Lily Tomlin might have been talking about today’s stock market when she said, “No matter how cynical you become, it’s impossible to keep up.” Wall Street for months has been working to take a dimmer view of the future, brace for uncomfortably corrosive inflation and dampen its optimism on economy. Yet so far these efforts are being outrun by reality. Friday’s hotter-than-hoped consumer price index hardly blew away forecasts yet it was enough to get bond yields melting up, Federal Reserve rate-hike expectations at a rolling boil and stocks sweating a near-retest of their 14-month lows hit just three weeks earlier. Facing a summer of an aggressive Fed, consumers in a combustible mood amid high gasoline prices and with the burden of proof firmly on those predicting inflation will retreat decisively, investors are backed into looking for conditions to get “so bad, it’s good.” In other words, that the moment when most of the plausible bad news seems priced in and the forces of mean-reversion start blowing from behind the bulls. We’re probably not quite there in a comprehensive way, even if some elements are starting to line up in that direction. Testing the tape After eight trading days holding in a narrow range and retaining just about all of its 9% rebound off the May 20 intraday low, the S & P 500 gave way starting Thursday, eventually falling more than 1% three straight days, losing 5% for the week and finishing exactly at 3900 – right on the May 20 closing low. The intraday trough from a few weeks ago was 3810, so there remains a couple-percent cushion. I’d suggested here that the market seemed due to give more of a scare to the highly confident bears asserting that every rally should be sold. This did not play out, the relief rally stalling well before it even got up to the index’s 50-day average, let alone the early-May high at 4300. At the year’s low, the index is essentially off 20% from its peak. There’s no strong reason the decline should halt there, except for the quirky history of 19% total setbacks in the index in a few non-recession or mild-recession corrections (2018, 2011, 1998, 1990). (There are other technical trend reasons many observers were targeting 3800-3900 as a decent downside target, detailed here more than a month ago when the index hadn’t yet fallen below 4100.) The average Nasdaq Composite stock has undergone a 50% drop from its high, a pretty comprehensive flush though one preceded by an unusually exuberant and persistent momentum surge in Nasdaq names. When indexes fall in price they also go back in time, and the S & P 500 now trades at a level first reached more than 16 months ago in early February 2021. This now qualifies as a fairly protracted consolidation of the post-Covid-crash advance in equities. There is no strict rule on such things, but the complex, multi-wave corrections that culminated in February 2016 and December 2018 both bottomed at levels first reached nearly two years prior. In one narrow regard, the three straight days in which more than 80% of S & P 500 stocks fell has approached so-bad-it’s-good status. Strategist Tony Dwyer of Canaccord Genuity notes that only 3% of S & P stocks were above their own 10-day average price near the end of the week, the lowest since sharp declines in June 2020 and October 2020 were close to running their course. Dwyer stops short of saying this is a clear signal to bet on a snapback, preferring to see the Volatility Index (VIX) accelerate higher far faster than it has. Yet he said in the final hour of trading Friday: “Today’s inflation data has picked up expectations for an even more aggressive Fed, which may take some punch out of their meeting and probable rate hike next week at the FOMC meeting…Expectations are already pretty grim and that is when I try to be careful and not get too negative into a sharp decline.” A fairly grim, or at least defensive, posture is also observable in various aggregate readings of investor positioning. Deutsche Bank says asset manager and leveraged funds are now net short equity-index futures to the greatest degree since the mid-2016 Brexit vote, and before that near the early-2016 correction low and the late 2011 U.S. debt downgrade panic. Bank of America’s Bull & Bear Indicator, which captures fund flows and other market-based risk-appetite measures, tells a similar story, well in the fearful depths that typically imply a contrarian buying opportunity, which worked well in 2016, 2018 and 2020. Though of course prolonged stressed market periods such as the 2000-’02 and 2008-’09 recessionary bear markets had this gauge pinned near the lower bound while prices continued to trend lower. Valuations have reset sharply lower, the S & P 500 back below 16.5-times forward earnings, right where it was when the index last bounced a few weeks ago. Yet this is merely in the range of fair value rather than cheap, even if the median stock appears a good deal less expensive than the overall index. Earnings forecasts are holding up fairly well, but this owes a lot to the massive upward revisions to energy profits, with the rest of the sectors collectively flatlining in terms of 2022 earnings growth. This suggests valuation is no longer the main headwind for the market, but the pendulum hasn’t swung so far as to rebuild a lush margin of safety either. The gloomier consumer The anxiety evident among investors is rather tame compared to the anger and despair showing up in consumer surveys. Friday’s preliminary University of Michigan consumer sentiment poll was profoundly weak, at a level lower than during the global financial crisis and if not revised higher will rank as the bleakest monthly reading since 1978. This is almost entirely about inflation, with an overlay of general societal malaise. And even with a strong labor market and broadly healthy consumer finances, it’s hard to see such a foul mood not leading to a broader consumer retrenchment. The silver lining here is that negative extremes in Michigan consumer sentiment have over time, been quite good contrary signals for how stocks perform over the subsequent 12 months. JPMorgan calculates that the S & P 500 has averaged a 25% gain in the year following the eight Michigan sentiment troughs going back 50 years, with the worst return at 14%. The catch here is that troughs are only known in retrospect after sentiment starts to recover from a low, and we’re not there yet. The Conference Board’s consumer confidence measure asks what respondents expect for stocks, and at last report the 28% who said they anticipate stocks will rise was the fewest since that familiar February 2016 moment with a six-month 15% correction and recession/deflation scare culminated. Other public-opinion work shows the lowest percentage of Americans on record saying it’s a “good time to buy a house,” a pretty good sign that the Fed’s hawkish forward guidance driving the 30-year fixed mortgage rate well above 5.5% has prompted a sudden and severe retrenchment in the real estate market. This all comes together to create a blurry but vaguely discernible picture of a backdrop that’s bad enough to allow for some market relief soon, yet not so bad that it’s clearly an outright positive for risk assets.
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