Discounting a Recession

It seems clear that the financial markets have moved past any rational response to a credit downgrade by Standard and Poor’s of U.S. debt from AAA to AA+, and moved on to worrying about recession. Bond investors clearly shrugged off any concerns yesterday as Treasury yields actually fell and bond prices rose on the day. Municipal bonds had a miserable day, perhaps reflecting investor concerns that a downgrade of the sovereign country could lead to downgrades in specific counties that currently have a AAA rating. Pinnacle clients in Howard County and Montgomery County as well as AAA rated counties in Northern Virginia should take note. While bond investors appear relatively sanguine about the downgrade, at least for the moment, clearly stock investors are not. Yesterday’s market riot continues a vicious sell-off that began last week that has now taken the S&P 500 Index down 17% from the highs of early July. While this decline still technically falls into the camp of a market correction, and is the same magnitude in terms of a peak to trough as last summer’s decline, as pointed out in last Friday’s Special Report, the selling over the past several days has been relentless. The question is whether or not it is warranted in terms of the actual conditions we see in the real economy.

For us, the answer is “maybe.” There is ample evidence that the economy is slowing. Last week’s release of second quarter GDP, the ISM Report, and consumer income and spending data all show the economy is potentially reaching “stall speed.” Last Friday’s payroll number was better than expected, but still not good enough for anyone to feel encouraged that employment is improving. In fact, the second quarter GDP growth estimate of +1.3% missed the expected number of +1.8%, and many pundits have pointed out the high likelihood that such a low number will ultimately be revised to a negative print. Coming on top of the first quarter revision to GDP growth that reduced growth to only 0.4%, the stock market seems to be suggesting that the economy may already be in recession. Yesterday morning, during a long discussion about portfolio policy and market conditions, the consensus of Pinnacle analysts seemed to put the odds of recession somewhere around 50 – 50, with the most bearish assessment being a 75% chance of recession. It looks to me like the stock market has put the odds of a recession somewhere between 80% and 100%.

The next question is how to adjust our portfolio construction to reflect the new economic reality. Our strategy is to reduce risk assets in the portfolio by 5% to 10%, depending on the portfolio policy. Last Friday we sold our first 2% and in the coming days we will try to sell an additional 2% - 3% of stocks, if the market will let us. And therein lies the problem. When the market goes into free-fall, as it has the past few days, it quickly becomes so oversold in the short-term that the high probability is that prices will actually bounce, rather than keep falling. History and experience tells us that it is best to wait for the bounce before wading into a market so full of sellers. So our thinking is to see if we can get a near-term bounce to finish our first 5% of selling, and then see if we can sell the remaining 5% of stocks at higher prices. Note that this strategy is far from going 100% to cash, or as we say on the investment team, “closing the blast doors.” We are simply continuing a pattern of risk reducing transactions that we have been executing for the past few months. We think the current trades will properly discount the odds of a recession. If the economy continues to slow, we should see U.S. corporate earnings estimates begin to fall sharply soon. We will see.