The Bear Market Phase II
In the short run, the market is a voting machine, but in the long run it is a weighing machine. -Benjamin Graham
Our short-term signals have been firmly green for over two weeks now, and the medium-term trend is neutral. The long-term trend is still negative but has dramatically improved. The market is overbought and a 3-5% pullback is warranted and could take place over the next month. Dips look buyable in the short-term, but until our medium-term signals confirm, we view this market as a hold, but I we might use healthy dips for short-term repositioning.
Inflation was the key driver that caused the market to fall 20% in the first half of 2022, and it is the stimulant that has pushed stocks sharply higher over the last month.
A lot of investors laughed at the idea of the Fed's "soft landing," but the market is now pricing this in as not even a possibility, but as a probability. Are investors getting a bit too positive? It really depends on whether or not inflation has peaked or not.
There are many possible outcomes here. If inflation goes down quickly from here, you could argue that the last rate hike will be in September and stocks can go up until deflation becomes a threat. If July's inflation number was an outlier and stays high for a long time, the S&P 500 could drop to new lows. At the moment, things look very risky, but we need to see how the next few months go.
Earlier this year, I listed three keys to a market bottom, and the first (and most important) key was that we achieve peak inflation and peak hawkishness from the Fed, and after last week's CPI data, it's worth examining whether that key to the bottom has been satisfied. In short, no, it has not.
In order for the Fed to declare the rate hike cycle is ending, they have to be very confident that:
The labor market will return to a better state of balance (not happening yet).
That inflation will gradually return to the Fed's 2% target (not happening yet).
That inflation expectations will remain well anchored near 2% (not happening yet).
Yet before we get too excited about a "soft landing", remember that these are the keys to a bottom, meaning we can confidently invest knowing the bottom in stocks is in and downside risk is limited. These are not the keys to a return to new highs.
From a valuation standpoint, to get to highs, we’ve got to be talking about a 19X-20X multiple on $240 for 2023 S&P 500 earnings. That’s not impossible, but it does require an environment that’s characterized by:
Sharply decelerating inflation that’s readily approaching 2%-3%.
A total economic soft landing where growth never really slows (meaning 10s-2s is completely wrong).
A Fed that flips from tightening policy to actively stimulating policy (meaning aggressive rate cuts).
If our medium-term signal firms up, we will be buying these short-term pullbacks. Caution is strongly advised, and moderate-to-tight stop loss orders will be set.
Don't mistake this possible new positioning with our long-term view of the market. We are still bearish over the long term. The market trend is turning, so we want to take advantage of that for as long as it lasts. We can't allow personal bias to blind our decision-making. If the short-term to mid-term trend is turning up, we will be taking advantage of that until conditions change (and I expect them to change before the end of the year).
I am favoring super-cap tech and growth over value during this phase of the bear market.
Some areas to possibly look for opportunity are the Vanguard Mega Cap Growth ETF (MGK), Invesco QQQ Trust (QQQ), and iShares U.S. Technology ETF (IYW).
I will be sticking to ETFs over individual stocks so we can dampen volatility while remaining nimble. This allows us to be fast and fluid as we are scaling in and out of positions.
We will be aiming to be 40%-60% invested, using moderate to tight stop orders to minimize potential losses.
Again, our midterm signals must confirm in order for us to start adding long-positions.
Why is the market going up?
The recent bull market narrative is to "buy stocks on the Fed's dovish pivot." Let's set aside our personal beliefs and look at market history, more specifically previous Fed hiking cycles and how that impacts the stock market.
I have been studying the historical Fed tightening cycles and their association with equity price bottoms.
I found it interesting that in over 66% of historical examples, Fed rate hikes have ended long before the bottom in stock prices. Or, said differently, markets continued to decline long after the Fed finished tightening. Specifically, the average market price bottom came a full 21 months after the last rate hike, with a minimum of 10 months afterward and a maximum of 41 months.
What does this mean for the current tightening cycle and equity markets? As the market is still pricing in another pair of 50 bps hikes at the next two meetings (September and November), this would imply that the likely earliest bottom in prices would be in October-January, but more likely (based on history) would not occur for a year or more after the Fed’s final rate hike of this cycle.
Hopefully, this provides a sane antidote to the bullish catnip being handed out these days.
Do I think the bottom is in?
No one knows if the June lows were the bottom or not. Our macro-recession model is showing a very high probability that we will enter a recession. In the last two recessions (2001 and 2008), we had huge rallies, much bigger than the rally we are experiencing today. Those rallies sucked a lot of people into the market at the absolute worst time. Why? because every single chart looks like it does today with higher lows, higher highs, and the VIX going to 20.
