By Rob Edel, Chief Investment Officer | Written as of September 13, 2022
Highlights this Month
- What could this mean for investment returns in the future?
- A return of the bull market (almost).
- Market sentiment is sending mixed signals.
- Some investors are losing their taste for equities.
- When it comes to bear market rallies, size matters.
- Economic fundamentals will determine if we are still in a bear market.
- Inflation continues to play a significant role in determining the future path of the economy.
- Is there still a way to avoid a recession?
August in Review
Markets turned lower in August, with the S&P 500 down 4.1% (total return in U.S. dollar terms) and the S&P/TSX down 1.5% (total return in Canadian dollar terms). Investors, however, were disappointed by additional losses in bonds and commodities. Yields moved higher as commodity prices, apart from natural gas and currencies, moved lower relative to a strong U.S. dollar. Stocks and bond prices moving in the same downward direction, while unwelcome, have become a more common event in 2022. Until last month, investors could at least count on commodity prices to provide some degree of portfolio diversification as concerns over higher inflation pushed real asset prices higher. As stocks, bonds, investment grade bonds, high-yield bonds, and commodities moved lower in August, cross-asset holders were left with some of their poorest returns since 1981 (Bloomberg, September 2022).
At least from a nominal perspective, cash was one of the few refuges providing investors with a positive return last month, with 3-month Treasury Bill yields higher than S&P 500 dividend yields. No wonder a recent Bank of America Fund Managers Survey showed that cash is increasingly becoming a more crowded trade, with investors taking more long cash positions than any other asset class in history.
What could this mean for investment returns in the future?
Returns in June were weak, but the market bounced back in July. Now with August having provided another setback, will the bear market retake control, or have investors already seen the lows for the year? According to Bloomberg, August has never been a strong month for equity markets, with average returns for the S&P 500 over the past 30 years marking it the second worst of any month. Unfortunately, it is September which has been the worst month historically. Further, research by BMO shows that both September and October have historically been the most volatile months, containing the highest frequency of 2% and 3% daily moves in the S&P 500. BMO also points out that while September might be a poor month historically, October has often provided positive returns, especially when August was down. As we move into these historically volatile months, we briefly review the bull and bear case for markets and, more importantly, highlight the variables we believe are key in determining which will prevail.
A return of the bull market (almost).
From a technical perspective, a case for a bull market became quite persuasive by mid-August, as market breadth improved, with more than 90% of S&P 500 stocks trading above their 50-day moving average. Both FactSet and Dow Jones market data show that over the past 20 years the market has, on average, provided positive returns in the year after crossing the 90% threshold. Also indicating improved breadth was the increasing number of stocks closing at 52-week highs in August. On August 15th, 34 stocks reached this milestone; the most since April. However, to the bulls’ disappointment, while the S&P 500 did get remarkably close to hitting its 200-day moving average, it failed to hold above this critical technical level as stocks turned lower in the second half of the month.
Market sentiment is sending mixed signals.
Bank of America’s Sell Side Indicator, which assesses Wall Street’s sentiment on stocks based on asset allocation recommendations, moved higher in August, its first increase since October 2021. According to Bank of America, extreme bearishness on the part of Wall Street is ultimately bullish for stocks as it is assumed portfolios are at their maximum underweight position and allocations to stocks can only move higher in the future. It is a little confusing, but an improvement in sentiment is taken as a bearish signal for stocks.
Working under a similar premise, the American Association of Individual Investors survey has been deeply bearish — which again can be taken as a bullish signal — but has started to recover from extreme bearish levels in August as more individual investors turn from being bearish to bullish. Finally, an August Reuters poll of 150 equity market strategists found that 60 percent of respondents saw that their 2022 forecast risks were skewed to the downside, but just over half believed there was a low chance of another major sell-off. It is hard to draw any definitive conclusions when it comes to sentiment. Investors are still more bearish, but that might be a good thing. However, the fact that they are a little less bearish might be a bad thing. As already noted, it is confusing.
Some investors are losing their taste for equities.
Market positioning paints a similar picture. Retail and institutional investors have been reducing their exposure to stocks, with global research by Bank of America observing that U.S. stocks funds endured their most significant weekly outflow in 11 weeks from September 7th. According to Bank of America, stocks have had no net inflows over the past six months.
Not only are investors not buying stocks, but they are also actively positioning against the market, with Commodity Futures Trading Commission’s (CFTC) net positioning turning short equities to levels not seen in two years, according to Strategas. But, similar to market sentiment, bad can be good, as the short sellers today will inevitably be tomorrow’s buyers. A market that becomes too bearish is always at risk of snapping back abruptly, especially if short sellers are forced to cover their positions. Even so, it is important to be careful as this contrarian interpretation of sentiment and positioning does not always work out as planned.
