SPDR S&P 500 Trust ETF (NYSEARCA:SPY)
The stock market is making another effort at a bear market rally. I was positive throughout the previous bear market rise – the summer rally from June to August – before turning pessimistic in the run-up to Powell’s address at the Jackson Hole symposium. As I explain in this essay, I am not buying the unfolding bear market rally this time, and I remain pessimistic.
The Bullish Case for the Summer Rally
My view for SPDR S&P 500 Trust ETF (NYSEARCA:SPY) is positive by default unless one of the following shocks occurs with a high probability:
- the Fed-induced liquidity shock, which I describe as the bear market’s Phase 1;
- the recessionary selloff, or the complete bear market’s Phase 2; or
- the credit crunch selloff, or the bear market’s Phase 3
From January 2022 to June 2022, the S&P 500 saw a Phase 1 selloff as expectations for more hawkish monetary policy surged dramatically. However, on June 16th, monetary policy tightening expectations looked to have peaked, implying that the Phase 1 selloff was likely over. At the same time, given the broad spread of the 10Y-3mo yield curve, the chance of an impending recession remained relatively low.
As a result, I hoped that the stock market would rebound sharply. This favorable prognosis was based on assumptions of peak inflation and peak Fed hawkishness, which reduced liquidity risk while keeping the danger of an impending recession low. Furthermore, given the 24% drop, I anticipated a 15-20% rally (which ended up being 17%).
More precisely, the Fed signaled a willingness to undertake a slight dovish pivot – or to stop the hiking cycle to assess the impact of previous interest rate rises before inverting the yield curve. This was the recipe for a possible gentle landing, which might have extended the summer rally into the second half and perhaps brought the SPY back to its earlier highs.
The Negative Case (That Ended the Summer Rally)
The summer rise largely stopped following Fed Chair Powell’s remarks at the Jackson Hole Economic Symposium on August 26th. The Fed Chair ruled out a dovish turn. Instead, it effectively replaced the soft-landing goal with the “growth recession” goal. As a result, SPY’s bullish scenario was entirely demolished. Here is what Fed Chair Powell said precisely (emphasis added):
Restoring price stability will almost certainly necessitate the continuation of a restrictive policy posture for some time. The historical record warns against premature policy easing…Restoring pricing stability will take time and require firmly employing our instruments to bring demand and supply into better balance. To reduce inflation, a protracted period of below-trend growth is likely. Furthermore, labor market circumstances will almost certainly weaken. Higher interest rates, slower growth, and softer labor market conditions will reduce inflation. Still, they will also cause some pain for consumers and companies. These are the unintended consequences of lowering inflation.
As a result, according to my model, the forecast for the S&P 500 is bearish, and I am not buying the attempted bear market rebound. Indeed, the Fed’s stated chance of an impending recession has risen to 25%. Still, traditionally, readings above 30% have resulted in a recession. This backs up my pessimistic predictions for the upcoming Phase 2 selloff. Also, when I predicted a summer rally in June, the Fed’s recession probability was only 4%. As a result, the macro environment has changed significantly since the June low.
Specific Analysis of S&P 500 Sector Performance
The SPY increased by 3.65% last week, but the consumer discretionary sector (XLY) outperformed by 5.78%. More crucially, consumer stocks that have been heavily shorted, like Royal Caribbean (RCL), have led the rebound. Consumer discretionary companies are highly susceptible to the high likelihood of a recession. The recent rally was most likely due to short covering. However, last week’s rebound was relatively broad-based, with all sectors rising.
Implications
The chance of a recession is very high right now, and the SPY P/E ratio of 22 and the future P/E ratio of 18 are both extremely high. The projected recession should result in profit downgrades. Given the SPY’s value, the recession has not yet been priced in. As a result, the SPY bear market will most certainly continue. Any short-term bear market rally is a buying opportunity.
Featured Image- Megapixl @Spettacolare
