A market that surges by 6% over two days to start a week and disgorges three-quarters of it by the end of it is a confused one — a hologram that refracts good employment news into monetary-policy menace, blurring newfound hope into familiar fear. Markets under stress in strong macro crosswinds move in jerky, dramatic ways because asset prices need to travel far to locate a buyer or seller with conviction at any given moment. While the simple story of Wall Street 2022 is, “Don’t fight the Fed, or the tape,” after a near-25% S & P 500 loss and the worst stretch for bonds in decades, the behavior can be beheld differently from one eye to the next. The recent action can be described variously as a promising but messy retest of the June market lows as the valuation and interest-rate reset runs its course — or, as yet another brief moment of relief before a further cascade lower in the face of a Federal Reserve that feels straitened financial conditions are the medicine itself and not an unfortunate side effect. Among the questions it would help to have answered to sort out the plausible from the probable are these: What’s priced into markets already? Will newly generous bond yields outcompete stocks for investor dollars? Is a climactic investor panic a prerequisite for a recovery to take hold? What’s priced in? The market as a whole has repriced pretty dramatically this year, which is not say it’ll prove to be enough. The S & P 500 at the Sept. 30 low of 3585 was off 25% from the Jan. 3 peak. To reach the median decline for all recession-related bear markets since the 1930s would mean merely a 27% total drop, to 3500, notes RBC Capital strategist Lori Calvasina. The average of all such declines would mean a 32% loss and a visit to 3260. The valuation reset has been swift and significant for the S & P 500, from 21-times year-ahead earnings in January to 16 now – near the modern-day average, but from a top-down view not yet cheap. Yet, as noted here, the valuation setup remains rather top heavy, the premium accrued in the mega-cap-growth boom not yet fully unwound. Apple and Microsoft are still near 22-times forward profits, Amazon and Tesla north of 40. The equal-weight S & P 500 is now trading at 13.5. The S & P 600 Small Cap is scraping multi-decade lows in P/E, both in absolute and relative terms. There might be no contention more broadly embraced by the consensus than forecast earnings looking too high into 2023. It’s tough to dispute the notion that estimates have downside given margin pressures, surging US dollar and decelerating global growth. Yet it’s not as if analysts have been oblivious to the risks. Deutsche Bank notes that third-quarter S & P 500 forecasts ex-energy have dropped by 8 percentage points since last quarter’s reporting period. This very well should lower the hurdle for companies to meet or beat expectations, though 2023 results almost surely have room to the downside. It’s also popular to argue that higher bond yields mean equities need to cheapen a lot further, though the historical record is quite mixed on this. A model based on the two-year Treasury yield suggests valuation should compress more, but rates were higher than they are now in the 1990s and P/Es remained higher for years. The current yield on investment-grade debt indexes around 5.6% is right at the 35-year median, says Bespoke Investment Group, which hints that roughly “average” equity valuations are not far out of whack. It truly does come down not to stock-vs.-bond algebra but whether the Federal Reserve is intent on throttling the economy and driving a recessionary decline in corporate profitability. With both nominal and real yields up a lot in just several months, a new cautious argument is emerging that bonds will now present stiff competition against equities. This is a reverse of the TINA (There Is No Alternative) case that stocks were rising in the 2010s because bonds offered minimal yields. But this idea doesn’t really hold together. TINA assumed bonds offered no alternative, but yields were low because investors (and, yes, central banks) shoveled trillions into bonds, finding them a suitable alternative to stocks. And flows into equity funds were anemic for most of the time yields were near zero. The availability of decent yields now should be welcomed for anyone freshly assembling a portfolio, furnishing an income cushion to dampen price swings and permit investors collectively to shoulder more equity risk. We’re not there yet – Treasury volatility is unnervingly high, forcing disciplined capital into a defensive crouch and placing observers on alert for some kind of capital-markets stress event. But the stock market can reach an equilibrium with a new higher prevailing yield level eventually, as it always has in prior cycles. Is more panic needed? There is no single textbook manner with which bear markets end. Often there is a crescendo of panic reflected in wholesale liquidation of stocks and a desperate bid for downside protection that registers in a vertical spike in the Volatility Index to a new high near or above 40. Then there are times when a combination of time and grinding price declines continues until selling dries up and investors lose interest. Both heading into the June lows and in late September the selling intensity got toward historic washout conditions. Things can always go to further extremes, of course. The VIX has been spending extended stays above 30. Institutional equity exposures are near extreme lows approaching levels of the Covid crash and before that 2016 and 2011, according to Deutsche. Apple, utilities and other perceived havens have recently succumbed, a part of the slow-motion surrender that should occur. Fundstrat technical strategist Mark Newton, surveying the full week’s rally-and-fade act resulting in a 1.5% S & P 500 net gain, says, “Overall, the early week strength seen on Monday/Tuesday with outsized breadth still looks quite important and positive. Moreover, the Thursday/Friday pullback really doesn’t take away from the benefits of what occurred earlier in the week, as it’s occurring on much lower negative breadth than the early week breadth surge.” The decline in margin debt in recent months has just touched the “overdone” threshold, according to Ned Davis Research, which is building toward a contrarian bullish signal, though went deeper before major bear-market lows were in in 2002 and 2009. These readings are flirting with some rare “fat pitch” readings, showing that the pendulum has already swung pretty far away from confidence and greed, but aren’t quite to “Just close your eyes and buy” status. Investors would probably be relatively lucky to have this market retrenchment culminate with valuation and investor positioning having come only this far, and with the S & P 500 still up a bit over the past two years. But with seasonal factors improving and a “payback year” pretty far along, who’s to say there won’t be a break in the market’s run of tough breaks before too long?
