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One of the best generalities that define a bull market is the ability of stock prices to climb a wall of worry. When whole sectors of the economy are faced with a steady drumbeat of negativity, yet continue to rally, that’s typically a bull market atmosphere.

Investors, CEO’s, money managers, and economists are in complete agreement that there will be a recession, possibly a deep one, over the next year. Historically, when the Leading Economic Indicators are this negative, we are already well into a recession with sharply rising unemployment and collapsing revenues.

As we have previously discussed extensively, past norms fail to account for the degree of excess stimulus and long-term labor scarcity that has buffered this economic cycle. While sectors like banking head lower, full employment and secular tech trends keep the economy and equity markets edging higher.

Economic turmoil this time is claimed to be held in abeyance, waiting for the deeply inverted yield curve (short-term rates far above long rates) to become un-inverted. That’s when the Fed is forced to respond to a contracting economy by cutting short-term interest rates. Such a signal was expected when a couple regional banks failed in March, but Fed Chair Powell continues to hike short-term rates and stocks continue to rise.

The brief bank panic hangs heavy over investor sentiment still, even if mega-cap tech seems to ignore any risk of contagion to the core economy. In 2009, hundreds of banks failed during one of the deepest financial panics in generations, and yet the three banks that failed in March and April caused far greater losses. Today, the Fed has the tools to ring fence a panic before it becomes out of control, unlike 2008. 

These bank failures sent depositors fleeing to the safety of mega-cap banks and brought out the sharp knives of hedge funds intentionally forcing regional bank valuations lower to trigger a financial sector panic. Despite efforts to merge small banks with their big brothers, short sellers have kept the pressure going, pushing all small-cap value stocks down and initiating tighter bank lending standards.

This financial uncertainty has increased the odds of recession until the FDIC decides to fix the insurance coverage standards. Consequently, the FDIC has fostered an unusual extreme between small-cap and large-cap stocks. When has anyone seen large-cap tech stocks and mega stocks hitting eight-month highs at the same time that small-cap indices like the Russell 2000 Value Index are testing two and a half-year lows?

Not only are some tech and housing stocks hitting all-time peaks in the face of 6% mortgage rates, but the bread-and-butter consumer staple companies are also joining the bulls in testing new highs while the regional banking index is heading back to the COVID-19 panic lows of three years ago.

Major sectors of the economy that correlate highly with new bull markets are indicating that the worst is far behind us, while other sectors are frantically waving yellow warning flags that one more straw may trigger trouble in River City. The historical warning signs exist of a deeper economic decline ahead, but the real time business activity and credit risk remain healthy.

Since our forecasted rally back in October, we have expected a wide trading range market during an economic cycle that we thought would defy the pessimistic investor majority. This allowed us to focus on a shorter-term perspective to navigate a less-exciting, flatter market that still contains the risk of a misstep by central banks and regulators.

Our calls for a February peak, a mid-March trough, and the rally into mid-late April arrived as forecast. The sell-off expected in May has so far been obfuscated by the wide split among major sectors of the stock market. With large-cap stocks testing multi-month highs and small-cap stocks testing multi-month lows, it can be argued we are having both a high and a low here.

The basic CNN Fear and Greed indicator, which isn’t normally precise in calling market tops, has indicated an overbought condition in April that is in need of sideways to lower prices. So far, the range-bound price action over the past month has partially relieved the downside urgency, but a modest corrective equity bias technically remains.

The lack of Put option (PCE) bets on a market correction also bolsters the contrary opinion & evidence that this market is a bit complacent and at risk of a modest downside shock in May or June.

The Regional Bank run since March that has exacerbated the dichotomy between large-cap and small-cap is contrasted below, with the Russell 2000 small-cap index nearing its 11-month bear market lows, while the Nasdaq 100 Index has hit new eight-month highs. Our expected seasonal low for May 12 (as well as May 19) is showing up on small-cap stocks, but not at all in large-caps.

Resolution or failure regarding the US debt ceiling and backstopping of regional banks are the critical short-term topics to be on high alert for this quarter. One month T-bill yields touched 5.8% on Friday and could surpass 6% this month without a debt resolution. Such a yield along with a US dollar moving above 103 would add short-term downside risk to the stock market.

The economy and stock market have been much more resilient, as reflected by large-cap tech, than most economists and managers expected. There are still headwinds from restrictive monetary policy that are justified until inflation and the economy weaken further. How this translates into earnings and multiples has been the guessing game for analysts, as investors attempt to price in expected outcomes six to 12 months into the future.

The near-term concerns of a June debt ceiling passage to avoid a short-term panic default, as well as the continued selling pressure on regional banks, are the news events to be focused upon for price action over the next month or two. Once resolved, the uptrend can resume.

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