Introduction
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The Federal Reserve lowered the federal funds rate by 50 bps yesterday in response to coronavirus risks. These risks have real impacts on lives, supply chains, productivity, etc., plus they have psychological impacts on buyer behaviors. Will the rate cuts save the economy? Probably not. Financial liquidity was already very easy, so will these rate cuts help? Not much. Will it cause businesses which are already reeling from low to negative 2019 earnings growth and may be highly levered, lever up more to grow? Not if they are suffering severe supply chain disruptions and lost sales from lower customer demand. Will it cause consumers to spend more on discretionary out to eat meals, vacations, and at brick and mortar retail stores? Not if they are scared to go out. Thus, the odds have risen that a slowing consumer economy, on top of an already weak manufacturing economy, moves the US to a recession.
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Financial markets corrected over 11% through yesterday, but the last seven recessions led to triple these losses and credit spreads are still moderate. Monday, markets were up almost 5% in anticipation of this Fed move and were down 2.5% yesterday after the rate cut. If a recession ensues, the market is likely poised for further disappointment.
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Why Did Markets Sell Off?
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Expectations started high as implied by equity, bond, and options markets valuations. The S&P 500 P/E ratio was at a high – the CAPE was the highest versus long-term bonds since the start of the data series (1872) (figure 1)! Credit spreads were moderate to low, except for energy bonds (figure 2). The VIX was very low (figures 3-4). While internals suggest some nervousness – cyclicals were lagging defensive sectors and the 10-year bond yield was declining – the overall market was rallying in anticipation of rebounding earnings and the ISM PMI (figures 5-6).
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Coronavirus could be the catalyst to push the economy into a recession. Business was weak last year, but the consumer was good before this hit to its psyche.
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The ISM manufacturing PMI was hovering just below 50 late last year and recently moved up to barely above the 50 threshold, with above 50 implying expansion. 2019 earnings growth was abysmal, with S&P 500 earnings up just 1% and mid- and small-cap stocks down 8%. While sales were up, margins declined due to rising wages and other costs, including supply chain disruptions from the trade war. 2020 EPS was expected to be up nearly 10% a few months ago (8% now), but now all bets are off.
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The consumer has been the bright spot. Consumer confidence is high, housing has been picking up (rates have declined), the financial obligation ratio is down (this may be because rates are down and people are fully employed) (figure 7), and the savings rate is high.
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However, business spending may be delayed. Cap ex follows earnings (figure 8) which will be curtailed due to reduced consumer demand, lost productivity, and further supply chain disruptions.
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The severe slowdown in China will lower demand for energy and commodities. China was 32% of world energy consumption growth from 2016-18 (source: Enerdata). Inventory will rise as China’s GDP growth drops to zero and if the US keeps pumping. On the other hand, OPEC may respond with supply cuts and at least one investor believes coronavirus could boost oil demand if people drive their cars instead of flying and taking public transportation. Nevertheless, S&P 500 energy stocks are down 25% and WTI is off 23% this year, and materials stocks are down over 11%. These sectors make up 6% of the S&P 500.
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In addition, industrials benefit from energy/materials capital spending, which will likely be curtailed. Industrial stocks are another 9% of the S&P 500, so in total 15% will surely take a nose-dive just from a slowing Chinese economy.
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Technology has been the darling of the market (figure 9). As I write this, the S&P 500 has risen 15% the last two years, but information technology is up 38%. Tech may be hit hard since it has more international sales exposure (56% including 13% to China compared to 38% for the S&P 500 including 6% to China) than other sectors and because of its large Chinese supply chain. The top five companies by market cap, all tech-like companies – Apple, Microsoft, Alphabet, Amazon, and Facebook – made up 18% of the total market cap in January, the highest percent concentration of the top five stocks in history, according to Morgan Stanley. Much risk is concentrated in a few stocks, and already two of them – Apple and Microsoft – announced profit warnings over the last week. Further, Google canceled its I/O developer event – its biggest event – this year.
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Tech is 24% of the S&P 500, so tech combined with energy, materials, and industrials gets us to 39% of the market.
