(The following was first published on The Kotok Report website and via LISTSERV. For details, visit https://kotokreport.com/.)

“Would A Recession Blindside The Market?” is the title of Doug Ramsey’s December 6^th Advisor Newsletter. Doug is Chief Investment Officer of The Leuthold Group and a fishing buddy when our calendars can overlap. I thank him for permission to quote his newsletter, which you can subscribe to here. 

Doug explains: 

The stock market’s record in anticipating recessions is far from perfect. Among the 15 economic downturns since 1928, there are three cases in which the peak in blue chip stocks and the business cycle peak transpired less than a month apart. The S&P 500’s pre-COVID peak of February 19, 2020, and the corresponding business cycle peak at the end of that same month is one of those instances, and we’ll give the market a pass for not sniffing out that one. (Insert joke about mask mandates here.) Another “joint” peak occurred in July 1990. The S&P 500 top was on the 16th, with the official business cycle peak at month-end. Was the stock market asleep at the wheel? Hardly. All eight of our bellwethers were shouting from the rooftops, with each having peaked at least six months beforehand. Finally, blue chip stocks failed to anticipate the steep economic downturn that began in September 1929. The DJIA peaked on the first trading day of that month, and so did what were then known as the “Railroads.” However, stock market breadth, as measured by the NYSE Daily Advance/Decline Line, had been trending sharply lower since early 1928, a sign the market was sniffing out trouble. That can’t be said of today, with the latest highs in the blue chips confirmed by the major bellwethers. In fact, if a recession were to somehow begin in next year’s first quarter, we’d have to consider it to be the stock market’s worst failure in history from an economic forecasting perspective. (On the other hand, that would rectify the worst forecasting failure by the yield curve.)

Let’s move on to another question.  What about the equity risk premium (ERP)? Well, it is negative or nearly negative, depending on which method you use to estimate it. ERP is a value-oriented assessment. Example: Take the earnings yield of the S&P 500 (about 4.25% today) and subtract the Treasury yield, and today you can get a negative or nearly negative number, depending on which Treasury maturity you use. There is a debate about which tenor is best. I use them all.   The idea is how much are you getting paid for taking equity risk instead of riskless government debt.

An alternative ERP is to take the yield on BBB corporate bonds and use that for comparison. Reason: BBB reflects corporate credit more closely than Treasury yields do. In either case the conclusion from ERP analysis is that you are not getting paid for taking the risk of owning stocks. Note that ERP extremes can persist for some time. They do not help you trade on a day-to-day basis. For a 300-year history of ERP, see “300 years of the Equity-Risk Premium,” https://globalfinancialdata.com/300-years-of-the-equity-risk-premium, by Bryan Taylor, Chief Economist, Global Financial Data. (Hat tip to Mike Cerneant for sending this.) The report is from Feb. 2020; but, perspective on variation in ERP is as valid today as it was then.

And then there’s the political question. What is the potential impact of the Republican trifecta? Well, here’s what we found. Source is the US House of Representatives: “Party Government Since 1857,” https://history.house.gov/Institution/Presidents-Coinciding/Party-Government/. I am going to eliminate the period preceding WW2 and the Roosevelt period during and after the Great Depression. That limits the sample size to Eisenhower, Bush (twice), and Trump. A Dec. 6 Barclays report (see “Has Red Sweep historically benefited equity markets? Barclays answers,” https://www.investing.com/news/stock-market-news/has-red-sweep-historically-benefited-equity-markets-barclays-answers-3759548), confirms that the sample size for GOP trifectas is only four (and there are plenty of warnings about limited sample size). But working with what they found, they conclude there is an outperformance of about 750 basis points compared to periods when Republicans controlled the White House but Congress was split. I ignored Democrat trifectas, since a recurrence is unlikely for at least four years.

And lastly, in a dangerous world, there can always be a “Doolittle Moment”. I wrote about that in April 2020 as the Covid crisis kicked into high gear. Does any of this help you buy, sell, or hold at 11 o’clock on a Tuesday morning? Probably not. But it may provide some strategic perspective.