The stock market began a stunning rally amid hopes that the Federal Reserve’s worst interest rate hike has passed and inflation has cooled off, But Bank of America analysts warned Tuesday that prices remain too high and stocks are still too expensive for a bear market, at least according to one rule that has been thought to be absolutely true in the past.
Bank of America analyst Savita Subramanian said Tuesday that a sustained bull market remains “unlikely,” even though the S&P 500 has risen more than 16% to 4,262 points since hitting a low on June 16 this year, the day after Fed officials mandated the biggest interest-rate increase in 28 years to combat decades of high inflation.
Subramanian and her team track a long list of indicators (a Fed cut, an increase in unemployment, or markets rising by 5%) that help signal the start of a bull market, but so far only 30% of these items have been met; Historically, 80% of the list has dropped off before markets start to fall.
Specifically, they write that no bear market since 1935 has ever ended when the consumer price index and the average S&P price/earnings ratio added up to 20 or more – a phenomenon called the “Rule of 20” that signals stocks remain too expensive relative to their earnings and there is probably still room to fall; with inflation at 8.5%, the metric is currently at 28.5. The S&P 500 firms would have to beat earnings expectations by an average of 50%, Subramanian says-or in more extreme scenarios, the S&P would have to fall more than 40% to 2,500 points, or inflation would fall to 0%.
The bank’s research shows that consumer staples and consumer discretionary sectors are most at risk in the current environment, although staple foods may fare better as retail giants like Walmart and Target report that consumers are increasingly shifting spending to essentials like food and gas, as opposed to discretionary items like clothing and home furnishings.
Analysts are not alone in raising flags: On Monday, a team led by Lisa Shalett of Morgan Stanley Wealth Management said it was “not ready to say it’s clear” Because recession indicators are still flashing and earnings expectations haven’t fallen enough to explain the economic slowdown, adding that “stocks are vulnerable to any data that doesn’t support a bullish narrative.” Major stock indexes fell into bear territory in June as investors anticipated the Fed’s biggest interest rate hike since 1998, but stocks have since largely recovered on hopes that inflation has finally peaked. In one moment of a 23% decline this year, the S&P is now just 11% behind since the beginning of January. Still, the economy unexpectedly contracted for the second straight quarter this year, and fears of an impending recession have still not abated. Expectations for economic growth declined in the third quarter, especially due to lower-than-forecast housing market data.
