Equity Market Strength is Masking a Recession | Mike Green

Current equity market strength, largely propelled by the mechanics of passive investing, is dangerously masking significant underlying economic weaknesses that point towards an impending or already active recession, according to Mike Green, Portfolio Manager and Chief Strategist at Simplify. This divergence between financial market performance and real economic health creates a precarious situation for investors and policymakers who may be misinterpreting market signals.

Key Insights

The Passive Juggernaut: Equity Strength Driven by Flows, Not Fundamentals, Masking Recessionary Undercurrents

Mike Green argues that the resilience and current valuations in the equity market are less a reflection of robust economic fundamentals or a productivity miracle, and more a consequence of the structural dominance of passive investing. With passive strategies now commanding over 50% of the U.S. stock market, their influence on market dynamics is profound.

"If you look at things like leading economic indicators, the only real positive contribution has come from the stock market... what I think people are trying to explain is the strength in the stock market. And for me that's much more about the growth of passive than it is about the level of interest rates or the productivity potential for the US economy." - Mike Green

Green highlights that as passive investing gains market share, valuations tend to accelerate upwards. This is partly due to the price-insensitive nature of passive buying and a significant multiplier effect: he estimates a dollar flowing into a passive investment can have a $17 to $20 impact on market capitalization, whereas a dollar redeemed from an active fund has only about a $2 impact. For mega-cap stocks, which dominate passive indices, this multiplier can be even more extreme, potentially $90 to $100 for every dollar invested. This mechanism allows the stock market to rise even amidst stagnant employment or weakening economic data, as it's primarily driven by flows replacing active managers with strategies that buy what has recently performed well.

The danger, Green points out, is that this market strength is increasingly used by policymakers to gauge economic health, ignoring other evidence of weakness. Should these passive flows reverse—perhaps due to widespread job losses impacting retirement contributions or an aging demographic beginning to withdraw assets—the market could face a rapid and severe correction, as the underlying economic supports are not as strong as equity prices suggest.

The High-End Consumer's Retreat: Stimulus Hangovers and Income Stagnation Signal a Spending Slowdown

While the high-end consumer has shown resilience, Mike Green contends this strength was largely an artificial byproduct of specific wealth transfers and is now showing clear signs of faltering. He attributes past robustness to factors like the significant income transferred to wealthy individuals from government coffers due to higher interest rates on their cash holdings, and the remnants of pandemic-era stimulus programs such as the Paycheck Protection Program (PPP) and Employee Retention Credit (ERC).

"My assessment for why that [high-end] consumer is so strong... I actually think that the Fed hiking interest rate by and large has transferred a significant fraction of income from the government coffers to the hands of those who are very wealthy... We're now seeing pretty strong signs that that's starting to falter." - Mike Green

This period of elevated spending is drawing to a close, with weakness emerging in areas like travel and leisure. The "rage spending" or "payback spending" seen post-pandemic lockdowns is dissipating. More fundamentally, Green points to anemic growth in real incomes and, critically, employment. He sees no major new fiscal stimulus on the horizon; the extension of Trump-era tax cuts is largely offset by the economic drag from increased tariffs and the resumption of student loan repayments, which he likens to a tax on consumers.

The implication is that sectors heavily reliant on high-end discretionary spending are likely to face significant headwinds. A slowdown in this segment can have broader repercussions, as the high-end consumer, despite being a smaller group, accounts for a substantial portion of overall economic activity.

A "Boiling Frog" Credit Contraction: Gradual Tightening and Mispriced Risk Point to a Slow Burn

Mike Green describes the current credit environment not as a sudden, systemic crisis akin to 2008, but as a more insidious, gradual deterioration comparable to the period leading up to the 2000 dot-com bust. There isn't an acute banking system breakdown cutting off credit instantaneously; instead, it's a slow realization that credit quality is worse than perceived.

"This is much more of a gradual. Wait a second, we're suddenly discovering that the people we're lending money to thinking that they were high quality credits with 700 FICO scores had 700 FICO scores because we were not counting their student loan payments or we were not recognizing their buy now, pay later... FICO scores were just wrong." - Mike Green

He points to analyses, including from the New York Fed, suggesting FICO scores were artificially inflated during periods of payment forbearance (like student loans) or due to the rise of uncounted "buy now, pay later" schemes. As these realities surface, true creditworthiness is re-evaluated downwards, tightening access to credit for households. This is evidenced by rising corporate bankruptcies and increasing delinquencies in the household sector. Furthermore, private equity markets are freezing up as IPO exits become challenging, partly because passive index funds typically don't buy new IPOs unless gamed through mechanisms like SPACs, a loophole now largely closed.

While overall bank credit may appear to be rising, Green notes this growth is concentrated in "non-depository financial institutions"—the shadow banking sector—financing things like levered ETFs and private credit secondary market purchases, rather than fueling broad economic expansion. High-yield credit spreads remain tight, not due to low fundamental risk, but because of technical factors like low new issuance forcing existing funds to reinvest returned capital into a scarce secondary market. This creates a dangerous illusion of stability.

Labor Market Mirage: Beneath Headline Numbers, Job Growth Falters and AI Looms as a Disruptor

Mike Green expresses significant skepticism about the proclaimed strength of the U.S. labor market. He argues that headline figures, such as a non-farm payroll gain of 140,000, are weak for an economy of its size and are often subject to substantial downward revisions, as later data from the Quarterly Census of Employment and Wages (QCEW) frequently reveals that the initially reported jobs didn't actually exist. He also notes that the birth/death model used in payroll surveys can corrupt the data.

