Yesterday was a volatile session of give and take after Monday’s rout. When it was over equities were marginally higher, although the Dow Industrials fell for the fourth straight session. This morning the 10-year Treasury yield sits at 2.93%, less than five basis points higher than where it was as the FOMC issued its statement last Wednesday afternoon. Shorter term rates, notably the 2-year notes, are lower today. The yield curve has steepened.
Somehow the messages of the bond and stock markets over the past four days appear to be different. The bond market’s message says that the Fed is on course to do what was expected before last week’s meeting. It set a course for raising the Fed Funds rate to, and past, neutral before the end of the calendar year. (At least what consensus assumes is neutral.) It also set a path for the reduction of its balance sheet, consistent with prior forecasts. The net result is the bond market has found little reason to change. Yields did move around quite a bit over the past four sessions, but that is typical post-FOMC behavior.
The stock market’s reaction was totally different. After an initial relief rally on Wednesday afternoon, stocks got pounded both last Thursday and again on Monday, falling close to 3% each day. NASDAQ losses were closer to 5%. In between, on Friday and yesterday, there were brief pauses, but a lot of damage was done as the S&P 500 fell below 4000 for the first time in over a year.
Market pundits, of course, have lots of explanations for what happened. They always do. They told us the obvious, that the economy is growing more slowly, that inflation is stubborn, that China lockdowns are causing issues, and that there is a war in Ukraine (really?). Many pointed to the ongoing purge of speculation. Indeed, that was the primary fundamental culprit, but the actual explanation may run deeper, as related to the valuation correction. Last Wednesday’s relief rally made some sense. There were plenty of investors fearing the Fed would take a different path and spook markets. But when Thursday started badly and quickly accelerated to the downside, a lot of active investors were caught on the wrong side of the trade and quickly had to shift directions. Remember two facts. First, a lot of investing today is done with leverage, either with borrowed money or using derivatives. When traders are wrong, they don’t have the luxury of waiting. Thus, quite often they all buy or sell at once, creating serious imbalances. Second, safeguards that used to be in place (e.g., the use of specialists, the uptick rule) have been stripped away, thus making short-term moves more pronounced. In addition, some of those caught in the wrong place at the wrong time may have put themselves in mortal danger. From 30,000 feet we don’t see that, but in the dark pools of trading such panic is quite visible. Trader avarice accelerates the moves up or down. In this market that usually means down. Add in the well-publicized problems over the weekend in the cyptocurrency world and the fire has more fuel. These plunges and surges have no fundamental basis. They will get reversed in time, but they are frightening to be sure.
So, what about the supposed recession, or the lockdown in China, or whatever else may be at the root cause of the declines of the past week? If there is to be a recession, it is highly unlikely it will happen this year. It might happen next year, but it’s simply too early to reach that judgment and too early for the market to drop 3% per day in anticipation of such an event. As for China, remember what happened in 2020. Lockdowns last weeks not years, and when they end growth resumes with a catch up. The lockdown is a disturbance; it isn’t the cause of a bear market.
The speculative purge is real. It is as real as it was in 2000 when the Internet bubble burst. It is as real as it was in 1987 when markets fell close to 40% in less than four months without any recession. When will it end? One hint will be when stocks stop going down on bad news. Look at Coinbase, the operator of the largest U.S. crypto exchange. Its stock was over $300 around Labor Day. Yesterday, however, it declined over 10% in anticipation of weaker than expected earnings after the close. In fact, the earnings were worse than expected, but the stock fell another 10% in the aftermarket. This doesn’t look like a story where all the bad news is discounted. About a dozen similar companies reported results over the past two days, including Peloton and Roblox. All followed similar patterns, weakness into earnings and big declines after. The purge shows no sign of ending, even though these highly visible names are already down 75% or more.
Remember again that many investors are using leverage. Even retail investors. To cover losses in bad stocks, they must sell good stocks. Some of the “good” stocks, like Amazon# or Meta Platforms#, have had their own sad stories to tell. Not as sad as Peloton or Coinbase, but sad enough to send their shares down 20-30% or more so far this year. A year ago, stocks were selling close to 30x forward earnings expectations. Today, the S&P is about 16 times, close to normal. Close to normal doesn’t mean cheap, it means normal. Bear markets usually end when stocks are cheap. It is going to take serious bargains to bring buyers back.
