For all its twists and turns, the 2022 market has also been a story of patterns repeating. Stocks fall, shorts cover, quants buy, then everyone jumps back in just in time to get torched.
It’s happening again.
After a month of drawing down positions, investors poured $25 billion into stocks in the week through to Wednesday only to see the S&P 500 plummet as the US Federal Reserve and other central banks stuck with hawkish stances that threaten to spur a recession.
The benchmark index ended the week with its worst three-day drop in two months, shattering chart support and putting it on track for its first down December since 2018, when rate deliberations caused similar uncertainty.
The latest bout of optimism was crushed after Fed chairman Jerome Powell reiterated that rates will go higher and stay there until inflation falls sharply.
Investors playing catch-up to a rally that added 14 per cent from October’s lows inopportunely piled back in last week hoping to ride a year-end surge.
Instead, they find themselves long a market where valuations remain stretched, earnings are expected to drop and other assets such as Treasuries are proving viable alternatives.
“We’ve seen major downside dislocations in equities and risk appetite in general, whenever the market has reinterpreted the Fed outlook, because every time it does that, it gets more and more negative,” Alec Young, chief investment strategist at MAPsignals, said.
“Dip-buyers have been hoping that peaking inflation would lead to more dovish Fed policy, and it hasn’t quite worked out.”
Stocks fell for a second week as economic data on retail sales and manufacturing signalled a slowdown, while central banks increased their hawkishness.
The S&P 500 dropped more than 2 per cent, sliding out of a five-week, 200-point trading range, and undercutting its 100-day average for the first time in more than a month.
To observers, the loss of support is a sign more pain is in store.
The renewed sell-off is the latest reckoning for equity bulls who have spent all year buying the dip, to no avail.
The S&P 500 has jumped more than 10 per cent from a low on two occasions this year, in March and from June to August, with both succumbing to selling that took the market to new lows.
This time, the rebound began in mid-October with a short-squeeze on the heels of red-hot inflation figures.
As asset gains gathered momentum in November, rules-based traders were forced to pile in, with trend-following quants buying $225 billion of stocks and bonds over just two trading sessions, by one estimate.
Fear of being left behind was so intense that tens of millions of dollars were spent on call options to play catch-up, adding fuel to the rally.
Fund investors who had pulled money out of stocks for three weeks in a row finally jumped back in.
According to EPFR Global data compiled by Bank of America, they added $25bn to US stocks in the week through to Wednesday and poured a record $14bn to value funds.
While this faith may prove prescient one day, for now, the timing has been painful.
Over the past three sessions, 95 per cent of S&P 500 members were down and $1.4 trillion was erased from the index’s value.
“The market had a really strong October and November, so you’ve got a little bit of trend-following by investors, and many perhaps thinking that this is the beginning of a new bull market,” David Donabedian, chief investment officer of CIBC Private Wealth US, said.
“I think there is some more downside here.”
Underpinning the latest rout was the growing concern about a looming recession, a threat that the bond market has flagged for months by the inversion of the yield curve and yet was brushed aside by equity investors.
Now, with the Fed raising its projection on peak interest rates to 5.1 per cent and cutting the forecast for gross domestic product to flat growth for next year, the reality is starting to sink in.
At 16.7 times forecast earnings, the S&P 500 was valued at a multiple that’s about one point above the 20-year average. And stocks will get more expensive should earnings estimates keep falling.
Since June, projected profits for 2023 have fallen 8 per cent to $229 a share, data compiled by Bloomberg Intelligence show.
Moreover, rising interest rates are eroding a decade-long bull case for owning stocks, sometimes labelled “there is no alternative”, or Tina.
Part of the competition comes from cash. At the start of the year, when three-month Treasury bills offered almost nothing, about 390 companies in the S&P 500 could be viewed as more attractive with higher dividend yields.
After seven Fed rate rises that took the payout on short-term government bonds to 4.3 per cent, the pool of stocks with above-cash yields dwindled to no more than 55.
Another threat is fixed income. For illustration, consider an analytical tool known as the Fed model that compares the income stream from stocks to that of bonds.
It shows the S&P 500’s earnings yield, the reciprocal of its price-earnings ratio, now sits at 1.9 percentage points above the rate from 10-year Treasuries.
An increase in the 10-year yield to 5 per cent from the current 3.5 per cent would need earnings to expand about 28 per cent to hold the current valuation advantage, all else equal.
“We have used the analogy — there’s an equity store and a bond store for your Christmas shopping,” Emily Roland, the co-chief investment strategist of John Hancock Investment Management, told Bloomberg Television’s Surveillance.
“The equity store, there’s not very much on sale.”