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As noted, consumers have been a bright spot. However, perhaps not anymore if they are scared to go out. Personal consumption expenditures make up 68% of GDP; while a good deal of this is for necessities (food, beverages and related retail are 4.6% and health care is 14.1% of the S&P 500), non-essentials could be hit hard. Say goodbye to leisure (restaurants, hotels, and travel are 1.7% of the S&P 500) and brick and mortar retail (3.5%), and hello to online sales (3.6%) (Amazon may get a boost if people do not cut back on overall spending levels too much). Corporations are cutting back on travel to protect employees and governments may ban travel (airlines are 0.3%). Lower commerce will negatively impact air freight/logistics (0.3%) and road and rail (1.0%). More insurance claims will not help health care insurance providers. REITs (3.2%) could get a boost from lower rates, but their tenants’ businesses could suffer and impact lease renewal rates.
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Does Market, Country, Business, and Consumer Reactions Make Sense?
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Yes!
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Real GDP growth is simply work growth plus productivity growth (real GDP growth = (1 + work growth) * (1 + productivity growth) -1). From 1999-2018, work growth contributed slightly more than half of real GDP growth, with the rest generated from productivity (figures 10-11).
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The coronavirus could be terrible in terms of lives lost around the world. One life lost is a travesty, and we could be talking about millions. If the population drops, this has a direct hit on GDP. The CDC reports (February 23) that there were 78,811 coronavirus cases in the world, and 2,462 people passed on; this is a 3.1% fatality rate. However, the mortality rate appears to grow with one’s age, with 80+ year-olds experiencing 14.8% loss of life versus 0.2% for 20-29-year-olds. Generally, the older one is the less productive he or she is (assuming the person is retired) and older people may also spend less (other than on health care) than those earlier in their lives who are buying homes, starting families, etc. Thus, this age bias to the fatality rate will limit the virus’s impact on growth versus a scenario where the mortality rate was higher for the young. However, a 1 in 500 fatality rate will still scare the young. The CDC reports that the flu causes 0.13% loss of life for those who get it, whereas coronavirus could be 20X worse assuming a 2%+ fatality rate. That figure may scare most.
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Productivity will slow. Supply chain issues, quarantines, staying home from work, working remotely, and simply worrying about others while on the job will all reduce productivity.
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In my opinion, coronavirus cannot be contained. What makes containment perhaps futile is that people who have it may walk around without symptoms and spread it to others. I heard a doctor say it can survive on a surface for a couple days, which means you can catch coronavirus, say from a Starbucks counter, for a couple days after someone coughs on it, you touch it, and bring your hand to your face (eyes, mouth, etc.). Wash your hands often! The normal flu can also survive for 48 hours on some surfaces.
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Maybe containment is possible if everyone in the world just stays home for a month without any contacts (quarantines last two weeks). In addition, you must be in a room where air ventilation does not move from room to room (I hear that cruise ships are not ideal). Also, you cannot have anyone – who could have the virus – deliver your food, so we all must become gardeners (in our rooms). My guess is that coronavirus may spread quicker in US since we are more mobile and may not be able to quarantine citizens like China has done.
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No!
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The scare may be at least in part an over-reaction.
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While a 2% fatality rate seems like a very big deal, it could be overstated. South Korea’s loss rate is only 0.7%, but perhaps this is because the virus is still new to that country. Many people with coronavirus may not be tested (I heard that South Korea is doing a lot of testing), so the denominator in the fatality rate could be much too low.
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Let’s assume 2% loss of life in China and that number of cases rises by 5X to 350,000. 2% of 350,000 is 7,000 people. Given its 1.4 billion population, 1 in about 200,000 people will lose their lives to this virus in China (if only 350,000 contract it).
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The normal flu causes way more loss of life in US – CDC estimates there were 18,000-46,000 deaths (32-45 million cases) from the flu this season through February 22. This does not stop commerce, and loss of life from the normal flu, like coronavirus, is more concentrated in the older population.
