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The pendulum shifts from lower to higher with market rebound

By August 15, 2022 No Comments

This year, the stock market is turning out to be a pendulum. A big swing down in the first half of the year is being followed by a big swing up to start the second half of the year. In markets, that’s usually how it works; volatility goes in both directions. But just like no pendulum can swing forever, the stock market is unlikely to keep up its frenetic pace. The recent stock market rally is a welcome sign, but we would temper against expectations for further, uninterrupted gains.

Where we are now

Last month, we noted that the stock market appeared to have a short-term bottom in place. We argued that key stocks in the S&P 500, like Apple, were giving reasons for optimism. Fast forward to today, and the S&P 500 has rallied more than 15% from its June low. Apple is up more than 30% over the same time. Importantly, the rally has been broad, at least in US indexes. Small cap and mid cap stocks, as measured by the ETFs, IJR & IJH, are each up 19% from their June lows. Non-US stocks aren’t performing as well, Vanguards all-world ETF, VEU, which excludes US stocks, is only up 8% from her lowest levels.

We look at this information and view the worst as over. We don’t expect the market to fall back to its lows from earlier in the year. With that said, if the year ended today the S&P 500 would still register its worst yearly return since 2008 with a loss of 10%. This can still end up being a “bad year” for stocks. Can it turn into a good year? Well, it will take an 11% rally in the S&P 500 to get back to its 2022 breakeven level. That would represent a 30% bounce from its June low. With four and a half months left in the year, that’s a lot to ask for. We expect the index to finish the year in negative territory.

How much bounce is left?

In our July newsletter, we recommended reading Charlie Bilello’s piece, The Upside of Downside. In it, he shared the following data showing how the market has typically bounced back strongly following some of the worst six month periods (which January-June 2022 qualified for):

Note that the average 3-month and 6-month returns following these rough patches has been 6%, and 15%. With the market up 14.50% since July 1st, it’s already close to the 6-month average return in just six weeks. Of course, there are returns in some years that well exceeded the average 15% threshold over 3 and 6 months (mainly in 2008-2009 or 1974).

For those wishing to be more optimistic about a further advance in the near-term, Steve Deppe, of Nerad & Deppe Wealth Management, has the data sets that will get you excited. He found that when the S&P 500 has risen 10% or more over a four week winning streak, a feat it just accomplished, the index has gone to average a 5% return over the next three months. Furthermore, Mr. Deppe published a study showing that when the index had negative six month returns, but posts a 10% advance or more in just 2 months, forward 6-month and 12-month returns are well above average.

Our best guess is that the market spends the next couple of months in a trading range, between 4,000-4,400 on the S&P 500, before having a better shot at rallying again after the midterms.

Markets vs the economy

We always remind readers that the market is not representing the economy today, it’s representing the economy of tomorrow. The sell-off in the first half of the year was the market displaying fear that inflation, together with the Fed’s interest rate hikes, was going to tip the economy into a recession. Moreover, the market was unsure just how high the Fed would have to raise rates, which made it hard for the market to settle on where everything should be priced (interest rates drive many popular market valuation models).

So in an attempt to explain the rally, here’s a few things that happened recently that have worked in the market’s favor:

  1. The June & July job reports came in robust, lessening fears over imminent economic doom
  2. The Fed communicated to the market that the end of their rate hiking cycle was in sight (market became more certain in where the high was for interest rates)
  3. Inflation, as measured by CPI, finally stalled out on a month over month basis, raising optimism that we are past peak inflation

What these factors mean more than anything is the market’s view shifted quickly. The market has greater confidence that the jobs market stays steady. The market has also gained confidence in the Fed’s ability to pull off a “soft landing” where the Fed’s interest rate hikes do not cause a meaningful economic downturn. And lastly and most importantly, the market has fully embraced the “peak inflation” narrative.

All fixed

What’s important to point out is just how fast the market moved to reflect these changing dynamics. Recall back to early June, the S&P 500 index was down about 13% on the year, painful but tolerable. Then in a span of seven days, the S&P 500 fell another 13% and was down 23% at its low. That seven day crash in June was a reflection of the worst of the three points above. The market started to believe the jobs market was about to fall off a cliff, it lost confidence in the Fed, and June inflation data came in hotter than expected, spooking markets even more.

But now? All fixed. It’s not that these worries aren’t still out there, it’s that the market is saying she’s no longer concerned about them. That could change of course, and if it does, it will likely be in the lightening fast manner that all investors should be used to by now. However, after big moves down and now a big move up, we expect markets to settle down and trade with less volatility on a day-to-day basis over the near term.

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