The stock market has rallied sharply since mid-July, while long-term bond yields have been stable to lower. Even the mighty US dollar has paused a bit in its uptrend. But inflation remains high (though likely peaking) and Fed officials continue to say they will continue to raise rates (and reduce the balance sheet) well into next year. The old market adage says “don’t fight the Fed” (i.e., be cautious when the Fed is tightening policy, and more aggressive when they are loosening), but it looks like markets have in fact been rallying in spite of the Fed lately.
Client Question: There is a possible world war going on along with a seemingly never-ending pandemic, inflation is at multi-decade highs, the Fed and other central banks are tightening monetary policy, and the world may lose access to Russian oil and gas entirely soon – why aren’t you massively bearish on stocks, which everyone knows is the high-risk asset class?
Answer: While naturally reserving the right to get more cautious on stocks (we downgraded equities to neutral on Feb. 14th), there are a few reasons we are not more bearish on stocks or the broader economic outlook at the moment.
The S&P 500 recently had its biggest pullback since March, though only about 5% from its early September all-time high and thus quite mild in the context of normal market volatility historically. The Russell 2000 has not hit a new high since mid-March but was also only about 5% off that peak, having been mostly range-bound since then. Major indices have since recovered much of those declines in the last week and are again approaching their highs.
Equity market volatility has been declining this year and has recently been below the long-run average. However, under the surface of the calm at the major index level, style rotation between Growth and Value has been extremely high.
The first chart below plots two rolling volatility series: the top section is the six-month annualized volatility of the S&P 500 index, while the bottom section is the volatility of the daily difference between the S&P 500 Pure Growth and Pure Value index returns. The dashed horizontal lines indicate the long-run average for each series.
In response to client questions, we update some indicators we discussed back in January to address the debate about whether recent market action is indicative of a defensive shift (potential equity market top) or a rotation within equities that maintains a “risk-on” environment. Our current view, as it was in January, is that risk appetite remains broadly intact and the weight of the evidence suggests that we are seeing a rotation, not a “risk-off” environment.