The S&P 500 has rallied 8% in just a matter of 10 days from lows of 3,850 all the way to 4,158 as of last Friday. What has caused such extreme optimism, and has the market really bottomed?
Granted, some of the winning stocks, i.e. non-profitable tech stocks, are down 60% to 80% from their highs, so investors are jittery in not missing the bottom. It is important to remember why they traded up since March 2020 and why they are falling so precipitously this year.
It is all down to the Fed's rampant balance sheet expansion, which caused a massive surge in liquidity that had to find some place to park, and that was in all things risky, regardless of whether they made fundamental sense.
Since the start of this year, the thing that has changed is the inflation backdrop. It is too high and most Fed members are caught with their tails between their legs admitting "they got it wrong." The Fed is now in a rate-tightening phase at a time when inflation is averaging in the range of 8% to 10% year over year. This turnaround is what has driven long duration assets, namely technology, down. As yields and rates move higher, the intrinsic value gets hit. The rational works both ways, in good times and bad.
There is no doubt that we are in a bear market, or at least the start of a slowdown. Whether it is a recession remains to be seen.
In the Russell 3000, 189 companies are unprofitable within the larger 429 technology companies in the index (about 44%). To date, the Unprofitable Tech segment has experienced a 73% drawdown versus the 2000 Tech Bubble drawdown of 89%, according to a Morgan Stanley report.
In the Russell 3000, for example, about 50% of stocks are down more than 30%, about 28.5% are down more than 50%, and 16% are down more than 70% from their 52-week highs. We have seen quite a bit of pain already, but to suggest it cannot drop further may be a bit naive. Who is to say they were ever at fair value to begin with?
One characteristic of bear markets is that rallies can be swift and painful in a short period of time, lulling all the stale bulls and squeezing out the hard-core bears. It causes pain both sides, on the way up and on the way down.
The month of May has been characterized by some month-end buying due to asset allocation portfolio rebalancing. Together with oversold indicators and charts, it caused a self-fulfilling rally. It is important to remember the derivative positioning of the market as June is heading into the famous Quadruple Witching, which has a huge negative gamma interest and makes the moves even more violent in both directions.
Given the decay in US economic momentum recently as the slowdown is felt in China, the European Union and now the United States, bond yields in the US have fallen from the heights reached a few weeks ago as it seems the safe haven status of bonds is slowly coming back. The market is also cutting its expectations of rate hikes by the Fed given the slowdown.
The big debate in the market is how many times the Fed will raise rates before it is forced to make a U-turn and cut rates effectively to support the markets. This sense of optimism of the Fed's next move being dovish is a bit of wishful thinking as the Fed has only one objective right now and that is to curb inflation.
We may have seen the peak in inflation at around 8%, but that is not to say inflation will not stay higher for longer at an uncomfortable level. Even if inflation is starting to come down, the Fed will not stop until it gets the rate to the more reasonable 2%-3% range.
This slowdown is real and the worry is if it leads to a full-blown recession. Unemployment numbers will be watched as companies are already talking of layoffs and downsizing due to rising costs and margin pressures. We all know the Fed plays a backward-looking role, and it only reacts to an emergency. To say the Fed is done raising rates when the market has rallied 8% is misleading. The higher commodity prices stay or the longer supply chain issues persist, the more the Fed will need to keep raising rates, unless we get a repeat of 2019 or 2008, and then all bets are off.
