Recently, overseas markets have seen increased volatility, especially with the U.S. stock market experiencing a significant pullback last week following the release of disappointing earnings reports from Tesla and Google. On July 24th, the S&P 500 and the Nasdaq Composite fell by 2.3% and 3.6% respectively, marking the largest single-day declines since the beginning of 2022, which has attracted widespread attention and even panic. In addition, commodities such as copper and crude oil have also continued to weaken, creating a situation where risk assets are falling across the board. Coupled with the market's "ingrained" impression that interest rate cuts and recessions often go hand in hand, concerns about the U.S. economy gradually falling into a recession are increasing. However, attentive investors may also notice that if we simply use the term "recession trade" to summarize, the performance of some assets is hard to explain, such as the sharp drop in gold, the rise in long-term U.S. Treasury bond yields, and the steepening of the U.S. Treasury yield curve.
Determining the exact position in the cycle is crucial for grasping the main asset trends. Where is the U.S. economy heading: towards recession, recovery, or stagflation? Are the current global markets and assets trading on a recession? What exactly are the recent market plunges and the chaotic assets trading on? We will provide analysis and answers in this article.
I. Is it a "recession trade" currently? Unlikely, as there are no clear signs and foundations of a recession; long-term bonds, the yield curve, and gold trends do not align.
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We do not fully agree that the current market is trading on a recession, mainly for the following two reasons: First, there is no clear evidence and signal that the U.S. economy is facing recessionary pressure. The just-released U.S. Q2 GDP annualized quarter-on-quarter growth rate of 2.8% not only greatly exceeded the expected 2% but also significantly outperformed the first quarter's 1.4%; the overall and core PCE for June also exceeded expectations. If the general pullback in risk assets has growth factors, it is more about a slowdown in growth, rather than a recession.
Second, the performance of some assets is clearly inconsistent with a recession trade. Assets that typically benefit from a recession, such as long-term U.S. Treasury bonds and gold, have generally weakened recently. During the sharp drop in the U.S. stock market, gold fell by 2.2%, and U.S. Treasury bond yields approached 4.3% from 4.2%. If the sharp drop in the U.S. stock market signifies a "recession trade," then recession-benefiting safe-haven assets such as gold and U.S. Treasury bonds should have risen. Moreover, the yield curve showed a "steepening" with short-term rates falling and long-term rates remaining flat, which does not conform to the characteristics of a recession trade. If the market is trading on recession expectations, the yield curve would more likely show a decline in both short and long-term rates with the short end falling more quickly. We reviewed past recession cycles and found that before a recession, the 2s10s spread and the 10-year U.S. Treasury bond yield were often like this. However, recently, long-term bond yields have not changed much or have even risen slightly, while the 2-year U.S. Treasury bond yield has quickly fallen, trading on easing expectations, which also does not align with the characteristics of a "recession trade."
II. So, what is the market trading on? There are factors of slowing growth, but more so, it is the profit-taking amplified by macro uncertainty and trading factors.
If it's not a recession trade, then what is the market trading on? Indeed, the pullback in some risk assets cannot be said to have no growth factors, but it more reflects a normal slowdown in growth (otherwise, the Federal Reserve would not and would not need to cut interest rates), so simply equating it with a recession would be an exaggeration.
