Unrealistic Expectations
Markets around the globe continue to reprice following last week’s Fed meeting where Powell & Co. made it clear that “higher interest rates for longer” is the present reality. The S&P 500 closed down -2.9% for the week (worst week since the collapse of Silicon Valley Bank in March) and third straight weekly loss. Same goes for the Nasdaq with a -3.6% slide – also logging a third consecutive week of losses. On a technical basis the S&P 500 is breaking down with the 200-day-moving-average at 4,190 in the crosshairs, but on a valuation basis even at 4,190 the S&P 500 would still be trading at an above average 17.5x P/E multiple. Yes, this could end up being just another run-of-the mill 5-10% pullback, but it could also be the start of something even more sinister if in fact we get the ‘hard landing’ scenario that everyone and their sister gave up on at the end of July. For those like me that lack the clairvoyance given the growing wall of uncertainties I see accumulating over the next six months a 5.6% three-month T-bill yield doesn’t look like that bad of an alternative to what is still only a 5.7% earnings yield offered by the S&P 500 at 4,200.
More on last week’s price action. The equity market is in a clear spot of trouble as indicated by the wide divergence between the equal-weight and market cap-weight S&P 500, the former up 1% ytd versus the ladder gaining nearly 13%. Michael Hartnett over at BofAML described this recent run as the ‘monopolistic bull market’ (rather catchy if you ask me) where the S&P 500 excluding the ‘Magnificent 7’ is up just 3% ytd. Take it a step further and exclude the big gains from Eli Lilly, Blackstone, Costco, Walmart in addition to the Magnificent 7 and the S&P 500’s gains for the year disappear entirely. Carter Worth of Worth Charting dug a little deeper into the concentration of the markets rally from the October ’22 lows. Using the Russell 3000 as a proxy (contains 98% of the investable equity market universe) while the index is up nearly 17% since October 13th nearly 48% of the constituents in the index are lower than they were when this rally began. That is far from a ringing endorsement that the equity market is in a sustainable new bull market and/or that the economic growth backdrop is strong.
In the past week many cyclical stocks have been breaking down, including many in the consumer services space, homebuilders, and semiconductors. The underperformance of the small-caps is particularly disturbing (Russell 2000 is down more than -11% from the July 31st closing high, roughly doubling the descent among the large-cap stocks), and along with this month’s -6% slide in the S&P 500 Industrials, seems to be back to pricing in the recession that practically every economist has stricken from their forecast.
Market breadth (measures the number or stocks advancing versus declining) looks terrible with only 30% of stocks on the “Big Board” trading above their 200-dma and less than 20% of stocks in the S&P 500 trading above their 50-dma (see chart below).
Keep in mind that many of these breadth, RSI, and technical signals are all nearing oversold conditions and depending how the stock market reacts to these conditions over the next week or two (rally or crash) will likely set the stage for the next several months. I don’t like to use the term crash irresponsibly as I do think in most cases its sensationalized or overly dramatic, but it was intentional on this occasion because market ‘crashes’ tend to occur from oversold conditions. Given the extreme volatility we’re seeing in the bond market, interest rates on the long-end of the curve blowing out, oil prices ripping, and the U.S. dollar continuing to put pressure on everything as it presses higher – the equity market and the economy are in a very fragile position where any sort of exogenous shock could set off a waterfall effect.
My advice is to remain patient and vigilant. That doesn’t mean doing nothing or doing something. It means one should stick with their plan and/or adjust it if it’s not working. There are opportunities, but things can shift quickly, and you must remain flexible with your view. Some view flexibility in an investment strategy as short-sited thinking or a lack of conviction. Some consider it to be a sign of weakness or bad analysis. It’s all those things (I used to share many of those sentiments) but having managed capital for other people for more than two decades now I’ve come to appreciate those that have the fortitude to change their minds as the facts change. Investors need to allow themselves the ability to adapt and evolve as things change – ‘marry your partner not your forecast’.
I came across a thread on “X” over the weekend that I think does a great job of accurately and objectively describing the reality of what ‘is’ and ‘has’ transpired in the equity market over the past couple of years.
I echo David’s view in that on a fundamental basis I lean firmly into the bearish camp and see more problems than solutions when I look over the horizon. However, the equity market has certainly withstood a lot of headwinds over the past 18 months. Obstacles, that when taken collectively, would send prices lower than they are today. But here we are with stock prices little changed from where they were three years ago. For some that may be a good thing and for others that may be dreadful, but at the end of the day stocks have displayed a lot more resilience (at the index level) than those with a bearish bias had expected. Perhaps it just hasn’t happened ‘yet’ and the day for reckoning awaits! Or perhaps through both time (18 months of chop) and price (a +20% drawdown in the S&P 500 in 2022 and the bond market working on the first three-year decline in history) capital markets have already repriced for the bulk of the bear thesis.
