The equity market does not believe the bond market…
Equities have sold off seemingly continuously since Jackson Hole (8/26), as the strong message from the Fed and uncertainty around Russia, China and economy have pushed equities to become “no bid” — in fact, as many noted, the Nasdaq is down 7 consecutive days. Since 1970, this is pretty uncommon, as highlighted later in this commentary.
In our view, there are 3 questions that primarily impact markets today (Russia/Europe, etc impact these 3):
- When will inflation be back to Fed target of 2%?
- When will the Fed finish hiking? (aka pivot)
- Is there a recession in 2023?
Below, we highlight the consensus answer from 3 major market cohorts: Fed, bond market and a typical equity investor.
- recall, James Carville famously quipped he wished to be reborn as the bond market
- note the varied perspective below but take particular note of the bond market
- bond market sees inflation approaching 2% by June 2023
- bond market sees Fed ending hikes by March 2023
- bond market does not see a recession (credit spreads, OIS swaps, etc)
Why is the Fed and Bond Market and Equity market so far apart??
If equity markets believed bond market, stocks would be bottoming now, ala August 1982
If equity markets believed the bond market, this is August 1982. That is, well before Fed even considers ending its tightening cycle, equities would be staging a rally:
- recall, stocks rallied August 1982, 10 weeks before Fed Chair Volcker even pondered ending inflation fighting
- in a vertical 4 month rally, stocks recovered the entire 27%
- so this is a key divergence to ponder
- are bonds right?
- or are equities diverging from bonds for a different reason?
2% INFLATION: Inflation swaps see inflation falling to 2% by mid-2023
Inflation swaps detected the surge in inflation in Fall 2021, well before Fed realized the need to tighten dramatically.
- so inflation swaps have proven to be ahead of Fed
- inflation swaps imply inflation falls to 2.5% by mid-2023
- yup, CPI is forecast to fall like a rock
DEFLATION: Inflation swaps see deflation next few months
In fact, looking at month-over-month data, the inflation swaps market sees outright DEFLATION:
- August CPI (9/13) expected to be larger decline than July
- Per swaps, 3 consecutive months of deflation
BONDS SEE FED HIKES: Completed by March 2023
This is also widely reported, but Fed funds futures sees Fed done raising rates by March 2023.
- peak in Fed funds seen at ~4%
- by March 2023
- Fed funds is currently 2.5% and expected to be 3.25% after September FOMC
- By YE, Fed will be >90% through Fed cycle per bond market
This has created some puzzling conclusions by bond market investors. Take a look at the comments from Jeffrey Gundlach, founder of Doubleline Capital:
- “to me, that’s a strange thing to predict”
- still, the bond market has a strong track record for seeing things ahead of the Fed
GASOLINE: Falling like a rock, down 25% in 85 days. Never seen during inflation era of 70s-80s
There are a lot of pundits comparing today to the 1970s and 80s. Inflation is unpredictable. But every time we compare today to that era, we find far more differences than similarities:
- notably, look at gasoline today
- it is down 25% in just 85 days
…Gasoline rose for a decade before it even started to fall
But look at the 1970-1990 period. Gasoline, using the Motor fuel CPI component (maps to gasoline) rose continuously:
- from 1972 to 1981, gasoline rose continuously
- it did not register a single peak to trough drawdown of more than 2% in that 10 years
- it did not register a yoy decline during that 10 years
It was not until 1981 that gasoline began to fall, and took 5 years to fall 25%, not 85 days
Moreover, look at the slow pace of fall in gasoline when it did finally break:
- gasoline peaked in 1981
- took 5 years to fall 25%
- in 2022, gasoline has fallen 25% in just 85 days
CPI FALLS LIKE A ROCK: Every time gasoline has just “flatlined”, CPI tanks
More importantly, look at CPI compared to gasoline:
- every time gasoline flat lines (shaded)
- CPI tanks YoY
See what we are getting at?
