The State of America – Prevailing Optimism

For those of you who would prefer to listen:

Things have felt pretty grim in America. That feeling is everywhere. This past month I’ve traveled from coast-to-coast and in between. You can see and feel the angst. Sentiment has seldom been as sour as seen in 2022. Investor confidence has reached basement-level lows. The political divide in our nation clearly plays a role in it. The one thing that Democrats and Republicans agree on is the belief that the country is headed in the wrong direction. They just defiantly disagree on the cause. They blame the other. That has been the state of America.

But there’s always that prevailing optimism; There’s hope. Just when you think all is lost, a spark can turn things around. That’s what this week felt like; At least to me. The 2022 midterms had some surprises, which could lead to more stability in Washington. I stress the word “could” because of course we’re talking about Washington. The other factor driving optimism for better days ahead was the declining rate of inflation which has draped the American people. Price increases are falling. Some reprieve could be around the corner. That’s the signal the Market sent this week.

Thursday was a day for the ages on Wall Street. The Dow surged 1,200 points. The NASDAQ rocketed 7%. It was the best day for the Stock Market since the early days of the Covid recovery rally in 2020. It wasn’t just a stock rally. Bonds rallied too. The Dollar had its biggest single-day decline in a decade. There was a massive amount of tension relieved in asset prices within a tension-filled 2022. You could just feel the burst. Participation was wide. The breadth was impressive. The stuff that got beaten up the most this year led the charge. And it kept building, as all the major averages closed at the highs of the day. The strength continued Friday.

So why the rally? There’s never a definitive answer. We think a number of factors are at play. What’s clear is the big boost came on the back of the better-than-expected inflation report on Thursday. Pricing pressures saw some needed reprieve. Inflation has been public enemy #1, so this data suggests the Fed could cut back on its aggressive tightening campaign a bit. The Market is now pricing in an 80% probability of a half-point hike rather than the previously expected ¾-point at the Fed meeting next month. That led to lower yields and a weaker Dollar, both of which have had a chokehold on asset prices all year. We outlined this scenario in our recent Market Update events. It’s playing out well. 

The election results certainly contributed to the strength in stocks too. There was no “Red Wave” that had been anticipated. In fact, one of our Washington sources called it a “Red Ripple.” But gridlock seems certain. The results have something for everyone. A divided government is widely expected. The Market sold-off on the news, but it largely took it all in stride, at first. Then selling started accelerating. It wasn’t the election that seemed to put the bigger dent in the Fall rally. It was fear and stress in “Cryptoland” that sent stocks southward. Rumors circulated that a well-known crypto exchange company based in the Bahamas was failing. Friday, it filed bankruptcy. A week ago, it was worth $34 Billion. Now it’s wiped out. Some are calling it a Lehman moment for cryptocurrencies. The Stock and Bond Markets are absorbing that stress fairly well.

The results of the midterm elections are still not fully known. The tallies keep coming in. But it’s clear that the polls showing the increased Republican momentum were wrong. Polling has been so flawed. Though the Republicans are expected to take the House, the Senate remains very much up in the air. Another 50-50 split, or even the Democrats picking up a seat is becoming increasingly likely. There will be another runoff in Georgia in December. Arizona and Nevada are still counting. It’s too close to call. Divided government and gridlock should be the result, but not in convincing fashion. That said, the Market likes gridlock. As I mentioned last week, the framework of divided government with a Democrat in the White House along with a split Congress has proven to be the best pairing for the Stock Market. Ian Bremmer said American Democracy was the biggest winner of these midterms. It sure has been tested.

Good news is still hard to find in the headlines. But the news appears to be getting a little less bad. In addition to these domestic issues, things could very well be improving overseas; Or at least becoming less bad. There’s talk about a ceasefire in Ukraine. An end to the 8-month war would be huge. There are also signs that China is moving away from its Russian alliance and Zero Covid policy. Well, baby steps on those. But it’s seemingly moving in a better direction. That matters to the Market. It’s really not about good or bad. It’s more about better or worse. Less worse equals better to the Market.

This week Russia withdrew from the key annexed city of Kherson. This is considered a stunning win for Ukraine, though some still fear a trap. The West has been united in its defense of Ukraine, led by the USA. American arms and ammunition have provided for the relentless Ukrainian resolve. Ukraine wants it more than Russia, that is crystal clear. The Ukrainian people are fighting for their homeland while the Russian military appears unsure why they’re even there. As Chairman of the Joint Chiefs of Staff General Milley said, “this is a war that didn’t need to happen. But Ukraine has the morale, the will and the leadership to win the war. Ukraine has the intangibles.” That’s the most important part, according to Milley. What Ukraine needed were the means, which is what the United States has been providing.

