Bear Market Bounce or the Beginning of a New Bull Market?
After a drubbing in June, global markets and asset classes rebounded strongly in July. To some extent a bounce was inevitable after markets reached such oversold conditions. It is common to see short, sharp rallies in bear markets and July certainly fit that bill. In addition to these technical considerations, the market narrative shifted more positively during July. Much of the June sell-off was over increasing concerns that the Fed’s actions would cause a recession.
The tone shifted as the Fed raised another 75bps (as expected) and Chairman Powell provided market soothing comments. His hawkish-at-all-costs tone shifted to one considered more dovish as he said the Fed would become more data dependent in the coming months to properly tune-in to the right balance between taming inflation and supporting economic growth. These comments fueled the rally and hope was restored that taming inflation without causing a recession was possible.
In the midst of this recalibration, second quarter GDP came in at -0.9%. Considering that first quarter GDP was -1.6%, the “technical” definition of a recession – two sequential quarters of negative real GDP growth – was met. Political squabbling aside, there are few economic indicators that would confirm anything other than economic strength. Yes, inflation is high and this is clearly impacting consumer sentiment. Last month we discussed how consumer sentiment has never been lower in the University of Michigan’s survey going as far back as 1977. But the labor market remains one of the strongest on record – the July unemployment rate was just 3.5%[1], job openings remain near record levels[2], and consumer spending remains at record highs[3]. Nevertheless, some economic indicators, such as ISM New Orders[4], are contracting and unemployment claims are increasing. Just as we predicted at the beginning of the year, the market is having difficulty gauging the “landing” spot of the economy as it descends from the unsustainable levels achieved in the stimulus-fueled 2021. We might even dub this the Great Deceleration.
Market Update
The global equity markets were up strongly in July. In the U.S, the Nasdaq experienced the strongest relative bounce finishing the month up +12.4%. Declining interest rates and very oversold conditions provided a perfect cocktail for a rebound at least in the short term. The S&P 500 and the Dow also rebounded nicely finishing up +9.2% and +6.8%, respectively. Despite these nice bounces, the S&P 500 and the Nasdaq are still down -12.6% and -20.5%, respectively, for the year.
The Fixed Income markets also rebounded from June losses. The Bloomberg Aggregate bond index rose +2.4%. Riskier bonds fared best as the High Yield bond index gained +5.1% but less risky Investment Grade bonds rose a solid +3.0%. While these rebounds are a nice reprieve, the High Yield and Investment Grade bond indices are still down -9.8% and -11.8%, respectively, for the year. 2022 has been a truly difficult year for investors as bonds have offered little protection and performed almost as poorly as stocks. The one silver lining is that it may not get much worse and new money into bonds can now earn yields that have been unavailable in recent years.
Finally, commodities saw a return to volatility with disparate performance across individual commodities. The broad Bloomberg Aggregate commodities index gained +4.0% in July leaving it up 22.8% for the year. Natural gas continues to be the big winner: up 26.6% for the month and +121% for the year. Oil, on the other hand, continued to weaken a further -10.2% to end the month at $98. Oil has now round tripped the surge brought on by Russia’s invasion of Ukraine. Similarly, wheat has now given back all the gains brought on by the fear that Ukrainian wheat will not reach global markets. The chart of the Wheat front month contract below is a valuable reminder that fear-induced surges are no different than the greed-induced surges we saw last year in Growth stocks and cryptocurrencies: assets that gain value quickly can also lose value quickly.
It’s Now All About Earnings Estimates
Last month, we spent time defining what a recession is and cited the group responsible for declaring such downturns. This “recession watchdog” (the National Bureau of Economic Research) has yet to opine on our current economic situation but, frankly, it does not matter much where we have been but where the economy is going. To that end, the economic narrative is simple: 2021 was unsustainably great, today is less great but still pretty great so what will the next 6-12 months be like?
We continue to believe the economy is decelerating to more normal levels and this would normally be a digestible trend for investors if not further complicated by surging inflation and rising interest rates. These two additional factors have created great uncertainty. So, the market has struggled to find any real conviction. Specifically, the market is uncertain as to what future corporate earnings will look like.
In the chart below, the S&P 500 index (in purple) is plotted against its forward PE (in green), which now stands at approximately 17.5x. Comparing this valuation to those pre-Pandemic, it seems reasonable. This means future gains in the index are likely to require higher earnings estimates. Much of the debate on the proper level for the S&P 500 centers then on the forward earnings estimates (the orange line). With second quarter earnings season wrapping up, there has been few downward revisions to earnings estimates. Or said differently, companies are guiding to earnings better than feared. So, the bull vs. bear debate hinges on the question of will the economy decline to levels that will require further downward corporate earnings revisions and, if so, by how much.
Forecasting earnings is a difficult exercise under more normal circumstances but in a decelerating economic environment, it is an even more challenging task. This leads us to lean more heavily on stock-picking and companies with powerful secular trends that have defensible earnings. If you can find these companies and own at a reasonable valuation, then it is possible to insulate one’s portfolio better against a significant downturn in economic activity.
Outlook
In short, we have not changed our outlook on the economy. It is decelerating from record levels. A process that at present looks more like normalization than recessionary. We also see many signs that inflation is peaking. Even gas prices are well off their highs[5].
We continue to expect that the Durable Goods part of the economy could experience a classic inventory-driven recession and those signs are emerging. WalMart, Best Buy, Temper Sealy, Whirlpool and Target (among others) warned this quarter about needing to discount “Pandemic” goods (e.g., patio furniture, TVs, bicycles and other goods bought during stay-at-home times) to clear unwanted inventories. It’s happening and along with the decline in related economic activity we are seeing a pickup in layoffs.
But what is also happening is that spending on Services continues to expand. Pent-up demand for travel and entertainment is driving a strong earnings recovery for businesses that were nearly bankrupted by stay-at-home mandates and other social distancing restrictions. Meanwhile other more idiosyncratic trends such as the demand for energy, healthcare and certain technologies continue to be strong. In short, there is plenty of value in this market, particularly with the pullback experienced this year, if you look in the right places.
Conclusion
If you took our advice last month and remained calm, you felt a lot better after July. That said, we are not convinced that recent gains were not simply a bear market bounce from oversold conditions as many macroeconomic variables remain unknown. In other words, we would caution against chasing this rally and prefer selectively adding to oversold positions with defensible earnings and high-quality fixed income. Patience remains the keyword of the day. It is too soon to declare the beginning of a new market cycle and a new bull market.
Disclosures
INFORMATION PRESENTED IS FOR EDUCATIONAL PURPOSES ONLY AND DOES NOT INTEND TO MAKE AN OFFER OR SOLICITATION FOR THE SALE OR PURCHASE OF ANY SPECIFIC SECURITIES, INVESTMENTS OR INVESTMENT STRATEGIES. BLOOMBERG IS THE SOURCE OF MARKET DATA. INVESTMENTS INVOLVE RISK AND ARE NOT GUARANTEED. PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RETURNS. BE SURE TO FIRST CONSULT WITH A QUALIFIED FINANCIAL ADVISER AND/OR TAX PROFESSIONAL BEFORE IMPLEMENTING ANY STRATEGY DISCUSSED HEREIN.