When the Fed unveiled its not-so-dovish-hike yesterday, it unleashed the worst of all possible worlds: on one hand, the Fed's measures to ease financial conditions were seen as not going far enough, not only because of the Fed's commitment for 2 more hikes in 2019 but the specific language for balance sheet being on "autopilot", guidance which was seen by market as further constricting already shrinking liquidity; on the other hand, the Fed's sudden U-turn just two months after Powell's quasi-euphoric economic speech on Oct 3 prompted fears that the US economy is slowing faster than what high frequency economic indicators are suggesting.
The Fed's statement was sufficient to prompt almost every bank to quickly fall in line and revise its forecasts from 4 or 3 rate hikes in 2019 to 2 if not less, while goalseeking a significant cut in sellside economic models to justify said downgrade to the economic outlook. Some banks even went so far as to aggressively boost their downside case scenarios.
Commenting on the Fed's statement and its latest economic model, which slashed its 2019 GDP forecast from 2.7% to 2.5%, Bank of America, which just a few days earlier was surprisingly optimistic on the economy, said that weaker global growth and tighter financial conditions with building risks in markets could curb growth, noting that "it is easier to paint a picture of how things go wrong rather than right in the medium term given that the economy is at later stages of the cycle." Meanwhile the bank's chief economist Michelle Meyer whose conviction has become as fickle as the market, wrote that markets are clearly focused on the downside risks, and explains that when "incorporating the latest moves in financial markets into our recession models show that the probability of a recession in the next 12 months has increased with some flashing yellow."
That's one way of putting it: while BofA until recently saw a less than 30% chance of a recession in 2019, according to one of its house models, the probability in the past two days has soared as high as 57%, or almost a two in three chance of a recession in the next 12 months.
The above example perfectly encapsulates the dilemma facing most other sellside strategists on Wall Street today: how do they "goalseek" their models lower, but not too low, without slashing their year end S&P500 price targets which at last check, averaged just above 3,050.
Of course, one look at the market action in the past 2 days shows traders are not waiting to find out how long sellside analysts can hold out without slashing their forecasts sharply lower to reflect these soaring recession odds, because while nobody knows what will happen tomorrow, let along one year from now, it is certain that the average forecast will be far lower than 3,052 in just a few weeks?
But how much lower?
That is the question, one which is especially difficult to answer now with the number of variables swirling around around the globe. As Bloomberg notes the key considerations, global growth is slowing, Brexit drags on, a trade war rages, stimulus of all types is being yanked and the yield curve is flirting with an inversion.
Still, as bad as it feels, at some point, all the bad things should get priced in, right?
"The market today is oversold. Does it mean it won’t go lower? No," Joseph Tanious, senior investment strategist at Bessemer Trust in LA told Bloomberg "It’s hard to say what is exactly the bottom of something that’s so technical in nature."
Unfortunately, if using strict technicals, the outlook is dismal: as Bloomberg notes, Tuesday’s session saw the "obliteration" of a level that had held for 10 months, the intraday low on the S&P 500. Below that, there is virtually no support.
Case in point, on Thursday the selloff accelerated from one round-number milestone, 2,500, to another, 2,450, in just a few hours for one simple reason. As we reported earlier, 2,480 on the S&P is the critical level at which CTAs, or trend-following quants, turn from long to net short for the first time in three years. Any moves below 2,480 will therefore not result in longs being sold, but short being added, and thus an even greater acceleration to the downside.
Incidentally, today's 2,450 low is the near-term target set by Morgan Stanley’s Mike Wilson, who predicted earlier this week that after sliding below the 2018 low, the S&P could make a "quick move" to 2,450, which it did. BMO's just as bearish technician, Russ Visch, similarly forecast a slide to 2,445, a level which was briefly touched at 2:15 p.m.
Meanwhile, Michael Shaoul, CEO of Marketfield Asset Management is expecting an even more dire scenario. With the S&P 500 failing to hold 2,500, the index risks sinking toward 2,400, a level that acted as support during the summer of 2017.
