Last Thursday’s bullishness was a headscratcher … what was behind it? … more importantly, what wasn’t behind it? … what about today’s rally?
As I write Monday early-afternoon, stocks are exploding higher.All three indexes are up big with the Nasdaq leading the way at 3.2% gains.Why? What is going on?To answer that, let’s back up to last week…What in the world was that monster rally last Thursday? And did it mark a sea change in market direction?For any readers who somehow missed it, last Thursday’s release of the latest Consumer Price Index showed month-over-month inflation increased at a rate of 0.4%. That topped the 0.3% Dow Jones estimate.Worse, core inflation notched its highest reading in 40 years.If you were looking for a silver lining, you could point toward a continuation of a “cooling” trajectory. The headline number of 8.2% was down from its June peak of about 9%.But even if we count that as a win, this was not a CPI report to celebrate. In fact, it all but cemented the likelihood of another 75-basis-point hike from the Fed in November.However, not only did the stock market celebrate last Thursday, it erupted in a jubilant spasm of frenzied buying.Upon the CPI report’s release, stocks tanked as you would expect. But then a reversal-for-the-ages ensued.The S&P witnessed an intraday roundtrip of 5.52%. The Dow rallied 1,400 points off its low. And the Nasdaq went from 2% down to 2.25% up.What in the world?
Analyzing the drivers behind last Thursday’s bullishness
A handful of factors contributed to Thursday’s dramatic about-face.First, we can thank 3,516.What’s that?It’s the level at which the S&P’s post-Covid rally fell by an official 50% from its peak. It’s significant because this is where lots of quantitative algorithms kicked into “buy” mode.As a quick refresh, the S&P dropped to 2,237 back on March 23, 2020. This was the pandemic bottom. The all-time-high came on January 3rd of this year at 4,796. That puts the midway level at 3,516.Below, we look at the 1-minute chart of the S&P last Thursday.Futures had dragged the S&P below 3,516 as the bell opened. The algos registered this and kicked into gear, and within a few minutes, we were off to the races.
Meanwhile, this algo-fueled rally surprised lots of speculative short-sellers who suddenly found themselves underwater as the market began climbing.(For any readers less familiar, a “short” position is when you’re betting that an investment will fall rather than climb.)That led to panic and the immediate liquidation of speculative short positions.Here’s Bloomberg:
“There were so many people set-up for a big decline after the CPI number that when it didn’t see any downside follow-through, the short sellers panicked and started buying,” said Matt Maley, chief market strategist at Miller Tabak & Co. “There’s no question that traders got caught offside in a major way.”
As further illustration of the short-covering aspect of Thursday’s rally, we can look at a basket of the most shorted stocks from Goldman Sachs. It went from down 5.4% to up 1.4% on the day as bears were forced to bail out of their positions.Next, we can point toward extremely oversold Relative Strength Indicator (RSI) levels.As we’ve pointed out in past Digests, an RSI level that becomes too oversold (or overbought) eventually snaps-back toward its equilibrium level.On the “oversold” side, the level of 30 is considered the line in the sand, with any levels below this signifying increasingly oversold conditions.Here’s how the S&P’s shorter-time-frame RSI looked last Thursday morning. The RSI stretched all the way down to roughly 10.
Finally, a narrative began to swirl that the report – while bad – would likely mark “peak” core inflation.Here’s one illustration (by the way, don’t miss the second sentence, which says it all).
Put it all together, and you get one of the most bullish rallies in the face of bearish news – ever.
But now, let’s look at what last Thursday was not
If last Thursday was a true sea change in market direction, well…why?We can’t really point toward easing inflation. Yes, the headline number was down slightly (though higher than estimates). But core inflation hit a record.We can’t point toward a stock market that now features an incredibly low valuation.According to multpl.com, the S&P’s price-to-earnings ratio is 18.6. While that’s miles beneath the nosebleed level of 35+ of not so long ago, it remains higher than its long-term average of 16.Can we point toward a slew of unexpectedly higher earnings to support higher market prices?No. Q3 earnings season has barely begun (even less so last Thursday). If anything, corporate America is reducing their earnings estimates.Can we point toward hopes that earnings will be in much better shape, say, 12 months from today?Not really. As we pointed out in our Friday Digest, an increasing number of well-respected hedge fund managers, corporate executives, and financial talking heads are suggesting we’re either in a recession, or will enter one in 2023.If the recession hasn’t even started yet, then the worst of the economic contraction is yet to come. And that means the worst of the earnings hit is still in front of us.
But let’s push back – after all, who’s to say that the analyst community hasn’t correctly priced forward-looking earnings to factor in a recession?
Okay, well here’s what we know…FactSet just reported that the analysts have put a 12-month bottom-up target price for the S&P at 4,696. That’s 31% higher than where the S&P closed on Friday. And again, that apparently factors in a recession.These analysts could be right.
