• Jon Wolfenbarger sees the US economy heading for a "rough recession."
  • Indicators like initial and continuing unemployment claims and loan demand show weakness.
  • A recession paired with high valuations spells trouble for stocks, he said. 

For Jon Wolfenbarger, the bearish signals for stocks continue to pile up.

Inflation remains relatively elevated, especially when looking at median CPI numbers, which the Cleveland Fed calls a "better signal" of the trend. Median CPI, which looks at the median component in the CPI, now sits around 7%. This means the Federal Reserve is likely to remain hawkish and keep interest rates high, according to Wolfenbarger, the the founder of investment research firm Bull And Bear Profits who has been warning of a significant stock market decline since late 2021.

Then there's the growing weakness in the labor market that's starting to show. For example, the number of initial unemployment claims is starting to jump at a recessionary pace, Wolfenbarger said. The four-week moving average of initial unemployment claims has risen 29% over the last eight months.

initial claims 4 week average
Federal Reserve Bank of St. Louis

Continuing unemployment claims are also up 24% year-over-year. "Anytime continuing claims increased at least 10% from the prior year, the economy was already in a recession or only a few months from being in recession," Wolfenbarger said.

On top of trouble brewing in the labor market, the recent closures of First Republic Bank, Silicon Valley Bank, and Signature Bank are fueling a pullback in lending.

According to the Fed's Senior Loan Officer Opinion Survey, 46% of banks now report that they're tightening lending standards. Both consumers and small business are reporting that it's been harder to access credit in recent weeks, which threatens to stall consumer spending — about two-thirds of the economy — and business expansion. 

lending standards
Federal Reserve Bank of St. Louis

On the flip side, demand for loans has fallen off a cliff since last year, as soaring interest rates have made borrowing less affordable. 

loan demand
Federal Reserve Bank of St. Louis

"I think it's inevitable, given what the indicators are doing, that we're going to have a pretty rough recession," Wolfenbarger said.

Wolfenbarger also cited the US government potentially defaulting on its debt as a risk, though he assigned a 25% chance of that happening. Treasury Secretary Janet Yellen has warned that the deadline for Congress to raise the debt ceiling could be as early as the start of June. 

Given his outlook for a recession, Wolfenbarger sees the S&P 500 bottoming out at 2,250. That's about 45% downside from current levels, and would be a 61% drop from the January 2022 peak. 

He said his call is driven by how high valuations remain. His preferred metric is the ratio of total market cap to GDP, or the so-called Warren Buffett indicator. The ratio is at 154%, higher than levels seen during the dot-com bubble a little over two decades ago despite the sell-off in 2022. 

market cap to gdp
Guru Focus

He also said 2,250 is where the S&P 500 would need to bottom at to restore 8% annualized returns with how high valuations are. He cited the below chart of John Hussman, president of the Hussman Investment Trust, showing that stock performance has typically suffered when the long-term outlook for returns is weak. 

stock valuations and stock performance
Hussman Funds

What others are saying

Many market onlookers have highlighted high stock market valuations in recent weeks. 

José Torres, a senior economist at Interactive Brokers, recently said in a client note that investors are not properly discounting recessionary and earnings risk.

"The forward 12-month P/E ratio for the S&P 500 is 18.1. That is substantial considering the high level of interest rates across the yield curve alongside a recession risk," he said. "As investors continue to anticipate rate cuts and fail to downgrade earnings expectations despite a potential recession, a tight labor market with hotter-than-expected employment and CPI data could have a multi-prong impact on equity valuations."

Morgan Stanley's Chief US Equity Strategist Mike Wilson, also pointed to the breadth of overvaluation in the market, dismissing the notion that tech stocks at the top of the market are inflating the S&P 500's forward P/E ratio.

He said the chart below "illustrates that the median stock multiple across the S&P is actually now higher than the index's multiple (i.e., the valuation excess is not just in the mega cap stocks)."

S&P 500 forward p/e ratio
Morgan Stanley

Calls for a recession are also increasingly common. In recent months, Wolfenbarger has pointed to popular recession indicators like the inverted yield curve and The Conference Board's Leading Economic Index as supporting evidence that a recession is on the way. Others have also cited these as evidence that a recession is imminent.

Cam Harvey, the director of research at Research Affiliates who discovered the inverted yield curve as a recession indicator, told Insider in April that his model would once again prove correct after saying in December that it would produce its first false signal since before the 1960s. He said the Fed's continued hawkishness drove him to change his mind, and that a recession "could start anytime given the lead time we've had already."

The Fed's recession probability model, which is based on the inverted yield curve, now assigns a 68% chance of a recession in the next year. That's up significantly from 57% in March, and is consistent with prior recessionary levels. 

recession probability
Federal Reserve

Last week, Societe Generale strategist Albert Edwards cited The Conference Board indicator in a note to clients, saying "the official US leading indicator tells us a recession is a done deal, not tomorrow, not next week, but today." 

The Conference Board's Leading Economic Index
The Conference Board's Leading Economic Index
Societe Generale

Wolfenbarger's call for 45% further downside is an outlier. For instance, Wilson is one of the most bearish strategists among the major Wall Street firms, and projects the S&P 500 will fall to between 3,000-3,300 this year before recovering to 3,900 by year-end.

But bubble gurus like Hussman and GMO founder Jeremy Grantham, both of whom called the 2000 and 2008 crashes, see potential for the kind of downside Wolfenbarger sees. 

Whether or not that scenario plays out depends on how deep a potential recession turns out to be. Labor market numbers will tell that story in the months ahead.