The bear market in US stocks may be nearing the end of Act I (adjusting to higher interest rates), and many investors are looking ahead to Act II (adjusting to lower earnings.) But the transition is taking longer than anticipated, and some are questioning whether Act II is truly coming at all.
That’s reasonable, and that uncertainty could make for some compelling short-term rallies in a stock market that’s been beaten up.
Of course, the stock selloff in the first 10 months of 2022 has been driven mainly by the surge in Treasury yields, with the 10-year note rising to 4.23% on Thursday, the highest since 2008. As Valuation 101 taught us, the jump in risk-free rates increases companies’ cost of capital and boosts sovereign bonds’ relative attractiveness compared with stocks. Investors refuse to pay as much for the same cash flows, and price-earnings ratios shrink. Here’s how forward P/E ratios have tracked 10-year Treasury yields so far in 2022:
If yields rise, P/Es will still naturally sink, but the balance of risks for sovereign bonds is nowhere near as bad as it was a few months ago. Yields are already approaching levels consistent with relatively hawkish monetary policy. In other words, the P in P/E ratios may soon stabilize, based on interest rates alone.
That introduces Act II of the bear market: growth.
Overall, Wall Street has made only modest downward adjustments to earnings outlooks this year. For all the recession hysteria, consensus earnings forecasts for 2023 are a meager 2% below where they started the year. Certainly, the overall figure is cushioned by energy earnings, and analysts have been more conservative about vulnerable consumer discretionary firms. But an average recession brings overall earnings per share down by 31%, and the median forecast in a Bloomberg survey of economists now puts the odds that there will be one in the next 12 months at 60%.
So why aren’t analysts more pessimistic in their earnings outlooks?
One obvious reason is that the hard data have given them no concrete reason to be. Retail sales have mostly continued to grow or at worst stagnate on a nominal basis, and unemployment remains extremely low. Meanwhile, third-quarter earnings appear poised to confirm the economy’s buoyancy.
Consumers are clearly fed up with inflation, but they keep spending and supporting corporate profits. At first, they were able to draw on sizable cash reserves accumulated during the Covid-19 pandemic. More recently, they have sustained their lifestyles by turning to credit. That can’t continue forever, and we may well have reached an inflection point, as Morning Consult’s head of economic analytics Scott Brave told me in a conversation Wednesday. But that isn’t in the hard data yet, and even then, it will look like a gradual deterioration in real spending, not a crash.
At the current rate, the economy could continue to send mixed signals until well into 2023. Bloomberg Economics, which forecasts a recession, isn’t expecting it to start until the third quarter of next year. Models are generally imprecise on timing, but on average it takes a while for these things to fester, as Bloomberg’s chief US economist, Anna Wong, points out. She noted that demand has even rebounded a bit in recent months.
Indeed, the long slog ahead is visible in the Federal Reserve Bank of New York’s Weekly Economic Index, a gauge of real economic activity scaled to the four-quarter growth rate and based on high-frequency data. It suggests that the economy is still cooling off after the unusual reopening dynamics from the Covid-19 pandemic. A crude trend-line exercise hints that, if the slowdown were to proceed at the current pace, the indicator wouldn’t even flirt with negative territory until March or April.
So, here we are: Act I of the bear market could conceivably be ending, provided inflation starts to behave in line with Fed forecasts, and traders aren’t finding many near-term catalysts to raise the curtain on Act II. Cue the contrarian bulls.
Naturally, that backdrop is fertile ground for short-term rallies, and that’s exactly what US markets have experienced, starting with the otherwise inexplicable 2.6% surge in the S&P 500 Index last week on a day when the Bureau of Labor Statistics reported that core inflation had reached a four-decade high. From the lows on Thursday to the highs on Tuesday, stocks rallied as much 7.8%, and several strategists have outlined the case for further upside:
- Morgan Stanley strategist Michael J. Wilson wrote this week that a bear market rally could take the S&P 500 to 4,000 and that he wouldn’t rule out an even larger jump to around 4,150.
- DataTrek Research co-founder Nicholas Colas said that a significant bear market rally was possible but that “it is critical that interest rates decline from here to support any further sustainable move higher for US large caps.”
That point on rates looks critical. With all the crosscurrents in the economy, it’s conceivable that bond yields could trickle back down for a while. But with the Fed committed to taming high and volatile prices, policymakers will probably keep a firm floor under bond yields until inflation looks to be well on its way to the Fed’s 2% target— something that could take months to materialize in the data even in the most optimistic scenarios.
Meanwhile, growth and consumer activity are nonstarters for the bulls. They may not confirm anyone’s bearish narratives in the immediate future, but any signs of strength in those indicators would only embolden the hawks at the Fed to do more. So in the near term, the fate of stocks remains wholly in the hands of monetary policy and the bond market. Whether or not Act II of the bear market ever materializes, the intermission itself could be almost as dramatic as the play.
Bloomberg News provided this article. For more articles like this please visit
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