Theories abound as to what sapped volatility from equities, everything from passive money flows to flat-out manipulation. But a simpler explanation is that investors look to the future and just don’t see anything worth freaking out about.
Deluded? Perhaps. Yet anyone arguing against the view needs first to explain away the events of last year.
You wouldn’t know it for all the mud slung at them, but lowly equity traders did a remarkably good job in 2022 adjusting share prices to the wounded profit potential of corporate America. At its low point, the S&P 500 traded at about 16 times what has since emerged as the likely earnings output of its constituents a year later. Compared with history, that’s a fair multiple.
Fast-forward to today and you find an equity landscape nowhere near as beset with urgency. Thirty-day realized volatility in the S&P 500 is plumbing depths not seen since the calmest years of easy money stimulus, while the index is up 8% since December.
Yes, dissenters abound. Everyone from Stan Druckenmiller to Marko Kolanovic and Mike Wilson says the worst is still to come for shares as endless inflation and a recession renew last year’s havoc.
Another interpretation sees an investor class that wasted no time acknowledging the onset of one trauma seeing few signs that a second one is brewing. They were right once. Could it happen again?
Count Phil Pecsok, chief investment officer of Anacapa Advisors, among those giving the market the benefit of doubt. His $30 million hedge fund bought call options on the S&P 500 in December, a time when bulls were scarce.
“Everybody’s saying, ‘oh, we’re facing a recession.’ Well, we’re not seeing it,” said Pecsok, whose fund has doubled the S&P 500’s gain since its inception five years ago. “Right now you’ve got a rising tide and we’re not fighting it.”
For anyone trying to make a case a recession is coming, there’s plenty of evidence. While broad measures of hiring remain strong, first-time weekly jobless claims just rose to the highest level since October 2021. Survey-based reports have shown credit tightening, a possible consequence of recent banking turmoil. And inflation remains well above levels targeted by the Federal Reserve.
While downturns in the economy almost always spell trouble for stocks, it’s possible investors believe they could weather a weak one through a combination of last year’s valuation adjustments and the shifting composition of large-cap indexes. By far the largest portion of the S&P 500 is big technology companies whose profits may prove less vulnerable to economic reversals, particularly if they remain brief and shallow.
Stocks have climbed in all but two months since their October lows, adding $5 trillion in value over the stretch, as economic data and corporate earnings held up better than feared. The resilience goes against dire warnings in the bond market, where traders dialed up bets that the economy will slip into a recession, forcing the Fed to cut interest rates.
Gleaning fundamental messages from markets is an exercise fraught with risk. The rise of passive and systematic strategies means many investors don’t buy and sell stocks based on economic or earnings outlooks. Rather, their investment decisions are guided by momentum and volatility signals.
Still, for all the technical advances, the market has demonstrated an ability to recalibrate around fundamental news. And a strong case exists that the market did a better job last year than Wall Street in handicapping corporate America’s earnings power.
The S&P 500 tumbled 20% in the first half of 2022, entering a bear market. Only after this bout of selloff did analysts start to revise their numbers. Their aggregate profit estimate for 2023 has since dropped 12%, according to data compiled by Bloomberg Intelligence.
What is the collective view of profits in stock markets today? One way of deciphering how much traders really think companies will earn is to apply a historical multiple to the index and see what pops out on the profit line.
Seven months ago, the S&P 500 bottomed out at 3,577, a level that when divided by a historical P/E of 18 was pointing to earnings of roughly $200 a share. At that time, analysts predicted $238 for 2023. That forecast has since slipped to $219.
Now, with the S&P 500 sitting at 4,131, the implied income is significantly closer to next year’s analyst forecast of $242.
In other words, unlike 2022, when stock prices forcefully adjusted for a swift earnings downturn, today’s market looks ahead and sees a brighter picture.
It’s a sanguine view that few investors share. In fact, stock-picking funds are going all-in on recession bets, data compiled by Bank of America Corp. show.
One bear case holds that despite last year’s bruising selloff, valuation excesses still looked extreme relative to past instances of stress. One model kept by Leuthold Group showed that at the market’s October low, a measure of the S&P 500’s P/E was higher than all other trough multiples since 1957. Should current valuations drop to the next highest level, the index would sink to 2,950.
Another popular argument among skeptics: The Fed’s yearlong monetary tightening has yet to make its full impact felt in the economy. And with the banking crisis forcing lenders to rein in credit, consumer and business demand are poised to weaken.
“I am a big believer in and observer of cycles, the most important being the credit cycle,” said George Cipolloni, portfolio manager at Penn Mutual Asset Management. “Where we are today in terms of the credit cycle – mid to late cycle – seems to be more consistent with the inverted bond yields versus potential lagging earnings results.”
As gloomy as it all looks, the market is refusing to budge. The S&P 500 has recovered half of the losses from 2022’s carnage. Along the way, short sellers were forced to unwind wagers, adding fuel to the rally. At the same time, the index has yet to breach resistance at a widely watched level of 4,200.
Stuck in a tight trading range, the S&P 500 saw its 30-day realized volatility hovering near the lowest level since late 2021.
With inflation softening while angst building over US debt ceiling, JPMorgan Chase & Co.’s trading team led by Andrew Tyler ponders whether — and when — the market can break out of this doldrum.
“The key will be macro data where economic growth will need to be maintained to hit these earnings targets,” the team wrote in a note. “Aside from the near-term risks, it does feel like the market is watching a race between inflation and the Fed, meaning, can inflation fall fast enough for the Fed to move down from restrictive territory before we see something bigger/worse than March’s banking crisis?”
--With assistance from Isabelle Lee.
This article was provided by Bloomberg News.