Recession signal hard to miss if stocks are taken at their word

“The market can be wrong, but I never dismiss it out of hand” — fund manager

Prices bounce around, emotion obscures logic, signals appear and vanish. The reasons for treating equities as a poor barometer for the economy are many. Right now, that might be for the best.

Pools of gloom await anyone looking for a message in stocks. There’s the $3 trillion (Dh12.45) in value erased, the bloodbath in banks and the trouncing in transports. In wonkier circles, shrinking valuations and negative rolling returns have started to ring the recession bell. A relatively calm week in the Dow Jones Industrial Average just ended with a 495-point thud.

It’s a pastime on Wall Street these days to look at the carnage, add it all up, and announce that the market is wrong. But what if it’s not? After all, even if equities have predicted “nine of the last five recessions,” as the economist Paul Samuelson famously said, that’s a better record than a lot of humans.

“I usually come down to the side of the market, because the market represents the collective views of a tremendous number of investors,” said John Carey, a fund manager for Amundi Pioneer Asset Management in Boston. “The market can be wrong, but I never dismiss it out of hand.”

As of Friday’s close, the S&P 500 was down 11.3 per cent from its September close, with more than half its constituents nursing bear-market losses of 20 per cent or more. The Nasdaq 100 has fallen 13.9 per cent from its record close in August, while the Russell 2000 Index of small-cap stocks has lost 19 per cent, leaving all three with declines for 2018.

Robert Buckland, Citigroup’s chief global equity strategist, employed a similar approach in assessing the future of corporate profits. The MSCI World All-Country Index is now pricing in a 1 per cent decline in earnings in 2019, below the 5 per cent increase forecast.

“Our models suggest global equity may now be too bearish on the earnings outlook,” Buckland said. “This suggests investors should buy the dip.”

Fair enough, but each time the sell-off deepens, the implications get harder to shake off. Take forward valuations and the idea that market’s price-earnings ratio embeds an estimate for next year’s profits. Since Bloomberg began tracking data in 1992, S&P 500 at this time of year has stood at an average of 17.4 times income that ended up materialising in the next year.

Assuming stocks are now valued at that average, it would equate to the market predicting $152.50 a share in 2019 earnings, not the $174.50 estimated by analysts. In other words, while Wall Street predicts 9 per cent profit growth for next year, the market could be said to see a 5 per cent decline.

Points drop in Dow Jones Industrial Average last week