Good morning. We’re back from the Juneteenth market holiday, just in time to see Jay Powell appear before Congress tomorrow and Thursday. It’s always a bit of a clown show when the Fed chair goes to Capitol Hill, but this time the circus might matter. The Federal Reserve is reaching a decisive point in the tightening cycle, when the trade-off between jobs and inflation should sharpen. Political pressure could nudge Powell, but which way? Send us your thoughts: firstname.lastname@example.org and email@example.com.
A bear market’s beginning is easy to identify: by the standard definition, it’s a 20 per cent decline, accompanied by a general feeling of dread. Calling the end of a bear is harder. Up 20 per cent is the obvious choice, but the baseline you pick is consequential. Well, the S&P 500 has now risen more than 20 per cent, if you measure with the most flattering baseline, comparing today to last October’s market low:
Of course, 20 per cent is an arbitrary number. What matters is that markets have momentum, and the question is whether it is more likely than not that a durable upward trend has been established.
Our reflexive response — one that many people we talk to seem to share — is scepticism. Earnings are falling. The economy, while surprisingly resilient, is undoubtedly slowing. An inverted 3-month/10-year yield curve is undefeated as an indicator that a Fed-induced recession is on the way, and it is deeply inverted now. And all the S&P’s gains this year have come from seven much-hyped tech stocks, largely buoyed by an artificial intelligence theme trade.
The problem is that, according to received market wisdom, a hated rally is likely to continue. Hatred means there are a bunch of investors out there who are underweight stocks, and who might change their mind (“stocks climb a wall of worry”, “be greedy when others are fearful” etc etc ad nauseam). So we thought it might be useful to take a level-headed argument for and against declaring the bear dead.
Ding, dong, the bear is dead
Inflation expectations are coming under control. Inflation is awful for bonds, but it is bad for stocks too, and market-based measures of expected inflation are trending down, clearing the way for better equity performance. Here is a chart of five-year break-even inflation (the five-year Treasury yield minus five-year inflation-protected Treasury yields), Cleveland Fed’s two-year inflation expectations model and the University of Michigan consumer survey of 12-month inflation expectations. Despite a shortlived jump in the Michigan survey, all are now down and falling:
Volatility is falling. Indices of equity, bond and dollar volatility are all coming down. That is good for investor nerves and, therefore, stock valuations:
The rally has broadened recently. Since the start of this month, stocks other than the sexy seven megacap tech stocks have started to move up, suggesting there is more to this rally than AI hype:
Profitability is set to rise. This is the argument made in several recent notes (one titled “Bye bye, bear”) by Bank of America’s Savita Subramanian, one of Wall Street’s noted optimists. Her starting point is this troika of charts, showing that stocks, which have fallen out of favour versus bonds, could get a boost from chunkier dividends:
Subramanian thinks companies are starting to prioritise efficiency in ways more prosaic than grand bets on chatbots. Capex has roared, shooting up 14 per cent year-over-year in the first quarter. Higher interest rates and labour costs are in the meantime shifting management focus to protecting margins and raising dividend payouts, making their stocks more attractive relative to bonds.
She sums up the bull case (emphasis hers): “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 you just rather own bonds? A two-year Treasury pays 4.6 per cent. If you think inflation will be in the 2-3 per cent range before long (a lot of people do), that’s a nice real yield with no credit risk and moderate duration risk. If you want credit risk, corporate bonds look very cheap indeed compared to stocks, according to Scott Chronert and his team at Citigroup. They point out that the yield versus equities in Baa industrial corporates are 2.5 standard deviations above their five-year average — making stocks look quite expensive relative to corporate bonds:
Sentiment is not that bad any more. Chronert of Citi declares that sentiment as judged purely by flows into equity funds as “putrid.” But sentiment surveys tell the opposite story. The AAII individual investor poll is now well into bullish territory, suggesting there is not much “wall of worry” left to climb:
The earnings crunch is coming. Mike Wilson at Morgan Stanley notes the average S&P earnings recession has bottomed out with a 16 per cent year over year contraction; we’re now at a 2 per cent contraction (6 per cent if you measure peak to trough). Operating leverage applies: fixed costs and expensive labour make falling sales deadly for earnings. S&P 500 sales have not contracted yet, which looks inevitable as the economy slows into the recession that the yield curve so unambiguously predicts.
Short-term economic strength and surprisingly resilient earnings may therefore draw investors into a trap. As Doug Peta of BCA Research pointed out in a note this weekend, “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 have bear market rallies, and this is one of them. The 2000-2002 bear market took 25 months to finally bottom, with three major bear market rallies along the way. This bear market, which is 18 months old, has seen false dawns too, as recently as August 2022. That rally, argues Nicholas Bohnsack and his team at Strategas, was a 17 per cent bounce spread over two months, but was ultimately killed by too-high inflation, too-expensive valuations and too-modest growth. With all three ingredients arguably still in place, a reversal could be coming.
What we think
We try to keep things simple around here. So long as the economy and earnings surprise to the upside — so long as they slow down more slowly than expected — stocks should keep their impressive momentum. That suggests the bear is over. But rate policy works with a (hard to predict) lag and excess household savings are declining at a (hard to measure) rate. To put the same point another way, we do not like to bet against the three-month/10-year yield curve, and so we still think it is more likely than not that in two or three quarters, we will be all out of positive surprises. If we are in a new bull market, our not-very-confident guess is that it will be short. (Armstrong & Wu)
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