Stock Traders Brace for a Steeper Dive as Fed Ups Recession Fear

(Bloomberg) — A hawkish Federal Reserve dashed any hopes investors had, plunging the stock market into a fatal spiral last week and stoking traders’ fears that even more losses are on the way.

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Any hope that stocks had traded on the bulk of the bad news heading into the Fed’s latest meeting has now been dashed. The S&P 500 has lost more than 4% since midday Wednesday, when the central bank raised rates by three-quarters of a percentage point and signaled a more aggressive-than-expected pace of hikes is on the way .

For the first time since June, traders are paying more to hedge against short-term swings in the S&P 500 than longer-term swings, a sign of confusion about where stocks are headed. Meanwhile, a cascade of estimate cuts by Wall Street analysts sends an equally grim message. Strategists at Goldman Sachs Group Inc., for example, cut their year-end outlook for the broad equity benchmark to a level that implies a 2.5 percent decline from the close of Friday. And there may be more pain to come, strategists said.

“This year’s uncomfortable stock market slump probably won’t end soon,” Yung-Yu Ma, chief investment strategist at BMO Wealth Management, said in an interview. “The reality is that a heavy cloud will continue to hang over stocks in the coming weeks and months until inflation eases significantly.”

Markets are reacting to the clear message from Fed Chairman Jerome Powell’s Wednesday press conference: The struggle to control inflation will create real economic damage. The bets are now stacked that it will cause even more trouble for the stock. On Friday, the S&P 500 nearly erased its two-month rally through mid-August and sent the two-year Treasury yield to the highest since 2007. The stock has fallen at least 3% in four of the last five weeks

Volatility has also returned, with the Cboe Volatility Index, or VIX, briefly rising above 32 on Friday for the first time since June. First-month VIX futures contracts are trading 0.7 volatility points above second-month futures, forming a so-called inverted volatility curve that usually indicates greater investor fear.

The price-to-earnings ratio for the S&P 500 that Goldman Sachs strategists consider fair when rates rise faster than expected is 15 times earnings, a level the bank adjusted from 18 times. The bank cut its year-end S&P 500 outlook by 700 points to 3,600 to take that into account.

Previous bear markets that hit during full-blown recessions have been brutal for the S&P 500, sending it down an average of 35% in the previous nine instances since World War II. A similar scenario could play out again if the benchmark falls below its recent low of 3,666.77 reached in June, said Sam Stovall, chief investment strategist at CFRA (the S&P 500 closed Friday down 0, 7% above this level). it could fall to 3,200, representing a 33% drop from an all-time high and implying a valuation multiple of 14.9 (based on a forward earnings per share estimate of $215), he said.

“This will be a bear market accompanied by a recession, but I don’t think we’re headed for a mega crisis,” Stovall said in an interview. “We may have to wait until the first quarter of 2023 for the final low to finally be reached.”

Of course, the bearish environment is also creating factors that bulls can lean on for the long term.

Dating back to 1995, that nine-month slump has sent stocks into their third-longest streak of extreme pessimism, data compiled by Ned David Research show. But in the year following previous streaks of this decline, the S&P 500 has risen an average of 20%. Adding to the long-term optimism is the hope that the sooner the Fed raises interest rates to the point where it fights inflation, the sooner it can begin to ease.

“For long-term investors, these are the opportunities we’ve been waiting for to buy stocks at bargain prices,” Eric Diton, president and CEO of Wealth Alliance, said by phone. “Bear markets don’t come around that often.”

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