Investors are betting that the US economy will continue to grow and they’re behaving as if there’s “no recession risk whatsoever,” market research firm The Leuthold Group wrote in a note last week.
That conclusion is based on a key indicator, the S&P 500 Cyclical/Defensive Ratio, which compares the most economically sensitive sectors, like consumer discretionary, industrials, and materials, to more stable areas of the market such as consumer staples, healthcare, and utilities.
The Leuthold Group calculates this metric based on price to earnings, price to cash flow, price to sales, and price to book ratios.
Cyclical stocks typically trade at a discount during recessions because their earnings are more vulnerable to economic slowdowns. Investors, meanwhile, pay a relative premium for the safety of defensive stocks with more inelastic demand.
In May, this ratio hit an all-time high of 1.19, indicating a 19% premium for cyclical stocks relative to defensive shares. This isn’t an anomaly, as the ratio has held above 1.05 — placing it in the top 10% of historical readings — for 13 consecutive months.
The Leuthold Group
Recession fears have come down since reaching a fever pitch in April. After the announcement of a 90-day tariff pause and trade negotiations with China, the odds of a recession have fallen from 66% to 28% on prediction market Polymarket.
However, several Wall Street strategists are still concerned, as a 28% chance of recession is still higher than the long-term average of around 15%. Torsten Sløk, chief economist at Apollo, and Jamie Dimon, CEO of JPMorgan, have been ringing the bell on stagflation concerns.
According to The Leuthold Group, a 28% chance of recession is still far too high based on what the market is pricing in. Ahead of past recessions — including 2000, 2008, and 2020 — cyclical sectors were trading at steep discounts to their more stable counterparts.
The average valuation gap at pre-recession market peaks was about 25% in favor of defensives. During these recessions, the average valuation gap increased to 38%.
“Much of the recession ‘discount’ in the comparative valuations of Cyclicals occurred during the twelve months (or earlier) preceding the pre-recession stock market peak. Today, that process does not appear to have begun,” the firm wrote.
The elevated S&P 500 Cyclical/Defensive Ratio also reflects some valuation shifts that have occurred over the last few decades. Defensive stock valuations have been declining as long-term growth for consumer staples and healthcare companies slow down.
These companies now trade at a 10% discount to the S&P 500, compared to a medium premium of 10% since 1990. During previous recessionary bear markets, defensives traded at a 33% premium relative to the rest of the market, suggesting room for a defensive comeback if recessionary fears return. If this does occur, investors heavily exposed to cyclicals will suffer the most.
Investors are continuing to bet on the most economically sensitive parts of the market. As long as cyclical stocks retain their valuation premium against defensives, it seems like there’s no recession scare to be worried about.
