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While there are cross-currents at work, the path of least resistance for the market is likely still lower. Disinflation is typically a tailwind for stocks, but recession risk remains highly elevated. As noted in previous reports, stocks historically bottom in a recession rather than before one.

Despite meaningful disinflation in recent months, Powell’s Fed remains committed to continued rate hikes—with the most dovish FOMC members planning another 50bps of tightening next year and the most hawkish planning another 125bps. So, the current Fed stance keeps recession risk high. The time window for a constructive Fed pivot has likely closed anyway.

Fed hiking cycle peaks and subsequent rate cuts are only bullish for the stock market in soft landing scenarios, not in recession scenarios. The disinflation seen so far may help keep a coming recession ”softish” at least. The late 1940s economic/market analog remains relevant. In the late 40s, an initial inflation-related decline was followed by a recession-related decline, but the ultimate low was not much lower than the earlier lows.

Earnings appear to be flattening out and rolling over, which would be consistent with going into an economic recession. In my view, the market is vulnerable to either a further decline in the P/E ratio (from interest rate pressure) or to a decline in earnings (from a recession) or some combination of both, over the next few quarters.

In terms of active tactical asset allocation tilts, I continue to favor underweight to stocks vs. bonds (i.e., mid-duration Treasuries). And at a 2.8% real yield, ultra short-duration inflation-indexed bonds (TIPS) continue to provide an attractive hedge against inflation remaining elevated and therefore diversification to traditional stocks and bonds. Within equities, small-cap value continues to look attractive on a medium to longer-term time horizon. Also, contrary to popular assumptions, in the drawdown from the beginning of the year to mid-October, small-cap value was actually down less than the S&P 500 (with 6.4 percentage points of relative outperformance).

The time to get constructively contrarian on a continuing bear market may not be too far off. One roadmap to keep in mind is that once the Sahm Rule indicator (a measure of the increase in unemployment) confirms an economic contraction, the market may be near the bottom (in terms of both time and price). Bear markets historically bottom well before recessions end.

In summary, risk remains skewed to the downside in the coming months. As a reminder, the market tends to move in the way that creates the greatest amount of frustration for the greatest number of market participants—in particular, bear markets (with sharp, counterintuitive rallies) tend to make fools out of both bulls and bears.

As always, the outlook remains data-dependent and everyone needs to put probability and reward-to-risk assessments in the context of their strategy, process, and time horizon.

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