Why Wall Street is freaking out and economists aren't

1. Bear market under siege: The Dow is down 4,000 points. The Nasdaq is in a bear market. A...

Posted: Dec 24, 2018 11:09 AM
Updated: Dec 24, 2018 11:09 AM

1. Bear market under siege: The Dow is down 4,000 points. The Nasdaq is in a bear market. And crude oil is in meltdown mode. All in the span of three months.

In short, investors are acting like a recession is around the corner.

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But here's the thing: Economists generally don't see an imminent downturn. Yes, the blockbuster growth of 2018 is likely to fade. And yes, major risks loom, most notably a mistake by the Federal Reserve or an escalation of the US-China trade war -- or both.

Still, some market veterans argue that a panicky Wall Street is prematurely pricing in a recession that may not hit until 2020.

"That's the funny thing about the stock market. It's an unusual indicator because it's dominated by emotions," said Kristina Hooper, global market strategist at Invesco. "We have to be careful not to assume we're heading into a recession."

It's a fresh reminder that the stock market is not the economy.

The odds of a downturn have certainly climbed. And it's possible that economists simply didn't see this one coming.

PIMCO estimates the chance of a recession in the next 12 months at 30%, the highest of the entire economic expansion. But that still means a 70% chance of no recession.

Goldman Sachs economists peg the chance of a recession in 2019 at just 10%. "We expect the current US expansion will continue for the next several years," Goldman Sachs chief US equity strategist David Kostin wrote in a client report this month.

Of course, that's not what the market is saying.

The Nasdaq plunged last week into its first bear market since the Great Recession. And the Dow suffered its worst week since 2008. The bull market, as measured by the S&P 500, is clearly under siege. Investors are deeply worried about slowing economic growth and an overly aggressive Federal Reserve.

"Markets appear to have bought into the immediate slowdown story," Ian Shepherdson, chief economist at Pantheon Macroeconomics, wrote to clients. "But the slowdown narrative is flimsy."

Shepherdson doesn't see a recession -- and a "mild" one at that -- until the first half of 2020.

Hooked on easy money

So what's behind this divide between investors and economists?

One possible factor: Wall Street got hooked on easy money, a powerful force that's slowly receding after a decade. The Fed has hiked interest rates nine times in three years.

"You have a Fed that's less interested in being a soothing nanny," said Hooper.

The US central bank has also shrunk its massive balance sheet by almost half a trillion, further draining the liquidity that juiced risky assets.

"It's being unwound rather quickly. That, of course, is adding to the fear," Hooper said.

History shows that if economists are right, and no recession is on the horizon, the market could still have room to grow.

Since 1945, US stocks have returned 12% on average in the year leading up to the six months before the start of a recession, according to UBS.

"We think that staying invested will pay off, although investors should prepare for greater volatility," Mark Haefele, global chief investment officer of UBS Global Wealth Management, wrote in a client report. "Growth is slowing, but we do not expect a recession."

2. Market breather: The stock market will be open for half a day on Monday and it will be closed Tuesday for Christmas. The break can't come soon enough.

December tends to end on a higher note as most traders spend the last week of the month on vacation. But even a Santa Claus rally would be unlikely to prevent what's on pace to be the stock market's worst December since the Great Depression.

3. Housing numbers: Investors will get one more chance this year to determine how the housing market is performing.

Despite high consumer confidence and low unemployment, home sales have sputtered in 2018. Houses are too expensive for many buyers, and the Federal Reserve's efforts to wean the economy off near-zero rates raised mortgage costs.

The S&P Case-Shiller Home Price Index on Wednesday is expected to show home prices in October rose 4.9% year-over-year, according to economists surveyed by Refinitiv. On Thursday, the US Census Bureau is expected to report new home sales rose 2.5% in November, and the National Association of Realtors is forecast to report on Friday that sales of existing homes rose 0.5% in November.

4. Coming this week:

Monday — US markets close at 1 pm ET for Christmas Eve

Tuesday — Markets closed for Christmas

Wednesday — S&P Case-Shiller Home Price Index

Thursday — Consumer confidence for December and new home sales for November

Friday — Pending home sales for November

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