The rally in stocks since the bank despair days of March has been impressive and the rebound from the October lows has been even more so. Why then, have the bulls become so frustrated this week? The answer, in short, comes down to psychology – specifically, how investors treat certain milestones or technical thresholds. Earlier this week, when I appeared on BNN Bloomberg’s Market Call show, I discussed how the S&P500 was nearing the intraday high of 4325 that it reached on August 16^th and how failure to breach this level could lead to an erosion in sentiment and potential correction.

 

 

In fact, the frustration hasn’t even been around testing that intraday high but simply closing above the 4300 mark (let alone the closing high of 4305 from back on August 16^th).  As the chart above shows, this has been breached a few times this week on an intraday basis, but every close has fallen short. Yes, Thursday saw plenty of cheers among this frustrated bunch as the S&P closed at 4293.94 – shy of 4300, but 20.04% above the closing low set last October. In other words, a technical bull market. Presumably, the ability to label this a bull market is sufficient to drive the index to yet higher levels, including the high from last August. Some may even have their sights set on the March 2022 peak of 4631 or perhaps even the record high of 4796, reached at the start of 2022. That would be a wonderful outcome, however, getting back to the pinnacle requires a suspension of a few market-related laws of gravity.

 

For one, even if we aren’t necessarily in a recession yet, we are in an earnings recession.  From just before hitting that August 2022 peak, adjusted earnings per share (EPS) for the S&P500 had declined by about 7.4%.  The nominal value is up from the recent low seen back in April, but this comparison is risky given that the daily EPS values will tend to move higher after the early read from quarterly results. So far, the past three earnings seasons have seen EPS dip lower on each go round.

 

 

Now, the market will tend to lead in terms of changes in direction of earnings and those lead times are variable. If we think back to last year, the peak in the S&P took place about 8 months before the peak in earnings. If you believe that last October represented the bottom of the equity market, then that same lead time would suggest that this quarter is going to be the trough for earnings. That assumes that last October was the bottom for the market and it also assumes that whatever economic situation we are heading into does not contain the word “recession”.

 

The current interest rate environment also doesn’t lend itself to a near-term return to record highs. It has been a long time (or perhaps never) that an event in Canada had an impact on U.S. markets, but that is exactly what happened this week when the Bank of Canada decided to nudge up rates a quarter point in defiance of the majority of economists. This came after the Reserve Bank of Australia did the same thing and, all of a sudden, next week’s Federal Reserve meeting outcome was thrown into question. The surprise definitely had an impact on Canadian bonds but take a look at U.S. treasuries. The 10-year yield was sitting comfortably around 3.65%, but then shot up to 3.80% Wednesday afternoon. At the front-end of the curve, yields backed up even more, with the 2-year touching 4.60% for the first time since May 26^th.

 

 

In the space of one week that 2-year yield has risen as much as a quarter of a point. This has created another opportunity to add exposure to bonds, both government and investment grade corporate, but I can’t say the same for stocks. One of the lesser discussed reasons is that in addition to a likely recession, continued pressure on earnings, stubbornly high inflation and ongoing geopolitical tensions, equities are being anchored by a more traditional investor attitude towards risk-reward.

 

Roughly three years after I was born, an economist by the name of William Sharpe developed something that we call the Sharpe Ratio, and it was intended to provide a comparison between the return of an investment and its risk (or volatility). What the ratio does is look at the incremental return of an asset compared to a “risk free” asset, divided by a measure of volatility. One example of a risk-free asset is a short-term government treasury bill. Now, the term “risk-free” in this context refers more to the risk of losing capital at the maturity of a treasury bill than the degree of volatility in that bill during its lifetime (say 3 months). The weeks leading up to last weekend’s vote to suspend the U.S. debt ceiling certainly created volatility in the bill market, but let’s step back and just focus on the return that these risk-free bills give us.

 

 

Back when Sharpe created his ratio, the U.S. 3-month bill yield was trading in the area of 4.50-5.50%. From the end of the second world war, the average annualized return on the S&P (excluding dividends) was about 9.4%. In other words, before even factoring in volatility in the stock market, the difference in return between it and the treasury bill was about 5%. What about the period after the financial crisis of 2008-09 and after the covid pandemic? Well, there wasn’t much to compare with given that the risk-free rate fell to basically zero. Even a paltry 4-5% annual gain in the S&P could deliver the same Sharpe ratio as back in the 1960s. Hence, people shunned safer investments for riskier ones.

 

Today, the game has changed back to where it was at the beginning. The 3-month bill is now trading around 5.20% and stocks now have to reach a higher bar. The main use of the Sharpe ratio was a means to compare investments on the basis of relative return against risk. Where stocks appeared to be a better bet when rates were rock bottom, the tables turned. Investors can get 5% or more in something that matures three months from now at par.

 

This is creating a problem for the stock market in two ways. First, it might be holding back potential equity investors from jumping into equities – additional fuel that could keep the bull market going. Without that fuel, the rally could stall out. The other risk is that an increased demand for short-term less risky paper could drain bank deposits even more and maintain pressure on smaller less-capitalized banks.  Those deposits may have also helped to support spending, especially in an environment of weaker employment and income growth. Given that deposits are still very buoyant.  U.S. M1 money supply is up about 360% from before the pandemic and the broader M2 supply figure is up more than 33%). 

 

Bottom line, the headwinds facing U.S. stocks after the bull-market award this week do not suggest something extremely dire. We do not anticipate a major correction but do see this market as running out of positive things to trade on. Nor should investors who have been in cash think that they have missed the boat. Some call this the “cash trap”, where investors miss an opportunity to participate in risk assets because of a decision to move to cash. As we know, investing shouldn’t be an on-and-off-switch game. Rather a tactical blend of risk assets, lower risk bonds and “risk-free” instruments should be used, which might include a heavier weighting towards the latter. And I’m not referring to GICs either, as these create another risk down the road (reinvestment risk) and remove the much-needed flexibility required to navigate uncertain waters. In that case, we avoid the cash trap and instead create a bootstrap method to enhance returns and protect against volatility while we wait for these market challenges to evolve.

 

On behalf of the Pyle Group, have a wonderful weekend.   

Andrew Pyle

 

CIBC Private Wealth consists of services provided by CIBC and certain of its subsidiaries, including CIBC Wood Gundy, a division of CIBC World Markets Inc. “CIBC Private Wealth” is a registered trademark of CIBC, used under license. “Wood Gundy” is a registered trademark of CIBC World Markets Inc. This information, including any opinion, is based on various sources believed to be reliable, but its accuracy cannot be guaranteed and is subject to change. CIBC and CIBC World Markets Inc., their affiliates, directors, officers and employees may buy, sell, or hold a position in securities of a company mentioned herein, its affiliates or subsidiaries, and may also perform financial advisory services, investment banking or other services for, or have lending or other credit relationships with the same. CIBC World Markets Inc. and its representatives will receive sales commissions and/or a spread between bid and ask prices if you purchase, sell or hold the securities referred to above. © CIBC World Markets Inc. 2023.CIBC Wood Gundy, a division of CIBC World Markets Inc. Insurance services are available through CIBC Wood Gundy Financial Services Inc. In Quebec, insurance services are available through CIBC Wood Gundy Financial Services (Quebec) Inc.

The CIBC logo and “CIBC Private Wealth” are trademarks of CIBC, used under license. “Wood Gundy” is a registered trademark of CIBC World Markets Inc.

 

For more information about this product, please contact your Investment Advisor.

These are the personal opinions of Andrew Pyle and the Pyle Group and may not necessarily reflect those of CIBC World Markets Inc.