(Bloomberg) — Markets, Boaz Weinstein said this week, are “persistently wrong.” Saying which one is more misguided right now has become the big challenge for investors faced with mixed signals between asset classes.
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Is it equities, where a previously limited lead of a handful of tech megacaps showed distinct signs of widening this week? A $6 trillion rally is in play. Or maybe it’s bonds, where fumes of gloom abound and bets on Federal Reserve rate cuts are ramping up in a market with twice the volatility. higher than two years ago.
For investors, the potential penalties for being on the wrong side of the trade — essentially, miscalculating the likelihood of a recession — increase with each step of the S&P 500, which crossed bull market territory this week. Analysts at JPMorgan Chase & Co. put the cost of misguided optimism at 20% if stock traders are found to have misjudged the economy’s trajectory.
“Something has to give,” said Peter Cecchini, director of research at Axonic Capital. “With equity valuations this stretched across many sectors relative to realistic 2023 earnings forecasts, we’re betting the giveaway is coming from equities.”
The S&P 500 added 0.4% this week to post its fourth consecutive gain. The tech-heavy Nasdaq 100 followed, posting its first decline in seven weeks as money flowed into weaker areas like banks and small caps. A gauge of regional lenders jumped 3%, while the Russell 2000 climbed almost 2%.
Defensive fund managers have begun to prepare for the rally. In a survey by the National Association of Active Investment Managers (NAAIM), exposure to equities has just increased at the fastest rate in more than two years. At 90%, the reading was the highest since November 2021.
For his part, Weinstein, the chief investment officer of Saba Capital Management, says getting too caught up in speculating about the economy is a mistake. “Instead of saying, ‘I think there will be a recession or there won’t be’, which I kinda yell at the TV screen when I hear that, I feel like that you have to think about ranges of results,” he said. , at the Bloomberg Invest event in New York.
This translates into a bet against corporate bonds in Saba, based on the idea that a moderate yield spread makes a bet against credit too juicy to pass up. For investors increasingly betting on stocks, however, the perils are mounting.
As the S&P 500 jumped more than 20% from its October low, entering what some see as a bull market, the resilience is at odds with ever-growing bond market warnings. The inversion of the yield curve – a widely observed indicator of an economic recession – worsened during this period, with long-term Treasury rates still lower than short-term ones.
The divide is illustrated by a model kept by JPMorgan that compares the market price of each asset to its implied value based on macroeconomic factors such as inflation volatility. While bonds reflect lingering uncertainty since February, the stock market is more optimistic, pricing less risk than before the pandemic.
If equities echoed fixed income in acknowledging the risk of inflation volatility, the S&P 500 would be 20% below its current levels, according to firm strategists including Nikolaos Panigirtzoglou.
Of course, searching for a consistent economic message across assets is often an exercise in futility because the trajectory of the economy is not the only thing that determines prices. A big force in the 2023 stock rally has been the euphoria around artificial intelligence supercharging IT and software stocks, with the seven biggest tech companies accounting for nearly all of the S&P 500 gains year-to-date.
It’s also possible that stock traders, after sending stocks into a bear market in 2022 amid growing fears of a recession, will readjust their expectations about the timing and depth of an economic downturn.
In fact, it’s not uncommon to see stocks rise in the face of recessionary warnings from the bond market. Using the yield spread between three-month and 10-year Treasury bills as a benchmark, a study by the Leuthold Group found that since the late 1960s, a trader buying the S&P 500 on the first day of the reversal returns and, with perfect timing, selling at the next high could have done anything from 5% to 23%. These gains averaged 13% over a holding period of approximately eight months.
This time, the reversal in returns occurred in November, which is seven months ago. Since then, the S&P 500 has climbed 13%, matching the average of previous post-inversion advances.
Chance? Maybe. But Doug Ramsey, Leuthold’s chief investment officer, views the market’s latest leg higher as another “pre-recession rally.” He said while yield reversals correctly predicted the previous eight recessions, equities tended to defy initial alarms as investors sought to exploit the last window of earnings before the eventual meltdown.
As small-cap stocks and depressed cyclical stocks such as banks rise from the ground lately, many market participants are welcoming the broadening of equity exposure.
Ramsey is skeptical, warning that the market could face “one last gasp for this recovery” given the Fed’s commitment to its inflation-fighting campaign.
In the previous eight instances of reversals in returns, the S&P 500 fell an average of 35% from intermediate peak to final trough, according to its analysis.
“When the really beat stuff finally comes together, it’s sometimes a sign that the party is about to end,” Ramsey said. “And unlike the endless market celebrations of the past decade, this one doesn’t pack a punch,” a reference to the Fed’s policy stimulus.
As divisive as asset moves are, 2023 is shaping up to be a punishing year for consensus betting. From selling Big Tech stocks to shorting the dollar and buying Chinese stocks, Wall Street’s once-hot trades at the start of the year are all shaky.
Even among the stocks, a battle is raging. Consider the Russell 2000 and the Nasdaq 100, which have taken turns outperforming this month. For six consecutive sessions, their return gap exceeded 1 percentage point. This is the longest period of major listless rotations since November 2020.
Optimism that the economy could avoid a severe recession, with the Fed poised to rein in its aggressive monetary tightening, is helping to fuel a rally in small caps – stocks that are generally more sensitive to economic swings.
The central bank is expected to suspend interest rate hikes next week for the first time in 15 months and leave policy on hold until December, according to economists polled by Bloomberg.
For Emily Roland, co-head of investment strategy at John Hancock Investment Management, investors had better hold back the urge to chase the gains as the economic outlook remains murky and today’s winners can easily become the winners. tomorrow’s losers.
“We are in this pivotal party,” she said. “But my analogy in terms of how to play, maybe you want to sip a light beer instead of reaching for tequila because you might have fewer regrets the next morning.”
–With assistance from Lisa Abramowicz and Carly Wanna.
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