History has a way of repeating itself, especially in the financial markets. By closely examining past economic cycles, we can often predict future trends. One such instance is the early warning signs that preceded the 2008 global financial crisis. As we observe similar patterns emerging today, it raises the question: Are we on the brink of another significant market downturn?
The Early Warning Signs of 200 Financial Crisis
Between January 2007 and December 2007, the banking sector experienced a dramatic 25% drop relative to the rest of the market. This sharp decline was an early indication of brewing trouble in the financial sector. Simultaneously, the consumer discretionary and homebuilding sectors also weakened significantly, signaling that consumers were under financial stress and the real estate market was starting to falter.
These sectors—banking, consumer discretionary, and homebuilding—are particularly sensitive to economic cycles. Their deterioration throughout 2007 was a critical warning sign that the economy was heading towards a downturn. When these sectors show weakness, it often precedes broader economic trouble.
Today’s Market Parallels
Looking at these same sectors today, we notice a troubling similarity. Over the past year, the banking, consumer discretionary, and homebuilding sectors have all been weakening. Historically, this kind of sectoral decline has only occurred twice in the past 20 years: before the global financial crisis and the 2020 recession. The current weakness in these sectors suggests that the US economy might be on a similar path.
Disconnect Between Market Rally and Economic Reality
Despite these warning signs, the US stock market is currently experiencing one of its most remarkable rallies in history. This apparent disconnect between market performance and underlying economic indicators raises concerns. To understand the potential paths for the stock market given this underlying weakness, we must dive deeper into the data and historical context.
Recently, we informed our members that a short-term market pullback was becoming a real possibility. But how significant could this pullback be? Could it be a minor 3-4% correction, a more substantial 10-15% decline, or something much larger, akin to the 2008 financial crisis?
The Role of Unemployment in Market Corrections
Large market corrections are typically accompanied by rising unemployment. Every major stock market crash of 30% or larger in history has coincided with increasing unemployment rates. Currently, the US unemployment rate is at a healthy 4.1%, which the market does not find concerning. However, if unemployment begins to rise, it would signal that the US is heading towards an economic downturn.
Stock Market Valuations and Historical Context
Today’s stock market is at one of the most expensive levels in the last 100 years. S&P 500 valuations are nearing those seen in 1999 and are now above the levels of 1929, just before the Great Depression. Typically, recessions lead to lower market valuations, and severe recessions can cause substantial declines. If the Shiller PE ratio were to drop to 20, it could trigger a 30% market drop, though we don’t see this as an imminent scenario.
Monitoring Key Economic Indicators
One key metric we’re watching is initial jobless claims, which have been trending slightly higher recently. This shows some weakness in the job market, but we won’t be overly concerned until initial claims exceed about 260,000. When this happens, it would indicate that the job market is cracking, putting the stock market at risk of a more significant correction.
If the job market shows signs of significant weakness, we’ll close most of our stock market exposure and add recessionary bets. For now, however, we’re still riding the bull market, holding onto many positions added during the market correction in April. Nonetheless, in the short term, the market appears overextended. The S&P has rallied by 13% since April and nearly 35% since October last year. A couple of bad economic reports could trigger a short-term correction.
The Role of the Fed
Over the past 30 years, we’ve seen numerous short-term, shallow market corrections that did not occur during recessions. Some were shallow 2-3% pullbacks, while others were larger 10-15% corrections. Most reversed on their own or were propped up by the Fed, a phenomenon known as the “Fed Put.”
However, with inflation still high, many believe the Fed won’t be able to step in as usual. Core inflation remains around 3.4%, much higher than the Fed’s 2% target.
However, we’re of a different opinion. Today, the Fed’s interest rate is above 5%, similar to the 1990s and well above the current headline inflation rate. The Fed has already discussed potential rate cuts in 2024, so the Fed Put is still here today.
Conclusion
In summary, while the stock market is currently rallying, underlying economic indicators suggest potential trouble ahead. Historical patterns show that significant market corrections often coincide with rising unemployment. Although we’re not immediately concerned, it’s crucial to monitor key metrics like initial jobless claims. For now, we continue to ride the bull market but remain vigilant for signs of a downturn. Click here to sign up! Subscribe to our YouTube channel and Follow us on Twitter for more updates!
