Did the stock market make a meaningful bottom last week? Financial markets had been taking a risk-off tone coming into the week, but when the Powell Fed was slightly more hawkish than expected, the market rallied.
The S&P 500 was -14.6% peak-to-trough on an intraday basis in 2022. Ed Clissold
of Ned Davis Research pointed out that the characteristics of cyclical bears and recession bears have been very different. Cyclical bears that don’t involve a recession tend to be shorter in length and less severe in magnitude compared to recession bears, though “most non-recession bears include a recession scare”.
Here are some ways of spotting a durable market bottom.
The Fed’s rosy scenario
If we were to cut through all the noise, it’s the Fed cycle that mainly dominates the stock market. The Powell Fed turned hawkish, as expected, at the March FOMC meeting. However, a number of unusual forecasts from its Summary of Economic Projections (SEP) caught my eye.
First, the “dot plot”, or expected Fed Funds rate, jumped from 0.9% to 1.9% by December 2022, which was roughly consistent with market expectations. The expected Fed Funds rate in 2023 and 2024 will overshoot its longer-run target, indicating an extra tight monetary policy. Core PCE inflation was revised up from 2.6% to 4.3% for 2022, indicating a hot inflationary environment, though Powell indicated in the press conference that he still expects inflation to moderate in the second half of 2022.
Here is the anomaly. Despite all of the tightening, the forecast GDP growth rate is still relatively strong at 2.8% for 2022 and 2.2% for 2023. Moreover, the unemployment rate forecast was unchanged at 3.5% in 2022 and 2023. The Fed expects a strong labor market and no recession.
This sounds like an unrealistic rosy scenario. If the Fed continues to anchor the long end of the Treasury yield curve with its guidance on the neutral policy rate, the yield curve will invert before the end of 2022. Inverted yield curves have been strong predictors of recessions. The Fed’s rosy scenario is leading monetary policy of tightening until something breaks.
If a recession is ahead, the downside risk to equity prices will be a lot more than the -14.6% peak-to-trough drawdown experienced recently. What could rescue the stock market from a recession bear?
The answer is financial instability, otherwise known as something breaking. Conventional measures of financial stress are rising, though readings are nowhere near crisis levels. Keep an eye on emerging market spreads (red line), which is raising a cautionary flag.
A key risk is the Russia-Ukraine war spikes food prices. The last time food prices rose sharply, it created political instability in the form of the Arab Spring in emerging and frontier markets. While that scenario may fraught with risk on paper, many EM countries are commodity exporters that benefit from higher commodity prices, especially in Latin America. Even in Africa, many countries have partial natural hedges. The UN defines a country as commodity-dependent if it is more than 60% of its physical exports are commodities, and 83% of Africa is in that category.
The elephant in the emerging market room is China, which is a voracious importer of commodities. The key question is its pandemic management policy in the face of its zero-COVID policy. While the recent market-friendly pivot is helpful for financial stability, those policies will do nothing if the Chinese economy slows and snarls global supply chains because of ongoing pandemic lockdowns.
While an analysis of Fed policy may point to a recession bear, the risk-on rally in the face of a hawkish Fed last week may be a reflection of excessively bearish positioning. The BoA Global Fund Manager Survey shows that respondents are all-in on their recessionary outlook. As well, a recent CNBC poll
of Fed watchers saw a 33% chance of a recession within the next 12-months.
Consequently, manager risk appetite has plunged.
also pointed out that short-selling is virtually nonexistent, which is potentially bullish.
On the other hand, insider buying is also nowhere to be found, though there was a brief episode of insider buys exceeding sales at the January low.
As a reminder, here is what insider activity looked like during the GFC market bottom. There were strong clusters of insider purchases that exceeded sales.
Here is the history of insider activity during the recent COVID Crash bottom.
As well, S&P 500 futures positioning is not signaling a capitulation bottom. Historically, hedge funds have been in crowded shorts in S&P 500 futures at past major market bottoms. Readings are still net long and hedge funds aren’t panicked just yet.
From a technical perspective, the market is insufficiently oversold for a major market bottom. I have highlighted the “good overbought” advance from the March 2020 bottom before. This was evidenced by the percentage of S&P 500 stocks above their 200 dma rising to 90% and remaining there. The overbought condition recycled in mid-2021 (top panel). Historically, such declines don’t end until the percentage of stocks above their 50 dma fall below 20% (bottom panel). The recent market weakness reached 25% and recovered. This analysis indicates further downside risk ahead.
In addition, the NYSE McClellan Summation Index (NYSI) has signaled major bottoms whenever it fell to -1000 or less. This indicator isn’t perfect as it was early to flash buy signals in 2008. Nevertheless, readings of -1000 have shown a strong track record of calling bottoms in the past.
Where does that leave us? I am about two-thirds of the way down the path to the recession camp, though my models are not calling for a recession just yet and I don’t like to front-run model readings. The path of Fed policy seems to be to tighten until something breaks. An inverted yield curve is almost inevitable at this point and other economic indicators are deteriorating.
Regardless of whether there will be a recession, analysis from Ned Davis Research indicated that stocks struggle during the first year of a fast tightening cycle. In the current circumstances, both the “dot plot” and market expectations are indicating a fast tightening cycle.
I am downgrading the reading of my Trend Asset Allocation Model from neutral to negative. Investment-oriented accounts should shift to a maximum defensive posture.
This is a bear market. The current episode of stock market strength is a bear market rally. Don’t be fooled. Sell into strength.