Friends of Finance,

I’ve been down on major market indices lately.

I’ve wrapped up most of the reasons why I’m not buying into the S&P 500 (NYSEARCA:SPY) in my two latest pieces – here (3 sectors to buy instead) and here (why treasuries are NOT the answer). And these conclusions extend to the Nasdaq (NDX) as well.

In short, I believe big tech has made the index overvalued and therefore future returns are likely to be sub-par. And these aren’t just my thoughts either, as confirmed by JPmorgan’s (JPM) 5% annual return forecast over the next 5 years.

My long-term view remains unchanged, but I believe that over the past two weeks, recent events have shifted sentiment in the short-term, significantly increasing the chances of a year-end rally in the broader market.

In this article, I want to discuss some key points that have, in my opinion, resulted in the change in sentiment and discuss what I’m doing about it.

Economic Events Unfold

It’s time to set the stage.

Economic growth has jumped to 4.9% in Q3 due to strong consumer spending fueled by higher wages and a tight labor market, marking the fastest GDP growth since the economy’s reopening in Q1 2021 after Covid.

Despite robust growth, October’s CPI stood at 0% month-over-month and 3.2% YoY, with the Fed’s preferred measure Core CPI at 4% YoY, indicating considerable decline in inflation over the past year.

Despite the heavily weighted shelter CPI standing at 6.7%, real time rent indices have already begun to show YoY declines in national rents.

As a result, the Fed decided to halt rate hikes at their recent FOMC meeting on November 1st. This caused yields across the yield curve to drop by 20-30 bps, triggering a significant stock market rally with the S&P 500 surging by over 6% in under two weeks.

Forecasts and Fortunes

But does this signal a full-blown bull market resurgence?

Not quite.

While inflation is projected to continue declining and further significant rate hikes are less likely, a looming recession cannot be shrugged off.

Here’s why.

Despite the consumer’s resilient performance in 2023, there are subtle signs of weakening. The savings rate is well below historical averages, pandemic savings are depleting, and credit card balances are mounting.

Moreover, car and credit card delinquencies are rising, with 7% of borrowers more than 30 days behind on payments. The restart of student loans in October is expected to dent consumer spending by 0.3%, painting a somewhat grim picture.

A weaker consumer could imperil EPS targets for the index, with highly optimistic consensus projecting double-digit EPS growth in 2024 and 2025. Should consumer spending shrink and a recession ensue, meeting these targets would be highly improbable.

The bond market has prophesied a recession for over a year with a deeply inverted yield curve. While some dismiss this as an error, it typically forewarns a recession 24 months in advance, indicating the expected start in October 2024.

Could the bond market be mistaken?

It’s possible, but it boasts an impressive track record, accurately predicting recessions in 1970, 1975, 1980, 1982, 1991, 2001, 2009, and 2020.

I’m pretty sure a recession is still looming, and I’m not alone. UBS anticipates a significant economic slowdown in 2024, catalyzing major Fed cuts of up to 2.75%.

According to their statement:

As the slowdown in the economy and the extra disinflationary leg begin in earnest, we expect the Fed in the second half of the year to turn to full-on accommodation, with more rate reductions, in line with what it has done historically.

I view UBS’s forecast of 2.75% in cuts by the end of 2024 as extreme.

For reference, the futures market currently indicates a 30% probability of total 1% cuts, while UBS’s forecast currently has a 0% probability.

Nonetheless, I anticipate the Fed to slash rates in response to a recession, as it has historically done each time.

An aspect to consider before discussing positioning is that rate cuts usually coincide with the onset of a market selloff. This held true in 2001 and 2009 during severe crises. The 2020 sell-off was short-lived, courtesy of unprecedented Fed stimulus.

It’s uncertain what will transpire this time, heavily dependent on the severity of the recession and the Fed’s response. However, if consumer spending slows, I anticipate companies with severely impacted cash flows to suffer, while those maintaining stable cash flows should fare well, and if they are interest rate sensitive, they might even benefit. In essence, I expect a negative impact on the index and a neutral to slightly positive impact on select stocks during a recession.

Strategic Standpoint

I maintain my skepticism about investing in the S&P 500. While sentiment has improved and seasonal tailwinds are approaching, history indicates significant strength in November and December. Consequently, we might witness a robust year-end rally in the S&P 500.

Yet, the risk-reward ratio appears illogical. The index trades at an above average forward P/E multiple, and a potential recession might overinflate future EPS estimates, historically leading to substantial index downturns. I’m not willing to gamble on these risks simply to eke out a 5% gain in the year-end rally.

My medium to long-term outlook is unaltered. Thus, I continue to position primarily in interest rate sensitive high-dividend value names such as REITs, Utilities, and preferred shares, expecting them to outperform as rates decline.

While acknowledging that these sectors may underperform as long as rates remain elevated, I’m content amassing substantial dividends, reinvesting at reduced prices, and anticipating imminent gains.

Full disclosure, I might engage in swing trades on select tech stocks to capitalize on the rally. However, this constitutes trading, not an upheaval in my core long-term strategy or portfolio.