Market Navigator – June 2022 edition

Monthly letter

The roller coaster ride continues. After a scary drop early in May, which pushed the S&P 500’s losing streak to seven weeks for only the fourth time since 1950, markets rebounded with vigor. Stocks ended the month with the sharpest weekly gain since just after the November 2020 election, another period of high anxiety.

Despite all the excitement, the May ride ended basically where it began with the S&P 500 finishing the month just a touch above unchanged. Not to be left out, the 10-year U.S. Treasury yield shot up to 3.2%, breaching the 3% level for the first time since 2018, before ending around 2.8%, close to where it began the month.

The whiplash in markets is consistent with a wider range of potential outcomes and complicated macro backdrop. With uncertainty elevated, each economic data point, earnings report, geopolitical and Fed headline is overanalyzed and over-extrapolated.

And the biggest factor of the market decline earlier in May appeared to center on growing recession risks. The shift in buying patterns from Americans buying stuff to buying experiences is creating a confusing backdrop.

• Data points from the goods side of the economy, such as home goods, are normalizing lower from unsustainably elevated levels. This gives fodder for those who are concerned about a recession.
  
• While the robust demand for services, such as travel and leisure, provides support for those who are overly focused on economic strength.

The truth is probably somewhere in the middle.

While risks to the economic outlook are rising, our view is the market was overestimating the near-term probabilities of a downturn. That’s a key reason we advocated against selling stocks in late May.

Indeed, at the May lows, the S&P 500 was down almost 19% from its peak—effectively pricing in a 65% to 80% probability of recession based on the average stock market decline around recessions of 29% (median 24%). Moreover, after the sharpest 90-day valuation contraction of the past 15 years and indiscriminate selling, stocks had moved to the most oversold condition since early on during the pandemic.

Given the persistence of the negativity, how oversold the markets had become, and the significant contraction in valuations, the rally seen since late May likely has further to go. We would still view this move in the confines of a very choppy and wide trading range.

For the S&P 500, currently trading just above 4100, the bottom end of that trading range appears to be around the 3800 level, or at a 16x forward P/E. The top end of the range appears to be in the 4300-4500 zone, where there is a confluence of fundamental and technical price resistance. 

Globally, we still hold a U.S. bias, given higher quality companies and a more resilient economy. It is notable and somewhat surprising that the international developed markets have held up well recently despite higher odds of recession – in Europe, for example. China’s earnings trends remain weak, but with better COVID-19 trends and government stimulus, we’ll likely see continued near-term stabilization.

We’re not ready to increase our international allocations yet given the challenging global backdrop and elevated geopolitical risks but are keeping an open mind and monitoring these recent trends for signs of persistence.  

On the fixed income side, we were pleased to see that high quality bonds reverted to providing ballast for portfolios, unlike what occurred earlier this year. Higher yields made high quality bonds productive again, drawing interest, and investors began shifting from a focus on inflation to economic growth concerns.

Finally, this month we’ve made two notable shifts in our House Views — we downgraded REITs and leveraged loans from attractive to neutral. The macro backdrop for REITs has become more challenging, and the yield relative to the 10-year U.S. Treasury has moved to the lowest level of the past decade. For leveraged loans, our view is that their significant outperformance relative to core bonds, from which we benefited, is likely behind us and much of the Fed tightening is now baked into market expectations. 

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