Last week, the Ivory Hill RiskSIGNAL flipped green on a short-term basis, but NOT the intermediate-term or long-term trend, which is still red. The market is very overbought, and a pullback is likely, so be on the lookout for pullbacks to continue, and if our intermediate-term signals flip green, we will begin slowly adding to our positions at a tepid pace as opportunities arise, but tight stops on any new buys will be adhered to.
With our short-term signals firming up, it is still wise to be patient. Do you remember General Custer? He was too quick to run out onto the battlefield and ended up with all the arrows in his back. Be patient, is the story's lesson.
2023 expected S&P 500 EPS are between $230-$240, much higher than feared. So, if inflation is really peaking and if we get to peak Fed hawkishness by the September meeting, then we can honestly say the chances of a “soft” economic landing will increase, and the recent gains in stocks could be justified on a fundamental basis.
But there’s a problem. The bond market is screaming that we are headed for an economic contraction that hasn’t even started yet. The economy hasn’t even begun to really feel the impacts of rate hikes and full quantitative tightening. By September, the FOMC will have hiked 300 basis points in six months. Rate hikes take time to filter through the economy. Normally, it takes years for 300 bps of tightening. Now it’s occurred in six months. There’s a delay on when that tightening actually: 1) Reduces consumer spending, 2) Reduces corporate profits and 3) Causes layoffs (which impacts spending and profits).
Here’s the point: Yes, if CPI peaks and the Fed signals peak hawkishness in September, those are positive events. But the economy still has to digest all this tightening, and that will materially slow things. That hasn’t even really started to occur yet, so celebrating the resilience of earnings and economic data when we’re still in an expanding economy (regardless of the GDP prints) is the same as a coach declaring victory because the game plan should work. Game plans are great, but things change once the game starts, and the “game” of the slowing U.S. economy (which is needed to slow inflation) hasn’t even started yet; we’re still in warmups.
Treasury yields surged on Friday in response to the strong jobs report. The 10s-2s spread got even more negative as bond markets reversed hopes for fewer rate increases, as 10s-2s hit -40 bps immediately following the jobs report.
Bottom line, the 10s-2s yield curve now is now screaming an economic contraction is coming, and the longer it stays this negative the more powerful that signal will become. And while markets remain hopeful for a less hawkish Fed, the bond market is clearly signaling a contraction ahead, and I think it’s wise to heed those warnings from a positioning standpoint.
The US money supply tends to lead the US economy and inflation by roughly nine months. This is probably the most important recession indicator yet. The clock is ticking down.
Many investors believe that the good times may be coming back after July's gains of 10% for the Russell 2000 and 9% for the S&P 500. In the first half of the year, investors were wondering how fast and how high the Fed would raise rates, when inflation would peak, and whether the unanticipated Russia/Ukraine black swan event would come to an end. Peak uncertainty resulted in losses for both stocks and bonds.
But in July, investors' perceptions appeared to be clear. Many predicted that the Fed would reach its terminal Fed Funds rate before the year's end. People started pricing in a drop in commodities and oil prices in the second half of the year even while inflation in the U.S. was north of 9%. Investors even started anticipating Fed rate reductions in 2023 as evidence that things might only get better from here. In contrast to the gloomy first half of 2022, July was filled with unrestrained confidence.
Naturally, that has led a lot of investors to believe that the bear market bottom was in mid-June, and that we are now on track to reach new highs. Since then, the S&P 500 and Russell 2000 have returned 13% and 14%, respectively. Those numbers must be taken into consideration, right?
Undoubtedly, in retrospect, we might realize that mid-June was the bottom. According to history, it's not a done deal. Far from it, in actuality. Since the tech bubble 20 years ago, there have been numerous occasions where stocks have risen by 20% or more from a bottom just to set new lows later, sometimes in a matter of weeks.
The Treasury market over the previous 40 years is a fantastic illustration of how things might go down. Although there were many brief increases in rates along the road, yields had been steadily declining up until this year.
Since the 10-year Treasury yield peaked in 1981, it has surged higher about a dozen times, typically by at least one percent, only to fall and set a new low. Many of those peaks were also followed by a brand new, lower bottom. Investors were "head-faked" in each instance, and yields dropped further. It's interesting to note that although the 10-year briefly reached 3.5 percent this year, breaking the streak technically, it immediately fell back to 2.7 percent.
In the stock market, we have seen a similar pattern over the past 25 years, but it has happened much less often. In each of the last five big market crashes in the past 25 years, stock prices went up and down a few times before going down again to new lows.
Let's examine each one individually.
This bear market had more fake breakouts than most others. Not only did the peak-to-valley trip take more than two years to reach its lowest point and another four to reach a new high point, but the S&P 500 had FOUR 20 percent rallies that didn't last.
The VIX was in the 30s and 40s for long periods of time during this bear market, so it shouldn't be a surprise that the prices of stocks went up and down so quickly. During the first half of 2001, the S&P 500 rose by about 20% in just two months. By October, investors had lost all the money they made.
