October 4, 2023

The cost of being wrong is increasing day by day in increasingly diverse markets

(Bloomberg) — Markets, Boaz Weinstein said this week, are “constantly wrong.” Determining which one is most astray at the moment has become the major challenge for investors facing conflicting signals across asset classes.

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Is it equities, where an advance previously limited to a handful of tech megacaps showed clear signs of broadening this week? A $6 trillion rally is at stake. Or maybe it’s bonds, where gloom abounds and bets on Federal Reserve rate cuts are increasing in a market where volatility is twice as high as it was two years ago.

For investors, the potential penalties for being on the wrong side of the trade — in effect, misjudging the likelihood of a recession — get higher with every move up the S&P 500, which entered bull market territory this week. Analysts from JPMorgan Chase & Co. estimate the cost of mistimed bullishness as high as 20% if stock traders are found to have misjudged the path of the economy.

“There has to be something to give,” said Peter Cecchini, research director at Axonic Capital. “With stock valuations stretching across many industries compared to realistic 2023 earnings forecasts, we’re willing to bet the return will come from equities.”

The S&P 500 added 0.4% this week, posting its fourth straight gain. The tech-heavy Nasdaq 100 lagged and posted its first decline in seven weeks as money poured into downtrodden areas like banks and small caps. A measure of regional lenders was up 3%, while the Russell 2000 was up nearly 2%.

Defensively positioned money managers are starting to warm up to the rally. Equity exposure has just increased at its fastest pace in more than two years, according to a poll by the National Association of Active Investment Managers (NAAIM). At 90%, the level was the highest since November 2021.

In turn, Weinstein, the chief investment officer of Saba Capital Management, says it’s a mistake to get too caught up in speculation about the economy. “Instead of saying, ‘I think there’s going to be a recession or not,’ which I kind of howl at the TV screen when I hear that, I feel like you have to think about ranges of outcomes,” he said . , speaking at the Bloomberg Invest event in New York.

That translates into a bet against corporate bonds on Saba, assuming that moderate interest rate spreads make a bet against credit too juicy to pass up. However, for investors who are increasingly going all-in on stocks, the dangers are mounting.

While the S&P 500 is up more than 20% from its October low, entering what some consider a bull market, its resilience runs counter to mounting warnings from the bond market. The inversion of the yield curve – a widely viewed indicator of an economic recession – worsened over that period as long-term government bond yields fell further below short-term rates.

The gap is illustrated by a model from JPMorgan that compares the market price of each asset to its implied value based on macroeconomic factors such as inflation volatility. While bonds have reflected lingering uncertainty since February, the stock market is more upbeat and less risk-assessed than before the pandemic.

If stocks mirrored the risk of inflation volatility, the S&P 500 would be 20% below its current level, according to company strategists, including Nikolaos Panigirtzoglou.

Of course, looking for a consistent economic message across assets is often a futile exercise, as the trajectory of the economy is not the only thing that determines prices. A big factor in the 2023 stock rally was the euphoria surrounding artificial intelligence boosting computer and software stocks, with the top seven tech companies accounting for nearly all of the S&P 500’s gains since the start of the year.

It’s also possible that after sending stocks into a bear market in 2022 amid rising fears of a recession, stock traders may be adjusting their expectations for the timing and magnitude of an economic downturn.

In fact, it’s not uncommon for stocks to rise in the face of the bond market’s recession warnings. Using the yield gap between three-month and 10-year government bonds as a signpost, a Leuthold Group study found that since the late 1960s, a trader has been buying the S&P 500 on the first day of the yield inversion and, with perfect timing, selling the subsequent high could have been anything from 5% to 23%. Those gains averaged 13% over a holding period of about eight months.

This time, the yield inversion occurred in November, or seven months ago. Since then, the S&P 500 is up 13%, matching the average of past post-inversion gains.

Chance? Maybe. But Doug Ramsey, Leuthold’s chief investment officer, sees the market’s latest rise as another “pre-recession rally.” In his view, while yield inversions correctly predicted all of the previous eight recessions, stocks tended to defy initial alarms as investors sought to capitalize on the last chance of profit before ultimate bust.

With small-cap stocks and depressed cyclical stocks such as banks emerging from the dust recently, many market participants are applauding the broadening of equity participation.

Ramsey is skeptical, warning that the market could get “one last gasp from this uptick” given the Fed’s commitment to its anti-inflation campaign.

In the previous eight instances of yield inversion, the S&P 500 fell an average of 35% from its interim peak to its latest low, his analysis shows.

“When the really knocked down stuff finally joins in, sometimes it’s a sign that the party is about to end,” Ramsey said. “And unlike the endless market celebrations of the past decade, this one lacks a punch bowl,” a reference to the Fed’s stimulus policy.

Contradictory as asset movements have been, 2023 will be a tough year for consensus betting. From selling Big Tech stocks to shorting the dollar and longing Chinese stocks, Wall Street’s once-popular early-year trades have all faltered.

Even among stocks, a battle is raging. Take a look at the Russell 2000 and the Nasdaq 100, which alternately outperformed this month. For six consecutive sessions, their yield gap has been more than 1 percentage point. That’s the longest stretch of big, listless rotations since November 2020.

Optimism that the economy can avoid a severe recession as the Fed is about to slacken its aggressive monetary tightening is contributing to a rebound in small caps – stocks that tend to be more sensitive to economic swings.

Next week, the central bank is expected to pause rate hikes for the first time in 15 months and leave policy on hold through December, according to economists polled by Bloomberg.

According to Emily Roland, the co-chief investment strategist at John Hancock Investment Management, investors had better hold on to the urge to chase profits as the economic outlook remains bleak and today’s winners could easily become tomorrow’s losers.

“We’re in this pivotal game,” she said. “But my analogy in terms of how to play it, you might want to have a light beer instead of reaching for the tequila because you might have less regrets the next morning.”

–With assistance from Lisa Abramowicz and Carly Wanna.

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