New bull or bear rally

The longer the market goes without collapsing, the more tenuous it’s going to get for the bears. As equities march higher, bears are forced to book their losses and unwind positions (pic: Bloomberg)

We are in view that a possible recession could hit equity markets. Out of the 7 rate tightening cycles, 6 of them have ended in recessions

by IFAST RESEARCH TEAM / pic BLOOMBERG

THE past two years have been a tormenting journey of investment for many investors around the world. Entering 2023, a couple of existing issues still persist, such as continued inflationary pressures, the ongoing Russia-Ukraine war, and uncertainty over the interest rate hike cycle, coupled with newly emerged issues such as the global financial rout and concerns over the US debt ceiling.

However, the persistent pessimism was so widespread that even a hint of good news was enough to spark a rally. The reopening of China’s international borders, optimism over the end of the interest rate upcycle, the resolution of the US debt ceiling issue, and excitement about artificial intelligence (AI) have sent the stock market rallying in 2023, extending its gain to 23.75% since October 2022 as of June 22, 2023, defying doom scenarios.

Yet, while equity prices took off on renewed optimism on a possible “shallow recession” to “no recession” scenario, bond markets are pricing in a sustained period of elevated macroeconomic uncertainty, with yields remaining at elevated levels in the past few months, sending mixed signals across the markets.

Doomsaying is never in short supply when stocks are rallying. A key question for anyone weighing a gamble on stocks now is whether all the trauma unleashed last year when the US Federal Reserve (Fed) jacked up rates did enough damage to sentiment to account for whatever is in store for the economy down the road. Simply put, is it the start of the new bull rally, or is it just another dead cat bounce?

Dead Cat Bounce?

“Even a dead cat will bounce if it falls from a great height,” the saying goes to describe a small, brief recovery in the price of a declining trend. To answer this question, we would first like to dig deeper into what has been driving the return of the market.

The market breadth is telling us that the recent market rally has been relatively narrow, with the 10 largest stocks in the S&P 500 index responsible for nearly 90% of the index’s return this year, with valuations of Apple (APPL), Microsoft (MSFT), Nvidia (NVDA) and Meta (META) having surged this year while smaller companies lagged. Nonetheless, a total of 394 stocks recorded gains since the market bottom in October 2022, compared to 120 stocks that recorded losses. Sector-wise, almost all the sectors have recorded positive returns since October 2022, with the technology sector and communication services being the market bellwethers. The core idea here is that if more stocks are advancing than declining, it is indicative of a stronger and more sustainable trend.

On a month-to-date basis, 10 of the 11 S&P 500 sectors are firmer for the month-to-date, compared to only six for the year. The market breath showed that the recent rally has brought more than 50% of the companies above their 200-day moving average, up from a low of 38% in March. Also, other market areas that lagged for most of the year have rebounded this month, easing worries about the market’s narrow leadership. This shows the widening of the market leadership and the proof of a more sustainable rally.

Next, we take a look back at the historical performance to get some colour on how the market performed after rallying 20% from the bottom in a bear market. The S&P 500 index managed to deliver positive returns in 3 out of 7 times in the past bear market after delivering a 20% return from the trough in a three-month period (see Table). Meanwhile, it recorded a positive return of five out of seven times, six and 12 months after 20% return from the bottom. In other words, the bulls successfully managed to snap themselves out of the bear market 71.43% of the time and almost 28.6% of the time these bear-market rallies are triggering that threshold, which we view as a false signal.

From here, we can see that the US economy holds up despite higher interest rates, while fears of an imminent downturn are fading. Thus, herein lies the paradox. The longer the market goes without collapsing, the more tenuous it’s going to get for the bears. As equities march higher, bears are forced to book their losses and unwind positions.

Markets Tend to Bottom Out

We are in view that a possible recession could hit equity markets. Out of the seven rate tightening cycles the Fed has conducted since 1980, six of them have ended in recessions. Given how much more aggressive the current rate tightening cycle is compared to the ones before, along with the Fed’s repeated warnings that rates are going to stay higher for longer, we think that it is only a matter of time before a recession hits.

Although investors are turning optimistic on the equity market, the fears over higher interest rates still lie within the market as the US job market remains resilient. Even though the Fed has signalled two more hikes are coming and is likely to keep rates elevated in the next two years, we still believe that the Fed may tone down once inflation rates appear to be under control, which will lift some pressure off the equity markets. The S&P 500 index was mostly able to reenter the positive territory in the first year based on the past interest rate hike cycle.

However, given that we are experiencing one of the steepest paces of interest rate hike cycles ever, the pace of market recovery might be affected. Nonetheless, we still believe that the equity market will bottom before the end of the interest rate upcycle, as markets tend to react upfront in anticipation of market direction.

Key Takeaways

After a few years of drawdowns, the extreme pessimism that’s gripped US stock investors is starting to dissipate, with the S&P 500 index experiencing the longest bounce of the year. Although major issues still remain, such as the uncertainty over the interest rate upcycle and the slowdown in economic activity, we believe that the market sentiment is overly pessimistic, which creates room for upside potential.

Moving forward, with the recent outperformance of equities, investors may be tempted to chase the rally for fear of missing out (FOMO). We also cannot rule out the possibility of a recession, therefore, at times like these, we think that it is prudent for investors to maintain a diversified portfolio rather than chase certain sectors that have already experienced a huge rally since the start of the year.