Getting stretched short term

Key takeaways

In late February, with stocks near all-time highs, we dialed back our risk posture in our House Views given the fog of uncertainty and a shift in the weight of the evidence toward a more mixed backdrop.

Our position has not changed, though on a shorter-term basis, markets are becoming stretched to the downside, and our work suggests the market is in the ballpark of a bounce.

Big picture 

Historically, it has been common for stocks to trade in a choppy fashion early into year one of a new presidential cycle as investors digest new policies. With the feverish pace of activity in Washington, the current cycle has been amplified. Moreover, the current elevated level of policy uncertainty came at a time of elevated investor expectations.

The recent market setback is serving to reset these high investor expectations.

• Since the peak on February 19, the S&P 500 has seen a peak-to-trough decline of 9.6%. For comparison, the average pullback (>5%) since March 2009 has averaged 10.2%.
• Further, over the past 40 years, the market has averaged a maximum intra-year decline of 14.1%, despite ending higher in most of the years.

Indeed, pullbacks are the admission price to the stock market and offer the potential for higher longer-term returns relative to other asset classes.

On a short-term basis, some “technical” metrics suggest that stocks are becoming stretched to the downside and due for a bounce.

The Relative Strength Index, which ranges from 0 to 100, just moved below 30 (oversold) for the first time since October 2023.

• Since 1995, the S&P 500 has risen 97% of the time over the next 12 months following similar extreme readings—excluding signals around recessions. That’s a key caveat.
• The market declined 12 months after signals during the 2001 and 2008-2009 recessions. The only non-recessionary decline came in 2022, when the Federal Reserve (Fed) aggressively raised rates.

Investors today are increasingly concerned about economic growth. Our head of U.S. economics acknowledges the downside risks given policy uncertainty but is currently not in the recession camp. 

With the market down 9.6% versus a median decline around recessions of 24% (average 29%) since 1948, this suggests the market is “pricing in” about a 1 in 3 chance of recession versus almost nothing a few weeks ago.

Valuation contraction is also moving to a short-term extreme. Although valuations, even with the recent setback, are not cheap, we have just seen a two-point decrease in the S&P 500’s forward P/E over the past 15 days. 

Outside of the pandemic, this is around the most valuation contraction we have seen. This also suggests stocks are moving within the vicinity of some near-term stability.

Bottom Line

Our work continues to suggest a more neutral overall risk posture is warranted. We recommend investors that are taking more risks relative to their benchmarks use any bounce to modestly dial back exposure toward long-term target allocations.