Ask Forstrong: The S&P 500 is up 20% off its low last year. Are we in a new bull market?

At its midpoint, 2023 is already a year of contrast and confusion. Linger on the following list. A cumulative 500 basis points of rapid Fed rate tightening. A severely inverted yield curve. China’s economy, six months after re-opening, still beleaguered by weak consumer spending and a slumping property sector. Silicon Valley Bank mismanaging itself into insolvency. SBF, once the golden boy of crypto, ignominiously under house arrest (at his parent’s home of all places). These are all now immoveable facts of the last year — and, deeply negative stuff.

But look around. Bull market vibes are everywhere. AI has entered the public consciousness, re-awakening animal spirits in the tech sector. Apple’s new “mixed reality” headset promises to transport users into digital utopia (if the goggles don’t make you dizzy, the eye-watering price of $3,499 will). Against all predictions, recession flatly refuses to show up. Supporting this is the remarkable run of expanding US payrolls, with an average monthly gain of 370,000 jobs this year. All the more remarkable is that 7% mortgage rates not only didn’t deflate the American housing market, but engineered a boom in homebuilding stocks. Regional bank failures have also not led to broader financial system contagion. Even Beyonce’s sprawling Renaissance World Tour sold out within minutes. And, now, the S&P 500 has just registered a 20% bounce off its October 2022 low. 

This is the stuff of bull markets. But what lies ahead? The key question is whether a durable market uptrend is underway. First, some perspective: a rally has hardly begun. All the S&P 500’s gains this year have come from seven over-hyped tech stocks, largely buoyed by the AI theme. This is not yet a broad-based bull market with widespread participation.

New Global Economy Emerging From The Pandemic

Looking ahead, the challenge is that “textbook macro” would suggest that a recession and associated stock market downturn is in the cards. Hawkish central banks, inverted yield curves and tightening financial conditions all support this. And, crucially, nearly everyone will point to “long and variable lags” from tighter monetary policy. Surely it is only a matter of time before higher rates crush the economy? 

On the surface, all that seems intuitive. But there is another argument that may stretch minds: we are entering an early cycle environment based on an entirely different set of macroeconomic conditions. A new bull market based on new investment leadership is unfolding. 

Stay with us here. To start, and at the risk of stating the obvious, the current business cycle is not a natural one. There is nothing textbook about today’s environment. Economic shutdowns and re-openings were fully coordinated by government, rather than traditional market forces. Different nations opened at different times and with different velocity. The current world economy remains highly de-synchronized. 

This, of course, is new territory. Ever since globalization gathered pace in the early 2000s, world trade and business cycles had become far more correlated, not less. But there is now evidence everywhere that pandemic distortions are rapidly normalizing. Supply chains have eased. The labour market is coming into balance. The global auto industry, which was rocked harder than almost any part of the economy, is showing swift improvement in production bottlenecks. 

All of this is underappreciated, in the context of supporting economic growth. But, even given post-pandemic healing, the question remains: where will global growth come from to drive the next bull market? Consider the last few decades. The abundance and positive supply shocks of the 2000s (moving 40% of global manufacturing offshore to China, the US shale boom, etc.), set up a slow growth and disinflationary decade in the 2010s. 

The opposite is now occurring. A chronic lack of investment in the 2010s has led to shortages today, and a revival in aggregate demand is taking hold simply because the world has underinvested in the real economy for years. Everywhere you look companies, facing higher interest rates and labour costs, are spending money to lift productivity — in ways that extend far beyond betting the farm on AI and ChatGPT. Capex in the US has soared, showing a 14% year-over-year growth rate in the first quarter of 2023. 

Underpinning higher demand is higher government spending. The structural changes in advanced economies mean more resources will go to things that are, in the words of economic historian Brad Delong, “state responsibilities” (i.e. healthcare because of aging, education because of the knowledge economy, decarbonization because of climate change and, lately, defense spending because of renewed conflicts). 

This is also not just a Western trend. A global capex boom is unfolding in international energy and transport projects as the world fillets itself into continental and mega-regional hubs. Countries across Asia, Latin America, Africa and the Middle East are embracing new infrastructure spending plans, while disposable incomes rise and populations grow.

All the above means that the appetite for more government spending is here to stay. It also means that any downturn will be mild and short-lived, given robust fiscal policy. This is also the exact opposite of the 2010s, which was characterized by austerity and retrenchment of public finances. 

A key reason why the recession call has been the wrong one is an under-appreciation for persistent government deficits and spending. Most investors are still assuming a fast-moving downturn like 2008 or 2020. But the current environment is far more like the 1950s and 1960s, where labour shortages and an investment boom prolonged the cycle and took longer to unfold. And, investors should not forget that the 2010s were a “clean the house” decade, with deleveraging being the most durable trend. Now debt levels and, thus, interest-rate sensitivity, are far lower, primarily in America and the Eurozone. 

