Well, we made it to the end of May and the dreaded “sell in May and go away” directive fell on deaf ears. I know, I know. This has never been a statistically proven strategy for stock investors, even when we expand the analysis to the actual reference period behind the phrase. As we discussed this time last year, the more modern interpretation is that stocks tend to underperform during May to October – not necessarily go down but simply underperform relative the October to May period. Still, if there was going to be a year when folks would cash out and head for countryside, this might have been one of them. Two major wars, oil prices above $100/barrel, affordability going out the window and global fiscal discipline flying out the other window.

But, while we caution investors against establishing strategies based on the calendar, we have also advised people to not make dramatic changes to their portfolios based on headlines. If you had liquidated your equities after every doomsday prophecy coming out of the White House, you would have missed what has been an impressive, albeit head-scratching, advance in stocks. Case in point, the S&P500 has added another 4% this month to the massive 15% bounce in April. The TSX has lagged with less than a 2% lift, however, this is intuitive given that the oil price rally has faded in recent days and technology shares represent a much smaller share of the TSX than the S&P.

While we cautioned against headline trading, we have emphasized the need to pay close to attention to economic fundamentals and to watch for any evidence that a major shift is about to take place. This is because there is no guesswork when it comes to figuring out how stocks will respond to a contraction in the economy. Unlike the TACO trade, there is no quick reversing out of a recession once it starts. It may be short (a couple of quarters), or it may be long (more than a year). It might be shallow (a couple of percentage points subtracted from aggregate demand and output), or it might be deep (a 5% or more contraction). But until countercyclical and policy responses take effect, equity valuations head lower to reflect the new economic reality.

Similar to a recession, the depth and duration of the equity market “revaluation” will vary, but again they are typically not going to be over quick. Now, I know many of you will point to the covid correction and say that there was an example of a rapid sell-off and a rapid bounce back. Vast chunks of the economy were indeed shut down, but this episode did not qualify as a traditional recession, despite how bad the indicators looked.

Knowing that the market experience into and during a recession is different than headline hopping, what should we be looking out for to signal that one might be brewing?  I have identified what I call the “high five” – indicators that have triggered economic corrections in the past and have the potential to do so again. These are the Federal Reserve fed funds rate, the US 10-year treasury bond yield, the unemployment rate, CPI inflation and the price of gasoline. As with other indicators, the rate of change in the direction is important, but so are the absolute levels that they get to.

In this analysis, the thresholds we are watching are 5% for the first four and $5/gallon for gasoline. Below, I have put together a dashboard showing where these indicators are now, the last time we saw it reach 5 and the probability that we could return to this level this time around.

Indicator                     Current Level             Last “5” Event          Chance of hitting 5

Fed funds rate             3.50-3.75%                 2023-2024                  Low to moderate

10yr US yield               4.5%                           2023                            Moderate to high

Unemployment rate     4.3%                           2021                            Moderate to high

CPI inflation                 3.8%                           2023                            Moderate

Gasoline                      $4.50/gallon                2022                            Moderate to high

Of course, this table is “crowded” with the post-pandemic years as the most recent experience at 5 and this makes historical inferences difficult given the data distortions that this period created. Rather than absolute levels, however, we know the pace of change in these indicators did have consequences.  The late and rapid tightening in Fed policy and spike in longer-term bond yields resulted in a bear market for stocks in 2022, but no recession.  One explanation was that domestic demand was still on fire from a rebound in job growth and stimulus cheques that the impact of higher interest rates was muted.

If there is one indicator that perhaps represents the most risk today it would be inflation. In terms of markets being surprised by inflation, we can look at the 1970s. Back then, inflation didn't move in a single spike, but in waves. Many investors in 1974 thought the worst was over when inflation dipped, only to be crushed by the 1979-1980 surge. Fast forward to the current environment and we’ve completed wave 1 (the post-pandemic spike). The risk now is that the current plateau (near 4%) isn't a landing, but the trough before "Wave 2."

As much as higher rates out of 2022 helped wrestle back towards the Fed’s target of 2%, core inflation became stuck even before the Iran war. The good news is that consumer inflation expectations haven’t shown a material move higher, but if we see more headline CPI prints close to or above 4%, then those expectations could shift. Already we have seen Fed officials shift from calling for a reduction in rates to standing pat and now shifting again towards the possible need for rate hikes.

