Why We Rallied
It's been a strong few months for the S&P 500, which is up about 13% from the October lows. There were five reasons for the rally:
1) P/E ratios got attractive, especially for small-to-mid caps.
2) Inflation peaked, which historically has sometimes marked the bottom for stocks.
3) Global liquidity turned upward. Every major bond market was pricing a central bank pivot, and the big central banks (particularly Japan and China) added about $1 trillion to their balance sheets.
4) Economic data remained surprisingly strong, which raised hopes of a "soft landing."
5) Possibly there was a bit of forced buying due to a "short squeeze."
Why the Rally Is Probably Over
However, I believe we've now reached an inflection point where these tailwinds will turn into headwinds.
1) The S&P 500 and Russell 2000 P/E ratios are once again looking high (although S&P 400 and S&P 600 still look cheap). (See this report from Ed Yardeni.)
2) Inflation is no longer surprising to the downside. The last couple prints have been exactly in line with forecasts, and leading indicators of inflation have been creeping back up. See, for instance, this chart of service sector wages, this chart of copper prices, and this Goldman Sachs forecast of crude oil prices. This is partly because of the global liquidity boost and continued deficit spending, and it's partly because of China ending its Covid-zero policy and reopening its economy. (China is the largest importer of crude and the second-largest importer of liquified natural gas in the world.)
3) With inflation set to stay high, liquidity has tightened a lot. The market is no longer pricing a Fed pivot, and analysts suggest the central bank liquidity boost may be over. Stocks have now gotten significantly higher than liquidity measures would predict, which suggests they may need to come down a little.
4) Economic data are deteriorating. Leading indicators have been pointing toward recession for months, but consumer savings and a glut of job openings have helped delay it. We're definitely starting to see weakness, though. Credit card debt has soared to an all-time high, we're seeing more late payments, and the housing market is cooling off fast, with inventories of unused construction materials piling up. We've seen "soft landing" hype before: in 2000 and 2007, just before those recessions hit. Unless the Fed pivots immediately, it's probably not "different this time."
5) The short squeeze is over for large cap tech, with most of the shorts already forced out.
Five Ideas for How to Reposition
How to trade a coming recession?
1) The obvious trade is long bonds, short stocks. Bond market valuations are very attractive relative to stocks, with bond yields only a little below the S&P 500's earnings yield, and bond markets having perhaps gotten too hawkish relative to policy rates. Given the historical correlation between 10-year yields and S&P 500 valuations, the gap that has opened between them may imply an opportunity for a statistical arb. Either stock valuations should drop or bond yields should rise. Historically, in a recessionary environment, the bond market has tended to recover first, and the stock market second. So now would be the time to long those bonds.
However, it should be noted that this recessionary environment is an unusual one in a lot of ways. Stocks have already sold off a lot, and valuations are pretty mixed. Bonds should perform well if we get a deflationary recession that allows to Fed to lower rates, but a stagflationary recession might force the Fed to keep rates high even as the economy stumbles. Thus, it may be worth getting a little more specific with our trade. Here are some other ideas:
2) Long investment-grade bonds, short high-yield bonds. If recession is coming, then high-yield spreads are probably way too low. It's possible that high-yield bond rates will rise even as investment-grade, Treasury, and policy rates fall.
3) Long high-quality small- and mid-caps, short low-quality large caps. In my opinion, large cap tech is still way too crowded. I wouldn't want to short Microsoft right now, given the success of Bing AI. But I'd be willing to take a swing at Amazon, Apple, and Netflix as long as I could balance the risk by longing some cheap, quality smalls and mids on the other side. In my opinion, the size factor is ripe for disruption. If you'd asked me two years ago, I would have said that AI would most benefit large cap tech. Now I think it will most benefit smalls. What changed between now and then is that AI went from being the exclusive domain of big companies to being publicly available at shockingly low cost. This happened way faster than I ever would have guessed, and you better believe that small, agile companies will capitalize on the opportunities provided by access to AI!
4) Long cash to buy the dip on energy stocks. Energy historically has struggled in a recession, so it's quite likely that energy stocks will see some downside soon. However, the current free cash flow yield on energy stocks is quite high, and the sector trades at 10x forward P/E. Meanwhile, investment in the sector is still much too low. I believe there will be a decade-long structural bull market in energy due to constrained supply, but that there will probably be some recessionary pain first. Meanwhile, money market funds offer a really high return on cash. My Fidelity money market is giving me almost 4%. Ain't nothing wrong with just collecting that money market rate and waiting for energy stocks to dip for the buy and hold.
With retail investor inflows at an all-time high, I believe the current market environment offers a good opportunity for savvy bears to execute some well-constructed long-short trades. If you look at how the smart money is positioned, it's pretty much the opposite of retail positioning here. There will be a time to get bullish on US large cap stocks, but we probably need to see some weakening of coincident economic indicators like employment first. (Stocks tend to do best when unemployment rates are high.) Remember, market positioning beats market timing, but ideally you could do a little of both!
Thanks for reading, and please share your ideas in the comments below!
It's been a strong few months for the S&P 500, which is up about 13% from the October lows. There were five reasons for the rally:
1) P/E ratios got attractive, especially for small-to-mid caps.
2) Inflation peaked, which historically has sometimes marked the bottom for stocks.
3) Global liquidity turned upward. Every major bond market was pricing a central bank pivot, and the big central banks (particularly Japan and China) added about $1 trillion to their balance sheets.
