‘Classic Bear Market Action’ (And The Real ‘Fed Put’ Question)

At least one widely-followed Wall Street strategist is undeterred in harboring a cautious outlook on US equities following January’s unfortunate theatrics, which found stocks careening hither and thither, but mostly thither, where thither means lower.

“We remain uninspired by last week’s price action at the index level despite strong earnings prints and resilient retail participation,” Morgan Stanley’s Mike Wilson wrote Monday. “We remain sellers of rallies and of the belief that the volatility and intraday swings we are seeing are classic bear market action,” he added.

I’d have to agree. Arguably, it would’ve been more constructive if stocks had plunged late last week, clearing the proverbial deck. Instead, Friday brought another (mechanical) rally. This week is a veritable minefield, but the “risk” of a counter-trend surge makes it psychologically challenging to press bearish bets.

As ever, it’s important to note that when it comes to explaining the wide distribution of daily outcomes, “classic bear market action” is apt, but doesn’t tell the whole story. The notion (perpetuated by mainstream media outlets) that an advanced economy benchmark equity index can recover from a ~4% intraday swoon to close green due entirely to investors buying dips in cash equities in their E*Trade accounts is wholly laughable.

Wild swings are, almost without exception, the product of mechanistic flows, hedging dynamics and the myriad self-feeding loops embedded in modern market structure. Importantly, that doesn’t mean no humans are involved. Blaming “the machines” is also too simplistic. Conceptually speaking, many of the dynamics we identify with “modern” market structure have existed for decades in one form or another. They’re just more efficient now, where “efficient” doesn’t necessarily carry a positive connotation.

In any case, that’s a tangent. Wilson’s latest was an extension of last week’s “Winter Is Here” warning, but the overarching point is that the Fed is poised to tighten into a slowdown, something that doesn’t bode particularly well for risk assets. “The safety net of forward guidance from the Fed is gone just as earnings revisions and PMIs appear set to decelerate, an unattractive risk/reward set up,” he wrote.

Tighter Fed policy means lower returns and heightened uncertainty. “Average equity returns are less than a quarter of what they are in easing cycles,” Wilson said, adding that the hit rate is much lower as well.

You’ll have to weigh that against the favorable return profile for buying after 10% drawdowns detailed here over the weekend.

It’s now widely accepted that the vaunted “Fed put” is struck much lower than it was in previous years, but the key to understanding the zeitgeist is the “Why?”. It’s not so much that the Fed is keen to see additional froth come out of the market. Rather, there’s immense political pressure for monetary policy to lean against inflation. Between that and the (overstated) risk of the Fed falling so far behind that inflation becomes embedded in the US economy, policymakers are less likely to blink even in the face of evidence that the economy is faltering.

In other words: It may make more sense at this point to discuss the Fed put in the context of the economy and corporate earnings, not so much in the context of any SPX level.

Wilson addressed that directly. “A Fed that’s focused on inflation and certainly not as much on the path of earnings revisions or higher frequency macro data/surveys increases the likelihood that we see aggressive tightening directly into this growth slowdown,” he said, calling that “a further negative for equity prices even if the economy remains on solid footing overall.”

Commenting in his own note Monday, JonesTrading’s Mike O’Rourke wrote that, “There is no denying that the [Fed] will officially commence the tightening cycle as US economic growth starts to decelerate.” That, he said, “is understandably the primary concern for financial markets.”