The paranoid bull market: stocks soaring but recession fears won't go away

If you get technical, you will discover the definition of a bull market is generally viewed as a rise of greater than 20% in a broad stock market index over a period of at least two months. If you then get really technical and pull up a chart of the S&P 500, you will see the below. Notice anything?

That’s right – the S&P 500 is up 26% from its lows in October. Now motoring along at over 4,400, it is only 8% off its all-time high set in January 2022. That means, by definition at least, this is a bull market. And yet, despite this all-conquering market printing gains left, right and centre, things feel bad. Sentiment is low, fear is high. So, why is this such a sad bull market, and should we be fearful of what is still to come?

The S&P 500’s gains are extremely concentrated

Firstly, it’s not quite as it seems. The S&P 500 is a market cap index, meaning the larger a company, the larger a weight that company constitutes in the index. With the rise of enormous tech stocks, this means it has a very top-heavy distribution. It also means the headline gains of the S&P 500 are a little misleading, given so much of the strong performance is derived from a few big names at the top.  

In fact, the top seven stocks in the index comprise a 27% weight. These stocks have all been on a tear recently, led by Nvidia (NASDAQ: NVDA), Tesla (NASDAQ:TSLA) and Meta (NASDAQ:META). 

While we will discuss the macro situation shortly, which has softened and led these stocks upward, but there is also the hysteria around generative AI. The latest obsession for investors is tied closely to a lot of these stocks – in particular Nvidia, which has tripled its market cap in 2023 alone and recently became the fifth company to breach the $1 trillion valuation mark. 

Looking beyond these top stocks, the gains are a lot less explosive. This contributes to the feeling that things are not quite as effervescent as the S&P 500 chart would lead you to believe. However, while the makeup of the S&P 500 explains some of the divergence, the biggest reason is delved into in the next paragraph. 

Will there be a recession?

Ah. Possibly the most commonly-asked question of the last year, and one that keeps us all up at night. It is also the most difficult to answer, with the only true conclusion being that nobody knows. 

However, a number of red flags are billowing in the wind which is sparking concern and suppressing sentiment. The first is the most obvious – interest rates. It is economics 101 that monetary policy operates with a lag. And if one thing is clear, it is that we are in the midst of a tightening cycle of historic pace and scale. 

As I wrote about last week, the Fed’s decision to pause interest rate hikes at the June 14th meeting broke a streak of ten consecutive rate increases. This constant hiking since March 2022 amounted to a pace not seen since the 1980s, jacking rates all the way up from near-zero to north of 5%. 

For asset prices, that means one thing: pain. And with the knowledge that monetary policy operates with a lag, the market is fearful that a recession is imminent. The simple truth is that you cannot hike rates to that extent without at least a little bit of pain. 

And yet, unemployment came in last month at 3.4%, the lowest since 1969. If anything, the economy is doing too well. The fear, as well as the sobering reality, is that there must be at least some softness in the labour market if inflation is to come down. And there must be at least some drawback when rates are hiked to this extent. 

If the economy does not slow down, inflation will not return to the 2% target that the Fed is so determined to hit. Fed chair Jerome Powell said as much, warning that more rate hikes were imminent and this is more of a pause rather than a pivot in policy. 

“Looking ahead, nearly all committee participants view it as likely that some further rate increases will be appropriate this year to bring inflation down to 2% over time”

Inflation has moderated somewhat since the middle of last year, nonetheless, inflation pressures continue to run high and the process of getting inflation down to 2% has a long way to go

Jerome Powell

Inverted yield curve warns of possible recession

As well as the expectation of potential pain down the road due to the lagged impact of tightening monetary policy, there is the old-fashioned yield curve indicator to worry about, too, which essentially shows where the market is at with regard to rate expectations and future forecasts. 

The almost mythical yield curve inversion is one of the most well-known recession predictors around. I published an analysis in April on how successful this has been as a predictor over the last forty years, so I won’t get too into the weeds again here. But in short, over the last forty years, every time the 2-year yield has been above the 10-year yield for a period longer than six months, a recession has followed in short order (between 12 to 18 months after inversion).

The yield curve inverted in July 2022, eleven months before I am writing this piece. And not only that, but it is the deepest level of inversion since 1981. People have noticed.  

However, this is far from a guaranteed recession indicator. And even if a recession does hit, no two recessions are the same. The violent catastrophe of 2008/09 may be the most prominent in our minds today, but there have been countless examples of both milder and briefer recessions. There is also the concept of pricing in – how much of the pullback has already been incorporated into asset prices? The S&P 500 did drop nearly 20% last year, its worst pullback since 2008. 

The Fed’s goal remains to toe the line between raising rates enough to curtail inflation, but not enough to trigger a nasty economic meltdown. The coveted “soft landing” is the ultimate aim – cool the economy off enough so that inflation is conquered, and let it continue jogging on in a sustainable fashion. 

But in the context of the historically tight monetary policy, it is no surprise to see fear so prominent in the market, even if that feels out of whack with how stock prices are moving in recent times. This is especially true when considering the strength of the top seven holdings in the S&P 500, and how much of the explosive gains are drawn from those names.

It’s not a dramatic conclusion, but right now, uncertainty remains high and it’s hard to really know. But it’s probably fair to say that this is one of the most paranoid and fearful bull markets we have seen. But hey, you’re not paranoid if they’re really out to get you, right?