The longer the stock market churns in place, the more time investors have had to cogitate over the causes of what could just be a standard and needed late-summer shakeout to reset stretched investor expectations, positioning and valuation. In recent weeks, these ponderings have been filtered through late-cycle psychology, the assumption that the economic expansion is beyond its prime — and that, like a healthy but older person — might be susceptible to shocks and disturbed by sudden changes in routine. As with all Wall Street preoccupations, there’s a plausible if conjectural basis for such a mindset: Unemployment at historic lows inherently has more upside than downside from here; the Federal Reserve is either finished or nearly so with an aggressive rate-hiking spree whose full impact is yet unknown; and now long-term Treasury yields, the U.S. dollar and crude-oil prices are all pushing against the upper end of their comfortable ranges, threatening to constrict economic activity beyond the Fed’s efforts. These macro factors are testing a market that lost momentum some six weeks ago, just as the consensus belatedly embraced the “soft landing” scenario, the indexes started running hot and the mood bordered on exuberant. .SPX YTD mountain S & P 500 YTD My last column before a late-summer hiatus, published July 15 with the S & P about 1% higher than Friday’s close, began: “Enough for now? “It’s the question to consider at moments like these, with the stock indexes running hot and investor attitudes swinging from decidedly downbeat to downright optimistic over a matter of months. “To start the year, it was a bold and minority position to predict the U.S. economy could land softly, that inflation would drop fast and the Federal Reserve would ease off the brake even while growth stayed resilient. Now, especially after the sturdy June jobs report a week ago and the reassuringly cool CPI print on Wednesday, this is something closer to the prevailing view.” There’s been no net progress since then after a modest push higher, 5% pullback and partial bounce. Bull-market pullback? If the job of a bull-market pullback is to digest big gains and rebuild a wall of worry, much progress has been made. All the sentiment surveys and investor-positioning gauges have come off the boil. Money-market funds in the latest week took in $68 billion, bringing the year-to-date total inflow to $1 trillion, more than ten times the net intake of equity funds in 2023. S & P 500 consensus earnings forecasts for the coming 12 months have inched up a couple of percent since mid-July even as the index has slipped, substantiating the notion that the quarter just past would be the trough for corporate profits, which are set to resume growing on a year-over-year basis. For sure, the 10-year Treasury yield has climbed half a percentage point over this period, hovering near 4.25%, the highs of last fall and before that 15 years ago. Much of this is because of sturdy economic performance for now and the pricing in of a Fed hoping to stay “higher for longer.” There’s no doubt the market is sensitive to these yield moves, unsure how the economy and market might handle them. That’s unclear, but it’s worth recalling that last year there was a similar reflexive anxiety when the 10-year was surmounting 3%. Under the right conditions, a new equilibrium among rates, consumption and equities can be reached. And even oil, which is in a speedy uptrend, is not at absolute prices that have proven particularly painful given current wage levels. There’s an insistence among plenty of cautious market participants that stocks are only as high as they are because eventual Fed rate cuts are anticipated. This is unprovable, really. Right now, the futures markets price in a potential rate cut by May. The Fed-funds futures market looking beyond a few months is something like the preseason college-football rankings: All we have available to work with before the season starts, but interesting mostly for how exactly they’ll be proven wrong. And note that just a few months ago, cuts were priced for the latter part of this year, and the market unwinding that assumption did not kneecap equities. This persistent anticipation of a reversal in Fed policy is another sign of late-cycle psychology, of course. Yet so far credit markets are registering no real concern, last week absorbing a record pace of new corporate-debt issuance right after Labor Day without pushing risk spreads appreciably higher. Bank of America credit strategist Oleg Melentyev on Friday took no great comfort in this: “A separate development driving credit markets here is the degree of a slowdown in net credit creation to 10th percentile [in the last three months]. Never mind the hype of a $50bn in [investment-grade] issuance out of the gate post-Labor Day, as it’s a normal seasonality that happened on the back of close to record low issuance over the summer, in percent of the market terms. This is the policy transmission in action – the lagged effects of tightening gradually working their way through the system.” Melentyev is among those seeing eventual rate cuts as the escape hatch, but doubts inflation will settle down enough to allow for them, arguing, “The most important considerations arguing against this benign outcome are wages, shelter, and oil.” Add these to the deep list of things offered as worries arriving this September, along with a possible UAW strike, Federal government shutdown, student-loan repayment restart and wobbly economies in Europe and China. It’s always healthy to have a litany of concerns to keep reckless optimism at bay – and in the current case it’s a good thing these headwinds are hitting a U.S. economy that was tracking near a 5% annual real GDP growth rate to start this quarter, according to the rough Atlanta Fed GDPNow tool. 2021 pattern Whether coincidentally or not, the way the stock market is metabolizing this macro flux has taken the S & P 500 on a path remarkably similar to the one traveled in 2021 – a year with a decidedly different set of underlying conditions. In the intervening year 2022, of course, the index peaked in early January and fell into October in a near-inverse of the 2021 trajectory, so this year is in effect a rather-symmetrical rebound. Not to be too literal, but this at least would suggest some more seasonal choppiness before a potential break higher. In a similar vein, Goldman Sachs head of hedge fund coverage Tony Pasquariello on Friday surveyed the push-pull of sturdy U.S. labor market, disinflationary momentum, a patient Fed, China’s struggles, the undeniable exceptionalism of mega-cap tech and the friction created by rising yields, to conclude: “Price action over the next month will likely resemble the past month … which is to say, uneven and choppy, not altogether good nor altogether bad … and then we’ll head into a seasonally strong Q4 period with lots to play for.” Remarkably, the parallel action between this year and 2021 is occurring at nearly the same index levels as well, which has made for a prolonged stutter-step in two-year trailing returns right around the flat line in recent months. As it happens, two prior times the two-year trailing return got stuck for a while at or just above zero occurred in early 2016 and late 1994, visible in the above chart made upon request by Bespoke Investment Group. Both of those prior periods were effectively mid-cycle slowdowns, a growth scare combined with bouts of financial stress just as Fed policy was around an inflection, resolving without a recession for years. Hard to know what to make of this, but it doesn’t seem it should be dismissed without a hearing.
