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Based on the economic outlook and market history, I think the market probably makes new lows before making new all-time highs. The market typically bottoms in a recession rather than before a recession, and the US economy looks likely to enter a recession before the end of 2023. In other words, the rally off the mid-October lows is probably a bear market rally rather than a new bull market. As of last week’s close, the S&P was just 17% off the previous all-time high, in mere correction territory. Meanwhile, an impending recession looks more likely now than at any point so far this year.

To recap, the max drawdown in the S&P 500 so far has been 25% over a 9-month period. That’s shy of historical central tendencies in terms of both depth and duration. Historically, the mean bear market duration is 17 months (with a massive range: of 1- 42 months), the median is 13 months, and the central tendency is 8-21 months. The mean decline is 39% (also with an extensive range), the median is 34%, and the central tendency is 27-49%.

The Fed might pause/pivot in the coming months but that’s only bullish for the equity market if we get a soft landing (i.e., avoid recession), which seems unlikely. In other words, a Fed pause (and eventual pivot) is likely bullish for Treasury bonds but not for stocks, at least in the near term.

If FTX is like Enron (as Larry Summers suggests), that would fit well with where we are now on the early 2000s market analog. The Enron scandal broke in October 2001, about a year before the ultimate low in the dotcom bust.

For active investors, tactical asset allocation likely warrants an underweight to equities relative to cash and mid-duration Treasuries. Within a domestic equities allocation, I continue to favor defensive sectors plus energy, and favor small-cap value over large-cap growth. While the path of least resistance might be lower, for now, emerging markets look attractive from a long-term contrarian perspective, and should benefit from a secular dollar bear market over the next 5-10 years.

Currently, short-duration TIPS continue to look attractive from both an absolute and relative return standpoint. As of last Friday, the 1/15/2024 TIPS bond yields 2.6% real, and the 1/15/2024 nominal Treasury bond yields 4.7% nominal. The breakeven inflation rate is 2.1% (i.e., 4.7% - 2.6%). Therefore, the TIPS bond is a better investment if you think the headline CPI runs above 2.1% annualized between now and Jan 2024. For example, if headline CPI annualizes at 4%, the yield to maturity in nominal terms would be 6.5% (4% + 2.5%). Higher than expected inflation continues to be a risk to traditional stocks and bonds.

In summary, the balance of risks to the market remain skewed to the downside. 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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