Now that the S&P 500 has started to turn up after bouncing off a head & shoulders downside target. Green shoots are starting to appear for the bulls, is it time for investors to buy stocks and bottom fish?
Rising recession fears
Let’s begin with why the market weakened. Recession fears were rising.
As an example, consider the recent changes in the signals from the fixed income markets. For most of 2022, both the 3-month and 10-year Treasury yields rose in lockstep as the market discounted an increasingly hawkish Fed. In early May, the 10-year yield began to fall even as 3-month yields continued to advance. This is an indication that the bond market is now shifting from fears of Fed tightening to fears of an economic slowdown.
A Google Trends analysis of searches for “recession” has exceeded the highs during the GFC, but just short of the COVID Crash. By contrast, searches for “inflation” is at an all-time high. Main Street is clearly worried about both inflation, which would cause the Fed to tighten monetary policy, and recession.
The Citigroup Economic Surprise Index, which measures whether economic statistics are beating or missing expectations, fell below zero, which is an indication of economic deterioration.
On the other hand, green shoots are starting to appear, if you know where to look. Inflation looks like it’s coming under control, which should allow the Fed to take a less hawkish path. The latest FOMC minutes indicate that two half-point hikes are baked in for the next two FOMC meetings, but the Fed would re-evaluate the situation at the September meeting.
Most participants judged that 50 basis point increases in the target range would likely be appropriate at the next couple of meetings…Participants judged that it was important to move expeditiously to a more neutral monetary policy stance. They also noted that a restrictive stance of policy may well become appropriate depending on the evolving economic outlook and the risks to the outlook.
The minutes also indicate that the staff forecast for core PCE has risen from 4.0% to 4.3% by the end of 2022. The median core PCE forecast of FOMC members, which is the Fed board of governors and regional presidents, is 4.1%, according to the Summary of Economic Projections published in March. Both core PCE and trimmed mean PCE have been at or under those levels for three consecutive months. These readings are already quite tame by the Fed’s own standards and more prints at these levels in the next few months would allow the Fed to become less hawkish.
In addition, the New York Fed
conducts a survey of consumer expectations and found that the median consumer expects inflation to fade over the next few years. Inflation expectations are well anchored and not running wild.
There is also some possible good news in equity valuation. The S&P 500 is trading at a forward P/E of 17.1, which is slightly above its 10-year average of 16.9. When the 10-year yield was trading at similar levels, the market traded at a forward P/E of 14-15.
While current valuations still appear to be a little rich by historical standards, much depends on the evolution of the E in the P/E ratio. If the economy were to weaken into recession, earnings would decline and put further pressure on equity valuation. Instead, corporate guidance has been positive, despite recent headlines from selected retailers and technology stocks.
reported that insiders have been stepping up their buying of company stock. The ratio of insider buys to sells has spiked.
Leuthold Group’s analysis of big block insider activity is also flashing a buy signal.
Leuthold Group Chief Investment Officer Doug Ramsey prefers to gauge insiders by measuring big transactions of either 100,000 shares or $1 million. He subtracts buys from sells to find “net sells” as a percentage of issues traded on the NYSE. This fell below 1% May 20, boosting this measure to “maximum bullish,” he says.
These readings are consistent with my own observation that insider buys (blue line) have recently exceeded insider sales (red line).
It’s impossible to say whether this constitutes the bottom of the current stock market pullback. Insider activity has its limitations as a market timing signal. At a minimum, these conditions should be a signal for a short-term rally. The pattern of insider buying in 2008 is an example of the limitations of insider activity as an investment signal. Insiders were early in buying in March and July. The market staged minor rallies after those instances but weakened further later in the year. Insiders went on to buy aggressively from October 2008 to March 2009. While they were on the whole correct, these signals were inexact market-timing indicators.
If the recent episode of stock market strength is a bear market rally, a template of current insider activity might be the 2015-16 period. Insiders flashed buy signals in July and August 2015 and the market staged minor rallies. Stock prices consolidated sideways in a choppy pattern and insider buys exceeded sales during the January and February 2016, which turned out to be the ultimate bottom.
Not out of the woods
While these green shoots are helpful signs, investors are not out of the woods and I am not ready to declare the May lows as the bottom for the current bear cycle.
Inflation surprise is still rising globally. While the trend in the US (red line) is decelerating, inflation is still running hot in most other countries, which will force central banks to tighten globally. As well, China is expected to experience a prolonged slowdown due to its zero-COVID policy. Can American Exceptionalism serve as a shield against a global slowdown?
While the recent rally is constructive, the Fed is still removing accommodation and quantitative tightening begins on June 1. Historically, equity returns during QT are lower than QE periods with greater volatility.
For the recession question, I present the CNN Business Op-Ed
by Lakshman Achuthan and Anirvan Banerji of the respected forecasting firm ECRI advising Americans to prepare for a recession. As well, New Deal democrat, who maintains a disciplined process of monitoring coincident, short-leading, and long-leading indicators, is calling for a possible recession that begins in Q2 2023 and he has gone on recession watch. Markets are forward looking. Current forward P/E valuations are implying a soft landing. Should a recession develop, stock prices should weaken to a bottom no later than Q3 2022, which is six months before the onset of the recession.
In conclusion, my base case scenario is this is a bear market rally and the March lows are not the lows of the bear cycle. The alternative scenario is the US economy achieves a soft landing and sidesteps a recession next year. If the market doesn’t weaken to a new low by early Q4 2022, the bottom is in for this cycle. I assign a 60-70% probability to the bear market rally and recession scenario and a 30-40% chance of a soft landing.