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A couple weeks ago, as we were discussing behavioral finance, I asked my students to tell me how many people lost their lives to homicide in Milwaukee in 2019. The number is 98. Milwaukee has a population of 592,025, so the fatality rate is 1 in 6,000. Thus, losing a life in Milwaukee to homicide is perhaps more than 25 times as likely as losing a life to coronavirus in China, but this does not stop commerce in Milwaukee even though it does in China. How much sense does that make? Of course, perhaps my estimates for China are 1,000 times too low (only a small part of the population has tested positive so far and the virus has yet to run its course).
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It Does Not Matter If Math Above Makes Sense Because if Consumers and Business Still Retrench, Markets Should Sell Off as Profits Fall
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News impacts behaviors. People internalize what they hear, and right now coronavirus dominates the media. People also herd, so they do what their neighbors do. 40-70% could be infected in a year, according to Marc Lipsitch, an epidemiologist and head of the Harvard T. H. Chan School of Public Health’s Center for Communicable Disease Dynamics. Vaccines will not come soon enough. People are lining up for supplies, etc. on West Coast and in Hawaii. Will this panic spread?
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The US economy is primarily consumer based, which runs at a pretty steady growth rate over most periods. Figure 12 shows that even during recessions, the median growth rate of personal consumption expenditures remains positive. During expansions, consumption and nominal GDP growth are about the same.
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Housing and business investment, on the other hand, are extremely volatile. While these make up a much smaller part of GDP (current residential investment is 3.8% and fixed investment is 16.9% of GDP), they are much more volatile, so they impact changes in growth. Both rise much more than nominal GDP during expansions, and both decline during contractions.
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As noted above, business investment has been weak. Fixed investment is up just 0.3% over the last 12 months. However, this was offset by a housing market that is strong (residential investment is up 3.8% over the last year). Plus, personal consumption expenditures were up 4.6% over the last year, ahead of nominal GDP growth (up 3.0%). If consumer spending deteriorates, we will have troubles.
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China Example
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China has ability to quarantine people and entire cities, but we may not have that option in the US, so US coronavirus cases may not peak early like what appears to be happening in China (newly reported cases peaked on February 12). As I write this on March 4th, the Chinese stock market outperformed (-0.7% for SPDR S&P China ETF) the US (-4.2% for S&P 500), European (-7.5% for iShares Europe ETF), and emerging markets (-6.7% for iShares MSCI Emerging Markets ETF) this year. Although, China may not be able to hold back a rise in cases indefinitely as city barricades are opening and eventually foreigners could bring the virus back to China.
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However, quarantine severely impacted the Chinese economy.
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Perhaps 30% migrate for the Chinese Lunar New Year holiday (I’ve seen as high as 40% and as low as 20%), but on February 28 only 40% were back to work compared to 100% last year. 60% of 30% migrators not working is 18% of the economy. All migrators may not work, so let’s assume 15% of Chinese workers are out of work for a month (a higher percent were not back to work earlier, and some of these workers will remain idle for a longer time), which is 1/3 of a quarter. 15% * 1/3 is a 5% loss to annual GDP. Of course, this does not count productivity loss for those who are working. It is easy to paint a picture where China’s 1Q real GDP growth is zero or less (it was running 6% before coronavirus, assuming we trust the numbers). China’s most recent PMI reading plunged to 35.7.
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If we assume (perhaps aggressively) a 2/3rd less severe impact on the US economy because we do not quarantine cities, then US GDP may slow by only 2%. Real GDP growth has been running about 2.0%, so this means US real GDP growth may drop to zero in 2Q. This should negatively impact business growth spending which is already weak. It may also negatively impact hiring and wage growth.
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Anything to the Rescue?
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Monetary Policy Easing Will Not Help Much
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Policy was already very easy around world before coronavirus as central banks worked to boost world economies, so how much easier can policy get? The US economy was in a nose-dive. Figure 13 shows my economic model, which I introduced in January 2018 in Positioning the Cycle. At that time, conditions were hot and I warned caution. The model includes credit, monetary policy, consumer, and business variables. The current reading is cold, and we’ve never recovered from current levels without a recession first; however, we also normally have not had such an accommodative Fed.
