Fed pivots usually lead to a higher stock market.
When Fed pivots occur outside of recessions, stocks rise. When Fed pivots occur during recessions, stocks rise.
But pivots don’t help stocks when they happen close to the start of a recession. Should investors look at the positives of a Fed pivot today, or the possibility of a recession in 2024.
In today’s S&P 500 Memo we look at how we believe this will play out.
Timing the Recession Will Prove Tricky
Many of you are asking: how much runway do stocks have in today’s Fed pivot before the recession hits?
We compared the S&P 500’s returns since the 2-year Treasury yield peaked in October of 2023 (i.e., Fed pivot signal) to those in the following 12 months following all Fed pivots:
- In only 2 months since then, stocks are already up more than 13%
- That’s already a big chunk of 12-month returns across all Fed pivots
With a large part of the Fed pivot already priced in, it’s hard to make a bullish call on stocks today like we did in October.
That said, the 1994 Fed pivot proved an exception. The S&P 500 rose a whopping 35% in the 12 months following it. We’ll go over that episode in more detail later in the memo.
It’s difficult to predict exactly when a recession will hit, but we can use the yield curve as a timing tool:
- Recessions tend to be preceded by inversions in the yield curve (on average 12 months before the start of recessions)
- When the yield curve steepens, it signals that a recession is imminent (on average between 4-5 months) [1]
Following the inversion of 2022, the curve began steepening in August 2023, which would imply that a recession is imminent. [2]
However, curve steepening isn’t a perfect recession indicator:
- In 1989, for example, it proved too early, triggering 16 months before the ‘90/’91 recession
- The S&P 500 rose 27% over that timeframe
We’d been expecting the recession to materialize in the first-half of 2024. However, we believe it’s now more likely a second-half story, as jobless claims haven’t been trending higher.
While deterioration in the job market may take some time to fully play out, last week’s big drop in services employment reported in the PMI for December tells us that’s where we’re headed.
1995 is another example of a Fed pivot that created a huge equity market rally:
- After the Fed raised interest rates by 300 bp between December 1993 and April 1995, no recession followed, but rather a 35% boom in the stock market
- The gains were driven by a surge in valuations, as the boost to housing from rate cuts also boosted manufacturing and earnings
- Valuations kept rising aggressively, reaching extreme levels until the Dot-Com bust flattened them
- The soft landing of 1994/1995 provides an example of how valuations could rise even more from today’s already high levels if a recession continues to get pushed out
However, the curve wasn’t inverted like it is today, as inflation wasn’t elevated (i.e., bond market wasn’t expecting a recession). And the housing market was in a much better shape.
Very different from the 1994/1995 soft landing, we see the weak state of the housing market as a key driver of a recession in 2024:
- Conditions for buying homes are the worst in over 60 years due to a jump in both mortgage rates and home prices
- If the housing market stays weak, the goods spending cycle won’t likely restart
- Without a recovery in goods spending, manufacturing and earnings probably won’t rebound
- That’d reveal weakness in demand, leading to layoffs as labor market hoarding unwinds
Investors are forecasting only modest rate cuts this year, like those seen in the pivot of 1994. We believe that the market will price in many more rate cuts in 2024 than is the case today.
Conclusion: How We Think 2024 Could Play Out for the S&P 500
Putting everything together, here’s how we see 2024 playing out:
- With a recession more likely in the second-half of 2024 but the Fed now having the market’s back, stocks could remain strong in the first-half
- That’d be consistent with the breadth thrust and technical breakout that followed the Fed pivot, with recession fears only getting priced in the back-half of the year
- Tactical vulnerabilities like a complacent put-call ratio, VIX divergence and the S&P 500 trading near resistance point to near-term risks of a pullback in January and February
- During this period, we’ll be monitoring whether recession risks do finally begin to rise (which would lead to a much deeper correction), or if equities can squeeze out another rally
We’ll make sure to keep you updated on these developments as they occur.
Our reading of the market makes us Neutral on the S&P 500 today. Without much conviction, we ran an analysis across Fed pivots to see what sectors we’d be better off betting on.
Traditional defensive sectors like Utilities, Health Care and Consumer Staples have proven relatively good bets during Fed pivots.
Among defensives, we believe that Utilities offer the most-favorable risk-reward and are currently rated a Buy score of 7:
- They’re priced at a 20% discount to the S&P 500, the biggest across the defensives
- The discount is one of the biggest for Utilities going back two decades
- We believe they offer a very attractive opportunity to buy cheap insurance against a recession
On the other side of the spectrum, Technology ETFs like XLK look like very expensive bets to make on a Fed pivot:
- Instead, we believe that the equally-weighted Technology sector (RSPT) offers a more calculated bet
- It avoids the high valuations of the megacaps that make up most of the (capitalization-weighted) XLK ETF, making them less vulnerable to recession risks
- RSPT provides similar exposure to the secular tailwinds benefiting XLK, but without the burden of high concentration to expensive megacaps
We have a Neutral rating on RSPT as we wait for a more opportunistic entry. That’ll largely depend on the market experiencing volatility in the near-term (as we expect) to allow for a favorable entry.
Footnotes:
[1] Yield curve steepening occurs when the yield of longer-maturity Treasury bonds rise more than the yield of shorter-end maturity bonds. For example, steepening would occur if the 10-year yield rises relative to the 2-year yield.
[2] Here, we’re using a 3-month smoothed 10-year/2-year Treasury yield curve to reduce the volatility of the readings.