Market Conversations: Looking for the market bottom: Are we there yet?

Brian Levitt:

I'm Brian Levitt.

Jodi Phillips:

And I'm Jodi Phillips. And today we have Talley Leger. Talley's an equity strategist at Invesco, and he's here to provide his views on whether or not the U.S. equity market has hit bottom and what might come next.

Brian Levitt:

Jodi, I hope he's going to tell us that the market has hit bottom or near bottom. I mean, I think my 401(k) would appreciate that.

Jodi Phillips:

Oh yeah, mine too. My college savings. My blood pressure would like that a lot as well. Look, I've heard you and Talley both call this an “everything” bear market. So how did you manage your emotions during this time, Brian?

Brian Levitt:

Well, you're assuming I managed my emotions.

Jodi Phillips:

Yeah, big assumption there.

Brian Levitt:

But maybe the fact that it was an “everything” bear made it a little bit more palatable. I mean, there just weren't too many places to hide this year, so you didn't end up kicking yourself for not being in other spots. I mean, I guess cash, I suppose, although it's not the greatest proposition when you're losing 8%, 9% after inflation in your cash.

Jodi Phillips:

Brian, the one thing I felt good about was I had that emergency cash stash, so thanks for that perspective. But look, I know how much you love your historical comparisons, so it has to help to know we've seen this before and that we've come out the other side, right?

Brian Levitt:

Yeah. I mean, we've seen this a couple of times in the last two years now. I'm trying to remember who said it. I don't know, it was one of those quotable investment gurus when they were asked how it felt to lose 25% of their net worth, and their response was, "Well, it felt the same as it did the last four times it happened."

Jodi Phillips:

Oh, ouch. Yeah, not great. That's how it feels, it feels not great. But it also feels not great to miss the upturn. And I know that there have to be some market timers who weren't happy being on the sidelines in October and that big day the market had around mid-November.

Brian Levitt:

Yeah, of course. And we've said it so many times that the great months, the great days always seem to occur during challenging times. And so trying to miss the worst days, oftentimes you end up missing a lot of the best days. And of course, as you point out, October was like the 11th best month. November 10th was like the 15th best one-day. And of course, that happened right after investors pulled, according to the Investment Company Institute, $27 billion from equity strategies. So we can't help ourselves.

Jodi Phillips:

Got to keep perspective. It's about staying above the noise. And that's why we have Talley here. So Talley has a list of market bottom indicators to help keep us focused on what really matters. And Brian, I've just got one question for him: Are we there yet?

Brian Levitt:

I mean, you sound like the kids in the backseat of the car. "Are we there yet? Are we there yet?" It's funny. I always answer them, "No, I wouldn't still be driving." But then someone says, "Are we getting closer?" Yeah, I certainly hope so, unless we made a wrong turn. And so I guess Talley will be our global positioning system here to tell us if we're on the right path.

Jodi Phillips:

Excellent. How did we ever survive road trips before GPS? I don't know. But I guess I'll add a few more questions to my list then. If we’re bottoming, what comes next? What does a stock market recovery typically look like? What are you seeing now, and what kind of leadership do you expect in a time like this? So let's bring him on, Brian, to answer.

Brian Levitt:

You know I love these conversations. Talley, welcome to the show.

Talley Leger:

Great to be back, as always. Lots of questions.

Jodi Phillips:

Absolutely. Lots to ask and lots to answer so thank you for helping. Look, can we just start at the beginning and give us a little bit of context about what happened this year with this “everything” bear?

Talley Leger:

Absolutely. So I think first and foremost, and this is broadly recognized, we had some of the frothiest paces of inflation seen in four decades. So a very different operating environment for most professional investors, and of course individual investors included in that. And in response to hot inflation prints, the Federal Reserve, our central bank, has been tightening financial conditions to cool down this overheating U.S. economy. And I would point out that we've been in this environment of tightening conditions and slowing activity since the first quarter of last year, so bordering on a year and a half to two years. So we've been, I think until recently, in this kind of broad, general de-risking phase of the market cycle.

Brian Levitt:

Basically, Jodi, what Talley is saying there is the U.S. Federal Reserve wanted us to feel less wealthy. And as you and I both said at the start, they have succeeded in making us both feel-

Jodi Phillips:

Mission accomplished.

