Is a Recession Priced Into Stocks?

Is a recession already priced into stocks? Well, that depends. There are certain sectors that have already discounted a recession and there are some that have not. The haves and have nots. Additionally, within each sector, there are specific industries that are attuned to economic developments and some that are not.

Without getting too detailed, let me summarize and then expound on a specific example.

Industries that have largely embedded a recession scenario: Hardlines Retail, Apparel, Transportation, Steel, PVC Chemicals, and Telecom.

Industries that have little, if any, recession risk embedded: Electrical equipment, regional banks, softlines retail, airlines.

If you haven’t figured it out, list number two is the one to avoid, if you think we will experience a recession.

Here is a list of stocks, primarily cyclicals, that should do well if we have a “soft landing” scenario: ACN, AEO, ASH, BA, CAKE, CIT, FCX, LEH, LOW, MAN, MRO, MU, JWN, OMX, OSK, PRU, STX, RIG, X.

On the other hand, here is a list of stocks that are currently discounting little recession risk, that could underperform if we do get a recession: C, DIS, WLP, S, AMZN, PCP, EOG, TXT, WM, WY, AMP, HOG, NTAP, BEAS, ACI, CENX, TMA, YRCW.

And here are your defensive plays that should do relatively well, even in a downturn: APD, AA, APC, CELG, CNP, CL, CEG, CVS, XOM, FPL, GOOG, HPQ, HNZ, INTC, JCI, LMT, MCD, MCK, NWS, NKE, PEP, QCOM, LUV, SPLS, UPS, TEVA, UTX, UNH, VZ, WMT, WYE.

Not Your Father’s Shit

Now, let us turn to the important matter of Fertilizer stocks, as an example. These stocks are not pricing in a recession. They are too busy banking coin and pricing in a boom. Driven primarily by Asian demand, and to a lesser extent, alternative energy, industry growth has dramatically overshadowed the normal cyclical nature and the high energy costs.

Historically, the correlation between GDP growth and domestic fertilizer consumption is not high to begin with. The global relationship, while stronger, is not overwhelming either. I would also argue that the global correlation is rapidly declining due to emerging market development. As markets develop, their demand becomes less GDP sensitive and more correlated to population growth and other factors.

If we look back to the past two recessions, we see mixed messages regarding consumption of fertilizer in North America. Nitrogen consumption increased in 1990-91, but declined in 2001. Phosphoric acid consumption declined in 1990-91, but gained modestly in 2001. And the third major category of fertilizer, potash, declined in 1990-91 and consumption was flat in 2001. But what should matter most to investors is whether domestic producers benefit from consumption trends, which makes looking at North American operating rates more relevant.

Moreover, the fertilizer industry has undergone some significant structural changes which have served to dampen the cyclical nature relative to historical trends. Declining economics in nitrogen and phosphates has led to meaningful capacity rationalization, while improving dietary trends in third world regions has been a boon for potash demand. Additionally, corn-based ethanol demand has benefitted domestic producers.

Much of these trends appear to be relatively insulated from a decline in U.S. GDP. What should not be overlooked, however, is the highly global nature of the fertilizer industry, and the potentially more relevant threats associated with economic weakness in third world economies. These risks are somewhat modest since GDP only sets in motion the underlying drivers of new demand above and beyond population growth. And, the impact those drivers have on food demand unwinds only slowly. The picture isn’t so bleak. Odd, no?

But where could we be wrong? Where is the downside? Regardless of the U.S. economic trends, fertilizer consumption and operating costs should remain fairly constant. But, a modest decline in pricing power is possible if the economy creates a situation where farmers become more cost sensitive. Presently, they are driving brand new pickups and drinking rich man’s whiskey. If that is your concern, take a look at Mosiac (MOS), which has lower exposure to U.S. and Canadian demand.

MOS gets only about 40% of its revenue from North America, while Potash (POT), Agrium (AGU) and CF Industries (CF) get roughly 70%, 85% and 90%, respectively.

Should we be concerned about valuations? Currently, valuations are well above any historical norm because strength in the market is weakly correlated to economic activity. Potash and phosphorous producers are in a relatively good position to cut back on supply if markets begin to get sloppy.

Know this: a U.S. recession is not a substantial risk to fertilizer stocks. However, a reversal in economic growth in China and India is. But even then, the risk of a sharp drop in consumption is limited because grain supply worldwide is so low and shifts in the workforce of those countries makes changes in demand less likely to slacken.

In summary, buy that shit.