Nothing like price to change narrative, right?
No circuit breaker this week, but let’s face it – the risk-off trade of long-duration Treasurys is clearly working. And it may only be just getting started if stocks do have further downside to come. History suggests we could still see a lot more pain ahead.
The threat of a recession weighs heavily in the background. Many economists and analysts predict a relatively short and shallow recession. They argue that a strong labor market and robust consumer spending will cushion the economy. The Federal Reserve’s efforts to combat inflation through a series of interest rate hikes have also started to show signs of success, with inflation rates gradually decreasing. And now it seems the central bank is done.
But what if the Fed paused too late? What if the recession ends up being deeper than most think?
Historical data provides valuable insights into stock market behavior during past recessions. Since 1950, the U.S. has experienced 11 recessions. In each instance, stock prices typically peak and start declining before the official start of a recession. They continue to decline during the recession but bottom out and recover as the economy starts to rebound.
A further 20% drawdown in the stock market is not just a possibility — it may be likely. If a recession is on the horizon, there’s a significant possibility of substantial stock market losses. This would undeniably have severe implications for investors. Stock portfolios would see substantial losses, and recovery could take time. Treasurys would likely continue to rally and perform well on a relative basis, bringing back the flight-to-safety dynamic that has been lacking for the past two years against widening credit spreads and rising default risk.
Now, of course it doesn’t have to happen right here.
And yes, my concerns around circuit breakers potentially getting hit this week, because of my immediate focus on the Bank of Japan, appear to be wrong in outcome.
But that doesn’t mean we are back to a risk-on world. Quite the opposite from what’s happening beneath the surface.
The Bottom Line
Regardless of whether the recent rip higher in stocks persists or not in the short term, the intermediate to long term remains murky at best. Recession risks remain real. And while the prospect of a further 20% drawdown in the stock market may seem alarming, it’s important to remember that stock market volatility is part of investing.
Path matters more than prediction. We could still be in a bear market, which makes fools of bulls and bears.
On the date of publication, Michael Gayed did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
