises interest rates to fight inflation which are the moves higher in the chart, they pause at the top of their rate hike cycle which is the “Table Top”, and then a recession appears as a result of their tightening cycle, and they begin dropping interest rates. Once the Fed has reached its pause status or “table top”, some of those pauses last over a year, while other pauses only last a few months. The pause makes sense because again it takes time for all of those rate hikes to impact the economy so it’s never just a straight up and then a straight down in interest rates. 

So then that raises the question, how long will this pause be?  Honestly, I have no idea, and this is the tricky part again about timing but the pattern has repeated itself time and time again.  However, as you can also see in the Fed chart above when you compare the current Fed rate hike cycle to those of the previous 3 cycles, the Fed just raised rates by more than the previous three cycles in a much shorter period of time, that would lead me to believe that this Fed Table Top could be shorter because the 9-month lag of the interest rate hikes on the economy will happen at a greater magnitude compared to the Fed rating rates at 0.25% - 0.50% per meeting as they did in the previous two Fed rate hike cycles.

Bulls or the Bears?

Only time will tell if the economic patterns of the past will remain true and a recession will emerge within the next 12 months or if this time it is truly different, and a recession will be avoided.  For investors that have chosen the path of the bull, they will have to remain on their toes, because historically when the turn comes, it comes fast, and with very little warning.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.