With just three months to go in 2022, the Dow Jones Industrial Average has fallen in and out of a bear market, often defined as a loss of 20% or more for the year. The Federal Reserve's September meeting sobered markets and led investors to believe that a more severe recession in 2023 is starting to look inevitable.
It's been a tough year for investors, and there is still a lot of uncertainty in the environment. Investors are trying to figure out when inflation will start to come down, when there will be more clarity on the economic outlook, and if the Fed will actually pivot sooner than expected and slow the pace of its rate hikes or even cut them.
Unfortunately, the only thing you can do right now is remain patient and wait for things to play out. There are, however, two things I would recommend investors keep an eye on today to help them monitor how the economy is progressing, which will affect the broader stock market.
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1. Earnings estimates
During calmer market conditions, stocks will often trade with a heavier emphasis on valuation. There are many ways to value a stock, but a common method is to use a company's earnings projections and assign a multiple.
So, for instance, if a company is projected to make $6 of earnings per share this year and the market gives the stock a multiple of eight, the stock trades at $48. Earnings can be very complex to model out, so investors frequently rely on projections made by analysts.
The problem is the market is currently unclear on how accurate current earnings estimates are right now. After all, high inflation has increased the cost of doing business, and if there is a severe recession next year, that could cause consumer spending to shrink and businesses to tighten their belts as well.
"The market reaction to early earnings releases suggests that slowing economic activity is nowhere near priced in," said Lauren Goodwin, economist and portfolio strategist at New York Life Investments. "Earning estimates are likely to continue their decline until we see a bottoming in leading economic indicators. We are not there yet, suggesting volatility ahead for risk assets."
I do think the market has some understanding that analysts' earnings outlooks are still bullish, but the question is how much of a revision downward will happen. So one thing you can do right now is watch how earnings reports come in and how they stack up to analyst projections. Then, keep an eye out for revisions following those earnings reports. Looking at how the market reacts to certain earnings reports and revisions -- and the extent of those revisions -- will tell you a lot.
2. The labor market
The unemployment rate in the U.S. in August was 3.7%. That's still relatively healthy and typically not the kind of rate you would see in a severe recession. However, the labor market can be a lagging indicator, meaning it can take some time for cracks to show.
Many expect that unemployment rate will soon start to rise. There have already been lots of job cuts, and a recession may lead companies to either stop growing -- and therefore hiring -- or begin layoffs to achieve cost savings.
Now, I do think the Fed is going to want to see some deterioration in the labor market. Otherwise, the economy could stay too hot and people could get used to high inflation, a situation that played out in the 1970s and one Fed Chairman Jerome Powell is trying to avoid at all costs.
But after three 0.75% rate hikes and with another potentially on the way later this year, the Fed is throwing a lot of weight at the economy, which could lead to more economic trouble than the Fed -- or anyone else -- would like. If the labor market starts to decline rapidly, be prepared for a severe recession.
But if it can moderate gradually, the Fed may somehow achieve a soft landing. The market clearly thinks this situation is not likely, but you never know in volatile times like these.
