Before Monday and Tuesday of this week, we have had six times where the markets tried to rally only to reverse and decline once again.
Thursday of last week appeared to be a bit different in that it was what is called a "positive engulfing day." This is when the markets trade lower than the day before and then reverse and trade to close higher than the range of the day before (engulfing the prior day's trading range). This gave investors a slight sigh of relief going into Friday, only to have the markets trade down once again on Friday- but not with the veracity of decline to match the veracity of the advance on Thursday (another positive sign).
The weekend came and went with no new negatives out of England, Russia/Ukraine, and Xi in China did not rattle any particular sabers to warrant concerns of more frictional conflicts with China. The difference "this time" is that England did not make any new commentaries that implied more severe cracks in their bond markets. My conviction level that a bottom is in place will go up if the S&P 500 can break above its current downtrend line around 3800 or trade higher than it traded on Friday (3712).
I know this seems quite focused and myopic, but the structure of a market bottom really must begin somewhere, and these are things that could begin to tip the scales to some extent that a potential bottom could be forming. Once this happens, clawing up above 3800-3900 would be the next test. I tend to be a little more defensive and believe that the markets need to make this move above 3900 to make me feel at all comfortable beginning to deploy sidelined capital.
What I am concerned about still, is that if the market cannot hold above the lows of Thursday and or if the 10-year interest rates stay stubbornly above 4%, then I do not feel that the backdrop will be strong enough to warrant additional commitments. The S&P 500 compared to the 10-year Treasury yield is currently fairly valued by many measures. There have been 26 stock market corrections since World War II with the average decline being 14%. Recoveries from those declines have taken on average only four months. I continue to believe that we remain in a secular bull market that started in 2009 and that this correction was just digestion of the market advance since the COVID low of 2020. The big reasons that I believe this are:
- Valuations are more attractive than they were before the drop.
- There is still plenty of cash on the sidelines.
- Investor sentiment is too bearish- most bearish since the Great Financial Crisis, yet we have full employment, rising wages, record profitability, and almost non-existent default rates.
- The Fed is likely to become less hawkish. Cracks are forming in our economy and other economies of the world, and we need to take a rest to see the effects of all the hikes that have been done so far.
- The U.S. Dollar is likely in the process of peaking. This was evidenced just last Friday and Monday of this week even with interest rates remaining stubbornly high.
- The economy is unlikely to spill into a protracted recession. Maybe the growth rates slow, but a major recession still does not seem in the cards.
- Earnings estimates could have been ratcheted down too low. This would provide room for upside surprises as evidenced by our major money center banks' earnings at the end of last week and Monday of this week.
My favorite analyst, Ari Wald, of Oppenheimer, stated this weekend that barring a move on the 10-year above 4% significantly, Thursday's turnaround marked a key reversal day (as I stated above). Ari believes that the retracement of 50% of the move from the COVID low to the November 2021 high is very significant. Second, the fact that as the chart I have included on number 3 above shows that the bounce has occurred from an incredibly oversold level. Third, the big down days are less and less aggressive (see chart below). And last, we are showing bottoming right when it "should" based on normal seasonal patterns; the final updated chart below.
In closing, the Sunday New York Times' third quarter section seemed to sum it up in their article, "Waiting for the Fed." I have often stated that it has seldom been a good investment strategy to 'Fight the Fed', and this year has been no exception given the veracity of interest rate hikes our financial markets have had to deal with this year. Yet, based on this article and the difference in the tone of many commenters throughout the world and within our group of Fed Governors, time will be needed to see the effect of 3-4 large Fed rate hikes back-to-back.
This Q3 earnings season will provide ample data to see if the earnings of our major companies are still resilient enough to weather this interest rate storm. Based on many measures, this seems to me to just be a very painful correction within a longer-term uptrend. Only time will tell. Stick with quality and patience and sound investment should prevail. I leave you with the average and median S&P 500 gains over the next 12, 8, and 3 months after extreme volatility on the downside, going back to 1997.
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