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Jon Wolfenbarger thinks the soft-landing narrative among economists and investors right now is nonsense.
With inflation well off its peak and the unemployment rate still at a historically low 3.5%, markets have become more optimistic that the US economy will avoid a recession. But for Wolfenbarger, a former JPMorgan and Merrill Lynch banker and the founder of Bull And Bear Profits, the signs are clear that a recession is on the way.
In a recent note, Wolfenbarger shared two pieces of evidence that a downturn is likely imminent. One is that the Institute for Supply Management’s Purchasing Managers’ Index continues to show signs of slowing economic growth. When the index registers a reading below 50, manufacturing activity is considered to be contracting. Although the services sector contributes more to the US economy, the manufacturing index has been below 48 for eight months now, a duration that’s starting to approach those seen in other recessionary periods.
Crescat Capital/Tavi Costa
The second is that real gross domestic income, another measure of economic growth like GDP, is now negative year-over-year for the third-straight quarter. GDI is the total of things like wages and corporate profits and tax revenue.
“Real GDI has never fallen three quarters in a row without the economy being in a recession,” Wolfenbarger said. This can happen even if GDP growth is positive over the same time, he added, and GDP can turn negative later than GDI. US GDP has been positive for three consecutive quarters.
Federal Reserve Bank of St. Louis
Here are just corporate profits, which are seeing negative growth, an occurrence which tends to signal recessionary periods.
Federal Reserve Bank of St. Louis/BullAndBearProfits
Of course, that’s bad news for stocks, which are moved by earnings performance. But Wolfenbarger cites a larger reason stocks are in trouble: high valuations.
Looking at measures like the Shiller cyclically adjusted price-to-earnings ratio and market cap-to-GDP (also known as the Warren Buffett indicator), valuations stand at historic highs. While both measures are off all-time highs, they’re near levels seen during the 1929, 2000, and 2008 bubbles, and are above long-term averages.
Here’s the Shiller CAPE:
GuruFocus
And market cap to GDP:
GuruFocus
During bear markets where recessions occur and valuations are above historical norms to start, stocks have fallen by a median of 51%, Wolfenbarger said.
This partially informs his call for the S&P 500 to fall to around 2,250, which would represent 48% downside from current levels. Another reason for his dire outlook is that stocks would have to fall that much to return to levels where investors could expect about 5% annual returns based on historic valuation norms.
Wolfenbarger’s views in context
In addition to the two signals Wolfenbarger highlighted, there are plenty of other economic gauges that show a downturn is coming.
One of the most widely followed is the Treasury yield curve. Shorter duration yields like the 3-month are currently higher than longer-duration yields like the 10-year. Inversions like this have a perfect track record of preceding recessions over the last several decades, and they happen in large part due to more severe Fed tightening cycles, which often end in downturns.
Federal Reserve Bank of St. Louis
Another indicator is The Conference Board’s Leading Economic Index, a composite measure of things like manufacturing activity, housing-market activity, stock performance, and consumer expectations. It also has a perfect hit rate in signaling a recession is coming, and is currently in downturn territory.
The Conference Board
A third is tightening lending standards. When banks are worried about the ability of consumers and businesses to pay back loans, they tighten standards for lending out money. This, in turn, slows down spending and business expansion, hurting economic growth.
Federal Reserve Bank of St. Louis
For now, however, the economy is holding up. But the longer the Fed keeps rates high, the more pressure on the economy builds.
As for valuations, some measures paint a milder picture than the ones highlighted by Wolfenbarger. But even those are sitting above long-term averages. For example, the S&P 500’s trailing 12-month price-to-earnings ratio is at 25, above the long-term average of 19, but below dot-com bubble levels of 45.
When it comes to Wolfenbarger’s 48% sell-off call, it’s well outside the mainstream of where strategists see stocks going. Even the most bearish strategists among those at major Wall Street banks only see the S&P 500 falling to the mid-to-low 3,000s.
But declines of 40% or more have happened twice since the turn of the century. With valuations high, a meaningful recession could make that three times, as Wolfenbarger is warning.
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