Despite the U.S. economic data repeatedly "slapping" the recession argument, strategists who have predicted the internet bubble warn that a "wave of bankruptcies" in the U.S. may be approaching. Historical data shows that in a recessionary bear market, the median decline in the U.S. stock market is 32%...

From a data perspective, 2023 has been the most incredible year for the U.S. economy so far.

The unemployment rate is only 3.8%, and the U.S. economy added a robust 336,000 jobs in September. The S&P 500 Index (SPX) has risen by 7.6% this year to date, and GDP grew by an astonishing 4.9% year-over-year in the third quarter. All of this has happened amid significant interest rate hikes by the Federal Reserve.

However, Albert Edwards, the Chief Global Strategist at Societe Generale, urges investors to look beyond the aggregate data. Edwards, who predicted the internet bubble more than 20 years ago, reveals a more chilling reality about the current state of the U.S. economy.

Edwards said in a report on October 26th, "I am a very macro person, but I admit that macro data conceals the depth of the pain the Federal Reserve has inflicted on the economy, which will soon be apparent to everyone."

Edwards said, starting with bankruptcy data. This year, the number of corporate bankruptcies in the U.S. has been rising steadily.

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Bankruptcies have increased by 61% just this year. Among them, the situation for small businesses is worse, as they have less cash reserves and are more sensitive to rising interest rates.

Experts believe that many companies are on the brink of bankruptcy. The quantitative easing policy after the global financial crisis and direct pandemic stimulus measures undoubtedly provided support for many zombie companies to extend their lives," Edwards said. "But now, the sharp rise in interest rates is leading to a surge in bankruptcies, the horror of which surpasses Freddie's worst nightmares."

Note: "Freddy's Nightmare" is a horror television series in the United States.

In addition, analysts' optimism is also weak. In the ratings adjustments for S&P 500 Index (SPX) component companies, only about 40% are upgraded. Edwards said that in a new economic cycle, this number is usually 60%-70%.The credit conditions for small businesses are also in a precarious situation. Credit conditions refer to the ease with which businesses can obtain loans. Edwards noted that the National Federation of Independent Business Small Business Credit Conditions Index is at the levels it was at the start of previous recessions.

He said that this typically implies a decline in profits and a softening labor market.

Edwards said: "In my view, the notion that we are at the beginning of a new economic cycle is absurd."

Is an economic recession really coming?

With economic data continuing to be strong, it is difficult to say that a recession will arrive in the near future. However, classic leading recession indicators suggest that the economy will continue to weaken.

The Institute for Supply Management (ISM) Purchasing Managers' Index (PMI), which measures the pulse of U.S. manufacturing activity, is in a contraction range. The Conference Board's Leading Economic Index, which includes indicators such as consumer confidence, manufacturing activity, stock and bond market performance, real estate market activity, and lending activity, has been in a recession for several months. The U.S. Treasury yield curve remains inverted, with the three-month Treasury yield higher than the ten-year Treasury yield. The latter two indicators have performed well in every recession over the past few decades.

But the current economic cycle is unprecedented in many ways, considering the massive amount of stimulus measures injected into the global economy in recent years, as well as the severe labor shortage currently existing in the U.S. economy (the U.S. economy currently has over 9 million job vacancies), which may mean that despite the warning signs, the U.S. could still avoid an economic recession.

However, the longer the Federal Reserve maintains high interest rates, the higher the risk of an economic recession. Although the inflation rate has dropped significantly, it has experienced a slight rebound in the past few months, which may require the Federal Reserve to continue its hawkish stance.

What does this mean for the stock market?

Although the S&P 500 has risen by more than 7% this year, Edwards believes this is another data point that masks the true health of the economy.This is because most of the index's returns are attributed to the so-called "Magnificent 7," which are technology stocks that have seen significant increases this year. Edwards said that the S&P 500 equal-weighted index has fallen by 5% this year, proving the substantial contribution of technology stocks to the index's performance. In an equal-weighted index, the performance of the S&P 500 constituents has the same impact on the overall index. In contrast, market capitalization-weighted indices are more influenced by large companies.

He said that the weak performance of the Russell 2000 index, which has fallen by 6.5% so far this year, once again indicates that smaller companies in the U.S. economy are underperforming.

If small companies continue to be weak and many go bankrupt, as Edwards warns, it will mean that the stock market is in danger. Edwards emphasized that companies with fewer than 100 employees typically account for half of new job creation. This means that if bankruptcies continue to increase, the labor market will face trouble.

Problems in the labor market could translate into a recessionary environment. Data from RBC Capital Markets shows that historically, recessionary bear markets mean that the median percentage decrease in stock prices is 32%. However, whether Edwards' scenario will come to fruition remains to be seen.