We follow a simple stock market investing strategy: stay invested in stocks as long as you don’t expect a recession within the next 6-12 months. Tactically, we also aim to short the stock market as a recession approaches.
However, timing the stock market top is notoriously difficult. Selling stocks in anticipation of a recession could cause you to miss the last leg of the bull market, while short-selling stocks prematurely is very risky due to “short squeeze”.
Yet, we believe that the probability of a US recession within the next 12 months is very high, and thus the stock market (SPY) is near the turning point – and we will attempt to time it.
Fundamentally, the stock market rises in anticipation of future earnings growth, which in-turn is a derivative of an economic growth. During recessions corporate earnings decline, and credit risk rises as some companies default, thus, stock prices fall.
We look at the PE ratio as a measure of expected earnings growth as embedded in stock prices. The average PE ratio for S&P 500 is around 15-16 times, which translates into an average GDP growth of 2-3%. Currently, the PE ratio for S&P 500 is around 22 times – which means that earnings growth expectations are well above the historical average, and thus, the expected GDP growth is also well above the historical average.
We look at the Yield Curve Spread as a measure of expected GDP growth as embedded in US Treasury Bond prices. Specifically, we pay close attention to an inverted Yield Curve – which implies a negative expected economic growth or a recession. Historically, a negative Yield Curve Spread had preceded each recession. Currently, we have a negative yield curve spread between the 5Y Treasury Bond and the 2Y Treasury Bond, while other parts of the yield curve have been occasionally inverted since March as well. Thus, the bond market is currently forecasting a recession.
We believe that the stock market growth expectations are irrational, mainly due to the ignored spillover effects of the trade war, and already slowing global economy. In fact, the stock market predictions are based on extrapolation of past trends and policies, such as the 2017 fiscal stimulus. Thus, the probability of the stock market sell-off and the bear market is very high, as the reality sets in. Practically, the only problem is predicting the timing of the actual stock market top.
Technical pricing process
We follow the S&P 500 (SPY) since the 2016 election, and analyse the pricing process in the chart below:
Peak 1: S&P 500 rose in expectations of US fiscal stimulus and peaked in January 2018 shortly after the fiscal stimulus was passed in Dec 2017. This point is market as Peak 1 on the chart, and reflects the profit taking of advanced pricing of US fiscal stimulus.
Peak 2: After the brief correction, the SPY continued to rise in response to strong economic data. However, the Fed was aggressively increasing interest rates also in response to the strong economy until October 2018, when it appeared that the Fed was willing to hike “beyond the neutral rate”. Thus, in response to the potential Fed error and the feared Fed-caused recession the stock market significantly corrected into January 2019. This point is marked as Peak 2 on the chart, and reflects an overly hawkish Fed.
Peak 3: The Fed reversed the course and instead of increasing interest rates resorted to decreasing interest rates. Thus, the stock market resumed the uptrend due to the “protective Fed put”. The Fed is still in the dovish mode and the stock market is near the all-time highs. This point is marked as Peak 3, and reflects primarily the “protective Fed put”.
To put it all together, the stock market priced the US fiscal stimulus, the delayed effects of Fed’s hiking cycle, and the expected effect of the Fed’s subsequent easing cycle.
What’s not priced in the stock market?
The stock market at this point is not pricing the negative effects of US-China trade war, and already slowing global economy, mainly due to the fact that US economy remains relatively unaffected. Yes, the daily trade headlines are causing stock market volatility, but each sell-off is bought and the PE ratio remains highly elevated.
On the other hand, the bond market is reflecting the global economic reality and pricing a recession. Thus, we have an apparent market inefficiency, which creates a major tactical trading opportunity.
Clearly, the resolution to an apparent market inefficiency will evident as either 1) the US economy starts slowing down significantly enough to force the stock market to lower the growth expectations, which could result in a 30% stock market drop, just to adjust the PE ratio to a historical average, or 2) policies are enacted (for example trade deal with removal of tariffs) to avert the global slowdown, in which case the bond prices would have to upgrade the growth expectations.
Timing the top
Our bias is that US economic data will start to deteriorate, and that policymakers will be unable to prevent the recession. Thus, we are timing the stock market top. Our timing method involves monitoring the news flow, and the financial market reaction, in context of important support-resistance levels. At this point, given that there is some policy uncertainty and early noisy data, we are not calling for the stock market top yet. However, we will continuously update our opinion. Follow us.