Santoli: Investors grapple with a sense of surrender after the Fed raises interest rates

Published Thu, Jun 16 20221:00 PM EDTUpdated Thu, Jun 16 20221:30 PM EDT

This is the daily notebook of Mike Santoli, CNBC's senior markets commentator, with ideas about trends, stocks and market statistics. What's suddenly alarming the market, leading to the downside dam break? Nothing truly sudden, just more of the same — only more so. The Federal Reserve and other central banks (Swiss National Bank, Bank of England) are behaving as if the fight against inflation with the blunt tool of higher interest rates is a must-win, and the price they're willing to pay in economic weakness is implicitly higher than is comfortable for equity investors. The mantra here for months has been that the path to a possible economic soft landing is narrow and bumpy, and the Fed acknowledged it might've become even more constricted and rocky. Consider the fact that one can make a plausible case that the Fed will have to jack rates much higher to corral inflation in a sturdy economy while an equally believable voice notes that financial conditions have already tightened precipitously and the economy can't absorb much more in rate hikes — and you can understand the confusion and sense of surrender in markets now. Aside from that, tactically, the two paramount rules of "Don't fight the Fed" and "Don't fight the tape" continue to dictate caution, defensiveness and low expectations. But with caveats: The Fed left open the chance that it would be able to modulate future rate hikes and in fact might have "front-loaded" the move to a neutral rate. As for the tape, it's a complete mess, with aggressively nasty downtrends and failed support — yet we could be nearing the hoped-for "as bad as it gets" type levels. Now, we have only 3% of S & P 500 stocks above their 50-day average, and at one point just about every Nasdaq 100 stock was down. This gets us closer to washout-type conditions. This is merely a first step to generating an oversold rally, which then must be scrutinized for signs of genuine, broad real-money buying, which itself often has to be tested. Many stages of "prove it" before things improve. For long-term investors, lower prices and slimmer valuations by definition raise multiyear expected returns, but in tenacious bear markets the rewards often come with further pain for a while, and after many have bailed out of the ride. The S & P 500 in a steep downtrend. Is it due for some relief now that it's hitting this trend line? Maybe, even if an earlier, more gradual path didn't really hold with the latest downside acceleration. The Nasdaq 100 has now lost a third of its value from the November peak, more than it gave up in the Covid crash. It would still take an additional 12% drop to return the index to its prepandemic peak, though strong earnings growth means it is less expensive relative to expected profits than it was even through most of 2017-2018. As for the S & P 500 valuation, it has dipped under 16-times forward earnings, well under its 10-year average. The index has spent almost no time under 15x expected earnings since 2015, touching 14-ish briefly near the panic lows in 2018 and 2020. The big, flashing caveat here is that P/E is only as good as the estimated "E." There is now growing acknowledgement that earnings forecasts are likely too high for the remainder of the year and 2023. Outside of energy, earnings revisions have flatlined. Prior instances when stocks fell dramatically without earnings forecasts falling were 2002 and 2011, and both times earnings did come down to close the gap. Still, applying a middling multiple to somewhat reduced earnings is one reason so many are targeting 3,400-3,500 as a working downside target for S & P 500 — this is also about halfway between the Covid crash low and the record high, and roughly gets to the pre-Covid peak. It also hits a couple other long-term averages (the 200-week moving average is now 3,477). Much talk that Friday's heavy quarterly expiration of options and futures is an exacerbating factor in the index swings, especially as various strike-price thresholds get tripped and market makers hedge exposures to a huge trove of expiring put options. There is some reason to think there will be cleaner positioning come Tuesday (Monday is a market holiday) with a pattern of short-term reversals around and after big expirations. Also, month-end rebalancing would likely feed some rotation back into equities. Nothing guaranteed or necessarily decisive, but noteworthy. Treasury yields started higher but are backing off, with risk aversion and growth worries edging aside the inflation/Fed story for the moment. What if the Fed gets lucky and inflation starts to moderate soon? Implicitly, the Fed is targeting gasoline prices, which it can't easily influence. Gas prices feed into consumer inflation expectations quite directly, which the Fed cited for its decision for a super-size 75 basis point hike. Is it meaningful, then, that gasoline futures are well off their highs as the seasonal peak approaches? Credit spreads are showing a fresh round of stress. Combination of growth fears, illiquid conditions and perhaps the (not unexpected) Revlon bankruptcy declaration driving a flight from junk bonds. Cash junk bond spreads are not yet to late-2018 levels, but the credit default swap market is registering more hedging/shorting activity than has been seen in a while. Bond volatility and macro fears set the scene for possible credit accidents. Not a prediction or a current observation, but it's a feature of this market that's keeping the warning lights bright. As noted, we have liquidation-type negative market breadth. Some indicators tracking up/down volumes over time are registering rare extremes. Sure, markets crash from oversold and not overbought levels, but we might be getting to a "close your eyes and buy" moment just for a trade at least. VIX under 34, concerned but not massive price-insensitive buying of downside protection. Many calls for a panicky 40 VIX print before there's a low, but this is a preference not a rule. Orderly grind lower in stocks and much hedge-fund de-risking along the way arguably means less hedging demand. But we'll see if the rooters get that 4-handle in a final flush.

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