After briefly hitting correction territory in the previous week, which is defined as a 10% decline from an earlier high, stocks had a modest rebound last week. The S&P 500 sits 7.6% below its mid-February high. The Magnificent 7, consisting of Microsoft (MSFT), Meta Platforms (META), Amazon.com (AMZN), Apple (AAPL), NVIDIA (NVDA), Alphabet (GOOGL), and Tesla (TSLA), has faired worse with a drubbing of 18.5% since mid-December. The pressure on stocks stems from an economic growth scare and policy uncertainty surrounding tariffs.
Stock Correction: Implications Of A 10% Decline In Stock Prices
With the S&P 500 closing over 10% below its February 19 high on Thursday, March 13, stocks officially entered a correction. In the twenty-one U.S. stock market corrections since 1980, the average return in the 12 months following was 13.4%, which on the surface would lead to significant optimism regarding future returns. If the data is sorted between periods when the U.S. economy entered recession within those 12 months after the correction, the results are less compelling at a 1.9% average gain. Of course, if an economic downturn is avoided, the results have been spectacular on average at 19.1%.
Weakening Economic Forecasts
The strong bond between avoiding recession and better returns following a stock correction makes monitoring the economy’s health even more critical. Economists’ consensus estimate of 2025 economic growth has dipped slightly to 2.2%, nowhere near recessionary levels. Unfortunately, economists have a poor track record of accurately predicting economic growth with enough lead time, and consensus estimates tend to lag behind real-time data.
Economic models attempting to forecast the current quarter of GDP growth were developed to address the challenges associated with consensus estimates. These estimates adapt to the most recent economic releases to predict growth. This methodology has its challenges but adds additional color to the economic backdrop. The Atlanta Fed model points to a contraction in economic activity in the first quarter, which is probably overstated because much of that downward estimate comes from a marked increase in imports to avoid future tariffs. The St. Louis Fed’s model remains in positive territory. The forecast difference between the two is vast for their first-quarter GDP estimate. After last week’s Federal Reserve meeting, the committee noted that “uncertainty around the economy outlook has increased.”
High-Frequency Recession Indicators
While accurately forecasting an economic downturn in advance with any accuracy is exceptionally challenging, monitoring some high-frequency data can help get an early warning about increased recession risks. These indicators were chosen because they are updated weekly or daily and have shown a strong correlation with economic activity. Indeed, other indicators are crucial, but they are typically only available monthly, sometimes with a significant time lag.
Jobs
The labor market is probably the most crucial part of the economy since consumer spending eventually wanes without wages to fund the purchases. Initial claims for unemployment benefits are reported weekly, but the four-week moving average of claims is used here to reduce volatility. While initial claims are above the lows, the level is not exhibiting a strong uptrend or at a level consistent with economic woes.
The other weekly job data is ongoing claims for unemployment benefits, which are also off its lows and show a slow uptrend. This indicates that it is taking longer for those losing their jobs to find a new one. Remember that the number of employees in the U.S. has more than doubled since 1970, so even though the current roster of those receiving unemployment benefits is as high as it was during the 1969-1970 recession, the numbers aren’t comparable. The bottom line is that the labor market is softening but has not yet reached recessionary levels.
Credit Spreads
The corporate bond market should undoubtedly be part of the mosaic to monitor the economy’s health. Baa corporate bond data has a long history and arguably provides a look at the “typical” credit quality of companies, as Baa credit rating is the lowest level of investment-grade bonds. The spread is the yield investors demand beyond U.S. Treasury bond rates to compensate for the default risk from buying corporate bonds. These spreads expand when investors worry that more bond defaults could be on the horizon, typically driven by deteriorating economic conditions. While the spreads on Baa corporate debt are above recent lows, the increase seems insufficient to trigger substantial fear of any impending economic downturn.
Financial Conditions
The Chicago Fed produces the National Financial Conditions Index (NFCI) weekly. It looks at 105 measures across three categories, risk, credit, and leverage, to create a measure of financial conditions. According to the Chicago Fed, “Positive values of the NFCI have been historically associated with tighter-than-average financial conditions, while negative values have been historically associated with looser-than-average financial conditions.” The chart shows that these periods of tighter-than-normal financial conditions have often been associated with recession. Like the previous measures, financial conditions have worsened but remain below warning levels.
Cyclical Stock Performance
The more economically sensitive cyclical stocks have recently been underperforming the less economically sensitive defensive stocks. This suggests that an economic growth scare is one cause of the recent stock weakness. While it should continue to be monitored, the relative weakness of cyclical stocks has improved off its most recent lows and isn’t at the level seen before past recessions.
Yield Curve
The 10-year Treasury minus 2-year yield is probably the most well-known predictor of recession. Historically, when the yield on the U.S. 10-year Treasury falls below the 2-year yield, also called yield curve inverting, a recession is coming. Since the 1970s, a yield curve inversion has occurred before every recession. The only blemishes on its record are the 1998 and mid-2022 inversions, which produced no subsequent economic recessions. The U.S. economy did see a significant slowdown in the first half of 2022 but rebounded in the second half. Unfortunately, even when the signal is correct, it has variable lead and lag times. The yield curve still has a better prediction track record than the economists and is used in about every Federal Reserve model, so it is worth watching despite its warts. The curve is not currently inverted, so this model forecasts no recession.
What To Watch This Week
The economic calendar releases for the week are not of the highest importance. The two most notable are February durable goods orders on Wednesday and personal income and spending on Friday.
Last week, the Federal Reserve left its projected rate cuts at two but increased the inflation and unemployment forecasts. In addition, the median forecast for GDP growth was lowered. Markets saw this as a somewhat dovish signal and pushed expectations closer to three cuts for 2025, with the first in June.
Conclusions
Correctly forecasting a recession is challenging in the best of times, but the post-COVID period, with its irregular economic cycles, makes it even more perilous. These high-frequency indicators should provide a reasonable early warning system for a sizable economic contraction. Currently, the odds point to an economic slowdown rather than a recession, which bodes well for reasonable returns from the correction bottom.
As always, there are no easy calls when it comes to forecasting the short-term movement of stocks or the economy, especially in a period of increased uncertainty around the severity of the tariffs. For example, though most are rightly concerned about the downside risk from tariffs, there is an upside if somehow this pressure results in better trade terms for U.S. companies. There is always uncertainty, so investors should have a portfolio with enough cash and bonds to cover short-term expenses. This cushion can help moderate the impact of stock declines on a portfolio and allow one to withstand the inevitable stock declines to experience the benefits of long-term ownership. Within the stock portion, focus should be paid to companies that can weather economic dislocations and perhaps even take advantage of them, regardless of their stock price movement.
Disclosure: Glenview Trust may hold any stocks mentioned in this article within its recommended investment strategies.
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