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Figure 14 shows that money supply is growing much quicker than GDP, and it leads the ISM PMI. In Don’t Fight the Fed? which I wrote in September, I noted how the Fed has always saved the day (see dips in 1987, 1996, and 2016) if it accelerated money supply (relative to GDP) during weak periods. Thus, the monetary growth acceleration (versus GDP growth) last fall looked like it was set to jump start the weak economy (note the hook up in the ISM Manufacturing PMI in figures 5 and 14).
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Certainty whether easy monetary policy would work this time was clouded by the fact that corporations are already levered up. Plus, their profits were declining, on average, in 2019 so levering up more may not be in their plans. Now, we have to ask whether they will borrow to invest and grow if their customers retrench and they cannot make products because of supply chain disruptions.
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Will consumers spend if they fear for their lives by going out? Firms and countries are already banning travel. Will they change these policies if rates go down? Not if they want to save face with their constituents.
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The one bright spot could be housing, which tends to be negatively correlated with interest rates (figure 15). Plus, mortgage refinancing is surging, which gives consumers more spending power. In Cracks in the Foundation of Housing?, I note how a high proportion (42%) of median net worth is tied to housing and net worth impacts spending. Housing also could make up a very significant part of GDP (much more than residential construction’s direct impact on GDP). If housing stays strong – people continue to shop for houses (they are not scared to go out) and workers show up to build the homes – this could be a big positive.
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To keep credit open, the Fed could also provide direct lending to weak businesses that are shut out by banks and financial markets. Lower rates plus perhaps more bad loans are not good for banks (as I write this, S&P 500 financial stocks are down over 11% this year).
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Could the US Enact Fiscal Stimulus?
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Yes, we did this before. The Trouble Asset Relief Program was signed into law in October 2008 as the financial crisis took hold. At $700 billion, it was nearly 5% of GDP. It is rumored that South Korea will have a stimulus package worth as much as 2% of GDP. However, Italy’s $4 billion stimulus is only 0.2% of its GDP.
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However, the US already had a big tax stimulus and Federal debt and the deficit is already elevated (figure 16), so how will market respond to more borrowing? Even if it responds negatively, the Fed could just buy up any new debt and save the day (again).
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If we drop money into consumers’ pockets, it is still unclear whether they will spend if they are scared to go out to the store. Will businesses spend on growth and hire if they are worried about profits?
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Concerned Doctors and Markets
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(1) Coordination of the coronavirus response is being handled through the administration and (2) doctors are being hushed on communications unless the administration approves.
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Administration in charge –
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I’d be more comfortable having a health care expert, who can best understand health care data and procedures, than Vice President Pence in charge of this potential health care crisis. Still, it is nice to have Pence involved so any actions are done with ample authority. Although, it is a little concerning that he once said smoking “doesn’t kill” and he has faced other criticism for health-related issues. Yet, politicians may face some criticism no matter what they do.
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Related concerns:
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- The CDC botched test kits, which is somewhat alarming given that it had a month warning from the crisis in China to get ready.
- Not calling this a pandemic, which means it cannot be contained, suggests that certain mobilizations may not be taking place.
- Acting secretary of Homeland Security did not know that coronavirus has perhaps a 20X higher mortality rate than the flu. I would not expect the general public to know this, but it was one of the first things I looked up and I expect a government official who is giving testimony to Congress should be well-aware of this statistic.
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Limiting communications –
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Why do health care statements have to be vetted by and coordinated through the Office of the Vice President? I suspect it is to control news to limit the availability of and type of information distributed to the public. This keeps nervousness that impacts spending at bay, especially if half-truths and only select information is distributed. I watched President Trump’s press conference last Wednesday evening. He seemed more positive than the health officials who spoke first.
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(Courtesy of Brent Donnelly of HSBC as provided by Dennis DeBusschere of Evercore ISI) More news on coronavirus would lower travel, consumption, and markets, which lowers the odds of President Trump being re-elected and raises the chance for Sanders, which then lowers markets because of possible higher taxes and less friendly market policies, which then lowers the chance of Trump being re-elected and raises Sanders’, and so on. Fear of getting sick for those with poor quality health plans leads more people to approve of Sanders’ health plan which raises the odds of him being elected and thereby lowers markets, which again lowers the odds of Trump being re-elected and raises the chance for Sanders, and so on. Of course, to make this more confusing, markets are up today credited to candidate Biden having a good showing in yesterday’s primaries.