When stocks went up more than 20% again in the Q4 of 2001, it looked like the rally might go on for a while. It did, though, and stocks kept going up for a few more months. By the summer of 2002, it had also given back more than it had gained. The second half of that year was the most dangerous. The S&P 500 went up more than 20% twice in about 5 months, but each time it went back down. The second 20 percent rally in Q4 didn't give back all of its gains, but it came pretty close. The tech bear didn't end until October 2002, and the S&P 500 didn't start an upward trend again until March 2003.
This is probably the most extreme example of how stocks can go up a lot and then go down again. Investors probably spent a lot of time trying to figure out how to accurately price many of the new tech and internet names when the tech bubble peaked and then burst, which caused a lot of the volatility. But the story shows how quickly people's feelings can change.
The housing market crash wasn't quite as volatile as the end of the tech bubble, but it still had its share of relief rallies that didn't work out.
The S&P 500 was near all-time highs when the first double-digit rally happened at the start of the recession. Since the recovery happened so quickly, investors probably didn't think about a long bear market at the time, but it came. In 2008, the S&P 500 rose by 10 percent or more three times, with a 24 percent relief rally at the end of the year being the biggest. In each case, the rallies didn't last very long. In one case, they didn't even last a month.
As with the tech bubble, it's interesting to note that the most volatile part of this bear market happened at the end. Not long after this point, the bottom was reached, and the stock market began to rise steadily.
2015 Junk Bond Market Crash
This was more of a correction than a bear market, but it had all the signs of a possible recession: weak consumer spending, slow growth in manufacturing, and a complete mismatch between supply and demand in the high yield bond market. At its worst, the S&P 500 fell only a little more than 10% from its highest point, but it went through a lot of ups and downs along the way.
In the second half of 2015, large-caps fell about 10% very quickly before recovering about half of it over the next month or so. After giving most of that relief rally back, the S&P 500 staged a 12% rally that brought the index effectively back to its old all-time high, where it stayed for most of the Q4.
The turning of the calendar to 2016 flipped the script again. Stocks kicked off the year with swift declines and didn’t end up establishing the official bottom until February, more than four months after the prior low. This was a good lesson that a) not all returns to all-time highs will stick and b) establishing new lows can take months or longer to play out.
2018 Fed Pivot
Q4 2018 is known as the "mini bear" because stocks fell by 20% out of fear that a recession in Europe would spread to the U.S. and that the Fed would tighten conditions as we went into this situation. The Fed changed its plans for policy quickly, and the S&P 500 was back to all-time highs before summer even started.
During this drawdown, there were two small relief rallies, each of which was 6 percent and had peaks and valleys that were almost the same. This bear market, if you want to call it that, was a little different because it didn't start because of a specific event. It was more like a constant worry about what could happen that started to get worse.
Even though none of them stuck, the bounces that happened here were not very important.
2020 COVID Recession
Since what happened two years ago was such a black swan, it's harder to really learn much from it. At one point, we were living our normal lives, but a few months later, the whole U.S. economy stopped working. Stocks moved so quickly because they didn't have much time to decide what to do. Things changed so quickly that there was almost no time for a relief rally.
This bear market only lasted a little over a month, though, because the government stepped in with a huge, multi-trillion-dollar stimulus package that fixed everything (I say that sarcastically, of course). During that short but sharp drop, stocks went up by more than 5 percent three times, but each time only for a few days. Even though this was one of the most important events in the world in the last 100 years, there isn't much we can learn about relief rallies from it.
2022 Hyperinflation Bear Market
All of this brings us to the year 2022. With inflation numbers the highest we've seen since the 1970s, the Russia-Ukraine war, and stocks and bonds both falling 20% at the same time, the current situation is its own black swan. Still, the S&P 500 is starting to show some interesting trends.
You might not even know it, but stocks have already bounced back by at least 11 percent twice and gained 7 percent in a third case. The first two lost all of their gains in a month or two, while the third is still up in the air.
The question is whether this year is more like the rough bear markets of 2000 and 2007 or the milder ones of 2015, 2018, and 2020. Since we're already 8 months into this, inflation is still at 9%, the Fed is still hiking into a recession, and all the data shows that this will still get worse before it gets better, it's more likely that it will look like the former.
There were four separate relief rallies in these two bears, but they all ended. So far, we're only on number three. Even though it's impossible to know what will happen, I think it's safe to say that investors shouldn't think the worst is over and the good times are back.
What did we learn from this?
There is no real pattern to how these bear market drawdowns happen, but I think we can learn a few things from them.
During a larger bear market, there are often more than one relief rally, and each one makes a new low.
No one knows how long a recovery can take or how long it can be before a new low is set. It could take as little as a few weeks or as long as a few months. When people say things like "stocks have been going up for a month and a half, so everything is fine again," investors shouldn't believe them.
Even if stocks go back up to their all-time highs after a correction, that doesn't mean they won't go down again.
It's important to keep your eyes open and remain patient here. There seems to be a lot of overconfidence among investors right now, and the past shows that they might be wrong. One of the biggest mistakes investors often make is getting too comfortable, and it could happen again this time. Don't think that the good times will last.
And remember – the one fact pertaining to all conditions is that they will change.
Feel free to reach out to me and use me as a sounding board.
Kurt S. Altrichter, CRPS®
Fiduciary Advisor | President