2023-05-11 15:05:36 ET
Summary
- The initial claims broke the 250K level resistance - this signals the trend higher (and a recession).
- Commodity prices confirm that a recession could be here.
- S&P 500 is not priced for a recession, and a major drawdown is likely.
A recession expected in Q2 2023
At the end of Q1 2023, on March 31st, I wrote an article: The Recession Expected To Start Next Week based on the forecasts by several major Wall Street firms. The term "next week" meant Q2 2023.
In fact, my own proprietary research has pointed to a recession by October 2023, based on the signals from the bond market and a probit based econometric analysis.
But these were just forecasts, and nobody can predict the future with certainty. Thus, as my major conclusion on March 31, I cautioned that:
The near-term recession will have to be confirmed with the data. Wall Street does not expect a sharp increase in the unemployment rate, but we do have to see some weakness in the weekly initial unemployment claims.
A recession by definition implies an increase in the unemployment rate. However, the unemployment rate is a lagging indicator. By the time the unemployment rate increases, the economy will be deeply in a recession.
The initial claims for unemployment data are widely accepted as a leading indicator of the unemployment rate because it is released on a weekly basis, and it's timelier.
The early-early indicator
On May 2nd I updated my forecast with an article The WARN Notices Are Predicting An Imminent Recession , in which I introduce the leading indicator for the initial claims for unemployment - the WARN Notices (the data largely unknown to many). Here is the definition of the WARN Notices from the article:
Essentially, the WARN Act requires companies to give at least a 60-day notice for any mass layoffs. A WARN Notice is issued about two months before a person is laid off and applies for unemployment benefits. Thus, based on the timeline, the WARN Notice is a valid leading indicator for the initial claims.
Thus, if the initial claims data is the leading indicator for the unemployment rate, the WARN Notices data is the leading-leading indicator. And, as I noted in the article, the WARN Notices were flashing red - confirming an imminent recession:
The study shows that the WARN Notices have been significantly rising in 2023. Thus, the initial claims will likely spike over the next few months . This is consistent with the predictions of the recession in Q2 2023 or Q3 2023 at the latest.
Essentially, the WARN Notices were predicting the spike in the initial claims, and thus, confirming the expected recession.
The initial claims - the early stage spike
As I pointed out in the March 31 article, the initial claims have been showing some weakness since the January 22nd low of 194K, and the subsequent spike to the 250K level on March 5th. Since March 5th, the initial claims have been pushing the 250K resistance on many weekly observations but subsequently retreated back to the low 200K level.
Based on this observed 200K-250K range, the 250K level breakout would be significant. Why? Because the data shows, once the new claims start rising, the trend continues. The initial claims spike right at the onset of a recession.
Just today, May 11th, the initial claims for unemployment breached the 250K resistance and spiked to 264K, well above the previous week's 242K level, and the consensus expectations of 246K. Here is the chart, it shows the 250K breakout.
I view this as an early-stage spike in the initial claims, because the level of 264K is still relatively low, and does not indicate a recession yet. But the trend is likely to continue, and once the initial claims breach the 300K level, the expected recession will be more obvious, and it will start showing up as an early uptick in the unemployment rate.
Cross-asset confirmation from commodities
During a recession, commodities drop as the demand is reduced. Crude oil ( CL1:COM ) has been in a firm downtrend, despite the OPEC+ attempted intervention, also negatively reacting to the early spike in the initial claims. Copper ( HG1:COM ) has tried to bounce with stocks after the October bottom, but just today as the new claims breached the 250K level, copper broke below a key support level and resumed its downtrend in what looks like a recessionary selloff.
Barchart | Barchart |
Sector performance: banks - the leading indicator
The Financial sector ( XLF ) is usually the leading indicator of a recession, because the inverted curve (which precedes a recession) lowers the bank's profitability, as the funding costs increase above the lending rates. This causes tightening of the lending standards, which eventually causes the contraction in consumption and business investment - and, thus, a recession.
We are all aware of the current banking crisis. Well, that was the early signal. Here is the chart of the regional banks ( KRE ) which are at the epicenter of the current banking crisis:
Implications for the S&P 500
Here are the two facts about the S&P 500 ( SP500 ) ( SPX ):
- Expected earnings: According to Factset, S&P 500 earnings are expected to grow for 2023 at 1.2%, driven by expected strong growth in Q4 2023 at 8.5%. Implication : no recession is expected in the current S&P 500 earnings forecast. During a recession, earnings should drop by 20%.
- The valuation: When you consider the expected earnings for S&P 500, which don't assume a recession, the 12-month forward PE ratio is around 18 - that's expensive even if you assume the earnings forecast will hold. The 12-month forward PE ratio should not be more than 15x, given the slow economic growth over the next five years as predicted by IMF. Implication : S&P 500 is overvalued.
Take these two facts together, and what do you get? Earnings should be revised down by around 20%, and the PE ratio should contract by 16% - when considering the 20% lower earnings. To make it simple, I think the S&P 500 is likely to decrease by 30-35% from the current levels.
It looks like the recession is here, and the revaluation process has started.
Note, the initial claims data can be revised, and there is a chance that next week the number will be revised to below the 250K level. Still, the banking crisis and the drop in commodity prices point out that we are in an early-stage recession. The data will eventually follow.
For further details see:
It's Happening - The Recession Is Here