Is recent market weakness a hiccup or the start of a bear? … the truth about returns in a rising rate environment … why the markets will likely turn north … timing the bottom

 

This week, the Nasdaq officially dropped into “correction” territory (meaning down 10%+ from the most recent high). As I write Friday morning, it’s down 12.5% from its November high.

Meanwhile, the S&P 500 has fallen 7% from its recent high, and the Dow, about 6%.

Today, we turn to our technical experts, John Jagerson and Wade Hansen, of Strategic Trader for some perspective and crystal-ball-gazing.

Is this a prelude to something far worse? Or just another localized valley as the market prepares to scale another peak in this bull run?

Let’s find out.

***It’s not time to panic

For newer readers, John and Wade are the analysts behind Strategic Trader. This premier trading service combines options, insightful technical and fundamental analysis, and market history to trade the markets, whether they’re up, down, or sideways.

Returning to recent painful market action, here are John and Wade with some perspective on the declines:

Although market drops are usually faster than market rallies, the two weeks it took to drop this far are a little slower than average for a bearish move. This indicates that although sentiment is negative, there isn’t any panic.

Is the decline related to the Fed raising rates, rising inflation, the Omicron variant causing work and school outages, or is this a natural retracement following a rally? Although this is probably a combination of all four factors, the connection with the Fed is tough to ignore.

As John and Wade point out, there are similarities between this recent drop and one from last September.

As you’ll recall, there were concerns then about Fed policy which resulted in the 10-year Treasury yield spiking. But it’s the speed of this spiking yield that was the real problem both then and now.

Back to John and Wade:

The issue here is that typically stocks and interest rates trend together. So, rising 10-year yields wouldn’t be a concern in a normal market.

However, once the rate of change increases to a certain point, that positive correlation breaks down.

You can see a comparison of current volatility with what was happening in the third quarter of 2021 below.

Source: TradingView

If investors from 15 years ago could see us worrying about a 10-year yield that was still below 2%, they would think we were crazy.

Still, traders have gotten used to easy money, and what worries investors today is how much higher rates might constrain growth or pop the value “bubble” in stocks.

As to John and Wade’s point that stocks usually climb alongside rising interest rates, it’s important to underscore this reality.

The central fear today is “rising rates will doom stocks.” That’s a false narrative.

What roils markets is “too much, too fast” when it comes to surging yields and rates. But measured increases actually correlate with strong market returns.

See for yourself. Here’s MarketWatch:

…during a Fed rate-hike period the average return for the Dow Jones Industrial Average is nearly 55%, that of the S&P 500 is a gain of 62.9% and the Nasdaq Composite has averaged a positive return of 102.7%, according to Dow Jones, using data going back to 1989 (see attached table).

Source: Dow Jones Market Data

***Why John and Wade aren’t worried

Some investors are panicking.

Just look at today’s reaction to Netflix earnings. The company beat both top- and bottom-line estimates, but is down a whopping 25% because of guidance suggesting slower growth.

This is what panic looks like.

John and Wade are not among this group. Here they are explaining why:

Worried? No.

But this is annoying, and any time the market drops like this, it can be a little stressful.

As we have said many times over the last few weeks, bear markets are scarce when earnings growth rates are still positive.

Now that we have a few more reports under our belt, it looks likely that earnings will be up 24% in the fourth quarter.

These estimates are always in flux. And the latest data suggest the number could be even higher.

For this, here’s FactSet, which is the go-to data analytics company used by the pros:

Based on the five-year average improvement in earnings growth during each earnings season due to companies reporting positive earnings surprises, it is likely the (S&P 500) index will report earnings growth of nearly 30% for the fourth quarter, which would be the fourth consecutive quarter of (year-over-year) earnings growth at or above 25%.

So, we have what should be a strong earnings season, combined with the historical data we just examined pointing toward healthy returns in a rising rate environment.

Given this, for the moment, let’s assume we’re experiencing a localized valley within a longer-term growth story. If that’s true, the question for traders becomes, “when will the bottom be in?”

***Looking for support

Let’s go straight to John and Wade:

In our view, technical analysis will be our best guide here.

The S&P 500 is closing in on convergence between two trend-based support levels.

The first is horizontal support near 4,534, where buyers stepped in the last two times the market dropped. The second is a long-term trendline support level near the 4,560 region.

We expect a high probability of a bounce between those two technical levels.

Once that happens, we can estimate the potential upside in the long term.

This projection is based on the information that we have available to us right now, so it is provisional, but we think it would be a mistake to bet against the market at this point.

Source: TradingView

As I write Friday, the S&P is below this level, trading around 4,464. We’ll be watching to see where it finds support.

***Lots of potential rebound catalysts are out there

John and Wade point toward several additional reasons why the market could soon turn the corner.

First would be strong earnings that changes collective market sentiment, refocusing scared investors on the actual strength that’s in this market.

Second is the Fed. John and Wade write “If the Fed signals more patience about raising rates considering the effect of Omicron, stock traders are going to jump back in quickly.”

Third is the U.S. Dollar. It’s been rising in recent days, which makes U.S. assets more attractive.

So, putting everything together, here’s John and Wade’s bottom-line to take us out today:

The early fourth-quarter reports look good, although there have been a few misses that were disruptive – like JPMorgan Chase & Co. (JPM), The Goldman Sachs Group (GS), etc.).

Market volatility is high, which isn’t unusual for earnings season, but the pace of rising rates has made traders a bit more bearish than usual.

As long as earnings continue to look positive, we will watch the market indexes’ technical levels to confirm that a bounce is coming before the end of January.

Have a good evening,

Jeff Remsburg