2023-05-20 08:26:00 ET
Summary
- Investor risk aversion peaked at the end of last year.
- Headline consumer prices and government bond yields peaked in June and October of 2022, respectively.
- The US currency and broader financial conditions have eased in the same time frame.
Originally published on May 12, 2023
By Talley Léger, Senior Investment Strategist
Over the past few weeks, we've experienced a tactical risk-off rotation in the form of bonds outperforming stocks and the defensive sectors of the stock market outperforming their cyclical counterparts. 1 While those trends may foreshadow another pullback at the S&P 500 Index level - akin to what we saw in December of 2022 or February of 2023 - I believe the primary uptrend (as defined by a series of higher highs and higher lows) should remain intact.
For US stocks to test and fail their October 2022 lows, I think five big concepts or peaks would have to reverse course and reach new highs, which I don't see happening anytime soon.
What does a stock market recovery depend on?
In my view, it relies on five peaks, four of which are clearly visible. Moreover, a monetary policy pivot may be on the horizon.
- Peak fear - My technical checklist of market bottom indicators suggests investor risk aversion peaked at the end of last year. Peak fear has usually coincided with major troughs in the US stock market.
- Peak inflation - Headline consumer price inflation peaked in June 2022. 2 Pandemic-related supply chain disruptions seem to be easing, with positive knock-on effects for inflation and stocks. I suspect policymakers and investors will be caught off guard by how quickly the disinflationary impulse asserts itself.
- Peak bond yields - The 10-year Treasury bond yield peaked in October 2022. 3 Peak inflation points to lower bond yields for now. Indeed, cooler inflation enhances fixed coupon payments, thereby increasing the value or attractiveness of outstanding debt issues (i.e., higher bond prices and lower bond yields).
- Peak US dollar - The US dollar index (DXY) peaked in September 2022. 4 Generally, strong US currency cycles end when Fed tightening cycles end. US policymakers seem closer to the end than the beginning of monetary tightening.
- Peak Federal Reserve ((FED)) - Since October 2022, we've enjoyed a broad easing of financial conditions, helped by falling government bond yields, a depreciating US currency, tighter corporate bond spreads above their Treasury counterparts, and rising stock prices. Together, those trends imply the Fed may soon pause its interest rate hikes.
Unfortunately, cycles don't die of old age … the Fed kills them with rate hikes! True, recent bank failures are the types of major credit events that end old market cycles. From a different perspective, however, financial crises can also begin new market cycles.
Is the herd right or wrong?
It's wrong. Ironically, mountains of cash have generally accumulated near big turning points in US stocks.
Cash hit an all-time high of $5.3 trillion this year
US stocks (dark blue, top panel) and cash balances (light blue, bottom panel) since 1990
Sources: Bloomberg, L.P., Investment Company Institute, Invesco, 4/21/23. Notes: Assets in taxable (i.e., Treasuries, repurchase agreements, agencies, large bank certificates of deposit, commercial paper, and banker's acceptances) and tax-exempt (i.e., federal, state, and municipal debt) money market mutual funds are short-term, high-grade securities. Natural log. Vertical dotted lines are used to highlight times when peaks in cash corresponded to troughs in stocks. An investment cannot be made in an index. Past performance does not guarantee future results.
In my experience, investors can be their own worst enemies, especially when it comes to making asset allocation decisions. Unlike shoppers at department stores, the investment community tends to run away from the stock exchanges when there's a significant markdown in prices.
Coming full circle, this is just another way of illustrating my first point about peak fear . I know it feels awful, but some of the best days in the stock market occur in the worst of times. As I'm fond of saying, chaos can create opportunities for patient, long-term investors … if they just stay the course.
Footnotes
1. Source: Bloomberg, L.P., April 27, 2023. Bonds represented by the Bloomberg US Treasury 7-10 Year Index, which measures the performance of public obligations of the US Treasury with a maturity between 7 years and 10 years. Stocks represented by the S&P 500 Total Return Index, which measures the performance of 500 of the largest companies in the US. US defensive sectors include the S&P 500 consumer staples, health care, telecommunication services, and utilities indices. US cyclical sectors include the S&P 500 consumer discretionary, energy, financials, industrials, information technology, and materials indices.
2. Source: US Bureau of Labor Statistics as of April 30, 2023
3. Source: Bloomberg, L.P.
4. Source: Bloomberg, L.P.
Important information
NA2867877
Header image: Manu Prats / Stocksy
This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.
All investing involves risk, including the risk of loss.
Diversification does not guarantee a profit or eliminate the risk of loss.
Past performance does not guarantee future results.
Investments cannot be made directly in an index.
In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.
Fixed income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer's credit rating.
A bond's yield is the return to an investor from the bond's interest, or coupon, payments.
A cyclical sector is an equity sector whose price is affected by ups and downs in the overall economy.
The discount rate refers to the rate of interest that is applied to future cash flows of an investment to calculate its present value. It is the rate of return that companies or investors expect on their investment. Inflation is the rate at which the general price level for goods and services is increasing.
Disinflation, a slowing in the rate of price inflation, describes instances when the inflation rate has reduced marginally over the short term. Deflation is a decrease in the general price level of goods and services that occurs when the inflation rate falls below 0%.
The Consumer Price Index ((CPI)) measures change in consumer prices as determined by the US Bureau of Labor Statistics. Core CPI excludes food and energy prices while headline CPI includes them.
An inflection point is an event that results in a significant positive or negative change in the progress of a company, industry, sector, economy or geopolitical situation.
Spread represents the difference between the yield on a corporate bond and a similar maturity US Treasury bond.
The ISM Manufacturing Index, which is based on Institute of Supply Management surveys of manufacturing firms in the US, monitors employment, production, inventories, new orders and supplier deliveries.
The S&P 500® Index is a market-capitalization-weighted index of the 500 largest domestic US stocks.
The opinions referenced above are those of the author as of April 28, 2023 . These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.
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