Why this latest market weakness isn’t likely to turn into a bear market … what investor sentiment is telling us today … the right perspective on rate hikes

 

When the stock market gets slammed, it’s critical that investors accurately identify the cause.

Is the volatility due to a shorter-term influence? In which case, stocks will grind through the painful selloff but then continue an upward march?

Or is the volatility due to something more significant? More of a systemic cause that suggests bear market losses are coming?

Properly identifying the reason behind the declines can make a tremendous difference in the returns of the average investor. That’s because too many investors misdiagnose volatility as the start of a brutal bear market that leads to selling stocks that should be held. Often, markets find support then turn north, leaving scared investors on the sidelines and missing out on strong gains.

Here in 2022, we’ve seen the Nasdaq fall as much as 15%, while the S&P’s pullback topped 10%. As we noted in yesterday’s Digest, this has rattled many investors. We highlighted research from Jason Goepfert at Sundial Capital showing that hedges on U.S. stocks have risen to the highest level in nearly two years.

But in recent days, we’ve seen markets right themselves (not including yesterday’s and today’s reaction to the latest CPI numbers). In last Friday’s Digest, we asked, “is this market support the beginning of sustained gains, or just a dead-cat bounce?”

Our technical experts from Strategic Trader, John Jagerson and Wade Hansen, believe it’s real. And in their most recent update, they detail why they’re confident it’s not the beginning of a bear market.

From John and Wade:

In last week’s update, we explained that a true bear market is very unlikely while the underlying fundamentals, jobs, wages, and earnings growth were all positive.

So far, it looks like our more optimistic outlook has been justified.

To John and Wade’s point, this earnings season has been strong. That’s despite some high-profile misses from select tech companies like Meta (Facebook).

Though FactSet’s weekly earnings data isn’t released as I write, as of last Friday, with 56% of S&P 500 companies reporting actual results, 76% of S&P 500 companies have reported a positive earnings per share surprise. And 77% of S&P 500 companies have reported a positive revenue surprise.

Such strong corporate earnings do make a recessionary bear market in our near future unlikely.

***But all eyes are on the Fed and its approach to tightening interest rates

Obviously, the number-one issue for the economy and investors today is inflation… which influences Fed policy… which could lead to a recession if there’s a misstep.

Yesterday, we learned that January’s Consumer Price Index number came in at 7.5%, topping the already-nosebleed forecast of 7.2%. This is putting significant pressure on Federal Reserve Chairman Jay Powell to raise rates enough to tamp down this inflation.

But when it comes to raising rates, “too much too fast” is a bad combination.

Back to John and Wade:

The biggest potential snag for the market remains the rate of change of interest rates.

Rising rates themselves aren’t an issue for stocks; a slow rise in interest rates and stock prices actually have a strong positive correlation.

However, when rates rise very quickly, it can drag on stock returns in the short-term.

Building on John and Wade’s point about strong returns in a rising rate environment, 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.

Source: Dow Jones Market Data

If you’re having trouble reading the chart, the short takeaway is that all three major indexes tend to post strong gains during rate-hiking periods.

But as John and Wade pointed out, when rates climb too fast, it can roil the markets. And that’s the greatest market risk as 2022 plays out.

A moderate pace of rate hikes has been priced into stocks. But the higher inflation goes, and the longer it remains elevated, the stronger the case that a quarter-point raise here and there won’t accomplish much.

That brings into play the potential for hikes at each Federal Open Market Committee (FOMC) meeting this year, combined with the possibility of half-point rate hikes – something that hasn’t happened since 2000.

That situation elevates the risk of “too much, too fast.”

But even before the March FOMC meeting, climbing yields could lead to market volatility. In recent days, we’ve seen the 10-year Treasury yield pop higher. Yesterday, it topped 2% for the first time in more than two years. As I write Friday morning, it remains over 2%.

John and Wade write that the climb in the 10-year Treasury yield “is faster than we would like to see. If rates continue to rise at this speed, then we will likely see another round of volatility like we did in January.”

***Have investors overreacted?

A moment ago, we mentioned yesterday’s Digest and analysis from Jason Goepfert and the high degree of hedging that’s happening today.

Goepfert’s equity-hedging index just climbed above 80% for the first time since April 2020. But this is actually a bullish indicator.

His research finds that this is only the 33rd week in 22 years that it’s been above that threshold. After 27 of those weeks, the S&P 500 rallied during the next couple of months.

But that’s not the only sentiment indicator suggesting markets are likely to push higher.

Here’s John and Wade:

JPMorgan analysts have shown that every time the VIX (the market’s “fear” index) rises more than 50% off its 20-period moving average, the market rallies.

The only time the signal fails is during economic recessions. That signal was triggered on Jan. 25, which signals additional upside from where the market is now.

We have run tests similar to this and found a slightly higher failure rate if you go further past 2008, but its track record is still better than 80%.

This view conforms to what we already know about behavioral finance; investors habitually overprice near term issues and underprice long term risks. So, the likelihood that investors oversold the market in January is high.

The next FOMC meeting will be on March 15-16. With yesterday’s data, along with Powell’s past comments, it’s a certainty we’ll see a quarter-point raise. The real question is whether or not we see a half-point raise.

Either way, we wouldn’t expect sustained fireworks in the market from that raise (unless it’s due to unexpected commentary from Powell). In fact, the CME Group’s FedWatch Tool now puts the odds of a half-point hike in March at 58%, so market participants are getting used to this idea.

The potential for meaningful market volatility due to rate hikes increases later in the year if we see a continuance of hikes beyond the market’s pain point.

But for now, we’re looking for excessive pessimism to pave the way for the markets to grind higher.

Here’s John and Wade to take us out:

We agree with JPMorgan’s analysts that for a variety of reasons, traders were too pessimistic in January and that the major indexes will regain their prior highs.

Have a good evening,

Jeff Remsburg