The Impermanence of the Market's and What is Being Priced In.
Today with futures, derivatives, and options markets, we are able to see where people are making bets about the future of our economy. Let's see what they are telling us.
(5-Minute Read Time)
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The Only Certainty is Uncertainty
One of the core beliefs in Buddhism and all Eastern religions is the idea of impermanence.
Everything is in constant change.
The only real constant in life is that there is no constant.
As Buddha himself once said:
Besides impermanence, another constant in life is that humans will bet on almost anything.
One of the biggest places in the world to place “short-term” bets on impermanence in the economy is in the markets.
With the creation of futures, derivatives, and options, you can now place a “short-term” bet on almost any outcome for the economy.
So if we know one of the core realities of life is the idea of impermanence and we also know people will bet on this impermanence and what may happen next, it should be a safe assumption we can use this unique data to give us a viewpoint on what people in the market think the future will look like.
So let’s take a quick look at different markets and see what we can learn from those who have “Skin in the Game” and see what they are telling us about the future of 2023.
Corporate Bond Market
The corporate bond market is one of the deepest, most liquid investment markets in the world.
Historically, this market has been a great leading indicator of what will happen in both the economy and the stock market in the future.
My old firm turned into a $15 billion dollar investment manager by taking the core concept of the bond market leading the stock market and applying it to stock investing.
One of the key data points we looked at was defaults (I talked about this HERE and HERE) but also what the market is factoring in for default risk.
As you can see below in the chart published by JP Morgan, right now the corporate bond market is factoring in only an 18% chance of a recession.
Another indicator that usually leads the stock market and economy is the high-yield market’s spread.
What is a spread?
A spread is just what corporations at a certain risk profile have to pay OVER the price of treasury bonds to be able to issue bonds in the market.
PLEASE REMEMBER - The lower the spread number, the less risk is embedded in the market.
The high yield market spread changes in real-time and historically has been a fantastic indicator of underlying risks in the market.
As you can see below (look at the column that says JPM US HY), the High Yield Index today is giving you a yield of 8.50% and is trading at a spread over treasuries of 444 basis points (4.44%).
How does this compare to recessionary times?
Well looking at the data below, compiled by JP Morgan’s High Yield team, you can see when the US faces a recession or is in a recession (red circle), spreads have averaged 971 basis points (9.71% over treasury rates).
In fact, looking at this data more closely, today we are trading BELOW the NON-Recessionary times spread (blue circle) of 519 basis points (5.19% over treasuries).
So clearly, the high-yield market, along with the corporate bond market, is giving us the all-clear and saying a recession is nowhere in the cards, as of today.
US Government Bond Market
The US Government Bond market IS the biggest and most liquid market in the world.
This market has always been used as a judge of current and future expectations for the economy.
In fact, many at the Fed, who make decisions on rates, use data specifically from this market to give them insight into their decisions.
One of the indicators used by the Fed is the “near-term forward spread” model. This looks at the 3-month rate 18 months forward LESS the current 3-month rate (ya, complicated, don’t worry about it, just look at the picture).
Looking at this indicator, today it tells us there is over a 90% chance of a recession in the next year!!!
Clearly, this is a WAY different message than what the corporate bond market is telling us. Maybe it’s just a one-off?
Let’s look at another fantastic Government Bond Market indicator that has predicted every recession since World War II.
That indicator would be the 2-year / 10-year spread.
Looking at this indicator, you can clearly see the yield curve is “inverted”.
What does this mean?
It means you can earn more money today loaning to the Government over 2 years than over 10 years.
Looking at the chart below, going back to the mid 1970s, you can clearly see anytime the yield curve inverted (the blue line gets below the dark horizontal black line at 0), a recession quickly follows (recessions are the shaded vertical colored areas).
Looking at these two indicators from the US Government Bond market, investors in this market are predicting a recession in the next 12-months with an extremely high probability.
US Stock Market
Last year we saw a correction in the stock markets around the world.
The US Market was down almost 20% on the year, which would put it in an official “Bear Market”.
As you can see below, if we did make a bottom in the stock market in 2022, it would make the -19.50% downturn in 2022 one of the smallest in the history of market downturns DURING A RECESSION going back to 1950 (light blue lines below).
Taking a deeper dive into these returns, we can break out any stock market return into two main inputs.
Earnings
Multiple you pay on those earnings
If Apple is earning $1 in profits and you pay $10 for the stock, you are paying 10 times earnings, which is your multiple.
As you can see below, a return is driven by these two inputs (the white dot is the total return for the year, the green line is earnings growth or contraction and the blue line is multiple growth or contraction).
Below is a snapshot of changes to both earnings and multiple over time.
As the multiple is usually the leading sentiment indicator in the market, it moves lower and bottoms BEFORE earnings move lower.
Just look at 2000 and 2007 above. You can see 2022 follows right along with this trend of a bear market starting with a lower multiple paid.
And as you can see below, we are now just starting to see the earnings roll over and weaken.
If we made a low in the market multiple last year when the market bottomed, and officially enter a recession, then it would be the highest trough multiple in recent bear market history.
Growing up in this industry, I was always taught if the Fed is raising rates and you are near a potential recession, never buy stocks until the market gets to under 12 times multiple. This was, of course, before the era of “Central Bank Policies” we have seen since 2008.
Most bear market downturns during recessions prior to 1990 saw single-digit multiples before we hit a bottom.
The 2022 trough multiple was 15.6 times on forward earnings, well ahead of the median since 1990 of 12 times multiple on forward earnings.
So clearly the stock market continues to not see a recession on teh horizon. If they are proven wrong, and we do test the median mutiple low of prior recessions, look out below.
If we use the peak earnings number from above of $252.07 for the S&P 500 and put a normal trough multiple on that number of 12-times earnings, that would have put the market bottom around 3,025 on the S&P 500, or 15% lower than the low we made in October and 26% lower then the market level today (chart of S&P 500 below, the red line would be low if we hit a 12-times multiple).
Looking at this data, we can clearly see the stock market is not pricing in a recession at all.
Confusion is Everywhere
After reading the above, if you feel like Homer below, you are not alone.
The market is confused and giving investors a mixed message.
One of these viewpoints will be right and one of them will be wrong. When we get more clarity, we will get an adjustment one way or the other.
Since some of the biggest markets in the world are pricing in completely opposite scenarios, expect more volatility (can be up or down) as we progress through 2023.
Final Thoughts
One thing we know for certain is that the market is impermeant and will change in the future.
These changes, both up and down, will bring on a mix of emotions. Emotions are the name of the game when you are dealing with your hard-earned money and investing over the short term.
If you are one of these investors trying to make an extra buck investing on a very short-term time horizon, then take this advice from a wise Buddhist monk.
Fortunately, most of us are what we call “long-term” investors.
These daily, weekly, and/or monthly changes really do not mean much to us. We know that over the long term, the markets will go up and if we keep our emotions in check, and do not make any irrational decisions, we will be better off in the future than we are today.
We just have to know we are not out of the woods just yet. One of these outlooks from the market is wrong and when it adjust, there will be more volatility. Let’s just hope that volatility is to the upside and not the downside.
Have a wonderful weekend!!!