QVMS - Pricing In Doom And Gloom

Summary

• This would be the most highly anticipated recession on record, if it comes to pass next year.
• Yet the stock market has been resilient in the face of all the doom and gloom.
• We're currently resolving a short-term overbought condition in the S&P 500.
• The real test will be next week's Fed meeting, along with its updated outlook for the economy and monetary policy in 2023.

Stocks fell for a fourth day in a row as the high-frequency economic data since Chairman Powell’s dovish tilt has been perceived to be too strong. The fear is not that we will see more than a 50-basis-point rate increase next week, but that when the Fed updates its “dot-plot” at the conclusion of next week’s meeting it will show a consensus that sees the terminal rate higher for longer. I think that would be a mistake, as recent data is not as strong as the headline numbers indicate, which Chairman Powell is aware of at this point. I think he's also being nudged by bank CEOs to be cautious about overtightening. That was yesterday’s message from several Wall Street heavyweights like Jamie Dimon and Brian Moynihan, who are preparing for a recession.

In fact, it seems like everyone is either preparing for a recession or forecasting one in what would be the most highly anticipated economic contraction on record. The good news is that analysts have stopped cutting estimates for the companies they follow after a torrent pace of downgrades last summer and fall. This has lowered the bar for 2023. Most Wall Street strategists have done the same by forecasting near-zero growth in S&P 500 earnings with new lows, if not retests of this year’s low, for the index next year. Why then has the stock market not discounted this widely anticipated event that is supposed to strike just months from now? This is one of the main reasons I remain cautiously optimistic about 2023.

Morgan Stanley’s Mike Wilson has been coined the best strategist on Wall Street this year because of his timely twists and turns in calling the broad market’s moves, while continuing to maintain a very bearish outlook for the long term. Honestly, his short-term calls were not rocket science, because all he was doing is looking at a chart of the S&P 500 and following the Volatility index ( VIX ). After making a no-brainer call that stocks would rally in early October, he turned negative again on Monday, as the S&P 500 contended with its 200-day moving average, and the Volatility Index simultaneously fell below the 20 level.

I say “no-brainer” because this has been the pattern all year long. The Volatility Index has traded in a range of 20 to 35 this year. When the index rose to 35, representing a peak in volatility, the stock market bottomed and turned up (green vertical lines). When the index fell below 20, representing a complacent market and bottom in volatility, the stock market topped and started to fall (red vertical lines). As I wrote several times last week, my main near-term concern was that the VIX was approaching 20 as the S&P 500 was reaching its 200-day moving average. Hence, we have had a near 5% pullback in the market over the past few days.

Here's another view of the S&P 500 with an overlay of the swings in volatility. The one caveat is that volatility tends to decline at the end of the calendar year and beginning of a new one, which gives me some hope that we can still have a year-end rally after we resolve the extremely overbought short-term condition in the market.

I suspect the next inflection point will be the Fed’s meeting on December 14. As expected, growth concerns are starting to outweigh inflation concerns in the marketplace. If the Fed expresses those sentiments in its updated outlook for the economy and monetary policy, we are likely to see risk asset prices recover into year-end. That's my expectation.

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