Brian Levitt:

I'm not sure I ever felt wealthy, but I certainly feel less wealthy now.

Talley Leger:

Well, you know what they say, don't fight the Fed. And I think this was a healthy reminder of that. And my point when I say financial conditions, together we're talking about a dollar that was too strong, bond yields that soared in response to the Federal Reserve's efforts in raising interest rates, the spread between corporate bond yields and their Treasury counterparts widened. And of course, as we're discussing, we had sharp drawdowns in stocks. So you put it all together, the Fed did its job and tightened these financial conditions, and that's the transmission mechanism for monetary policy. It's the channel through which the Fed really engineers these desired economic slowdowns.

Brian Levitt:

Don't fight the Fed. Very good advice. Talley, when did you first get concerned? I remember talking to you at the beginning of the year and I think we even wrote a blog, what is the nightmare scenario? So when did you first start getting concerned?

Talley Leger:

Yeah, so I would say that I started getting concerned at the tail end of the first quarter of this year. Now technically, hindsight, as we know, is 20/20, so I wish I nailed it in January. But at least I had a change of tone and heart as we had this kind of counter trend. I think it was an 11% rally in the stock market in the context of what we would eventually recognize as a downtrend in the market. And we've had several of these sharp bear market rallies. We had another one in June into July over the summer. But yeah, that would be my long answer. I started getting concerned around the end of the first quarter of this year.

Jodi Phillips:

So Talley, as we mentioned in the intro, you have a list, a dashboard of market bottom indicators that you look at, that you update to keep us focused, to keep perspective. Can we walk through a couple of those? Can you point out a few that you rely on and what they're telling you?

Talley Leger:

Yeah, so that's the problem with putting out these frameworks. You're married to them, especially when they get popular and everybody asks you. And as a paranoid analyst, I'm always second guessing myself and questioning myself, hey, was this the right mix of indicators to serve up to folks? And I mean, look, it worked well in 2020 and I thought it has done a pretty decent job of taking the pulse of the downdraft in stocks so far.

Brian Levitt:

Talley just defined marriage. I'm always second guessing myself and questioning myself as well.

Talley Leger:

That's right. A lot of lessons are healthy reminders here to be taken away. But the point is, I think the answer is the market bottom really depends if you're a glass half full or glass half empty kind of person. And I tend by nature to be an optimist. 

Brian Levitt:

And so walk us through some of these market bottom indicators and which are your favorites and what are they telling you right now?

Talley Leger:

We've made a lot of progress, Brian. At the beginning of the year, we only had one of the eight. The first one was the bull-bear spread, talking about the investor sentiment survey. That sentiment survey has been deeply bearish, very negative all year. It was the only one that we had back in January, and it actually helped keep me disciplined in saying, nope, we're not there yet, all year, until some of the others started to kick in. So this is important on the checklist of market bottom indicators.

Another one, while sentiment is important, I think it's also good to have positioning on side as well. And that would be what we call the equity put-to-call ratio. “Put” meaning sellers, “call” meaning buyers. So when the put-to-call reaches a trigger of one or higher, that means you've got technically more sellers than buyers. In the past that's proven to be a very useful contrarian indicator and helps us zig when others are zagging. We now have investors putting their money where their mouths were earlier in the year. So this is a sign of a capitulative wash out low in stocks when you have more sellers technically than buyers. So I thought that was an encouraging one.

Jodi Phillips:

You had mentioned that there are eight indicators. Are there any other ones that you would want to highlight?

Talley Leger:

Yeah, so sticking on the positive side of the checklist for now until we pivot, Brian, I think you'd be happy to hear this one. The Economic Policy Uncertainty Index actually peaked earlier this year and has come down. And I think getting through or past the midterm elections has helped us, at least in terms of removing, if we do have gridlock in Washington, some of that political discord and allowing fundamentals and interest rates and inflation and monetary policy to work their magic for markets.

Brian Levitt:

I'm comforted that we're making progress. I'd like to hear more about the indicators that aren't yet flashing and what are those telling you right now?

