Thursday, November 10, was a celebration for the bulls and a downer for the bears. Prices took off before the opening and never looked back.
Thursday saw the DJIA rise by 3.7%, S&P500 by 5.5%, the NASDAQ by 7.4%, and the Russel 2000 rise by 6.1%. This removed a lot of angst among traders, and the VIX fell by almost 10%.
But Thursday was not the end of it. Friday saw the S&P500 and Russell 2000 rise close to 1% and the NASDAQ by 2%. The DJIA took a breather with a small increase. The positive follow-through was reflected in the VIX falling another 4%;
The reason for the rocket launch? The government reported that price inflation slowed ever so slightly, and investors rejoiced over the possibility that interest rates would peak sooner and at a lower level.
The increase in the CPI was 0.4% which was 0.2% lower than the expectation of 0.6%. That is a 4.9% annualized rate of growth. Core CPI came in cooler than expected as well. It is entirely possible that the consensus view is correct, and inflation will be transitory. But we believe 12 years of money printing cannot be rectified in a year. But there is a first time for everything.
The chart above compares the Nominal US GDP growth rate to the yield to maturity on the US 10-year Treasury. Notice how they tend to rise and fall together. To quantify the relationship, we can use regression analysis. This statistical method reveals the following equation, which we can use to get our arms around where rates might go in the next year or two.
YTM = 2.95% + 0.46 x (GDP Growth Rate) R-Squared = 0.2 / T-Stat = 7.8, 9.0 respectively
The black line in the chart above is the “Predicted” 10-Year YTM. Naturally, it is less volatile than actual rates as market prices typically overshoot, and statistical analysis is intended to remove some of the noise or extremes in the data. The government reported that GDP grew by 9% over the last 12 months. Plugging that growth rate into the formula above, we get a predicted rate of 7.09%.
We may or may not see that YTM as GDP growth rates will change in the future. We expect Nominal GDP to fall, and this will reduce pressure on 10-year YTMs to rise. Before last week’s big bond market rally, the 10-year yielded as much as 4.3%. It is now down to 3.81%.
A fall in the inflation rate would explain this price action, as is the potential for a recession, resulting in a fall in real GDP even as inflation remains elevated. We do not see a significant slowdown soon. There are still ten million jobs available for people who want to work. Big tech, a big beneficiary of the C19 lockdown, is laying people off, but everyone else is looking for people. As a result, we are still in the camp that rates are likely to continue to rise over time.
What does this mean for the equity market? Over the weekend, we saw articles titled “The Pain Trade is for Stock to Rally into Year End.” and “Why the Odds Favor the Bulls.” So investor psychology continues to drift toward hope. Let’s take a moment to have a look at some charts.
SPY, the ETF treat tracks the S&P 500, is still in a downtrend. Yes, the index has bounced hard since the October low, but the upper trendline has not been broken yet. We need to see this to put some weight on the bull case from a technical perspective. But even if it does, it could signal a more significant lead correction from the October low that would take SPY up to 430 before the next leg down manifests.
IWM, the ETF that tracks small-cap stocks, is at a moment of truth. It is butting up against a downtrend line. It suggests that stocks could return to bear mode at any time. Or it could mean a more significant correction from the June low is in play. That would take IWM back up to 200.
As a final thought, since we were firmly in the bear camp, our trade suggestions focused on bearish bets. A growing list of stocks trade at a single-digit PE based on trailing earnings. Our recent note on Mosiac is an excellent example of a stock that trades at a single-digit PE. But that is not enough. To make a bullish trade suggestion, we focus on how we think companies will perform in the challenging economic environment world is experiencing right now. It can make the list if we believe they can manage or benefit from inflation. They can make the list if they are likely to do well in a flat economy scenario.
We prefer bullish versus bearish trade ideas. They are much easier to trade. Further, bear markets are peppered with big countertrend rallies that usually scare people out of their short positions.
Now is not the time to be complacent. The big rally in stock prices over the past month is starting to give people the sense that the worst is behind us. While that could be the case, we do not think it is. We still think surprises will be to the downside. Stay on your toes.
