By Pete Biebel, Senior Vice President
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As we gaze back at market activity over the past two months, the view is clouded with the haze created by the specter of excess speculation that so prominently characterized January’s trading. The smokescreen of the rallies in washed-out meme stocks and last year’s big losers convinced many investors to refocus their outlook to a much rosier view of the future. But, keeping things in perspective, we need to remember that short-term rallies in continuing bear markets are supposed to do exactly that: They extend long enough and high enough to convince investors that a new bull market has begun.
My point of view has been far more skeptical. My most recent article of three weeks ago, which provided several examples of what I considered to be the fishiness of the January market action, had me doubting the sustainability of the rally. I theorized then that whether this was a new bull market or just a temporary rally would likely be revealed in the next two or three weeks. Since then, the deterioration in the market has convinced me that the market established an important intermediate-term top in the blow-off rally in the first two session this month (that followed the Fed announcement on February 1). And, for reasons I’ll describe below, I believe there’s a good chance that the 2/2/23 high may have been the market’s high for many months if not for the year.
The primary drivers of that pessimism are my belief that the market will see a lower low (below the mid-October 2022 low) sometime in the next several months and my belief that our economy will be in recession later this year. Even though the future currently looks sunny, with our economy continuing to slowly expand and the unemployment rate remaining bullishly low, there are several instances of anecdotal evidence that support a gloomier outlook.
But first, let’s examine what clouds may have darkened the market’s skies recently. The big disturbance in the stock market’s ecosystem has been a fairly sudden and fairly significant change in the bond market’s expectations with respect to future Fed discount rates. The market’s expectation for the Fed’s terminal rate (i.e., the peak rate in the current tightening cycle) has spiked from 4.88% in mid-January to 5.40% now. Where the bond market had expected the Fed to stop hiking at a lower rate and to begin cutting its target rate later this year, the Fed Funds futures market is now in much closer agreement with the Fed’s own outlook. The bond market is telling the stock market to expect higher rates for longer than previously projected.
Also troubling is that the inversion in the Treasury yield curve has gotten worse. Conventionally, short-term interest rates are lower than long-term rates. When inflation expectations are high and Fed Funds rates are increasing, short-term interest rates tend to rise. When the market fears a slowing economy, long-term interest rates are depressed. A combination of these circumstances can cause short-term rates to rise above long-term rates, creating an inverted yield curve. Currently, more than 80% of the yield curve is inverted. Historically, every time the curve was more than about 50% inverted our economy has eventually gone into recession. The current state of the yield curve is indicating that a recession is almost assuredly in our future.
Historically, in the course of an economic cycle, the market always makes its low sometime after the recession has begun. Therefore, if indeed the economy is headed for a recession, then the market averages are very likely headed for a lower low. But that’s a circular argument. More damning is that, in episodes of steep drawdowns, the S&P 500 Index (SPX) always made its low sometime after the yield on the two-year Treasuries hit its peak. In other words, the market didn’t see maximum pessimism until after the economy was showing signs of slowing and rates began to decrease. The fact that the two-year yield is much higher now than it was at the October stock market low argues that we should expect a lower low on SPX later this year.
The good news is that I’ve been wrong before, and I wouldn’t mind being wrong this time. All it would take to prove the error of my theory would be for SPX to rally about 100 points above the February high. If the index can clear the 4300 level, then I would have to jump on the bullish bandwagon.
For my gloomy outlook to be wrong, the market would need an excuse to move higher. In order for the market’s valuation to increase, it would need some combination of higher earnings and expanding P/E ratios. Unfortunately, neither of those seems likely. Earnings, generally, are expected to be flat if not lower. And the current level of the market’s Equity Risk Premium (ERP) indicates that P/E expansion is extremely unlikely. ERP compares the expected return in the stock market with the risk-free rate of return available in Treasuries. As an asset class, stocks are clearly riskier than bonds. So expected stock market returns need to be higher than that available in bonds in order to compensate for the additional risk. With the available yield in short-term Treasuries already at multi-decade highs, stocks already look too expensive relative to bonds.
