After a seven week string of declines that brought the S&P 500 down -20% on an intraday level (and -18.5% on a closing level) the equity market had a solid bounce last week up 6.6%! This has many asking if this is yet again another golden opportunity to “buy the dip” and put more money back into the equity markets? However, my humble opinion is that this is a classic “bear market bounce” or as it is also called in some circles “a dead cat bounce”. There are just too many steep hurdles ahead for this market-economy to miraculously rebound in any sustained fashion. The path of least resistance is for a continued slowing of the economy and lower equity markets alongside very high odds of a recession.

Here are some of the more obvious reasons for my continued bear market viewpoint and expectations of a better buying opportunity in 2022.

History of Rate Hike Cycles

History tells me that we get a recession 80% of the time when the central bank starts a rate hike cycle to cool the economy and inflation. The likelihood of recession is even higher when we have a fast rate hike cycle which we are seeing play out in North America. And it is not just the Federal Reserve that is raising rates—it is now a near global event!

Quantitative Tightening

I have covered this in prior communications but QT basically removes LIQUIDITY from the system and this is a very negative event for equity markets. Again this is a global event and it has just started! Many smart investors such as Stanley Druckenmiller repeatedly tell us that liquidity is the most important variable for equity markets.

The Rapid Surge in Oil Is a Big Risk

Several have referenced the fact that when oil doubles this quickly a recession often follows, especially when there is no quick fix on the horizon. When I combine this negative head wind to the items listed previously, it pushes my recession odds to 90% for 2022. I realize this is much higher than most estimates, but we have NEVER had all 3 at play all at once and on a GLOBAL basis.

The Lagged Effects of Higher Interest Rates

Most investors do not realize that rate changes and QT have a LAGGED effect on consumer spending, economic activity, corporate activity and ultimately equity markets. It typically it takes 8-12 months for these to come home to roost and we are just TWO months into this change. We are already seeing some early side effects from tighter financial conditions such as the consumer racking up credit card debt to allow the continued spending behaviour they are accustomed to (and strong evidence that housing is close to capitulation). In the near future we will see more declines in aggregate consumer spending and this has yet to hit home and is NOT PRICED in fully.

Inflation at 40 year Highs

This is another tremendous hurdle that will continue to dampen consumer spending over the next several months. Granted, inflation has peaked and will now start to roll over, but it will remain sticky and hamper spending and corporate sales/profit margins and eventually jobs.

The Massive Housing Bubble Is Starting to Implode

All leading indicators on housing are showing serious weakness and this is a big risk for a 2022 recession. Mortgage applications are down 56% YOY, new building permits are plunging, pending home sales are down 3.9% in April and now down 6 months in a row, new home sales are down 27% YOY etc. The next shoe to drop are the prices of homes. As higher mortgage rates sink in, I expect to see home prices drop in both US and Canada in the second half of 2022. How much? That is the question.

Additionally, in the US the practice of mortgage refinancing is referred to as the “Home ATM”, as home owners take on more debt with lower rates so as to allow more consumer spending. But that ATM is now shut with refinancing down 76% YOY! In Canada we have our own version known as the “Home Equity Line of Credit”. This products has been terribly abused and now stands at a record highs of $737Billion! D Rosenberg makes the analogy that if this was in the US (10x Canada GDP) it would be akin to $7.37 TRILLION of additional leverage (YIKES!!). Keep in mind a lot of this is tied to variable rates which is a big risk for future consumer spending as rates rise.

So the QUESTION you need to ask as mortgage rates rise is what happens if/when real estate drops 10-20%? Less consumer spending for sure and a strong tail wind for a recession in 2022 is my bet. What worries me the most is the nightmare scenario where BOTH housing and equities decline at the same time which could result in panic selling for the unblemished 40-54 y/o. These investors only know about steady annual home appreciation and “buy the dip” stock markets. They have never had to face the reality of home or equity bear markets. How will they react?

Consumer Financial Stress Is Just Starting

We saw a surge in the use of consumer credit card debt in the last two months. In the US, the savings rate has plunged from 6% in January (so already low) to 4.4% in April. This is the lowest level since 2008. These are both scary stats for me as it tells me the consumer is also rolling over and this will hurt corporate revenues and profits in the next quarter. I think markets are just starting to see this.

There is an outstanding report from Brooke Thackray,  “Retail Rollover—Is It the Canary in the Coal mine?”. My vote is a resounding YES. This is a classic “demand destruction” story where the consumer stops buying which leads to lower prices on stuff, followed by lower inflation and ultimately a slower economy. The Central Banks are creating this situation and praying for a soft landing, but odds are stacked against them as most often we see a recession.

Already we are seeing surveys such as the University of Michigan Consumer Sentiment Survey revealing that sentiment is ALREADY at recessionary levels and this is before the full slated rate hikes and layoffs kick in. We saw early evidence of consumer stress in the Walmart and Target reports last week that I covered in my previous note. CEO’s know this and are just starting to prepare for weak consumer activity ahead. Have a look at my last attachment below regarding CEO confidence levels. The US economy is 70% dependent upon the consumer and all I see is frugality and rising defaults ahead.

Profit Margin Squeeze Is Coming Next

We saw glimpses of this in this quarter e.g. Walmart and Target, and I expect a lot more is coming in the next quarter which the markets have NOT fully priced in! Analysts have not yet readjusted for this and when they do P/E ratios are going to look expensive once again. Please check out the great Barron’s report on this issue featuring another one of my favourites: S. Pomboy — she is one of the best folks.

History of Bear Market Bounces

Finally and perhaps most assuring for me is that bear market bounces are very common in bear markets. In the 2000-01 bear market we had 6 such bounces ranging from +5% up to +15% gains and in 2007-08 we had 8 such temporary bounces only to once again see equity markets continue to slide lower. So this is my base case scenario for this transient bounce as well as the reasons mentioned above and others covered in my most recent communications.

Conclusion on the Bear Market Bounce 2022

From my perch the odds are very much tilted towards LOWER equity markets and VERY HIGH odds of a RECESSION in 2022. The SIMULTANEOUS rapid escalation of interest rates AND the depletion of massive liquidity from the global financial system is one very tall wall of worry for me. History tells me to expect an average decline of 35% if we get a run of the mill recession, so we have additional down side risk of 20% from here. However my fear is that with BOTH an equity and housing bubble declining at the same time we could see an over shoot on this -35%!

Recall the “Fed Put” will not kick in to save the decline this time as long as inflation remains sticky. Very soon we will start the nervous debate on the mid-term US elections, which typically brings a low in the equity markets in July-August. Supporting my bearish outlook is one of my favorite MACRO CYCLE brains at ECRI (led by Lakshman Achuthan) put out a May 26 report stating “It’s Time to Prepare for a Recession”…I pay attention to this!

-Terry

 

PS—I am off visiting my 90 y/o parents in Newfoundland for the next week and Jas is also away. Slow response to inquiries is to be expected. Zach is steering the ship and can reach me if need be.

Great Attachments This Week

Retail Rollover—Is it the canary in the coal mine? - another outstanding report by Brooke Thackray

ECRI—OPINION—It’s Time to Prepare for a Recession - brilliant report!!!!

Sector Differences - shows why our clients have done so well in 2022….we focused on the DEFENSIVE sectors

Eric Parnell—We have only Just Begun - agree 100%

Barron's—A Profit Recession is Brewing - great report

Business Executive Surveys - yikes they are all hunkering down

Cullen Roche on Bonds - reasons to be in bonds right now