"It is true that valuations for U.S. equities now look much more reasonable than they did a few weeks ago, but it’s even true for global equity markets where buyers have remained scarce," Shaoul said. "The best that can be said at present is that the current wave of liquidation looks likely to exhaust itself in the near term."
Unless of course the liquidations continue, in which case the next stop would be a 20% drop from the Sept 20 highs, also known as a bear market, which looms at 2,344.6 on the S&P 500.
Here Bloomberg attempts to paint a rosier picture, noting that at 16%, "the plunge easily exceeds the average decline of the past 27 corrections since World War II that didn’t swell into bear markets."
Ah yes, but what if this is not a correction? As we showed yesterday, the current decline is already well below the average drop of the S&P for the last five corrections since 2009, and the greater the divergence, the more likely this is not a correction but a full-blown bear market.
And considering that the S&P only needs to drop another 130 more points to meet the 20 percent threshold for a bear market, the index could easily slide that much in two days at the current rate of decline, which has also been faster than usual. It’s been 91 days of pain since the top. That’s about three quarters of the length of a typical correction, but again - that assumes the current drop is a correction, and not a bear market.
Some are already bracing for impact, such as Laurence Benedict, founder of Opportunistic Trader: "On this move, we will be in a bear market at some point late this year, beginning of next year. I don’t think people understand the amount of damage that’s been done. All those things said, I don’t want you to jump out of your window. But overall, there’s more to the downside."
Others try to spin the market move as half-pregnant: in a note to clients, Ed Clissold, chief U.S. strategist at Ned Davis Research, said that as far as he can make out, stocks appear to be in a "non-recessionary bear market", which have normally lasted 213 days, down 25.4%, although it was not immediately clear how many bear markets take place without a recession.
"Cyclical bear markets that have not overlapped with recessions have been shorter and less severe than bear markets that have," Clissold said. Supporting this view is the absence of economic data pointing to a decline in GDP, as everything from hiring to profits to factories are booming, although as we noted at the top of the article, all that may be about to change due to the Fed's own confused dovish (but not too dovish) messaging.
Of course, if we are indeed entering a bear market, the pain is only now starting as the following stylized chart from Goldman of historical corrections and bear markets shows.
Worse, if Nomura is right in noting that the current selloff bears the biggest similarity to the 2007/2008 crash, then the S&P may keep dropping until its hits 1,500, almost 50% below its September highs.
Still, there is a possibility that this is all just a false alarm. Should investor sentiment improve and the PEG ratio go back to 1, that alone Bloomberg calculates, would lead to an 11 percent rally for the S&P 500. A return to the historic average of 1.3 would mean a 44% upside.
Yet even here, pitfalls abound: the Fed model, which compares the value of stocks and fixed income, suggests there may be plenty of room to fall until equities look more attractive than the less risky alternative. The spread between the S&P 500’s earnings yield and 10-year Treasury yields now sits at 3.1% points.
Compare that with 2015, when the Fed initiated its hiking cycle and stocks entered a correction. When the market finally bottomed in August, that difference was a wider 3.9 points, meaning equities were cheaper versus bonds. To get to that big a spread, the S&P 500 would have to drop 11.6 percent from current levels, all else equal, data compiled by Bloomberg show.
Despite all the mounting bad news, most investors refuse to capitulate and continue to look for the next data point, signal, press conference, news release, tweet, or anything else for that matter, that can help turn things around. Topping the list of things that can reincarnate the bull market would be any positive developments in the trade negotiations with China, strong upcoming earnings reports and rising consumer confidence, among other things.
Should the U.S. and China resolve their trade dispute, markets might finally take a breather, Chris Gaffney, president of world markets at TIAA Bank, said in an interview. “If we can put that big piece of uncertainty away, if we can file it away -- it gives companies confidence that they can start investing more on the capex side,” Gaffney said. “Trade is the main trigger that could boost these markets.”
“People are thinking, at this point it won’t take much. People are on the sidelines waiting for an entry point and if they think they’re starting to see it, they may rush back in.”
And while that assessment is likely accurate, and it won't take much to break the hypnotic selling trance, the likelihood of an optimistic trade outcome in the near term now looks virtually nil especially with headlines such as this one "China Hacked IBM And HP, Then Went After Their Clients."