US small-cap and industrial stocks are declining, raising a recession warning. However, given the year’s overall positive performance in equities, some investors are dismissing these declines as minor disturbances.
The S&P 500 Industrials index peaked on August 1 and has since fallen by approximately 8%. The index edging towards a correction phase. The S&P 500 is experiencing its most challenging week since March 10, when Silicon Valley Bank faced a crisis. This contributes to this recession warning sentiment.
This decline was triggered by several major US airlines revising their profit forecasts downward for the third quarter due to a sudden surge in oil prices. Furthermore, it has dropped by 2.8% since Wednesday, coinciding with the Federal Reserve’s announcement emphasizing the prospect of “higher for longer” interest rates.
Market turbulence sparks cash rush
In contrast, the small-cap Russell 2000 Index has experienced a more substantial drop, surpassing 11% since its closing high on July 31, roughly twice the decline observed in the S&P 500 Index during the same timeframe. Such significant declines in small-cap and industrial stocks give a recession warning.
According to strategists at Bank of America Corp, investors are withdrawing funds from global equity investments at the swiftest rate since December, reinforcing the recession warning sentiment.
“Cash becomes the King,” as investors seek refuge in cash funds at a rate not seen since the onset of the coronavirus pandemic. This trend is driven by the Federal Reserve’s unwavering hawkish stance, as reported by strategists at Bank of America Corp.
Navigating market uncertainty and historical trends
Analyzing signals like small-cap stocks can be complex, especially considering the substantial market growth earlier in the year. The S&P 500 had a fall but hasn’t yet erased all of its gains for 2023. Identifying a clear trigger for a significant market decline at this point is not evident. It clearly gives a recession warning.
Historical data adds another layer of complexity to the current market situation, in the last three instances where the S&P 500 experienced declines of at least 1% in both August and September, it rebounded notably in October, with gains of 8% in 2022, 8.3% in 2015, and 11% in 2011, as reported by Ryan Detrick.
Looking further back to the 1950s, in 10 occurrences of such declines in August and September, the index has been higher in October in nine of them. This historical pattern suggests that October has often been a positive month following such setbacks.
Earnings season signals optimism
Nonetheless, there is optimism for the stock market. Earnings season is approaching, and according to a model from Bloomberg Intelligence. It may hold more significance for stock prices than interest rates at the moment. Companies are projected to report only a slight 1.1% decline in profits for the third quarter, followed by anticipated gains for at least the next year.
Furthermore, the Federal Reserve recently revised its economic growth forecast, expecting more robust growth than anticipated just a few months ago.
Kim Forrest, founder and chief investment officer at Bokeh Capital Partners, noted that though the earnings season is just around the corner, there’s a lack of companies revising their earnings and revenue projections downward.
She emphasized that while the timing of an eventual recession remains uncertain, the largest US companies are not currently indicating an immediate threat.
Navigating economic growth projections and market opportunities
According to forecasts from analysts surveyed by Bloomberg, economic growth is expected to decelerate through the middle of the next year but then resume an upward trajectory. This is offering a glimmer of hope amid recession warnings.
For certain investors, the recent market declines present an attractive buying opportunity.
The decline in small-cap shares could be interpreted as an indication of anticipated slowing growth. These companies, typically among the first to hit bottom before broader markets recover, have strong connections to the domestic economy and often operate with less diversified business lines than their larger counterparts. This makes them a riskier investment during periods of recession warning and uncertainty.
Anticipated growth deceleration during recession warning
Infrastructure spending and the trend of US companies relocating their production back to North America contribute to increased business opportunities for industrial firms.
Jeff Cianci, the research director at Catherine Avery Investment Management, pointed out that this additional revenue isn’t as reliant on interest rates.
He also mentioned that the valuations of the industrial and materials sectors they invest in are currently undervalued compared to their potential, and he believes the market is factoring in a risk of a downturn that they don’t anticipate.