Doom and Gloom: When Will it End?
It's been a very rough four-and-a-half months to start the year—the third worst at this point on record for the S&P 500 and the worst since 1970. The S&P 500 has had its longest stretch of lower weekly closes since mid-2011. More than $10 trillion of "paper wealth" (measured via equity market valuation contraction) has been lost since the start of 2022.
As shown in our crowd-favorite drawdowns table below, both the Nasdaq and Russell 2000 (small caps) are in bear market territory (at least -20% on a closing basis), with the S&P 500 so far avoiding the same fate at the index level. Relative to either this year's high (second column) or the 52-week high (sixth column), the S&P 500 is down less than 20%. But the details in the table are more telling, with the S&P 500's average member maximum drawdown now at -24% from the members' year-to-date highs (fourth column) and -28% from the members' 52-week highs (seventh column).
Source: Charles Schwab, Bloomberg, as of 5/13/2022. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Past performance is no guarantee of future results. Some members excluded from year-to-date return columns given additions to indices were after January 2022.
More than half of S&P 500 stocks are now in a bear market. The primary culprit is the drain of liquidity, both in terms of the “fiscal cliff” and monetary tightening underway. There are only two other periods in the past 40 years when financial conditions tightened more than they have in the past four months: the Global Financial Crisis and the COVID-19 bear market eras. As shown below, there has been an epic round-trip in M2 money supply growth—helping explain both the market's surge coming off the pandemic low in March 2020, and the bear market(s) that recently got underway.
Money supply's round-trip
Source: Charles Schwab, Bloomberg, Federal Reserve Bank of St. Louis, as of 3/31/2022. M2 is a measure of the U.S. money stock that includes M1 (currency and coins held by the non-bank public, checkable deposits, and travelers' checks) plus savings deposits (including money market deposit accounts), small time deposits under $100,000, and shares in retail money market mutual funds.
Not much has been spared
The liquidity drain has not spared three primary asset classes: stocks, bonds, and commodities. Over the past 30 trading days, all three asset classes are down simultaneously—a "feat," since it has occurred less than 9% of the time since 1965. Relatedly, credit spreads are up more than 150 basis points since the start of this year. Given that the stock market is generally a discounting mechanism as it relates to the economy, equities' message about the impact of draining liquidity on the economy is fairly dour.
In addition to the liquidity drain underway, there has also been the popping of what might be described as the stay-at-home (SAH) bubble. Piper Sandler Cornerstone tracks an SAH basket of stocks (Peloton, Meta/Facebook, Shopify, Under Amour, Wayfair, Tupperware, Amazon, Sleep Number, Tempur+Sealy, Restoration Hardware, Netflix, Carvana, and Carmax), which is down more than 54% from its peak about six months ago.
Rampant speculation-driven segments of the market have gotten hit particularly hard. The chart below shows drawdowns for several key spec areas, with recent peak-to-trough declines all worse than -40%. The rout in the crypto space has garnered much media attention, with a less-publicized, but probably important driver of equity market contagion being crypto-related margin calls.
Spec areas' epic drawdowns
Source: Charles Schwab, Bloomberg, as of 5/13/2022. Goldman Sachs (GS) non-profitable technology basket consists of non-profitable U.S.-listed companies in innovative industries. Technology is defined quite broadly to include new economy companies across GICS industry groupings. Goldman Sachs (GS) retail favorites basket consists of U.S. listed equities that are popularly traded on retail brokerage platforms. Goldman Sachs (GS) most-shorted basket contains the 50 highest short interest names in the Russell 3000; names have a market cap greater than $1 billion. ISPAC Index is a passive rules-based index that tracks the performance of the newly listed Special Purpose Acquisitions Corporations (“SPACs”) ex- warrant and initial public offerings derived from SPACs since August 1, 2017. The Meme Index is constructed by Bloomberg and contains 37 stocks that are considered actively traded and/or discussed among day-traders, retail investors, and chatrooms. Individual stocks shown for informational purposes only. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Past performance does not guarantee future results.
Consistent with rising recession risk (we believe the needle points more definitively to recession vs. soft landing), the following S&P 500 industries are all down between 20% and 35% from their peaks: Autos, Media/Entertainment, Homebuilders, Asset Managers, Retailers, Software, Banks, Investment Banking, Employment Services, Consumer Finance, and Hotels/Restaurants/Leisure. The Bloomberg consensus of economists' odds of recession has jumped to 30%, which may not seem high, but it's nearly double the norm of 17% for a group that generally tends to skew quite optimistic about the economy. (Hat tip to my friend David Rosenberg of Rosenberg Research.)
In terms of history, there have been a dozen recessions since WWII, with a median peak-to-trough S&P 500 decline of 24%, and an average decline of 30%.
Silver lining in form of sentiment?
If there is a silver lining to the market's carnage, it's that investor sentiment has turned quite sour, which often can serve as a contrarian indicator. However, although attitudinal measures of sentiment (which I'll get to) are showing extreme bearishness, behavioral measures may have to deteriorate further to establish a firmer contrarian base.
