The long-term outlook for stocks remains questionable, as most of my leading indicators of risk assets suggest sub-par performance over the next year or so.
Importantly, the attractive yields on offer afford investors the ability to be paid to wait.
Shorter-term however, there remains potential for stocks to move higher in spite of all these long-term fundamental headwinds.
Investors will do well to continue to use any rallies to take profits and reduce high-beta equity exposure.
For a long-term investor, now is not the time to be overweight equities
Markets these days are so focused on short-term fluctuations and narratives we often lose sight of the big picture. To assist myself in sifting through all of this noise and key to assessing my allocation to stocks on a cyclical basis in my leading indicator dashboard. This comprises of a number of key measures of market internals, speculation, positioning, sentiment, macro and liquidity variables, as well as financial conditions that help determine when it is safe to buy-and-hold the broad stock market, and when it is not.
As has been the case for some time now, we remain stuck between a very bearishly positioned market that wants to rally (in the form of favourable market internals and bearish positioning), and a swath of headwinds that do no support stocks (the business and liquidity cycles, monetary conditions, higher yields etc.). Regardless of the potential for further gains over the short-term (as I will discuss later), I continue to find it increasingly difficult to justify any meaningful allocation to the broad US stock market (outside of tactical trades) given the number of material headwinds that remain.
Buying with the growth and liquidity cycles at your back is far easier (and more profitable) than buying when these dynamics are holding you down, as is seemingly the case at present.
Indeed, the business cycle outlook continues to suggest a material slowdown in the economy is on the cards this year. The ISM New Orders less Inventories spread suggesting a Manufacturing PMI of sub-45 is one such example.
Another is the Conference Board’s US Leading Economic Index, which has reached levels only seen twice - during the GFC and COVID lockdowns - over the past 60 years when measured on a six-month average month-over-month basis. Historically, stocks have not performed well during such readings.
Though such leading indicators are mightily depressing, I should add they are likely being skewed to the downside as a result of many soft-data points (i.e. surveys) that are included in many leading economic indicators have been biased downward due to 40-year high inflation. While many of the hard data leading indicators remain downward, but less so. Meanwhile, the economy continues to proves robust, driven by labour market and services sector strength.
How long will this last? My bias has been for a while now that any growth slowdown or potential recession will not occur in earnest until the second half of 2023, as this cycle plays out slower than expected. With the PMI looking like it may bottom out around the 40-45 level, stocks have done a solid enough job pricing in such a slowdown.
This does not mean you have to buy-the-dip.
Indeed, regardless of whether stocks have priced in a potential recession or not (I doubt it), corporate insiders continue to sell. It tends to pay to do what the executives and insiders do - and when they put their money where their mouth - rather than what they say. Few people know the inside of a company better than the corporate executives themselves, and as we will see later, corporate insiders are net-selling across much of the US equity complex.
Other leading indicators of risk-assets remain unfavourable too. US excess liquidity is one, pointing to a bottom around the latter stages of this year.
Likewise, the recent move higher in yields is also not supportive of stocks.
Nor are monetary policy conditions worldwide supportive of valuations.
Meanwhile, we mustn’t forget the S&P 500 is still very expensive. My interest rate adjusted CAPE ratio model is still above the 70th percentile for the past 60 years.
Valuations are the weighting machine after all. While they matter little in the short-term, over the long-term the price you pay determines much of the return you receive. Such fundamental indicators point to a poor decade for stocks.
Nowhere is this more prevalent than the high-beta areas of the market. Now is not the time to be overweight high-beta stock market sectors and assets.
Investors need to readjust their expectations and understand a buy and hold approach is very unlikely to reap any rewards given the current market conditions.
Fortunately, you can be paid to wait
There is simply no need to go out and buy the S&P 500 or buy the Nasdaq when short-term Treasury yields and offering what they are. You can be paid to wait. With the outlook for earnings, liquidity, growth and credit all poor and likely to translate into heightened volatility over the next year, now is not the time to buy and hold broad equities.
The S&P 500 earnings yield less six-month T-Bill yield disparity is at its lowest point in over 20 years.
