Liz Looks at: The Second Half

By: Liz Young Thomas · July 13, 2023 · Reading Time: 7 minutes

Going Halfsies

The second half of 2023 is underway, and another earnings season is fast approaching. The first half seems to have flown by, despite a tumultuous spring and regional bank crisis, and many investors are still scratching their heads about what went on.

The divisiveness between so-called “bulls” and “bears” grew wider, almost resembling a political landscape where each side looked at the other with anger and resentment, unable to find common ground. Understandably so, given the plethora of conflicting data — not the least of which is the unexpectedly feverish stock market rally in the face of leading economic indicators and bond market signals that are clearly waving a red flag.

In fact, never since the data series began in 1959 has the annualized 6-month change in the Leading Economic Index dropped below 3% without a recession to follow. That measure currently sits at -8.4%.

Yet the coincident indicators (the ones that don’t signal a macro shift ahead of time, but react at the same time as said shift) have been durable. Data sets such as payroll employment, industrial production, and personal income are holding up and fighting the theory that fast rate hikes cause clear economic destruction.

On top of this, the first half of 2023 saw an enthusiasm around AI that drove prices of AI-related stocks up at an astonishing pace. The returns of most of the remaining stocks in the S&P 500 paled in comparison, but investor sentiment and excitement around this new theme was contagious.

A Watched Pot…

You know how that statement ends. We’ve been watching the recession and drawdown pot for what seems like forever, and not a bubble has boiled to the top.

Is it just taking longer, or is it never going to happen? If I knew the answer to that question with certainty, I could finish this article right here and be on with my day. Unfortunately, or perhaps fortunately for entertainment purposes, I don’t know. What I do know is that some of the market-based relationships are out of whack, and things don’t stay out of whack forever.

For example, when rates rise, so does the discount rate on companies’ future cash flows, which mathematically pressures their present value. In other words, higher rates make future earnings less valuable in today’s dollars, thus investors are typically less willing to pay up for them. But the opposite has been true YTD.

The chart below shows the expansion in the S&P 500 price-to-earnings (P/E) multiple while the real yield on 10-year Treasurys remained high and even rose further (inverted here to show the typical relationship vs. the current divergence).

Not only have valuations risen, but they currently sit above their 5-, 10-, and 15-year averages, making them look expensive by historical standards, and by the nature of the current environment.

Using trailing P/Es (because they offer a longer historical perspective), the current 10-year yield range (between 3-4%) suggests a median trailing P/E of 17.4x. As of this writing, the trailing P/E sits well above the median, and even well above the middle range, at 24.5x. Tough to argue that it looks cheap or attractive as an entry point.

New bull markets don’t typically start from already elevated P/E ratios, which makes me continuously skeptical of this rally’s staying power. Nevertheless, it carries on, and the phrase “don’t fight the tape” plays on repeat in all of our heads.

The volatility index (VIX) hit a 3-year low of 12.91 at the end of June, further amplifying the calm and positive market tone. But some might say it also further amplified the tone of complacency, which is not usually a set-up for continued upside. And although we should heed the warning to not fight the tape, the phrase that’s said louder and perhaps with more proven power is still, “don’t fight the Fed.”

Fight Club

The title of my 2023 annual outlook was “This Ends One Way or Another” and it’s clear that it hasn’t ended yet. As each month goes by without a right-sizing of valuations, or an obvious and wide-reaching negative effect of monetary tightening, it becomes more and more tempting to wonder if it may not ever end the way I expect it to. And I am not alone, as evidenced by the massive flip in investor sentiment over recent months.

The bulls and bears keep fighting, with bulls not fighting the tape and bears not fighting the Fed. During this period, I’m also reminded of a warning that’s often flagged by chartists to notice and be wary of extremes. Much like large divergences, extremes don’t last forever.

Although the absolute level of bulls vs. bears in the chart above doesn’t appear to be at extremes, the almost instantaneous reversal in the two is quite extreme. Generally, large and swift moves can be followed by large and swift moves back in the other direction as markets and investors attempt to settle on some sort of middle ground.

Respect the Cycle

I’m bordering on overusing that phrase, but I stand by the statement that we must respect the cycle. It’s true there was no clear recession and no lasting nor significant drawdown in the first half. It’s also true that I absolutely did not expect the strong returns we’ve seen over the first six months of the year.

But liquidity is still shrinking, inflation is falling but has taken a meaningful bite out of many Americans’ finances, and the Fed is on a mission to send hawkish messages until they’re satisfied. The second half of this year is likely to see few, if any, additional rate hikes and is likely to mark the beginning of a new phase of monetary policy — one that’s characterized by holding rates high and waiting for the first signs of a cut. It’s also one I don’t think we know how to finish.

This is my 19th year in the biz, and it never ceases to amaze me how unpredictable and fascinating markets can be. I suppose the element of surprise is one of the main draws to this industry, which can be an intoxicating adrenaline rush, and a never-satiated thirst to figure it all out.

The lags may be longer this time, the catalysts may be different, and the reaction function of markets to a global pandemic are unprecedented in modern times. But the economic cycle doesn’t tend to skip phases. It just keeps us guessing about their timing.


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