2023-12-18 09:00:00 ET
Summary
- The bearish thesis on the S&P 500 has collapsed due to the Fed's unexpected dovish pivot.
- The pivot from "higher for longer" to rate cuts - before a recession - is bullish for the stock market as it could cancel the recession.
- Tactically, it is recommended to be bullish on the S&P 500 but expect volatility leading up to the 2024 US election.
The Bearish Thesis Collapsed
I've been bearish on S&P 500 ( SPY ) over the last 12 months. The bearish thesis was simple - the Fed inverted the yield curve in response to the inflationary shock, which historically led to a recession. Moreover, the Fed Chair Powell warned about the " pain " in his Jackson Hole remarks in 2022 and reiterated the need to keep interest rates "higher for longer" to bring inflation down.
The reference to "pain" was, what appeared to be, the required increase in the unemployment rate to 4.5% in 2023/2024 for inflation to return to the 2% target. The "higher for longer" interest rate policy implied that the Fed would keep monetary policy tight until the unemployment rate actually increases - which implied a recession. The likely recession further implied that corporate earnings would decrease by 15%+, which was not anticipated by the analysts.
Thus, the bearish thesis was based on the prediction that earnings would be significantly downgraded for 2024 as the recession becomes obvious - and this would trigger a recessionary bear market in S&P 500. The cornerstone of the bearish thesis was the Fed's promise of "higher for longer".
In one of my bearish articles, somebody asked me in the comment section what would make me become bullish on stocks. The answer was simple: I replied that I would turn bullish if the Fed starts cutting interest rates before the recession comes, which would essentially cancel the recession.
In my view, the probability for this "soft-landing" or the 1995-like scenario was very small (in 1995 the Fed cut interest rates before a recession).
And yet, it looks like that's exactly what's happening - the Fed just signaled the plan to start lowering interest rates over the next 2 years, while the unemployment rate is still 3.7%. Yes, unemployment is expected to increase to 4.1%, but mostly due to the increase in labor supply, and not job losses. This does not look like a recession. Thus, the Fed abandoned the "higher for longer" policy and no longer sees the need for "pain". Thus, the bearish thesis collapsed.
Tactically Bullish
To briefly refresh my playbook, I am fundamentally bullish on the stocks unless:
- The Fed is expected to aggressively increase interest rates, which could cause liquidity shock and the PE multiple contraction, and thus, a significant correction in the stock market, especially if the market is overvalued. This is essentially what happened in 2022 - the Fed tightened monetary policy, which caused the 2022 bear market as the PE contracted from over 30 to just below 20.
- There is an imminent recession and a significant earnings downgrade risk, and thus a high probability of a recessionary bear market.
- There is a high probability of a credit crunch and forced selling due to a spike in corporate bankruptcies, defaults, and the resulting margin calls. An example is the September 2008 Lehman Brothers bankruptcy.
- Any external shock that indirectly or directly increases 1) inflation, 2) the risk of a recession, or 3) the spike in credit spreads. Example, geopolitical events.
So, what do we have now?
As early as September, the Fed was signaling one additional hike in 2023, but now the Fed is predicting the cuts over the next 2 years - and this by itself could cause PE multiple expansion. Yes, the current PE ratio for S&P 500 ( SP500 ) is around 21, but it could continue to expand as the bubble reinflates. So, this is bullish.
The pivot from "higher for longer" to "cuts" significantly reduces the probability of recession, simply because the Fed apparently does not want (need) a recession. The labor market shortage means that the job market is likely to remain tight, which is likely to support consumption. As a result, the 2024 expected earnings are not likely to be significantly downgraded - or at least not enough to cause a bear market. So, this is bullish because it's not bearish anymore.
The credit spreads are still very tight, and the probability of a serious credit event (for example in the Commercial Real Estate space) is now lower given that the Fed is expected to lower interest rates, and given that the probability of a recession is much lower. So, this is also bullish.
Thus, it seems appropriate to be tactically bullish on S&P 500. What does this mean?
Implications
The S&P 500 already made a strong move higher from the October's 10% correction lows. Thus, and the probability of technical profit-taking is now high, which suggests that tactically there could be a better entry point.
At the same time, there are likely to be heavy inflows into the stock market from the institutional investors who have been underweight stocks this year. For example, BlackRock was underweight US stocks because:
We are underweight the broad market - still our largest portfolio allocation. Hopes for rate cuts and a soft landing have driven a rally. We see the risk of these hopes being disappointed.
Obviously, the Fed's pivot was completely unexpected by Wall Street, and consequently, I expect to see the upgrades to the S&P 500 2024 targets and institutional inflows into the stock market. Thus, some long exposure is recommended.
For me, I converted the bearish short call option position to a bullish covered call, with max profit at the 5000 level, as the opening move.
Volatility Expected
Overall, I expect a modest uptrend in S&P 500 but with high volatility going into the 2024 US election - which will be a good environment for traders. Specifically, these are the factors that could cause volatility:
- Inflation. Will the inflation fall quickly as estimated, and thus allow the Fed to cut as expected? The good news on inflation might not as cheered anymore, but the bad news will be severely punished by the market. Nevertheless, the Fed is dovish, and it seems content with 3% inflation, so any dip due to higher inflation will be a buying opportunity.
- Long-term interest rates: If the long-term bonds "sniff" that the Fed is content with the 3% inflation, we could see a rise in 10Y yields toward 5% again, and this could potentially be a reason to be bearish again. Similarly, the US Treasury Bond auctions will be important.
- Growth and unemployment: the assumption is that the Fed's expected cuts will cancel the recession. However, the lagged effect of prior hikes could be starting to hit the economy, and we could actually get a recession. Thus, the bad news on growth and employment will be bad news for the stock market.
- Political/geopolitical: The new year will start with another possible government shutdown, which could cause a 10% correction and a better entry point. The new year will also start with the election in Taiwan. The geopolitical situation in the Middle East could escalate and push oil higher - which would make it hard for the Fed to cut. The year ends with the US elections, and all the uncertainties associated with it.
These are all risks that could cause volatility in the stock market. However, as long as the recession is avoided and the Fed cuts as expected, the market is likely to grind higher.
SPY Sectors
This is the performance of SPY and SPY sectors over the last month, which is a reflection of what could lead the market in 2024. The top-performing sectors were Real Estate ( XLRE ) and Financials ( XLF ). This reflects a steepening of the yield curve, which is good for the banks, and lower interest rates and thus lower credit risk for REITs. The Industrials ( XLI ) and the Materials ( XLB ) also outperformed due to a lower probability of a recession. Thus, overall, the recent SPY sector performance is also bullish for the sustainability of the market rally, as it shows broadening due to fundamental reasons.
SPY is the most popular ETF that tracks S&P 500, popular with institutional investors due to high liquidity ($458 billion AUM) and individual investors due to low fees (0.09%). Note, the short interest for SPY is still very high at 12%, which could also support the uptrend as the shorts are forced to cover.
For further details see:
SPY: Tactically Bullish - The Bear Thesis Collapsed