Home Most Popular The End of the New Bull Market: A Closer Look at the Current Financial Landscape

The End of the New Bull Market: A Closer Look at the Current Financial Landscape

The End of the New Bull Market: A Closer Look at the Current Financial Landscape

As investors and traders, it’s important to stay on top of market trends and analyze the factors that drive stock performance. Over the past few months, we’ve witnessed a significant shift in the financial landscape, leading many experts to believe that the new bull market is coming to an end.

The S&P 500 (SP500) is currently lower than its levels on June 1, and on October 25, it closed less than 20% off its October 2022 intraday panic lows, marking the end of the “bull market” as we know it. The summer rally that drove the market to new highs is dissipating, leaving investors with questions and concerns about what lies ahead.

Understanding the Drivers of the Summer Rally

To understand the recent market movements, we need to examine the key factors that drove the summer rally. One significant contributor was the easing of financial conditions, which allowed for a short volatility dispersion trade to develop. This trade sent the S&P VIX Index (VIX) to pre-pandemic levels and pushed the 1-month S&P 500 correlation index to its highest point since 2018.

This shift in financial conditions masked the underlying weakening story beneath the stock market’s surface. The top 7 stocks in the market dominated the gains, while many others struggled to keep up.

The Changing Times and Possible Multiple Contraction

Given our current position in the market cycle, it is unlikely that we will revisit the highs seen in July. The one scenario that could lead to a strong rally is if financial conditions ease once again. However, with the Federal Reserve committed to keeping rates restrictive and the significant increase in long-end Treasury rates and the dollar over the past months, the chances of a return to summer highs seem highly challenging in 2023.

This higher rate and tighter financial conditions environment may usher in a period of multiple contraction, similar to what happened in 2002. Back then, after a significant rally, the market experienced a contraction in multiples, with the price-to-earnings (P/E) ratio narrowing. If history repeats itself, we could see multiples contract back to levels seen in October 2022, erasing the gains from the summer and pushing the S&P 500 below 4,000.

Watching Credit Spreads and their Impact on Equities

Another crucial aspect to consider is the widening of credit spreads. The P/E ratio has room to contract, as credit spreads remain tight. When credit spreads widen, the S&P 500 earnings yield climbs, and stock prices and P/E ratios decline. The current spread is around 4.43%, compared to the peak of 6.1% in October 2022. Unless the market perceives Treasuries as riskier than junk bonds, rates on high yield debt may increase to match the rise in Treasury rates.

The Fed’s Role in the Continuing Tightening Cycle

Based on market-based expectations of headline inflation, it is likely that the Federal Reserve will continue to tighten monetary policy over the next six months. This tightening is a response to strong growth and higher inflation expectations. As a result, rates on the back of the Treasury curve may rise, and the yield curve may steepen further. These dynamics would lead to tightening financial conditions, higher implied volatility, and lower P/E ratios, ultimately resulting in lower stock prices.

Technical Challenges and the Failed Breakout Attempt

From a technical perspective, the S&P 500’s recent performance is also cause for concern. The index not only fell below the August 2022 highs but also dropped below the February 2023 highs after failing to surpass resistance at the April 2022 highs. This failed breakout attempt and the breaking of the uptrend from the October 2022 low suggest a negative trend for the market.

Looking Ahead: The Dwindling Bull Trap

While the Federal Reserve may have initially allowed some easing of financial conditions, the current environment calls for tighter policies and sustained tightness in financial conditions. This will likely lead to higher implied volatility, lower P/E ratios, and lower stock prices, completing the massive bull trap that we’ve experienced during the summer rally.

As investors and traders, it is crucial to stay informed and analyze market trends. By understanding the current financial landscape and the factors driving market movements, we can make educated decisions that align with our investment goals and risk tolerance.