Short the S&P 500 As Recession Fears Become Real

Investors should short the US stock market as ongoing fears of a recession become self-fulfilling, according to a research note from TS Lombard.

The investment research firm now has the US entering a mild

recession

as its base case, arguing that the Fed’s current tightening cycle will determine how long the recession lasts. If the Fed overtightens, the recession could become more pronounced.

“In the current environment there is still a path (if small) to a soft landing, but the problem is that central banks are getting panicky and recessions can become self-fulfilling. The rumour mill has started churning that the Fed is angling for a ‘softish’ recession to bring inflation down. Headlines and forecasts negatively impact investor, consumer and corporate behaviour and we are already starting to see cracks appear,” TS Lombard said.

But in the short-term, bad news is good news for the market and there could be a rally seen in stock prices even in the face of deteriorating economic data. That’s because slower growth helps tame inflation, which means the Fed doesn’t need to raise interest rates as much as previously thought. 

“Rising recession fears have thus led to declining yields and, in a roundabout way, to a rally in equities,” TS Lombard said. But those rallies should be viewed as an opportunity to short stocks, according to the note, because in the long-term a recession is ultimately a big negative for stock prices.

“This seems pretty obvious but it is worth repeating given recent price action: growth matters for equities. Equities see significant gains when growth is above trend, struggle when it is below trend and fall when it is negative,” TS Lombard said.

The likely recession TS Lombard expects is sure to hurt corporate earnings, which over the long-term have been the main driver of stock prices. 

“Counter-cyclical inflation depresses margins, but consensus EPS estimates are still at very elevated levels. It is thus likely that we get downgrades in consensus EPS estimates. US earnings revisions have already turned negative, and we expect this trend to accelerate. If there is a recession earnings are likely to decline rather than just grow more slowly, especially in real terms,” TS Lombard explained.

With growth set to moderate, and expectations still anchored to the post-pandemic boom of 2020 and 2021, there seems to be more room for equity prices to fall, according to TS Lombard. And investors can take advantage of that by following the firm’s recommendation and shorting the SPY ETF.