US housing trends, which have been persistently surprising to the upside, prove the larger point. Why has this resilience caught most investors by surprise? Simply because most investors put too much emphasis on higher mortgage rates and not enough on strong household balance sheets, demographic trends (millennials moving out of their parent’s basement) and, most importantly, a decade of underbuilding (from GFC PTSD).

We are entering an early cycle environment based on an entirely different set of macroeconomic conditions. A new bull market based on new investment leadership is unfolding.

Recession Already Discounted

The final point about a new bull market relates to sentiment and investor positioning. Even if a recession does arrive, what has already been discounted in markets? Would anyone be caught off guard and change their investment posture if a downturn did unfold? In an environment of chronic recession calls (now with us for over 18 months), investors remain deeply pessimistic. Most have already aggressively de-risked. From Bank of America’s widely tracked fund manager survey, the pros have the highest overweight to bonds since March 2009. Relative to history, the top 3 investment over-weights are bonds, consumer staples and cash. 

Investors are vulnerable here. The big turning points in yields over the past 900 years show that history’s greatest secular bear markets in bonds (“real rate reversals”) all started with major mortality crises, such as pandemics, famines and military conflicts — exactly the climate we have today. What’s more, cash rarely outperforms in this environment. According to data from JP Morgan, during the last seven business cycles, in the two years following the last rate hike from the Fed, cash underperforms duration assets by an average of 14%. 

In an October 2022 Ask Forstrong article entitled “Pivotal Moments: Are Markets Forming A Bottom?”, our portfolio management team concluded that the conditions for a durable market bottoming had arrived. From the piece:

“Why should we be discussing a new bull market when the outlook seems so bleak? The best answer is that levels of investor sentiment are now consistent with past bottoming processes. Markets do not form tops when investor sentiment is universally pessimistic. Rather tops occur with everyone predicting ever-sunnier skies ahead … markets fully discount that view and upside surprises become much more difficult to deliver. By contrast, bull markets are born out of pessimism.”

The above view remains in place: markets continue to move through a bottoming process and are finding a new equilibrium with new leadership. This is always bumpy. And it always takes the shape of the classic “wall of worry”. A hated rally is likely to continue simply because so many investors are not yet in on the gains. 

Looking ahead, we are now again at a moment in time where “upside surprises” can start to deliver again. Which ones? Chinese growth, just when everyone has given up on the world’s second largest economy, is almost certain to deliver a positive surprise in the second half. While an imminent end to the Ukraine war may not be here, investors have underestimated European resilience (witness the impressive speed with which Berlin found substitute sources of gas and built emergency infrastructure). Ongoing European dynamism would still surprise nearly everyone. 

Lastly, trends in corporate earnings will surprise markets and draw investors back into equities. Many have pointed out the average S&P 500 earnings recession bottoms out with a 16% contraction (currently at -6%). But this assumes a disinflationary backdrop like the one we saw in 2008, where nominal growth and profits dropped sharply. Amid higher inflation, investors need to think differently. Nominal growth is far more important than real growth for earnings. Looking at it that way, S&P 500 revenues have been robust and are still increasing, even as margins are coming down. This is the same phenomenon as happened during the 1970s where rising nominal sales never lead to a big earnings collapse.

Investment Implications

Many investors are still using the 2010s playbook, expecting a return to an era of slow growth and subdued inflation. This is a classic case of investors becoming accustomed to the conditions of the past and extrapolating them well into the future. 

Yet the world has already moved on from that macro regime. Over time, asset classes that do well will reflect the underlying macroeconomic dynamics. Higher yields will now weigh on non-productive assets like cryptocurrencies and longer duration assets like growth stocks. Under that view, the rally in the NASQAQ in 2023 should be viewed as a classic “echo bubble”, a pattern that can be seen in periods after all the biggest manias. Many investors refuse to abandon the assets that have made them a lot of money in the past. And so they continue to pile in.

But winners of the past bull market are rarely winners of the next one. Instead, investors need to stay oriented toward an environment of “higher for longer” interest rates and resilient growth amid higher fiscal spending. In the same way that the consensus consistently overestimated growth and inflation in the 2010s, the opposite will now occur: investors will, as they have so far this decade, consistently underestimate growth and inflation.  Positive economic surprises will lead to flows into equities (from cash and bonds) and rotation within equities (from defensive and tech sectors to cyclical and internationally stock markets). 

A new bull market is indeed unfolding. Just not the one most investors expect.