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Positively –
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Positively, various firms are working hard to produce a vaccine, but it will likely come too late for the first 40%+ who contract the virus. This assumes it is not available until next winter and the virus impacts 40% of the world in a year.
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Can We Handle Pending Influx to the Health System?
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Hospitals will be overwhelmed. In 2017, 7.0% of the population had one or more hospital stays (who did not pass away), and the average length of the stay is 4.5 days in 2012. If we assume 40% contract the virus and 2% don’t live through it (2% of 40% is 0.8%), we assume twice this amount are hospitalized (now we are up to 1.6%), and we assume the length of stay is nine days or double the normal stay (so 1.6% rises to 3.2%), then quickly we can estimate that the hospital system will have 50% more (3.2% more on 7.0% level) than the typical volume over the next year. However, it is worse than this. People with the virus who end up at the hospital may be very sick and they must be quarantined so they do not infect others who are ill. Where will hospitals put all these people?
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The number of current cases in US is probably understated as we are not testing enough.
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The vaccine will not be available in mass for about a year. Hopefully we will we have enough vaccine for everyone. A 2006 CBO report on influenza pandemics suggested that we would not have back then, but the goal was to make sure there was enough vaccine for an outbreak within six months by year 2011 (page 2). Vaccine production capability at the time would have only covered 3% of the population (page 6). Hopefully, the US hit the CBO’s goal by 2011.
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There is some evidence that this coronavirus has a low mutation rate. This is good news. Once everyone has it then we are in the clear for the future, right? Maybe! However, this also means that creating a vaccine will not be as profitable for health care firms, especially if it arrives after half of the population has had it. If saving lives is not an incentive enough for health care vaccine providers (I expect and hope it is), perhaps government should force them to produce it and share their knowledge with other vaccine manufacturers to get it out as quickly as possible to the population.
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We can also hope that coronavirus dies down in the summer. There are many possible reasons why the incidence of the flu drops in the summer – more light means more vitamin D and a better immune system, more humidity causes the flu virus to drop more quickly to the ground, school is out so transmission rates decrease, and people are outside more often. However, dying down does not mean it is gone, and it could be back during the colder months. Plus, MERS, a coronavirus, cases continued when temperatures were at 110 degrees in the Arabian Peninsula.
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Are Financial Markets Down Enough?
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Stocks were off 12% from the S&P 500’s peak this year by end of Friday. They rallied nearly 5% on Monday in anticipation of the Federal Reserve lowering rates. Then, on Tuesday, the Fed lowered rates 50 bps and the market fell almost 3%. At the end of Tuesday (yesterday), they settled off 11.5% from the all-time high. As I write this, they are down just 8.5% from the high.
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This is quite a correction in a short time. However, the market is still not fully pricing in a recession. Valuations began high. The median drop for the last seven recessions for the S&P 500 (price return) was 32.9% (figure 17). The minimum was 11.3%, but we had two recessions over a short period of time in early 80s so perhaps these should be combined and then the minimum drop is much higher. All declines started before the official recession began (average of 7.1 months before), with the earliest 14 months before in November 1968. All but one bear market ended before the recession was over (the exception was 2001 which lagged 10 months after the Internet Bubble and then 911), with an average lead of 2.1 months and the longest lead was 5 months. The last two recessions had very large drawdowns, and both were associated with bubbles.
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Credit spreads are still moderate (except for energy), equity markets still have above-average P/Es, the VIX is up a ton and high but could go higher in recession, etc. On the other hand, the yield curve is inverted which it does before recessions.
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To end on a positive note, some may claim a recession could be mild and have a V-shaped recovery. Plus, as I have noted in at least one prior article and/or presentation, a recession could be healthy as it rids the economy of excesses that have been building for some time (corporate debt, private equity/venture capital, momentum in high-flying stocks, etc.). The longer the economy endures without a recession, the more people forget about risks and make unwise decisions which compound the crisis during the eventual day of reckoning.