by (Bloomberg) – Markets are “consistently wrong,” Boaz Weinstein said this week. For investors faced with conflicting signals from different asset classes, figuring out who is currently misleading the most has become a major challenge.
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Is it stocks where a surge previously confined to a handful of tech megacaps has shown clear signs of expansion this week? A $6 trillion rally is at stake. Or maybe it's bonds, where doom and gloom abound and bets on Federal Reserve rate cuts are mounting in a market where volatility is double what it was two years ago.
For investors, the potential penalties for being on the wrong side — basically misjudging the likelihood of a recession — get bigger with every rise in the S&P 500 that entered bull market territory this week. Analysts at JPMorgan Chase & Co. put the cost of a mistimed move higher at up to 20% if stock traders are found to have misjudged the direction of the economy.
“Something has to happen,” said Peter Cecchini, director of research at Axonic Capital. “Given that equity valuations in many sectors are stretched compared to realistic projections for earnings in 2023, we'd bet that the return will come from equities.”
The S&P 500 gained 0.4% this week, posting its fourth consecutive rise. The tech-heavy Nasdaq 100 lagged, posting its first decline in seven weeks as money flowed into troubled areas such as banks and small-caps. An index of regional lenders rose 3%, while the Russell 2000 rose nearly 2%.
Defensively positioned money managers have started to brace for the rally. In a survey by the National Association of Active Investment Managers (NAAIM), equity exposure rose at the fastest rate in more than two years. At 90%, the value was the highest since November 2021.
For his part, Weinstein, Saba Capital Management's chief investment officer, thinks it's a mistake to get too caught up in economic speculation. “Rather than saying, ‘I think there's going to be a recession, or not,' which I kind of yell at on the TV screen when I hear that, I feel like you have to think about different outcomes,” he said at the Bloomberg Invest event in New York.
This leads to a bet against corporate bonds at Saba, based on the view that a narrow yield spread makes a bet against corporate bonds too lucrative to pass up. However, for investors who increasingly rely on equities, the dangers increase.
While the S&P 500 is up more than 20% since its October low and entered what some are calling a bull market, its resilience has been at odds with the ever-growing warnings from the bond market. The inversion of the yield curve – a widely watched indicator of an economic recession – has worsened over this period as long-term government bond rates fell further below short-term government bond rates.
The gap is illustrated by a model led by JPMorgan that compares each asset's market price to its implied value, which is based on macroeconomic factors such as inflation volatility. While bonds have reflected ongoing uncertainty since February, the stock market is more confident and pricing in less risk than before the pandemic.
Should equities acknowledge the risk of inflation volatility like fixed income, the S&P 500 would be 20% below its current level, according to the firm's strategists, including Nikolaos Panigirtzoglou.
Of course, finding a consistent economic message across all assets is often a futile endeavor, as the evolution of the economy is not the only factor driving prices. A big force in stocks' rally in 2023 was the euphoria surrounding artificial intelligence, which boosted computing and software stocks, with the seven largest tech companies accounting for nearly all of the S&P 500's year-to-date gains.
It's also possible that, having sent stocks into a bear market in 2022 on mounting recession fears, stock traders may readjust their expectations about the timing and magnitude of an economic downturn.
In fact, it's not uncommon for stocks to rally amid bond market warnings of a recession. Using the yield gap between three-month and 10-year government bonds as a guide, a study by Leuthold Group found that since the late 1960s, if a trader bought the S&P 500 on the first day of yield inversion and, perfectly timed, sold at the next high, he could have had it all can be between 5% and 23%. With a holding period of around eight months, these increases averaged 13%.
This time the yield reversal happened in November, seven months ago. Since then, the S&P 500 is up 13%, in line with the average of previous post-inversion increases.
Coincidence? Possibly. But Doug Ramsey, Leuthold's chief investment officer, sees the market's recent rise as another “pre-recession rally.” In his view, while yield inversions have correctly predicted all of the previous eight recessions, stocks have tended to defy initial alarms as investors sought to take advantage of the final window of gains before the final downturn.
With small-cap stocks and cyclically weak stocks like banks out of the way lately, many market participants are cheering the expansion of equity ownership.
Ramsey is skeptical, warning that given the Fed's commitment to its anti-inflation campaign, the market could see “one last breath on this bounce”.
In the previous eight instances of yield inversion, the S&P 500 fell an average of 35% from mid-high to ending low, its analysis shows.
“Sometimes when the really down people finally join in, it's a sign that the party is about to end,” Ramsey said. “And unlike the endless market celebrations of the past decade, this one is missing a punch,” a nod to the Fed's stimulus policy.
As conflicting as wealth movements have been, 2023 is shaping up to be a tough year for consensus betting. From selling big tech stocks to going short the US dollar and long Chinese stocks, the once-hot deals on Wall Street earlier in the year are all faltering.
Even among stocks, a battle rages on. Consider the Russell 2000 and the Nasdaq 100, which took turns outperforming this month. For six consecutive sessions, their return differential was more than 1 percentage point. This is the longest stretch of large, listless rotations since November 2020.
Optimism that the economy can avoid a deep recession is helping a revival in small-cap stocks — stocks that are typically more sensitive to economic fluctuations — and the Fed is poised to rein in its aggressive monetary tightening.
The central bank is expected to pause rate hikes next week for the first time in 15 months, putting its policy on hold until December, according to economists polled by Bloomberg.
For Emily Roland, co-chief investment strategist at John Hancock Investment Management, investors should hold back the urge to make profits as the economic outlook remains bleak and today's winners could easily become tomorrow's losers.
“We're in that key party,” she said. “But my comparison in terms of gameplay: you might want to have a light beer instead of tequila because you might have fewer regrets in the morning.”
– With support from Lisa Abramowicz and Carly Wanna.
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