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S&P 500 Forecast: Is the Stock Market Signaling an End to the Economic Slowdown?

S&P 500 Forecast: Is the Stock Market Signaling an End to the Economic Slowdown?

Ryan Grace,

Key Talking Points:

  • Equity sector and factor analysis points to increased investor risk appetite and could be a sign markets are positioning for an acceleration in economic growth heading into the end of this year.
  • Pro-cyclical areas of the market such as energy, financials, and consumer discretionary could be poised to outperform.

Is the post-COVID recovery over or is economic growth about to accelerate into the end of the fourth quarter?

Over the past few months, the labor market recovery has been tepid at best, retail sales growth has underwhelmed expectations, and the rise in costs of basic goods and services is increasing at an uncomfortable pace… leaving some economists to wonder whether we’re doomed to suffer through a period of stagflation.

Now, what I’ve described is generally not a positive environment for equities, and stocks responded in kind, with the S&P 500 pulling back roughly 5% from its all-time high at the beginning of September. Now with that said, the market is a discounting mechanism, and economic data is reported on a lagged basis. So, instead of looking through the rearview, what signals can we use to potentially understand what’s instead on the road ahead of us?

I believe the key to what’s next for markets can be found by analyzing equity sector and factor performance.

To start, let’s look at S&P 500 sector performance across a 1 and 3-month trending basis.

S&P 500 Sector Performance - 10/14/21

S&P 500 Sector Performance, Ryan Grace

When analyzing equity sectors, we’re now seeing a meaningful performance shift away from the defensive positioning evident as recently as a month ago. Pro-cyclical sectors such as Energy (XLE), Financials (XLF), and Consumer Discretionary (XLY) are now outperforming the more interest rate sensitive, traditionally defensive areas of the market such as Real-Estate and Utilities.

Additionally, we’re seeing further confirmation of increased risk appetite when looking at equity factor performance.

Factors are the attributes associated with the outperformance or underperformance of a stock, independent of a company’s fundamentals or operating metrics. As a result, we can use factor analysis to derive signals from a top-down market perspective. E.g., during periods of risk aversion, we might see crowding into, and hence the outperformance of stocks that typically exhibit minimal levels of volatility compared to those with higher betas and longer duration growth prospects.

These factors can often give us a hint as to what the market collectively “thinks” is going to happen next. Now, on both a relative and absolute basis, we’re seeing a trending outperformance of factors more closely associated with the pro-cyclical, risk-on positioning reflected across sectors.

Factors such as small cap, value, and high beta are showing signs of material alpha generation, against what we might consider more defensive exposures in the form of low volatility, quality balance sheets, and large-cap growth.

All of which I believe demonstrates a preference for risk, even in the face of recent volatility and calls for an uncomfortable period of economic stagflation.

Equity Factor Performance - 10/14/21

Equity Factor Performance, Ryan Grace

If we zoom out, we can also see this materializing across broad based equity index performance.

Over the past month the Russell 2000 (IWM) has outperformed both the S&P 500 and the Nasdaq 100, which given the Russell’s higher degree of sensitivity to the health of the U.S. economy, I think this is again a signal that investors are positioning for future growth.

Quite the contrary to how markets have reacted during prior bouts of economic uncertainty.

Russell 2000, S&P500, Nasdaq 100 1-Month Performance – 10/14/21

Russell 2000, S&P 500, Nasdaq 100, Ryan Grace

So, what does this all have to do with the path forward for risk assets and economic growth?

In my view, cyclical stock market sectors and risk-oriented factor exposures would not exhibit the upside momentum currently underway, if investor consensus was pricing in a further slowdown in economic growth. Again, if we believe the market is a machine capable of pricing in the highest probability outcome over the immediate term, these signals, coupled with rising interest rates and declining levels of implied volatility are starting to price in a more optimistic outlook as we head into the fourth quarter.

In other words, we could be entering into a market regime where cyclical businesses and high beta growth names trade much better than they did last quarter.

Though, in closing, it’s worth mentioning these same signals could also offer a helpful sign for when to get out of the water… Should rates reverse and these factors turn south, it’ll be all the warning I need that economic growth is about to get worse.

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---Written by Ryan Grace, Chief Market Strategist at tastytrade

You can follow Ryan on Twitter @tastytradeRyan

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

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