Talley Leger:

Yeah, so the two... And I'll say this honestly in my heart of hearts, that while I am an optimist, I'm being positive here, looking for reasons to be bullish, there are two indicators that served me well in 2020 that I quite frankly have not seen this time around yet that would give me a lot more, shall we say...

Brian Levitt:

You'd scream it from the hilltops rather than blog it on our website.

Talley Leger:

That's right. So the point is the VIX, so that would be the fear index, the volatility index, while it has been on the rise and in motion, it didn't give me a reading above 40 that I would prefer to see, meaning more blood in the streets and fear in the marketplace that would be indicative or supportive of this notion of a significant damage in the market that would get me excited as a contrarian.

Brian Levitt:

Some big blowout volatility event that happens.

Talley Leger:

That's right. And we've seen this, and you talk about every generation facing its set of challenges and the Time cover magazines. That's what we like to see, the market kind of climbing the wall of worry and moving from the lower left hand corner of our screens to the upper right hand corner.

Brian Levitt:

Ironically.

Talley Leger:

Yeah.

Brian Levitt:

Talley, the VIX hasn't gotten to 40. What's the second indicator that hasn't flashed yet to give you more comfort?

Talley Leger:

So Brian, it's very similar to the VIX. It's high yield corporate bond spreads above their Treasury counterparts. So again, very similar dynamics. Spreads had been widening as a reflection of this general risk off tone, but we didn't quite get the signs of fear or risk aversion that I would've preferred to see. And this might be a little bit wonky, but I was looking for that spread to reach at least 700 basis points above Treasuries. And it's a low bar, I'm not asking for much, but we never quite got there. And I had been waiting for the major credit event of the cycle. As I've said, when the Fed starts tightening, we were discussing tightening financial conditions, things start to break. And perhaps the crypto debacle, that major news, was the ultimate credit event for the current cycle. And so maybe I got that, at least conceptually.

Brian Levitt:

So it's the crypto exchanges which probably are not sitting in the high yield bond indices. And maybe otherwise it's a testament to the fundamental strength of some of those businesses and those high yield bond indices.

Talley Leger:

That's right.

Jodi Phillips:

So Talley, you divided us into the glass half full contingent … the glass half empty folks. All right, I'll ask you the glass half empty question then. So what's the worst case scenario?

Talley Leger:

I think the worst case scenario, and I was deeply involved in this year's outlook, drafting the scenarios, and I had to give a really good nod to the worst case dark outcome that I think most investors are aware of, that the Fed in response to hot inflation overdoes it in a kind of 1970s Burns or 1980s Volcker style, raises interest rates too much and really breaks the back of the economy.

I think personally, with many of my colleagues at Invesco I'm coming in the middle of the road with kind of a shorter, shallower economic recession. And that gets to the point where we actually have seen some really good moves in stocks. And I don't want to steal our own thunder here, but the kinds of rotation in leadership that would, I think, underscore where we're coming out as a team and as a group on the more positive side of the ledger.

Brian Levitt:

It's interesting you bring up Volcker, because when I think of Volcker, Paul Volcker, of course, the Fed chair in the late '70s, early 1980s, what I think about is inflation peaking in 1980, early 1980, Volcker raising rates through the year. So similar parallels to what we're dealing with right now. Inflation seems to have peaked in the spring. Right now, Jay Powell raising rates through the year. You did have a recession in '81, but if you invested when inflation had peaked, you were pretty happy over the next few years. And so do you think that that is an interesting parallel? Is that one that we can hang our hats on? And how would you start to think about positioning if so?

Talley Leger:

I think that's a really good point. Crazy markets, huh? Did inflation peak before bond yields? And did the economy bottom before stocks? Usually you'd think it'd be the opposite way. But yeah, I mean, look, on that score, and I've got a whole host of different tools in my toolbox to help guide the outlook here. I developed this proprietary supply chain disruption index, which has kind of helped confirm this more strategic... Moving away from the popular technical checklist to the strategic or cyclical bottoming process for stocks. And I think that's really where it starts. And inflation is kind of public enemy number one here, and it has been coming down with an improving supply chain outlook.

