It’s been a nearly frictionless seven months for the S&P 500, which has risen 26% since late October.
But as rising stock prices continue to placate investors and even change the minds of some of Wall Street’s most bearish strategists, the market may be quietly beginning to turn around.
That’s the view of John Wolfenbarger, founder of the investment newsletter BullAndBearProfits.com and a former investment banker at JPMorgan and Merrill Lynch. In a recent note, he laid out some charts that show why stocks are hitting new highs even as the threat of a recession looms.
The first comes from history. In previous Federal Reserve (Fed) rate-hiking cycles, stocks have risen until the central bank began to cut rates. But as soon as the Fed started to ease policy, the market runs into trouble. This was the case in 2000 and 2008, two of the biggest market sell-offs in history. The Fed is expected to start cutting rates later this year, which could spell trouble for stocks.
Bull and Bear Profit
Of course, this depends entirely on the Fed’s reasons for cutting rates. The Fed is trying to guide the economy to a soft landing and bring down inflation without too much disruption to consumer spending or the labor market. If inflation falls from its current 3.4% in the coming months, the Fed could cut rates to avoid an unnecessary recession. On the other hand, if inflation rises, the Fed may be forced to keep rates high, which could eventually have a negative impact on the economy and lead the Fed to cut rates in response. The latter outcome would sink the markets. At this point, the market consensus seems to think that’s unlikely.
Second, Wolfenbarger noted that the unemployment rate is starting to rise. The graph below shows that the unemployment rate has risen above its two-year moving average, shown in black and red, respectively. This happened in 2001, 2007, and 2020, at the start of the last three major recessions. The bottom of the graph shows the corresponding price movements of the S&P 500. When the unemployment rate is trending significantly upward, stock prices are falling significantly.
Bull and Bear Profit
Wolfenbarger also said corporate earnings are an important metric to watch when trying to pinpoint the peak: First-quarter earnings were strong, but if earnings start to fall as the economy slows, stock prices will fall along with them.
Putting all this together, Wolfenbarger has a pretty pessimistic outlook for the stock market going forward. Ultimately, he sees the S&P 500 falling by more than 50%, which he attributes in part to investor exuberance and complacency.
For example, market valuations are sky-high: The Shiller CAPE ratio is currently above its 1929 level and only below its 2000 and 2022 highs. The CBOE Volatility Index, which measures how much volatility investors expect in the market over the next 30 days, is also near its lowest level on record.
This is happening despite persistent inflation, high interest rates and red flags from classic recession indicators like the Treasury yield curve, which has been a perfect recession indicator for the past few decades.
“We have never seen a soft landing following a significant Fed hiking cycle and yield curve inversion like we have seen this cycle,” Wolfenbarger said in the note. “I don’t think it would be wise to bet that this will happen for the first time in history.”
In previous yield curve inversions, the severity of the bear market has correlated with the duration of the inversion. The current 580-day inversion would represent a roughly 65% ​​drop in the S&P 500.
OVOM Research/Bullandbearprofits.com
Wolfenbarger first began warning of a market crash in late 2021, after which the market fell 25% on fears that the Fed would push the economy into recession. But those fears have since faded, and the S&P 500 is up 47% since October 2022.
Bullish sentiment is increasingly prevalent on Wall Street, making Wolfenbarger and his views somewhat of an outlier compared to bears like Jeremy Grantham, Marko Kolanovic and Albert Edwards.
Whether Wolfenbarger’s view comes to fruition will depend on how well the economy holds up as the Fed continues to tighten monetary policy. For now, at least, the resilience of the job market and consumer is giving bulls a lot of money to gain.
