Research.LeutholdGroup

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There is still considerable debate about whether the bear market has yet set its low. Certainly, if the U.S. economy is headed for a deep recession, stock investors will face additional, significant downside risk. Several smart bears on Wall Street suggest the S&P 500 could decline to about 3,000—or -25% from today’s level—as analysts are forced to cut earnings estimates. However, if the economy manages to avoid recession or experiences only a modest contraction, a new bull market may already be unfolding. While, understandably, downside risk typically gets the most attention, investors should also consider what the “upside risk” could be in the coming year if the “low is already in?”

Our studies of economic and stock market history are meant to provide perspective, not an investment roadmap. But occasionally a current trend will resemble the past so closely it’s eerie.

Take the current inflation cycle. If (as we believe) June’s CPI inflation rate of 9.1% represents the peak for this business cycle, then many of its characteristics have lined up almost perfectly with the “average” of past inflationary episodes.

The debate surrounding “how long” U.S. inflation could remain elevated and how quickly or slowly it will return to “normal” is far from over. However, at the very least, it appears that inflation has peaked. During the last few months, the annual CPI, PPI, and wage inflation rates have declined noticeably and significantly from their respective cycle highs. Several concerns still need to be addressed. Will inflation persist at its current unacceptable level and require much more aggressive policy action? Could inflation expectations yet become unanchored? Is a recession inevitable? Or, now that we’ve seen the inflation peak, will conditions promptly return to normal?

Inflation has been slowing for the last several months and finally appeared in the “headline” numbers last week. Although a single comforting CPI report will not eclipse ongoing concerns about inflation, leading up to that report, there was a broad array of evidence that inflation was moderating and has probably peaked—e.g., falling commodity prices, decelerating wage inflation, declining import and export prices, renewed deflation in the Adobe Digital Price Index, various private sources (like Costar and RealPage) illustrating that rents had decreased, a downturn in used vehicle prices, a complete collapse in shipping rates, and increasing numbers of retail price discounts due to inventory overhangs.

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Lower than expected CPI figures give the Fed an opportunity to ease the pace of tightening. Markets, probably bracing for yet another higher than expected reading, shoot higher. Our Scorecard sees inflation’s downward trajectory continuing.

In August 2020, the 10-year U.S.-Treasury bond yield hit an all-time low of about 50 basis points. Since then, the primary problem for bond investors, understandably, has been “more sellers than buyers.”

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The U.S. stock market has been ugly all year. Last week, with a Fed meeting and presser—surprise—the stock market had yet another LOUSY showing. Nonetheless, despite the Federal Reserve reiterating that the pain is far from over, investors should note that the S&P 500 has stopped falling. It might not feel like it, but after trending persistently lower during the first five-and-a-half months of 2022, the stock market has now been “Flat” for the last “Five.”

Thanks to the 2009-2021 experience, an entire generation of investors can’t distinguish between a stock market that’s down in price and one that’s actually “cheap.” The current bear market seems on course to make that distinction relevant again.

There might be “too much money chasing too few goods,” but some monetary measures imply there’s “no longer enough money” to finance production of those goods and still support a stock market that’s far from cheap.

A rotation from Growth to Value resumed in grand fashion in October. Qualitatively, new leadership sounds like a good thing. Statistically, bulls ought to hope that the tape gets back into gear.

The main yield curve drivers—fiscal and monetary policies—might be suggesting a steepening move is coming soon, while bank stock performance may also be hinting at a turn in the curve. However, a durable selloff in the U.S. dollar would be needed to support a steeper yield curve, so the tightening pain could last a while longer.

With an 8% S&P 500 advance in October, our valuation measures bounced pretty hard off the contemporary lows. The estimate for downside to the median,1957-to-date, widened from -21% to -27%; while the “New Era” estimate (1995-to-date) worsened to -12% from -5% at the beginning of October. 

During the last 18 months, the U.S. economy and financial markets have been challenged by persistent declines in real liquidity growth. Slower real monetary growth—with a lag of one year or more—tends to moderate real economic growth, inflation pressures, and corporate profit expansion. In a more coincident fashion, stocks and bonds also struggle as liquidity becomes inadequate.

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Since at least Jackson Hole, the narrative has been that inflation is a big problem, and the Federal Reserve was up for the fight—certifying it would raise interest rates quickly, substantially, and for a long time. Powell gave his “tough-love” speech on August 26th when the S&P 500 was at 4,200 and the Treasury yield was near 3%.

“Money illusion” continues to complicate analysis of the economy and financial markets. It might be a time when age and experience will actually prove helpful: Only investors who are 65 or older have experienced gaps between “nominal” and “real” data as wide as today’s.

