US in recession: Can the S&P 500 continue rising?
By Tim Worstall
08:33, 1 August 2022
If we were a bear of very little brain we'd be wondering why the S&P500 index (US500) is rising at the same that we're confirmed to be in a recession. We could also make much the same rumination about the FTSE100 (UK100). Stock markets are rising as we gain the confirmation that the economy is heading around the u-bend? Why?
There's a short answer which is that this is how the world works. The longer one is that the world works this way because stock markets are a leading indicator.
Think back to what happened in Feb 2020 as it became clear that the coronavirus was really going to be a significant problem. We wanted to be short the S&P500 minis – say – because the index dropped 30% in a month. This was long before how bad it was going to get became clear – the market fell in advance of the events, it's a leading indicator. That same market then started climbing from that point as the information flowed through that while bad, this wasn't the end of humanity. Again, a leading indicator.
What is your sentiment on SPY?
S&P 500 (US500) stock index price chart
Depends where you start counting: US recession or not?
Just a little aside about politics – there are those who point out that the billionaires made trillions during the pandemic. They always start their counting from the nadir of the index, that 14 to 18 March time period, conveniently leaving out that 30% fall beforehand. But then, you know, politics.
While we're on the subject of politics this is also the response to those claiming that the US can't be in a recession because employment is strong. Yes, but, unemployment is a trailing indicator – it happens well after the recession starts. It costs money to fire and much, much, more to rehire. So employers hoard labour during the first few weeks or months of bad times and only layoff or refuse to hire months into the downturn.
There are many other leading and trailing indicators out there and economists make their bones soothsaying about them.
Say, wholesale stocks – the recession starts when people stop buying, or buy less. But the factory doesn't know that until the wholesaler calls up and shouts not to send any more because the warehouse is full. So, rising inventories are a signal that production will soon decline – a recession. All those economic statistics that are bandied about, they're not so much important in themselves – although the economists of ten think they are – they're just attempts at catching wisps of information about which way things in general are about to go.
For us as traders or investors we need to take another step back and think about why leading indicators are so important to us. This is because stock markets as a whole are forward looking. This is the very same thing as calling them a forward indicator – but why?
FTSE 100 (UK100) stock index price chart
Why are stock markets leading indicators?
The standard answer is that the current value of a share (or any investment for that matter) is the net present value of the future income stream from that share. So, add up all the future money flow, convert that to today's value and that's what the share price should be.
If inflation looks to be going up then that future money is worth less – so, high inflation reduces share prices. Also, the further away the profits are then the less they're worth. So, in inflationary times the people making profits and paying dividends now become worth more than those investing for some glorious future in some years.
But the important implication for us here is that the current share price is based on that future. So, if we change our view of that future then the share price changes. It isn't what the company did last year that changes share prices. It's what we think it will do next year and next decade that does. So, our entire valuation model is based upon the future – stock markets are therefore views into the future, they're leading indicators. When our views of what that future is going to be change then so do the valuations.
Stock markets are already priced for recession
This then explains why stock markets fall before recessions start, or as they do. We may or may not see the whole economy numbers – GDP and so on – but each individual company is going to be feeling the effects of the slowdown that has just started. Simply because that's what a recession is, a slowdown in production by all those different companies.
OK – but this then carries on. The recession has started, shares drop 30%, as they did over coronavirus. Or 25% as the S&P 500 did from the beginning of the year to the recent nadir. The stock market fall has already happened: that is, even as the official economic figures about past performance – those GDP ones – were waiting to be calculated.
Now we're in a situation where the stock market prices already include that we're in, or there's going to be, a recession. So, any new news about what the future will be like still tells us about that future. But from the starting point where we've already adjusted to the fact that there's a current recession.
Which is why stock markets do tend to rise during recessions: because they've already fallen before that.
Now, as a guiding tool this isn't perfect for there have been recessions worse than we thought they would be, even second legs to them. But the current rise in the markets isn't some aberration. It may or may not be safe to be betting on the general direction of the markets right now but it's not obviously unsafe.