Could we see an increase of 1-1/2 percentage points to return to 5%? The odds remain low to moderate, but this might be an example where we don’t have to reach this threshold for the economic impact to be negative. Keep in mind that when the Fed did rachet rates to above 5% in 2022, job growth was high and consumer debt was on the decline thanks to government stimulus. Today, job growth is anemic, and employees are worried about the impact that AI might have on their jobs. Debt is also back on the rise.

If the Fed funds rate and inflation reaching 5% is still a moderate risk, we can’t say the same about unemployment. This is an indicator that has a tendency of moving rapidly in one direction or the other as the cycle shifts. Here the 5% rule is even more important. Since 1950, every time US unemployment rose from a cycle low and crossed 5%, a recession began within 6 months. Alongside the inflation unwinding in the 1970s, the unemployment rate experienced a pattern of higher cyclical lows and higher highs, eventually breaking above 10% by the early 1980s. We would return to those levels in 2009, only one year after breaking 5%. Again, some will argue that a 5% unemployment rate is no big deal since we were last there in 2021, but it was on a downtrend from a pandemic peak of 14.8%! A rise in the rate from the recent low of 3.4% is a different thing altogether and could represent a recession "tripwire".

There is less consensus as to what a $5 a gallon price of gasoline would mean to the US economy. Clearly, households are feeling pressure, but some say that gasoline doesn’t matter like it did in the 1970s.  Energy represents a smaller footprint of the US economy than back then, so we shouldn’t be too worried. The problem with this argument is that it ignores the squeeze on discretionary spending. Simply put, high gasoline prices act as an immediate tax on the consumer.

When you combine $5 gasoline with 5% yields, the "margin for error" for both households and small businesses disappears. In 2022, even with a "service-heavy" economy, the spike to $5 gas was the primary driver that cratered consumer confidence and helped trigger a bear market. It is a common misconception that the bear market started when gas hit $5. In reality, the S&P 500 began dropping in January 2022, and the $5 gas in June acted as the "accelerant" that drove the market to its deepest summer lows.

The main reason though why the argument fails is that it also ignores what is happening on the debt front. While the US is more service-oriented and energy-efficient than it was in 1974, the Total debt-to-GDP ratio (government, corporate, and household) has more than doubled since the 1970s, when it was roughly 150%. Back then, the economy could absorb 10%–15% interest rates because the total debt burden was manageable. Today, debt-to-GDP is now over 350%. And because we are so much more leveraged, a 5% Fed Funds Rate today could exert the same economic gravity that a 12% rate did in the 1970s. Every 1% move in rates now sucks significantly more cash out of the private economy to service debt.

Which brings us to the 10yr bond yield. In October 2023, the 10yr yield hitting 5% was the literal "turning point." Stocks rallied the moment yields began to retreat from that 5% ceiling. Moving up to that threshold can create a different response, even though that hasn’t materialized since the start of the Iran war. The 10yr yield spiked to around 4.6% on May 19th and this saw some downward pressure on stocks, but the S&P500 was still trading sharply higher than the end of last year when the 10yr was even lower at 4.20%.  The retreat in long yields in the past week has indeed added fuel to equity momentum, but if we are simply at a new floor in a continued uptrend, then 5% is the next target. And, when you move to this level, so-called “zero-risk” government bonds become more attractive than riskier stocks, thus raising the prospect for a rotation of out equities.

As market disclaimers state – past performance is not an indicator of expected returns. This is true, but history does contain echoes and when certain macroeconomic variables shift direction and breach levels that have created significant economic cracks in the past, it bears watching. Again, the appropriate strategy in our opinion is to be agnostic to headlines, to not get swept up in crowded trades (did someone say semiconductors) and to be even more attentive to the macro landscape. Eight major financial institutions this week raised their targets for the S&P500 to 8,000 by the end of the year. Possible, but only if we don’t experience a “high five” scenario.

On behalf of the Pyle Wealth Advisory team, have a wonderful weekend.     

Andrew Pyle