“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 acceptable and worrisome. In the five months since the stock spike, investors have felt a typical degree of discomfort with the process the economy and markets are undergoing: pricing amid inflationary pressures, the start of a financial tightening cycle, slowing growth and a consequent valuation reset. It’s not clear yet if all of this will break through to acute suffering and more lasting asset depreciation, as several key macroeconomic factors – nominal and real bond yields, earnings cuts and oil prices – still remain below Wall Street’s apparent pain line. Last week’s market action — the S&P 500 plunged 1.2% in choppy, indecisive trading, maintaining most of its 9% rise from its May 20 low, and refusing plenty of decent excuses to collapse further — fits well into this category of routine discomfort. It’s fair to note that there is skepticism about whether the index low of two weeks ago, just above 3800, was a reliable low, and for good reason: earlier rallies this year were brief interludes to further new lows. The longer term downward trend remains in place. And it’s hard to see anything as a “completely clear” signal for risk-taking anytime soon, given the Federal Reserve’s particular focus on raising interest rates to combat an inflationary trend that, even if this has reached its peak, that idea cannot prove for another few months. Still, the market slippage last week doesn’t negate the case that the recent rebound is fairly well supported and could continue higher to test the audacity of the now-confident camp urging all rallies to be sold. Bottom or bear bounce? The one-sided positive market size metrics from the initial three-day disaster of the lows led to a number of signals that generally have pretty good long-term implications for returns over several months to a year (with the big exception being the multi-year recessive bear markets from 2000 and 2007). Stocks also remain fairly well in line with other asset classes. The S&P 500 is within half a percent of where it was four weeks ago, and the 2- and 10-year Treasury yields, junk-bond spreads and full-year earnings forecasts for the S&P 500 are ahead of the curve. 2022 are also almost all in the picture. same place now as then. A model used by Fidelity macro strategist Jurrien Timmer to measure the fair value of stocks based on the 2-year Treasury yield (as an indicator of the Fed’s likely policy path) explains most of the stock valuation compression this year. The slope is tracking well, although the stock remains slightly above the implied correct values. Timmer believes that because the year’s decline in P/E has moved the price into the range of fair rather than cheap, upside potential is likely to be limited, even if fundamentals were to provide good support from recent lows . A market that is uneasy and bracing itself against the familiar headwinds, but not yet forced to price in really painful potential results – this is the theme of the moment. Deutsche Bank strategists, who tracked the investment positions of all investor categories on Friday, reported that “While a slowdown seems priced in across the board, very few [positioning indicators] are at the level of a recession.” This makes sense, by the way, since last week’s jobs report and the ISM manufacturing survey showed nothing close to recessionary conditions. Still high equity allocations compared to history.Watch the earnings outlook The real pain point for stocks would, of course, be the earnings outlook collapsing, just as valuations are starting to look pretty appetizing based on current KKR & Co. Chief Investment Officer Henry McVey says he believes the market is now moving from a mode in which inflation is the main concern, to earnings expectations slashed in the second half and into 2024. Morgan Stanley notes how wide the earnings revisions are — the net percentage that is increased vs decreased – seems about to go negative Not great but the S&It annual r performance path of the P 500 shows that this is not exactly news for the market and there have been times when this gauge has burst below zero in a mid-cycle slowdown rather than a recession. With Fed officials consistently wavering investors last week from hopes they’ll look for an opportunity to pause their rate hike campaign in the coming months, yields seem like one of the more obvious things that could test stocks’ pain threshold. . Watch rates, oil The 10-year yield is back at the 3% threshold, not far below the over 3.1% peak it briefly reached in early May, which was itself just below the 3.25% level reached the end of 2018, which caused a rapid decline in the stock market in late December of that year. A break above this zone also represents a break of the multi-year downtrend in yields, so such a move wouldn’t go unnoticed. Real rates — returns adjusted for market-implied inflation expectations — are another thing to look for when looking for sources of potential pain. Real returns have recently turned positive again. When it hit 1% in 2013, it coincided with the attention-grabbing but ultimately benign “taper tantrum.” The same level at the end of 2018, later in the cycle and with stocks more expensive, proved harder to digest for equities, which had a nearly 20% slump that ended as the Fed signaled a pause in its tightening efforts. It is certain that oil rising above the March war-panic peak of $130 a barrel for WTI oil (was $120 now) would also pose an obvious additional challenge, although it remains a lesser burden now than the was from 2011-2014, adjusted for the larger size and lower energy intensity of the current economy. It is reasonable to sum up by saying that there is no shortage of potential sources of pain. Yet the markets have already absorbed a great deal of unpleasantness and have not finally broken down, largely because investors have collectively been fearing and flinching for months, anticipating pain rather than chasing pleasure.
Examining the stock market’s pain points as it tries to hold on to this resilience from the lows