Rallies, recessions, and realistic thinking


The S&P 500’s surge over the past nine months doesn’t feel to us like the start of a new bull market, but rather like the last leg of the current rally.


June 27, 2023

Jim Allworth
Investment Strategist
RBC Dominion Securities

  • The market rally from the September lows has gone far enough to turn many sceptics into believers. Joining other major markets in new high ground this summer is not out of the question for North American averages.
  • “Fear of missing out” has been propelling the North American averages higher and could go on doing so for some months yet. But the attractive valuations of last September are giving way to loftier price-to-earnings ratios that we believe will need the economy to cooperate to be justified.
  • Reliable leading indicators of U.S. recession continue to worsen, suggesting to us that this latest advance in share prices will eventually give way to a more challenging period for equity investors.

A year ago, our 2022 Midyear Outlook was looking at an equity market landscape that was mostly the opposite of today’s:

  • Central banks, including the Fed, had started 2022 prepared to be somewhat tolerant of a pick-up in inflation but changed their tune as prices rose much faster than policymakers expected in the early months of the year. Mid-2022 would mark the opening stages of what would come to be the steepest series of rate hikes ever. Still to come for the Fed would be an unprecedented run of four successive 75 basis point (bps) jumps, followed by four more subdued increases totalling an additional 125 bps.
  • Also at this time last year, the stock market’s price-to-earnings (P/E) multiples had already been pressured lower by the sharp rise in bond yields that came with Fed tightening. The S&P 500 Index was down by 27 percent from its January 2022 peak while the Nasdaq was a whopping 38 percent off its high-water mark set in November 2021. Both had been heavily burdened by the big decline in P/E ratios among the previously high-flying mega-cap growth stocks. The six largest such stocks constituted more than 25 percent of the value of the S&P 500 at the peak of the market in early January last year.

Enter the rally

Most global equity indexes went on losing some more ground into last September before turning higher into a new up-leg. That rally from September has continued up to the present day. From September until May this was viewed by most as no better than a bear market rally that would eventually peter out. But as the S&P 500 moved convincingly above its trading range over the past six weeks it has rekindled investor optimism. Market sentiment gauges have soared as “fear of missing out” (FOMO) has replaced caution.

For our part, we think this equity market up-leg has further to run. The UK’s FTSE All-Share Index, the EURO STOXX 50, and Japan’s TOPIX have all posted new highs for this cycle. Before the rally is over, we expect the S&P 500 and Canada’s S&P/TSX Composite will do the same.

New bull or last gasp

However, this doesn’t feel to us much like the start of a new bull market, but rather much more like the last leg of the current bull run. Whichever it is, the market is certainly in a different place than it was back at the September lows. At that point, most indexes had been falling steeply for nine months, some even longer. The P/E ratio for the S&P 500, an extravagantly overvalued 23.1x at the peak of the market in early January 2022, in our view, had fallen to a much more palatable, slightly undervalued 15.9x by September. This downswing in the index and in valuations occurred even as reported earnings were rising—the running 12 months earnings per share had risen from $208 to $219. Meanwhile, over the same interval, investor sentiment followed the market lower, sinking all the way from unsustainably bullish readings at the top in January to equally unsustainable bearish ones at the bottom in late September.

Since then, everything has been turned pretty much topsy-turvy. The U.S. equity market has gone up for nine months instead of down, and the S&P 500 is edging closer to new all-time highs. P/E multiples are back above a rich 20x. And, as noted above, sentiment readings have roared higher, getting closer to (but not yet at) the unsustainable levels that last prevailed at the top of the market a year-and-a-half ago.

Don’t fight the economy

This strong upswing in equity index values (mostly contributed once again by a handful of mega-cap Tech and tech-related stocks as well as by a wave of investor interest for anything even remotely related to artificial intelligence) is persuading some market watchers that the U.S. economy will avoid a deeper downturn. However, most reliable leading indicators of recession (see our U.S. Recession Scorecard ) have been moving inexorably toward even more negative readings.

S&P 500 Index versus S&P 500 Equal Weight Index

Both series indexed to the S&P 500 Index value on Feb. 3, 2023

S&P 500 Index versus S&P 500 Equal Weight Index

The line chart shows the value of the S&P 500 Index and the S&P 500 Equal Weight Index at the end of each week from February 3, 2023 through June 23, 2023. As of June 23, the S&P 500 had risen by 7%, while the equal weight index was 4% lower.

  • S&P 500 Index
  • S&P 500 Equal Weight Index

Source – Standard & Poor’s, FactSet; weekly data through 6/23/23

Of course, even leading indicators of U.S. recession that have been repeatedly and consistently right over the last 70 years or more could be wrong this time. Earnings and GDP growth could conceivably be pulling out of their funk starting right now. And if current consensus earnings estimates for $231 per share a year from now and $246 per share for all of 2024 prove to be correct, then that may be what is happening. That would put today’s index value at almost 19x year-ahead earnings—not cheap, but perhaps not overly risky either, in our view.

However, our Recession Scorecard tells us that the underlying economic assumptions needed to bring in those improved earnings are becoming more and more improbable by the week. We expect that a U.S. recession will arrive later this year, that actual earnings will come in lower than current consensus estimates, and that share prices will go through a challenging period during which unrealistic optimism on the part of investors gives way eventually to unrealistic pessimism.

Only resilient stocks need apply

We continue to recommend Market Weight equity exposure for a global balanced portfolio because we think this advance has further to go into the summer months. However, we increasingly think individual stock selections should be restricted to companies that an investor would be content to own through a recession. For us, that means high-quality businesses with resilient balance sheets, sustainable dividends, and business models that are not intensely sensitive to the economic cycle.

RBC Wealth Management, a division of RBC Capital Markets, LLC, registered investment adviser and Member NYSE/FINRA/SIPC.

Jim Allworth

Investment Strategist
RBC Dominion Securities

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