Late-Cycle Behavior Leaves Stocks Wide Open To More Downside

Authored by Simon White, Bloomberg macro strategist,

Economic surprises show that the consensus continues to lag where we are in the economic cycle.

But the cycle is in its very late stages, with a recession highly likely. Equities are thus at risk of making new lows before they can post a durable rally.

Economic cycles operate in well-defined sequences. As the cycle matures, leading data, such as housing or manufacturing, turn down first. It is followed by more coincident data such as retail sales or industrial production. Finally, lagging data like unemployment and bankruptcies are the last to deteriorate.

The consensus, according to the aggregate view of economists, continues to be wrong about how late we are in the cycle, and therefore about the more likely path for stocks.

We can see this by looking at economic-surprise indices, which Bloomberg breaks out by sector. What they show is that surprises for leading sectors are falling, while surprises for coincident and lagging sectors are rising. This means economists are overestimating leading data and underestimating coincident and lagging data.

I looked at this last August and it was the same message. The consensus has yet to catch up that we are very late in the cycle, when leading data are still strongly underperforming coincident and lagging data.

Stocks will be unable to post a durable rally and exit their bear market until the cycle turns. As the chart below shows, it’s not until leading data start to outperform coincident data once more that stocks turn up.

(NB: Stocks are only one of 10 inputs to the Conference Board’s Leading Index, so they do not drive it.)

Unfortunately, when leading data are as depressed as they are today relative to coincident data, the cycle does not turn without there being a recession. Stocks have another 15% or so downside if the US has a recession, based on the historical data.

A recession call is consensus. But economies are not markets, and there is less reflexivity – just because everyone believes a recession is coming, does not mean it will not happen (as with markets – when everybody is long or short, the market goes the other way).

The upset would be we have a recession, but stocks do not make new lows. Anything can happen of course, but you are fighting against the “four most dangerous words in finance:” this time is different.