‘It’s not healthy’: Stocks’ recent advance may signal more pain ahead for the markets. Here’s why

US stocks started the fourth quarter with sharp gains such as the Dow Jones Industrial Average, the Dow Jones Industrial Average,
+ 2.38%
It appears to be heading for its biggest two-day high in more than two and a half years.

But as tempting as it may be to call a bottom in stocks, Nicholas Colas, co-founder of DataTrek Research, said Tuesday that investors should prepare for more near-term carnage as many reliable historical signs of a permanent bottom are still missing from the markets.

Valuations are still very high, Colas said, and although 2022 has seen massive two-way volatility in stocks, historically sharp moves higher tend to indicate that more volatility may be stored in stocks.

We see: Analysts say Wall Street’s ‘fear gauge’ still doesn’t point to a stock market bottom approaching

“We are pleased that US stocks saw a nice bounce today, and it is best to consider this move as just another day in a difficult year,” Colas said.

Although they have been extremely popular since the beginning of 2022, historically, single session increments of 2% or more are relatively rare in the markets. Colas said that since 2013, years with 2% or more fewer accomplishments in a day tended to have stronger year-over-year performance.

The only exception to this was 2020, when the S&P 500 posted 19 daily gains of 2% or more. However, Colas argued that most of these massive moves occurred during the first half of the year, when markets were still reeling from the start of the COVID-19 pandemic.

During the second half of the year, the S&P 500 saw exaggerated moves in just two sessions, as Colas shows in the chart below, using data from DataTrek.

year

S&P 500 Total Return

Number of days with 2% + movements

2013

+ 32%

1

2014

+ 14%

2

2015

+ 1%

3

2016

+ 12%

4

2017

+ 22%

0

2018

-4%

4

2019

+ 31%

2

2020

+ 18%

19 (but only 2 during H2)

2021

+28%

2 days

2022

-22.8% (Price moves through Monday without reinvesting dividends)

14 days

Put simply, S&P’s strong one-day gains (+2%) are not a sign of a healthy market,” Colas wrote.

How do we know that the bottom is inside?

In the past, when long-term bottoms were reached, stocks typically received them with a significant intraday movement of at least 3.5%. This was true of cycle lows that occurred in October 2002, March 2009 and March 2020.

By this benchmark, Monday’s bounce wasn’t significant enough to signal a meaningful turning point.

day after cycle low

S&P 500 . performance

October 10, 2002

+ 3.5%

March 10, 2009

+ 6.4%

March 24, 2020

+ 9.4%

Average

+ 6.4%

Ratings are still historically rich

Colas also argued that stock value is still relatively rich based on a common metric for valuing cyclically adjusted stocks.

Instead of using forward earnings forecasts, or tracking 12-month earnings, the Shiller ratio is based on the average inflation rate of corporate earnings over the past 10 years.

According to Shiller PE ratio, the average long-term valuation of stocks dating back to the 1870s is between 16 times and 17 times cyclically-adjusted earnings. As of Friday, the S&P 500 index — which was created in 1957 — was trading at a profit of 27.5 times, and after Monday’s rally, it was trading at 28.2 times, Colas said.

Does this mean the stock is now cheap enough to warrant a purchase? It depends on one’s overall point of view, Colas said. But the one thing investors can be sure of is that the stock has exited the valuation “risk zone” north of 30 times its adjusted long-term earnings.

Datrick

How about VIX?

The last two prolonged periods of market weakness offer some insight into how the moves in the Cboe Volatility Index, aka VIX, VIX,
-3.49%
It may come into play as investors try to anticipate when the final bottom of the market will arrive.

During the 2020-2021 dot-com explosion, VIX saw “a series of sudden spikes that dented market confidence and valuations.” In the end, it took two and a half years for stocks to bottom out after prices peaked in March 2000.

By comparison, after the 2008 financial crisis, markets fell more quickly — but not before VIX peaked above 80, more than double its intraday high from June.

“As painful as the next few months may be, long-term investors can’t be blamed as they hope 2022 looks closer to 2007-2009 than 2000-2002,” Colas said.

US stocks head for straight gains on Tuesday, with the S&P 500 SPX,
+ 2.65%
rose 2.9% to 3,784, the Dow Jones Industrial Average DJIA,
+ 2.38%
It was up 2.6% at 30,258 and the Nasdaq Composite,
+ 2.98%
It rose 3.3% to 11,174.

Market strategists have attributed the recovery in equities to a decline in bond yields sparked by expectations that the Federal Reserve may need to “pivot” toward a less aggressive rate hike.

Neil Dutta, head of US economic research at Renaissance Macro Research, said in a note to clients on Tuesday that the Reserve Bank of Australia’s lower-than-expected overnight rate hike represented the latest in a string of “gains” for investors betting on the Fed’s pivot.

Dutta wrote: “This is great, but I’m thinking in the back of my mind, this can’t go on.”

Read: What does the hub look like? Here’s how the Reserve Bank of Australia coined a pessimistic surprise.

Colas told his clients last week that VIX would need to close above 30 for at least a few consecutive sessions before a “tradable” recovery can arrive.

We see: Wall Street’s “fear gauge” may be the key to the timing of the next market recovery. Here’s why.

This summoning ended up being true. But unfortunately, the close above 40 in VIX that Colas has been waiting for since spring has yet to arrive.

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