Stock Outlook: Are We Expecting a Bull or Bear Market?

Key Takeaways

The Case for a Bear Stock Market

For now, the economy remains resilient. But many economic indicators are pointing the same way—down. In the interest of full disclosure, we are in the bear camp, and it’s how we’re positioning our asset allocation portfolios.

1. Manufacturing stats are abysmal. The ISM purchasing managers’ index (PMI) measures the ordering activity at U.S. manufacturing firms, and it’s considered to be a key indicator of economic health. Last month was the eighth straight the index was below 50, which indicates an economic contraction. That’s the longest run below 50 since the Great Financial Crisis.

2. The lagged effect of higher interest rates is only starting to take hold. More than 60 years ago, Nobel Prize-winning economist Milton Friedman argued that it takes six to 16 months for Federal Reserve (Fed) rate hikes to show up in the real economy. More recently, economists and market participants have been using 12 to 18 months as a rule of thumb. If it’s 12 months, then we’ve only felt the effect of the first three of 10 rate hikes so far!

3. We’re in a corporate earnings recession. Ultimately, financial payouts have to tie to economic payouts. That’s one reason why we’re so skeptical of the latest rally in equities.

4. The yield curve is inverted. Yield curve inversions often precede recessions. The shape of the yield curve is a representation of bond yields at different maturities. Under normal conditions, the curve points up—yields rise as the curve moves out in terms of maturities. This inversion suggests that bond investors believe the economic trajectory is downward. If that historical relationship holds, then we could be looking at a recession.

5. Fiscal stimulus is fading. It’s been estimated that federal spending has been contributing more and more to economic growth in recent years. However, the debt ceiling agreement to avoid default will cut spending going forward. That’s another risk for growth, particularly if we tip into recession and require federal stimulus to get out.

And so, for these and other reasons we remain defensively positioned at the margin in our asset allocation portfolios.

The Case for a Bull Stock Market

Inflation Is Moderating

The main bull argument is that inflation is moderating, allowing the Fed to take its foot off the economic brake while a resilient labor market helps prop up growth—thus achieving the proverbial “Goldilocks” economy. In effect, the thought is that the Fed will be able to thread the needle between inflation and recession and pilot the economy to a soft landing.

But if those conditions are met (resilient economic growth and tight labor market), they are likely to be inflationary. And if the labor market remains strong, that means the Fed has more room and strong motivation for additional interest rate hikes or to keep rates higher for longer.

High rates are the Fed’s main tool that it can use to slow down consumer demand and economic growth. Given all the Fed rate hikes still to be felt in the real economy, we think a recession is already the most likely outcome. Now consider what happens if the Fed raises rates even further. This merely makes a recession more and more probable. In other words, I find the bullish case to be contradictory.

The Current Stock Rally Appears to Forecast a Soft Landing

Another argument is that the current stock market rally is itself evidence that the economy is on track for a soft landing. The idea here is that the market is correctly forecasting the economic environment to come.

Of course, the problem here is that the yield curve is inverted, so the bond market is forecasting the exact opposite outcome to equity investors. They can’t both be right.

Stock Market Performance Isn’t That High

Additionally, there’s an argument to be made that the stock market is not actually up that much. The “Magnificent Seven” large-cap tech stocks—Meta, Apple, Alphabet (Google), Amazon, Netflix, Nvidia and Microsoft—are driving the broader averages higher.

Without these stocks, the S&P 500^® Index would be roughly flat this year. So basing your economic outlook on strong recent stock returns is highly problematic, to say the least.

Past Performance Is No Guarantee…

Further, past stock market returns are a notoriously poor predictor of future stock market returns. That is Investing 101. It’s called the “weak form” of stock market efficiency, and it implies that past prices are no indication of future prices. In other words, technical analysis and charting are essentially voodoo.

If you’re relying on the strength of the stock market this year to make the bull case, just remember this:

The stock market was booming before the 2008 financial crisis, the 2000 dot-com bust and the 1987 crash. The mere fact that the stock market has been strong is absolutely no reason in and of itself to believe it will continue to be strong going forward. Hard stop.

And so, for these and other reasons we remain defensively positioned in our asset allocation portfolios. We’re not advocating for wholesale moves into and out of any asset class but instead look for opportunities for modest changes to manage inflation risk and slower growth.