4) Economic data remained surprisingly strong, which raised hopes of a "soft landing."
5) Possibly there was a bit of forced buying due to a "short squeeze."
Why the Rally Is Probably Over
However, I believe we've now reached an inflection point where these tailwinds will turn into headwinds.
1) The S&P 500 and Russell 2000 P/E ratios are once again looking high (although S&P 400 and S&P 600 still look cheap). (See this report from Ed Yardeni.)
2) Inflation is no longer surprising to the downside. The last couple prints have been exactly in line with forecasts, and leading indicators of inflation have been creeping back up. See, for instance, this chart of service sector wages, this chart of copper prices, and this Goldman Sachs forecast of crude oil prices. This is partly because of the global liquidity boost and continued deficit spending, and it's partly because of China ending its Covid-zero policy and reopening its economy. (China is the largest importer of crude and the second-largest importer of liquified natural gas in the world.)
3) With inflation set to stay high, liquidity has tightened a lot. The market is no longer pricing a Fed pivot, and analysts suggest the central bank liquidity boost may be over. Stocks have now gotten significantly higher than liquidity measures would predict, which suggests they may need to come down a little.
4) Economic data are deteriorating. Leading indicators have been pointing toward recession for months, but consumer savings and a glut of job openings have helped delay it. We're definitely starting to see weakness, though. Credit card debt has soared to an all-time high, we're seeing more late payments, and the housing market is cooling off fast, with inventories of unused construction materials piling up. We've seen "soft landing" hype before: in 2000 and 2007, just before those recessions hit. Unless the Fed pivots immediately, it's probably not "different this time."
5) The short squeeze is over for large cap tech, with most of the shorts already forced out.
Five Ideas for How to Reposition
How to trade a coming recession?
1) The obvious trade is long bonds, short stocks. Bond market valuations are very attractive relative to stocks, with bond yields only a little below the S&P 500's earnings yield, and bond markets having perhaps gotten too hawkish relative to policy rates. Given the historical correlation between 10-year yields and S&P 500 valuations, the gap that has opened between them may imply an opportunity for a statistical arb. Either stock valuations should drop or bond yields should rise. Historically, in a recessionary environment, the bond market has tended to recover first, and the stock market second. So now would be the time to long those bonds.
However, it should be noted that this recessionary environment is an unusual one in a lot of ways. Stocks have already sold off a lot, and valuations are pretty mixed. Bonds should perform well if we get a deflationary recession that allows to Fed to lower rates, but a stagflationary recession might force the Fed to keep rates high even as the economy stumbles. Thus, it may be worth getting a little more specific with our trade. Here are some other ideas:
2) Long investment-grade bonds, short high-yield bonds. If recession is coming, then high-yield spreads are probably way too low. It's possible that high-yield bond rates will rise even as investment-grade, Treasury, and policy rates fall.
3) Long high-quality small- and mid-caps, short low-quality large caps. In my opinion, large cap tech is still way too crowded. I wouldn't want to short Microsoft right now, given the success of Bing AI. But I'd be willing to take a swing at Amazon, Apple, and Netflix as long as I could balance the risk by longing some cheap, quality smalls and mids on the other side. In my opinion, the size factor is ripe for disruption. If you'd asked me two years ago, I would have said that AI would most benefit large cap tech. Now I think it will most benefit smalls. What changed between now and then is that AI went from being the exclusive domain of big companies to being publicly available at shockingly low cost. This happened way faster than I ever would have guessed, and you better believe that small, agile companies will capitalize on the opportunities provided by access to AI!
4) Long cash to buy the dip on energy stocks. Energy historically has struggled in a recession, so it's quite likely that energy stocks will see some downside soon. However, the current free cash flow yield on energy stocks is quite high, and the sector trades at 10x forward P/E. Meanwhile, investment in the sector is still much too low. I believe there will be a decade-long structural bull market in energy due to constrained supply, but that there will probably be some recessionary pain first. Meanwhile, money market funds offer a really high return on cash. My Fidelity money market is giving me almost 4%. Ain't nothing wrong with just collecting that money market rate and waiting for energy stocks to dip for the buy and hold.
With retail investor inflows at an all-time high, I believe the current market environment offers a good opportunity for savvy bears to execute some well-constructed long-short trades. If you look at how the smart money is positioned, it's pretty much the opposite of retail positioning here. There will be a time to get bullish on US large cap stocks, but we probably need to see some weakening of coincident economic indicators like employment first. (Stocks tend to do best when unemployment rates are high.) Remember, market positioning beats market timing, but ideally you could do a little of both!
Thanks for reading, and please share your ideas in the comments below!
Comment:
Here's a fascinating chart! The spread in confidence between "smart money" and "dumb money" is near a two-year low:
twitter.com/fxevolut.../1627473712768495616
twitter.com/fxevolut.../1627473712768495616
The fifth one was going to be long emerging markets equities, short US equities. EM dividend yields are super high relative to the US, which tends to favor higher forward returns. And emerging markets tend to benefit from high commodities prices. But I think you have to be careful with your EM exposure. Most emerging markets funds have way too much exposure to China/Taiwan risk, whereas most of the actual value in EM is in Latin America, Poland, and South Korea. Also, like energy equities, EM may take a hit as we go into a recession, so it's useful to have some cash on hand to add on any dip.