2022 will go down in the history books as the year of the return of inflation, the likes of which have not been observed for at least forty years, and as one of the years in which the higher correlation between stocks and bonds in recent history. In addition, the return of a bear market, officially for about six months, represents another factor with which an entire generation of investors, especially the one who started their career after 2008-2009, has never confronted. This can be read from the weekly analysis edited by Edoardo Fusco Femiano, founder of DLD Capital SCF. After the new low of the year, on 12 October last year, the share indexes gave rise to a rebound which today we can still classify as a movement in countertrend with respect to the primary trend. This type of valuation is certainly valid today with reference to the S&P 500 and the Nasdaq 100.
The reference framework for the Dow Jones and the Dax is significantly different. In fact, contrary to what happened in the rebound that developed between June and August, that of the last month was decidedly “value driven”, ie driven mainly by three sectors: industrial, financial services and basic consumption. As a result, the technical framework for the indices with a greater component of value stocks appears even more constructive today.
Rebound similar to that between June and August?
Fusco Femiano’s answer is Yes. With reference to what was observed in the framework of the first rebound of the stock market, between the months of June and August, one of the factors supporting that recovery in value was the compression of relative strength between US 10-year yields and the S&P500. We are seeing the same factors in last month’s rebound.
The compression of bond yields, in the last month, was in fact generalized, developing both in the corporate sector and in that of Treasuries. Much of this yield compression, the report reads, is the result of one stabilization of expectations on the Fed Fundsfollowing the last monetary policy meeting of the Fed, combined with the release of the latest data on US inflation, which came out well below analysts’ estimates (7.7% vs 8.1%).
Significant rebound or even reversal?
In conclusion, the signals coming from the intermarket scenario and from expectations on the inflation and Fed Funds plan are better than in previous weeks. According to Fusco Femiano we are facing a significant rebound, but we are not yet seeing a reversal of the trend primary stock market. If the technical picture appears to be improving, what other factors could influence what we will observe in the coming weeks? Mainly the evolution of the macroeconomic outlook and the consequent influence on corporate data among those cited by Fusco Femiano.
The first aspect to take into consideration is the current valuations versus the outlook for next year: The S&P500 today trades at more than 18 times expected earnings for 2023 (earnings per share: $220, source: Factset), a level that has historically not been associated with minimal market significance. A second aspect to always keep in great consideration is the further accentuation of the inversion of the yield curve: A condition that usually heralds the arrival of a recession.
The implications of the start of a recession on equities
The S&P500 has experimented 15 bear markets from 1968 to today. In the event that a bear market is associated with a recession, the average correction of the American index has been greater than 40%, writes Fusco Femiano.
The real risk of a recession is what the market has not yet definitively priced in: in the last two recessions, 2000-2002 and 2008-2009, the decline in earnings on an annual basis was equal to 26% and 50% respectively and the overall decline in the index in both cases it was more than 50%. This last aspect is linked to another historical evidence: in the one hundred year history of the S&P 500, the minimum of a bear market occurs after a recession and after the Fed has initiated the first rate cut.
Coming to the conclusions, reads the report, on a technical level the markets today are certainly more constructive than in the previous weeks and the rebound observed both on bonds and on equities is the best news: after all, any bull cycle starts with a bounce off a low. However, the chances of a recession are very real today, as the Kansas City Fed President did not fail to observe last week, Esther George.
The effects of a recession on stock markets are therefore all the more relevant at this stage of the economic cycle, especially in the light of a bear market that has been going on for several months, interest rates on a constant rise and volatility that has remained silent these months. All these elements must make us keep in mind that equity indices, and in general all asset classes, are at this stage they can fluctuate significantly between supports and resistances and, above all, that the game today is mainly played on the theme of the future outlook. As always, concludes Fusco Femiano, time will be able to direct the investor who knows how to use information and money management in his favor.