Market Navigator – May 2023 edition

Monthly letter

The debate rages on – a new bull market or just a bear market rally?

As the popular market indices grind higher, and with the markets now more than six-and-a-half months past their cycle price lows, the bull-bear debate intensifies.

The case for a new bull market

• At the October lows of last year, the S&P 500 registered a peak-to-trough decline of about 25%, near the median pullback around prior recessions.
• At that bottom, investor sentiment was at a negative extreme. The market found its intraday low on the very day of a worse-than-expected inflation report. When markets no longer go down on bad news, that often tells you that the bad news is priced in. This is something we highlighted at the time.
• Moreover, since then, the market has climbed a wall of inflation, Federal Reserve (Fed), recession, and earnings worries higher.
• Depressed investor sentiment and positioning remain a support for this market.
• And during the current quarterly reporting season, corporations are exceeding analysts’ earnings expectations—which were lowered ahead of the reporting season—further aiding equity prices.

The case for just a bear market rally

• Historically, bear markets have not tended to end until the Fed was done raising rates and often well after they began easing. Likewise, if an economic downturn later this year is still in the cards, stocks have never bottomed before a recession even started.
• If a new bull market is underway, it’s one of the weakest starts to one in modern history. Indeed, the S&P 500 is up only 16.6% versus the average price gain of 32.6% six-and-a-half months into a new bull market. Historically, the first part of the bull market tends to take off like a rocket.
• Moreover, the headline indices are relatively flat since last December, with the strong year-to-date gains aided by better starting points following a correction just prior to the start of the year.
• What’s also curious is during the early phases of a bull market, a broad-based risk-on environment often takes hold. Instead, today we see a very uneven recovery.
• Since the February peak alone, small caps, transportation, and financials are each down roughly 10% or more, though the popular averages have stayed elevated aided by the sharp outperformance of a sliver of mega cap growth companies.

• With the S&P 500 sporting an 18.2x forward estimated P/E, this is among the most expensive markets have traded over the past 25 years, outside of the pandemic and the technology bubble overshoot.
• Although momentum and positioning can lead markets to trade well beyond what one may consider rational on a short-term basis, we struggle fundamentally to justify paying the top end of the valuation range when the macro risks arguably remain well above average.
• Notably, the volatility index (VIX) recently declined below 16, versus a long-term average near 20, the lowest level since November 2021. The VIX suggests a degree of investor complacency relative to the elevated macro risks we still see ahead.
• Indeed, our economics team continues to see elevated recession risks later this year as the lagged impact of higher interest rates combined with tighter credit conditions and the likelihood of a weakening jobs market weigh on growth. This time could be different, but these factors along with a deeply inverted yield curve and the sharp drop in the Conference Board’s Index of Leading Economic Indicators (LEI) suggest, if nothing else, a notable slowdown in economic activity in the back half of the year.
• Despite the anticipation of an economic slowdown, the consensus expects S&P 500 earnings to rebound to a record high in the second half of the year. We see a disconnect and view it as likely that earnings projections will eventually need to be revised lower. Moreover, we expect the battle over raising the U.S. debt ceiling to also inject volatility into the markets over the coming months.

Bottom line and positioning

Instead of categorizing the market as a bull or bear, perhaps the proper view is one of a wide, choppy trading range that continues to frustrate investors on both sides of the debate.

More insightful in our view is assessing the risk/reward and asking the question of whether investors are being adequately compensated for taking on an aggressive risk-on stance today. The weight of the evidence in our work suggests the answer is no.

Even if the S&P 500 is finally able to move above the ~4200 level and the fear of missing out kicks in, it’s hard for us to come up with a scenario where the market upside is much greater than 3% to 5% from current levels, even using generous assumptions. This is versus the potential downside of about double that if we simply went back to the lower end of the recent trading range near 3800.

Therefore, within the context of a longer-term asset allocation plan, which should continue to serve as an anchor for investors, we advise taking less risk relative to targets.

From a tactical basis, we are underweight equities alongside an overweight to fixed income and cash. We continue to advise an up-inquality portfolio bias, with an emphasis on U.S. large caps within equities and minimizing credit risk within fixed income.

We continue to keep an open mind regarding our market outlook, especially given the unusual nature of this post-pandemic cycle. Yet, as much as anyone, we are anxious to move from defense to offense, but, at present, we see patience as a virtue.

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