According to Strategas, six month forward S&P 500 returns over the past 20 years have tended to be better when CFTC net positioning is very long versus when it is very short. Another interesting observation from Strategas was the positive performance of the utility sector last month: 93% of utility stocks traded above their 200-day moving average at the end of August — second only to the energy sector at 95%. No other sector was even close.
Since the June 16th S&P 500 bottom, the utility sector has outperformed the S&P 500 index by 5.2%. Utility stocks are often defensive investments that can pay reliable dividends, but they are not your typical leaders at the start of a new bull market. Some investors may suggest buying utility stocks, but there are better places to be if you believe stocks are on the verge of bigger and better things. By favouring utilities, it does not look like that is what the market is thinking.
While it is possible that the market saw its 2022 low on June 16th, we remain cautious. We believed there was a high probability that the market would take action in July, and the first half of August was, in fact, a bear market rally and not the start of a new bull market. Rosenberg Research recently detailed the anatomy of a typical recession-inspired bear market, pointing out that a pause in the Fed rate hiking cycle can cause the market to rally, but stocks soon turn lower again once the recession takes hold. It is not until well after the Fed’s final rate cut that the market follows through. Following this roadmap, the market might have gotten slightly ahead of itself in July, given that the Fed has made it clear that they will continue raising rates. According to Rosenberg Research, even in non-recessionary bear markets, it is typical to see a retest of the low, and during recessionary bear markets, the final low is much slower to reveal itself. Bear market rallies can be very enticing in their attempts to lure investors back into the risk assets. According to Bloomberg, the Nasdaq jumped more than 20% on seven separate occasions during the dot-com crash before finally finding its ultimate low.
When it comes to bear market rallies, size matters.
According to Bloomberg and Longview Economics, there is a strong correlation between the magnitude of the bear market’s decline and the ensuing relief rally. Specifically, Jefferies Group has found that the subsequent rally should retrace 67.7% of the preceding decline. Some strategists believe that recouping 50% of a decline is enough to signal a new bull market, a feat the S&P 500 achieved in mid-August. According to CFRA Research, however, the chances of positive returns after a 50% retracement have been slightly better than a coin toss, with returns after 30 days in the black only 54% of the time. Morgan Stanley tends to agree. Of the eleven 50% retracements since 1980, seven turned out to be bear market rallies, not bear market bottoms. Morgan Stanley does concede that the July and August rally has been impressive. If it turns out to be a bear market rally, it would be the fifth largest retracement since 1980. Perhaps the fact that trading volume during the summer months has been unsurprisingly low played a role. Markets can be moved around more easily when traders are away from their desks, and trading volume takes a holiday.
Economic fundamentals will determine if we are still in a bear market.
While sentiment and current positioning can impact markets in the short term, economic fundamentals will determine whether we are still in a bear market or if a new bull market has started. A recent article published by Barron’s highlighted that small business optimism has declined due to inflation and higher interest rates, which signals that the U.S. could already be in a recession. Additionally, a recent Strategas survey showed that 87% of institutional investors believe the U.S. will be in a recession by next year. Interestingly enough, the consensus is that there will be virtually no change in earnings growth in 2023, which is a bit of a disconnect.
Forecasted earnings for next year have only declined 3.6% from their peak, and CIBC expects them to grow 8.3% year-over-year, hardly what one would expect during a recession. CIBC also points out that earnings have fallen an average of over 27% during the seven recessions since 1970. Either earnings estimates must come down a lot more, or fears over a recession next year are misplaced. We are likely still in a bear market if it is the former. If it is the latter, perhaps markets have seen the lows.
Inflation continues to play a significant role in determining the future path of the economy.
Inflation and the central bank’s reaction to inflation are destined to play a significant role in determining the future path of the economy and earnings. There is little doubt that inflation is set to decline; the question is how fast and by how much? Even if the monthly increase in CPI falls to zero, Scotiabank notes that headline CPI will only fall to 3.1% by March of next year, which is still above the Fed’s 2% target. Financial markets appear undeterred by this high bar, with two-year inflation break-even rates falling to just under 2.4% at the end of August.
The challenge in bringing down inflation lies not with cyclical and more volatile components like energy, food, or even used car prices but more sticky components, like shelter costs and service-related demand (restaurants, hotels, and transportation). J.P. Morgan Asset Management recently pegged the latter as contributing 4% to year-over-year inflation. According to Strategas, this so-called “sticky” inflation is still too high to claim “mission accomplished” in the fight against inflation.
Wage growth tends to be one of the stickiest components targeted by policymakers. Despite increases of over 5% (average hourly wages rose 5.2% in August), workers have seen their pay slip in real terms, given that nominal CPI has been far north of 8% (headline CPI was 8.5% in July). Regardless, policymakers know that wage growth above 5% for an extended period will likely cause inflationary expectations to move higher eventually and could create a self-sustaining wage/price spiral.
