By the end of the year, the economy will be in a full-blown recession and stocks will be tumbling.
By the end of the year, the central banks will have ended their rate-hiking cycle, inflation will continue to trend down and stocks will be staging a strong rally.
By the end of the year, inflation will still not be tamed, the Fed and the Bank of Canada will be warning of more rate hikes and the stock market will be struggling to find direction.
You could make a plausible case for any of these scenarios, which is why predicting the short-term direction of bond and stock markets is almost impossible. Of course, that doesn’t stop people from trying.
Last week, some commentators were taking an optimistic tone. The Wall Street Journal published a column on the improving odds of a so-called soft landing. I tuned into an interview on CNN in which the focus was on how the public was ignoring the success of U.S. President Joe Biden’s economic program. I then received an analysis from one of my brokers that said current conditions are “creating the fundamental foundation for the upcoming secular bull market.”
Meantime, the U.S. Bureau of Labour Statistics announced that the unemployment rate for June was 3.6 per cent, not far off its record low. It’s no wonder there’s a sense of optimism in the air.
Of course, not everyone feels bullish. But there seems to be a subtle change in tone.
So, should we listen to the optimists? What data should we be considering when making our financial decisions at this point in time?
Noah Solomon, president of Toronto-based Outcome Metric Asset Management LP, said in a recent note to clients that his company had modelled some of the most commonly used macroeconomic variables that influence stock market returns. The objective was to determine whether and how these factors have historically influenced markets and what they are signalling now. Here are the results.
Fed policy. Investors have been told for years: “Don’t fight the Fed.” It’s good advice, Outcome’s modelling concluded. The results showed one-year real returns for the S&P 500 of 6.6 per cent after a period of interest-rate hikes by the Fed. That compared with 10.6 per cent after periods when the Fed was slashing rates.
“As of the end of June, the Fed [had] increased its policy rate by 3.5 [percentage points] over the past 12 months,” the client note said. “From a historical perspective, this change in stance lies within the top 5 per cent of one-year policy moves since 1960 and is the single largest 12-month increase since the early 1980s. Given the historical tendency for stocks to struggle following such developments, this dramatic increase in rates is cause for concern.”
Valuations. Over the past several decades, valuations have shown an inverse relationship to future equity market returns. When stocks are cheap on a P/E basis, gains follow. When they’re expensive, future profits will be reduced, or investors may suffer losses.
Outcome’s research shows when P/E valuations are in the top quintile (most expensive) of their historical range, gains in the following year are 6.9 per cent. When they are in the lowest quintile, the next year’s gains average 9.4 per cent. When valuations are sky-high, as they were in 1998-99, the result is usually a crash.
Right now, the S&P P/E is 23.46, which is in the top quintile historically. This is “at the very least not a ringing endorsement for strong equity market returns,” Mr. Solomon writes.
Yield curve. It’s been widely accepted that an inverted yield curve (when short-term rates are higher than long-term ones) signals a recession. Is it true? To what extent?
Outcome studied the difference between the 10-year U.S. Treasury yields and the Fed Funds rate, which is a short-term rate. It found that inverted yield curves have predicted every recession since 1955, with only one false signal.
When the yield curve is normal (long-term rates are higher), stocks perform better. The steeper the curve in favour of long maturities, the better. The S&P 500 averaged gains of 9.3 per cent in the year after a positive yield curve in the top quintile. It lost 0.4 per cent in the year after a steep inverted yield curve.
The Fed Funds rate is currently more than 100 basis points higher than the yield on the 10-year U.S. Treasury Bond. That’s one of the largest gaps in history, Mr. Solomon says. “Given the strong historical connection between inverted curves and subsequent recessions, it follows that there is a distinct possibility of a recession occurring in the near term,” he wrote.
Note that he said “possibility.” Not probability.
“There are no flawless, silver bullet indicators for stocks, which means I am not suggesting that investors should run for the hills based on the preceding analysis,” Mr. Solomon concluded.
“Although the macroeconomic indicators discussed in this missive represent some of the more powerful historical drivers of stock prices, the fact remains that there are thousands of variables and millions of interactions that have and can influence markets. …
“This being said, if the past proves to be prologue, the odds argue for tepid returns from stock portfolios over the near to medium term, and that investors may want to resist the temptation to add exposure and chase 2023′s rebound in stocks.”
Gordon Pape is editor and publisher of the Internet Wealth Builder and Income Investor newsletters.