Stocks Are In The “Death Zone,” According To This Expert

Stocks Are In The “Death Zone,” According To This Expert

Posted On February 22, 2023 10:05 am

Stocks slipped on Tuesday putting the indices in jeopardy of recording their 4th consecutive weekly decline.

The backdrop to the weakness is the growing realization that the economy, especially the job market, is still strong enough to prevent any form of a pivot, or even a pause, from the Fed.

But hope springs eternal and the bulls new narrative is not, will the U.S. avoid a recession, but there might not be a need to even have to navigate a soft landing. Instead, there will be no landing at all; meaning the economy can continue to grow, albeit at a slower rate, inflation will wane, and stock prices will adjust to a higher interest rate environment.

There are different definitions of recession and I’ve been of the mind that, as far as Main street is concerned, unless there are large lay-offs across lower-paying jobs, such the service industry or manufacturing, it doesn’t quite qualify as a recession. 

For Wall Street, the definition may vary and a recent report from Morgan Stanley (MS) today suggests stocks still have a long way to fall as companies are likely to face an earnings recession in coming months. 

In his latest note, Mike Wilson of Morgan Stanley, who has been spot on for the past year earning him the #1 ranked analyst in 2022 by Institutional Investors survey, wrote,

“The risk-reward for equities is now “very poor,” especially as the Fed is far from ending its monetary tightening, rates remain higher across the curve and earnings expectations are still 10% to 20% too high.”

According to Wilson, that doesn’t bode well for stocks, as the sharp rally to start this year has left them the most expensive since 2007. This according to the measure of equity risk premium, that is the risk of owning stocks relative to the risk free rate of return offered by the bond market, in which one can now earn 4.5%+ a year on a 2-Year Note. 

Wilson says stocks have now entered a level known he calls the “death zone,” suggesting the SPDR S&P 500 (SPY) could drop by as much 26% to around the 300 level by summertime.

The case against a ‘no landing’ scenario is essentially circular; if the economy remains strong enough to avoid recession then the Fed will continue to hike rates, which leads to a higher probability of a recession.

The Fed has its work cut out for itself in trying to navigate a soft landing, but that refers to the broad economy, not the stock market which they seem perfectly fine letting fall.

Our job as traders is to not become too opinionated with our own thesis or outlook nor too stubborn with our positions.

Which is why my students and I only trade what the market gives us, not what we think the market will or should do. Speculation in this business is one of the quickest ways to go out of business.

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About author

Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.