The RiskSIGNAL Report: Do Bear Market Rallies Turn Into Long-Term Bull Markets? - Issue #11
After the June lows, the S&P 500 is up 13% and the Russell 2000 is up 18%, and a lot of investors think we are back to business as usual.Because of this, investors think the mid-June low was the bottom in this bear market and we’re well on our way to new highs.Market conditions say otherwise.
Do Bear Market Rallies Turn Into Bull Markets?
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 battle field 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 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 had 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.
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Kurt S. Altrichter, CRPS®
Fiduciary Advisor | President
8400 Normandale Lake Blvd, Suite 920, Bloomington, MN 55437