Is the stock market rally running out of gas?

Better-than-expected second-quarter earnings and consumer inflation (CPI) data from July helped push the S&P 500 more than 17% above its June low, until stocks fell in the second half of last week. It was an impressive two-month rebound, with stocks recovering 57% from their drop from 24% to the June low. Some have maintained that stocks have never broken past lows once they have recovered more than 50% from a bear market decline, but that is not in line with history. So where do we go from here?

Bond yields seem to hold much of the answer regarding how stocks trade in the short term. The market bottomed out in June right after both 2-year and 10-year government bond yields hit their recent peaks. Now that yields have risen again, the pressure on share prices seems to be increasing.

The stock market generally masks some of the current effects. Yet it is self-evident in the market segment most prone to higher rates and reduced risk appetite. As authorized by the AR
AR
K Innovation ETF (ARKK
ARKK
), the high expected growth and expensive valuation segment shows a remarkable negative correlation with returns. ARKK was a whopping 43% lower from its mid-June low until this week’s sell-off. In evidence of the impact of higher returns, the ETF fell 62% from its 2022 high at its mid-June low. ARKK is an excellent example as its portfolio has negative estimated earnings for the coming year but is expected to have superior earnings growth over the long term. The ARKK portfolio also has a higher valuation, with an estimated forward enterprise value-to-EBITDA ratio of 42 times versus 13 times for the S&P 500.

Cyclical stocks outperformed commodities during the rally from the mid-June lows. Cyclical stocks are more exposed to the economy than staples. The outperformance of cyclical stocks means the Federal Reserve will be less likely to be forced to continue raising interest rates aggressively, or the market may be looking beyond the economic slowdown. During the rally, there were other pullbacks in the cyclical versus staple relationship, but the magnitude of the recent relative outperformance of staples will have to be monitored.

The probability of a US recession within 24 months by Bloomberg Economics remains at 100%. It’s been at 100% since April, so the stock rally and cyclical outperformance happened despite the reading. Interestingly, the probability of a recession within 12 months rose to nearly 31% in July, from 0% in June. These models use a “set of financial market, real economy and economic imbalance indicators” to measure recession risk. No indicator is foolproof and the analysis is complicated because stocks tend to recover before economic data recovers.

The one-year forward Fed Funds futures rate is probably the most crucial variable, crossing the odds of a recession and bond yields. This measurement shows what the markets expect from the Fed Funds rate in one year. The high of 4.06% in mid-June corresponded to both low stock prices and high government bond yields. Expectations for future Fed Funds rates have eased but have started to rise, which was first reflected in pressure from highly anticipated growth and the expensive valuation segment of the stock market.

The Kansas City Federal Reserve bank is hosting the annual Jackson Hole summit this week. Historically, this has been a venue for some crucial monetary policy signals, so markets will be listening closely for clues about the size and timing of the needed rate hikes. The most watched speech is Chairman Powell’s discussion on Friday’s economic outlook. Any increase in one-year forward Fed Funds futures based on aggressive comments is likely to continue downward pressure on equities and vice versa.

Given the background, investors should focus on an asset allocation that provides the financial means to continue market volatility and the likely economic downturn. Aside from holding some safe and liquid assets to cover living expenses during economic and market turmoil, this downturn should provide a long-term buying opportunity for those able to add equity positions. However, the short term appears to be choppy. Within equities, investors should focus on quality companies that can survive the looming recession and thrive once the turmoil is over. A company’s ability to raise prices without destroying demand for its products is also critical. Investors should avoid the high expected growth and expensive valuation segment of the stock market. This segment may have sharp gains, but the risk/reward looks unappealing with potentially higher returns and a looming recession.

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