Outside Day, Inside a Bear

For those of you who would prefer to listen:

This was sort of an important week. There have been a lot of them in 2022, but this one was a standout for investors. We are always looking for positive signals. 2022 has brought few. But there are some. 

October started out with a bang and some big gains. The first 2 days brought a 6% rally. The bad news: It has since given them up. The good news: Rallies are showing up.

Something significant happened Thursday. The Dollar reversed hard and fell despite a really hot inflation report. Bond yields spiked at first, but then also fell. The Bond Market rallied in price with lower yields. 

The Stock Market reversed big time too. The S&P erased a 70-point decline with a nearly 100-point gain Thursday. The Dow saw a 1500-point swing to close up 800+. It was what’s called an outside reversal day. Those are generally bullish. 

The reversal rally came in the wake of another red-hot CPI (Consumer Price Index) report. Inflation is still high. It’s still really high. The headline rate was 8.2%. Any hopes that inflation is peaking were dashed. There was little to like in that report. That said, the reversal suggests that the Market already factored in the bad report. This was a rare 5% Stock Market swing. 2+% decliners early and erased, leading to 2+% gains on the day have only happened 4 other times. Importantly, each time they led to higher gains both a week and a month later. So there’s that. 

Why did it happen? Of course, one never knows. Some believe that algorithms triggered buy programs when the S&P had officially given up 50% of its Covid rally. Machines dominate trading these days. 50% retracements are not uncommon for large corrections. It was also reported that options hedgers needed to cover short positions when booking profits. If you recall, short positions bet against the Market going up. Closing them forces purchases. Bear Market rallies can be powerful. Short-covering is usually the trigger.

There was also more activity in the UK, which has been putting pressure on currencies and bond yields. The new Prime Minister and her cabinet have been conflicted with the British central bank. Their polar policies have confused and disturbed the Market, sending the British Pound to a new low and wreaking havoc on its bonds. The British Chancellor was fired Friday. In Britain they say sacked. He was in office just 6 weeks. British Prime Minister Truss is expected to reverse some of her government’s economic plans. It’s rumored that Conservative MPs are considering Prime Minister’s removal. Thursday brought some hope the Bank of England could do another U-turn and extend the bond-buying program beyond Friday’s deadline. The United Kingdom is still a mess.

The Dollar has been strong all year. As bad as things are in America, they are worse in most everywhere else. Rising yields and a strong Dollar are bad for stocks. The Dollar and the Bond Market have been dictating the Stock Market. That’s pretty normal, particularly in this type of environment. It will continue. 

Inflation remains the primary problem for the US Economy. It has now moved from the goods to services side. Lower gas prices in September were offset by increases in shelter, food, and medical care. Another problem: Gas prices have risen in October. Rent was up 0.7%, the highest monthly increase since 1990. Annualized growth of 6.7%, the highest on record. Medical care services were up 1% month-over-month. That is the largest increase since 1984. CPI is the most high-profile measure of inflation, and this is the final report before voters head to the polls.

The red-hot CPI report gave no reason for the Fed to pause. They are going to keep tightening. The odds of another 75 basis point (3/4%) rate hike in November is essentially guaranteed. It won’t stop there. A month ago, the Market assigned just a 9% probability of a ¾% point hike in December. Now it’s 67%. That would get the Fed overnight rate to 4.75% by year’s end. Remember, it started the year at zero.

A 5% overnight rate cannot be ruled out now. An important question being asked: Is this Fed rate hike campaign even working? Time is clearly needed. But there isn’t any evidence yet that what they’re doing is having any effect on inflation, but it sure is devastating to the Market and asset prices in general. The 5-year breakeven rate is still around 2%. That is the Market saying this inflation is not going to be long-lasting, so the Fed needs to not overdo it. The problem is the Fed is known for overdoing it. That’s precisely the source of the stress right now. You know the old adage, Bull Markets don’t die of old age. They get murdered by the Fed.

The Federal Reserve has few friends these days. Their stated mission to fight inflation was going to bring pain. That’s their word. Pain is happening. Everyone is feeling it. The American central bank has a credibility issue. It was late to prevent bubbles last year. Now it’s aggressively trying to win that credibility back. Friday made things more complicated. After the Market closed, news broke that one of the Fed heads violated its personal trading policy. The Fed probably has less credibility and even fewer friends. 

Earnings season officially kicked off this week. It’s the time when fundamentals come to the forefront. Every 3 months, Corporate America submits its report card to see how it’s doing and where things are headed. It’s refreshing to focus on facts and not emotions and anecdotes. Q3 S&P earnings growth is now expected to be 2.6%, down from the 9.8% estimate back in July. They might still be too high for 2023. Companies face the ongoing threats of a weakening consumer, higher wage costs, sticky inflation, and the Strong Dollar. Energy is expected to be responsible for all the earnings growth. Every other industry will likely show contraction in Q3.

Expectations have shrunk a bit as the Market has priced in the slowdown to a large extent. Wall Street analysts have cut forecasts by $34 Billion. If the consensus is correct, this will be Corporate America’s worst quarter since 2020, in the depths of the Covid lockdown. The Big Banks always lead off and Friday brought some solid reports from JP Morgan and Wells Fargo, indicating the American Consumer remains in decent shape. So far, so good.

Here’s a theme likely to continue. Pepsi reported a revenue increase of 16%. On the surface, that is beyond impressive. But when you dig a little deeper, you find that it all came from price increases. Total volume of sales actually shrunk by 1% while pricing increased by 17%. Not many companies have pricing power like the big brands. It’s clear that demand is slipping in the slowdown. 

There’s still pent-up demand to travel. Airports are jammed. Americans continue to fly the friendly skies. Delta said its planes have been 90% full since Spring. Inflation can certainly be found in airfares. People are paying it. Perhaps more surprising, international flights exceeded domestic for the first time since the pandemic began. Europe is at fire sale prices with the Dollar at multi-decade highs. There’s a reason for it. Europe is facing some serious challenges.

Back to the Market: Despite Thursday’s powerful reversal, Friday brought more red. The 1-day rally couldn’t gain momentum. That’s been the case for much of 2022. There is little confidence out there. Sentiment is just so sour. It’s no surprise. There have been a series of fakeouts all year. Something positive heading into the weekend is this: Despite all the volatility, the Dow did finish the week in the green. We say it all the time; The Market is a discounting mechanism. It is forward-looking with anticipation. It prices things in advance. Expectations are low and negativity is sky-high. A lot of bad has definitely been factored in. Another positive, yields in the Bond Market are back to levels we haven’t seen since 2011, yes 11 years. With a 4% 10-year Treasury, Investment Grade corporates are at 5%+. There are some really attractive bond issues right now on sale. We’ve been doing work there and will continue to take advantage of the opportunities in the Bond Market.

We do see a path for higher stock and bond prices into year-end. October is known for bottoms. The process is always a grind. That generally leads to strong Novembers and Decembers. There’s one mitigating factor. The 10-Year Treasury yield at 4% and the strong Dollar have chokeholds on stocks. Both provided some relief on Thursday. They tightened their grips again Friday. But the ingredients are there. Whether this is a bottom or not, the rally brought some much-needed relief to an extremely oversold situation. Bear Markets are brutal. But Bear Market rallies are the most powerful. They tend to happen when investors just can’t take it anymore. This backdrop is so ripe for a more sustainable rally.

Have a nice weekend. We’ll be back, dark and early on Monday.


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