Last week’s rally triggered my two-day rule at Tuesday’s close, putting the offense back on the field for the first time this year. The sharp gains all week formed a very decisive V-shape that often signals the bottom of a bear market or major correction. However, sometimes the rally is a sharp recovery within the context of an enduring bear market. There are proponents of both.
On the positive side, sentiment readings and other technical measures strongly support the thought that a bottom was put in. A lot of technical damage had been done. Market sentiment going into last week was dreadful. While the rally was encouraging for bulls, there was no one day of panic, of total capitulation, that often coincides with bottoms. But I may be quibbling.
I have said previously that, in my view, a true bottom needed two things to happen. First, speculation had to reach a climax. While the selling pressure on the most speculative names certainly offered signs of real carnage, I was not convinced that the final washout stage had occurred. The other sign of a bottom is the ability to see blue skies over the horizon. In that regard, we have seen some moderation of interest rates, Fed Funds futures now expect 1-2 fewer rate hikes this year, inflation may have peaked, and GDP remains in positive territory. Earnings have generally been good with a few high-profile exceptions. On the other hand, inflation is still high, the slowing economy comes after only two rate hikes to date, and, most importantly, oil prices keep moving upward. While most investors and economists try to back out food and energy costs when judging the pace of core inflation, oil isn’t just used to make gasoline. We use fossil fuels to heat our homes, run our manufacturing plants, power our utilities, and transport goods to market. Almost all components that go into manufactured products have some fuel costs imbedded within. If you read my notes with any regularity, you know that I often point to Memorial Day as the seasonal peak, coinciding with the start of the summer driving season and the end of the heating season. But the war in Ukraine, and the Covid-lockdowns in China may change that equation this year. Note, I said may, not will. But logically, as more Russian supply fails to get to market and China reopens after lockdown, it would make sense for the price of oil to keep rising this Summer, longer than normal. Any sustained rise will make the inflation fight more difficult. The inflation battle is what is driving central bank action around the world. The stronger the inflation forces, the more central banks will be forced to act.
In addition, while speculation has clearly been reduced, it has happened without any intervention by the Fed to reduce the size of its balance sheet. That is still a future event. The Fed has said that by late Summer it intends to withdraw, through sales and roll offs, a reduction of close to $100 billion per month. Money supply growth is half of what it was last Fall. The savings rate has fallen below 5%. Productivity is down. All these factors suggest challenging economic times, at least through the balance of this year. If there are blue skies peaking over the horizon, I don’t see them yet.
Perhaps said simply, while markets were falling sharply and then recovering just as fast, there was little fundamental cause behind either move. Inflation forecasts, GDP estimates, earnings outlooks and the Fed roadmap have remained the same throughout. About the only change of substance was the aforementioned escalation in the price of oil.
I have noted before that a logical time for a bottom is somewhere between September and October. By then the Fed Funds rate will be close to 2% and investors will be better able to assess how fast inflation is fading and whether a recession is a realistic probability. I also pointed to a market ending its steep downward path of abject fear and morphing into a volatile sideways market through the Summer. Stocks last week rallied 6%. There are now markers below, the lows of the previous week, and above, long-term trend lines that may prove to be resistance to the current recovery. Indeed, it is quite possible that over the Summer a broad trading range of 3800-4400 would seem natural. On the positive side, the economy is likely to continue to grow, as are earnings. Interest rates, after spiking early in the year, seem to be settling within a range. Credit spreads have widened, but not to the point of suggesting that markets are already factoring in a recession. On the negative side, inflation is still elevated, and the Fed has only begun its fight to reduce inflation and overall demand.
So, which way do markets break if they churn sideways for several more months? Here are some keys to look for:
1. The trend in oil prices will be key. Seasonal factors favor some slowdown in the recent rise, but political factors will be more dominant than usual this year. For the fight against inflation to work, oil prices need to moderate at some point. We are already seeing signs of demand destruction at the pump, a good sign.
2. All eyes will be on inflation. Whether you look at CPI, PCE or any other index to measure the trend, hopefully the speed of any decline will be important markers for investors. So far, there are few indications of falling inflation.
3. 10-year Treasury yields have been relatively tame lately, moving between 2.75% and 3.20%. If they stay in that range, it would be good for equity investors. If inflation proves to be more persistent than hoped, a rise toward 3.50% or more would be harmful for equity investors.
4. As noted, I am not convinced that the purge in speculation is over. In fact, I am fairly convinced that it isn’t. Many of last year’s hot names are now on the critical list. There are still dozens, maybe even hundreds, of SPACs more likely to die than survive. Again, watch Bitcoin as a marker of speculation. That, after all, is exactly what it is.
5. Let us not forget that this is an election year. We could end up with an even more bifurcated Congress than we have today. That almost assures that nothing happens. Economically, that’s a good thing.
6. Financial corrections create their own mini-crisis events. We have seen several already. The freezing of nickel markets in London underscores the lack of liquidity which will only get worse as the Fed sells assets. Stable coin has become the newest oxymoron. A few hedge funds have already collapsed and closed. None were of the scale of Long Term Capital Management back in 1987, but who knows? Third world countries like Ghana and Sri Lanka are on the brink of collapse, suffering from too much debt, high import prices and a very strong dollar. It is unlikely we have seen the last such crisis. It is too early to tell whether the next one will be more disruptive than the ones mentioned above.
In conclusion, last week’s rally and any subsequent follow-through are to be enjoyed. It is possible that enough speculation has been wrung out of the market, and that the Fed can still engineer a soft landing without any economic downturn, but it is too early to conclude either. Bear market bounces of 5-10% are common. For the moment, I would treat this as one. The big jump last week brought retail investors back into the market in a big way. At true bottoms, as euphoria morphs into complete fear, that doesn’t happen. Unfortunately, too much optimism remains. Stock prices are back to fair value, but only if you assume current 2023 earnings estimates are accurate. That would only be close to true if the Fed is successful at engineering a soft landing. Right now, I would label that a hope, not an assumption.
If you bought stocks last week, you should be a happy camper. But it may be too late to be aggressive here. The good news is that some stocks had fallen to very attractive levels. If you missed the opportunity last week, a retest of recent lows could give a second opportunity. Looking ahead there are still storm clouds, decelerating growth, an uncertain battle against inflation, and plenty of remaining speculation. Be cautious.
Today, Morgan Freeman is 85.
James M. Meyer, CFA 610-260-2220