Not since the late 1970s has uncertainty surrounding monetary policy and the Federal Reserve been so pronounced. Of course, current anxiety about Fed actions is the direct consequence of the highest inflation in 40 years. Nonetheless, the aggressive and unorthodox policies enacted this year by the tough-talking and tough-acting Fed have led to some of the most pessimistic investor-sentiment readings in history.

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Until mid-year, inflation fears intensified, bond yields rose, the Fed raised the funds rate, and the stock market declined. Since mid-year, inflation fears have intensified, bond yields have risen, the Fed has persistently raised the funds rate… but the stock market stopped falling. The S&P 500 surged from its June lows, collapsed in August, and is now basically unchanged over the last several months.

The balanced portfolio strategy of allocating 60% to equities and 40% to fixed income generated a highly satisfactory 7.9% annualized return over the last 30 years. Despite the excellent returns earned by investors following this strategic model, the past couple of years have seen a parade of articles with headlines such as “Is the 60/40 Portfolio Obsolete?” and “Is the 60/40 Dead?” Given the central importance of this moderate allocation strategy to investment industry practices, we felt a closer look at the 60/40 portfolio was in order.

How much more and for how much longer will the Federal Reserve keep raising interest rates? Will a significant upturn in the unemployment rate stop them? A surprising drop in a headline inflation reading? Or will recent Fed actions “break” something, resulting in a financial shock? Who knows?

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Both the headline and Core CPI are a tad hotter than expected. While shelter contributed the bulk of the upside surprise, it’s set to slow in the coming months. Our Scorecard indicates that inflation pressure should begin to ease a bit fairly soon.

Sentiment measures have been lousy most of this year. The CNN Fear and Greed Index is at 19—categorized as “extreme fear.” The AAII Bulls Less Bears indicator has been below -20 much of the year and is now at -31—lower than 98% of the time since its 1987 inception. The Investors Intelligence Bull/Bear Ratio, which tracks the market sentiment of financial advisors, is currently less than 1.0, illustrating panic. The 10-day moving average of the CBOE Equity Put/Call Ratio is higher than at any time since the March 2020 pandemic collapse. And, finally, the stock market’s “fear gauge”—the CBOE VIX Volatility Index^®—has frequently been above 30 this year (as it is now).

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The lagged impact of an array of contractionary economic policies in place since early 2021—a severe deceleration in monetary growth, substantially less fiscal accommodation, a surge in the U.S. dollar, and significantly higher yields across the yield curve—is already slowing both real economic growth and inflation and will surely moderate profit growth. However, there is mounting apprehension that company earnings growth will not only diminish but collapse as the Federal Reserve pushes the economy into a recession.

The P/E multiple on Trailing Peak GAAP EPS has plunged 44% from its year-ago peak of 32.5x. The current ratio of 18.1x is below its “New Era” median (1995-to-date) —but some conditions characterizing the New Era no longer apply.

The current bear has been no more than moderate based on conventional measurements. However, the loss of market wealth in relation to GDP is not too far from the levels suffered during the Great Financial Crisis.

The 60/40 strategy is having a terrible year, and its failure to protect investors in the bear market prompted us to take a look at the history and theory of the 60/40 guideline. We offer an early preview of the study, with a focus on 2022’s abysmal year-to-date returns.

The latest ISM Manufacturing numbers resulted in a downgrade to that factor from “green” to “yellow.” Unemployment claims is the lone component with a green light on the dashboard. Overall, the various measures we track suggest the risk of a “real” recession is high—better than 50%.

The latest BoE and RBA pivots fueled the market’s hope that global central-bank hawkishness has possibly peaked. We believe the market is likely to be lured by the prospect of a Fed pivot in the near term, only to be disappointed as that hope fades away.

With overwhelming concerns about inflation, overheated economic growth, and Federal Reserve tightening, any good news is mainly perceived as “bad news.” Reports showing strong consumer spending, healthy industrial activity, better housing numbers, or solid job figures only raise fears that the Fed will be forced to lift interest rates higher for longer. It’s a tough environment for investors. Typically, evidence of “economic health” is a good thing. Until the Fed blinks, however, and inflation anxiety moderates, news that is ordinarily good will be “bad.”

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We’ve heard no references lately to the famous “Fed Model” for stock market valuation. We think we know why: The model’s usual proponents probably don’t like its current verdict—which is that stocks are far more expensive than at the early January market peak.

Just a few unrelated concepts to end a turbulent week.

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Over the years, I’ve never tried to “figure out” what the Fed would do. Rarely spent much time adding up the number of doves versus hawks comprising the board. Didn’t find much value in parsing “Fed Speak,” carefully examining changes in the minutes from the last meeting, trying to reconcile widely diverging opinions among the multiple speeches of current members, and certainly never did a deep dive into the dot plots. Turns out, that was a mistake!