‘Disconnected From Reality’ In A Nefarious Bear Market

Speculative bear market rallies are nefarious beasts.

Not only are they dangerous, they also have the power to distort reality.

As Morgan Stanley’s Mike Wilson put it Monday, “They make one question their fundamental analysis and assume the market ‘knows something’ and this becomes a set-up for the next potential trap.” Cue the studio thunderstorm sound effects.

I’m always amused by the personification of markets and the implicit notion that the price action has an agenda of its own — that bear markets and bull markets are somehow separate and distinct from the humans and algos that trade them, and are thus capable of having a sense of purpose.

Wilson said Monday that last week’s stumble for equities looked like a “real sign of exhaustion.” Stocks’ troubles were tied to a rethink among markets about the likely trajectory of Fed policy in the context of hot US data. “We think the risk-reward is as poor as it’s been at any time during this bear market,” Wilson went on.

He likened the current conjuncture to last summer’s ill-fated rally which went down in flames with Jerome Powell’s brusque Jackson Hole address.

That episode saw the Nasdaq 100 trim its bear market losses to under 20% from more than 30%. The current rebound is (or maybe “was” is more apt) of comparable magnitude.

“Sector leadership YTD looks aligned with last summer’s bear market rally,” Wilson wrote. The figure below illustrates the point. Growth leadership is indicative of investors pricing policy-related relief for long-duration equities. Duration (in rates) sold off last week, and if the latest round of Fed pivot speculation proves misguided, tech shares are vulnerable.

Recall that the Nasdaq 100 re-rated to 24x recently amid a five-week streak of gains which some called “surreal.” Big-tech snapped that streak last week.

Relatedly, the Dow’s underperformance in the 2023 rally stood in stark contrast to the outperformance witnessed during the early stages of the rebound in Q4. I discussed that at some length here last week. That’s the same general theme Wilson illustrated on Monday.

Importantly, it’s not earnings that drove YTD tech performance. “Tech and Comm Services earnings are down -13% this quarter, the worst YoY growth rate since the GFC,” Wilson observed, adding that despite having dropped, forward estimates for Tech are still some 40% above pre-pandemic levels.

Needless to say, many believe forward estimates are still too optimistic. Round after round of layoffs in the sector suggest the C-suite is taking seriously the need to cut costs, but it’s questionable whether any savings from a “year of efficiency,” to quote Mark Zuckerberg, will outweigh margin pressure.

The bear case is straightforward: If this is indeed a repeat of last summer’s rally, then it’s on shakier footing at least from the perspective of the policy-earnings setup.

Although the Fed is obviously less inclined to aggression now than they were in July, officials are adamant that the “job isn’t done” on inflation, and recent jobs data suggests the threat of a wage-price spiral remains.

Meanwhile, earnings growth for corporate America has turned negative on a YoY basis and even bottom-up consensus (which has been derided for being overly Pollyanna-ish) expects a shallow earnings recession.

Wilson drove it home. “With hope for a Fed pivot now dwindling and fundamentals deteriorating further, price is about as disconnected from reality as it’s been during this bear market,” he wrote Monday.

And then, for emphasis: “Back in late July, we hypothesized that the market was trying to price a Fed pivot that wasn’t ultimately coming any time soon. Did the market just make the same mistake? It appears it may have, except the difference this time is the earnings picture looks much worse.”