Jodi Phillips:

So Talley, thinking about what a recovery could potentially look like, I mean, are we going to go back to the same big names that drove performance last time around, or would we expect to see some broader leadership?

Talley Leger:

I mean, look, I think no two cycles are identical, and we've got our frameworks and our indicators to help investors get their arms and minds around these processes. But look, through it all, I don't think that the business cycle disappears. I don't think that the central bank and all its wherewithal disappears. And these are two really important forces or concepts that help shape our decisions and choices when it comes to broad asset allocation. So yeah, directionally, generally, the things that I would expect in a recovery type of scenario seem to be playing out.

And that really started, I would argue, back in October. So bonds starting to fall at the wayside relative to stocks, meaning stocks have begun to improve and lead the charge generally. Within stocks, the cyclical or pro-economy sensitive sectors of the market have been breaking out here. And even the riskier, smaller-cap value stocks have been perking up and responding to this general improving risk on tone that we're starting to see in the markets.

Brian Levitt:

Now, if the Fed stops raising interest rates, or we get the pause, I don't think any of us are thinking about an easing cycle, but if we get the pause, does that change the environment for the U.S. dollar, and what does that mean for international investing?

Talley Leger:

Well, that's another really interesting point, Brian, that the dollar actually so far, tentatively, is looking like it peaked in October as well, which would confirm exactly what we're discussing about this... And I know it's early, but we want to be forward looking, this general kind of about face in positioning and firming in investor risk appetite. So if the dollar continues to come down, and these are markets, right? They're forward looking, they're real time market variables, they tend to get ahead of the Fed. And perhaps they are discounting, at least a downshifting pace of interest rate hikes from the Fed. And remember, this has been the most intense rate hike cycle that we've seen in decades. So to me it's less about a pause or even rate cuts and really more about a downshifting pace of those interest rate hikes.

Brian Levitt:

Do you know what the biggest challenge, Jodi, with recoveries is?

Jodi Phillps:

What's that?

Brian Levitt:

Everybody misses them. And you know why people miss them is because they're still looking in the rear view mirror, believing that the world isn't good. And by the time things are good, a lot of the market recovery has already happened. It's really, and what Talley seems to be saying, it's really about things getting a bit better relative to expectations, inflation better to expectations, the Fed tightening starting to slow a bit. And that's how recoveries begin. I guess they say it's always darkest before dawn, which isn't necessarily true, but that's what they say.

Jodi Phillips:

More philosophical than I was expecting to get, Brian, I have to say.

Talley Leger:

Well, Brian, maybe this is sharing too much or oversharing, TMI as they say, but in our personal investing conversations, as you know, I have stuck to the plan, I stayed buckled in. You reminded me of that in your Compelling Wealth Conversations program and Financial Literacy program. And with my existing holdings, I own a lot of equities, especially US midcaps. So I did benefit from one of the, if not the best, Octobers that we have seen in a long time, I think, months to be invested in stocks at all. So I benefited there, but I'm still, as I've said to you, I'm still kicking myself, this is the greed factor coming in here, for having not put new money to work sooner to reap the rewards of that fantastic October.

Brian Levitt:

Well, and if we do see a recovery and the beginning of a new cycle, then I would assume you'd have ample opportunity to take advantage.

Talley Leger:

That's right.

Jodi Phillips:

So Talley, before we wrap up, I always like to ask our guests, what didn't we ask you that we should have? What else didn't we cover that you think is important to point out?

Talley Leger:

Thank you. And I wanted to bring us back because there was something I was playing around with, being a fan of building indices. And this goes back to my point about being a paranoid analyst. So this time around, second guessing the personal kind of human judgment and intuition, the assessment of the indicators on the tactical side, the checklist, what if I got it wrong? What if my lens is distorted or cracked? So I tried in that spirit to remove myself from the decision making process by trying to coax out or introduce a sense of statistical significance to the eight indicators. And the way I did that, not to get too wonky here, but I used a Z score transformation to try and express each one of these indicators in common units of standard deviation away from their respective means.

Brian Levitt:

That's what I was going to do.

Talley Leger:

Yeah.

Jodi Phillips:

Beat you to it.

