{"id":7574,"date":"2019-10-21T15:47:00","date_gmt":"2019-10-21T19:47:00","guid":{"rendered":"https:\/\/www.zacksim.com\/?p=7574"},"modified":"2022-02-27T17:54:53","modified_gmt":"2022-02-27T17:54:53","slug":"investors-pricing-much-recession-risk","status":"publish","type":"post","link":"https:\/\/zacksim.com\/financial-professionals-insights\/investors-pricing-much-recession-risk\/","title":{"rendered":"Are Investors Pricing in Too Much Recession Risk?"},"content":{"rendered":"

October kicked off with some weak economic reports. The Institute for Supply Management released manufacturing data showing that U.S. factory activity continued its slump, with the manufacturing index falling to its lowest level (47.8) since June 2009. Global manufacturing activity also remained firmly in negative territory in September, posting its fifth consecutive month of contraction. Nearly every major economy took a hit, the report said.1<\/sup><\/p>\n

Markets were rattled by this data, and recession chatter followed.<\/p>\n

I\u2019ve seen this pattern more in 2019 than perhaps any other year in this decade-long economic expansion: market watchers and prognosticators cling to the slightest whiff of economic weakness, and use it to declare imminent recession. Whether it\u2019s the trade war, the inverted yield curve, weak corporate earnings, negative interest rates, or some other concern, the refrain is that this economic cycle is doomed \u2013 soon.<\/p>\n

There\u2019s also been a notable response in the equity markets to rising fear of recession. I\u2019ve been observing a notable rotation away from cyclical sectors and towards defensive sectors. In the third quarter, Utilities was the top performing sector (+9.3%), followed by Real Estate (+7.7%) and Consumer Staples (+6.1%).2<\/sup>\u00a0Since September 30, 2018 (roughly over the last year), Consumer Staples and Utilities have been at the top of the performance chain, with Staples outperforming Information Technology by a margin of 2-to-1 and Utilities outperforming by a margin of 3-to-1.3<\/sup><\/p>\n

Investors have also been hedging in other ways. There are nearly 2.5 times the amount of put options on the S&P 500 Index as there are call options, and the cost of hedging has soared to one-year highs across several equity benchmarks.4<\/sup><\/p>\n

The demand in the market to go defensive is clearly high, but in my view, investors might be over-compensating \u2013 and over-paying \u2013 <\/em>to defend portfolios against a recession that may not be as imminent as many believe.<\/p>\n

As investors rotate, or consider rotating, into traditionally defensive sectors like Utilities and Consumer Staples, many may not realize that the Utilities sector\u2019s price to earnings ratio is at an all-time high. <\/em>The Utilities sector\u2019s P\/E has risen ahead of previous recessions as investors have made similar moves, but never to this degree. It is now the most overvalued sector, in my view. Consumer Staples is not far behind, which has me convinced that investors are over-playing the defensive hand, and paying dearly for it.5<\/sup><\/p>\n

The Recession May Not Be as Near as Many Believe<\/strong><\/p>\n

Manufacturing data was quite weak and there are clear signs that global growth is slowing, in my view. But few reports point out that manufacturing only makes up 10% of U.S. economic output, and that the U.S. and global economy are still expected to grow north of 2% in 2019. Services in most developed countries remain strong and expanding, and the U.S. consumer \u2013 which comprises some 70% to total U.S. GDP6<\/sup>\u00a0\u2013 continues to spend at a healthy clip. Patches of weakness are being counterweighed by bigger patches of strength, in my view.<\/p>\n

I\u2019ll share a few more data points to support my argument. Small businesses, which are often considered a key growth engine for the U.S. economy, have been increasingly reporting labor shortages, <\/em>where 57% of owners have said they\u2019re hiring or trying to hire. A majority of these business owners have reported finding few, if any, qualified applicants for open positions. This points to strength in economic activity, and also points to a skilled labor shortage in the United States (a good problem to have, in my view). A key takeaway from the NFIB Small Business Jobs Report is that \u201chiring has slowed down, but it\u2019s due to the inability to find qualified workers, not because of a lack of customers.\u201d7<\/sup><\/p>\n

The U.S. consumer is another proxy for the health of the U.S. economy, and signs point to steady spending as we enter the holiday shopping season. Total retail sales for the June 2019 – August 2019 period was up 3.7% from the same period the previous year, with a particularly strong showing in July.8<\/sup>\u00a0In the latest ISM Non-Manufacturing report, the statement from the Retail Trade sector was that \u201cbusiness continues to pick up as we quickly approach Q4. Week by week, we inch closer to a much-anticipated holiday retail season, which requires not only last-minute buys, but a push to fill open positions.\u201d9<\/sup><\/p>\n

Finally, data in the broad labor market also offers evidence of the U.S. economy\u2019s stability. Job growth as measured by non-farm payrolls remains strong, with reports last showing that the U.S. added 136,000 jobs in September, bringing the jobless rate (3.5%) \u2013 its lowest level in 50 years.10<\/sup><\/p>\n

Bottom Line for Investors<\/strong><\/p>\n

If the market delivers a positive turn of events \u2013 which we may already see early signs of with a potential trade \u201ctruce\u201d \u2013 there could be an upside rally which effectively unwinds many of these defensive positions. We could see mean reversion in cyclicals.<\/p>\n

Hopefully readers see the bigger takeaway here, however. In my view, owning a diversified portfolio means that regardless of whether defensive sectors or cyclical sectors outperform, you\u2019ll participate in the upside. <\/em><\/strong>Having a diversified portfolio, at the end of the day, is the optimal way to be on the defensive in uncertain economic times, in my opinion.<\/p>\n","protected":false},"excerpt":{"rendered":"

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