Stocks have had an impressive rally over the past five months, equal to a 50% retracement of the S&P 500 bear market losses. While many firmly believe that the bear market is now over, I remain skeptical.
The 0.5 Fibonacci retracement is a key level that is commonly reached during bear markets but, in the case of the S&P 500, has never been successfully crossed during a bear market in the last 77 years.
This makes 0.5 Fib a proverbial “line in the sand”. Breaking it in earnest would be a significant signal that the bear market is likely over. Needless to say, I watch her closely.
0.5 retracement review
The S&P 500 today spent three days above the 0.5 Fib retracement level as measured from the highs in January 2022 and the lows in October 2022. The index has since rejected the level. I’m watching level 4,200 for a possible retest and a successful breakout. Right now, the daily RSI is moving away from overbought territory.
Looking at the 2008 bear market, we can see that the S&P 500 also hit the 0.5 Fib retracement level, twice. It hit level 1,417 for three days, declined, and then rose above the level in the retest. It actually reached halfway through the 0.618 Fib retracement level before the bear market continued. The daily RSI was close to overbought territory.
The 2001 bear market produced a 0.5 Fib retracement that lasted three days before reversing. This also coincided with the daily RSI reaching overbought territory.
Based on history, the current market action is not unusual for a bear market. Typically, major bear markets will rally at the 0.5 Fib retracement level at least once. But for decades, bear markets did not break through the 0.5 Fib retracement level. The 2008 bear market was one of the closest bear markets to doing so. What this means to me is that the 4200 level on the S&P 500 will put me on alert for a signal that the bear market is over with confirmation at the 4300 level.
The bear case
Ultimately, market price action is everything. This is why technical analysis is essential. But for fundamental reasons, my base case is that the bottom of the S&P 500 is ahead. This anticipation is largely centered on the probability of an income recession which will be difficult to manifest without weakening employment.
The US unemployment rate is the lowest in 53 years at 3.4%. This current data does not indicate any weakness in the workforce. But each of the last four recessions has been preceded by low unemployment.
One of my favorite leading indicators to use to predict unemployment is the National Association of Home Builders (NAHB) index. When the index falls, it often precedes a rise in unemployment. With the exception of the 2020 COVID recession, where people were laid off immediately by term, the last three major recessions have seen a decline in NAHB around 790, 487, and 608 days before the unemployment low.
The NAHB index fell from 84 in January 2022 to 31, a significant and rapid deterioration. I’m measuring the most recent high of January 2022 instead of the high set in December 2020, which may be an outlier due to the whiplash effect resulting from the 2020 lockdowns. Using this date, one would expect that down unemployment rate to be reached between May 2023 and March 2024.
One of the reasons employment remains strong during this period is the effect of employers hoarding employees due to a tight labor market. This market tension is the result of COVID-related events, including:
- A significant number of employees who have been made redundant and do not return to their previous jobs,
- Many employees who have decided to retire to avoid the consequences of COVID in the workplace,
- Countless others have changed their employment status, either because they were inspired to change their lifestyle or because they achieved financial freedom thanks to the impressive gains in financial assets resulting from the stimulus. .
It would be different if the labor market started from a baseline. Instead, starting from a deficit means that there is additional ground to cover before leading to real job losses. I think this is the main reason why market participants are so skeptical of indicators that predict recession. Every “time” is different and that is one of the differences today.
The main indicators
Leading indicators point to recession. The Conference Board’s US leading index is convincingly in recessionary territory with a consistent record over the past 60 years. The 10Y-2Y Treasury yield curve is the most negative since the 1980s at -0.76 while the 10Y-3M curve is surprisingly negative at -1.0. These economic indicators do not suggest anything other than a recession.
Morgan Stanley’s Earnings Leading Indicator predicts a year-over-year decline in S&P 500 earnings of almost 10% in 2023. I think given the momentum in the economic data, this will prove to be the minimum downside , my base scenario being -15. % by the end of 2023 or the beginning of 2024.
So far, the S&P 500 correction has mainly been in valuations after hitting a P/E adjusted operating profit of 24 at the end of 2021. At a P/E of 18.76 today, the index is quite valued if income does not decrease.
Given that I expect earnings to decline 15% over the next 4-5 quarters, that would put the S&P 500 at around 3,300 and a fresh low for the bear market. Last week I added to my short positions on the S&P 500 with a stop loss at 4300. I still have significant buying power in reserve as I expect the market to be limited for weeks.
Risk for the thesis
This investment thesis carries several risks. First, of course, is that the recession does not materialize. Currently, employment remains strong (as discussed) and household balance sheets are relatively strong despite low savings rates and increased credit balances. The housing market is showing some weakness, but the potential for a catastrophic event is low. I am writing an article on the subject which is going to be a deepen my thoughts on the housing marketyou don’t want to miss it.
Another risk is a real pivot of monetary policy. If the Federal Reserve shifts from removing liquidity from the financial system to adding liquidity, that would change my thesis and I would react immediately. I have often written on this subject and in my opinion the pivot is not imminent. There are other sources of liquidity for the market and a major one is the Treasury Department. Due to the debt ceiling, the Treasury Department must defer new borrowing and use funds from the General Treasury Account which adds liquidity to financial markets. More liquidity would nullify my thesis.
Another risk to consider is that the market has already priced in the recession and the associated decline in earnings. This is plausible, given that stock markets are very good at hitting bottoms before recessions end. For this to be true today, the stock market would have to price in the recession before it officially started, before yield curves flattened, before the Fed pivoted, and before employment fell. weakens. It is a very rare phenomenon.
The current rally in equities challenges the bear market narrative. Testing the Fibonacci retracement at 0.5, the S&P 500 is sitting on the edge of a new bull market. History shows that bear markets always end when the 0.5 retracement level is successfully crossed. For the current market, this signal would be around 4,250 on the S&P.
Economic fundamentals have me leaning towards a further decline in stocks due to the recession and lower earnings. Two factors that I believe are confusing investors are the prolonged strength of the labor market and the additional liquidity of the TGA. On the other hand, I think the case of the bear is alive and well. But the price action has reached a line in the sand, and if that line is crossed, I will have to change my thesis.
Finally, we haven’t discussed inflation in today’s discussion. I have already written on the subject. The next CPI print could be hot or cold and the market could react aggressively to it, but I don’t think the inflation picture changes that thesis at this time.
What do you think, will the S&P 500 hit new lows? Leave a comment below.