Are business cycle contractions good or bad for stocks?

According to supply executives, the manufacturing side of the U.S. economy contracted in November for the first time since May 2020. In other words, the U.S. central bank — the Federal Reserve (Fed) — has finally succeeded in cooling down an overheated economy through restrictive financial conditions.

What does that mean for stocks?

Understandably, many investors may be inclined to sell stocks on such bad economic news. However, history suggests that could be a regrettable course of action. Contrary to popular belief, U.S. stocks have generally enjoyed positive returns following the onset of manufacturing recessions.

After dips in industrial activity since 1957 (or when the ISM Manufacturing Index fell below 50), the S&P 500 enjoyed double-digit returns three and 12 months onward. Moreover, the success rate or probability of generating a positive return increased the longer investors held on to their stocks (Figure 1).

How’s that possible?

As I wrote in a recent blog, the delayed relationship between stocks and gross domestic product (GDP) argues that a market rally in the present could be followed by an economic recovery about half a year in the future.

While more economic and earnings challenges may lie ahead of us, in my view, investors shouldn’t let that distract them. Rather, enlightened investors should prepare for a market recovery first and an economic recovery second.

Are we drawing the right conclusions?

As a paranoid analyst, I question my assumptions. That healthy process can help sharpen the tools in any investor’s kit. For example, are we looking at the right mix of indicators and are we interpreting them correctly?

True, my technical checklist of market bottom indicators worked well in real-time back in early 2020, and it did a decent job of gauging the duration and magnitude of stock-market drawdowns this year.

While we’ve made a lot of progress, perhaps I was wrong to assume peak fear would manifest in the Chicago Board Options Exchange (CBOE) Volatility Index (VIX) and the Bloomberg U.S. Corporate High Yield average option-adjusted spread, which have remained reasonably well-behaved.

When the Fed tightens financial conditions, things start to break. Indeed, the latest cryptocurrency debacle may well have been the ultimate credit event I was expecting in the current market cycle. That’s important because the cryptocurrency exchanges probably aren’t captured in the high-yield bond indices. Said differently, relatively narrow corporate bond spreads above their Treasury counterparts may be a testament to the fundamental strength of some of those below-investment grade businesses.

Is investor risk aversion good or bad for stocks?

Fortunately, there’s a way to remove some of the human element from the investment decision-making process and to avoid cherry-picking the indicators. Specifically, I introduced a level of statistical significance to my eight tactical indicators by combining and expressing them in common units of standard deviations away from their mean or average.

Few of my readers likely know that sigma is the 18th letter of the Greek alphabet, myself included before I searched it on the internet. However, variability’s a concept we all understand and experience in our lives on a daily basis. Stock market investors have certainly been on a roller coaster ride in 2022!

In fact, investor risk aversion experienced a two-and-a-half sigma or statistically significant event in late September, driven mostly by a low percentage of New York Stock Exchange (NYSE) stocks above their 200-day moving averages, an inverted American Association of Individual Investors (AAII) Sentiment Survey Bull-Bear Spread, and a high CBOE Equity Put/Call (P/C) Ratio (Figure 2).

From a contrarian perspective, peak fear — which has usually coincided with major troughs in U.S. stocks — at that time explains the setup for the 8.1% return we saw in October, which was the 11^th best month for the S&P 500 Index we’ve seen in 35 years!¹

Admittedly, investor risk aversion in 2022 hasn’t been as high as it was back in the Great Shutdown of early 2020 or the Great Recession of 2007-2009, which were massive market dislocations and more than four-sigma events.

Nonetheless, proverbial blood in the streets and significant damage in stocks get me excited as a contrarian. We’re in this together, and after double-digit drawdowns, I think most investors would welcome the transition from contraction to recovery.