Nasdaq, Nikkei, and S&P are Rocked: Is this a Reset or Recession?

Since my first article, the markets have dropped significantly today due to growing fears of US recession. The Japanese stock market had its worst single day trading session since the 1987 crash with the Nikkei dropping 12.4% yesterday. The major US indices are also down dramatically today. While the odds of a recession have increased, the panic selling may be a reset and not the beginning of a bear market.

After the Japanese selloff, I was prepared for the US markets to follow suit. At the opening bell, the S&P 500 was down nearly 4% and the Nasdaq was down over 5%. As the trading day has unfolded, both indices have pared back some of those losses. While the US stock market has fared much better than their Japanese counterpart, the fear of recession still looms.

Unemployment ticked up to 4.3% in July according to the Bureau of Labor Statistics on Friday, stoking fears that the Federal Reserve (Fed) has overtightened and may trigger a recession. There is a general principle that inflation and unemployment have an inverse relationship, also known as the “Philips Curve.” As a quick aside, this relationship does not always hold. Inflation and unemployment can rise together as it did in the 1970s (stagflation). However, the logic of the Philips Curve can still be helpful, particularly in an environment where the Fed is actively tightening the money supply by raising short-term rates through the discount window (the rate at which commercial banks borrow from the Fed). This tactic is meant to lower inflation.

As rates rise — and therefore borrowing costs increase — economic activity usually slows as business and households spend more of their excess income/revenue on servicing their debt. This means less consumer spending and lower production. But the danger of higher for longer rates is that businesses must cut costs, and the easiest way to cut costs is to layoff employees. If people start losing their jobs, this increases the likelihood of foreclosures, auto delinquencies, credit card defaults, and business failures. So, while the Fed has managed to pull inflation down, they now run the risk of raising unemployment which could trigger a recession. Thus, the inverse relationship between inflation and unemployment holds true in this case.

In addition to the poor jobs report, last week, the Fed decided to hold rates steady, further increasing the anxiety among traders. The Fed is notoriously late to the party. They were late in raising rates when inflation started rising, and there is fear that they will be late again and trigger an unnecessary recession.

But before we settle on a dire outlook, this is the first bad jobs report, and the Fed seems poised to lower rates in September which could bode well for investors. Also, unemployment only increased 0.2% from June to July. While this could be the first indicator of recession, this is insufficient data to convince me that we are inevitably on that path in the next 12 months.

Goldman Sachs increased their odds of recession in the next 12 months from 15% to 25%. In other words, they still think there is a 75% chance we won’t see a recession in the next 12 months. In a note on Sunday, Jan Hatzius and other analysts wrote, "While we now think the risks are somewhat higher than the historical unconditional average 12-month probability of about 15%, we continue to see recession risk as limited because the data still look fine overall and we do not see major financial imbalances.” I concur with this outlook.

At this juncture, I think the markets were overdue for a reset. One measure of stock prices —and whether they are expensive or not— is the forward price to earnings ratio (P/E ratio). According to JP Morgan Asset Management, the forward P/E ratio of the S&P 500 index reached an expensive 21x which is well above the average ratio of 16.69x. When markets get overvalued to this degree, traders will look for any reasonable excuse to sell at a premium.

Well, they got a couple reasons to sell with a bad unemployment report and the Fed holding rates higher for longer. As of right now, this an overdue return to fundamental valuations and investors need to be reminded that this usually happens once per year. On average, the market experiences an annual correction (10% decline). According to JP Morgan Asset Management, the S&P 500 experiences average intra-year drops of 14.2% but that the index still produced a positive return 33 out of 44 years. To put this into context, the S&P 500 is currently down 8.49% from its peak as of the August 5 market close. This is a typical intra-year market decline. Investors should also note that the market is still up 9.35% year-to-date.

Many in the financial media are wondering aloud if we are on the verge of another 2008/09 Financial Crisis. Interestingly, I am currently recording an entire Financial Crisis series on my podcast, and I have read several academic books and articles to understand the implicit risks taken by commercial banks and Wall Street. Little about today feels like the excessive risk taking that occurred in the years leading up to the crisis.

Banks were highly levered in the 2000’s and the financial instruments at the forefront of the madness, such as subprime mortgage-backed securities, were built on faulty ratings from the rating agencies and the ridiculous implicit assumption that real estate prices would never decline. We also cannot forget that lending standards, partly driven by the Community Reinvestment Act (CRA) which pressured banks to lend to households with low credit scores and no income verification, were excessively loose and reckless.

To boot, real estate was super-charged by excess Fed policies, terrible malincentives from the affordable house push, such as the CRA, and by the moral hazard created by bank deposit insurance and Wall Street bailouts. The events of the early 2000’s set the stage for a real estate disaster and the widespread failure of America’s largest financial institutions by the end of the decade.

Compare that to today, which is drastically different. Banks have significantly less leverage and much healthier balance sheets. Also, the current rise in real estate prices is driven by a 5 million home shortage compared to an estimated 5 million home glut in the 2000’s. In healthy markets, prices are bid up when there are shortages. That’s Econ 101. However, if prices rise in the face of a massive glut, as it did in the lead up to the Financial Crisis, that is a tell-tale sign of a bubble destined to burst.

Also, most of the nation’s largest banks were, frankly, on the verge of collapse in 2008 and 2009 due to systemic risks. Even though banks such as Silicon Valley Bank (SVB) failed last year, those failures were relatively isolated, and they were moved into receivership by FDIC in an orderly fashion. Even the nature of SVB’s failure was less dramatic. SVB’s balance sheet was full of boring 5 to 10 year treasury bonds, which unfortunately lost significant value when the Fed started raising interest rates (there is an inverse relationship between interest rates and bond valuations). Compare that to most of the nation’s banks holding toxic subprime loans packaged as collateralized debt obligations and then slapped with a AAA rating by rating agencies. When real estate prices finally deflated, the house of cards collapsed. Nothing about today feels like it did in the early days of 2008.

While an economic collapse is unlikely, investors should brace for volatility. The sky-high valuations of the “Magnificent Seven” and AI stocks may continue to cool as enthusiasm wanes. Further declines may be ahead, and the events of the last few days remind me of the 1987 stock market crash, albeit a much smaller one. However, what few forget about the 20% single day crash on Oct 19,1987 (“Black Monday”), is that the S&P 500 ended the year positive — up 5.25% on the year. That kind of reversal could happen in this market. In other words, don’t lose sight of your long-term financial goals.

By: Drew Benson

President and Founder, Benson Wealth Management, LLC

Senior Wealth Advisor, RJFS

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