The stock market is undergoing quite a rip higher. While this bear market bounce was not unexpected, the steep trajectory of the bounce and its extent did catch us on the back foot.
Bear markets are characterized by wicked bounces as short-seller do their thing and try to make a buck on the fall. When a bounce occurs, they run to the exits pushing share prices even higher. The extent of that bounce depends on the degree of bearishness going into it. One of the weaker areas of the market is tech. The triple Qs were hit hard in the selloff, and it even poked its nose below the lower trend line.
When this happens, one has to consider two choices. (1) The market is going into a massive selloff, or (2) share prices are oversold, and a bounce is due. In the current situation, stocks were oversold and needed a bounce to kick the sloppy short out of the market. Now the Q’s are up again the upper trend line in the bearish trend channel. If the bar market remains intact, the tech stocks should return to their bearish ways.
Emotionally, this is a tough call. If you listen to the financial pundits, they act as if the Fed is closer to a pivot to lower interest rates than a continuation of a tightening stance. The folds think the Fed is more concerned with GDP than inflation. We disagree, but that is what makes a market. This chart we shared on Twitter early in the day explains why.
Inflation is running at a 9+% rate, and the consensus is that if the Fed gets short-term rates up to 2.5 to 2.75%, inflation will come to a screeching halt. We cannot think of a more misguided notion. Inflation will accelerate if the Fed stops raising rates and selling assets on its books. This “pivot” is what the talking heads say is the reason for the strength of this rally. They may be correct, but if the Fed is in the 8% inning of their tightening cycle, inflation will get worse, not better. The sad thing is that stock investors will be happy. Stock prices tend to rise in hyperinflationary environments as they represent a claim on hard assets. We think the Fed will stand firm and continue to raise rates far beyond consensus expectations because their life depends on it. If the dollar collapses, so does the Fed and the dollar as a reserve currency.
The bullish turn is not just an equity phenomenon. Bonds are doing better as well. The credit markets suggest economic stress is not as bad as people think. The chart below shows the economy is on a knife’s edge between a significant recession and a robust recovery. The pendants suggest the latter. We lean toward the former as we think the economy will get much weaker as people suffer the pain of inflation.
The derivative markets are telling us the markets are also at a critical point. The VIX is a measure of investor uncertainty. It, too, has fallen to a critical point. If the economy is on the all-clear, expect the VIX to continue to fall. Pop in the VIX will indicate that the bear is exerting itself, and we should expect lower stock prices and economic contraction.
What about the S&P 500? It sits at a moment of truth. Technically, it is overbought. This situation is what we would expect before the next leg down.
What about small cap stocks? IWM is at a critical juncture as well. If it is going to turn down, this is the place where we would expect that to happen.
Our money is on the bear. We think the financial media’s obsession with a Fed pivot is misguided. As we sit back and examine the world we are sitting in, we do not see an economic backdrop that supports a bull market. Nor do we see an interest rate environment that supports a bill market.
Mike & I are working on a video to explain the relationship between monetary pooliyc, inflation, and the business cycle. We hope to have it done in the next few days. Circle back. You should find it informative.
