This article is written on OCT 6, 2021
Scenario analysis shows most likely scenario is a rally into YE
Many investors are tempted to say that equities suffered so much damage in the past two weeks, that the ability of stocks to rally into YE is diminished. I believe the opposite, actually. Using scenario analysis, I think the most likely scenario, the highest probabilities, is a rally into YE.
The two key pivots are:
– Omicron developments –> more lethal or milder
– Fed tapering –> still “hawkish pivot” or “dovish” walkback
Let’s look at each scenario separately and then look at them combined
SCENARIO: Omicron either more lethal or milder –> I assign 95% probability it is milder
Omicron is a key pivot. Many skeptics caution that clinical data will not be known for months. But that was not the case with Delta. Incoming data on cases showed quickly the healthcare severity of the Delta-variant.
– if Omicron is more lethal, this is a negative development, obviously
– if Omicron is milder, this is a meaningful positive
– if milder
– shows subsequent variants might be less lethal
– border restrictions lift
– consumer confidence will not be as shattered
– I think odds of a “worse” Omicron are only 5%
– if Omicron was worse than expected, I would see more doctors sounding the alarm
– instead, I have multiple media stories on Omicron cases, but not about “death surges”
SCENARIO: Fed stance –> markets can still rally even if Fed tapers at faster pace, because this doesn’t hurt economic recovery
There is a bit of market amnesia regarding the Fed. It was just months ago that investors were begging the Fed to accelerate the taper timeline. In fact, many pundits even said the Fed was creating great harm by delaying the start of a taper.
– so the sell-off associated with a Fed “hawkish pivot” is simply short term, in our view
– this is position squaring and “sell first, ask later”
– hence, the dramatic increase in cash on the sidelines
– why do I think markets can rise even if Fed remains “hawkish pivot”?
– it is priced in, especially looking at cash balance surge + VIX surge
– economic recovery is not harmed by Fed tapering
But I also think the Fed could reverse and walkback towards a “dovish stance” if Omicron is worse than expected. Or if there remains tumult in markets.
– a dovish pivot would be a positive surprise
– mostly, as long as it is not due to financial conditions deteriorating
I don’t have any real insight into the odds here. Nor do I have any idea what a dovish pivot means. But we also think it is better to look at this through the lens of the market:
– I think Fed accelerating bond purchases is priced in, to an extent
– given the 5% decline in equities, a lot of this is priced in
– hence, I don’t see downside
– and given investors thought this was needed, means eventually stocks will resume their upwards trajectory
– I assign this a 50% chance
COMBINED SCENARIOS: Based on the above, I see 3 of 4 scenarios leading to a market rally into YE
The probabilities that I assigned above are just our own judgements, and do not reflect a necessarily science-driven result. But it serves as a framework for looking at the chance for what could happen into YE. I have 4 scenarios:
– BAD –> Omicron more lethal + Fed hawkish –> 2.5% cumulative probability
– NET GOOD –> Omicron more lethal + Fed dovish walk-back –> 2.5%
– GOOD –> Omicron milder + Fed hawkish –> 47.5%
– GOODER –> Omicron milder + Fed dovish walk-back –> 47.5%
Overall, 3 of 4 see markets rally. You might ask, why would equities rally if the Fed is accelerating tapering? Foremost, unless tapering weakens the economy, this should not harm financial markets.
– moreover, interest rates have fallen in the past week
– lower rates = support for P/E
– and creates more TINA
Thus, stocks should rally.
But you get the bigger picture. While there was a lot of carnage in the past few weeks, this does not negate the probability of a strong equity rally into YE. That remains our base case:
– our YE target remains S&P 500 4,800.
– I realize that is a tall order
– and the future is uncertain
SECTORS: Leadership still Cyclicals/Early-cycle aka Epicenter
Relative sector performance is shown below and as I can see, 5 sectors are showing positive relative trend:
– Basic Materials
– sort of Financials/Banks
These are all cyclical groups. And also have general positive exposure to reflationary trends. Inflation, incidentally, in isolation is not a bad word. The real risk to markets is:
– too much inflation hurting consumer confidence
– or unanchored inflation expectations, fear of uncontained inflation
This is not necessarily what markets seem to be pricing. If markets were worried about either of the above, Defensive stocks or Growth stocks would be leading. Instead, I am seeing Cyclicals lead.