Talley Leger:

That's a dorky way of saying I just took myself out and I just let the data and the statistics... We all remember our statistics from high school math and first year…

Brian Levitt:

And what did it tell you?

Talley Leger:

Well, I'm happy to say that it told me that after having expressed this thing in common units that we can all understand, standard deviations, it's a variability concept, we actually had a north of 2-Sigma event in late September, which now, again, in hindsight, as I said, is 20/20, looking back perfectly explains from a contrarian perspective, we had so far peak risk aversion, and that was the setup for a fantastic month of October.

Now, having said that, it wasn't the level of significance that we saw, say, back in early 2020 or 2008 or 2009. Those were 4+ Sigma events, really massive dislocations in markets. But again, I think the story here at the end of the day, is this market draw down is probably shaping up to be something along the lines of a shorter, shallower contraction.

Jodi Phillips:

Well, as a paranoid investor, I'm glad to know that paranoid analysts are crunching the numbers the way that you are. Thank you for that.

Brian Levitt:

And we may not be there yet, Jodi, but it sounds like we're certainly getting closer.

Jodi Phillips:

Yeah, that was my one question. We're not there yet, or we wouldn't still be driving, but we're getting closer.

Brian Levitt:

Well, Talley, thank you so much for joining us. This was very informative. I hope you can enjoy some time over the holiday season where you can step away from your advanced statistics and maybe enjoy some time with friends and family.

Jodi Phillips:

Have some half full glasses.

Talley Leger:

That's right. Thanks, guys. It was great to be on. Good talking.

Jodi Phillips:

Thank you.

 

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Important Information

 

Some references are U.S. centric and may not apply to Canada.

All figures are in U.S. dollars.

The opinions expressed are those of the speakers, are based on current market conditions as of November 22, 2022, and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

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In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.

The risks of investing in securities of foreign issuers can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.

Stocks of small and mid-sized companies tend to be more vulnerable to adverse developments, may be more volatile, and may be illiquid or restricted as to resale.

A value style of investing is subject to the risk that the valuations never improve or that the returns will trail other styles of investing or the overall stock markets.

Inflation prints refer to Consumer Price Index reports issued by the U.S. Bureau of Labor Statistics. In June 2022, U.S. inflation reached a 40-year high of 9.1%.

According to the Investment Company Institute, investors pulled $27 billion USD out of equity mutual funds and exchange-traded funds in September 2022.

According to Bloomberg, October 2022 was the 11th best month for the S&P 500 Index in 35 years, rising 8.1%. Nov. 10 was the 15th best day for the index since 1957, rising 5.5%. The index experienced an 11% rally from March 8, 2022, to March 29, 2022.

The S&P 500 Index rose from a level of 136 on Jan. 1, 1981, to a level of 330 on Dec. 31, 1991.

The American Association of Individual Investors Bull-Bear Spread is the net percentage of positive minus negative respondents to the association’s sentiment survey.

The Chicago Board Options Exchange Equity Put/Call Ratio is a measure of seller relative to buyer positioning derived from the options market.

The Economic Policy Uncertainty Index utilizes U.S. newspaper archives to gauge the level of policy-related economic uncertainty.

The Chicago Board Options Exchange Volatility Index®, or VIX, is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices.

The Bloomberg U.S. Corporate High Yield Average option-adjusted spread measures the spread of US dollar-denominated, below investment-grade, fixed-rate corporate bonds above their Treasury counterparts. When the spread is wide, investors demand high compensation for taking risk.

The Supply Chain Disruption Index includes the Institute for Supply Management manufacturing and services supplier deliveries, backlog of orders, and inventories; the Baltic Exchange Baltic Dry Index, which is a composite of the bulk time-charter averages; spot prices for dynamic RAM chips measured by inSpectrum; and the Drewry Hong Kong-Los Angeles container rate per 40-foot box.

A basis point is one hundredth of a percentage point.

A Z-score is a numerical measurement that describes a value's relationship to the mean of a group of values. Z-score is measured in terms of standard deviations from the mean.

Standard deviation, or Sigma, measures a range of total returns in comparison to the mean. A 2-Sigma event, for example, refers to returns that are two standard deviations away from the mean.

Risk aversion is the tendency of an investor to avoid risk.