But this past April – just six months ago – the same analyst community put a 12-month bottom-up target price for the S&P at 5,221.If we were still holding them accountable to that price target, it would require a 46% surge from last Friday’s close over the next six months.Possible but not likely. The analysts were probably wrong.Now, I’m not claiming I could predict more accurately, but that’s the point. Putting too much faith in fallible human analysts is foolishness. The pros get it wrong – woefully wrong – rather frequently.
Continuing on with our “what could it be?” analysis…
Maybe the markets have simply fallen far enough, and this bear market pain has exhausted itself?Since 1946, the average bear market decline has clocked in at nearly 28%. During a bear market with a recession, that loss extends to almost 36%.The most that the S&P has dropped during this bear market is about 26%. Translation – though close, it hasn’t even reached an “average” bear market decline yet.Could it be that the Fed is about to change its tune and spark a dove-fueled rally?While anything is possible, it’s unlikely. Last Thursday’s hotter-than-expected CPI print took care of that.Plus, keep in mind, the Fed’s next move isn’t a reversal, it’s going neutral. In other words, the Fed will simply stop raising rates, but rates will remain at nosebleed levels for months. That means continued pain for the economy.I’m having a flashback to many decades ago, when my older brother put my hand in my grandfather’s vice clamp then ratcheted it down. I can assure you that my pain did not end when my brother eventually stopped tightening, left things as they were, and ambled inside for ice cream.Can we bank on the U.S. dollar finally softening, which would help earnings for multinationals?It might happen. But in the meantime, the U.S. Dollar Index sits just under its two-decade high and other major global currencies are spiraling. You can see this in the chart of the U.S. Dollar Index dating back to January 1, 2002 below.
What about the 10-year Treasury yield? Is it finally cooling off, bringing relief to stock valuation models?Nope. Last week it topped 4% for the first time in more than a decade. It’s at 3.96% as I write.Okay, but perhaps we can point toward the strengthening U.S. consumer?Wrongo! Last Friday, we learned that consumer spending was flat in September, coming in below expectations.
Okay, so with this much bad news, why is the market exploding today?
None of these issues by themselves support a rally – especially not today’s monster rally (or last Thursday’s).But, counterintuitively, perhaps all of them together do, thanks to one thing…Sentiment.“It’s darkest before the dawn…” “You eventually drop so low that the only direction you can go is up…” “when everyone is bearish, that’s when you want to be bullish…” “You want to buy when there’s blood in the streets…”Any of those sound familiar?As we’ve covered in today’s Digest , bearish data, perspectives, and indicators are everywhere.It’s dark… we’ve dropped low… bears are ubiquitous… there’s plenty of blood in the streets…Put all of that together, and we find ourselves in a market that’s ripe for a raging sentiment-reversal rally. And we might be watching it start right now.Sometimes, all it takes for this to happen is for news to go from “awful” to “slightly less awful.” That’s because after what feels like an eternity of market drudgery, that faintest whiff of slightly better news produces a fierce hope… that sparks a turn… that blossoms into a full-blown market surge.In recent weeks, extraordinary bearishness has weighed on the markets. Frankly, it’s been unsustainable. This degree of recent pessimism always eventually results an emotional snap-back.As I began outlining this issue over the weekend, I thought this snap-back rally might begin sometime in the coming weeks based on a positive earnings surprise. Well, as it looks right now, it could be starting early.But…Unless such a sentiment-fueled rally is supported by a stream of new and sustained bullish data, the potential upside is limited.As evidence, look at the rally in the S&P from June to August. Sentiment only takes you so far without matching fundamentals coming in as a support buttress.As we look ahead to what could be a challenging earnings season, stubborn inflation, the likelihood of a recession, and all else we’ve touched on today, are you willing to bet on “a stream of new and sustained bullish data” in our near future?I’m not quite there.Now, it is coming at some point. And we know that the market will recover. We have a 100% perfect track record on that.However, if the question is “was last Thursday a major inflection point for the market?” my answer is “no” – even though we might be starting a whopper of a relief rally that could see the market surge 10% – 12% over the coming weeks.
But let’s not miss the forest for the trees
Let’s be clear about one thing.It doesn’t matter all that much whether last Thursday marked a sea change for the markets.That’s because waiting to buy until the market has bottomed is a fool’s errand.As we’ve pointed out in past Digests, the wiser plan focuses on a different question: Is the market low enough that buying today is likely to generate good returns for me, say, three to five years from now?We believe that answer to that question is “yes” for quality, top-tier stocks.Sure, you might sit on losses if today begins a sentiment rally that will eventually fizzle and result in deeper lows. But longer-term, today’s prices are likely to treat your portfolio well in the years to come – even if the true bottom remains in front of us.In the meantime, the market looks like it wants to run. Let’s see how much juice it has.Have a good evening,Jeff Remsburg
