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Price Volatility

Wealth Insights | Equities | Asset Allocation | Economy

Weekly Market Analysis: Bear Today, Bull Tomorrow

3 Things to Know 

The bull case

Bearish sentiment – a positive sign for equities – has been rising sharply this year. A year ago, 24% of investors said they were “bullish.” Today, net bearishness is -22% -- and that’s after the S&P has dropped by 18%.


 

Summary

Though US markets have bounced upwards in what appears to be the third bear market rally this year, the extent of the coming recession remains uncertain. Bulls see the current bearishness as a positive sign for equity performance. When markets have declined by as much as they have this year, and sentiment remains low, future prospective returns have often been unusually strong. Short positioning in markets suggest the same. But, the US recession has not happened yet. And from a bearish perspective, there are many data sets to suggest that a sharp slowing could unfold as we enter 2023.

The bull’s best case would be a soft landing for the US economy, a period of moderating growth. But the speed of Fed rate increases – whose impact is now rippling through the economy, with a lag -- cannot be underestimated.

The bear case

There is enough data to suggest a sharp economic slowdown could unfold in 2023: the Fed is likely to raise rates further as it also reduces liquidity. In the last 100 years, equities have never reached bottom before a recession started.


 

Portfolio considerations

CIO will overweight equities during the trough of a recession. The median 12-month US equity return once a bear market bottom has been reached is 37%. Even stronger opportunities in riskier market segments can be worth our attention in the coming year.

 

The balanced view

In CIO’s view, the powerful impact of the Fed’s rapid rate increases can’t be underestimated. With a dramatic rise in yields, the economy could weaken. CIO expects earnings to contract 10% in 2023, after rising 6% this year. The decline in share prices in 2022 is a “down payment” toward reaching a bear market bottom in 2023.

Individual investor net bullishness and S&P 500 12-month returns at extreme lows

Source: Bloomberg as of Nov. 16, 2022. Past performance is no guarantee of future results. Real Results will vary.

 

The bull case

2021 saw real economic growth in the US of nearly 6%, and Investors remained positive coming into 2022. Then everything changed: 24% of investors said they were “bullish” a year ago. Today, net bearishness is only -22% even after the S&P has fallen by 18%. Bearish sentiment is good for equity performance. Given that a coming recession has been anticipated for most of 2022, it’s well priced into markets. The bull case was also evident on November 10 when broad US markets jumped 5.5% and the Nasdaq surged 7.4% after just a whiff of good news on inflation. More should be expected. Supply chains have been clearing and the only major inflation source remains shelter costs. With the Fed fixated on seeing real evidence that inflation is abating, this was truly good news. As layoff announcements mount and inflation slows, bulls expect the Fed to declare victory soon, as evidenced by a 27-basis-point drop in 2-year US Treasury yields on the day the October CPI was released.

The bear case

The US recession has not happened yet. And there’s plenty of data to suggest a sharp slowing could unfold going into 2023. The Fed is likely to increase rates further and sustain higher rates into a shrinking employment picture. The Fed is also reducing liquidity even as it raises rates. Its Quantitative Tightening program is poised to shrink money and credit outright in 2023. As a result, banks are tightening lending standards and Fed policy rates are now above long-term bond yields. The US money stock has slowed from a 28% growth rate in early 2021 to 2% in late 2022. Demand in the economy is being limited where it once was allowed to boom. The yield curve remains inverted, which has signaled an impending recession in 90% of prior instances since 1960, with an average lead time of 10 months. Finally, in the last 100 years, equities have never bottomed before a recession has begun.

CIO’s balanced, realistic view

The bull’s best case would be a “soft landing” for the US economy, a period of moderating growth with demand and supply growing together at a sustainable pace. However, the speed of Fed rate increases and their impact can’t be underestimated. A recent drop in long-term US bond yields won’t stop a decline in the housing sector in 2023. The housing industry still faces a collapse in production and employment in 2023 just to “catch down” to the present home sales pace. Fed Chairman Powell’s comments, deliberately reiterated by regional Fed presidents in the press every week, point to a Fed using the rear-view inflation mirror to drive forward-looking policy. Forward-looking inflation data suggests inflation could cool while employment weakens in a way that can force the Fed to react once again. With a dramatic rise in yields and drop in wealth, the economy could weaken, and earnings should contract 10% in 2023, after rising 6% in 2022. In CIO’s view the decline in share prices in 2022 is a “down payment” toward reaching a bear market bottom in 2023.

Portfolio considerations

Once the scope of the 2023 recession is understood and a path to recovery is visible, equities could lead the economy out of recession. CIO will overweight equities during the trough of a recession. The median 12-month US equity return once a bear market bottom has been reached is 37%. Even stronger opportunities in riskier market segments could be worth Citi’s attention in the coming year. In the meantime, the unusually severe repricing of fixed income markets offers the chance to add income and rebuild risk diversification into portfolios, likely for the longer run. If overzealous Quantitative Tightening and a consequent employment contraction forces the Fed to correct itself, CIO expects 10-year US Treasury yields to fall back to 3% by year-end 2023. If this proves correct, the prospective total one year return on the 10-year Treasury would be roughly +10%.

Note: Past performance is no guarantee of future results. Real results may vary.