Last July, I wrote the following:

“Collectively, these factors [negative earnings/sales growth, widening credit spreads, flattening yield curve, weakness in cyclicals, etc.] point to an equity market that is increasingly fragile and in the past one that was about to become much more volatile. The response from market participants today: “no one cares.” Volatility is low, stocks are still acting like a 6-month CD, and monetary policy is easy.

All true, but investing is about the future, not the past. No one knows when the Minsky moment of this cycle will occur, but a necessary precursor is low volatility and the illusion of stability. Add fragility to the equation and you have a powder keg just waiting to explode.”

Fast forward to today and we have seen an explosion of some sorts. The S&P 500 has declined 15%, the Russell 2000 is down 26%, and high yield credit spreads are at their widest levels since October 2011. Sentiment has shifted 180 degrees.

All of the risk factors I was writing about last year are now being trumpeted by pundits who were telling you to buy with both hands at the market top. That requires a reevaluation for if market participants are now openly fearful of these risks and prices have adjusted, we will need additional negative factors to push markets lower.

More and more, this seems to be the consensus, that there will be nothing but negative news for the remainder of 2016. The same people who were sanguine about the economy and stocks with the S&P at all-time highs are now convinced we are on the verge of another global recession and bear market similar to 2000-02 and 2007-09.

If they are correct, the odds favor further declines. The average S&P 500 decline during a recession is 43%. With elevated valuations at the start of the decline last year (click here for my piece on this topic last March) such a drawdown would not be unreasonable.

But what if the U.S. doesn’t enter a recession here? Yes, that is the question. Then the analysis becomes much more complicated. While there have been a number of bear markets without a recession (most recently in 2011), they tend to be shorter (average of 12 months) and shallower (average of 30%). With the median stock in the Russell 3000 already down 34% from its 52-week high, there’s no guarantee of significant further losses even if this is a non-recessionary Bear Market.

Which brings us back to the crux of the matter: will the U.S. economy avoid recession?

The market’s silver linings playbook for the remainder of 2016 depends on it. Let’s begin…

1) The U.S. economy avoids recession.

a) While ISM Manufacturing is weak, it soon reverses course and proves to be similar to 1985, 1995, or 1998, other periods when the U.S. was able to avoid recession with interim manufacturing weakness.

b) The larger services economy continues to grow at a moderate pace, and its downturn follows the same path as short-term weakness seen in 2011, 2012 and 2014.

c) Retail sales have growth 3.4% last year and excluding the noisy Autos/Gas are up 3.8%. With continued job growth and falling unemployment, consumers will begin to feel better about spending and sales will rise.

d) Jobless claims remain near their lowest levels since 1973. They will remain low as job openings are near record highs.

e) After the longest stretch of economic data misses in history, expectations have been reset lower and we begin to see beats exceed misses for the remainder of the year.

Simply put, the bullish case is that the global manufacturing slowdown and commodities collapse is not enough to pull the entire U.S. economy into recession.

2) Bearish intermarket market factors change course.

a) The yield curve starts to steepen again after hitting an expansion low of 94 bps this week.

b) Credit spreads, at their widest levels since October 2011, start to tighten again as they did back then.

c) The ratio of higher beta (cyclical) stocks to low volatility (defensive) stocks begins to improve after hitting its lowest level since March 2009. (For our research on the signaling power of the defensive Utilities sector, click here).

d) Inflation expectations start to rise after hitting their lowest levels of the expansion.

3) The Dollar and Commodities are no longer extreme headwinds.

a) The Dollar Index is already down year-over-year as expectations for the next Fed rate hike have been pushed back to 2018. The Dollar does not embark on another record advance as it did from mid 2014 through early 2015.

b) After suffering their worst bear market in history, Commodities bounce or at the very least stabilize. This helps soothe credit markets as default expectations decline.

c) After suffering its worst decline in history, Crude Oil bounces. Calls for $0 Oil are proven wrong.

d) Emerging Market currencies begin to rise, reversing a five-year decline.

4) S&P 500 Earnings and Revenues improve as the headwinds from a stronger dollar/weaker commodities wear off and the U.S. avoids recession.

a) After 5 consecutive quarterly declines, S&P 500 Earnings turn positive.

b) After 4 consecutive quarterly declines, S&P 500 Sales turn positive.

Silver Linings and Open Minds

As I write, the S&P 500 is breaking below its January lows, a “key” technical level according to the many nouveau technicians who have a knack for rearing their ugly heads at inflection points. At 1810, all hope seems lost. Investors who loved the market so at 2135 hate it 15% lower. Surely we are going straight to 0. 

But what if we don’t? What if the market’s silver linings playbook begins to take form?  What are the odds of that actually happening? In the midst of a sharp decline with nothing but bad news, they seem impossibly low. Indeed, but the odds aren’t 0%. There’s a chance that at least some of these factors will begin to improve.

Regardless, when negative sentiment gets as extreme as it did this week, you often see bounces, even if this is the next great bear market. We saw many bounces in 2008 and the most vicious bounces historically have taken place during bear markets, not bull markets. And so, if a rally should unfold in the coming weeks/months, another reevaluation will be necessary. Did the playbook unfold with factors suggesting further gains or a bounce to be sold into to as was the case last November? Let’s hope for the former (likely means no U.S. recession) but be prepared for the latter.

As investors, it is important to be able to understand the case for both sides (bullish and bearish) and accept that there is no impossible in markets. Only then can you be flexible and intellectually honest enough to change your mind as the facts inevitably change.