In contrast, we believe that the recent volatility in risk assets, especially in the U.S. stock market, is more due to the accumulation of excessive gains in the previous period, catalyzed by macro variables to take profits (such as the rotation of funds from "big to small" in the U.S. stock market after the expectation of interest rate cuts heats up, and the Trump trade's suppression of copper, oil, and new energy), and further amplified by sentiment and trading factors (such as some hedge funds choosing to temporarily close previous trades before high volatility and unclear direction), leading to increased volatility and "confusion" in logic. Specifically,
► The underperformance of leading individual stocks, such as Tesla and Alphabet, is the direct trigger for the sharp drop in the U.S. stock market. Alphabet, the parent company of Google, met overall expectations for its Q2 performance, but YouTube ad revenue was below expectations [1]; Tesla's overall performance was below expectations, and automotive revenue fell by 7% year-on-year [2]. The performance of both companies was announced on the 23rd and fell by 5.0% and 12.3% respectively on the 24th, dragging down the overall market performance. Leading individual stocks have been the main drivers of the U.S. stock market's significant rise since 2023 and have a large profit-taking position, so their performance has a strong demonstration and amplification effect on the overall U.S. stock market. Currently, the market value of the top technology companies in the U.S. stock market (MAAMNNG) accounts for as much as 30% of the total market value, significantly exceeding the 16% during the internet bubble period. It seems that the concentration and even "bubble level" is very high, but their revenue, operating cash flow, and net profit as a percentage of the overall non-financial comparable scale have risen to 12.3%, 24.1%, and 28.4% respectively, far higher than the 5%, 9%, and 12% during the technology bubble period.
► The Trump trade and the interest rate cut trade are intertwined, leading to increased macro uncertainty and triggering asset rotation. On the one hand, macro uncertainty will naturally lead to increased volatility, such as changes in expectations for interest rate cuts and uncertainties in the U.S. election results and policies. We reviewed historical situations and found that before the November election month, intense election situations would suppress risk appetite, the VIX index would rise, and the U.S. stock market would perform poorly. The early start of this round of election debates by a quarter led to the election trade being advanced as well, and the rise in Harris's polls after Biden's withdrawal also increased the uncertainty of the election situation, leading to a reversal of the previously heated Trump trade.Additionally, with the rising expectations of interest rate cuts, assets have also seen a rotation from leading technology stocks that previously relied on the numerator to small-cap stocks that benefit from the liquidity of the denominator, often referred to as a "big-to-small" shift. Coupled with the fact that technology stocks have accumulated substantial profit-taking positions and underperforming earnings, this has further amplified the rotation and switching of funds. The "Trump trade" has also put significant pressure on certain technology stocks, copper, and oil assets.
Clustering and technical factors have amplified volatility. Prior to this round of decline, the RSI of the S&P 500 on July 10th once exceeded 80, indicating an obvious overbought condition, with gold and copper also nearing 70, both in a relatively "euphoric" state. The ratio of bullish to bearish options in the U.S. stock market approached the highs of July 2023 (which was also the period of the last U.S. stock market correction), and the speculative net long positions in gold and copper were also above the 90th percentile since 2000. The sharp short-term market decline may have also triggered the liquidation of some trades.
III. Where has the market fallen to? Technology stocks lead the decline, with risk premium being the main drag, copper is close to being oversold, and financial conditions tighten.
U.S. technology stocks are leading the decline, with a shift towards a cyclical style. The current decline in the U.S. stock market is not a universal fall but rather a spread from the clustering around technology stocks. Since the peak on July 10th, the S&P 500's communication services and information technology sectors have led the decline with a drop of 10%, but real estate (up 4%), energy (up 3%), finance (up 2%), and industrials (up 2%) have still risen. After the pullback, the RSI of the S&P 500 and the Nasdaq index has fallen from over 80 to 46.1 and 40.9, respectively. The CBOE U.S. stock market bearish/bullish options ratio has risen from a low of 0.61 to 0.74, but it is still low, at the 33rd percentile since 2015.
The risk premium is the main drag. With the risk-free interest rate essentially unchanged and profit expectations also remaining stable, the contraction in valuation is mainly due to the rise in the risk premium, reflecting the dominant role of sentiment. The U.S. stock market's "seven sisters" fell by 11.5%, with the rise in the risk premium dragging down 12.1%. The Dow Jones index still rose by 2.2%, with profits contributing positively.
