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.
Green shoots
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.
Marketwatch 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.
” This is an indication that the bond market is now shifting from fears of Fed tightening to fears of an economic slowdown.”
Cam,
HYG also had a good run in parallel. That could not be because of fears of an economic slowdown.
May be the rise in treasury prices is also an indication of something else. Too far too fast (of a rise in yields)? The Fed won’t tighten too much?
JPMORGAN’s Chief US Equity Strategist’s take:
Dubravko Lakos-Bujas, the bank’s chief U.S. equity strategist, noted Friday that “market internals point to an extremely bearish setup, suggesting investor sentiment is already very negative and portfolios are defensively positioned for end of cycle and a recessionary outcome.”
“Anything short of a recession will likely catch most investors completely wrong footed, in our view, especially after broad and severe drawdowns that are 75% of the way to prior recession bottoms,” he said.
Stocks have been under pressure this year as rampant inflation and tighter monetary policy from the Federal Reserve have raised concern over a potential recession coming. This, according to Lakos-Bujas, has led investors to load up on defensive names and shun cyclical and growth names. However, the scales may have tipped to far in favor of defensive positioning.
“At the current juncture Defensive stocks possess valuation risk while flushed out Cyclicals / Growth / Small-caps are presenting an increasingly attractive risk/reward,” the strategist said. “Investors are likely to rotate out of Defensive stocks if this sell-off proves to be another mid-cycle scare.”
The consensus on Wall Street is not that the economy will fall into a recession, but a recent slate of softening economic data and persistently high inflation has added fuel to worries over a severe slowdown in the economy.
Either way, Lakos-Bujas sees energy as the best “risk-reward sector under both outcomes, and a sector that provides stronger growth prospect, improving quality, attractive valuation, and rising shareholder return.”
Morgan Stanley’s Mike Wilson recently put a year end target of 3900-4100 implying lot of choppy action.
No one really knows how it all turns out. I am inclined to be cautiously optimistic. Waiting to read what Cam has to say about the 6%+ rally this week.
Thanks for posting.
When was this opinion written? After this week’s rally? Does JPM also have a YE target?
Most people think of this as a bear market rally that won’t have legs.
This note came out yesterday. He’s basing it on near recession positioning in the market.
I posted it to share other views that I come across.
I have the same data feed and others.
Summary:
1. Hedgies, institutions, retails all abandoned the cyclical/growth trades. Totally lopsided.
2. Retails sold almost all of more speculative names.
3. Three days of NYSE up volume > 80%. A plus.
4. All major indices bounced off respective VWAP lines from COVID low. A major relief.
5. This is a short-covering and pair-trade reversal rally, evidenced by meme stocks rally, e.g. GME.
6. ETH and BTC did not participate in the rally and continued to lose ground. One more step toward final bottoming.
7. Private funding dried up. Deals dried up. Another positive step.
8. Watch for diesel price for improvement in inflation.
The +8% rally from recent lows on three successive 80% upside days may mark a trend reversal – but personally it also seemed like a good time to cut losses I incurred during the month of May.
If a trend reversal has started, there’s plenty of time to board the train – IMO Friday’s close will not in retrospect be seen as an attractive entry point.
Agree, too many investors conditioned to buy the dip, although this rally could have some legs.
Cam,
Given the strength in the US job market, it is hard to imagine a deep recession, IMHO.
Also, we might have a (shallow) recession based on real GDP, the nominal GDP may still stay positive given relatively high level of inflation.
Do you agree? Will it impact your view of the US stock market since the prices are based on nominal numbers?
Initial jobless claims have been bottoming and they have started to climb.
Watching NFP this coming Friday. The labor market should begin to cool about now. Expectations is 320K vs. 428K in March. The Fed will also be watching average hourly earnings. Will it slow down or accelerate?
They can rationalize price action, no matter what happens.
Really all you can do is follow the trend, but the trend can change when you least expect it. I think this is where the lure of bottom and top picking originates.
Looking at a chart from 2009, we are still in an uptrend, even 2020 did not break that uptrend (depending on how one makes the channel, if the lower part goes to march 2009 lows , no break, if to the lower part of 2011, a very brief break which would be interpreted bullishly), so where are we? Well, if we go sub 1600 then they will say we were in a bear, if we head sideways or up we could be anything, but looking at the scale of things, we could still be in for more of a rally because they usually show on weekly charts which means they have to last weeks.
What is certain is the the federal deficits will continue. Talk about cake and eat it….we want to print more so we can borrow more but we want the currency to maintain it’s purchasing power.
So what are prices telling us? Why is TLT:JNK still in a down trend? Admittedly it was at this level in Oct 2018 and then went in an uptrend until the Covid low.
Remember when the Fed said that because inflation had been so low that a catch up period of greater than 2% would be good….what happened to that?
The only thing I am sure of is that federal deficits will continue for as long as the government can pull it off. Who will stop them? Will the average person shoot themselves in the foot and choose what is in the box “Depression”? Lets forget about social security, medicare, etc etc for 10 years to pay off the debt? Not gonna happen.
So long term we get money printing until planet of the apes….but the Nikkei could show us what to expect
Putin Says Russia Open to More Talks With Ukraine
https://www.wsj.com/articles/ukraines-troops-could-abandon-key-eastern-stronghold-regional-leader-says-11653737308?mod=hp_lead_pos8
There are signs of budding peace here.
This is a standard old communists’ playbook. By “talks” it means things are not going by plans and need time to adjust. Both Russia and Ukraine need time to adjust. It is going to be very bloody and lengthy.
Both sides are now fighting in ways that slowly and surely going beyond traditional military styles. Russia is here to wipe out Ukraine in any which way possible. In old days Russia probably can achieve that. Perhaps more difficult today.
Russians and Ukrainians are for the most part from same origins. Ukrainians are capable of what Russians can do. I hope that it won’t get to the point that Ukrainians feel that all hope is lost and there is nothing to lose. Then you will see the feared asymmetrical warfare got taken to Russian land. Nothing is off limits, even the most dreaded germ/virus warfare. Very easy to take the fight to Moscow and St Petersburg. How can you stop determined people who are not afraid of death?