The market has enjoyed a very good run in 2023 as bulls ignored the pessimistic bears and forced widespread short-covering. Money was sucked in from the sidelines and there was much celebration that the bear market was over. The bulls justified the action based on a Goldilocks economic thesis in which inflation was not too hot and economic growth was not too cold.
Quite a few high-level market strategists scoffed at this theory, but the market stayed strong even when Fed head Jerome Powell made hawkish hints and the odds of additional rate hikes increased.
The bears' theory was that poor earnings would cause fear of a recession to build, but the general reaction to earnings was positive. According to Charlie Bilello, with about 80% of S&P 500 companies reporting, earnings are down 23% year over year, which is the most significant decline since the second quarter of 2020 when Covid worries were at their peak. In addition, profit margins have dropped to 11.2% from 13.4% a year ago, most likely due to the impact of inflationary pressures. Margins are being squeezed because costs are going up.
The bulls' response to earnings weakness is that the market has already discounted it and strong employment signals a recession is unlikely. The problem is that there are growing worries about a rebound in inflation and a more hawkish Fed. The Fed faces a daunting task in trying to drive inflation down to its 2% level without causing significant economic slowing. The bulls have been very optimistic that the Fed can pull off this trick, but the track record of the central bank is not favorable.
The market started to roll over late last week, and the question now is whether CPI, PPI, retail sales, housing starts and other economic reports due this week will give the bears more traction.
Seldom have we had high-level bears with such firm conviction, but that may be a big part of the reason the market enjoyed so much recent upside, which was driven by short squeezes and poor positioning.
This week will be a crucial test, starting with the Consumer Price Index report on Tuesday morning. The market has been quite optimistic about cooling CPI in recent months, but there are concerns and worries this time.
We have a mixed start on tap based on the early going here on Monday, and we will see more positioning action in front of the CPI report.