When the Fed raises interest rates and extracts money from the market via a reduction of its balance sheet, the result is less money to invest in all asset classes. It also means that P/E ratios compress, meaning high P/E ratios decline faster than low P/E ratios. The reason is pure math that I won’t get into this morning, but it happens 100% of the time when rates rise and there is a purge of speculation.
When does this all end? At any time, we might get a relief rally. Even in bear markets, stocks at times can fall too fast and create short-term trading opportunities. Some bear market rallies can be quite steep. None recover to previous highs, they just set the stage for a further decline. Some bear markets have two or three phases, with the last usually being the steepest, where all but the strongest hands capitulate. Below are some hints to look for if you are trying to identify a bottom.
1. Stocks stop falling on bad news. We haven’t seen that yet.
2. There are some fundamental “green shoots”, signs out on the horizon that improvement is coming. Today this might include slower inflation, or signals from the Fed that it doesn’t feel the need to raise interest rates further. We haven’t seen that yet either. The Fed only got started raising rates, and it hasn’t taken steps to reduce the size of its balance sheet yet.
3. Pay attention to my 2-day rule. Ignore all sharp rallies that don’t last at least two full trading sessions. That hasn’t happened yet this year. Should it happen, it might not signal an absolute bottom, but it could signal a tradable relief rally.
Right now, we are caught between two influences. One is the eradication of excess speculation. The other is the reaction to tightening Fed policy. The expression “Don’t fight the Fed” is apt. If the Fed stays on target, interest rate increases should end sometime in the first half of 2023 if not sooner. Since stocks look ahead, that suggests the worst of Fed tightening should be over within the next year. That should be discounted no later than this Fall, maybe sooner. As for the speculative purge, many of the names talked about all day on CNBC will be forgotten months from now. Many, yes many, are headed to oblivion or the graveyard. There may be some kind of future for fake meat based on peas, or video games with avatars, but these aren’t likely to be the robust businesses that dominate our economic future. Thirty years ago, gallium arsenide was set to replace silicon, and casinos were going to sprout up in 50 states. We hear the same tales every bull market, only the actors change. I don’t know when today’s purge ends, but we are a lot closer to the end than the beginning. As noted earlier, stocks overall are no longer very expensive, but they aren’t cheap enough to entice very nervous investors to jump back in. Maybe we are getting close.
Stocks are long duration assets. They can be traded, and in the short run during a bull market, they can be traded profitably. But for investors, they are a depository of permanent long-term oriented capital. The ideal investment is in a company that can grow at a sustainable steady rate and provide its owner a secure and rising annual dividend, perhaps supplemented by the benefits of stock repurchased with excess capital. Just as one-hit wonders are an asterisk to the history of Top-40 music, names like Peloton are likely to be an asterisk on stock market history. It isn’t just wannabees like Peloton that get bid up to excessive levels. When the Fed pours new money into markets and Congress adds trillions more, all assets get bid up, ranging from your house to Bitcoin. But the stocks of good companies, with steadily rising earnings and dividends, will ultimately track their records of success. As investors, there is no need to sell any of those names today. To the extent they were overvalued, that has largely been corrected. Just understand that those gems built upon a steam of fake news will never see their former lofty heights again.
Which brings me, finally, to today. By the time you read this the Consumer Price Index for April will have been released. If inflation shows any sign of moderation, it could lead to a rally. Conversely, a higher number would set off more selling. The moves either way could be extreme, aggravated by some of the trading influences I noted earlier. But one month means very little. The Fed is only getting started. A bad number today only reinforces the need for a steady stream of rate increases over the coming months. A good number today is only a blip. Don’t overread today’s news. After today, there will be several weeks with very little news. Retailers will report earnings. Dow component Disney# reports tonight. There the focus will be on streaming. If numbers replicate Netflix’s recent results, they won’t be well received. The key isn’t so much the news as the reaction, as noted earlier. Without much news, markets could be quite volatile. The fight against inflation is just starting. The odds of a recession a year or more from now shouldn’t change. It’s hard to make any near-term call. Longer term, a lot of damage has been done. The leading averages are two-thirds of the way toward a full-fledged bear market. The NASDAQ is already there. I don’t see a real bottom until closer to Labor Day. If there is any solace, markets tend to recover quickly from short recessions and speculative purges. The worst one can do is sell late (capitulation at the end) and buy back much too late. The biggest bull market gains, percentagewise, are always at the beginning. If your nerves overwhelm you, take a little bit off the table to reduce downside risk, but don’t do anything all at once.
Today, Cam Newton is 33. Fashion designer Valentino turns 90.
James M. Meyer, CFA 610-260-2220