"And for all again, the claims that this was a very strong employment report, remember we're talking about even before we adjusted downwards for the expected revisions. You're talking 140,000 jobs gained... This is not an economy that is on fire by any stretch of the imagination." - Mike Green

Beyond the numbers, Green sees Artificial Intelligence (AI) as a significant deflationary force and a looming threat to employment, particularly for entry-level white-collar roles and routine service tasks. He describes this as the "productization of services," where AI allows companies to achieve the same output with fewer people. This is already manifesting in reduced hiring for recent college graduates. The gig economy (e.g., Uber, DoorDash) further masks true unemployment levels, as individuals may be statistically employed but consider themselves underemployed or are in precarious work. Green highlights a divergence in unemployment rates between those under 25 who are eligible for gig work in some states versus those who are not, suggesting the gig economy is absorbing slack that would otherwise appear as unemployment.

The combination of weak underlying job creation, the potential for significant AI-driven displacement, and distortions in how employment is measured suggests the labor market is far more fragile than it appears, a weakness that will eventually become undeniable and likely force the Federal Reserve to act.

The Misunderstood Inflation Picture: Why Official Data Overstates Price Pressures, Delaying Necessary Fed Action

According to Mike Green, the Federal Reserve's current stance on inflation, and its reluctance to cut interest rates, is partly based on a misreading of inflation data. He argues that market-derived inflation expectations have remained stable, indicating the Fed has not lost control of inflation. In contrast, survey-based measures like the University of Michigan's consumer sentiment survey have become unreliable, potentially skewed by methodological changes and even bot activity.

"If we look at market derived prices for inflation, we're seeing the exact opposite, right? Most of the increase is actually in real interest rates. Inflation compensation really hasn't budged... The Fed should be cutting, but they're not because they're just as scared as everybody else." - Mike Green

Green emphasizes that official Consumer Price Index (CPI) figures are being distorted upwards by "imputed prices"—categories like Owner's Equivalent Rent (OER) and the cost of portfolio management services. OER, a major component of CPI, is a lagging indicator based on a moving average of realized rents, and it remains elevated even as current market-based rent indices (like Zillow's or the Cleveland Fed's new tenant rent index) show prices falling or quiescent. Ironically, these imputed categories, not actual goods and services, are where the most persistent inflationary pressures appear.

He believes that the actual rate of change in the price level is low, with some alternative metrics like Truflation suggesting inflation is already below the Fed's 2% target. This disconnect means the Fed is likely maintaining an overly hawkish policy based on flawed or lagging data, thereby exacerbating economic stress and delaying necessary monetary easing.

Quotes

Mike Green: "My analysis suggests that valuations accelerate upwards as passive gains share. And so if employment remains strong, if we continue to move in a direction where passive is gaining share, then the stock market can rise even in a period of relatively stagnant employment, simply by replacing active managers with those who simply buy whatever has gone up the most, the most recently."

Mike Green: "The simple reality is is that manufacturing payrolls continue to contract even if I use the last non farm payrolls, which I think will be subject to further downward revisions. So I'm just not seeing the stimulus that's going to translate to the income increases that Vincent [Deluarde] sees."

Mike Green: "As AI goes further and further down the development path, we're going to find that low cost AI is probably more than adequate to solve many of the problems of converting services into products. And therefore the demand ends up being far less than we think it is."

Market Implications

Mike Green outlines several market implications stemming from his analysis, suggesting a cautious and selective approach for investors:

• Fixed Income Opportunities: He views long-duration U.S. Treasuries, particularly Treasury Inflation-Protected Securities (TIPS), as attractive, citing real yields on 30-year TIPS around 2.75-2.8% as compelling. He believes concerns about U.S. government financing are overblown and suggests that if the Fed is forced to cut rates significantly due to economic weakness, a return to a zero or even negative interest rate environment is plausible.

• Credit Market Caution: High-yield credit spreads are deemed too tight and not reflective of rising underlying risks. Green attributes this tightness to technical factors, such as low new issuance, rather than strong corporate fundamentals. Investors should be wary of chasing yield in this segment without adequate compensation for risk.

• Bearish Housing Outlook: The narrative of a persistent housing shortage is questioned by Green. He views the pandemic-driven demand surge as temporary and points to significant headwinds: unfavorable demographics (low birth rates, slowing immigration, aging boomers needing to sell homes), and the impact of teaser-rate mortgages resetting at much higher current rates, which will impair household spending ability.

• Navigating Passive Dominance: Investors need to be acutely aware of the market distortions caused by passive flows. The immense multiplier effect means that even small net inflows into passive funds can keep markets elevated, but this also implies that any reversal could lead to severe and rapid declines. The aging demographic profile of passive investors, who will eventually become net sellers, is a long-term structural headwind.

• AI Investment Cycle Parallels: Green draws parallels between the current AI investment frenzy and the dot-com bubble. He anticipates an initial phase of overinvestment and inflated valuations, eventually leading to a collapse in the price of the "commodity" (AI processing and services, much like bandwidth in the early 2000s). He posits that low-cost AI solutions will likely become sufficient for many applications, reducing the perceived unlimited demand for high-cost, cutting-edge AI.

• Digital Assets Nuance: Green sees the price of Bitcoin as largely driven by institutional adoption and flows (e.g., BlackRock's Bitcoin ETFs) rather than intrinsic fundamental value, and notes potential schisms within the Bitcoin development community. However, he distinguishes this from other areas of digital assets, expressing interest in the potential of tokenization on platforms like Solana. He specifically highlights the concept of "fiduciary tokens" – digital securities with embedded compliance and clearly defined purposes – as a genuine financial innovation, contrasting them with what he sees as less constructive innovation in the ETF space, such as the proliferation of highly leveraged products.