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Net Net: Promoting innovation and managing change

Recession sign is in play and has 81% accuracy

Earnings recession risk?
Earnings recession risk?

Since corporate profits turned negative in mid-2015, Wall Street has pondered whether it's just a passing phase or a signal of something worse. History strongly suggests the latter.

Recessions have followed consecutive quarters of earnings declines 81 percent of the time, according to an analysis from JPMorgan Chase strategists, who said they combed through 115 years of records for their findings.

The news gets worse: Of the remaining 19 percent of the time, recession was only avoided through either monetary or fiscal stimulus. With the Federal Reserve holding limited easing options and a deeply dysfunctional Washington thwarting a fiscal boost, the prospects for help are not good.

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The warning comes amid a stock market hovering around correction territory and a mixed economic picture. Citigroup this week warned of escalating risks for a global recession, though data Thursday on durable goods orders suggested the manufacturing sector may be shaking off a contraction phase. Fed officials in recent days have been talking down recession risks.

"Absent a pickup in consumption and further weakening in the U.S. dollar, we continue to see rising risk of earnings recession in the U.S." JPMorgan's equity strategy team said in a note to clients.

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Corporate earnings began to weaken significantly in the third quarter of 2015. The drop became more pronounced in the nearly completed fourth quarter reporting season, which is likely to see a drop of 3.6 percent.

Worse, future estimates are declining, indicating the damage won't end until at least the third quarter of 2016. First-quarter profits are likely to fall 6.5 percent, while the second quarter is expected to show a 1.1 percent drop, according to FactSet. Sales already are well into recession territory, with four consecutive quarterly declines.

Despite the mounting problems, JPMorgan still only assigns a one-third chance of recession this year, though the probability seems to be rising. The firm said its Qualitative Macro Index measuring business conditions shows "a cycle that remains in contraction (weak and decelerating) over the coming months."

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The index's reading is consistent with a bear market 64 percent of the time and has been below the current level just four times since 1980, each occasion signaling a recession. Those cycles also featured the Fed raising rates in the face of inflation — the central bank is currently in the early stages of what is expected to be a gradual tightening cycle — though the target funds rate was much higher, averaging 2.7 percent compared with the current 0.38 percent.

For investors, the ramifications are substantial.

A QMI at current levels has signaled a bear market 34 percent of the time. The four readings below generated average peak-to-trough plunges of 35 percent in the .

As such, JPMorgan is advising significant shifts in positioning.

In what it calls a "fairly unique" backdrop, the firm is advocating a move to a balance between momentum and value, with a focus on emerging market and commodity-linked stocks, as well as multinationals and dividends. It is advising limited exposure to discretionary, tech and health care or at least moving toward "reasonably priced sub-industries."

"Absent a more material pickup in top-line growth or U.S. dollar weakening, margin compression is likely to intensify on sluggish productivity, tightening labor markets and rising wages, as well as increasing credit costs," the firm said in the note. "More so, at 6.6 years old the current cycle appears to be suffering from age-related degeneration."