The charts always look like this during bear market rallies. Markets are designed to suck the greatest number of people in at the most inopportune time.
Investors have loved the media narrative over the past month, but this economy is not out of the woods yet. China just reinstituted some COVID-related lockdowns, which could tighten up supply chains again and halt some of the progress on inflation, and the housing market continues to contract. It’s still a little early to tell, but there’s certainly no lack of optimism around Wall Street that we may be clearing the worst of economic conditions and heading back down the other side of the mountain. With growth and high beta stocks up 15-20% over the past month, it’s probably worth tempering expectations a bit going forward because the rate of change we’ve seen over the past several weeks is likely unsustainable.
I think everyone needs to calm down. This has been a good little run, but we can’t ignore the conditions surrounding this market right now. Here are a few things to consider.
Bear Market Rallies Are Normal
Last week I displayed that past bear markets have featured multiple moves higher only to have those rallies fall to new lows. A lot of those rallies had gains mostly in the 6-12% range (we’re on the high end of that currently), but the 2001-2002 tech bubble provides a good example of exactly how volatile stocks could get under the right circumstances.
The tech bear market had four rallies of around 20% each before finally hitting the bottom that established the start of the bull market. The 2022 bear market included an 11% climb in March and a 7% bounce in May that both lost legs to go higher. The current rally off of the June low is around 14-15%, so it’s not necessarily "out of the range" of past bear market rallies that failed to hold. The rally we’ve seen over the past few weeks has been strong, but it’s not a done deal.
Here's another look at bear market history when market cap to GDP hit a then record 150% in 2000:
The Nasdaq 100 Index ETF (NDX) dropped 40% initially from the top, bottomed in late May, had a 43% counter rally ("The lows are in" narrative was all over the wires) before peaking in September and then dropping another 80% over the next two years.
For reference, the US hit over a 200% market cap to GDP in 2021 and the June lows just saw the US bounce off of the 2000 tech bubble top. Now back at 170%.
I am not making a prediction here, but historically, true bear markets don't bottom until much lower valuations with much more excess gone.
The Bond Market is Still Flashing Red Alert
The bond market can usually tell a lot about the economy, and I think they are telling the correct reality. Some people may question how well the 10Y/2Y Treasury yield spread works, but it has been good at directionally predicting terrible market conditions. Not only is the spread negative right now, which has often been a sign of an upcoming recession in the past, but it has always been negative.
This number has only been this low a few times in the last 50 years: from 1978 to 1982, in 1989, and in 2000. And now. In each of these situations a recession came about a year after the inversion. Is this time different? We'll see, but the past narrative says the answer is no. That means there's a good chance that stocks haven't hit rock bottom yet.
The Housing Market Looks Fragile
Lumber is historically a strong indicator of a healthy housing market. The theory behind it is that when the economy is strong, material and commodity prices tend to rise due to the increased demand resulting from higher industrial production and manufacturing. In this case, I’m looking at lumber because there’s a need for building materials in almost every corner of the economy. Lumber is most prevalent in the housing market, where a stronger economy generally means more home construction, home improvement projects, etc. That, in turn, results in higher lumber prices. Also, most peoples' wealth is in their home so this also has a connection to consumer credit.
Over the past two years, there has been a lot of volatility in lumber prices. However, when we look at what has happened to housing prices and interest rates over the past six months, the current 60%+ drop in lumber prices from their top in 2022 feels like the real thing.
In some markets, home prices have reached their peaks, and the number of people applying for a mortgage is falling. At the same time, inventories are starting to grow again. We saw that one of the main things that caused the housing bubble was a lack of homes for sale. If the situation with the supply of homes keeps getting better, the crash in the housing market is far from over.
We've seen the number of homes for sale more than double this year in many cases where prices are at least 20% overvalued. Assuming that all of this new supply doesn't disappear soon, the next step is for housing prices to go down and reflect the change in the supply/demand curve.
We've already seen these changes start to happen in some markets, but it seems likely that they're about to become more national.
Given that GDP growth has been negative for two quarters in a row, inflation is still at 8.5%, the housing market is shrinking, and the Fed is still raising interest rates in a slowing economy, does it seem right that the S&P 500 is only about 12% from all-time highs?
I think that the current optimism about an expected Fed pivot and inflation reaching its peak is a bit much, considering everything else that needs to be thought about. I think our risk signals are mostly right. In the short term, they say to take more risk, but in the medium and long term, they say to take less risk.
It looks like there will be one more big drop before we reach what we can call a firm bottom.
I think we have a little while longer to wait until we get to that point.
Kurt S. Altrichter, CRPS®
Fiduciary Advisor | President