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By Bhawana Chhabra

“When all the experts and forecasts agree — something else is going to happen.” — Bob Farrell’s Rule No. 9

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The recent string of better-than-expected data releases (non-farm payroll report, gross domestic product, Institute for Supply Management PMIs) has investors pricing in a soft-landing/no-landing scenario at a time when we believe the 2024 outlook is more clouded than many appreciate. That is why valuations are so important: ensuring that there is a sufficient margin of safety when making investing decisions in case things go awry.

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We set out to measure recession risks priced into various asset classes, equities of the largest economies and the S&P 500 sectors, and our analysis shows that Bob Farrell’s rule couldn’t be truer in light of the unprecedented optimism that is priced in across many of these assets, particularly U.S. equities and high yield credit. On the other hand, U.S. Treasuries, gold, investment-grade credit and commodities offer a better “margin of safety.”

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Starting out with equities, we used our What’s Priced In? model to separate the fundamentals from the sentiment priced into equity markets. The model enables us to calculate a sentiment gauge we call the Pessimism Indicator.

Historically, we have seen the Pessimism Indicator at its lowest level before the bear market kicks in, and the highest at the end of the downturn. We compared previous bear markets to the current value to measure the pessimism currently priced into headline equity markets. Interestingly, an additional comparison of recent price action with previous bear markets only confirms what our Pessimism Indicator highlights:

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• Developed equities (led by the United States) are the most optimistically priced. Our Pessimism Indicator is lower than at the start of previous bear markets, implying a zero per cent chance of a recession priced in. The current decline of three per cent in the MSCI World Index (compared to an average of minus 38 per cent) pegs recession pricing at a mere seven per cent as well.
• At the country level, the U.S. and Canada are the most optimistically priced. The S&P 500 has a zero per cent probability priced in on our Pessimism Indicator as well as current price action, and Canadian equities have a six per cent probability priced in on average across these two metrics).
• It’s slightly less optimistic across the Atlantic, with an average 25 per cent and 21 per cent recession probability priced into Germany and the United Kingdom’s equity markets, respectively.
• Japan and China are more reasonably priced, with Japan’s equities already pricing in a U.S. bear market to the tune of 51 per cent (mainly on account of the Pessimism Indicator). Interestingly, this is occurring while the Nikkei is at three-decade highs. China stands at 88 per cent based on weak price performance as well as a high pessimism index.

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In terms of the S&P 500 sectors, utilities, consumer staples and energy are already 70 per cent through the average drawdown seen during previous bear markets. Real estate and consumer discretionary are halfway while industrials, tech, and health care are the most optimistic with less than a 10 per cent drawdown compared to averages seen previously.

We believe this analysis would be incomplete without looking at how the other asset classes are faring. Overall, commodities seem to be ahead of the curve. Crude and industrial metals such as aluminum and copper are already down more than the trend, mostly on the back of bleak global demand. This implies they already have priced in recession to the fullest extent.

In terms of fixed income, high-yield credit is pricing in the least amount of recessionary risks (both on spreads and absolute yields). Investment-grade credit, which is typically up five per cent in recessions, is 11 per cent below its cycle high. Similarly, gold, which is up six per cent during such periods, is down three per cent from its peak, implying these asset classes are currently offering a good inflection point for rebalancing out of the most optimistically priced assets in anticipation of a downturn.

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All in, with U.S. equity market pricing absolute perfection to justify, investors should look beyond the S&P 500 to diversify their portfolio when seeking assets with an appropriate “margin of safety.” Developed markets in general are unattractive on this basis while Japan and China screen well on the equity front (as do utilities, consumer staples and energy in the U.S.).

Beyond stocks, high yield offers little room for error. Risk assets in general are at risk of selling pressure, while we would look to gold, investment-grade credit, U.S. Treasuries and commodities as having a better risk/reward profile at this time.

Bhawana Chhabra, CFA, is a senior market strategist at independent research firm Rosenberg Research & Associates Inc., founded by David Rosenberg. To receive more of David Rosenberg’s insights and analysis, you can sign up for a complimentary, one-month trial on the Rosenberg Research website.

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