At the level of major asset classes, gold's overbought condition has eased, copper is close to being oversold, and U.S. Treasuries are near overbought. After this round of correction, gold has eased from the overbought range, with the RSI falling to 51. Copper is approaching the oversold range, with the RSI already at 31. The U.S. Treasury index is close to being overbought, with an RSI level of 61.
It is worth noting that the recent general decline in risk assets, without a significant increase in safe-haven assets, has led to a tightening of financial conditions, which is actually conducive to the implementation of interest rate cuts by the Federal Reserve. The recent volatility has caused the financial conditions index to rise from a low of 98.9 on July 16th to 99.3, a new high since June 10th. Tightening financial conditions help to suppress demand and inflation, and the volatility of risk assets also helps to suppress the wealth effect, which in turn helps to facilitate the implementation of interest rate cuts by the Federal Reserve in September. Imagine if the market had recently been "euphorically" trading on interest rate cuts or Trump 2.0, with U.S. stocks, copper, and oil surging, and U.S. Treasury yields falling rapidly, which could lead to stronger economic data in the next one or two months, adding uncertainty to the September rate cut. At the beginning of the year, it was precisely the excessive trading of interest rate cuts that caused the Federal Reserve to postpone the rate cut, as the saying goes, "the less you expect a rate cut, the more likely it is to happen."
IV. Are there risks of recession and bear market? Adjustments are a normal phenomenon before interest rate cuts and slowing growth, but they should not be simplistically equated with recession.
In fact, we have always believed that the definition of "recession" is relatively vague. First, there is no strict definition of a recession itself; the NBER's recession cycle provides a more official definition, but the data is very lagging; two consecutive quarters of negative GDP growth are also not a strict indicator of a recession. Second, there is an essential difference between a simple economic slowdown and a recession in trading, with the former being able to recover quickly after the Federal Reserve adjusts financial conditions, as reflected in assets such as the U.S. stock market before and after the interest rate cut in 1995, which did not fall, and the U.S. stock market in 2019, which had a phased pullback but quickly regained its upward momentum. Therefore, simply equating a normal and minor slowdown in growth with a recession may lead to overly pessimistic views on risk assets and overly optimistic views on safe-haven assets.
Our judgment of the current situation is that the economy is in a slowdown channel (which is why the Federal Reserve needs and can cut interest rates), but there are no signs or foundations for a recession. The U.S. economy itself is in a slowdown channel, but the slope is more gentle due to the unexpected leverage added by residents and businesses at the beginning of the year. Due to healthy balance sheets, financing costs that are only slightly higher than the return on investment (for example, the mortgage interest rate for residents is basically equal to the rental return), and the "rolling" misalignment between various parts of the economy such as consumption, real estate, and investment, which form a hedge, all make this cycle distinctly "atypical," so there are no obvious signs or foundations for a recession, unless there is an unexpected external shock. Next, if the Federal Reserve starts an interest rate cut cycle, it can instead promote the repair of interest rate-sensitive sectors, such as real estate and investment, to hedge against the gradually slowing consumption of resident services.In this process, it is also normal for growth and profitability to decline. Taking 2019 as an example, under the same background of a soft economic landing, U.S. stock earnings and valuations also experienced a period of upward earnings during the interest rate hike cycle, with valuations under pressure; when interest rate hikes ceased, valuations remained under pressure, and earnings were also under pressure; after the start of the interest rate cuts, valuations were the first to recover, while earnings continued to be under pressure. Against the backdrop of slowing earnings, the U.S. stock market saw corrections of 6.8% and 6.1% respectively before the interest rate cut in May 2019 and during the first interest rate cut in July 2019. Other risk assets such as copper and oil also corrected at the beginning and during the interest rate cuts. At the beginning of the interest rate cuts, when earnings and valuations were "out of sync," U.S. stock market volatility would increase, which is also one of the reasons we have been reminding investors to "buy the dip" and "don't buy unless it falls." However, if the medium-term growth prospects are not pessimistic, the downward amplitude is limited, and the Federal Reserve's interest rate cuts can play a positive role, then there is no need to be overly panicked and pessimistic, that is, "you can buy back after a significant drop."
