Analysis | It’s Far Too Risky to Assume That the Bottom Is In

That said, the July rebound was truly something to behold. My colleague Cameron Crise had a great Macro Man column on the Bloomberg terminal today in which he looked at all incidents in which the S&P dropped 7.5% in one calendar month and regained at least that much in the following month. It doesn’t happen often. In fact, this is only the sixth such occurrence since World War II. The others came in October 1974, October 2002, March 2009, January 2019 and April 2020. Regular readers will recognize those as famous buying opportunities when the market was at or near a major bottom. The S&P 500’s average return 12 months after these turnarounds: 30%.

False all-clears do happen during long bear markets, then, but this rebound is quite something. Cameron also notes that there were five such incidents between 1931 and 1940, and most of them were terrible times to buy. By comparison with the Depression era, all of the five turnarounds since 1974 came once the Federal Reserve had already slashed rates very aggressively. That hasn’t happened yet, and surely can’t happen for a while. So this bounce involves great, indeed unprecedented, confidence that the Fed will soon execute a dramatic pivot. 

Is this premature? Morgan Stanley Wealth Management’s Lisa Shalett certainly thinks so, and comes up with a great Wayne’s World reference to make her point in a Monday note: 

“With another 75-basis-point hike in the fed funds rate, inflation metrics rolling over and recession indicators flashing red, both stocks and bonds have rallied on the prospect of a policy pivot. Mission accomplished? Not!”

She is sticking to the view that we’ve just witnessed a big bear-market rally, driven by investors who “seem to believe that inflation is defeated and expect the Fed will start cutting the fed funds rate as soon as next March.”

Concern that rising interest rates will drive the economy into a recession has been escalating as the Fed tightens monetary policy aggressively to bring down the steepest inflation in four decades. Chair Jerome Powell has said that failing to restore price stability would be a “bigger mistake” than pushing the US into a recession, which he has continued to maintain the nation can avoid.

Shalett offered three reasons why she sees more volatility for US equities:

• First, policy operates with a lag, which investors seem to be ignoring. “The implications of tighter financial conditions, higher interest rates and balance sheet reduction are still ahead of us. They are also moving up on the premise that inflation is tamed and that real yields will fall, supporting rich valuations for stocks and credit.”

• Second, policy uncertainty rises with the Fed abandoning forward guidance. This demands higher risk premiums. “A data-dependent Fed suggests more market volatility and surprises in both directions. With the full impact of policy still ahead, and with unknowns on inflation, liquidity, jobs and geopolitics, we prefer to wait for wider risk premiums that more appropriately value the uncertainty.”

• Third, stocks are at best only fairly valued, Shalett added. Shalett estimates that the equity risk premium is some 300 basis points versus an average 350 basis points for the past 13 years. As such, she expects weak growth in the near term and “higher-for-longer inflation.”

“The forward price/earnings ratio on earnings that are still likely to be downgraded is 17.8,” she said. “During periods of aggressive Fed policy and going into recessions, history shows that the preferred entry point for stocks is when the ERP is above 450 basis points.”

As I covered yesterday, forward earnings estimates tend to have come down a lot from their peak by the time the market can make a navigable low. That absolutely hasn’t happened yet, and the process of downgrading appears only to have just started. These charts from Societe Generale’s chief quantitative strategist Andrew Lapthorne tell the story. Nasdaq profit forecasts for every quarter out to the second quarter of next year have been cut, and suffered a particularly sharp cut in the last few days, while the buoyancy of the energy sector hides the fact that for the rest of the S&P 500, the earnings growth forecast for this year is teetering close to zero. As it would be unusual to suffer an economic recession or equity bear market without an outright fall in profits, this suggests more to come:

Given the magnitude of the unknowns, Shalett said she is “surprised at the power of the ‘risk-on’ sentiment… If valuations were truly washed out and compelling, we might understand the willingness to make some wagers. But they are not.”

To illustrate, here is how the Bloomberg measure of the S&P 500’s prospective price/earnings multiple has moved over the last 25 years, compared to the S&P’s relative performance to Bloomberg’s Treasury index. Lows for the p/e ratio tend to align nicely with good opportunities to buy stocks relative to bonds. But in all previous cases, the buying opportunity came with the p/e ratio below 15; this time it stopped at 16 and rallied, even though the prospective earnings on which that p/e is based look too high to many people. Further, it’s not as though stocks have done very badly relative to bonds this time. I’ve circled the four buying opportunities signaled by Cameron Crise’s hunt for months of big stock turnarounds that I mentioned earlier, and this looks nothing like any of them:

It’s important to keep an open mind. No previous stock market selloff of the last 100 years was preceded by a global pandemic, or the desperate fiscal and monetary measures that accompanied it, so these waters are uncharted. But on balance, it’s best to work on the assumption that the bottom is not yet in. 

