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With tightening monetary policy, an ongoing global growth slowdown, and relatively elevated valuations, the path of least resistance continues to be lower for the equity market. Rising nominal and real interest rates continue to pressure valuation multiples, particularly for large-cap growth stocks. The market looks like it has room to “catch down” to where real rates are currently, and there is a strong chance real rates continue to rise based on the Fed’s framework.

Defensive sectors like health care, utilities, and consumer staples continue to show relative market strength. Also, the energy sector has been a standout given the nature of the current economic and geopolitical problems in the world. In the initial market drawdown from the beginning of the year to the mid-June lows, energy was the only sector that was up, and health care, consumer staples, and utilities were down the least. The same has been true in the recent decline from the mid-August interim high.

Some valuation models and historical analogs that I cross reference suggest the market might be about 15-20% overvalued currently. Chances are that the forward P/E multiple is understating valuations. I suspect that market expectations for 2023 earnings are lower than what has been published by the analyst community. In other words, there’s a difference between what’s projected by analysts and what’s actually priced into markets.

On equity markets internationally, the China CSI 300 Index has not shown any follow-through to the upside after its May-June rebound and looks likely to retest its lows. The Chinese market was the first to peak (in Feb 2021) and may be the first to trough. If it makes new lows, it will become an 18-month-long bear market for the benchmark Chinese index.

As noted earlier in the year, the TINA effect has been greatly reduced as interest rates have risen. There are arguably some reasonably attractive alternatives to stocks, at least over the near term. For example, a 2-year TIPS note yields 1.3% in real terms, i.e., after inflation. That’s in the 88th percentile over the past twenty years.

Also, the Fed continues to drain liquidity via quantitative tightening. Net liquidity had improved from late June to mid-August due to idiosyncratic factors but is now a headwind again for the market and is likely to remain so until further notice.

The silver lining of a hawkish Fed and an ongoing global growth slowdown is that inflation expectations continue to decline. As previously commented, I think the market is more concerned with inflation than growth. While, in my assessment, a recession isn’t fully priced into the market and represents a downside risk, it’s likely the lesser of the two evils to the extent they are mutually exclusive. In general, I continue to view the current drawdown as a cyclical bear market in an ongoing secular bull market.

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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