The Bear Market Rally Sharply Reverses
Sept. 4, 2022
|
|
|
Overview: Still on the Path to Recession
The strong market rally that began at the mid-June market low persisted until mid-August when its sharp 8.7% loss quickly made clear that it had only been an ordinary Bear Market Rally and classic Bear Trap as opposed to the start of a new bull market. Although our StormGuard-Armor (bull-bear) indicator had been rising, it remains firmly negative, thus confirming that this market decline will be much more serious than a moderate correction. In late August the Fed strongly confirmed that it is purposely driving the economy into recession to cool it off and bring down inflation. Fed Chairman Powell left no doubt that he will continue to (1) aggressively raise interest rates until inflation abates, and (2) continue decreasing their balance sheet (Quantitative Tightening) by $1T/year. He warned that "households and businesses can expect to experience pain and job losses." Slowing the economy inherently means that business revenues will drop, earnings will shrink, and stock prices will follow suit. “Don’t fight the Fed” is sage advice!
|
|
Market Action Analysis
The bear market rally reversed direction abruptly following its August 16th high (chart right). The S&P500 has since trimmed 8.7% in just 12 trading days, leaving the index with a 4.1% net loss for August. With the June bottom only 7.4% further down, a retest of the low seems all but inevitable. It’s second nature for technical traders to examine such “support” and “resistance” thresholds that often become a group-think self-fulfilling prophecy. Had recent economic news been positive, this possibly could have been the start of a new bull market with a sequence of higher lows and higher highs. However, Fed Chairman Powell left no doubt that he will aggressively raise rates and trim the Fed’s balance sheet until inflation is under control. Although Chairman Powell is pressing elevator's down button, you can still get off and use the stairs.
|
|
6-Month S&P500 Market Index
.
|
|
What Lies Ahead?
Fasten your seat belts. Most of the economic indicators used by analysts have from one to six months of lag in response to stimulative action taken by the Fed or Congress. This is the primary reason why the Fed cannot orchestrate a “soft landing.” By the time economic statistics are reported and actionable, the momentum of economic retraction results in grossly overshooting the goal. Equities markets have a form of momentum that plays out on a much shorter time scale during a market crash that is driven by fear and margin-call forced selling (capitulation). Historically, there are many instances when the markets lost 15% to 25% in a matter of two weeks, which would indeed qualify as the “pain” that Powell says we can “expect to experience” (unless our investments are defensively positioned). That said, we should keep in mind that Powell did previously act twice to limit the market's pain to investors.
The chart below suggests four hypothetical trajectories for the market, which is likely to substantially decline further.
Four Hypothetical Technical Analysis Trajectories for the Market
|
|
Bear Markets Continue to Rhyme
As noted last month, Mark Twain famously said, "History doesn't repeat itself, but it often rhymes." The two charts below are taken from last month’s Newsletter and show what happened in 2001 and 2008 following their large bear market rallies, which occurred at about the same time in their life cycles as the bear market rally just completed in mid-August. Both charts include a pink circle marking a decline similar to the current decline from the current bear market rally high.
The very act of creating a recession to quell inflation will inherently reduce consumer spending, lower corporate revenues, lower net earnings, and thus commensurately lower share prices. Additionally, if P/E multiples contract back to their historical average of 15 from today’s 20, then another 25% will come off the top of share prices. Furthermore, there is additional downside risk from (1) a likely worldwide energy shock this winter, (2) a damper on our economy from higher European inflation, (3) a continuation of lockdowns and supply chain interruptions, and (4) the capitulation-induced downdraft that stops only when there are no more willing (or forced) sellers and the market is both fundamentally and technically oversold. While the future is not certain, I believe the deck is heavily stacked in favor of a hard landing.
This Happened After the 2001 Bear Market Rally This Happened After the 2008 Bear Market Rally
 
|
|
Defensive US Dollar Index Fund
Recently I received a very interesting note from Zechariah Montera of Fross & Fross Wealth Management, enquiring about manually substituting one of the US Dollar Index funds (USDU and UUP) for inverse ETFs SH and DOG that were selected by the Merlyn.AI Sector Nectar strategy. In the YTD chart (right), UUP has clearly outperformed all US Treasury, TIPs, and bond defensive ETFs during the period. UUP has a bit longer history and more AUM than USDU, but otherwise are virtually identical.
|
|
Defensive Funds Review: Discovering UUP
|
|
|
These funds are based on the US Dollar Index DXY-Z, plotted in the chart below with a more complete history. Of some concern is that the current spike in its performance is reminiscent of its 2001 performance peeks, indicating that a sharp decline may occur in the near future, albeit not before Europe solves its energy supply problems and contains other risks presented by Russia.
We are encouraged by our early experimentation and are considering the possibility and implications of creating an extended UUP- ticker based on the history of the DZY-Z index for use with some of our Bear Market Strategies. Any such updates will be announced in next month’s Newsletter.
US Dollar Index Symbol: DXY-Z .
|
|
Patience, not panic! Rules, not emotion!
|
|
|
|
May the markets be with us,
|
|
|
|
|