This war is about survival for Ukraine. But it’s also about the World Order, the rules-based order, which has been in place since the Second World War. What was considered a major test for NATO and the Western World has proven to bring the alliances closer together when they appeared to be in tatters. This was a tactical blunder by Vladimir Putin and his support and even his troops are proving weaker than imagined. This is no small deal. Defense stocks, which have soared this year to all-time highs as the war escalated, faced some new pressure this week. That is the Market suggesting peace is a possibility. 

The Russian invasion of Ukraine was considered a bit of a blueprint for China and Taiwan. Presidents Putin and Xi formed an alliance in February, just weeks before Russia advanced on its neighbor. It was called a “friendship with no limits.” Putin wanted to destroy the “old” World Order. Xi wanted to create a new one. This perceived New World Order threatened traditional norms and tested Western resolve. The calculated move backfired big time on the Russian leader and China has been pretty silent while seemingly distancing itself. General Milley reminded us the United States still has the most powerful and most dynamic military in the world. It looks like there are indeed limits to China’s friendships.

President Biden will meet with President Xi next week in a highly anticipated event at the G20 Summit. It’s reported that there will be no joint statement to be issued and there are no expectations for any specific agreements. But the fact that they are talking is huge. The fact that President Xi is leaving China for a foreign trip is also quite significant. This will be only the second time the Chinese President has left the country since the pandemic began. China has had a strict Zero Covid policy, locking down cities for single cases. It has been devastating to the Chinese Economy as well as global supply chains.

China seems to be working on an exit strategy from Zero Covid, though they deny it’s happening. The key is to watch what they do, not what they say. The Chinese Communist party will not admit mistakes. Zero Covid policy is a clear example of this. Chinese health officials say the country will ‘unswervingly’ adhere to Zero Covid. They stress these policies are the most economical and effective. While officials say they are sticking with this policy, there are some loosening signs taking place and expectations are building for more reopening. That will also have a significant impact on supply chain improvements. The Chinese Stock Market has been rallying of late, and US companies with substantial exposure to China have been rallying too. This is key for a Global Economy that is facing serious recessionary pressures. China remains the second largest economic power behind the United States. 

Change is inevitable. Things evolve. People come and go. But process and culture stick. They’re based on shared values and vision. What’s best for a New World Order is competition, not conflict. That order requires rules and fairness. Rules need to be embraced and followed. That hasn’t been happening. Perhaps there is a change in the air. There are signs suggesting it’s so. We’ll learn more next week with the G20.

Back to the Market: The path of least resistance seems to have swung to the upside into year-end. Seasonality often takes over. November and December are historically the best months for stocks. It’s even more pronounced in a midterm year. The set-up was certainly there. Internal momentum is building, and long-term trends are even firming as half of the stocks in the S&P 500 are now making 20-day highs, with some back above their 200-Day Moving Averages (DMA). The S&P itself is now slightly below its simple 200-DMA, which has been a major level of resistance all year. That level is currently around 4080. It’s close. The S&P closed Friday just below 4000.

We still think this rally is a Bear variety. Bear Market rallies are amongst the most powerful. We’ve seen a few of them in 2022. We think this is another one. Things got so negative, and positioning got way crowded to the downside. Valuations came down a lot and overshot a bit. It was inevitable for the pendulum to swing back, forcing shorts to cover. To be sure, there was real buying at hand too, as risk-seeking investors grab what’s perceived to be bargains amongst the rubble. We always have to remind ourselves that bottom formation is a process. Everything going on today fits that bill. Time is what’s needed most. Patience really helps that cause. Patience is an ingredient that has been lacking in America.

Here’s some more reason for optimism: Over the last 90 years, the S&P 500 has generated a median return of 3% through year-end and 17% during the 12 months following midterm elections. Gains have generally been stronger under divided governments. The S&P gained 5.5% on Thursday alone. It sure looks like this rally has legs into the new year. And it looks like the State of America could very well be back on track to a better place.

To all you veterans, thank you so much for your service to our great nation. We are so appreciative for your sacrifice and your oath to the Constitution and commitment to the American people. You are America’s heroes. We salute you!

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

Mike

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