Things are falling into place from a purely technical, tactical, and seasonal standpoint. Strong, broad rally in the Dow Jones to break the short-term downtrend, rising above the 50-day average and tracking for a second close there, the period after October options expiration often means the window for bears to have their way is closing.
It’s a more subdued version of what we saw last year, when the drop in the benchmark was deeper and volatility was higher, but the overall cadence was similar.
Naturally, nothing is guaranteed, and skeptics continue to point to a logical stopping point for this rebound around 4,500, as well as the possibility that this week has brought a mere reprieve rather than a pardon from the inflation/Treasury-yield surge pressures. Consider the powerful rally that lasted into early October as evidence that a “all clear” can only be issued in retrospect.
Retail sales are another positive economic data surprise, lending credence to the idea of reacceleration. Consumer sentiment appears to be quite low, owing entirely to inflation fears and concerns about a lack of government policy clarity. We saw similar behavior in 2011, when both of these issues were on everyone’s mind, but the recovery continued.
With investor surveys and trader positioning becoming more defensive, we did get a decent attitude adjustment, which can act as fuel for a market comeback once it gets going as caution turns back to FOMO. The NAAIM equity exposure index has a low-neutral reading.
The short-term Treasury yields are grabbing attention, with the 2-year note ripping to a new 19-month high and a full Fed rate hike priced in by next September. This reflects the robust growth indicators as well as the elevated inflation risks. Just the market’s best guess, which can change rapidly, but here we are for the time being. So far, the market appears to view this possibility as “a hike for the right reasons” rather than a “definite policy mistake,” but it’s still early and much can change.
The Japanese yen is collapsing against the US dollar as a result of better US growth and rate expectations, a global risk-aversion indicator, albeit one that is prone to getting ahead of itself with these sharp short-term moves.
Goldman Sachs’ remarkable quarter exemplifies the capital-markets boon being served up to Wall Street’s middlemen. It’s not surprising that the stock is up only slightly after such a strong run, especially given investors’ reluctance to pay up for last quarter’s victories. However, these, along with the flush and unconcerned credit markets, represent supportive bull-market forces at work.
Market breadth is adequate but not exceptional, with NYSE up/down volume 70/30 and Nasdaq volume not quite 60/40. At this point, it doesn’t appear to be the start of a headlong bullish stampede directly back to the highs, but rather a grind.
The VIX falls below 17, the good data and firm index price action being too much for it as we head into the weekend.
After weeks of facing down loud and persistent threats – stubborn inflation, rising yields, an energy shock, supply-chain chaos, legislative sluggishness, a Fed eager to taper bond buying, flattening earnings projections, and a potential Apple iPhone supply cut – the tape ran out of reasons to keep going down, at least for the time being, with the Dow Jones gaining nearly 2% for the week and closing within 2% of the old record high.
Naturally, it is far from certain that stocks will now decisively resume the relentless rally that preceded the Sept. 2 high. But, for those of us who saw the recent market volatility as a routine shakeout to reset expectations and valuations, a kind of stress test that the bull market appeared to be passing, last week fit those premises reasonably well.
Even though the S&P never fell more than 6%, cyclical sectors held their ground, credit markets never really flinched, bank stocks managed to rally on impressive earnings reports, and investor pessimism had welled up on cue to offer a contrarian bullish message.
In assessing Thursday’s sharp rise in the market, which pushed the Dow Jones back above its 50-day average, Renaissance Macro Research technical strategist Jeff de Graaf says it was “a good day, strong enough to kick off the seasonal rally, but not a game changer.”
Update on the Mystery Broker
The veteran financial advisor and longtime source known as the Mystery Broker was one skeptic who was persuaded by the market action to turn more favorably toward stocks last week. (You can read about his background and the history of his market calls in this July column.)
In an update sent late Thursday night, after the Dow Jones had staged its best one-day rally in seven months, Mystery Broker backtracked on his earlier call, made in late April, that the index was headed for a 10% correction. He now expects a more typical fourth-quarter gain, possibly deferring a true correction until early 2022.
He caught the entire 90 percent S&P surge from the March 2020 low to this past April, dubbing it a new bull market and predicting that equities would quickly discount a peak in the Covid crisis and the reopening of the economy. Nonetheless, he believed that by April, overheated speculation into the first quarter in expensive and aggressive growth stocks, over-reliance on mega-cap Nasdaq names, and vulnerability in leadership groups such as semiconductors would drive a broad retrenchment to correct valuation excesses and re-energize the bull market.
He lost about a 6% point-to-point gain, despite the fact that at the September 2 high, the market was up 8% from when he became cautious, and two Mondays ago, at the recent low, the index was barely 2% above that level.
Observing the recent pullback, he noted that the market had been dealt “multiple punches since early September, but few punches actually landed.” Resilience in the face of the aforementioned threats, a near-perfect technical bottoming effort, the start of a seasonally strong period that rarely fails to deliver when stocks are already up significantly for the year, and a good flush in investor sentiment all contribute to his call.
He continues to favor cyclical and financial stocks, as he has all year, and believes large corporations are well on their way to overcoming supply constraints and pushing through price increases.
