(Bloomberg) — A recession will torpedo stocks. Or banking turmoil. Or a government default, or falling earnings, or a too-aggressive Federal Reserve.
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Doom-saying is never in short supply when stocks are rallying. Lately, it’s reached fevered levels. Could all the pessimism be revving up price action that just pushed the S&P 500 to its highest level in nine months? In the sometimes contrarian world of investing, stranger things have happened.
When everyone’s leaning one way, it doesn’t take much to coax them to the other. And even after a 17% rally in the S&P 500 since October, bearishness is the rule in equities. Sentiment among money managers dipped in May to the lowest level this year, according to a Bank of America Corp. survey. While allocation to stocks crept up, in part because of price appreciation, money was shifting to the safety of technology and out of economically sensitive shares like banks.
Hedge funds, whose caution paid off last year, are sticking to their guns. Those tracked by Goldman Sachs Group Inc. last week saw their cyclical holdings falling to the lowest level since October 2020 relative to defensive shares, according to data compiled by the firm’s prime brokerage unit.
Whatever catastrophe they have in mind, it hasn’t come to pass — yet. As equities march higher, bears are forced to unwind positions. Regional lenders, a group targeted by short sellers during the latest banking turmoil, jumped almost 8% over five days for the best week in 16 months.
“The longer the market goes without collapsing, the more tenuous it’s going to get for the bears,” said Andrew Slimmon, a senior portfolio manager at Morgan Stanley Investment Management. “The market extracts the biggest pain it can and the pain trade is higher.”
Pessimism was so widespread that even a hint of good news has been enough to spark a rally. Up 1.7% over five days, the S&P 500 scored its best week since March, briefly topping the 4,200 level for the first time since August. Underpinning the strength were signals that American lawmakers were making progress on debt-ceiling talks.
A key question for anyone weighing a gamble on stocks now is whether all the trauma unleashed last year when the Fed jacked up rates did enough damage to sentiment to account for whatever is in store for the economy down the road. And while more than a seven-month rally is needed to prove it did, the case for belief isn’t baseless.
One argument in favor of equities focuses on valuations over time and holds that enough skepticism is baked into share prices to cushion them should analyst estimates for next year prove overly optimistic. It’s an optimistic argument, but with a basis in history — the observation that the S&P 500’s price-earnings multiples over the past three decades have averaged 20, and dividing that ratio by today’s index level would give a market-implied profit target of roughly $221 a share. That’s much lower than the $242 expected by analysts tracked by Bloomberg Intelligence.
A host of counterarguments exist, first among them that even if 20 is the average, it’s way too high a multiple to assign when the Fed’s war on inflation has yet to be won. A common theme of bear cases today is that stock multiples must contract, possibly significantly, to account for a litany of altered circumstances, including higher interest rates and the prospect of an economic downturn.
“During a recession, you’re going to see risk appetites decline, so it’s unlikely that investors are going to be willing to pay 18 times earnings,” said Jake Jolly, head of investment analysis at BNY Mellon Investment Management. “That’s why we think that the bottom is still ahead of us.”
But buoyant valuations can be framed as the market’s way of saying that the current profit contraction is no hurdle to share gains. One reason may be that in the economy, hiring and consumer spending continue to buck predictions of a softening.
It’s also notable that some of the things that helped P/E ratios inflate since 1990 are showing signs of stabilizing. Among them are corporate profit margins, which measure how much of sales companies turn into profits.
Ben Snider, a strategist at Goldman Sachs, wrote in a recent note that S&P 500 companies reported better first-quarter margins than the previous period, halting a trend of worsening profitability since 2021. The improvement is likely to continue next year, his team forecast.
“The key question is, what’s the likelihood of $240?” said Slimmon at Morgan Stanley, referring to analysts’ expected profits for 2024. “The longer the market doesn’t fall out of bed, the more the market will, at some point later this year, start anticipating a recovery in earnings. I think it will price off next year’s earnings and it’ll actually price in a higher multiple.”
In 2016, when corporate earnings slipped, the S&P 500 climbed almost 10%, in anticipation of a recovery that indeed happened the following year.
There are signs that defensively positioned investors are willing to believe the market has more upside. During the rally on Wednesday and Thursday, Scott Rubner at Goldman Sachs received more inquires than any time all year and saw clients start “re-engaging” in stocks.
“Investors will continue to add risk next week if we see any positive developments over the weekend and the top of the range gets extended to 4,300/4,400 to the topside,” Rubner, who has studied flow of funds for two decades, wrote in a note. “The worst thing would be a correction shortly after the cover bid is completed.”
At 17%, the S&P 500’s rebound since the October low roughly matches the size of the advance made during the two months through last August. That bounce proved a bear-market trap.
While this recovery has lasted longer, Fiona Cincotta, senior market analyst at City Index, isn’t convinced the worst is over because the risk of an economic recession still looms large.
“You have seen that being reflected in the earnings season, particularly with retailers this week,” she said. “I don’t see it going into a prolonged bull market.”
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