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Analyzing the market sell-off: Routine S&P 500 correction or something more serious?


It’s as if the market is pre-grieving the demise of the economic expansion while it remains very much alive – vigorous, even. The S & P 500 ‘s three-month correction deepened to more than 10% off its peak during a week when third-quarter GDP was reported at a sizzling 4.9% annualized rate, inflation continued to ease slowly and corporate earnings growth is coming in three-percentage points ahead of forecasts with the requisite three-quarters of all companies beating expectations. A full year after economists, as a group placed a 100% probability of a recession over the next year and no recession, has emerged, investors collectively are dumping exactly the stocks (consumer cyclicals, banks, basic materials) most tied to economic activity. Standard late-cycle psychology is entrenched and will never fully be banished until the cycle is reset, with the expected onset of a stalling economy and continually pushed out into the near future. The market is now implicitly concluding that consumer fatigue and 15-year-high bond yields will be too much to absorb – and if it’s not then the Federal Reserve will have to force the issue and possibly cause some tearing in the economic fabric. It’s tricky for those who prefer to respect the market’s message rather than tell it how to act. For sure, stocks always try to anticipate the next turn in fundamentals and tend to do so better than any individual handicapper over time – but the market also overshoots and runs astray at times, creating opportunity for those with a conviction in a variant view. Any buying interest? Aside from the macro unease and sell-the-news response to most mega-cap earnings reports, last week’s 2.6% slide in the S & P 500 also reflects the more disorderly risk-fleeing action that follows a broken uptrend. The 200-day moving average gave way and the widely cited potential support area of 4200 put up no fight at all. According to Goldman Sachs’ trading desk, this has turned systematic trend-following hedge funds close to a recent record-short position in the indexes. With a close at 4117, the index has now returned to a zone where it spent nearly two months churning in April and May before breaking higher. It’s also close to the halfway point between last October’s low and the July high. On paper, this should be an area where some buying interest emerges. .SPX YTD mountain S & P 500, YTD The S & P 500 is also down 10% over the past two years and at a level first reached 30 months ago, with U.S. GDP now 18% larger than it was then and annualized earnings 10% higher. This guarantees nothing but does suggest valuation risk has come down, if not certainly been eliminated. In the time since stocks began their 10% slide in July, the one-year-forward consensus profit forecast for the S & P has risen from about $235 to $241. This places the S & P 500 at around 17 times forward earnings, roughly the past decade’s average. (You will say Treasury yields are much higher now, so stocks appear unattractive, but I’ll answer that the current stock-bond valuation spread was quite routine in the two decades before 2000.) The equal-weight S & P is near a 14 multiple and the equal-weight consumer discretionary sector is under 13, near the 2022 low P/E. It’s never smart to insist a recession is priced into stocks in advance, investors almost never play it cool once a downturn is upon us. And cyclical stocks can be hazardous value traps at low valuations. But, again, someone watching the macro data and willing to bet the consumer can hang in there will have plenty of names to choose from. Bank of America equity and quantitative strategist Savita Subramanian points out that “Consensus long-term growth expectations for S & P 500 earnings have dropped to record lows, a rather powerful contrary indicator.” She has an index target of 4600 for year’s end, essentially a round trip to the July high. Yes, market breadth is lousy, the equal-weight S & P 500 less than 5% above the October 2022 low, but this is also how markets look when they’re getting “sold out.” We probably didn’t quite get to “so bad it’s good” conditions by the end of last week, but have entered the zip code in terms of oversold readings and tactical investor positioning and the like. This untrustworthy market action last week occurred while the bond market was uncharacteristically steady. The 10-year Treasury yield took a look above 5% on Monday then settled back to finish at 4.84%. US10Y YTD mountain U.S. 10-year Treasury A relief, no doubt, but the yield never ticked below 4.8%, the prior high from the first half of the month. Value could well be building in longer-term bonds as yields stay elevated well above inflation, but a retreat in yields below 4.6% or so might be needed to hint to bond-fearing equity investors that the fever is breaking, as markets struggle to arrive at a proper equilibrium among rates, economic conditions and equity valuation. Multiple culprits Aside from the yield story, there are other factors at work, confirming the old wisdom that market corrections always have multiple culprits. Terrorism and regional military conflicts are rarely long-term market inflection points in themselves, but they can exacerbate risk-off impulses. The past three Fridays have seen unsettled trading and a levitation in the CBOE Volatility Index , evidence that traders were clenching up ahead of a weekend of potential escalation in the Israel-Hamas war, only to see some relaxation the following Monday. Gold making new highs and Bitcoin making a strong run add to the sense of foreboding among global asset owners. It recalls the lead-up to the U.S. invasion of Iraq in March 2003. Stocks had attempted a strong rebound off the bear-market low the prior October, but the S & P 500 fell some 14% in less than two months starting in January as an invasion was viewed as nearly certain. Much else was happening, but once the military action started that March, stocks surged as the overhang of uncertainty lifted. This is also the time of year when weakness is pinned to tax-loss selling by mutual funds with an October-ending fiscal year, a presumed contributor to general autumn turbulence and to the many notable late-October market bottoms throughout history. I mused here a few weeks ago that there seemed perhaps a bit too much investor reliance on the fourth-quarter seasonal-strength story, and indeed there has been none so far aside from a weak bounce off the early-month low. Now is exactly when the historical pattern says the late-year tailwinds ought to kick in, perhaps helped this year by a general loss of faith that they will. Not to mention the modest challenge to the hope and belief that the Magnificent Seven tech giants could remain impervious to higher rates and doubts about their growth outlook. When investors grow unsure of supposed “sure things,” the potential for pleasant surprise is restored. Of course, if the tape doesn’t soon find some relief given the pervasive price damage done and typical calendar support into November, it would add credence to the idea that the market is contending with something more serious than one can see by simply looking at the incoming economic evidence.

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