Mentioned above was equity market contagion associated with margin calls. Shown below is a margin debt chart with data from our friends at Ned Davis Research (NDR). Buy signals per this data are triggered when the rate-of-change rises above -21%; sell signals are triggered when the rate-of-change falls below +48% (orange dotted lines).
As shown, this indicator remains on a sell signal, with more of a retreat in margin debt rate-of-change needed to get to a zone that might bring on a buy signal. As shown in the accompanying table, although the S&P 500 performance following prior sell signals was fairly weak three-to-18 months later, the declines were not extreme. Conversely, the gains following buy signals were quite strong.
Margin debt off boil
Source: Charles Schwab, ©Copyright 2022 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at www.ndr.com/copyright.html. For data vendor disclaimers refer to www.ndr.com/vendorinfo/, as of 4/30/2022. Sell signals generated when rate of change in margin debt falls below 48%; buy signals generated when rate of change in margin debt rises above -21%. Past performance is no guarantee of future results.
Another behavioral sentiment indicator not yet hitting the kind of extremes that have worked well as contrarian indicators is the equity-only put/call ratio. As shown in the chart below, the ratio plunged to historic lows in the aftermath of the COVID-19 bear market in 2020, but the rebound higher has not (yet) brought to an extreme. A sharper shift away from call buying to put buying may still be needed for a sustainable market bottom to form.
Put/call not yet at extreme
Source: Charles Schwab, Bloomberg, as of 5/13/2022.
There are a few behavioral sentiment indicators that are flashing a more optimistic signal for stocks, including fund flows. NDR tracks fund flows back further than we have access to data, hence the cut-and-paste version of their chart below. As shown, the four-week total of equity fund flows (including mutual funds and exchange-traded funds) has recently sunk into negative territory. In fact, outflows during the final week of April were the largest in three years. As shown in the accompanying table, annualized returns for the S&P 500 were historically healthy in the lowest zone, where flows fell recently.
Fund flows reverse
Past performance is no guarantee of future results.
Another set of behavioral sentiment indicators that is flashing a more optimistic signal for stocks is the always-popular "Smart Money" and "Dumb Money" Confidence indicators from SentimenTrader. As shown below, the positioning of the former has vaulted to very bullish (non-contrarian) territory, while the positioning of the latter has descended to very bearish (contrarian) territory. "Dumb Money Confidence" is nearing one of the lowest readings in 23 years. Stocks historically rebounded consistently over the subsequent couple of months after similar extremes, even during protracted bear markets.
Smart Money more bullish
Source: Charles Schwab, SentimenTrader, as of 5/13/2022. SentimenTrader's Smart Money Confidence and Dumb Money Confidence Indexes are used to see what the “good” market timers are doing with their money compared to what the “bad” market timers are doing and are presented on a scale of 0% to 100%. When the Smart Money Confidence Index is at 100%, it means that those most correct on market direction are 100% confident of a rising market. When it is at 0%, it means good market timers are 0% confident in a rally. The Dumb Money Confidence Index works in the opposite manner.
A collective of attitudinal and behavioral sentiment indicators is measured via NDR's Crowd Sentiment Poll, which, as shown below, has moved well into "extreme pessimism" territory. As shown in the accompanying table, although the best historical performance has occurred when sentiment has gotten completely washed out and then begun to rebound, the current zone of < 57 has been met with healthy annualized gains for the S&P 500.
Crowd feeling/acting bearish
Source: Charles Schwab, ©Copyright 2022 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at www.ndr.com/copyright.html. For data vendor disclaimers refer to www.ndr.com/vendorinfo/, as of 5/10/2022. Past performance is no guarantee of future results.
Volatility spikes likely to persist
Finally, as shown below, volatility (as measured by the VIX) is up, but not to the extremes seen during the COVID bear market or the Global Financial Crisis. Near-term we are likely to be subjected to extreme "two-way" volatility, with a recent example being last Friday's plunge in UMich Consumer Sentiment being met with a counter-trend surge in stocks. For what it's worth, that is typical bear market behavior. Implied volatility indicates a rash of 2% daily moves is likely between now and at least the summer.
"Fear index" not at extreme
Source: Charles Schwab, Bloomberg, as of 5/13/2022.
The Federal Reserve is on a mission to squash inflation via the tightening of financial conditions. Investors need to understand the demise (at least for now) of the so-called "Fed put." The Fed had the flexibility to change gears in periods like late 2018—when it shifted away from tightening due to equity market volatility/weakness—because inflation was low. Now the Fed concedes it may have to allow more economic and/or market harm to bring inflation down, with equity market volatility/weakness in a vacuum not likely to trigger a shift in policy.
There is no perfect signal of when bear markets end. What we do know is that in bear markets, from a technical perspective, support becomes less relevant and resistance becomes more relevant. Assessing technicians' consensus, as an example, resistance sits somewhere between 4330 and 4400 on the S&P 500, a range (for now) that represents a key hurdle. Although Friday brought a "volume thrust" (with higher volume associated with stronger stocks), historically persistent declines tend to end (or pause) with a string/series of positive breadth days. For now, rallies are more likely countertrend, while bouts of weakness are the trend.