The stock market ‘has cracked this year,’ strategist says, and there are 2 things to watch for next

As the economic slowdown eats into profits, corporations are reclaiming the slogan of “trust in the process” popularized by the Philadelphia 76ers in the post-Iverson era.

Markets, for their part, have already begun to price in the risks of recession, with the S&P 500 and Nasdaq falling into bear markets this year — down 20% and 32% year-to-date, respectively — and the Dow down more than 9%. .

“The market goes first, so the market has cracked this year,” Liz Young, head of investment strategy at SoFi, told Yahoo Finance Live (video above). “The market has shown us its pessimism. It has shown us its reaction to the microenvironment.”

The market’s decline is largely due to the Federal Reserve aggressively raising interest rates, and thus the slowing economy due to decades of high inflation: Fed Chairman Powell recently acknowledged the risk of the economy entering recession, but said he was thinking about it that he is It would be “very premature” to stop interest rate hikes at this point.

“Until we see inflation come down in a meaningful way for consecutive months, I expect it to continue to climb and continue to tighten,” Young said. “I think they’re quite comfortable tightening up maybe too far, and then trying to apologize to the markets with the tools they’re supposed to stimulate.”

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In the meantime, Young suggested that investors should be on the lookout for two more signs that the business cycle may be turning around.

Contraction of earnings

A sharp drop in earnings could be the next shoe to drop, according to Young. The market has not seen a downward revision in its earnings estimates since the start of the coronavirus pandemic.

“I think the part that hasn’t been fully priced in is the earnings contraction,” he said.

In a Nov. 4 note, Goldman Sachs cut its earnings target for the S&P 500 for the full year and also for 2024. The bank now sees earnings reaching $224 by 2022, down from $226. Additionally, the company’s strategists lowered their earnings expectations for 2023 to $224 (previously $234) and to $237 in 2024 (from $243).

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This image was created by Yahoo Finance using the Dall-E AI image generator.  (OpenAI)

This image was created by Yahoo Finance using the Dall-E AI image generator. (OpenAI)

Young added that if the U.S. were to fall into a recession, he would expect a 10% to 15% decline in profits. At the same time, he said, the skewing of profits would vary by sector due to inflation.

“Goods inflation is likely to come down much faster and to a more manageable level than services inflation, which tends to be stickier and includes things like rents, and businesses are dealing with sticky wage inflation,” Young said. “So sectors that are commodity-intensive and could benefit from lower commodity inflation and lower commodity prices will do better and may not see much impact on earnings.”

Economic uncertainty

The U.S. unemployment rate is currently near a 50-year low, and the Fed sees a generally overheated labor market as demand for workers outstrips the supply of labor market participants.

But that could change as the Fed continues to raise rates.

“The final piece of the puzzle is that the economy falters, and you see real data in the economy, in the labor market, that inflation is coming down, that things are actually contracting,” Young said.

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A bright spot for investors would be that by the time the economic data stumbles, the stock market may already be in recovery mode, as stocks tend to turn lower before a recession ends.

According to historical data from JPMorgan, on average, the S&P 500 bottoms three months after a recession begins and reaches a cyclical high 10 months before a recession ends.

“A recession is quite likely at this point; it doesn’t mean it has to be bad, it doesn’t mean it has to be armageddon,” Young said. “Recessions reset the business cycle, which can be positive in this environment.”

Bradley Smith is an anchor for Yahoo Finance. Follow him on Twitter @thebradsmith.

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