The bull narrative is over, and now the market must convince the Fed to pivot. The stock market may have finally realized that rallying in hopes of the Fed stopping its rate hikes was the wrong approach. The equity market seemed to forget that what will likely cause the Fed to change direction isn’t by rallying in anticipation of a Fed pause but by forcing the Fed’s hand into pausing.
It may have finally reached a point where the market realized it made a mistake, with financial, industrial, staples, and energy stocks screaming higher off the October low, hoping the Fed would pivot. However, the problem is that the Fed hasn’t shifted because core CPI is still showing that it is very hot and sticky. Core CPI is also not falling fast enough for the Fed in my view.
Plenty of Issues At Hand
However, the market is finally waking up to the fact that all is not rosy. Stocks are overvalued, the S&P 500 earnings are expected to be flat versus last year, and that bank earnings estimates may need to drop, despite the economy holding together.
Yes, the market rallied following the hotter-than-expected core-CPI print on Tuesday, but that was due to implied volatility melting, not because the market was cheering the results. That is why the market faded all afternoon, with a final $4.4 billion market on close buy imbalance saving the day.
Spreads Are Widening
Now everything is starting to unwind, and cracks are forming in the markets as credit spreads widen, implied volatility jumps, and financial conditions tighten. The Markit CDX High Yield Index is ripping higher and indicates that high yield spreads are widening versus Treasuries, resulting in S&P 500 implied volatility moving higher. This is a classic sign of financial conditions tightening, which is not constructive for stocks.
Short Covering in Bonds
We see these spreads widen again because there is a frantic race to cover short bond positions, which is obvious and apparent in the 2-year Treasury rate. Levered Funds have built a giant short position in the 2-year futures over the past several months, a bet on rates rising, which they did.
This led to the SG Trend Index, which measures CTA performance, rising sharply. One can see this short position at work, as it performs better as 2-year rates rise. But the recent crash in yields started in some part initially by a flight to safety, which triggered a mad dash to cover shorts.
This sends an optic that something terrible is likely to happen in the economy, and maybe globally, resulting in widening credit spreads and rising implied volatility, causing financial conditions to tighten.
If the equity market hadn’t kept betting on a Fed pivot and allowed the financial conditions to tighten, inflation would have probably been dealt with already. But because equities kept playing, the Fed will likely soon pivot the game, bidding up the industrials, financials, staples, and energy like the worst had passed, financial conditions eased, gave life back into the economy, and allowed inflation to stay sticky and elevated.
More Pain To Come
Now the market has woken up because there is probably more pain to come, and Silicon Valley Bank, along with the on-again-off-again issues at Credit Suisse, has reminded everyone. But importantly, the S&P 500 is overvalued, trading at 17.9 times 2023 earnings estimates, an insanely high valuation for S&P 500 that is expected to show no growth in 2023 versus 2022. That seems like a very high multiple to pay for no growth.
The S&P 500 PE multiple doesn’t have to fall very far, just back to the October lows of around 16, to push the index back to about 3,500. But a move typically associated with market bottoms comes closer to 14, and that would mean an S&P 500 trading around 3,100, assuming earnings of $220.38 for 2023.
Typically, when markets want to either object to what the Fed is doing or are in a period of fear, a drop to a PE of 14 is what we get for repricing, not a rally in the hopes of a Fed pivot.
The hopes that inflation would subside quickly and the Fed would pause was wrong and mistaken for months. In the end, inflation has proven to be sticky, forcing the Fed to keep raising rates, but the effects weren’t fully felt because financial conditions eased a lot over the past five months.
But now the tide has turned, and investors seem to have realized the S&P 500 has no earnings growth, valuations are high, financial conditions need to tighten, and the banks may struggle. So now, the massive rally in the market off the October low is being unwound globally.