In the stock market, we should be prepared for things to get worse before they get better. The recent reversal in the market averages makes the early-February spike higher look like a false breakout. There’s an old market adage that big moves come from false moves, suggesting that a big move lower might now unfold. And we’re overdue for a spike in volatility. At the early-February stock market high, the CBOE Volatility Index, VIX, hit its lowest level in more than a year with a reading in the low-17s. VIX has increased a bit since then, ending last week a skosh below 22, but much higher readings likely lie ahead. Every bear market, at some point, registers a VIX reading greater than 40; through last year’s carnage, VIX got no higher than the mid-to-upper 30s.
If SPX was to fall back to its October low, it would be a decline of about 13% from current levels. Investors should be considering what actions, if any, they should take now if there’s a good chance the market could see a drawdown of 15% or more. The first step is to talk to their advisors. Perhaps some lightening up or hedging would be in order. With short-to-intermediate-term bonds offering attractive yields, such investments can provide a comfortable and temporary safe harbor for sideline cash while we wait for the storm to blow through. Another important part of the plan, and one that is often overlooked, is to establish some framework for deciding at what price levels and under what circumstances we would shift back to increasing equity positions.
SPX ended last week near 3970, down 2.67% for the week but still up 3.40% for the year. The NASDAQ Composite Index (COMP) fell 3.33%, decreasing its YTD gain to 8.87%. The Dow Jones Industrial Average (DJIA) lost 2.99% for the week, dropping its net return for the year to a loss of 1.00%. Four of the eleven U.S. equity sectors are also now showing net losses for the year, from Consumer Staples (-2.47%) to Utilities (-5.52%). The best performing sectors YTD are last year’s biggest losers and are also last week’s biggest losers. The Consumer Discretionary sector fell 4.46% last week but is still up more than 11% for the year. Communication Services lost 3.81% for the week but is still up nearly 11% for the year.
SPX is likely to find a pocket of support just below its current level in the mid-3900s. Falling below that zone would be an additionally bearish development. Falling below the mid-January low at 3885 would likely result in an acceleration of the downtrend.
The week ahead brings a shortened list of earnings announcements and a full calendar of economic reports. Today’s data on Durable Goods Orders and the Dallas Fed survey would typically not draw a lot of attention, but with the consensus expecting weaker numbers from both reports, the market reaction might be greater than normal. Tuesday’s PMI and Richmond Fed announcements, along with Wednesday’s ISM and Construction Spending data, all expect modest improvement. A little disappointment in those numbers could go a long way. The employment numbers on Thursday and the PMI and ISM data on Friday seem to be the key reports of the week.
|Monday 2/27/2023||Durable Goods Orders, January, M/M||+5.6%||-4.0%|
|Durable Goods ex-Transportation, January, M/M||-0.1%||0.0%|
|Pending Home Sales, January, M/M||+2.5%||+1.0%|
|Dallas Fed Manufacturing Survey, February||-8.4||-9.0|
|Tuesday 2/28/2023||International Trade-Trade Deficit, January||$90.3B||$89.7B|
|Case-Shiller Home Price Index, December, M/M||-0.5%||-0.5%|
|Chicago PMI, February||44.3||45.0|
|Consumer Confidence, February||107.1||108.4|
|Richmond Fed Manufacturing Index, February||-11||-5|
|Wednesday 3/1/2023||PMI Manufacturing – Final, February||47.8|
|ISM Manufacturing Index, February||47.4||47.9|
|Construction Spending, January, M/M||-0.4%||+0.2%|
|Thursday 3/2/2023||Motor Vehicle Sales, February, SAAR||15.7mm||15.0mm|
|Initial Jobless Claims||192K||200K|
|Unit Labor Costs, Q4, SAAR||+1.1%||+1.4%|
|Friday 3/3/2023||PMI Composite – Final, February||50.5|
|ISM Services Index, February||55.2||54.5|
Links to previously published commentaries can be found at benjaminfedwards.com/Latest Investment Insights/Weekly Market Commentary/Market