I don’t know what the right answer is. However, our work has me thinking that when the new bull market arrives its not going to look like the last cycle and it will begin with lots of stocks trading at cheap valuations – the P/E of the Magnificent 7 is 31x vs 16x for the ‘S&P 493’ and 13x for international equities (ACWI ex-USA).
As for bonds, I have to admit I’m becoming fearful at the pace of the sell-off on the long-end of the curve, the yield on the 10-year T-note is up an incredible +50 basis points this month alone and pushing 4.62% as I type. Equities have digested this move surprisingly well to this point, but I don’t expect multiples can maintain current levels with yields this high, let alone moving even higher. In addition to yields breaking out to the upside, so too is the DXY dollar index which is making a run at taking out the March 2023 highs. The combination of the two is adding to the overall tightening in market liquidity and financial conditions and will act as an albatross for the EM equity space in particular and a negative for ex-oil commodity markets. The U.S. dollar is overvalued by any measure but differentials in monetary policy expectations are a large part in any valuation in the FX market and the path of least resistance is for the overvaluation excess to become even more acute.
As for the Fed, they obviously made an overt move to take the punch bowl away with its hawkish “higher for longer” message last Wednesday and put words to forecasts as the dot-plots now show the funds rate to be 50 basis points higher than estimated three months ago for 2024 – 5.1% from 4.6%. A 50-basis point shift for long-duration asset valuations is a very big deal. The fact that real 10-year rates have soared to 2%, the highest since 2009, is a tell-tale signal to equity investors to shed exposure – which is what they have been doing in recent sessions.
I don’t think the Fed or any of us who attempt to handicap their actions and the implications on the economy can accurately get our arms around the full impacts of this tightening cycle 6 – 12 months from now. I say that with the utmost humility and curiosity. When you add it all up, Fed policy is even tighter than it looks. When you account for the effects of QT, the Fed has already de facto tightened the equivalent of +730 basis points since February 2022. In the past two years, real 10-year rates have ballooned nearly +300 basis points and there is no evidence of the U.S. economy ever in the past having failed to enter a full-blown recession in the aftermath of such a surge in inflation-adjusted borrowing costs.
Keep this in mind as you think about portfolio exposures looking out over the next twelve months because in that time window the economy and financial system will be enduring the full brunt of all the tightening of the last eighteen months. It’s the polar opposite of all the accommodation that was being doled out in 2020/2021 and boosted the money supply to unprecedented levels. It was the rising tide that lifted all boats. Everyone had pricing power and consumers’ bank accounts were flush. House prices, car prices, collectibles, crypto currencies… you name it, prices were ripping as money was cheap and abundant. This movie is now in reverse where money is scarce and expensive (30-year mortgage rates north of 7%, higher for auto loans). One company’s price hike today is another company’s price cut because there is only so much of the consumers’ budget to go around. Rationing, substitution, going without, these are all behavioral adjustments households are making in real-time now and it’s only going to become more engrained in the months and quarters ahead. Again – it now is a relative game when it comes to wages and prices. Money velocity has stopped expanding with banks shrinking their balance sheets and constricting the supply of credit and this is bumping against contraction in the monetary aggregates.
Bottomline, I still have doubts that the economy and financial markets can withstand the tightening tsunami that has been thrown at it over the last year-and-a-half. Any time I hear a talking head on any network emphatically proclaim that the U.S. won’t experience a recession because it hasn’t happened yet makes me want to throw something at the screen. Yes, those that thought it would already be underway were wrong, but such an argument is not much different than saying because we haven’t gotten any snow in Boston in December there won’t be a winter. That’s just foolish to say and lacking analytical rigor. The risk of recession is real and needs to be accounted for. Acknowledging it and prudently preparing for the elevated probability is not the same thing as saying it’s a certain outcome.
I can see an optimistic scenario as well and that keeps me balanced from getting too confidently positioned in the bearish camp. For starters, investors need to acknowledge that this wall of worry confronting us over the next couple of quarters: student loan repayment, fiscal retrenchment, possible government shutdown, UAW strike, surging gas prices, inflation remaining sticky (3%) to the upside of the Fed’s target, Europe slipping into recession, China’s lack of economic verve… are not new developments. Most of these things have been known to market participants for some time now. The more they are discussed, accounted for, and possibly hedged by market participants, the less risky they become to market prices. It’s fair to assume all these events are pretty well discounted to asset prices at the moment. Should they worsen beyond expectations, then further price adjustments are likely. Should they improve then prices would likely react favorably.
In a nutshell, as the S&P 500 slips down into the 4,200 level I’m more inclined to be a buyer of equities than a seller. A deeper sell-off down to around 4,000 would have me even thinking and acting more opportunistically. However, a decisive break below there and I would have to reevaluate, as that would suggest to me that stocks are discounting a recessionary outcome and such an outcome brings a whole other can of risks into the equation.
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