As Bank of America's Savita Subramanian writes in an overnight note titled "Is it about time for a recession?", while the bank's economists do not officially predict a recession in the coming year, instead forecasting slow and steady growth in the US, the strategist admits that over seven years and more than 270% into this bull market, "one wonders how much longer this cycle can last."
While BofA writes that it has not yet found a model that accurately forecast recessions, "and even if we did, not all recessions result in bear markets" in examining some of some of the bank's favorite indicators’ recent trends, it has "found evidence for an imminent recession." It adds that while the range of signals is wide, in aggregate they do suggest that, if data were to continue to weaken in line with the recent pace, history would point to a recession in the second half of 2017.
Admittedly, other macro indicators, such as consumer confidence and initial jobless claims, still point to healthy growth. But historically, equity returns have been strongest prior to the peak in building permit issuance growth (2012 in this cycle) and the probability of a bear market has been high when the yield curve was inverted (not until 2018 based on the trend).
How did BofA determine that a recession is imminent? Here is its explanation:
What if current trends persist? We chose five macro indicators and determined what levels tended to coincide with historical recessions and bear markets. While we are cognizant that trends change and that relying on the recent trend can often give you false signals when trends reverse, we also think that there is some value in considering what might happen if the current trends were to persist. In this exercise, we extrapolated the trends over the last few years in an attempt to estimate when the recessionary thresholds will be breached. In this scenario, the range of potential recession start dates implied by these models was as early as July 2016 and as far off as April 2019, with an average start date of October 2017.
If BofA is right and if a recession is coming does that mean that a bear market is imminent? As Subtamanian explains, not every bear market coincides with a recession, but the most painful ones do. Standard & Poor’s identifies 13 bear markets since 1928, of which 10 have coincided with US recessions. The exceptions were 1961, 1966 and 1987, which precisely because they did not occur alongside recessions, were relatively short-lived and followed by swift recoveries. The general rule of thumb is that the stock market leads the economy by 1-2 quarters, and on average, the market has historically peaked 7-8 months before a recession. But the range has been remarkably wide, from the peak of the market coinciding with the start of the recession and as early as 2.5 years before the start of the recession (1948).
Furthermore, not every recession comes with a bear market, especially the short ones There were several recessions where the market declines have been modest (i.e. less than 20% bear market declines), as in 1945, 1953, 1959 and 1980 (and technically 1990, which was 19.9%, but is generally considered a bear market). These non-bear market recessions tended to occur when the recessions were short and/or market valuations were low.
This feeds back to BofA's analysts because as it writes, the macro indicators the bank looked at tend to coincide with recessions more than bear markets, although some of them were also able to capture some of the nonrecessionary bear markets (although usually with a lag). For example, building permits signaled the non-recessionary bear markets in 1967 and 1987 (Chart 25), while the yield curve also signaled the 1967 bear market (Chart 21). The yield curve and building permits appear to have the most predictive power with respect to bear markets, although both have instances where they failed to trigger our bear market signals. Additionally, the yield curve had one case of a false bear market signal in 1978— although some would argue that it was simply too early relative to the 1980 bear market. And in many cases, the signal occurred after the market had already peaked. But based on this exercise, our indicators suggest that the start of the bear market could come in the middle of next year.
Here BofA has another warning to those looking to sell upon reading the report:"The end of bull markets have been painful to miss." It writes that even if we are in the later stages of this bull market, and despite concerns about a near-term market correction, BofA cautions long-term oriented investors against going too far in reducing their equity exposure. History would suggest that unless you can pinpoint the peak of the market to within a 12-month timeframe, you are typically better off staying invested .
Some of the best returns often come at the end of bull markets, and these gains are usually enough to offset the subsequent losses. Over the last 80 years, the minimum equity market returns achieved in the final two years of a bull market were 30%, with median returns of 45% (vs. 17% preceding the August peak); returns preceding the 1937 and 1987 peaks were particularly strong: 129% and 93%, respectively (Table 5). The returns in the last two years have averaged over 40% of the total returns of the cycle. Similarly, the lowest returns achieved in the last 12 months of a bull market were also impressive at 11%, with median returns of 21%. These robust returns suggest the opportunity cost of selling too early is quite painful.
Putting all of the above in context, one should recall that both the current business cycle, as well as the "270% bull market" are entirely creations of central bank liquid generosity, which is why it is safe to say that as of this moment the world finds itself in uncharted territory. It also explains why, if Bank of America is right and a recession may be "imminent", then there have been substantial hints by both central and commercial banks, not to mention economists, that the next step by the Fed may be to buy equities outright. In that case, the outcome may be a pinnacle in paradoxes: a crashing global economy as stocks rise to new all time highs.