The stock market temps are up $25 billion and getting another hit

(Bloomberg) — For all its twists and turns, the 2022 market has also been a story of patterns that repeat. Stocks go down, shorts cover, lots buy, and then everyone jumps in time to get burned.

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It’s happening again.

After a month of pulling positions, investors pumped $25 billion into stocks in the week through Wednesday only to see the S&P 500 plunge as the Federal Reserve and other central banks stuck to hawkish stances that threatened to spur a recession. The benchmark index ended the week with its worst three-day drop in two months, shattering chart support and putting it on track for its first December drop since 2018, when concern about interest rates wreaked similar havoc.

The recent wave of optimism was crushed after President Jerome Powell assured that interest rates would go up and stay there until inflation drops sharply. Investors are playing catch-up bulls that untimely added 14% from last week’s October lows in hopes of riding higher into the year-end. Instead, they find themselves a long market where valuations remain extended, earnings are expected to decline, and other assets such as Treasury bills prove viable alternatives.

“We’ve seen significant disruptions to the downside in equities and risk appetite in general, the more the market reinterprets the Fed’s outlook, because every time it does, it gets more and more negative,” said Alec Young, chief investment strategist at MAPsignals. Young, chief investment analyst at MAPsignals, in an interview. “Regression buyers were hoping higher inflation would lead to more dovish Fed policy, and it didn’t quite work out.”

Stocks fell for a second week as economic data on retail sales and manufacturing indicated a slowdown while central banks increased their tightening. The S&P 500 fell more than 2%, slipped out of a five-week, 200-point trading range, and below its 100-day average for the first time in more than a month. For mapmakers, the loss of support is a sign that more pain is in store.

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The renewed selling is the latest reckoning for the stock bulls who have spent all year buying the dip, to no avail. The S&P 500 has jumped more than 10% from lows twice more this year, in March and June-August, with both succumbing to fresh selling that sent the market to new lows.

This time, the recovery began in mid-October with a massive short squeeze on the heels of a very hot inflation print. As asset gains gathered momentum in November, rule-based traders were forced to pile in, as trend-following quants bought $225 billion in stocks and bonds in just two trading sessions, according to one estimate. The fear of being left behind was so intense that tens of millions of dollars were spent on calling options to play catch-up, adding fuel to the rally.

Fund investors who have pulled their money out of stocks for three consecutive weeks have finally jumped. According to EPFR Global data compiled by Bank of America Corp., they added $25 billion in new money to US stocks in the week through Wednesday and poured a record $14 billion in fund value.

While that faith may one day turn out to be true, the timing was painful for now. Over the past three sessions, 95% of S&P 500 members have fallen and $1.4 trillion has been erased from the index’s value.

“The market in October and November was really strong, so you have a little bit of trend following by investors, and many probably think this is the start of a new bull market,” said David Donabedian, chief investment officer at CIBC. Private American Wealth, he said in an interview. “I think there are some downsides here.”

The latest trend has been driven by growing concern about a looming recession, a threat that the bond market has been looming for months via an inversion of the yield curve, yet has been ignored by equity investors. Now, with the Federal Reserve raising its forecast for peak interest rates to 5.1% and lowering its GDP forecast to flat growth for next year, reality is starting to set in.

At 16.7 times expected earnings, the S&P 500 is valued at a multiple of one point higher than the 20-year average. And the cost of shares will increase if earnings estimates continue to fall. Data compiled by Bloomberg Intelligence showed that since June, projected earnings for 2023 have fallen 8% to $229 per share.

Moreover, rising interest rates are eroding the decade-old bull case of stock ownership, sometimes called “No Alternative,” or TINA. Part of the competition comes from cash. At the beginning of the year, when three-month Treasury notes offered almost nothing, about 390 companies in the S&P 500 could be considered more attractive with higher dividend yields. After seven Fed increases raised short-term government bond compensation to 4.3%, the group of stocks with the highest cash yields has narrowed to 55.

Another threat is fixed income. To illustrate, consider an analytical tool known as the Federal Reserve Model that compares the flow of income from stocks to bonds. It shows the S&P 500’s dividend yield, which is the cross-correspondent of the price-to-earnings ratio, and now stands at 1.9 percentage points above the 10-year Treasury rate. An increase in the 10-year yield to 5% from the current 3.5% would require a dividend increase of about 28% to retain the current valuation advantage, all else being equal.

“We used the analogy — there’s a stock store and a bond store for your Christmas shopping,” Emily Rowland, chief investment strategist at John Hancock Investment Management, told Bloomberg Television’s Surveillance. “Stock shop, there is not much to sell.”

– With assistance from Jonathan Ferro.

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