Investors are creatures of habit. Treat them a certain way long enough and they'll adapt to expect those relationships to hold in the future.
Over several decades, investors have been taught that recessions bring interest rate cuts. More recently, over the past 15 years, they've learned that interest rate cuts cause the stock market to go up immediately.
So it's not hard to understand why investors have largely been cheering bad economic news lately, assuming that bad economic news means a recession is coming, which means the Fed will cut rates, which means stocks will resume going up.
Unfortunately, it's not that simple. As we discussed in From Inflation to Recession: The Outlook for a Continuing Bear Market in 2023, rate cuts haven't always been enough to stop big recessionary bear markets. The past 15 years of "rate cut = stock market spike" conditioning has happened outside of recessionary conditions.
Regardless, we haven't even gotten to the end of the Fed hiking rates, much less cutting them, so investors are seemingly getting ahead of themselves. But it at least helps explain why the stock market has tended to rally on bad economic news lately.
Until yesterday.
Yesterday the December retail sales numbers were released. They weren't good. On top of December's weak performance, the November numbers were also revised lower. I don't remember where I saw it (or I'd credit them), but someone pointed out that we've never had a two-month decline in retail sales as large as we just experienced in Nov/Dec outside of a recession.
That's starting to become a trend, as the number of "this has never happened before outside of recession" type data points are piling up. I could probably rattle off 6-10 examples without having to dig much. (We have to watch this type of information for clues as to when recessions are starting in real time because their start and end points aren't formally declared until long after the fact.)
Turning point?
The interesting thing about yesterday wasn't so much the data point, but rather the market's reaction to it. Rather than rally on this bad news, stocks swooned. And just as importantly, bonds rallied. That's exactly how I'd expect both stocks and bonds to respond to news that the economy is slipping into recession. But until yesterday, we weren't getting those reactions.
It's too soon to say anything of substance has changed. There are still plenty of other indicators pointing to continued economic strength, which is why I'd been leaning toward thinking recession was probably still a ways off. It could also be that stocks just ran into their nemesis that has thwarted them since this bear market began.
Either way, the potential that we could be closer to recession already has my attention. Fortunately, as we note frequently, we don't have to anticipate the timing of this sort of thing precisely right, because our trend-following momentum signals are going to confirm (or not) any changes we need to make to our actual positioning anyway.
But it's worth watching, because if these recent economic data points — and the market reactions they create — are indicating we're close to (or already in) a recession, it would signal an important shift. Not so much to the stock side of our portfolios, where SMI investors are already allocated very conservatively. But it could mean longer durations are getting more attractive on the bond side, which would be a marked change from the past 18 months. That's one area we'll be focused on as this recession timing becomes more clear.