What is left to bear in this case?
With seasoned market participants shifting from defense to offense as a result of the market’s recent tenacity in resisting would-be downside catalysts, it’s worth asking where the bear case for stocks now lies.
The most immediate focus of those looking for downside is likely to be the same cluster of issues that have been in the air for months, albeit in more extreme form: the inflation, labor-shortage, supply-chain, and energy-shock themes that persist and disrupt corporate profitability, forcing the Fed to tighten more quickly and driving a more disorderly rise in bond yields.
It’s probably no coincidence that last week’s market rally was fueled by a moderation in longer-term Treasury yields that were attractive to both value and growth stocks, even as two-year yields shot to 17-month highs to price in a late-2022 Fed rate hike or two.
Morgan Stanley strategist Mike Wilson has been warning of a version of this, a jagged mid-cycle adjustment period in which the S&P eventually loses between 10% and 20% of its value: “The Fed tightens policy due to rising inflationary pressures and a hot labor market, rates rise, and valuations compress 10-15%.” The Dow Jones falls 10% as earnings offset some of the multiple compression.” The 20% setback scenario is the same set of circumstances as the 10% setback scenario, but with a sharp slowdown in US growth.
Wilson cites mid-cycle lulls in 1994 and 2004 as examples of such a sequence. Slower growth, combined with a Fed seen as rigid in sticking to its tightening plan, was also the combination that accompanied the fourth-quarter market drops in 2015 and 2018, two rare years when late-year strength was absent.
All true, but income growth and low household and corporate debt burdens are pretty good buffers against anything bad in the economy, and history shows that the first rate hike in a cycle is usually regarded as appropriate and rarely coincides with a major stock-market peak.
Inflation is unsettling consumers, as evidenced by Friday’s University of Michigan Consumer Sentiment report, which showed another weak headline reading near 2011 levels (a year with a near-20% market drop) and growing concern about inflation.
Nonetheless, household income growth has been so strong that it has more than preserved spending power, retail sales were far higher than expected last month, and survey-based inflation projections aren’t particularly accurate.
To be sure, it appears that analysts are expecting too much of companies’ ability to defend and even expand profit margins as we approach 2022. According to Bernstein Research, Dow Jones margins are expected to expand from already-record levels.
Bears may also object to the notion that last week’s rally was technically flawless and reflected new real-money commitments to stocks. Last fall, the market had a comparable ferocious rebound after an initial correction before rolling over into the end of October.
The Dow Jones’s rise on Friday fell just short of its mid-September high, and there are some signs that the once-unwavering retail-trader bid in stocks has weakened in recent months.
Not exactly a damning indictment of a generally encouraging market rebound in an economy that appears to be resuming its upward trend. It is still a bull market and isn’t on the verge of losing it.
However, it never hurts to recognize two-way risk in a stock market whose gears have slipped a little recently in a spring-loaded, fast-evolving economic cycle that has opened up a broader set of possible outcomes than we became accustomed to over the previous decade.
Retail investors are committed to purchasing stocks, particularly on down days. According to the firm, there is a strong correlation between buying and negative price action.
“Retail demonstrates resilience and buys the dip once more, compelling many institutional investors who share our fundamental views to cover and chase,” Morgan Stanley chief U.S. equity strategist Mike Wilson told clients on Monday.
The major averages have had a difficult few months as investors become concerned about inflation, supply chain bottlenecks, Federal Reserve tapering, and Chinese growth. However, the Dow Jones is down about 1.6 percent from its all-time high.
Wilson believes that recent declines in the major averages have been justified as supply chain issues, cost pressures, and earnings revisions cause fundamentals to deteriorate. However, inexperienced investors continue to buy stocks while ignoring the risks.
“In the meantime, earnings revisions are deteriorating, but not quickly enough to cause a larger decline in the broader indices.” The bottom line is that until these flows abate or reverse, the index will remain elevated even as the fundamental picture worsens,” Wilson added.
Wilson wondered if the retail buying spree was a way to hedge against inflation.
“Stocks provide some protection against that rise, so we may finally be witnessing the ‘Great Rotation’ from bonds/cash to stocks that has been predicted so many times in the past,” he said.
‘Belief is everything.’
According to Morgan Stanley, its business conditions index predicts further deterioration in the Purchasing Manager Indices, which typically correlate with equity markets.
“However, consumer confidence remains shakier than one might think given their proclivity to buy the dip,” Wilson added. “This disparity between markets and confidence must be resolved in some way over the next few months.”
The Wall Street firm urges investors to prioritize consumer services over consumer goods. As a result, Morgan Stanley included McDonald’s on its Fresh Money Buy List.
“During the Covid-impacted period, the MCD top line performed well in the US,” Wilson said. “Key international markets that were heavily impacted in ’20 are now in recovery mode, and future sales drivers across markets are becoming more visible.”
“As a franchised model, direct cost exposure is lower, and larger check sizes continue to support margins compared to pre-Covid, while pricing is being used to partially offset cost inflation at the store level,” he added.