Investors appear unfazed by recession risks, with market behavior suggesting an unwavering confidence in continued U.S. economic growth.
According to The Leuthold Group, equity managers are acting as though “there’s no recession risk whatsoever,” supported by trends in the S&P 500 Cyclical/Defensive Ratio. This metric tracks the valuations of economically sensitive sectors—such as consumer discretionary, industrials, and materials—against more stable ones like consumer staples, healthcare, and utilities.
Historically, cyclical stocks underperform during recessions, as their earnings are more vulnerable to economic slowdowns. Defensive stocks, benefiting from inelastic demand, typically attract premium valuations during such periods. But in May, the Cyclical/Defensive Ratio reached an all-time high of 1.19, marking a 19% valuation premium for cyclical stocks. For over a year, the ratio has remained in the top decile of historical readings, signaling a strong appetite for growth-sensitive equities.
Recession concerns peaked in April but eased after a 90-day tariff pause and renewed trade talks with China. Prediction markets, such as Polymarket, saw recession odds drop from 66% to 28%. However, this remains nearly double the long-term average of 15%, prompting caution from economists like Apollo’s Torsten Sløk and JPMorgan’s Jamie Dimon, who warn of potential stagflation risks.
The Leuthold Group argues that even a 28% recession probability is inconsistent with current market pricing. Prior to recessions in 2000, 2008, and 2020, cyclical sectors traded at substantial discounts to defensives. On average, these valuation gaps favored defensives by 25% at market peaks, widening to 38% during downturns. The firm notes that this pre-recession discounting process has not begun in the current cycle.
Changes in market dynamics also play a role. Defensive sectors have experienced declining valuations over the past decades, reflecting slower growth trajectories for staples and healthcare companies. Once trading at a 10% premium to the S&P 500, defensive stocks now sit at a 10% discount. During past bear markets, defensives commanded a 33% premium, suggesting room for a rebound if recession fears resurface.
For now, cyclical stocks continue to dominate, with investors prioritizing growth potential over safety. As long as these sectors maintain their valuation premium, the market appears to be pricing in economic resilience. However, advisors should remain vigilant. A shift in sentiment could see defensives regain favor, posing risks for clients heavily allocated to cyclicals. Balancing portfolios to account for potential volatility will be key in navigating this uncertain landscape.