There is at least one very promising item in the regular data download that accompanies the beginning of the month. The ISM Manufacturing survey for the US regularly asks purchasing managers about prices paid. That number topped 90 at one point last year. Now, after a sharp and unexpected fall last month, it’s back to 60. That’s encouraging for inflationistas because over time it’s been a pretty good leading indicator of producer price inflation. The following chart shows the Prices Paid index, with the year-on-year producer price index lagged by six months:

Flukes happen, but this looks encouraging from the point of view of anyone who wants inflation to come down. Whether because demand is being destroyed, or (more likely) supply chain pressures are easing, it looks like there is a reduction in pressure in the pipeline.

That might help to reconcile some of the more contradictory signs coming out of the bond market. Looking at the yield curve, it suggests growing conviction that a recession is imminent (and also by extension belief that inflation will soon be licked). The most-watched version of the yield curve, the gap between two- and 10-year yields, is now as deeply inverted as it has been in 16 years. In other words, shorter-dated yields exceed longer-dated yields, a stance that only makes sense if you expect the economy to slow down shortly.

Less closely watched, but a more fail-safe recession indicator because it tends only to invert once short-term rates are being hiked and an economic slowdown is truly imminent, is the three-month/10-year yield curve. (Note that it somehow briefly inverted on the eve of the Covid lockdowns in February 2020.) The two have moved in different directions for much of the last 12 months, but now the three-month curve has flattened dramatically. It’s within 21 basis points of inverting:

Then there is the strange behavior of inflation breakevens. The five-year/five-year breakeven, much beloved of the Fed and measuring the market’s judgment of the likely average inflation rate for the five years that start five years hence, has risen sharply in the US in the last few days. It’s still below its peak from earlier in the year, but it’s heading in a direction that suggests the Fed will be outright lenient. And judging by the equivalent breakeven for Germany, where the possibility of a return of inflation suddenly took hold of the imagination a few months ago and receded as soon as forecasts managed to exceed those for the US, it looks as though this is an American phenomenon. While much of the market is positioned for a hawkish mistake by the Fed, breakevens suggest there’s more of a risk of a dovish one:

To be clear, the markets from which breakevens are derived aren’t the most liquid corner of the fixed-income market, and it’s possible this is a false indicator driven by quirks of liquidity. But it’s mighty strange.

To contradict the bond market, it’s now time to pour gasoline on the fire. The generic gasoline future contract moved over to a new month today, so the sharpness of Monday’s fall could be overstated — but somehow the futures price of gasoline is back where it was on the eve of the Ukraine invasion. Prices at the pump tend to follow with not much lag: 

All of this might conceivably change the American political calculus. Gas prices matter a lot. They’re visible, they move quickly, and they can really hurt. Ahead of the latest fall in the futures price, the American Automobile Association’s estimate of the average price at the pump was showing a year-on-year inflation rate that was its lowest since early 2021, barring a few days just before the Ukraine invasion. True, year-on-year inflation is still at a nosebleed 32%, but the direction of travel is unmistakable: 

Plenty of geopolitical factors will help to determine whether the gasoline price stays so low, and cheaper gas will do nothing to deal with the issues of rising rents and rising sticky prices elsewhere in the economy. It’s conceivable, however, that they could change psychology. That’s very far from a certainty, but for stock market bulls and US Democrats alike, it’s a ray of hope.

OK, this could be a life-changing one for anyone who subscribes to the Bloomberg terminal and needs a B-unit (the little credit card-size gizmo that can take your fingerprint and converse with a computer to allow you remote access to the terminal). As I admitted yesterday, I left my B-unit behind in a cabin in New Hampshire, closing myself off from remotely accessing the system.

Several readers, and several colleagues, told me today that there is now a B-unit app available for iPhone and Android. Download it, and spend a few seconds letting it look at your face, and you no longer need a B-unit. The downside is that you become even more dependent on your phone, but that Rubicon was passed a long time ago. It’s worth doing. (And if you’d like to listen to something, I’ve had some complaints about refusing to link to “Ice, Ice Baby” by Vanilla Ice, which I will continue not to do. If that’s too frustrating, try this version of Under Pressure, from the memorial concert for Freddie Mercury, with David Bowie accompanied by Annie Lennox in the role of Mercury.)

— With assistance by Isabelle LeeMore From Other Writers at Bloomberg Opinion:

• Why Stocks Took July Off From Fundamentals: Mohamed El-Erian

• Blaming Inflation on Central Banks? We Enabled Them: Daniel Moss

• Wishful Thinking Won’t Help the Fed Beat Inflation: Bill Dudley

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

John Authers is a senior editor for markets and Bloomberg Opinion columnist. A former chief markets commentator and editor of the Lex column at the Financial Times, he is author of “The Fearful Rise of Markets.”

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