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Since the US yield curve has reversed and scared the market, there has been a debate over whether the recession alert sign was real.
Barry Bannister, Head of Institutional Equity at Stifel, responds that this is the case and that the implications are more serious than most people think. In a note to customers, he writes that the shares are likely to sink in December, with a recession expected in May. After that, he sees a "dangerous" market where the S & P 500 could generate a 0% return for five years.
A reversal of the yield curve occurs when short-term bond yields exceed their long-term counterparts, which is a sign that investors are deeply concerned about the economy. As this happened before each of the last seven recessions, it is considered one of the most reliable recession signals. And recently, the trade war has prompted investors to look for safer assets.
But Bannister notes that this has also triggered false alarms over the years. He therefore uses another measure of the yield curve that he says more accurate: a 50-day moving average of the gap between 3-month bonds and 10-year bonds. He says this version of the yield curve has correctly forecasted each recession of the last 50 years without any erroneous prediction.
"A 50-day moving average over 10 years has not given any false signals of recession in the last 50 years," he said.
Bannister, who has long had a gloomy view of the market, shows the history of the measure at the top of this chart. The second chart below shows that these reversals of the yield curve were followed fairly quickly by the decline in earnings of the S & P 500.
Bannister indicates that his yield curve measurement reversed on June 20th. His forecasts of the timing of liquidation and the market recession are based on historical averages of what happened before the previous crises.
"If a recession arrives in May 2020, stocks could plunge in December 2019 with the standard delay until the start of the recession," writes Bannister. Also average, he says, would be a 26% decline in S & P 500 earnings and a 32% drop in the index itself.
The difficult times
This seems rather serious, but Bannister adds that the combination of low interest rates and share buybacks has pushed equity valuations to very high levels, leaving little room for improvement in the years to come.
"The S & P 500 is at the top of the range provided by our 10-year forward price band model," he writes. "The S & P 500 is overvalued / held with a total annual compounded return of close to 0% for the five years from 2Q 2019 to 2Q 2024E."
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Based on this appalling forecast, he advises investors to buy defensive stocks instead of those more exposed to the business cycle, as defensive companies tend to do better in the middle of the recession. And he also calls a lot of caution.
"The implication of a S & P 500 near 0% forecast over five years is clearly a non-linear and dangerous market, especially for high beta," he said.
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