Bear Market Rally or Bottom?

October and November were great performance months so far in 2022. Is it sustainable or more of a relief rally? No one knows but based on data, it looks like a possible trend. 

In July, I posted “A Rough First Half, What the Other Side May Look Like” where I presented three scenarios. 

Optimistic - Inflation will go away and Russia will leave Ukraine. 

Pessimistic - Inflation gets worse and some unknown threat shakes the market.

So far, we’re not in either of these. It looks like our base case is playing out. 

Neutral - Our most probable scenario, where inflation comes down but remains elevated. Housing is going to slow, a big component of inflation. 

Inflation is slowing but prices remain elevated. The Fed is interested in price stability, not price levels. Imagine speeding up on a freeway and you’re going 65 accelerating to 80. You reach 80 and start to slow down slightly but still going at least 80. That’s where we’re at now. Still above the speed limit but not going faster.

The latest CPI reading came in high at 7.8% but slowing, and the markets rewarded the news with the 14th best up day in stock market history. Volatile markets continue to provide the best market days.  

The inflation target the Fed looks at is PCE, which was 5.1% on the September reading. PCE is preferred because substitutions are accounted for. If no one is buying beef, instead buying chicken, PCE will pick that up. CPI will read a higher price on beef and on chicken regardless of who buys what. 

Markets are reacting to the trends in data and the trends may change. Earlier in the year, trends in the data kept getting worse and worse. Now they’re heading in a direction that is less worse. The market isn’t necessarily wrong if there is a change in trend. It is simply reacting to new information. The trap investors fall into is assuming the market has it wrong. 

The other mistake is to assume trends will be that way going forward. Prior to the big jump, investors piled into trades that would pay off if the market went down. So much so that the put/call ratio had never been higher, meaning the number of downside bets have never been higher than on November 7th. 

When CPI came in less bad, it was off to the races. Below is the same put/call ratio but I also dropped in the S&P 500 and magnified it to 30 days back. You can see buying puts causes downward pressure on markets if done in high enough volumes. 

The opposite effect happens when investors unwind those positions. Tack on any sidelined cash, you have a pop in the market. 

All that cash that was raised from selling throughout the year needs to find a home. Selling pressure eventually creates buying opportunities and buying pressure. Not all that cash will go back to stocks. Fixed income is showing life with healthy yields, finally. Rising rates benefit savers. Keeping cash is no longer a zero opportunity as money markets are paying something a little more than a fraction. 

This isn’t a signal for an all-clear. Not that the market even needs one. 

The effects of interest rate hikes are usually lagged by 12-18 months, meaning the economy hasn’t felt the impacts of the hikes yet. Yes, mortgage and auto loan rates are higher but purchases have not significantly slowed yet. High prices have caused consumers to trade down or forgo purchases outright. Hiking this fast could mean a recession is on the horizon.

There will still be volatility and the sentiment will shift. We’d be cautious to be overly optimistic here but caution against being too pessimistic. Investing is an optimistic pursuit which is ironic because the best times to invest are when sentiment is most pessimistic.

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