Good morning. We have returned from the Juneteenth market holiday and are now anticipating Jay Powell’s appearance before Congress tomorrow and Thursday. The Federal Reserve is currently at a critical juncture in the tightening cycle, where the balance between jobs and inflation becomes more apparent. Powell may be influenced by political pressure, but which direction will he lean? Share your thoughts with us at [email protected] and [email protected].
Exiting Bear?
Determining the beginning of a bear market is relatively straightforward – a 20% decline, accompanied by a pervasive sense of fear. However, identifying the end of a bear market is more challenging. The obvious choice is a 20% increase, but the baseline selected is significant. By measuring against last October’s market low, the S&P 500 has now risen over 20%:
It is important to note that the 20% threshold is arbitrary. What truly matters is market momentum and whether a sustainable upward trend has been established.
Our initial response, shared by many we have spoken to, is skepticism. Earnings are declining, and although the economy has been surprisingly resilient, it is undoubtedly slowing down. The inverted 3-month/10-year yield curve, a reliable indicator of an impending Fed-induced recession, remains steep. Furthermore, the S&P’s gains this year can be attributed to seven tech stocks, largely driven by the artificial intelligence theme trade.
However, according to conventional market wisdom, a despised rally is likely to continue. The fact that investors are underweight in stocks suggests that they may have a change of heart (“stocks climb a wall of worry,” “be greedy when others are fearful,” etc.). Therefore, it may be useful to present a rational argument both for and against declaring the bear market dead.
Ding, dong, the bear is dead
Inflation expectations are gradually stabilizing. While inflation is detrimental to bonds, it also negatively impacts stocks. However, market-based measures of expected inflation are currently decreasing, paving the way for improved equity performance. The following charts depict the decline in five-year break-even inflation, Cleveland Fed’s two-year inflation expectations model, and the University of Michigan consumer survey of 12-month inflation expectations:
Volatility is subsiding across equity, bond, and dollar markets. This reduction in volatility bodes well for investors and, consequently, stock valuations:
The recent rally has broadened, with stocks beyond the popular seven mega-cap tech stocks beginning to rise. This suggests that there is more substance to the rally than just AI hype:
Profitability is expected to increase, as noted in recent Bank of America reports. The author argues that stocks, which have fallen out of favor compared to bonds, could benefit from higher dividends. This is supported by charts indicating a rise in capex and a shift in management focus towards protecting margins and increasing dividend payouts. The report concludes with a bullish forecast: “We are off of [zero interest rates] and real yields are positive again, volatility around rates and inflation has subsided, estimate dispersion (earnings uncertainty) has declined and companies have preserved margins by cutting costs and focusing on efficiency. After a fast-hiking cycle, the Fed has latitude to ease. The equity risk premium [ie, the compensation stock investors receive over risk-free bonds] could fall from here.”
The bear is only sleeping; don’t poke it
Wouldn’t it be wiser to invest in bonds instead? Two-year Treasuries offer a 4.6% yield, which, considering an anticipated inflation rate of 2-3%, provides a favorable real yield with minimal credit risk and moderate duration risk. In terms of credit risk, corporate bonds look incredibly cheap compared to stocks, as demonstrated by the significant yield difference between Baa industrial corporates and equities:
Sentiment has improved. Despite a previous assessment of sentiment as “putrid,” sentiment surveys now indicate a more optimistic stance among investors. The AAII individual investor poll shows a bullish trend, implying there may not be much “wall of worry” left to overcome:
An earnings crunch is imminent. The average S&P earnings recession has bottomed out with a 16% YoY contraction, currently sitting at a 2% contraction (6% if measured from peak to trough). Fixed costs and rising labor costs amplify the impact of falling sales on earnings. While S&P 500 sales have not yet contracted, it appears inevitable given the economic slowdown predicted by the yield curve. This may entice investors into a trap, as Doug Peta of BCA Research highlights: “The delay in the earnings decline will exert considerable pressure on underexposed professional asset managers, whose compensation and continued tenure is based on their relative short-term performance. Positive economic surprises will be accompanied by flows into equities (from cash) and rotation within equities (from defensive sectors to more cyclically exposed sectors).”
Bear markets typically have bear market rallies, and this appears to be one of them. The 2000-2002 bear market took 25 months to hit its ultimate bottom, with three significant bear market rallies along the way. The current bear market, which is 18 months old, has also experienced false optimism, most recently in August 2022. Strategas’ Nicholas Bohnsack argues that the previous rally was a 17% bounce spread over two months, only to be thwarted by high inflation, expensive valuations, and tepid growth. With these same factors still in play, a reversal could be imminent.
Our perspective
We strive for simplicity in our analysis. As long as the economy and earnings continue to exceed expectations and slow down at a more gradual pace, stocks should maintain their positive momentum. This suggests that the bear market may be over. However, rate policy operates with a lag that is difficult to predict, and excess household savings are decreasing at an uncertain rate. In other words, we prefer not to bet against the three-month/10-year yield curve, which leads us to believe that within the next two or three quarters, positive surprises will be scarce. If we are indeed in a new bull market, we cautiously predict that it will be short-lived. (Armstrong & Wu)
One good read
Yum.
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