A Fall Correction?

Vincent Deluard, StoneX global macro strategist, believes we might be about to see a Fall correction, defined as a 20% or greater decline in equity prices. Since mid-July, the S&P 500 and Nasdaq 100 have fallen by 8%. Risks abound: rising bond yields, widening credit spreads, high valuations, stubborn inflation, a lofty oil price, a rising dollar, and expectations of solid earnings per share (EPS) growth that might be dashed.

Investment implications

Deluard concludes that the investment implications of this negative outlook are straightforward: overweight cash, with CD’s yields at 5.5%; 2-year Treasury Inflation-Protected Securities (TIPS) at 3.1% in real terms; and buy cheap international equities.

Miracle on the Hudson

Deluard makes this analogy: “Buying the S&P 500 index at 22 times earnings feels like betting on a repeat of the miracle landing on the Hudson River.” On January 15, 2009, US Airways Flight 1549 struck a flock of geese, and both engines lost power shortly after take-off from LaGuardia Airport. The pilot, Chesley "Sully" Sullenberger III, executed a perfect water landing on the Hudson River, and all 155 people on board were rescued by nearby boats. Hence, “Miracle on the Hudson.” Can equity markets execute a similar smooth landing?

“Sure, everything can go right,” Deluard adds. “Economic growth may remain resilient despite mounting headwinds. Inflation may slow despite $80+ oil, base effects, and health insurance costs' rebasing in November. Powell may throw four bonus cuts in 2024 despite his promise to stay ‘higher for longer.’ Margins may soar past their 2021 peaks despite rising interest expense and wage pressures.” Or maybe some things will go wrong.

Summer grinds precede autumn corrections

A stalled equity market over the summer suggests that more investors are becoming increasingly uncomfortable with this narrative. The summer grind concept identifies a stalled bull market. This was true in the summer of 2021, 2019, 2017, 2014, 2007, and 2000. “The ‘summer grind’ idea is to identify a stalling bull market when stocks tend to drift sideways during the summers, which precede major corrections,” Deluard adds. He describes how summer grinds can be defined by:

• a period of directionless trading
• the poor market breadth and
• failure to confirm new highs

These features have preceded the last six major stock market corrections. Market action this summer has met these conditions:

• The S&P 500 index trades within 5% of a one-year high
• June-to-September returns are less than 2%
• Large caps have outperformed small caps by more than 5% in the prior nine months

S&P 500 summer grinds

Source: Bloomberg, StoneX.

Narrow market breadth is a significant risk

Deluard closely tracks market breadth or the degree to which a handful of stocks provide market leadership. “I pay particular attention to breadth because it often leads market trends,” says Deluard. The Magnificent Seven megacaps – Amazon, Alphabet, Apple, Nvidia, Meta, Microsoft, and Tesla – have provided the bulk of equity market returns. At the other end of the size spectrum, the Russell Microcap Index is back at its October 2022 low and has lost 5% in the past five years.  Most stocks are in a secular bear market.

“By some measure, the 2023 rally was the narrowest in history,” Deluard explains. “The Russell Top 50 Technology Index has outperformed the Russell Microcap Index by an incredible 70% since November. That outperformance is even greater than during COVID or the first internet bubble when tech stocks’ earnings were soaring, contrary to where we are now.”

Bear market drivers

Three macro factors are negative for equity markets:

• rising real bond yields,
• higher oil prices, and
• a stronger US dollar

“Rising real yields seem the most important for me,” says Deluard. “I would say that the yield on the 2-year Treasury Inflation-Protected Note spiking by 630 basis points is the most negative. I do not believe that stocks’ valuations have fully adjusted to such a massive and rapid increase in the real risk-free rate.”

Rising oil prices and a strong US dollar are less critical for the energy-independent US economy and the valuation of US assets. However, they still negatively impact overseas profits and foreign demand for US goods. S&P 500 index companies derive some 40% of their revenue from overseas. 

Fading EPS growth

We have gone through a period in which analysts have typically revised their forecasts for higher EPS growth. Expected 12-month forward earnings have increased by 6.7% since February. This increasing period of rolling optimism appears to end as lower economic growth forecasts hit corporate sales estimates and rising costs, making it more challenging to raise profit margins, already at peak levels. Buy-backs are now less likely to fill the earnings gap.

High borrowing costs limit the extent to which large firms can use buybacks to support EPS growth with buybacks as profits slow. S&P 500 index buybacks have fallen 34% since their 2022 peak, as even the most cash-rich tech giants have cut their repurchases. Buybacks have fallen by 45%, excluding energy and the five big tech platforms. “I find it hard to reconcile with the consensus estimate that earnings will be 17% higher in a year,” says Deluard.

Junk bond spreads signal bear markets

Investors should also monitor the junk bond market, notably spreads on the Bloomberg US Corporate High Yield Ex-Energy index and risk-free Treasuries. As the chart below illustrates, these spreads have increased. This has knock-on effects on the perceived risk in equity markets, expressed by the VIX fear index. “A rise in spreads would indicate fears of an economic slowdown and a more widespread drop in risk appetite.”

High Yield Bond Spreads and the Vix Index

Source: Bloomberg, StoneX.

Equity valuations are historically high

The equity risk premium shows the valuation of equities compared to risk-free assets like bonds. A low risk premium indicates that equities are expensive. The US equity risk premium is among the lowest in the world. “The premium for US stocks over their international peers has never been greater,” says Deluard. “A large allocation to cash and an overweight of international equities could help investors navigate what I believe will be a difficult end of the year.”

Global Equity Risk Premia  

Source: Bloomberg, StoneX.

Technical position at an inflection point

Some investors monitor technical indicators to gauge the next move in markets – and we’re now at an inflection point. “If small caps catch up and close the current breadth divergence, the summer grind will likely be resolved with a fourth-quarter rally and new all-time highs on the S&P 500 index,” says Deluard. “Conversely, a failure by the S&P 500 index to recapture its August low would leave the 200-day moving average of 4,189 as the next target in this correction.” That’s just 1% below the current S&P 500 index level.

Analysis by Vincent Deluard, CFA. Director, Global Macro Strategy. [email protected]

Financial reporter: Paul Walton. [email protected]