The stock market may have peaked, and everyone may have missed it. It's nearly impossible for anyone to call a top in the stock market, and one only tends to know it in hindsight. But that doesn't mean we can look at history and try to help us determine if this time will be different. If history proves to be an accurate predictor of the future, then the S&P 500 could drop as much as 39%.
Going back to the early 1990s, the yield curve has given us plenty of insights into where the stock may be heading. Over the past 30 years, the curve has been amazingly consistent, with the S&P 500 peaking at the bottom of and troughing at the top.
But more importantly, it's the period of time that follows the bottoming of the yield spread on the 10-year and two-year. It's the steepening that appears to be the killer of the equity bull markets or at least present the equity market with some serious turmoil.
The spread between the 10-year and two-year notes appears to run a rather defined cycle, with the spread narrowing towards zero as we enter or approach a recession and widens in periods when the recession has passed. This is a normal part of the economic cycle. More interesting is that despite the actual interest rate, the spread has consistently peaked around 2.6% to 2.8%, while bottoming around -50 bps to 0%.
Around 1990 to 1991 appears to be the mildest reset seen in the S&P 500 as the yield adjusted and began to steepen. During that period, the S&P 500 declined about 20%, and it was a shorted-lived pullback.
The periods of course with the greatest resets came during the year 2000 and 2008. Each period was different but in ways the same. During those times, the yield curve was steepening because the two-year rate was moving lower relative to the 10-year, likely because the Fed was cutting rates.
As the markets fell and rates were falling, one could assume the economy was going through a slowdown or perhaps recession, causing the Fed to cut short-term rates. When the two-year began to rise, it was indicative of an improving economy.
However, this time is different because it isn't that the yield curve is steepening because the two-year is moving lower away from the 10-year. This time, it's the 10-year moving higher away from the two-year. But it may not matter which way the two-year is moving relative to the 10-year, the only thing that may matter is the signal the spread is sending to the market, which is the economy is improving, and that rates are likely to continue to rise.
If rates continue to rise on the long-end of the curve only because the two-year remains anchored due to the Fed's zero interest rate policy, then 10-year rates could easily push back to 2.65% over the next two years or so, and the equity market is not priced for that type of rate environment.
Mispriced Market
The S&P 500 is currently trading with an earnings yield that is just 3.15% higher than the 10-year rate. It has only been more expensive since the great financial crisis two other times January 2018 and October 2018.
That means that if rates continue to rise on the 10-year, and the S&P 500 does not fall, the index will grow even more expensive relative to the 10-year. A mere 35 bps increase in the spread of the S&P 500 earnings and the 10-year rate would send the S&P 500's earnings yield to around 4.9%, or an equivalent P/E ratio of 20.04, down from its current 21.6. If earnings for the next 12 months are estimated at $176.55, then the S&P 500 would be valued at 3,603, or 4.8% lower, assuming rates on the 10-year do not continue to rise. If the 10-year continues to rise, then S&P 500 needs to continue to fall.
But if rates are normalizing on the long end, then P/E ratios must fall more than mentioned above. The historical average of the 12-month forward P/E ratio for the S&P 500 is 15.4, which means that the S&P 500 could be worth as little as 2,718, a drop of 39%, rivaling the 2000 and 2008 pullbacks. This isn't to say that will happen, but it gives a sense of just how overvalued equities truly are. A P/E ratio of 17.5 would garner a value of 3,090, a drop of about 22%, more in line with what was witnessed in 1990.
Technical Trends
Technically, the S&P 500 has broken the March uptrend, which could be a very negative sign, indicating a change in trend. There are a number of places where there are big technical gaps that need to be filled around the October lows at 3,300, and then the May 2020 level around 2,860.
Interestingly, the 61.8% retracement of the March 2020 move higher to the February peak comes at 2,860. The 61.8% number is deemed important as part of the Fibonacci sequence, which many technical analysts use.
Overall, where the equity market goes from here will be totally up to the bond market. What makes matters worse is that there may be nowhere to hide for the first time in some time.
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