Two market contradictions that keep me up at night

I’ve been writing since October when the S&P was at 3600 that a run of bad economic data was going to spark a rally in equities, and that has mostly played out. While we could certainly see more upside from here, a durable recovery relies on this recession to be mild and short, while the inflation downturn must be deep and protracted.

Variant Perception’s Recession indicator is telling us a recession has likely already begun. The question going forward is no longer when a recession arrives, but how long and deep it will be.

If the economy rebounds from here, inflation will likely be sticky and the Fed will keep rates high. If the economy suffers a deep and painful recession, this would send earnings and equities to new lows. The bullish scenario - a mild recession, is like threading the needle between sticky inflation and a deep recession. Possible, but unlikely.

This brings me to contradiction #1 - The economic environment in which inflation falls back to 2-3% and the Fed has to quickly cut rates is not the environment where stocks do well.

This current “mini-regime” where the equity market cheers bad economic data will not last forever. For that reason, I am reducing equity exposure from my prior bullish stance and staying on the lookout for a transition into the “bad data = lower equities” regime. You’ll know it has arrived when you get two consecutive days when equities and yields both move in the same direction.

Contradiction #2 - The performance of the energy sector in the face of weakening global growth and oil grinding lower has been nothing short of heroic. Energy has been the beneficiary of large inflows looking for a place to hide in an equity landscape where most other sectors have been decimated. Energy is a cyclical sector, so in a recession, those inflows would likely reverse and undo some of the outperformance relative to oil.

In my previous post about long term asset allocation, I highlighted a large allocation to energy equities, as well as to the Russell 2000. I am reducing my exposure to both by half, as a recession requires a more defensive posture.