- The recession frenzy that consumed investors this summer has given way to talk of a melt-up in the stock market.
- Chris Harvey, the head of equity strategy at Wells Fargo, sees various reasons why investors could instead be greeted by a 10% correction in the first half of the year.
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It was not that long ago that Wall Street was consumed by recession talk.
The dour atmosphere prevailed for good reason: a reliable recession indicator in the form of the yield curve flashed for the first time since 2007, and trade tensions reached boiling point.
For Chris Harvey, the head of equity strategy at Wells Fargo, that period in the summer seemed like a great time to buy stocks. And it actually was, considering the market’s ascent since then.
But several months into the rally, Harvey says the opportunity has changed from a chance to buy to a chance to sell because “sentiment is just too darn high.” His count of headlines mentioning “recession” based on Bloomberg data is down nearly 70% since August. Also, the CBOE Volatility Index has fallen 40% below its long-term average.
Instead of the ‘r’ word, investors are now talking about a melt-up in stocks.
“The last time sentiment felt this positive (4Q17, on the heels of tax reform) stocks initially rallied in 1Q18 before running head-first into a 10% correction,” Harvey said in a recent note to clients.
This scenario could repeat itself with a 10% correction in the first half of 2020, Harvey added.
3 sources of support are fading
His rationale is not entirely that investors’ exuberance will succumb to the law of gravity. He identified three additional factors that could interrupt the ongoing rally at any moment.
The first is fatigue being felt by “traditional marginal buyers.” They include companies that are buying back shares at a slower pace after a record-setting spree in 2018 that was spurred by tax reform. Harvey estimates that the year-over-year growth of net buybacks slowed to a -5.7% pace in 2019 from 50% in 2018.
The second source of support that is fading lies in the credit market, Harvey said.
He attributes nearly all of the S&P 500‘s gains in 2019 to expansion in the price-earnings ratio; investors were willing to pay higher multiples on stocks because the yields they got from fixed income shrank. If rates or credit spreads do not fall further, as Harvey expects, investors may rethink the valuations they’ve ascribed to stocks.
Last — and by no means least — is that the Federal Reserve may pause its balance-sheet expansion in the first half of the year and knock the market off its perch.
Despite these risks, Harvey expects stocks to round out next year on a higher note. His year-end target for the S&P 500 is 3,388, implying a roughly 5% gain from current levels
“If we do see a healthy equity sell-off in 1H20, we would buy weakness, all else equal,” Harvey said.
He added, “Until that time, we recommend reducing portfolio risk slowly and opportunistically.”
One area investors may want to start paring their holdings is semiconductors, which Harvey downgraded to “neutral” from “outperform.” He flagged the industry’s 28% total return over the past 12 months as running well ahead of the S&P 500, which earned 16%. Also, its relative forward P/E has expanded into the 95th percentile over the past six years.
On the other hand, real estate investment trusts are trailing the market and trade near “technically oversold levels.”
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