Did you even notice that the stock market has declined by about five percent? It feels like an under-the-radar drop for most investors. What do I mean by that? On the occasions I am somewhere other than my house or the office, civilians (i.e., non-financial advisors), despite the selloff, still ask me which stock they should buy now. Not even “if,” but “which.” During market pullbacks, investors usually ask me if they should sell, not what they should buy.
On the other hand, professional investors are feeling anxious that a top has been put in. And rightfully so. The Leading Economic Index (LEI) declined in July 2023 for a 16th consecutive month. As explained in a prior column, the LEI “provides an early indication of where the economy is heading in the near term. It is a tried-and-true predictor of recessions.”
It is practically a rule that a recession should start immediately, given the LEI. However, rules are meant to be broken. In that prior column, written on July 31, 2023, I said the odds of a recession for this year are coming down. It turns out that this quarter is shaping up to be a boom, not the bust of a recession.
According to the Atlanta Fed GDPNow model, Gross Domestic Product (GDP) is up a whopping 5.8 percent. However, someone forgot to tell the stock market. The S&P 500 fell below its 50-Day Moving Average (DMA) on August 15, 2023. That was the indices’ first time below that level in four months. I expect the S&P 500 to continue its downward trend and test its 200-DMA. That would result in a roughly 10 percent correction. I intend to remain invested through that slide, should it occur. And I’ll tell you why.
It sounds ominous that the stock market’s trend should cross below such a significant technical indicator. Nonetheless, a pullback to the 50-DMA has historically been bullish three months to one year later.
The above chart above from Bespoke shows the performance of the S&P 500 for periods ranging from one day to one year. The light blue bars represent the average return of all such periods. The dark blue bars signify average returns after the index crosses below the 50-DMA following streaks of the S&P 500 trading above the 50-DMA for more than 90 days. The excess average return following those dips has been notable.
Some breaks of the 50-DMA result in testing the 200-DMA. Why do I expect that to happen this time before the market resumes its upside trend? It is because I can’t answer the question “What makes the stock market go up next?” Well, I can give a long-term answer to that question: a growing population, improved productivity, and corporate innovation—you know, the stuff that makes up a burgeoning economy. But for the short term, I don’t have much to look forward to until corporate earnings stabilize. Although that should happen this quarter, earning reports are still a couple months off. And by “stabilize,” keep in mind that earnings for S&P 500 companies for the third quarter of 2023 are expected to be virtually flat (up 0.2 percent year-over-year).
In the meantime, the futures market is pricing in an almost two-thirds probability that the Fed will hike interest rates at least once more by their November 1, 2023 meeting. (I have previously gone out on a limb arguing that the Fed is done raising rates for this cycle, but I am less confident in that assumption today.) Until sometime before that Fed meeting, the stock market will likely struggle with “what if” combinations of not knowing what will happen with inflation, interest rates, or corporate earnings.
Two months of the stock market going nowhere isn’t the only possibility. The next most likely outcome is that the stock market will drop between 2 and 4 percent in a week—some week—before the November 1 Fed meeting and create a bottom.
So, why do I expect the stock market to bounce back (beyond the apparent long-term consideration of earnings growth)? Bond spreads are a bullish signal for me. The drop in stock prices appears to be more of a re-rating of price-to-earnings ratios due to higher real (i.e., inflation-adjusted) interest rates than a concern about corporate earnings.
The spread of U.S. corporate bond yields over Treasuries remains very low. When bond spreads increase, that reveals investor concern regarding whether companies can generate enough profit to make interest payments. Current spreads of investment-grade corporate bonds and junk bonds over Treasury bonds are just 1.26 and 3.95 percentage points, respectively. That compares to 1.20/3.95 in February 2023, prior to the Silicon Valley Bank blow-up, and 1.19/3.79 on July 31, 2023, at the recent peak of the S&P 500. While you could argue that bond investors are acting slower than equity investors, bond spreads typically spike when real trouble is around the corner. Bond spreads tell me that any pullback should be limited to a garden-variety correction.
