Written by David Randall
NEW YORK (Reuters) – A week of heavy selling has rocked US stocks and bonds, and many investors are bracing for more pain ahead.
Wall Street banks are adjusting their forecasts for the Federal Reserve account that shows no evidence of a downturn, indicating further tightening ahead to fight inflation after another rate hike this week.
It’s down more than 22% this year. On Friday, it briefly fell below its mid-June closing low of 3666, erasing a sharp summer recovery in US stocks before paring losses and closing above that level.
“The market is now going through a crisis of confidence,” said Sam Stovall, senior investment analyst at CFRA Research, with the Fed’s intention to raise interest rates higher than expected.
If the S&P 500 closes below its mid-June low in the coming days, Stovall said, it could trigger another wave of heavy selling. This could send the indicator as low as 3200, which is in line with the average historical decline in bear markets that coincides with recessions.
While recent data has shown that the US economy is relatively strong, investors are concerned that the Fed’s tightening will lead to deflation.
The crash in the bond markets added to the pressure on stocks. Yields on the benchmark 10-year Treasury, which move inversely to prices, recently reached around 3.69%, the highest since 2010.
Higher yields on government bonds can weaken the attractiveness of stocks. Tech stocks are particularly sensitive to rising yields because their value is highly dependent on future earnings, which are discounted further when bond yields rise.
Michael Hartnett, chief investment analyst at BofA Global Research, believes that higher inflation is likely to push US Treasury yields to 5% over the next five months, exacerbating the sell-off in both stocks and bonds.
“We’re saying new highs in returns equal new lows in equities,” he said, estimating the S&P 500 will drop to 3,020, at which point investors should “indulge” in stocks.
Meanwhile, Goldman Sachs (NYSE:) cut its year-end target for the S&P 500 by 16% to 3,600 from 4,300.
“Based on our clients’ discussions, the majority of equity investors have taken the view that a hard landing scenario is inevitable,” Goldman analyst David Kostin wrote.
Investors are looking for signs of a capitulation point that the bottom is approaching.
The Cboe Volatility Index, known as Wall Street’s fear gauge, rose above 30 on Friday, its highest point since late June but below the 37 average level that saw a surge in selling in previous market lows since 1990.
Bond funds posted $6.9 billion in outflows during the week ending Wednesday, Bank of America said in a research note, citing EPFR data, while $7.8 billion was removed from equity funds and investors invested $30.3 billion in cash. The bank said investor sentiment was the worst since the 2008 global financial meltdown.
Kevin Gordon, Senior Director of Investment Research at Charles Schwab (NYSE:), believes there are more downsides ahead as central banks are tightening monetary policy in a global economy that already appears to be weakening.
“It will take longer to get out of this predicament not only because of the slowdown around the world but because the Fed and other central banks are heading for a slowdown,” Gordon said. “It’s a toxic combination of risky assets.”
However, some on Wall Street are saying the dips may have been exaggerated.
“Selling has become haphazard,” wrote Keith Lerner, chief investment officer at Trustee Advisory Services. “The increased likelihood of a June S&P 500 breakout may be what it takes to evoke a deeper fear. Fear often leads to short-term bottoms.”
Jake Jolly, chief investment analyst at BNY Mellon (NYSE: NYSE), said the main signal to watch over the coming weeks will be how sharply lower estimates of corporate earnings will fall. He said the S&P 500 is currently trading at about 17 times expected earnings, well above the historical average, indicating that the recession has not yet been priced in the market.
Jolly said the recession is likely to push the S&P 500 index to trade between 3,000 and 3,500 in 2023.
“The only way we’re seeing earnings not shrinking is if the economy can avoid a recession, and right now that doesn’t look likely to be the best,” he said. “It’s very difficult to be optimistic about stocks until the Fed designs a soft landing.”