SPY - Bank of America Predicts A 'Full-Blown Recession': SPY Implications

2023-05-11 11:53:50 ET

Summary

• Bank of America research recently showed that a full-blown recession is likely coming.
• We look at this research in more depth and share our take on its implications for the SPDR® S&P 500 ETF Trust.
• We also share our approach for weathering the current macro environment.

Bank of America Corporation ( BAC ) research recently showed that a full-blown recession is likely coming. In this article, we look at this research in more depth and share our take on its implications for the SPDR® S&P 500 ETF Trust ( SPY ). We also share our approach for weathering the current macro environment.

Bank of America: Why A Recession Is Coming

BAC recently looked at a large number of data points to determine whether or not a recession is coming, and all of them seemed to indicate that we are due for a recession. In this article, we look at 10 of them.

First, BAC observed a clear decline in manufacturing activity, with the March ISM reaching its lowest level since May 2020 (which was near the peak of the COVID-19 lockdown-induced recession). While not yet at a recession level, the trend is clearly one towards a recession, as data over the past seven decades indicates that 11 out of the 12 times that the ISM dipped below 45, recession followed.

Moreover, the new orders component of ISM indicates that whenever new orders have dipped below 45, recessions have almost always followed.

Additionally, global earnings have already begun to decline year-over-year as part of a precipitous decline over the past year. As the chart below shows, this rapid decline seems to resemble the pattern of past recessions, and the downward momentum has prompted BAC's model to forecast a 16% year-over-year decline in earnings by August of this year:

Additional evidence that a recession may be on the way soon is that the U.S. Treasury 2-year/10-year yield curve has inverted pretty deeply. This condition has proven to be one of the most reliable recession indicators.

Fifth, oil prices have appeared to have peaked after a sharp rise. This repeats the pattern seen in five out of the past seven recessions.

Sixth, while the jobs market remains incredibly tight, the ISM manufacturing PMI - assuming it follows historical patterns - is indicating that the U.S. labor market will take a hit in the coming months.

Seventh, home prices have begun to tumble after a rapid run-up in recent years. Leading the way lower are countries like Sweden (-13% y/y), Australia (-9% y/y), and New Zealand (-14% y/y), while the U.S. and Canada have seen home price trends flatten but not begin to fall meaningfully yet. However, with interest rates remaining higher for longer and the jobs market expected to weaken in the coming months, the U.S. and Canada could certainly be in for some additional negative downward momentum.

Eighth, the jobs market may also soon experience headwinds from tightened lending standards from banks towards small businesses moving forward, as the normally fairly tight correlation between small business loan availability and initial jobless claims has become markedly broken in recent weeks:

Of course, the rapidly growing field of direct lending - championed by massive alternative asset managers like Blue Owl Capital Inc. ( OWL ), Ares Management Corporation ( ARES ), Blackstone Inc. ( BX ), and Brookfield Asset Management Ltd. ( BAM ) - is stepping in to fill much of this gap, but the trend line departure is still sharp enough that it could indicate a weakened jobs market.

Ninth, Eurozone bank lending has declined for three months in a row, which has been a rather rare occurrence outside of major economic disruptions.

Tenth, the apparent peaking and beginning of a rapid decline in U.S. job openings will likely push the Federal Funds rate rapidly lower soon. This is a very typical pattern for recessions:

SPY Implications

What does all of this mean for SPDR® S&P 500 ETF Trust? First and foremost, recessions are generally a very negative catalyst for stocks, and the S&P 500 (SP500) is no exception. In fact, the data indicates that stocks consistently perform poorly during recessionary periods. In 1933, the S&P 500 fell by 86%, in 1938 it fell by 54%, in 1970 it fell by 35%, in 1975% it fell by 48%, in 1982 it fell by 27%, in 2001 it fell by 36%, in 2009 it fell by 57%, and in 2020 it fell by 34%. As a result, while it is impossible to know if the SPY has a meaningful further downside - and sometimes SPY only fell by much smaller amounts than these listed examples - it certainly seems that the risks are largely to the downside in SPY right now.

This is further confirmed when looking at SPY's valuation. According to a compilation of leading valuation models, SPY is right in between being considered fairly valued and overvalued.

For example, the Buffett Indicator seems to indicate that SPY is clearly overvalued at 1.2 standard deviations above its historical trend line.

Moreover, the Price to Earnings model says something similar at 1.1 standard deviations above its historical trend line.

The Interest Rate model takes a more friendly view of SPY, indicating that it is only 0.27 standard deviations above its historical trend line.

That said, the S&P 500 Mean Reversion model and the Yield Curve model both strongly suggest that the Buffett Indicator and Price to Earnings models are correct in predicting that SPY has material underperformance in its future.

When looking at SPY's top holdings, we see a similar pattern emerging:

For example, SPY's top holding by far - Apple Inc. ( AAPL ) stock - is currently trading at a premium valuation of 29.51x compared to its 10-year average of just 19.84x. This comes despite interest rates being near their 10-year peak:

We see further examples of this throughout SPY's portfolio, confirming the broader models' conclusion that SPY is likely overvalued. When combined with the compelling data that a recession is imminent and that SPY tends to perform poorly - and potentially very poorly - in a recession, the risk-reward does not look favorable at all for SPY at the moment.

Investor Takeaway

Given the overwhelming evidence that a recession is imminent - and that is even ignoring the massive geopolitical risks seen in China, Korea, the Middle East, and Eastern Europe, each of which could explode at any time and lead to World War 3 and/or a global depression - and that SPY is overvalued, we rate SPY a Sell.

Instead of investing in the broader market indexes like SPY, we are instead focusing on four areas of the market right now:

1. Taking advantage of the yield curve while preserving our portfolio optionality by investing in short-term, high-yielding cash-like instruments such as 1-3 month maturing treasuries ( SGOV ).
2. Investing in precious metals like gold ( GLD ) and silver ( SLV ) along with miners like Barrick Gold Corporation ( GOLD ).
3. Investing in non-SPY-correlated businesses that pay attractive dividends.
4. Buying recession-resistant, underfollowed, high-yielding businesses trading at extremely attractive valuations.

Following this approach - along with strategic, opportunistic capital recycling - has enabled us to outperform SPY by roughly three to one since launching our portfolio in late 2020.

Given the negative outlook for SPY moving forward, we continue to rate it a Sell and expect our strategy to continue outperforming it moving forward.

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