‘This is not healthy’: The latest rally in equities could signal more pain for markets. this is why

US stocks started the fourth quarter with strong gains as the Dow Jones Industrial Average DJIA,
+2.38%
it appears headed for its biggest two-day rally in more than two-and-a-half years.

But as tempting as it might be to say stocks have bottomed out, Nicholas Colas, co-founder of DataTrek Research, said Tuesday that investors should brace for more carnage in the near term as several reliable historical signs of a durable background. markets.

Valuations remain too high, Colas said, and while 2022 has seen immense two-way volatility in equities, sharp moves higher historically tend to indicate there could be more volatility in store for equities.

Watch: Wall Street’s ‘fear gauge’ still doesn’t signal stock market bottom is near, analysts say

“While we’re happy that US stocks rebounded nicely today, it’s best to view this move as just another day in a tough year,” Colas said.

While they have been extremely common since early 2022, historically speaking, single-session gains of 2% or more are a relative rarity for the markets. Since 2013, years that contained fewer single-day gains of 2% or more tended to deliver stronger performance over the course of the year, Colas said.

The one exception to this was 2020, when the S&P 500 posted 19 daily gains of 2% or more. However, Colas argued that most of these outsized moves occurred during the first half of the year, when markets were still reeling from the onset of the COVID-19 pandemic.

During the second half of the year, the S&P 500 saw exaggerated moves in just two sessions, as Colas shows in the chart below, using data from DataTrek.

Year

S&P 500 Total Return

No. of days with 2%+ moves

2013

+32%

1

2014

+14%

two

2015

+1%

3

2016

+12%

4

2017

+22%

0

2018

-4%

4

2019

+31%

two

2020

+18%

19 (but only 2 during H2)

2021

+28%

2 days

2022

-22.8% (price movement until Monday without dividend reinvestment)

14 days

“Simply put, strong rallies in the S&P 1-day (+2%) are NOT the sign of a healthy market,” Colas wrote.

How do we know the bottom is in?

In the past, when long-term lows hit, stocks typically met them with a big intraday move of at least 3.5%. This was true for the cycle lows that came in October 2002, March 2009, and March 2020.

By this benchmark, Monday’s rebound was not large enough to signal a significant turning point.

Day after low cycle

S&P 500 Performance

October 10, 2002

+3.5%

March 10, 2009

+6.4%

March 24, 2020

+9.4%

Average

+6.4%

Valuations remain historically rich

Colas also argued that stocks are still relatively highly valued based on a popular measure of cyclically adjusted stock valuations.

Instead of using future earnings expectations or earnings over the past 12 months, the Shiller index is based on the inflation-adjusted average of corporate earnings over the past 10 years.

According to the Shiller PE ratio, the average long-term valuation of stocks dating back to the 1870s is between 16 and 17 times cyclically adjusted earnings. As of Friday, the S&P 500, which was created in 1957, was trading at 27.5 times earnings and, after Monday’s rally, it was trading at 28.2 times, Colas said.

Does this mean that the shares are now cheap enough to justify the purchase? That depends on the macro vision of each one, Colas said. But the one thing investors can be sure of is that stocks have moved out of the valuation “danger zone” north of 30 times average long-term adjusted earnings.

DATATREK

What about the VIX?

The last two prolonged periods of market weakness offer some insight into how movements in the Cboe Volatility Index, also known as the VIX, VIX,
-3.52%
could unfold as investors try to anticipate when the market’s latest bottom might hit.

During the dotcom boom of 2020-2021, the VIX “experienced a series of continuous spikes that lowered market confidence and valuations.” Ultimately, it took two and a half years for the stock to bottom out after prices peaked in March 2000.

By comparison, after the 2008 financial crisis, markets bottomed more quickly, but not before the VIX peaked above 80, more than double its intraday high since June.

“As painful as the coming months are, you can’t blame long-term investors for expecting 2022 to look more like 2007-2009 than 2000-2002,” Colas said.

US stocks headed for back-to-back gains on Tuesday, with the S&P 500 SPX,
+2.65%
rose 2.9% to 3,784, the Dow Jones Industrial Average DJIA,
+2.38%
rose 2.6% to 30,258 and the Nasdaq Composite COMP,
+2.98%
3.3% to 11,174.

Market strategists have attributed the rally in stocks to a pullback in bond yields fueled by expectations that the Fed may need to “pivot” to less aggressive interest rate hikes.

Neil Dutta, head of US economic research at Renaissance Macro Research, said in a note to clients on Tuesday that the Reserve Bank of Australia’s lower-than-expected interest rate hike overnight marked the latest in a string of “wins” for investors betting on a Fed “pivot.”

“This is great but in the back of my mind I’m thinking, this can’t last,” Dutta wrote.

Read: How is a pivot? This is how Australia’s central bank framed a dovish surprise.

Colas told clients last week that the VIX would need to close above 30 for at least a few consecutive sessions before a “marketable” bounce could come.

Watch: Wall Street’s “fear gauge” could hold the key to the timing of the next market rally. This is why.

That call ended up being correct. But unfortunately, the close above 40 on the VIX that Colas has been waiting for since the spring has yet to come.

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