For many investors, the past two years have been nothing short of a roller coaster. In 2021, nothing could go wrong, with the major U.S. stock indexes climbing to new highs and the benchmark S&P 500 (^GSPC +0.19%) navigating a peak correction of a mere 5%. In 2022, the wheels fell off the wagon.
Last year, the ageless Dow Jones Industrial Average (^DJI +0.19%), broad-based S&P 500, and growth-focused Nasdaq Composite (^IXIC +0.10%) all fell into a bear market and produced their worst full-year returns since the Great Recession: down 9% for the Dow, 19% for the S&P 500, and 33% for the Nasdaq.
Image source: Getty Images.
The big question on the minds of new and tenured investors is simple: What happens next for stocks, following an abysmal 2022?
Based on one indicator, it's crystal clear where Wall Street's top money managers expect stocks to head next.
Hedge funds have placed a clear bet on the direction stocks will move
With an abundant number of surveys and metrics at investors' fingertips, there's no shortage of ways to gauge sentiment on Wall Street. However, one of the more intriguing ways to determine the thinking of the smartest money managers at the world's top hedge funds is to follow their aggregate positions in S&P 500 futures -- derivative contracts that predict the future price movement of the S&P 500.
Earlier this week, Liz Ann Sonders, the Chief Investment Strategist at Charles Schwab, took note of a sizable shift in collective hedge fund sentiment on social media platform Twitter.
Hedge funds currently sitting with largest net short position in S&P 500 futures since late 2011 pic.twitter.com/pqvTCbtmiA
-- Liz Ann Sonders (@LizAnnSonders) April 11, 2023
As you can see from her tweet, hedge funds are sporting their largest net short position in S&P 500 futures since the latter half of 2011. With short-sellers expecting the price of a security to decline, it clearly shows that Wall Street's brightest money managers are expecting the S&P 500 (and futures contracts) to fall.
Numerous metrics and indicators support the possibility of additional downside
A combination of valuation-based metrics and recession-probability indicators support the possibility that stocks are headed lower.
For instance, the S&P 500's forward-year price-to-earnings (P/E) ratio on April 10 was 18.1. While this is more or less in the middle of its forward P/E range over the past 25 years, it represents a lofty multiple, given how many negative earnings revisions we've witnessed from S&P 500 companies of late.
To add, the S&P 500 hasn't bottomed from a significant pullback over the past quarter of a century with a forward P/E north of 14. In 2022, the S&P 500's forward P/E ratio never dipped below the mid 15s.
10 Year-3 Month Treasury Yield Spread data by YCharts. Gray areas denote U.S. recessions.
In addition to valuation-based metrics, a confluence of recession-probability tools points to trouble ahead. Even though the U.S. economy and stock market aren't linked at the hip, no bear market has found its bottom after World War II prior to a recession being declared.
The best example I can offer is the Federal Reserve Bank of New York's recession probability indicator that examines the spread (difference in yield) between the three-month and 10-year Treasury bond to determine how likely it is that a recession will occur within the next 12 months. With the yield curve highly inverted and indicative of economic turbulence, the probability of a recession as of March was 57.77%. This is the highest reading in four decades.
With the exception of October 1966, anytime the N.Y. Fed's recession probability indicator has topped 40% since 1960, we've had an economic downturn.
Other recession-probability tools, along with an incredibly rare decline in M2 money supply, concur with the near-term bearish sentiment expressed by hedge funds.
Image source: Getty Images.
Wall Street's brightest money managers may be a contrarian indicator
However, being bearish alongside the world's top money managers could be a fool's bet.
Digging a bit deeper into the data posted by Liz Ann Sonders reveals hedge funds took large net-short positions in S&P 500 futures contracts in late 2011, during the second half of 2015, during the second quarter of 2020, and, as noted, right now. In the three previous instances when net-short positions peaked, fund bearishness proved to be a contrarian indicator, with stocks eventually exploding higher from a short-lived swoon. It's quite possible we're witnessing a reactive, not proactive, move from hedge funds.
Something else to consider is that Wall Street and its investors tend to be forward-looking. Even if you throw the kitchen sink at corporate America and its investors, history very clearly shows that buying and holding is a tried-and-true moneymaking strategy.
Market analytics company Crestmont Research has, for years, examined the rolling 20-year total returns, including dividends, of the S&P 500. Crestmont has found that if an investor (hypothetically) purchased an S&P 500 tracking index at any point since 1900 and held that position for 20 years, they would have generated a positive total return 100% of the time (104 ending years, 1919-2022). Regardless of the noise bearish indicators and metrics make from time to time, the long-term trend of the Dow, S&P 500, and Nasdaq Composite on Wall Street is decisively "higher."
As one final note, optimists have a little history on their side, as well. Two weeks ago, Carson Group's Chief Market Strategist Ryan Detrick pointed out that when the S&P 500 closes out the first quarter of a year with a gain of at least 7%, the market has always finished the year in the green (16 out of 16 times). Further, in 15 of 16 previous instances where the S&P 500 gained 7% or more in the first quarter, the market gained even more ground between April 1 and December 31. The S&P 500 closed out the first quarter of 2023 with a gain of (drum roll) 7%.
Collectively, hedge fund money managers are smart folks -- but history may not be on their side.
