‘This is not healthy’: The latest advance for stocks could signal more pain ahead for markets. Here’s why

US stocks started the fourth quarter with strong gains as the Dow Jones Industrial Average DJIA,
+2.49%
seems set for the biggest two-day rally in more than 2½ years.

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

Valuations are still too high, Colas said, and while 2022 has seen immense two-way volatility in stocks, sharp moves to the upside tend to signal that more volatility may be in store for stocks.

See: Analysts say Wall Street’s “fear gauge” still doesn’t signal the bottom is near

“As happy as we are that US equities recovered well today, this move is best viewed as another day in a difficult year,” Colas said.

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Although very common since early 2022, gains of 2% or more in a single session are historically a relative rarity for the markets. Since 2013, years with fewer single-day advances of 2% or more tended to result in stronger performance over the year, Colas said.

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

In the second half of the year, the S&P 500 saw exaggerated moves in just two sessions, as Colas uses data from DataTrek to show in the chart below.

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 action to Monday excluding dividends reinvested)

14 days

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“Put simply, strong 1-day S&P rallies (+2%) are NOT a sign of a healthy market,” Colas wrote.

How do we know the soil is in?

In the past, when long-term bottoms were hit, stocks typically greeted them with a large intraday move of at least 3.5%. This was true for the October 2002, March 2009, and March 2020 cycle lows.

Based on that benchmark, Monday’s rebound wasn’t big 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%

Valuations are still historically high

Colas also argued that stocks are still relatively highly valued based on a popular measure of cyclically adjusted stock valuations.

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Rather than using expected earnings estimates or past 12-month earnings, the Shiller ratio is based on the inflation-adjusted average of corporate earnings over the past 10 years.

According to the Shiller PE ratio, the long-term average valuation for stocks has ranged between 16 and 17 times cyclically adjusted earnings since the 1870s. On Friday, the S&P 500 — which was founded in 1957 — was trading at 27.5 times earnings, and after Monday’s rally it was trading at 28.2 times, Colas said.

Does this mean stocks are now cheap enough to warrant a buy? That depends on the macro view, Colas said. But the only thing investors can be sure of is that stocks have exited the valuation “danger zone” north of 30 times average adjusted long-term earnings.

DATA TREK

What about the VIX?

The last two protracted bouts of market weakness offer some insights into how movements in the Cboe Volatility Index, aka VIX, VIX,
-3.32%
could play out as investors try to anticipate when the final market bottom might be reached.

During the 2020-2021 dot-com explosion, the VIX experienced “a series of rolling spikes that shattered market confidence and valuations.” Ultimately, it took stocks 2½ years to bottom after peaking in March 2000.

By comparison, markets bottomed faster after the 2008 financial crisis — but not before the 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 for hoping 2022 will look more like 2007-2009 than 2000-2002,” Colas said.

US stocks headed for consecutive gains Tuesday with the S&P 500 SPX.
+2.72%
up 2.9% to 3,784, the Dow Jones Industrial Average DJIA,
+2.49%
up 2.6% to 30,258 and the Nasdaq Composite COMP,
+2.97%
up 3.3% to 11,174.

Market strategists have attributed the stocks rally to a fall in bond yields, fueled by expectations that the Fed may need to “pivot” to less aggressive rate hikes.

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 smaller-than-expected rate hike overnight represents the latest in a series of “wins” for investors they are banking on ” Fed’s Pivot.

“This is great, but in the back of my mind I think this can’t possibly last,” Dutta wrote.

Read: What does a pivot look like? This is how Australia’s central bank staged a dovish surprise.

Colas told clients last week that the VIX would need to close above 30 for at least a couple of consecutive sessions before a “tradable” recovery could occur.

See: Wall Street’s “fear gauge” could hold the key to timing the next market rally. Here’s why.

That call was correct. But unfortunately, the close above 40 on the VIX that Colas has been waiting for since the spring is yet to come.

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