Expensive and Tight

These countertrend rallies in bear markets are always tempting to investors.  So much money has been lost, its only natural to expect a mean reversion, especially when the previous trend higher lasted for so long.  Investors have been conditioned to expect the US stock market to bounce back from downtrends, and do it quickly, going up aggressively, like what happened after every big pullback since 2008:  2011-2012, 2015-2016, 2018-2019, and 2020.  But during each of those selloffs, the Fed was on the long's side, pumping up the markets.  Valuations were on your side as the market was not overvalued at each of those previous bottoms.  This time around, you don't have the valuation buffer to support stocks, and you don't have the Fed backstopping the market.  These are probably the 2 most important factors in investing in stocks:  1. valuations  2. monetary policy.  

The trailing P/E for the SPX is 19.5, which is well above the average of 15.5.  

Those SPX earnings are driven by near record profit margins, which historically are mean reverting.  Given how much corporate tax rates have been cut, how much corporate lobbying is entrenched in Washington, its so good, it can't get much better  type of scenario.  Given the populist lean among current politicians, I doubt they give even more tax breaks and tax cuts to corporations.  The political tide is slowly shifting away from corporations.  Corporate welfare is losing favor, even among Republicans.

Now let's take a quick look at monetary policy, in particular, the shape of the yield curve.  Here's the 2-10 yield curve, at -65 bps, showing a massive inversion, signaling a Fed that is very tight.  Inverted yield curves are both signs of a pending economic slowdown and a Fed that is too tight.  Both negatives for equities.  

 

With cash yields so high, the bar for equity investments is raised, as the competition is now 4.5% T-Bills which are risk free and provide future optionality.  Under current monetary conditions of short term rates that are high, with QT working in the background, with no fiscal stimulus impulse for the coming year, those are brutal conditions for equity investors.  

Recently, I've noticed many touting the improving technicals for overseas markets, the falling bond yields, weaker dollar, and the breadth thrusts in the stock market, but those are minor short term positives going against major intermediate term negatives of long term downtrend, high valuations, and tight money. 

If you are buying after a 200 point SPX rally from 2 weeks ago, 400 points above the closing lows from last October, you are betting on this bear market to either be over, or for a bear market rally to extend to lengths that are uncommon.  The financial markets are a probability game.  The high probability scenario is for the bear market to continue, as you have rarely seen bear markets bottom with valuations so high, especially under tight monetary conditions.  And betting on a continuation of a bear market rally after its been over 3 months since the last mini panic bottom is pushing your luck.  

Those that get caught up in the day to day movements can get enamored with short term strength, extrapolating it into the future, and buying into the suddenly positive news stories that permeate after a bear market rally.  These mini buying frenzies are often led by speculative garbage (BBBY, CVNA, AMC, bitcoin, etc.) which get bid up by speculators looking for quick gains. 

Never lose the forest for the trees.  Stay with the long term trend and fade the short term countertrends, in both bull and bear markets.  Added to NDX and SPX shorts this week.