Do equity indices bottom before recessions?

An interesting debate taking place right now (November 2022) relates to whether the equities market has already priced in a recession, and is now moving up into what could be a new bull market. This could mean that the forward-looking equities market, represented by equity indices (e.g., Wilshire 5000, S&P 500), has bottomed before a recession.

I have conducted a rather extensive review of various equity indices to see if there is a historical precedent, prior to November 2022, for an index that has bottomed before a recession. I could not find any. The figure below (source: Federal Reserve Bank of St. Louis) shows the Wilshire 5000, which covers all American stocks.

The figure shows two areas where the index bottomed after a recession and during a recession. These are only illustrations of a broader pattern - I could find no instance in which a bottom occurred before a recession, in any index (including the S&P 500). So, do equity indices bottom before recessions? Apparently not. The video linked below discusses this and other cases in more detail.

A simulation-based valuation of the S&P 500: October 2022

The figure below shows two simulation-based valuations of the S&P 500. They assume a fair price-to-earnings (PE) ratio for the S&P 500 that is the inverse of half of the 10-year U.S. Treasury yield. The price (at the top) is the most recent top value of the S&P 500.

The numbers on the left consider a rather benign scenario: S&P 500 earnings in 2022 are up by 10% from the previous year, and the 10-year U.S. Treasury yield is at 3.00%. The numbers on the right refer to a more likely scenario: S&P 500 earnings are up by 5%, and the 10-year U.S. Treasury yield is at 4.00%.

The second scenario takes us to a fair price for the S&P 500 of 2,693.12, which is 44.11% down from the most recent high. The video linked below discusses these simulations, some of the most recent values for the simulation inputs, and a few other options.

A simulation-based valuation of the S&P 500: August 2022

A simulation-based valuation of the S&P 500: July 2022

The figure below shows two simulation-based valuations of the S&P 500. They assume a fair price-to-earnings (PE) ratio for the S&P 500 that is the inverse of half of the 10-year U.S. Treasury yield. The price (at the top) is the most recent top value of the S&P 500.

The numbers on the left consider a rather benign scenario: S&P 500 earnings in 2022 are up by 10% from the previous year, and the 10-year U.S. Treasury yield is at 2.50%. The numbers on the right refer to a more likely scenario: S&P 500 earnings are down by 10%, and the 10-year U.S. Treasury yield is at 3.50%.

The second scenario takes us to a fair price for the S&P 500 of 2,638.16, which is 45.25% down from the most recent high. A sobering thought, given the rally that we are in right now, which many believe to be nothing more than another bear market rally.

The recent negative GDP growth figure was revised down to -1.6%

As it turned out, the negative GDP growth figure mentioned in our last post was revised down to -1.6%, from -1.5%. This is related to our recent post on the Atlanta Fed. From Tradingeconomics.com:

  

"The American economy contracted an annualized 1.6% on quarter in Q1 2022, slightly worse than a 1.5% drop in the second estimate. It is the first contraction since the pandemic-induced recession in 2020 as record trade deficits, supply constraints, worker shortages and high inflation weigh. Imports surged more than anticipated (18.9% vs 18.3% in the second estimate), led by nonfood and nonautomotive consumer goods and exports dropped less (-4.8% vs -5.4%). Also, consumer spending growth was revised lower (1.8% vs 3.1%), as an increase in spending on services, led by housing and utilities was partly offset by a decrease in spending on goods, namely groceries and gasoline. Meanwhile, private inventories subtracted 0.35 percentage points from growth, much less than a 1.09 percentage points drag in the second estimate. Fixed investment growth remained robust (7.4%) but housing investment was subdued (0.4%, the same as in the second estimate)."

Is the Atlanta Fed predicting an imminent recession?

Fed funds rates, 10-year Treasury rates, and recessions