Published November 25, 2022
The stock market began its decline one year ago. We posted the first chart below around that time to point out the danger ahead from the failed break higher in smallcap stocks.
Since that failed breakout, we have seen an absolute assault on markets by the Federal Reserve with interest rates being raised at an almost unprecedented pace. The short-term 2-year interest rate has jumped from near zero to 4.50% in twelve months (second chart).
The post-pandemic surge in the rate of inflation behind the Fed’s aggressive push has now peaked and begun turning downward. As a result, it will be difficult for the Fed to justify many more rate hikes with a slowdown then pause a reasonable scenario. This leads to some calls that the stock market has already seen the bottom for this cycle. Here’s a commentary from Barrons discussing one of those views:
“If the economy manages to avoid recession or experiences only a modest contraction, a new bull market may already be unfolding,” wrote Jim Paulsen, chief investment strategist at the Leuthold Group.
A peak in short-term rates could also mean the 10-year yield, a key component to stock-market forecasts, has also peaked. Higher short-term rates have played a role in pushing the 10-year yield higher this year, but recently, the 10-year yield has dropped to around 3.7% from a multiyear peak of just over 4.2%. That’s partly because higher short-term rates should ultimately reduce demand and long-term inflation, lowering the yield on the long-dated bond. That’s key for stocks because a lower yield on 10-year government debt increases the value of future profits, boosting equity valuations.
All of these indicators, though, do point to weakening economic demand. Earnings forecasts might have to decline in the next few quarters. Wall Street hasn’t cut earnings estimates for 2023 as much as it has historically by the end of a calendar year. And this isn’t a normal year; earnings pressure could be worse, given the risk of a recession.
But the stock market would likely resume rising before actual earnings results hit bottom. The market historically tends to hit bottom three to six months before earnings estimates bottom, according to RBC data. To be sure, if profit forecasts drop enough, stocks would find a new bottom. But if earnings expectations drop even by 11% from here, and the S&P 500 doesn’t fall as much, the index would remain above its low for the year.
Plus, an environment with profit projections falling likely includes falling bond yields. If company earnings—and stocks—are declining, then investors could rush into safe 10-year government bonds, the interest payments of which are guaranteed. That would bring the 10-year bond’s price up, and its yield down. The yield is attractive anyway, as it’s well above average annual inflation expectations for the next decade of 2.31%. In this scenario, a falling 10-year yield would support—or even boost—earnings multiples, even while earnings projections are dropping.
If it sounds like stock-market volatility is in store overall, that’s because it is. The S&P 500 could even revisit its low for the year.
There just won’t be enough economic destruction—or time—for the market to reach a new low before it sniffs out the end of all the carnage.”
The chart at the beginning of this article shows that smallcap stocks, which kicked off the market’s downward thrust, have not pushed further downward and may have put in the proverbial double-bottom.
Stocks kicked off the holiday-shortened week slipping back on concerns about China’s Covid case levels. The Nasdaq dipped -1%. Tuesday’s trade recovered that dip, however, as investors were cheered by a further drop in interest rates. Investors have come to view the Federal Reserve as being near a point of slowing down interest rate hikes as inflation appears to have peaked. That sentiment was confirmed by Wednesday’s release of minutes from the last Fed meeting. Investors responded by pushing stocks higher with a +0.6% rise on the minutes. Coming back from the Thanksgiving holiday, investors continued with a positive view, pushing the S&P 500 higher while Nasdaq stocks dropped back – the rotation of money from tech/consumer stocks to industrials being a recurring theme in recent weeks.
The S&P 500 (SPY) rose +1.64% this week but failed to push past long-term resistance at the 200-day moving average. The Nasdaq 100 (QQQ) added +0.81% while smallcap stocks (IWM) pushed higher by +1.28%.
Warm wishes and until next week.