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The media’s using the “R” word a lot this week. That’s because Main Street’s definition of a recession is two consecutive quarters of declining gross domestic product, and on Thursday, the BEA announced the economy shank 0.9% in Q2. The contraction in economic activity in the quarter follows a 1.6% drop in Q1, prompting most to conclude a recession is upon us, regardless of whether economists and political spin doctors agree.

Does it matter?

The National Bureau of Economic Research (NBER), an independent non-profit, nonpartisan organization comprising 1,700 economists, issues the official proclamation of a recession. Its economists, most of whom are academics, consider GDP, GDI, employment, and other data to decide whether the U.S. is in recession. This week, some – including the spin doctors – argue that because unemployment remains low, the economy hasn’t met the criteria necessary to be labeled an official recession, despite declining GDP.

Does NBER making it “official” matter? Not really. Recessions occur over time, and they’re part of a cycle. Cheap money causes economic growth, causing inflation, which causes higher interest rates, causing slowing economic activity, which causes job loss. Recessions don’t begin or end overnight simply because we’ve labeled them. What matters to investors is the rate of change in the various inputs and our best guess at what happens next.

Remember, NBER concludes whether we’re in a recession or not after the fact. So when they say, “yep, we’re in one,” is pretty irrelevant to us.

Real Money’s James DePorre summed it up nicely today: 

“The debate over the exact starting point of a bear market or a recession is not very helpful. It makes it easy for journalists to write headlines, but for investors, the important thing is to recognize trends at an early point. Those that saw the bear market that was developing in 2020 were better able to navigate it than those that are waiting for some arbitrary definition to be fulfilled.”

We live in the reality of the markets, and a rearward-looking confirmation of a recession (or not) isn’t handy because stocks are a leading indicator. The stock market sniffs out economic weakness and strength beforehand, so waiting for economists to ring a bell to signal the beginning or end of a recession isn’t very profit friendly.

What you should be watching

Instead of tracking NBER, investors should keep tabs on the Fed because the best returns happen when the Fed is our friend, not our foe. Unfortunately, the Fed remains our enemy. This week, it increased interest rates by 0.75% for the second consecutive month. That means that the Fed Funds rate has risen by 0.25% in March, 0.50% in May, 0.75% in June, and 0.75% in July this year. For perspective, it’s been decades since we’ve witnessed as rapid of a pace of tightening.

The Fed’s not done, either.

During the Fed’s “after party” on Wednesday, Chairman Powell struck a hawkish tone, suggesting more rate increases are likely in its quest to wrestle PCE (its favorite inflation gauge) down to 2%. Following his comments, the CME’s FedWatch tool pegs odds of 0.50% or 0.75% increase in September at 75% and 25%, respectively.

What happens after September is murkier. There isn’t a meeting in October, and a lot can happen between now and when the Fed meets in November and December.

As of now, the odds favor a pause. On Twitter, Real Money Pro’s Tom Graff wrote on Thursday, “As of right this moment, fed funds futures are projecting that it is more likely than not that the last hike will be in November.”

Currently, the CME’s odds place rates between 3% to 3.5% in December, up from 2.5% today. In July 2023, it predicts rates will be between 2.75% to 3.5%, so the Fed is expected to be on the sidelines after Thanksgiving.

If so, stocks could enjoy an easier path higher. Remember, stocks tend to discount six to 12 months into the future, so searching for stocks that may lead during the next bull market now makes sense.

The Smart Play

Many companies are saying in their second-quarter earnings calls that business conditions are challenging. Slowing demand, shifting spending habits, a strong Dollar, and an inability to pass along the entirety of higher input costs are squeezing margins. As a result, I suspect analysts will ratchet down their profit outlooks for the back half of 2022 and 2023. Additionally, I suspect more bad economic news is looming, including job losses. Over the past two months, a steady stream of companies have said they’re scaling back hiring and considering job cuts.

Although that bad news will capture lots of headlines, I advise focusing less on the news and more on how stocks react to it. 

Analysts are notoriously late to the party to downgrade stocks, and individual stocks bottom before the index, which bottoms before the economy. We may already be seeing this happen, given many stocks were still trading nicely above their May lows when the S&P 500 was putting in fresh lows in June.

It's also important to remember that summertime is notorious for downside volatility. Many investors disappear on vacation, so volume tends to be light, making it easier for keyword-reading software programs to move stocks up and down. Unfortunately, this illiquidity and gamesmanship may make stock prices choppy until the fourth quarter, when volume increases and seasonal strength returns.

For this reason, continue playing defense until there’s more conviction, but begin using down days to buy. Start with small positions, then increase your long-side bets if those smaller positions are working. Also, use stops on long and short positions to contain losses, shrink your timeline on short positions, and lengthen your timeline on longs.

As for sector exposure, recessionary-stage stocks and selectively, early-stage stocks should be your focus. Historically, healthcare does well in a recession, so concentrate attention there, particularly on stocks growing double-digit percentages on the top and bottom line trading above their 200-day moving average.

It’s still a bit early to buy technology stocks. However, it is a good time to add them to watch lists. Increasingly, my screens are finding interesting ideas in the sector that are growing by double-digits, including solar stocks. To illustrate my point, here are some of the technology stocks I’m watching outside of solar. Each is delivering double-digit growth and trading above the 200-DMA: Harmonic Lightwave  (HLIT) , Synopsis  (SNPS) , Axcelis  (ACLS) , Digi International  (DGII) , Sanmina  (SANM) , and Silicon Motion  (SIMO)

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