- in 2022, gasoline has fallen 25% from its peak
- in 1981, this was a precursor to a massive decline in CPI
- perhaps this is what the bond market is seeing?
DISINFLATION: ISM survey shows surging share of respondents seeing lower prices
Take a look the trend in “prices paid” in the ISM surveys:
- we highlight respondents reporting outright “lower” prices
- this figure is surging in manufacturing to 27% in August
- this was 6% in May
- for services, this figure is 8%
- and seems two months behind ISM manufacturing
- read this as inflation seems to be “falling like a rock”
STRATEGY: Nasdaq Composite down 7 days consecutively, which is actually a constructive signal
Equities have become “no bid” again — no doubt a few things over the past few days are adding to concerns:
- Russia tinkering with energy supply to Europe
- September is a seasonally tough month
But the fact is, since Jackson Hole (8/26), the Nasdaq composite is down 7 days consecutively.
Of 23 prior instances, only 5 were “traps” leading to further declines
Our data science team compiled instances of “down 7 days consecutively” since 1970:
- these instances are plotted as “red” dots below
- there are 24 unique instances
- we highlight only the first instance, as stocks could fall more days consecutively
- it is evident that stocks bounce after 7 consecutive days of decline
But 5 instances are a trap…
- there are only 5 instances this was a “trap” and stocks fell further
- May 1973
- July 1987
- December 2000
- June 2001
- January 2008
- the other 18 were “bullish” signals
The table with these instances is below. The forward returns are promising:
- median 1M, 3M and 6M forward returns are +2.5%, +4.1% and +10.3%
- median 12M forward returns are +24%
- win ratio is 74% for next 1/3/6 months and 70% for next 12 months
STRATEGY: 2H rally view intact
Given the list of market worries above, the natural question is how is there a positive thesis on equities into 2H2022? Here is our take:
- our continuing analysis shows leading indicators point to disinflationary/deflation
- US corporates remain impressively resilient, enduring the pandemic global shutdown with cost discipline
- and US corporates are weathering the inflation surge impressively as well
- the US economy has managed to absorb rapid Fed rate hikes so far
- and US economic relative positioning far stronger in 2022
- US net beneficiary of higher energy prices, absolute and relative (US exports oil)
- US is on-shoring assets = future competitive advantage
- US has labor issues, but this will be solved by either automation or rise in workforce participation
- investor sentiment is rock bottom and worse than GFC by some metrics
- fixed income markets show far less inflation in swaps, etc
- and while many believe “bonds are getting it wrong” including Fed officials
- the drop in energy and housing and other indicators are supportive of this lower inflation outlook
- hence, Fed could do far less tightening as the market is doing Fed’s work
Bottom line. We see 2H rally thesis intact.
STRATEGY: 2022 Bear market was 164 days, or 25% duration of prior bull
Our data science team put together the comparative duration of bull markets and bear markets, and the corresponding ratio:
- since 1942, there have been 14 such cycles
- median ratio of bear vs bull is 31%, meaning a bear market is roughly 1/3 duration
- since 1982, this ratio is only 15%
- in 2022, the preceding bull market was 651 days
- the current bear market was 164 (using 6/16)
- or 25% ratio
As seen below, this ratio is solidly within the ranges seen since 1982.
- many investors think “more time” is needed for this bear market
- but given the shortness of the preceding bull market 651 days versus 1,309 median
- the corresponding bear market should also be shorter
BUY THE DIP REGIME: Stocks already saw fundamental capitulation
And we want to revisit the chart below, which looks at the internals of the S&P 500 — the % stocks >20% off their highs, aka % stocks in a bear market.
- this figure surged to 73% on 6/17
- this was only exceeded 3 times in the past 30 years
- each of the 3 prior instances was the market bottom
- we think this is the 4th instance
BUY THE DIP: forward returns strong
And stocks have the best forward returns when this figure exceeds 54% as shown below:
- in 3M, 6M and 12M
- the best decile for returns
- is when this figure is oversold >54%
- hence, buy the dip regime is in force
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