With inflation below 4%, the markets need a new catalyst to keep stocks on an upward trajectory. So far, they have yet to find one.
The S&P 500 fell 8.5% from its late-July high to its early-October low, and this near-correction began immediately after the big investment firms walked back their recession forecasts. With the benefit of hindsight, it looks like optimism peaked when U.S. GDP accelerated in the second quarter.
The downward drift for equity prices since reveals that the market has likely squeezed all the juice it can from the two ripest headlines supporting this 2023 rally: "Falling inflation" and "Still positive GDP."
Investors have refocused their attention on more concerning trends. Bond yields have risen aggressively in recent months and now represent legitimate competition for stocks. Five percent on money markets and close to 6% on investment-grade corporate bonds qualify as attractive 12-month returns.
Our federal government narrowly avoided a shutdown on Oct. 1, but another deadline looms in November. The war between Israel and Hamas adds another layer of tension to a geopolitical landscape that already included Russia-Ukraine.
Sentiment has turned sharply negative. By some measures, market pessimism is at levels similar to October 2022 when equities bottomed. From a contrarian perspective, we find this encouraging. The best buying opportunities occur when nobody wants to buy.
Bond yields are the highest in 16 years, but this is nothing extreme or worrisome from a long-term perspective. Yields were consistently higher than this during the 1980s and 1990s. The S&P 500 averaged 13.2% per year in the 80s and better than 16% annually in the 90s.
Equity valuations are still recalibrating to reflect interest rates likely to stay higher for longer. But much of this adjustment has already occurred. The forward price-to-earnings ratio of the S&P 500 fell below 18 last week (down from 19.8 in June).