To control wages without causing undue harm to economic growth, policymakers have set their sights on decreasing job openings, which have recently soared above the pool of workers available and looking for work. With the ratio of job openings to unemployed workers reaching a record ratio of 2:1 in July, it is a seller’s market for workers who have seen their bargaining position improve as of late. If policymakers can slow the economy enough to decrease the number of job openings without destroying the current jobs market, and increase the unemployment rate, perhaps they can achieve the much-heralded soft landing. Controlling inflation, and avoiding a recession, is the ultimate goal.
The battleground is set. While workers appear to have the upper hand from a supply and demand perspective, as BCA Research recently pointed out, they are unlikely to put up an organized and unified front against ‘the man’ given that union membership remains historically low. The outcome of this battle has enormous implications for corporate earnings. One of the reasons profit margins have reached such elevated levels is the ability of companies to grow revenue faster than expenses, of which wages typically comprise a significant component. BCA Research also states that consumption has held up very well, which bodes well for corporate revenue.
Inflation helps increase nominal revenue growth even more. If companies can keep wage growth under control, earnings may continue to expand. Profit margins are key. According to Yardeni Research, only the energy and real estate sectors have not seen downward revisions in profit margins, but, barring a recession, margins might be able to hold out if strong nominal revenue growth can out-pace wages and expenses.
Is there still a way to avoid a recession?
When it comes to avoiding a recession, a lot comes down to what the Fed and other central banks do with interest rates. Markets rallied in July and the first half of August because traders believed an early pivot to easing financial conditions by the Fed was in the cards once signs of economic weakness and falling inflation started to materialize, which, arguably, was beginning to transpire. Not only did the market expect the Fed to stop raising rates in early 2023, but it expected it to quickly pivot to rate cuts soon after.
A vast majority of respondents to a survey by Axios have very little confidence in the Fed’s resolve to bring inflation back down to 2%. However, a speech by Chairman Powell at the Jackson Hole Economic Symposium in August said otherwise, as Powell emphasized the Fed’s commitment to bring inflation back to the 2% target, even if it meant some economic pain and higher unemployment. As a result of Powell’s apparent resolve and concurrence by his colleagues, the market started re-pricing peak Fed Funds for early next year, with March 2023 futures rising from 3.25% at the end of July to 3.75% by the end of August. In addition, rather than expecting over 80 basis points of easing in 2023 after rates peak, the market ended the month anticipating a mere 30 basis point decline in Funds for the rest of 2023.
Unfortunately for U.S. markets, the Fed’s mission to lower inflation by tightening financial conditions conflicts with investor desires for strong investment returns. While increasing overnight interest rates is the main lever central banks must pull to tighten financial conditions, it is not short-term rates themselves but the impact of short-term rates on stock prices, the U.S. dollar, credit spreads, and long term bond yields that have the most significant impact on financial conditions. While higher stock prices may be suitable for investor returns, it also serves to countermand the Fed’s attempt to tighten financial conditions. Same for credit spreads and 10-year bond yields.
Tighter credit spreads and lower 10-year bond yields buoyed investors’ returns in July and the first half of August but, along with a stronger stock market, also helped ease financial conditions. While having been on an upwards trajectory for most of the year, a falling U.S. dollar has also helped ease conditions, helping the Fed in its quest. While investors have gotten used to the “Fed Put” over the years, with the central bank coming to the market’s rescue in times of volatility, do not expect the Fed to lose much sleep over a declining market in the near term. A good old fashion bear market works in their favour, as do higher credit spreads, rising 10-year bond yields, and a stronger U.S. dollar. Corporate profits would be less enthusiastic.
Overall, whether negative market action last month signals the bear market is intact or not depends less on the calendar month we are in, market sentiment or positioning; most important will be inflation and central banks’ policy in reaction to inflation. According to Bank of America, high sticky inflation remains the most considerable tail risk for markets, in which central banks like the Federal Reserve feel compelled to risk global recession to quell. In this environment, corporate earnings estimates look too high and negative revisions will likely be what lead the next leg of the bear market lower. Of course, the Fed could lose its nerve and end its tightening cycle before inflation is under control, despite its claims to the contrary, which would be incredibly detrimental to its credibility. The ideal outcome for the Fed is to bring inflation back down to target without causing a recession and a jump in unemployment. To accomplish this, the Fed hopes to destroy jobs opening, but not jobs. It is possible, but not likely.
This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information presented here has been obtained from sources believed to be reliable, but not guaranteed. Nicola Wealth is registered as a Portfolio Manager, Exempt Market Dealer, and Investment Fund Manager with the required provincial securities commissions. All values sourced through Bloomberg.