As for the risk of a bear market in U.S. stocks, we believe that the current pressure is limited, and it is more comparable to 2018. Based on the indicator system we constructed in "How Many 'Red Lights' Are Lit in the U.S. Stock Market from the Bear Market Indicator System," comparing the situations at the beginning of the bear market cycles of the 2000 tech bubble, the 2008 financial crisis, the fourth quarter of 2018 earnings inflection point, and the 2020 pandemic impact, we found: 1) The slowdown in fundamental expectations is closer to the situation before the interest rate cut after the 2018 rate hike, not a crisis scenario. The current growth expectations are weakening, as are economic leading indicators (LEI index) and PMI, with rate-sensitive sectors such as investment and real estate at the bottom of the cycle, and consumption has also slowed down. However, in the context of this "rolling" slowdown, the probability of recession is currently only 30%, and there is a significant difference in household debt pressure, corporate sector profitability and interest payment pressure, and banking system liability levels compared to the crisis period. 2) Valuation indicators are higher than in 2018 but not yet at the 2000 level. The dynamic PE and Shiller PE levels of U.S. stocks are higher than at the end of 2018, but there is still a significant gap compared to the 2000 tech bubble, and the dividend yield/T-bond yield, which measures the cost-effectiveness of equity assets, is much better than in 2000. 3) The concentration of this round of trading is strong, and the volatility is greater than the 2018 level. Whether looking at bullish sentiment indicators or market volatility, they are currently higher than at the end of 2018 but still lower than the 2000 level.
V. Future trends and market points? Corrections provide better entry opportunities, be cautious with the large denominator flexibility in the early stage, and shift to molecular benefit assets after cashing in.
Our base assumption is that U.S. growth will slow down but not enter a recession. For this reason, those trades that rely solely on interest rate cuts for the denominator cannot be extrapolated excessively, and when the interest rate cuts are realized, such trades should "fight and retreat." On the contrary, risk assets that are more focused on the molecular end of pricing are inherently weak before and after interest rate cuts, as we described in the case of 2019, but corrections also provide better entry opportunities.
► For asset classes, the correction of risk assets instead provides a better opportunity for the Federal Reserve to cut interest rates. Therefore, trades that benefit from the easing of interest rates can still be participated in, but due to asset front-running, the easing has already passed half the game. Assets that only benefit from the improvement of liquidity on the denominator side of interest rate cuts and do not have other beneficial logic need to "fight and retreat," such as U.S. Treasuries, gold, and small-cap stocks lacking earnings support. Assets that solve both molecular and denominator problems after interest rate cuts will be better. After interest rate cuts, assets that benefit from the decline in financing costs, leading to increased demand and thereby improving molecular end earnings, will have a relatively higher allocation value. The realization of interest rate cuts may also be the end of the interest rate cut trade, gradually shifting back to reflation benefit assets, such as U.S. stocks and crude oil and other bulk resource products.
► For U.S. stocks, we are generally not pessimistic, so "you can buy back after a significant drop." According to our financial liquidity model and U.S. stock valuation earnings model calculations, the S&P 500 index correction pressure point is around 4900-5100 points, with a short-term technical support level of 5300. With the Federal Reserve's interest rate cut expectations and financial liquidity repair, we expect it to still have the potential to recover to the S&P 500 index level of 5500 points. The correction of technology stocks may be larger, with the Nasdaq correction pressure point around 16200-16900 points, with a short-term support level of 17000, and it is also expected to achieve positive returns at the beginning of the year. In terms of sectors, small-cap growth that benefited from liquidity in the early stage is relatively superior, but "fight and retreat"; later, technology leaders and cyclical stocks that benefit from both molecules and denominators will be superior, and this is the case whether considering the election or interest rate cut trades.
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