Over the last few weeks, many people have asked us, “When do you think the stock market will bottom?” We usually avoid these types of questions, as answering them implies a level of foresight that humans just don’t generally possess. However, this week we’ll attempt to give you a glimpse into the types of information we look at to determine the likelihood of a market bottom.
Historically, there have been two main types of bottoms—the normal, gradual bottom where investors have discounted earnings declines, recessions or other cyclical factors and the abrupt crisis bottom driven by central bank intervention. We recently experienced the later in April 2020 when the Federal Reserve panicked, slashed interest rates, and began a multi-trillion-dollar asset purchase program.
So, let’s first look at the second type of bottom and assess how likely it is over the foreseeable future.
There are a few critical data points that the central bank monitors to determine if they need to rush in and save the markets from panic.
Presently, only two of the eight major fundamentals are flashing Fed Intervention. Bond market volatility (MOVE Index) and equity volatility (VIX) are both in the danger zone (as many of you are hyper aware given investment volatility over the last few months). Critically absent from the panic stage are credit spreads. While corporate bond prices have fallen significantly this year, most of that decline has been due to interest rate increases and not credit spread—the extra interest investors receive to take default risk. When investment grade bond spreads reach 4.0%, the financial markets are usually telling the Fed that the system is about to seize up.
So, even though many talking heads are saying the Fed has done too much monetary tightening and will shortly pause and reverse; we don’t see it happening this year. In a recent survey of institutional investors, most agreed with us, expecting the Fed to remain aggressive until the middle of 2023.
Without abrupt central bank intervention, we will most likely have to ride out a typical earnings recession with the corresponding market declines. Investors in the stock market are always focused on the next one to two years of earnings growth. The stock market typically begins to weaken a year before corporate earnings begin to fall. After the recession becomes a certainty, investors again focus past the decline to renewed earnings growth—usually 6-9 months prior to the earnings trough.
Granted, this scenario only plays out if we avoid a major central bank induced crisis. A crisis would flip us back to the second type of bottom with the central bank rushing in to save everyone.
We’ve written many times over the last six months, that we think stocks are within their fair value range at current prices. If we don’t have a particularly bad recession, then we may already have seen the worst of the declines in stock prices. But, the markets tend to overshoot to the downside, at least for a few months before the emotions of scared people run their course.
We continue to be conservative in our approach to adding equity exposure. We are focused on determining where, if anywhere, the next crisis may emerge. Usually, when the Fed gets aggressive, they don’t stop until they break something. So, it’s important to figure out where that break might happen before getting too allocated to stocks.
