A market that rises 6% in two days to start a week and flushes out three-quarters of it by the end of the week is a confused market – a hologram breaking good employment news into a monetary policy threat, leaving renewed hope is faded into familiar fear. Markets under stress from strong macro winds move jerkily and dramatically as asset prices have to travel far to find a confident buyer or seller at any given moment. While Wall Street 2022’s simple story is “Don’t fight the Fed, or the tape,” after a nearly 25% loss on the S&P 500 and the worst for bonds in decades, behavior may be different from one eye to the other. The recent move could be variously described as a promising but messy retest of June’s market lows as valuation and rate resets go their way — or, as one more brief moment of relief before a further cascade lowers in the face of a federal Reserve feeling tight financial conditions is the drug itself and not an unfortunate side effect. One of the questions it would help to have answered to distinguish the plausible from the probable is: what’s already priced in the markets? Will the New Generous Bond Yields Outperform Stocks for Investor Dollars? Is a climax in panicked investors a precondition for a recovery? What’s priced in? The market as a whole has re-priced quite drastically this year, which is not to say that it will prove to be enough. The S&P 500 at its September 30 low at 3585 was 25% off its January 3 high. Reaching the median drop for all recession-related bear markets since the 1930s would only mean an overall drop of 27%, to 3,500, notes RBC Capital strategist Lori Calvasina. The average of all such declines would mean a loss of 32% and a visit of 3260. The valuation reset has been rapid and significant for the S&P 500, from 21 times its annual gain in January to 16 now – near the modern day. daily average, but not cheap from above. However, as noted here, the valuation structure remains rather top-heavy, with the premium built up in the mega-cap growth boom not yet fully settled. Apple and Microsoft are still near 22 times forward earnings, Amazon and Tesla north of 40. The equal weight S&P 500 is now trading at 13.5. The S&P 600 Small Cap scrapes multi-decade lows in P/E, both in absolute and relative terms. There may be no opinion more broadly embraced by the consensus-than-expected gains that look too high in 2023. It’s hard to dispute the idea that estimates are trending downward given pressure on margins, the rising US dollar and slowing global growth. Yet it is not the case that analysts have been unaware of the risks. Deutsche Bank notes that the S&P 500 forecast for the third quarter excluding energy is down 8 percentage points since the previous quarter’s reporting period. This should very well lower the hurdle for companies to meet or exceed expectations, although the results for 2023 almost certainly have a negative side. It is also popular to argue that higher bond yields mean stocks should fall much further, although the historical record on this is rather mixed. A model based on two-year government bond yields suggests that valuation should weigh more, but yields were higher in the 1990s than they are today and the P&L remained higher for years. Current returns on investment-grade debt indices of about 5.6% are right on the 35-year median, Bespoke Investment Group says, suggesting that roughly “average” stock valuations aren’t far off the mark. It really doesn’t come down to the algebra between stocks and bonds, but to whether the Federal Reserve intends to slow the economy down and trigger a recessive drop in corporate profitability. With both nominal and real yields soaring in just a few months, a new tentative argument is emerging that bonds will now compete fiercely with equities. This is the reverse of the TINA (There Is No Alternative) case where stocks rose in the 2010s because bonds offered minimal returns. But this idea doesn’t really hold up. TINA assumed that bonds offered no alternative, but yields were low because investors (and yes, central banks) put trillions into bonds and found them a suitable alternative to stocks. And flows into equity funds were anemic for most of the time returns were close to zero. The availability of decent returns should now be welcomed for anyone building a new portfolio, providing an income cushion to dampen price swings and collectively enable investors to bear more equity risk. We’re not there yet – government bond volatility is frighteningly high, forcing disciplined capital into a defensive stance and alerting observers to some sort of stress event in the capital markets. But the stock market may eventually reach equilibrium with a new higher dominant yield level, as it always has in previous cycles. Is more panic needed? There is no single textbook way bear markets end up. Often there is a crescendo of panic reflected in the massive liquidation of stocks and a desperate attempt to gain downside protection, which registers in a vertical spike in the volatility index to a new high near or above 40. there are times when a combination of time and grinding price drops continue until sales dry up and investors lose interest. On the way to both the June and late September lows, sales intensity reached historic washout conditions. Of course it can always go to extremes. The VIX has issued extended stays over 30. According to Deutsche, institutional equity exposures are near extreme lows approaching the levels of the Covid crash and before that in 2016 and 2011. Apple, utilities and other alleged refuges have recently succumbed, part of the slow-motion surrender that is supposed to take place. Fundstrat’s technical strategist Mark Newton, who oversees the entire week’s rally-and-fade act resulting in a 1.5% S&P 500 net profit, says: “Overall, the strength of the early week seems to on Monday/Tuesday with too large latitude is still seen as quite important and Positive Furthermore, the pullback from Thursday/Friday does not diminish the benefits of what happened earlier in the week as it occurs at a much lower negative latitude than the increase in width at the beginning of the week.” The decline in margin debt in recent months has just reached the “overdone” threshold, according to Ned Davis Research, which is moving toward a contrarian bullish signal, though it went deeper before major bear market lows in 2002 and 2009 goods. flirting with some rare “thick pitch” readings, showing that the pendulum is already quite a ways away from confidence and greed, but not quite the “close your eyes and buy” status. Investors would probably be relatively lucky if this market austerity culminates in valuation and investor positioning having only come so far, and with the S&P 500 still a bit off in the past two years. But with seasonal factors improving and a “payback year” pretty far off, who’s to say there won’t be a breakout in the market’s series of tough breaks before long?
