Wall Street storms higher – Bear rally or trend reversal?



Stock markets staged a fierce comeback in the past month, emboldened by hopes that inflation has started to lose its kick and China is about to relax its covid strategy. Those are steps in the right direction, but fall short of signaling a trend reversal. Most leading indicators point to a recession that is yet to come, valuations remain stretched, and earnings estimates are still too rosy. The storm is probably not over yet. 

Markets party 

After a bruising year, equity markets finally received some good news lately. Softer inflation numbers out of the United States were heralded as the beginning of the end in the Fed’s inflation battle, and coupled with signs that China is preparing to reopen its embattled economy, sparked a fierce rally in risk assets. 

Alas, this rally that has propelled the S&P 500 index nearly 14% higher from its lows, seems premature. Signs that inflation is cooling are definitely welcome news, but inflation is still running at almost four times the Fed’s target, so it's too early to declare victory. A peak in inflation is one thing - how quickly it will come down is an entirely different matter. 

What is pushing inflation lower is equally crucial. By most indications, price pressures are simmering down because demand is collapsing at a stunning pace. That’s what business surveys suggest, with companies issuing grave warnings that the economy is headed straight for recession as higher borrowing costs and the cost of living crisis take a bite out of consumers’ wallets. 

Trouble ahead

It’s not only business surveys warning of a recession. In fact, every leading indicator argues the same point. Inventory levels are extremely high, which is a classic sign of a downturn. Fearful of shortages, big retailers ordered way too much and are now swimming in excess inventory they cannot unload.

Housing has fallen off a cliff. Home sales are down dramatically this year, which is natural considering that mortgage rates have exceeded 7% for the first time in two decades, discouraging borrowing. Home prices have also started to cool off, because of the same dynamics. 

Consumer confidence metrics are similarly alarming. Depending on which sentiment measure you look at, American consumers are either as gloomy as they were in the depths of the pandemic or the most pessimistic in four decades. People are unlikely to make major spending decisions if they feel so disheartened. 

Most importantly, the Fed’s favorite recession indicator is screaming of trouble ahead. The yield curve is deeply inverted, with 3-month Treasury yields currently trading far above 10-year yields. This means bond traders are betting the economy is about to hit a wall, and it has preceded recessions with terrifying accuracy. 

Globally, the situation is even worse. The latest forecasts from the European Commission expect the economy to begin contracting this quarter already, while the outlook for China remains dire as the devastated property sector continues to deleverage. This process involves serious economic pain and takes years to play out.

Unrealistic valuations

In the markets, the core problems are that valuations are still way too expensive and earnings estimates have not been calibrated lower to reflect the weakening economic data pulse. Therefore, even though the latest rally can go further purely on momentum and short-covering, it is likely to run out of steam before long. 

On the valuation front, the S&P 500 is trading at a forward earnings multiple of 16.5x, whereas most selloffs over the last decade concluded with a multiple closer to 14x. Bear in mind that the last decade was characterized by very low interest rates, which artificially boost valuations. 

Hence, in the higher interest rate regime of today, the market could bottom at an even lower multiple. This provides ample scope for further downside purely from a valuation perspective, before even considering earnings declines. 

In earnings, analyst estimates for next year remain overly optimistic, and out of sync with what leading indicators suggest about the economy. They will most likely be revised lower as demand loses power, especially on a global level, as S&P 500 companies receive almost half their revenue from overseas.

Big picture

All told, the storm is probably not over yet. By every metric, a recession seems almost inevitable. Interest rates simply rose too far and too fast, right as government spending started to roll off. The real question is how long and how deep any recession will be. 

The bright side is that it could be relatively brief and shallow, since it is driven by policy actions, not some external shock. If the Fed and the government are essentially causing a recession to squash inflation, they can also turn the ship around before it sinks completely. 

Make no mistake, there will be more financial stress. Crypto exchanges blowing up and UK pension funds facing collateral issues are simply the first symptoms of what happens when liquidity gets drained. More accidents will inevitably follow as a decade of zero interest rates is unwound. 

Yet, investors need to keep things in perspective. While equity markets could resume their slide as valuations and earnings estimates adjust to reality, every crisis eventually passes and markets move higher over the years. It pays to be cautious, but ultimately, a healthy dose of optimism is needed to succeed in the stock market. 

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