Since the early days of the secular bull market that started in 2009, equities have benefited from QE (quantitative easing) and zero interest rate policies (ZIRP). As inflation has arrived in 2022, markets have been rattled by reversals in those accommodative policies causing worry about the economic and earnings impact due to tighter monetary policy and interest rate hikes.
Thus the question most often asked is whether equities have entered a period comparable to the secular bear of 1966 to 1982, a bear characterized by runaway inflation and chronic economic weakness. We believe equities remain in the same secular bull market that started in 2009. While inflation has been far less transitory than expected by the Fed after it first became a market influence, they and other central banks appear more responsive and less likely to get behind the curve in the inflation fight than they did in the 1970s.
We have raised cash in various strategies waiting for better buying opportunities in especially hard-hit sectors (communications, consumer discretionary, and semiconductors). In addition, we are monitoring developments that would make a secular bear market highly probable.
Reviewing Dow Jones Industrial Average’s (DJIA) return data, the 2022 decline has thus far been more consistent with an ongoing bull market than a secular (long-term) bear. If a secular bear is underway, this would be the first, having started from record market highs. The initial bear in 1929 was shorter but far steeper, while the initial bears ending in 2001 and 1966 were longer with more significant declines.
Relative strength trends (our charts of Xs and Os that many are familiar with) will also warrant attention in assessing the market. While we monitor relationships between U.S. and non-U.S. equities, our continued overweight to the U.S. is the focus of this update. The current trends can be considered cyclical (regularly occurring), not secular (occurring seldom). In a cyclical market, the current trends should be short-lived, followed by the resumption of the longer-term price and relative strength trends that have persisted since 2009. It would be premature to change our view that the market is a cyclical (short-term) bear within a secular (long-term) bull. However, that could change if the bearish message from the market and relative strength trends becomes increasingly decisive.
A Bottoming Process
For over two months, we have emphasized the stark differences between macro and fundamental indicators (GDP, inflation, P/E ratios, etc.), which have been almost universally bearish, and sentiment (investors’ attitude) and tape data (long-term market activity), which have been positive. Two of Wall Street’s most popular adages, don’t fight the Fed and don’t fight the tape, are at odds. Most recently, the Fed is winning. Since the CPI report on September 13, the S&P 500 Index has been down 8 out of 10 days by 11.1% (through 9/26/22). This price action created a very oversold market, which should be a setup for a rebound. The question is will the rebound be a bear market rally (similar to the July/August rally) or push through and continue to high market highs and resume the long-term secular trend? Knowing where the market is in forming a bottom is paramount in helping to understand the cyclical versus secular environment.
Bottoming Process – 4 Steps
The four steps to a bottoming process are: oversold, rally, retest, and breadth thrusts. After the market reaches deeply oversold levels (which have occurred several times this year), it eventually mounts a rally. Retests of the lows follow most rallies. Successful retests are followed by breadth thrusts (90% of stocks moving higher in a single day), which signal the downtrend has transitioned into an uptrend. Unsuccessful retests mean the process resets to step 1. Despite some short-term breadth thrust signals during the June-August rally, we highlighted that intermediate-term breadth had not been confirmed and that a retest of the June lows appeared likely. With the market now at the June lows, we focus on a successful retest and whether the current decline is passing or failing the retest. The bottom line is that it is too soon to draw a definitive conclusion.
Following the four steps in a bottoming process, the S&P 500 Index (SPX) should marginally break below the June lows (which has occurred) and reverse and rally (the market rallied nearly 2% yesterday but needs more to confirm). We note that selling sessions, according to Jeff Saut of Saut Strategies (a strategist we have followed for nearly 15 years), typically last 17 to 25 sessions. Some have gone further, but we are now 27 sessions into this selling stampede, so the timing is right for some upside reversal. We believe the Federal Reserve will continue to raise the Fed Funds rate to between 4% – 4.5%, about 1% higher than we currently are. Analysts are now reducing earnings estimates for the S&P 500. We will know more about how far as companies begin to report third-quarter earnings next month. That should limit the upside for stocks, at least in the near term.
Seasonality and Mid-Term Election Years
The period from late August through mid-October is the weakest time of the year. The seasonal winds shift as the calendar moves through October. On average, November and December are the two strongest months of the year.
In most years, even after the autumn pullbacks, the market is usually higher than where it started. The year-end rally often enjoys the benefit of a primary uptrend. But what about years when the market is down, as this year with the S&P 500 down 22.5% year-to-date? If the losses hold through the end of September, this year would be the worst first nine months since 2002 and the fourth worst since 1926. When the S&P 500 has been up through September, over the last three months of the year, it has risen 83.1% of the time by a median of 4.7%, with slightly better results for mid-term election years. When the S&P 500 has been down through September, it has risen only 54.8% of the time by a median of 2.3%. Several of the down years came in the 1930s. Since 1946, the results have been mixed. Median returns have been slightly higher when the S&P 500 has been down through September (+5.5%) than when it has been up (+4.7%). However, in mid-term election years and years with a down market through September 30, the results have risen 80% of the time by a median of 5.6%.
Consumer Confidence Surprises to the Upside
Reported September 27, the Conference Board’s Consumer Confidence Index increased 4.4 points in September to 108.0, above the consensus of 104.5. The key takeaways (below) are a positive turn within a negative market environment.
- Strong labor markets and falling gasoline prices boost consumer confidence.
- Core durable goods orders jump, a positive sign for factory activity.
- New home sales rebound strongly, and new and existing home price y/y growth moderates.
- Richmond Fed regional activity is steady, following contraction.
While the outlook is bearish in the near term, equities are in oversold conditions. Accordingly, we see the action as consistent with the early stages of a basing/bottoming process. Bond yields are influencing the current stock market’s movement. The decline in stock prices has made valuations attractive in absolute terms and compared to bond yields. In addition, there are elevated cash levels and too much bearish sentiment. The Fed’s hawkishness has probably peaked; likewise, the U.S. dollar looks to have possibly peaked, and the economic slowdown does not look like a deep recession to us.
Most of this year, our stock portfolios have been defensively positioned with varying overweights to cash. Cash positions in the stock portfolios are currently in the 20% to 25% range. If there are indications of the markets breaking down from here, we will become more defensive. We believe most, if not all, of the bad news is reflected in current prices. With that noted, and until we see a break in the overall long-term trend, we believe we remain in a secular bull market that should have years left to run unless there is some terrible surprise.
As of September 29, 2022. The material presented in this commentary is provided for informational purposes only. Past performance is not indicative of future results.
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