As 2023 dawned, the market setup looked sharply askew in a negative direction, in terms of recent performance and investor expectations. The S & P 500 had just sustained its worst calendar-year loss in half a generation. Professional economists as a group projected record-high odds of recession as of Dec. 31. Investors were racing into cash-equivalent vehicles which offered the enticing novelty of 5% yields. Those playing in stocks overwhelmingly favored the defensive sort, with a crowded consensus believing the old favorites of Big Tech would remain out of favor. It presented a rather clear chance for an assertive contrarian approach — perhaps emboldened by the strong rebound rally off October’s bear-market low — to reach for the most-punished, aggressive stocks while betting that the economy could hold up even as the Federal Reserve gradually lifted interest rates toward its yet-unknown ultimate destination. As noted here in January , such a case was taking shape, though it appeared a highly contingent and fragile one in need of further confirmation. Yet after a near-15% total return for the S & P 500 so far this year led resoundingly by those old Nasdaq favorites, a swing toward greater bullishness by investors, a wider adoption of the “soft landing” economic scenario and a Fed in a data-dependent holding pattern, the market is on more even footing and the risk-reward tradeoff into the second half is a closer call. Textbook consolidation Last week’s modest 1.4% decline in the S & P 500 did little to alter either the favorable underlying market trend or the notion that more consolidation might be in store. The action was textbook in several ways, the indexes hotly overbought coming into the June 16 monthly options expiration, the week following the June expiration historically weak and sentiment and investor positioning having migrated toward more optimism and risk seeking. The long-running weekly Investors Intelligence survey of professional market-advisory services has burst higher from persistent bearishness toward the upper range of net bullishness. The chart here shows this gauge mostly reflects underlying market action itself, and when at similar levels following a long stretch of subdued attitudes has typically not lined up with a significant market peak. Ned Davis Research chief U.S. strategist Ed Clissold made a similar point as his firm’s short-term sentiment composite readings climbed into bullish territory: “A cyclical top rarely comes when sentiment barely reaches the optimism zone. Instead, look for the sentiment composites to remain in excessive optimism in the face of bad news as a sign that the market has reached the top of the wall of worry.” Climbing the wall of worry Importantly, Wall Street has worked hard in the first half to add levels to that worry wall as some bricks fell away. In January, the complaint about the New Year’s rally was the outperformance by “junky” speculative stocks, even though this is true both in new bull markets as well as fleeting head-fake rallies. In February, hot January jobs data had the Fed supposedly jacking short-term rates to 6%. March brought the SVB Financial failure and talk of a sudden credit crunch. By April, the market recovery was being assailed for being too narrowly dependent on a few mega-cap tech names, while as soon as the debt ceiling deal was reached in DC, a fresh scare story was spun about the Treasury sucking dangerous amounts of liquidity from markets as it furiously issued debt to rebuild its cash stash. I’ve generally pushed back against each of these whipped-up perceived threats, not because they presented no hazard but because the crowd rushed so quickly to propagate them, which said more about investor skittishness than the imminence of the danger. That being said, it seems as if the recent rally, the draining of volatility from the tape and the decent run of economic data lately have made investors less prone to searching for the next nasty catalyst, another sign that the bull-bear debate is on more even footing. This isn’t quite the same as saying “everyone is bullish.” The median year-end S & P 500 target among Street strategists is 4250, 100 points below Friday’s close, and the most-bullish forecast is for about a 5% further gain. Overvalued already? Sure, the AI-driven speculative energy has washed over the limited number of big stocks geared to that theme, sending Nvidia stratospheric. But it all only got rolling seven months ago. We haven’t even seen a parade of IPOs to capitalize on the fever yet, and no genuine mania worthy of the label lacks those. Still, stocks have rapidly recaptured a big chunk of the valuation decline achieved by last year’s bear phase. The Nasdaq 100 peaked in November 2021 at 31-times forecast 12-month earnings, bottomed just under 20x and has raced back up to 27x. Arguably the old peak was even higher, given that earnings in the following year fell short of expectations. So if profits are poised to come through as anticipated in the next year perhaps the index is a bit farther from that valuation apex. And just as the market’s performance has been skewed toward these hit hyper-cap tech stocks, so is the S & P 500’s valuation. WisdomTree CIO Jeremy Schwartz last week noted that outside the “expanded tech sector” — the traditional grouping before S & P carved away many Internet stocks — the rest of the index now trades right at its 30-year median forward P/E of 16.7x. As all this shows, the bullish factors are no longer unequivocal or unrecognized, while the bearish inputs carry asterisks detailing possible mitigating elements. Without bestowing any undue authority on them, the traditional antecedents of an economic recession such as the long-inverted Treasury yield curve and steep decline in the Leading Economic Indicators are probably best not dismissed either. There’s a decent case to be made that the market did a fair bit of work anticipating a slowdown last year, and even now with cyclical weathervane stocks such as Capital One Financial, General Motors, Whirlpool and Best Buy all down between 30% and 40% over the past two years. RBC Capital strategist Lori Calvasina was early in espousing this view and has even invoked the late-1940s cycle in which the stock market essentially ignored a brief recession following the post-World War II inflation shock and fiscal retrenchment. An intriguing, but as-yet untested, take. .SPX 1Y mountain S & P 500 1-year Big picture: The market this year has chewed through plenty of perfectly valid excuses to falter without doing so. The main indexes are in a clear uptrend, digesting an upside overreach in the short term, the S & P 500 still comfortably above its 50-day average yet nearly 10% below where it traded 18 months ago – when U.S. nominal GDP was 15% lower and the Fed was about to jack rates up by five percentage points in record time. Meantime, housing activity and industrial production seem already to have begun their rebounds. There seems no fat pitch about to be delivered, but Bespoke Investment Group on Friday addressed the hard-to-trust economic outlook alongside the reassuring tape action: “As we say time and time again, when the signals are mixed, we’ll always defer to the market. At this point, the market still hasn’t even broached the prior highs from last August, so the bulls still deserve the benefit of the doubt. Given the economic and interest rate backdrop, though, investors should hang on to, and even consider shortening, the leash.”
