Was a Stellar First Quarter the Start of a New Trend or Is It the Precipice of a Big Correction?

Investor optimism was high in the first quarter of 2019. This was, no doubt, thanks to stellar gains on the S&P 500. There are still a couple days left in March, but the S&P 500 is up more than 13%. And investors continue to be bullish as we enter the second quarter of the year. But is that optimism warranted or are recent gains on the S&P 500 overblown and a correction later in 2019 imminent?

Is S&P 500 Heading for More Gains or a Colossal Correction?

After a horrendous fourth quarter, in which the S&P 500 tumbled 14%, the Nasdaq was down 18%, and the TSX slipped 11%, the markets rebounded. The fact that the markets turned was not a total surprise; the “January effect” typically results in a seasonal rally following a December decline.

What was surprising though was just how bullish the markets have been since the start of the year. In January, the S&P 500 increased 9%, the Nasdaq rose 12%, and the TSX soared 14%. To put that into perspective, since 1950, January gains average around 1%.

And yet, stocks continued higher in February and March. Again, the S&P 500 is up more than 13% year-to-date, the Nasdaq has advanced 18%, and the TSX has increased 14%. All three indexes have erased their December losses and are just a few points from wiping out their October losses.

Should investors buy the comeback with hopes that the second quarter will be just as frothy? Don’t bet on it. Some are questioning why the first quarter was as strong as it was. Gains certainly weren’t fuelled by strong fundamentals. First quarter earnings expectations are down with Wall Street predicting a 3.4% earnings loss for the S&P 500 while 73 S&P 500 companies have issued negative EPS guidance.¹

Meanwhile, the bond market is signalling a recession. The curve on short-dated yield has risen above the longer-dated yields, which suggests the record long 10-year bull market run for the S&P 500 is coming to an end.

Yield curves invert because investors are more concerned about the near-term (2 years) outlook for the economy than the long-term (10 years). As a result, fearful investors turn their attention to safe, long-term Treasuries which pushes down long-term rates.

The inversion yield is one of the most accurate and closely watched indicators, when it comes to predicting a recession. In fact, the inversion yield has flashed a warning sign for every single recession since 1960.

Most recently, the inversion yield last flashed a warning signal in 2007, just before the financial crisis. What the inversion yield cannot predict however, is when a recession will hit. Or how bad a stock market correction will be.

The fears of a recession and stock market correction are real. Economists say the risk of a U.S. recession is at its highest level in more than six years.² Meanwhile, almost half of all polled CEOs in the U.S. believe the U.S. could enter a recession by the end of 2019. And if not in 2019, then certainly in 2020.³

How far stocks could fall during a recession is always open for debate. But some analysts think the S&P 500 could tumble at least 40% from its top.

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Sources:

1. “Earnings Insight,” FactSet, March 1, 2019; https://www.factset.com/hubfs/Resources%20Section/Research%20Desk/Earnings%20Insight/EarningsInsight_030119.pdf.
2. “U.S. Recession Risk Hits Six-Year High Amid Trade War Shutdown,” Bloomberg, January 11, 2019; https://www.bloomberg.com/news/articles/2019-01-11/u-s-recession-risk-hits-six-year-high-amid-trade-war-shutdown.
3. Ciolli, J. “A jarring new survey shows CEOs think a recession could strike as soon as year-end 2019,” Business Insider, December 17, 2018; https://www.businessinsider.com/next-recession-ceo-survey-shows-economy-could-melt-down-by-year-end-2018-12.

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