The RiskSIGNAL Report - The Bear Market Phase II
The RiskSIGNAL Report - The Bear Market Phase II
If you’ve been paying attention, you probably noticed that there was some inflation news released last week, and stocks are trying to inch their way back up. Is this good news? Is the bottom in?The US NY Empire State Manufacturing Index was reported for August at -31.30. This is VERY typical of a recession.
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 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 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.
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Best regards,
-Kurt
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Kurt S. Altrichter, CRPS®
Fiduciary Advisor | President
Email: kurt@ivoryhill.com | ivoryhill.com
8400 Normandale Lake Blvd, Suite 920, Bloomington, MN 55437