It has not paid to overthink the market situation this year, or to dismiss the time-faded book of Wall Street maxims. “Don’t fight the Fed” is most of what an investor has needed to know to set properly grim expectations for stock and bond returns — especially with a Federal Reserve so pugnacious in attacking inflation while welcoming economic injury. All the historical-pattern work ahead of time showed stocks suffer more in fast Fed tightening cycles than gradual ones, and this one has been the most rapid in decades, furnishing diversified investors with a 23% gut punch in the S & P 500 and negative 14% total return in the Barclays Aggregate Bond Index . Other rules of thumb that have held up: Markets in downtrends under their 200-day moving average feature fleeting, failed rallies, and stocks’ typical weakness in September tends to occur in the second half of the month. All these hostile conditions remain in place, reinforced by government-bond yields globally rushing to decade-plus highs, real inflation-adjusted yields crossing deep into restrictive territory for economic growth and risk-taking and the U.S. dollar rampaging skyward. Still, even selling stampedes can overshoot and eventually exhaust themselves, at least for a while. Valuations eventually adjust to dimmer realities through a combination of lower prices and passing time. And investor attitudes can tilt too far toward pessimism, even if foul tempers are the only fair response to grueling investing conditions. Guide to market retests Which brings us to another weathered Wall Street playbook, the guide to retests of a previous market low, suddenly relevant after last week’s near-5% slide in the S & P 500 took it below its previous June 16 closing low midday Friday before a partial recovery left it slightly above. It’s not exactly a scientific exercise, given that a successful retest in advance is pretty indistinguishable from the start of a fresh down leg, with only the strength and breadth of the next rally hinting at which it is. By Friday the tape certainly was flashing some oversold extremes, shades of the “so bad, it’s good” setup that preceded the powerful but ultimately short-lived June-to-August rally. The McClellan Oscillator, a longstanding indicator tracking a running tally of advancing-vs.-declining stocks, hit lows only exceeded twice in the past five years, the last time during the early-2020 Covid crash. It suggests a good bounce, at least, isn’t far off in time. Only about 17% of S & P 500 stocks are above their 200-day average, a fairly extreme reading seen only a few times in the past few years, though at the June index low this number got down to 10%. At 23% off its record high, the S & P 500 is right at the average bear-market decline in times when no economic recession has occurred. Under recession scenarios, the typical drop has stretched to 30%, with obvious downside overshoots in times of global credit crisis (post-2007) or generational bubble implosion (2000). Two years gone For sure, the prospect of a recession of at least modest depth has become more rather than less likely with interest rates growing restrictive, the Conference Board Leading Economic Indicators rolling over, the housing market wheezing and the Fed apparently poised to “err on the side of erring” by tripping the economy into a retrenchment. If the S & P 500 were to find itself within a few weeks in the vicinity of the year-to-date lows around 3650, down a percent from here, it would place the index at a level it first reached two years earlier. This is not a textbook indicator of any sort. But a fair number of downturns over the past dozen years have run their course around when the index had given up two years’ worth of gains, such as late 2018, early 2016 and in the fall of 2011. Truist Advisory Services co-chief investment officer Keith Lerner on Friday tempered his broadly cautious market stance a bit in noting the S & P had fallen around 15% in five weeks, suggesting “it doesn’t make sense to pile on to the negativity in the short term and become even more defensive after a large selloff has already occurred.” To remain or turn aggressively bearish for a trade here is to bet on some kind of financial accident or stress event – surely possible with the high-velocity asset-market moves but hard to handicap with any precision. Whatever one’s favorite bear-case downside target for the S & P 500 — 3400 and 3200 are pretty popular ones right now — it’s worth remembering the index tends not to spend a lot of time in the area of whatever the ultimate low ends up being, and the news will still be bad at the eventual bottom. In other words, the lack of any visible “all clear” moment right now isn’t itself some clinching argument for much deeper losses in stocks. Sentiment too negative? It’s an unscientific survey and a small sample size, but the number of bearish respondents to the American Association of Individual Investors weekly poll popped above 60% for the fifth time in its 35-year history. The four other times came in pairs, two in 1990 and two in the 2008-2009 bear-market climax phase. The first 60% reading was not at the decisive market low, though a year after each of them stocks were higher. For longer-term portfolio builders, lower prices mean better future returns – eventually. Lerner went back to track whether it has made sense in the past to buy the S & P 500 once it has dropped 20% from a record high. Of the nine prior instances since 1950, the short-term results were quite mixed, with positive index returns six months later only 60% of the time and some big further losses in 2008. A three-year time horizon puts odds in a buyer’s favor after a 20% decline, up every time but once with an average total index gain of 29%. Are equities still “too expensive” with bond yields here, the 10-year near 3.7%? The S & P index, maybe, at just under 16-times forecast profits, with some cross-asset models saying it should be perhaps two multiple points cheaper. Yet it remains mostly the very largest handful of stocks inflating the aggregate P/E. Outside of the five largest S & P 500 names (Apple, Microsoft, Alphabet, Amazon and Tesla), the rest of the index is closer to a 14 multiple, with the equal-weighted S & P around 13. I looked at a selection of blue-chip stocks’ forward price/earnings ratio last week compared to prior times in the past 20 years (in 2018, 2011, 2008, 2003) when the 10-year was at about today’s level. Names such as JP Morgan, Home Depot, UPS and Merck are all in line with, or lower than, their valuations from those earlier periods. The median stock in the market is in the region of fair value, even as the earnings path looks challenged — and granting that “fair” is not the same as “cheap.” None of these observations amounts to a green light and flat open road ahead for investors. Monetary tightening is happening at warp speed and the global risk-free rate has radically repriced to lift the hurdle rate for all economic and investing endeavors. Corporate profit margins are stressed. The three-year S & P 500 total return is still 9% annualized, meaning the bear hasn’t yet really cut into muscle for longer-term investors. Yet after this coming week, seasonal factors start to improve fast through Election Day, gasoline futures are at an eight-month low, the two-year Treasury yield looks overstretched and due for a pause, and “peak inflation” is a process deferred but not yet denied. We’ll see how this all plays into the feared market retest now underway.
