- The S&P 500 has risen 26% since late October, but one bear says a pullback may be imminent.
- Historical trends show stocks falter when the Federal Reserve cuts rates amid looming recessions.
- Investors also seem complacent about inflation and high rates, warns Jon Wolfenbarger.
It's been a near-frictionless seven months for the S&P 500, with the benchmark index up a cool 26% since late October.
But as the rally continues to placate investors — changing the minds of even some of the most bearish strategists on Wall Street — the market may be quietly starting to roll over.
That's according to Jon Wolfenbarger, the founder of investing newsletter BullAndBearProfits.com and a former investment banker at JPMorgan and Merrill Lynch. In a recent note, he laid out several charts showing why stocks could be in the process of topping out as the threat of a recession looms.
The first draws on history. In prior Federal Reserve rate hiking cycles, stocks have continued to rise until around the time the central bank starts to cut. But as soon as the Fed has started easing policy, the market has run into trouble. Such was the case in 2000 and 2008, two of the biggest market sell-offs in history. With the Fed expected to start cutting rates later this year, it could spell trouble for stocks.
Of course, this entirely depends on the Fed's reasoning behind cutting rates. The central bank is looking to guide the economy to a soft landing, where they can bring inflation down without upsetting consumer spending and the labor market too much. If inflation comes down in the months ahead from its current level of 3.4%, the Fed could cut rates in an effort to avoid an unnecessary downturn. On the other hand, higher inflation could force the Fed to keep rates elevated — which could eventually cause something to turn sour in the economy and prompt the Fed to lower rates in response to that instead. The latter outcome is what would sink the market. Right now, market consensus says it's unlikely.
Second, Wolfenbarger pointed to unemployment starting to tick higher. The chart below shows that the unemployment rate has crossed above its two-year moving average, represented in black and red, respectively. The last three times that happened was in 2001, 2007, and 2020, when the last three major recessions started. The bottom part of the chart shows corresponding S&P 500 price action. When the unemployment rate has significantly trended upward, stocks have fallen meaningfully.
Wolfenbarger also said that corporate earnings are another important indicator to keep an eye on when trying to identify a peak. While earnings were just fine in the first quarter, if they start to decline alongside a slowing economy, stocks will go with them.
It all adds up to give Wolfenbarger a fairly dire outlook for stocks going forward. He sees the S&P 500 declining by more than 50% when all is said and done. This is in part because of what he sees as investor exuberance and complacency.
Market valuations are sky-high, for example. The Shiller CAPE ratio is now above levels seen in 1929 and is only lower than highs seen in 2000 and 2022. The CBOE's Volatility Index, which shows how rocky investors expect the market to be in the coming 30 days, is also near historic lows.
This is all despite the fact that inflation has proved sticky, rates are high, and classic recession indicators like the Treasury yield curve — which has a perfect track record of signaling downturns over the last several decades — are flashing red.
"There has never been a soft landing after a significant Fed rate hiking cycle and yield curve inversion like we have seen in this cycle," Wolfenbarger said in the note. "We do not think it is wise to bet on something like that happening for the first time in history."
During prior yield-curve inversions, the severity of bear markets has been correlated with the duration of the inversions. The current inversion of 580 days implies a drop of around 65% for the S&P 500.
Wolfenbarger first started warning of a market crash in late 2021, and the market subsequently dropped 25% amid fears that the Fed would push the economy into recession. Those fears have since dissipated, and the S&P 500 has rallied 47% since October 2022.
Bullish sentiment increasingly pervades Wall Street, making Wolfenbarger and his views very much outliers along with bears like Jeremy Grantham, Marko Kolanovic, and Albert Edwards.
Whether or not Wolfenbarger's views come to fruition depends on how long the economy can hold on as the Fed continues its tightening efforts. As of now, at least, the resilience shown by the job market and consumers has rewarded bulls generously.
