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 The Federal Reserve's Annual Jackson Hole Summit Occurs This Week. 
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The better-than-expected second-quarter earnings and July consumer inflation (CPI) data helped carry the S&amp;P 500 to over 17% above the June low until stocks declined in the second half of last week. It has been an impressive two-month rebound, with stocks reclaiming 57% of their 24% decline to the June lows. Some have insisted that stocks have never broken the previous lows once they recover over 50% of a bear market decline, but that is not consistent with history. So where do we go from here then?


Bond yields seem to hold much of the answer regarding how stocks trade in the short term. The market low in June came right after both the 2-year and 10-year Treasury yields made their recent peak. As yields have crept up again, the pressure seems to be building on stock prices.

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 S&amp;P 500 And Inverted Treasury Yields 
 Glenview Trust, Bloomberg 
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The stock market overall disguises some of the impacts currently. Still, it is self-evident in the segment of the markets most susceptible to higher rates and a loss of risk appetite. As proxied by the AR 
 AR 
 K Innovation ETF (ARKK 
 ARKK 
 ), the high expected growth and expensive valuation segment shows a remarkable negative correlation with yields. ARKK was a whopping 43% off its mid-June low until this week’s sell-off. As evidence of the impact of higher yields, the ETF was down 62% from its 2022 high at the mid-June low. ARKK is an excellent example because its portfolio has negative estimated earnings in the coming year but is expected to have a superior long-term earnings growth rate. The ARKK portfolio also has a higher valuation, with an estimated forward enterprise value-to-EBITDA ratio of 42-times versus 13-times for the S&amp;P 500.


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 ARK Innovation ETF And Inverted Treasury Yields 
 Glenview Trust, Bloomberg 
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Cyclical stocks had been outperforming staples during the rally off the mid-June lows. Cyclical stocks are more exposed to the economy than staples. The cyclicals outperforming implies that Federal Reserve is less likely to be forced to continue to increase interest rates aggressively, or the market is looking beyond the economic slowdown. There were other pullbacks in the cyclical versus staples relationship during the rally, but the extent of the recent relative outperformance of staples will need to be monitored.


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 Cyclical Versus Staples Stocks And Yields 
 Glenview Trust, Bloomberg 
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The Bloomberg Economics probability of U.S. recession within 24 months remains at 100%. It has been at 100% since April, so the stock rally and cyclical outperformance occurred despite the reading. Interestingly, the odds of a recession within 12 months rose to almost 31% in July from 0% in June. These models use a “range of financial market, real economy, and economic imbalance indicators” to measure the risk of recession. No indicator is infallible, and the analysis is complicated because stocks tend to start rebounding before the economic data recovers.
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 Probability Of Recession Within 2 Years 
 Glenview Trust, Bloomberg 
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The one-year forward Fed Funds futures rate is probably the most crucial variable, which intersects with recession probability and bond yields. This measurement shows what the markets expect the Fed Funds rate to be in one year. The high reading of 4.06% in mid-June corresponded with both the low in stocks and the high in Treasury yields. Expectations for the future Fed Funds rate had been easing but have started to climb, which showed up first in pressure on the high expected growth and expensive valuation segment of the stock market.
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 One-Year Forward Fed Funds Futures Rate 
 Glenview Trust, Bloomberg 
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The Kansas City Federal Reserve bank hosts the annual Jackson Hole summit this week. Historically, this has been a location for some crucial monetary policy signals so that the markets will be listening closely for clues regarding the extent and timing of rate hikes needed. The most closely watched speech will be Chair Powell’s discussion of the economic outlook on Friday. Any increase in the one-year forward Fed Funds futures rate based on hawkish comments is likely to continue the downward pressure on stocks and vice versa.
Given the backdrop, investors should focus on an asset allocation that provides the financial means to persist through the market volatility and the likely economic downturn. Aside from holding some safe and liquid assets to cover living expenses during economic and market turmoil, this downturn should be a long-term buying opportunity for those able to add to stock positions. However, the short-term seems likely to be choppy. Within stocks, investors should focus on quality companies that can survive the looming recession and thrive once the turmoil passes. A company’s ability to increase prices without destroying demand for its products is also critical. Investors should avoid the high expected growth and expensive valuation segment of the stock market. This segment can have sharp rallies, but the risk/reward does not look attractive with possible higher yields and a recession looming.
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Yields likely determine how stocks trade in the short term. Future Fed Funds rate expectations have started to climb again, which put pressure on the high growth and expensive valuation stocks. Chair Powell’s discussion at Jackson Hole on Friday will be crucial to the outlook for future rate hikes.

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