- 3 things we need before we can say it’s not a bear market rally
- Markets technically set up for a short-term rip; however
- Trade with a healthy sense of caution…
Trade it? Or fade it?
If you are like me… it’s a case of fade it.
And shortly I will give you three good reasons why.
But first, there’s a solid case for this rally to go a little further yet.
For example, it’s not often you see the S&P 500 “gap higher” when starting a week…
For those less familiar, this is where the index opens much higher than the previous week’s close.. but also holds those gains.
95% of equities in the S&P 500 closed higher on Monday.
However, when I look at what stocks showed the strongest gains… it was the ‘Cathie Wood’ names… which tells me there was a lot of short covering.
Further to last week’s missive – we were oversold in the very near-term and sentiment was extremely negative.
And it’s from those areas where you tend to get vicious (bear market) rallies.
Those who are “short” cover their positions (i.e., buy back stocks) to lock in profits.
Smart.
Let’s take a look at the technical bounce underway – and where it’s like to face its next litmus test.
The Rip before the Dip
October 18 2022
The white dotted white lines highlight what I think will be the expected rally over the next couple of weeks (ahead of the next Fed meeting).
For example, it could push somewhere between the 10-week (red) and 35-week (blue) EMAs.
However, that’s where I think we will face selling pressure.
If true, it will form the next “lower high”
The tricky thing about bear market rallies is they will generally feel like the “low is in”.
And inevitably, they will fool some (less experienced) traders.
But when I look at the moving averages in relation to each other – and the slope of the 35-week EMA – it’s still sharply lower.
Probabilities suggest any rally will fail.
However, the “good news” is we are a little further into the bottoming process.
For example, we are in a better position now than we were in June (i.e. sentiment is now far worse)
That’s a good thing.
What’s more, companies are starting to take much needed cost measures and are lowering expectations.
All this is part of the process…
But let’s revisit the fundamental reasons why I think any rally is another opportunity to rebalance your portfolio.
What’s Still Missing
Before I get to what (I think) are the key ingredients for any sustained rally… a quick word on Q3 earnings.
So far, they have been reasonably good.
For what it’s worth, I think the balance of S&P 500 companies will either meet or exceed very low expectations.
And in part, this will probably give rise for some stocks to catch a bid (like Netflix today)
However…
It’s not Q3 I’m worried about… they will be okay.
It’s what we are pricing in for 2023 which is the concern.
With that, three things which are front of mine for me to turn bullish (or less bearish)
- 2023 earnings revisions to come down from 8% (assumed) growth
- 2-Year Yields to peak and trend lower
- US dollar to peak and trend lower
1. 2023 Earnings Revisions
I’ve talked about 2023 earnings at length in previous posts.
The short summary here is in the event we have a recession next year (my base case) – earnings will likely contract (not expand).
For example, that could see earnings in the realm of $200 to $210 per share (vs today’s consensus target of $240 per share at 8% growth)
15x multiple of $210 of earnings puts as at 3150 for the S&P 500
That’s a lot lower than today’s close of 3719.
But let’s talk more to bond yields… as this is what is influencing the market’s direction (and sentiment)
2. 2-Year Yield Has Not Yet Peaked
Last week I explained why equities are taking their cues from both bond yields and the dollar index.
Take today…
Markets started in positive fashion as yields fell… however as yields started to rally – equities lost steam.
Now it’s my view the rapid ascent in 2-year yields is not over.
October 18 2022
Now whilst the 2-year yield expects the Fed is going to raise a further 75 basis points in the first week of November – it’s unlikely it has priced in a further 75 basis for December.
At the time of writing, Fed funds futures have this as a 60% probability.
I think it’s higher based on the latest 6.6% YoY Core CPI inflation read for September (and strong job gains)
However, once the Fed offers ‘guidance’, the 2-year will likely re-price.
And I think that will be higher.
Now in my experience, we will generally see the 2-year yield start to retreat about 1 rate hike before they are done.
Therefore, if the 2-year yield backs off in November (which is possible) — there’s a chance that December might be the last hike for a while (which some believe)
However, this is something we need to see before we can start assuming the lows might be in.
Needless to say, if the Fed indicates there is a pause coming (which will require several consecutive months of meaningful inflation declines) – you can expect a massive rally in stocks.
3. US Dollar Needs to Reverse
October 18 2022
This week the dollar index has faced a little overhead resistance – giving a lift to stocks.
Recently I said to expect this – as it’s overbought in the near-term (see lower window – MACD)
And whilst I expect a pullback in both bond yields and the dollar (giving weight to a short-term rally in stocks) — there is ample headroom for the dollar index to go further.
The point here is there is nothing long-term bearish about this chart.
Similar to what King Dollar did between 1996 and 2002 – it will likely “zig zag” its way higher.
For example, once the Fed started slashing rates in 2001 (helping to offset the dot.com bust) – only then did the US dollar make new lows (forming a new long-term down trend).
This is what we will need to see before the next bull market starts in earnest.
Not before.
Putting it All Together
Before I close, what I’m most interested in this earnings season (as we’re still early) is the headwinds opposite the dollar.
For example, Netflix said today currency headwinds cost them over $1B in earnings. From Forbes:
CFO Spence Neumann attributed the flattened results almost entirely to foreign-exchange problems that are dogging all U.S.-based international companies thanks to the strong dollar. Neumann said bad exchange rates will cost the company about $1 billion in revenues.
The investor letter said the impacts would equate to 9% of year-over-year revenue growth.
Ouch!
Next week we will hear from giants such as Apple, Amazon, Google, Microsoft and Meta.
That’s your ‘super bowl’ of earnings.
Put together those 5 stocks constitute more than 25% (~$7 Trillion) of the total S&P 500 in market cap.
What are they going to say about dollar strength? And will they offer guidance?
Echoing the sentiment of Netflix – Adobe told us whilst they maintain their Q4 outlook – they revised down expectations for 2023. From CNBC:
- Adobe called for about 9% growth in the upcoming fiscal year, compared with almost 13% growth in the most recent quarter.
- But the forecast would have been 4% higher if it were not for the stronger U.S. dollar
This will be a prevailing trend…
In summary, don’t be surprised for stocks to add another ~7% to 10% on better than expected earnings this quarter. The bar has been set low.
However, until we see:
- Consensus 2023 earnings being lowered (in the likely event of a 2023 recession); and
- Bond yields and the dollar index start to peak and/or reverse course…
… it’s premature to think it’s something more than an (expected) 10% type bear market rally.
Fade it.