As institutions, pension funds and global asset managers slowly rebalance out of equities into higher yielding bonds and short-term paper (they don’t need the risky stuff anymore), this is a significant and fundamental headwind facing risk assets over the foreseeable future. If institutions and the like are this disincentivised to take risk, why shouldn’t you be too?
This dynamic was noted recently in a fine manner by the FT’s Robert Armstrong, opining that “sometimes it’s useful to ask a dumb question. So here’s one: why would you buy equities right now, when 6-month Treasuries are paying more than 5 per cent?” No duration risk is required.
With the relative valuations between the two the widest in years, expect bonds to outperform stocks.
Although many view bonds as un-investible given the changing structural forces in play (and as the past year has taught us, this was justifiably so), stocks are likely is a worse position. The Wall Street Journal’s James Mackintosh noted recently: “The central lesson of financial history is that, over the long run, U.S. stocks beat bonds. But buying stocks when they are expensive—at 18 times estimated earnings for the next 12 months, they have rarely been pricier outside the dot-com bubble and the post-pandemic boom—is a recipe for substandard returns. At the same time, Treasury yields are back up to decent levels. There’s plenty of scope for bonds to disappoint if inflation turns out to be endemic. But at least they start out at a reasonable valuation, based on current yields.”
This then begs the question: Is there any value in the US stock market? Perhaps, if we break down the market into its various sectors and sub-sectors, energy and metals and mining are the clear standouts in terms of valuations and cyclical tailwinds, but they’ve been on a terrific run over the past few years so continued consolidation may well be on the cards.
Still, stocks could move higher short-term
Having said all that, I now say this, the short-term risk to stocks remains to the upside. Herein lies the advantage of having a secular, cyclical and tactical approach to markets.
Indeed, as was highlighted within my equity allocation dashboard, market internals and positioning dynamics still remain largely supportive of markets. Traders rejoice.
For the most part, everyone and their dogs are still bearish. Indeed, commercial hedgers (i.e. the smart money) remain nearly max-long while small trader put buying is still highly elevated. It is difficult for the market to top when everyone is positioned for it.
Markets have a way of finding the maximum pain trade for investors. Seemingly, this continues to be stocks up, not stocks down.
In terms of market internals, the most cyclical and economically sensitive areas of the market continue to outperform to the upside. Positive divergences like these tend to resolves themselves in a bullish manner.
Nowhere is this more prevalent than the relative performance of semiconductor stocks versus the Nasdaq 100, as well as in the recent price action of junk bonds. Again, positive divergences such as these tend to resolve themselves to the upside. Cyclical outperformance or underperformance generally leads the way.
Offering further short-term support for markets is the VIX complex. A number measures of the implied volatility term structure have diverged bullishly from the recent lows, as we can see below. What this means is implied volatility is being bid lower for shorter-dated optionality relative to longer-dated optionality (such as the regular VIX relative to the six-month VIX), suggesting near-term uncertainty is falling.
Another minor bullish divergence can be seen via my FX Flows indicator.
And finally, from a seasonality perspective, we are nearing a very bullish period of stocks that is Q2. In all, these forces could continue to force the market upwards, particularly if FOMO kicks in further.
From a technical perspective, key support on the S&P 500 resides at 3,950, also coinciding with the 200-day moving average, while a daily 9 DeMark sequential buy signal has just triggered. The line in the sand for bulls is probably around the 3,900 put wall area, a point in which there seems to be a large negative gamma area for dealers, and at which we could see a monetization of puts which would force the dealers to buy back their short-delta hedges, potentially providing supporting flows. However, should we break through the 3,900 level or see the put wall shift lower as traders buy more OTM puts on net in line with the move lower, then this sell-off may well continue.
Regardless, risk assets remain hyper-sensitive to macro variables, with yields and the dollar leading the way. Interest rate volatility in particular is having a material impact on risk-assets. Should rates continue higher and thus interest rate volatility continue to increase, expect equities to move lower in tandem.
In summary, should these technical levels hold and the recent move higher in rates and the dollar subside, there remains potential for stocks to move higher over the next month or two in spite of all these long-term fundamental headwinds. Given the latter, investors will do well to continue to use any rallies to take profits and reduce high-beta equity exposure. The higher we go short-term; the more pain is likely to be felt long-term.