• Stocks are up more than 23% since last October.
  • But the rally isn't likely to last, warns Rayliant's Phillip Wool.
  • Wool said a likely recession, poor market breadth, and rising interest rates threaten stocks.

Stocks are once again in a bull market, with the S&P 500 now up more than 20% since October's lows.

Phillip Wool, a portfolio manager at $17 billion asset management firm Rayliant, would add four letters to that description: "Stocks are in a bull@#$! market," he wrote in a June 12 note to clients, the censors his. 

The market has been on a tear in recent months due in large part to investor enthusiasm about artificial intelligence and what it means for the profit margins of stocks most involved in it. But Wool says the AI hype is taking investors' focus off of fundamentals, and is fueling a rally driven by only a small percentage of stocks.

Weak market breadth

"We see this year's rally in AI stocks on the back of ChatGPT hype as fanning the flames of investor greed, spurring a 'fear of missing out' that accounts for no small part of the recent run-up," Wool said in the note.

He continued: "That view is backed up by data on individual investor trades, which point to a marked increase in exposure to tech shares over the last few weeks. Indeed, stats from VandaTrack show retail investors purchasing over $1.5 billion worth of US stocks in a single day in late May, concentrated in tech names, while single-stock call option volume has dramatically outpaced trading in puts over the last few weeks."

Looking at the Wilshire 5000 index, Wool highlighted that money is more concentrated in top stocks than during the dot-com bubble a little over two decades ago. Nearly all of the recent rally can also be attributed to the index's top 10 stocks, he said. 

"During the late-90s tech bubble, over one-third of returns came from these mega-cap stocks," Wool said. "In the recent bull run, by contrast, almost the entire market return was accounted for by just ten companies' performance."

wilshire 5000 market concentration
Rayliant

Weak breadth has been a hot topic on Wall Street in recent weeks, as it can signal that a rally is unsustainable. 

"Historically, narrow leadership has been a hallmark of late-stage bull markets rather than the start of a more prolonged upswing," said UBS CIO Solita Marcelli in a recent note.

According to research from LPL Financial, when 0-48% of stocks in the S&P 500 are trading below their 200-day moving averages like is the situation currently, the index's returns are usually negative over the following one-, three-, six-, and 12-month periods.

market breadth and subsequent performance
LPL Financial

Alarm bells still signaling a recession ahead

The excitement that has pulled some traders off the sidelines and driven the market upwards has Wool worried that investors have forgotten about recession warnings. 

He said Rayliant's models show a "very high likelihood" of a downturn.

Classic recession signals like an inverted Treasury yield curve and The Conference Board's Leading Economic Index have been signaling a downturn is ahead for months now. Both are shown below.

yield curve inversion
Federal Reserve Bank of St. Louis
LEI
The Conference Board

Wool pointed out that the Federal Reserve's recession probability model, which is based on the Treasury yield curve, now assigns a 70% chance of a downturn in the next 12 months. 

recession probability
Federal Reserve

Consumers are also burning through savings they've built over the last few years, Wool said, as indicated by credit card debt and loan payment delinquencies rising. 

"Fundamentals still matter…eventually," Wool said.

This sentiment that investors are ignoring fundamental signals of a downturn is shared by other strategists. 

"The excitement about generative AI has distracted investors from the possible risks of a looming recession," said Lauren Goodwin, an economist and portfolio strategist at New York Life Investments, in a note this month.

Morgan Stanley's Mike Wilson echoed these thoughts, though the bank is not calling for a recession for the broader economy.

"Investors are more bullish than in early December, or at least far less bearish, given optimism around technology diffusion, specifically artificial intelligence," he said in a note. "While we believe AI is for real and will likely lead to some great efficiencies that help to fight inflation, it's unlikely to prevent the deep earnings recession we forecast for this year."

Still, some see a soft landing scenario ahead for the economy. The labor market continues to impress, with the US economy adding 339,000 jobs in May, well above expectations. Inflation has also fallen to 4%, prompting the Fed to pause its rate hike campaign this week. 

Wool doubts the Fed is done hiking however, citing the market's view. According to the CME Group, traders assign nearly a 75% to the Fed hiking another 25 basis points at its July meeting.

The Fed's continued hawkishness will weigh on the economy and earnings, Wool said.

Where stocks go from here

Wool said in an email to Insider on Friday that he expects the S&P 500 to fall 15% in a "simple downside scenario," or back to October lows (closer to a 19% decline) in a harder landing scenario.

That's probably less severe than during a normal recession because the economy is still hanging in there, he said. Nevertheless, it's a still a bearish outcome. A 15% decline would put the S&P 500 at 3,800.

In addition to recession worries and poor market breadth, Wool said the Treasury issuing what could be more than $1 trillion in new debt this year would also send interest rates up, hurting stocks.

Wool's view is slightly more bearish than the average Wall Street strategist's year-end price target of 4,000 for the index. But bigger bears do exist.

Morgan Stanley's Wilson has 3,900 year-end target, but has said that the index could fall to a range between 3,000-3,300 before then. Piper Sandler's Michael Kantrowitz also sees the S&P 500 falling to 3,225 by the end of 2023 as a recession unfolds in the second half of the year. 

Incoming data in the months ahead will tell whether or not bearish forecasters are right. For now, a new bull market rages on.