The prevailing wisdom regarding the equity market seems to be that growth is slowing, a recession is looming, and stocks have not yet priced in the effects of a recession on corporate earnings. Thus, the general expectation is that the market will move lower in the coming weeks and months.
At this week’s low on the S&P 500 (futures) at 3788, the market had fallen 9.4%(!) from its fleeting post-CPI high (4180, which was attained one day before Fed chairman, Jerome Powell, once again set in motion a selloff with renewed hawkish rhetoric). This latest swoon would appear to reinforce the conventional wisdom.
Alas, the economic reports this week provided no additional clarity. Some, such as consumer confidence, core durable goods, and personal income, were better than expected, while others (such as leading indicators, existing home sales, and personal spending) were weaker.
Nothing in the data, however, suggests a recession is imminent. In fact, the Atlanta Fed GDPNow forecast for Q4 rose from 2.7% to 3.7%. Moreover, after the release of the personal income number, Renaissance Macro tweeted:
“Sorry, but recessions don't happen when real incomes net of transfers are on the rise and this is up 3.2% annualized since June. Retail gasoline prices have declined about 25 cents per gallon so far in December. Thus, one should expect to see real incomes continue climbing.”
But even without a recession on the near horizon, the cumulative effects of rising rates, a slowing housing market, and equity valuations that are likely at least 25% above fair value (~3000 on the S&P 500) could still weigh heavily on the market in the near and intermediate terms.
Indeed, we continue to believe the market will eventually trade at or below 3000 on the S&P 500. Although whether that happens quickly (H1 2023) or in a more drawn-out way (H2 2023 or sometime in 2024) is anyone’s guess.
The interesting thing, however, is that if one had no idea about the macro backdrop and were looking only at how institutions and speculators were positioned in the futures and options markets relative to retail traders, one could be forgiven for thinking we were on the verge of a rally in risk assets.
To give one an idea of the current state of affairs:
Institutions recently turned relatively bearish the 2-year treasury note—a longtime bullish signal for stocks, especially when coupled with the other positioning we are about to describe.
Institutions are relatively bearish the euro, while speculators are relatively bullish—institutions tend to get the euro direction “wrong” (in reality, they are likely long European equities and shorting the euro to hedge their currency risk), while speculators tend to get the euro direction right—a rising euro has historically been bullish for risk assets (especially emerging markets).
Speculators are relatively bullish Eurodollar futures, which when coupled with being relatively bullish the euro, has historically been bullish for Energy, Materials, and Industrial stocks (as well as other cyclical sectors).
Despite the widening of the interest rate band in Japanese government bonds, speculators are still relatively bearish the yen—a hallmark of carry trades and supportive of risk assets.
Speculators sold dollars last week as though their lives depended on it. As a result, relative sentiment in the U.S. dollar likely won’t turn bullish (for the dollar) anytime soon. Instead, bearish dollar relative sentiment might take some pressure off (recently rising) real rates, which could reignite investors’ risk appetites.
Speculators turned relatively bullish crude oil futures last week after a brief period of relative bearishness. When speculators are relatively bullish crude oil futures (a sign of positive growth), good things tend to happen for equities. The same is true when institutions are relatively bullish natural gas, which they also currently are.
On the equity front, institutions are still relatively bullish equities, but where it gets complicated is when we consider how they are also positioned in long-duration bonds and along the yield curve (the combination of those three pieces of information is more predictive than just looking at their positioning in equities).
If we are in an environment where investors will continue to care about inflation and where equities and bonds will continue to have positive correlations, then how institutions are currently positioned in the 10-year and 30-year bonds is likely bearish for equities.
However, if we have transitioned into a state where investors are more concerned about growth than inflation and where equities and bonds will have negative correlations, then institutional positioning in bonds is bullish for equities.
We have been working under the assumption that the former is the case (i.e., that the market still cares about inflation and equities and bonds will have positive correlations, simply because there has been no evidence to date of a reemergence of negative correlations). Under that assumption, our composite relative sentiment indicator will likely range between 64%–73% next week—a moderately bullish reading (after having dipped into the low 50s the last couple weeks).
If the latter is the case, however, (i.e., equities and bonds will switch to having negative correlations), our composite relative sentiment indicator would instead range between 89%–97% next week—an extremely bullish reading.
Given the uniformly bullish positioning—for risk assets—in the dollar, the euro, the yen, the Eurodollar, the 2-year note, crude oil, natural gas, and equities, one wonders whether the market a) may be about to transition back to caring more about growth, b) sees that growth as sufficient to avoid a recession?
We found it somewhat surprising how intently speculators sold the dollar last week—they now have their most bearish relative position in the dollar since just after Powell threw the kitchen sink at markets, liquidity-wise, in late-March 2020. That bearish dollar positioning certainly doesn’t match up with the continued hawkish rhetoric of the Fed.
Similarly, the Fed funds futures market also appears to be at odds with Fed rhetoric, forecasting only two more 25 bp hikes and a 25 bp cut by November of 2023, in contrast to the Fed “dot plot,” which is suggests three more 25 bp rate hikes and no cuts until 2024.
On the one hand, this Fed funds pricing could be bearish from the perspective of “growth will crater, thus the Fed will pivot.” On the other, it could be a forecast for rapidly decreasing inflation while growth remains resilient coupled with the reality that the U.S. government fiscal situation might require lower rates sooner rather than later.
High-yield credit spreads are also not buying the notion of an imminent recession. Such spreads are (slightly) narrower in December despite the strong selloff in equities.
Thus, while the financial media chatter has had a bearish tone since the December FOMC, the ‘smart money’ is acting as though we’re headed for a soft landing.
We’re hesitant to follow suit, however, as:
The smart money has been relatively bullish equities since late June, and while equities are higher now than then, every foray higher by equities this year has been (violently) snuffed out by hawkish Fed rhetoric or unfavorable data.
The downside potential for equities seems greater than any reasonable upside potential, especially if earnings season (which will kick off in a few weeks) disappoints.
Mega-cap tech names, already down 25%–70% from all-time highs, likely still have a long way to go on the downside given how overvalued they were at the end of 2021—and they still make up a disproportionate percentage of the broad market indices.
And if we are headed for a recession sometime in the second half of 2023, the equity market would generally start anticipating that now and pricing it in.
Thus, it’s hard to be a bull right now. But if risk assets do rise, the smart money will once again look like the cat that ate the canary.