“Some discomfort is normal but call me if the pain gets bad,” the doctor will say, leaving it up to the patient to determine the line between the tolerable and the worrisome. Investors in the five months since stocks peaked have mostly been feeling a typical degree of discomfort for the procedure the economy and markets are undergoing: Pricing in an inflationary squeeze, the start of a financial-tightening cycle, decelerating growth and a resulting valuation reset. It’s not yet clear whether all this will break through to acute suffering and more lasting impairment of asset values, with several key macroeconomic factors — nominal and real bond yields, earnings downgrades and oil prices — still short of Wall Street’s apparent pain threshold. Last week’s market action — the S & P 500 slipping 1.2% in choppy, indecisive trading, retaining most of the 9% ramp from the May 20 low while declining plenty of decent excuses to break down further — fits well into this category of routine discomfort. It’s fair to observe that skepticism prevails as to whether the index low two weeks ago just above 3800 was a reliable trough, and with good reason: Previous rallies this year have been brief interludes before further new lows. The longer-term downtrend remains in place. And it’s difficult to see anything like an “all clear” signal for risk-taking soon given the Federal Reserve’s singular focus on hustling rates higher to fight an inflationary trend which, even if it has peaked, can’t prove that notion for another few months. Still, the market’s slippage last week does nothing to hurt the case that the recent rebound is fairly well-supported and could continue higher to test the nerve of the now-confident camp insisting that all rallies should be sold. Bottom or bear bounce? The lopsided positive-market-breadth statistics from the initial three-day ramp off the lows triggered some signals that tend to have pretty good long-term implications for returns several months to a year out (with the huge exceptions being the multi-year recessionary bear markets starting in 2000 and 2007). Stocks remain pretty well in tune with other asset classes, too. The S & P 500 is within half a percent of where it stood four weeks ago, and the 2- and 10-year Treasury yields, junk-bond spreads and full-year 2022 S & P 500 earnings forecasts are likewise all in pretty much the same place now as they were then. A model used by Fidelity macro strategist Jurrien Timmer to gauge fair value for stocks based on the 2-year Treasury yield (as a proxy for the Fed’s likely policy path) explains most of equities’ valuation compression this year. The slope tracks well, though stocks remain a bit above the implied proper values. Timmer believes that because the year’s P/E decline has merely taken it to the range of fair rather than cheap, upside is likely limited even if fundamentals should offer good support at the recent lows. A market experiencing unease and bracing against the known headwinds yet not yet forced to price in truly painful potential outcomes – this is the theme of the moment. Deutsche Bank strategists who track the investment stance of all categories of investors on Friday reported that “while a slowdown in growth looks priced in across the board, very few [positioning indicators] are down to recession levels.” This makes sense, incidentally, given that last week’s jobs report and ISM manufacturing survey showed nothing approaching recessionary conditions. Hedge funds have radically cut back on equity risk and rampant call-option buying of the past few years has largely receded, yet short interest is low and households continue to carry elevated stock allocations relative to history. Watch the profit outlook The real pain point for stocks would obviously be the profit outlook giving way just as valuations have begun to look pretty palatable based on current earnings forecasts. KKR & Co. chief investment officer Henry McVey says he believes the market is now transitioning from a mode where inflation is the main preoccupation to earnings expectations getting cut significantly over the second half and into 2024. Morgan Stanley notes the breadth of earnings revisions — the net percentage being raised versus cut — looks about to flip negative. Not great, but the S & P 500 annual-return path shows this isn’t exactly news to the market and there have been times when this gauge cracked below zero in a mid-cycle slowdown rather than recession. With Fed officials last week consistently waving investors away from the hope that they will be looking for an opportunity to pause their rate-hiking campaign in coming months, yields would seem to be one of the more obvious things that could test stocks’ pain threshold. Watch rates, oil The 10-year yield has climbed back to the doorstep of 3%, not far below the peak above 3.1% it hit briefly in early May, which itself was just short of the 3.25% level reached in late 2018, which helped trigger a rapid stock-market tumble into late December that year. A break above this zone also represents a breach of the multi-decade downtrend in yields, so such a move would not go unnoticed. Real rates — yields adjusted for market-implied inflation expectations — are another thing to watch on the hunt for sources of possible pain. The real yield has recently turned positive again. When it got to 1% in 2013 it coincided with the attention-getting but ultimately benign “taper tantrum.” The same level in late 2018, later in the cycle and with stocks more expensive, proved tougher to digest for stocks, which had a near-20% setback that ended as the Fed signaled a pause to its tightening efforts. For sure, oil ramping above the March war-panic peak of $130 a barrel for WTI crude (from $120 now) would be an obvious additional challenge too, though it remains a less-onerous burden now than it was from 2011-2014 adjusted for the larger size and lower energy-intensity of today’s economy. It’s fair to sum up by saying there is no shortage of potential sources of pain. Yet markets have absorbed plenty of unpleasantness already and have not decisively broken down, in large part because investors collectively have been fearful and flinching for months now, anticipating pain rather than chasing pleasure.
