It has been an eventful couple of weeks as the S&P 500 has rallied roughly 17% from the local lows spurring an amazing tug of war between bulls and bears. To be frank, both sides have presented very compelling arguments. On the bull side of The Great Divide, the argument is that the recent market price action that has occurred since the June lows has been "impressive," which, by market technician measures, confirmed a new bull market. BUT, on the other side of The Great Divide, the bears continue to make their base for continued volatility/drawdowns based on the prevailing macroeconomic conditions.
During our Coffee with Andrew today, we will discuss our assessment of The Great Divide and where our investment thesis sits between the two camps. Earlier this week, our Investment Committee met to discuss the current crossroads, which reaffirmed our thesis for a continued volatile market and slowing economic data.
As we know, bear market rallies can cause a ton of confusion as investors often begin to question their thesis, abandon their approach, and begin to chase the upside. This happens in every market rally and can lead to good outcomes but also bad outcomes. To help negate this behavioral issue, the DCA Investment Committee relies on an A|B test function which helps us determine our investment allocations. Our A|B test process compares market internals (price action) to prevailing economic conditions. Simply, if the market is trying to price a recovery, what assets are leading the way? Is this confirmed by improving economic data? Answering these questions helps us not get our heads on a swivel.
When analyzing this latest bear market rally, placing the price action in the context of previous bear market rallies is important. For my data-hungry readers, I present you the following statistic(s): the average gain in the S&P 500 out of the last 40 bear market rallies is 17.2%, that average roughly 40 trading days. In comparison to today, we have seen a bounce in the S&P 500 of 17.4% lasting 41 days. Really nothing more than average based on this data. Recall that in the 2000s, we saw two 40%+ and one 50% bear market rallies before the market officially bottomed. Furthermore, the market internals of this rally aren’t indicative of an economic rebound. Historically, we see early cyclicals outperform as the economy nears/enters a recovery (think change in growth rate direction), but over the last month we have seen junk/low quality, and high short interest (think "meme" stocks) perform extremely well. This is not uncommon as these equity factors were top performers during the bear market rallies during the 2000 and 2008 bear markets. Lastly, the recent rotation within the market has been predominantly defensive as utilities, staples, low volatility factor, and dividend factors leading the way. This is not common in renewed bull markets.
In the perspective of prevailing economic conditions, we can contextualize why defensive equity sectors and factors are leading the charge. We have yet to see a rebound in leading economic data, which is why investors are still preferencing defensive-based assets. One of the telling signs came from the recent housing activity reports over the last couple of weeks. As you may know, mortgage rates have fallen from 6.04% (30yr fixed) to 5.47% as of earlier this week. While not a big reduction in borrowing costs, it was a move lower that should have helped stall the collapse in the housing market. This has not been the case as housing data has deteriorated across sentiment, new home sales, and existing home sales. With housing being the most important economic barometer, given its multiplier effect and its highly correlated lead time to overall growth, it is hard to argue that the economy is not slowing. Below is the Housing Sentiment Index, which shows the largest decline outside of COVID in the history of the data.
To make matters more complex, the financial markets have been hyper-focused on the Federal Reserve’s monetary policy mandate. Many market participants have argued that the Federal Reserve will pivot (pause interest rates), thus inducing an economic soft landing. We don’t find that to be probable given the elevated level of inflation and the trend higher in unit labor costs. Recall from previous discussions that unit labor costs have a strong correlation to Core PCE, the Feds inflation gauge. The tight labor market alone is driving up a bid for wages which in turn is keeping Core PCE elevated well above the neutral zone. This alone will cause the Fed to continue its tightening mandate. We have also yet to see the Federal Reserve pause its monetary tightening policy below the rate of inflation. The chart below shows the Fed raising rates at least until neutral.
Bear market rallies are a common occurrence and should be handled with care. When reviewing both market internals and prevailing economic conditions, we can conclude that we are not yet out of the woods. While it is always a fruitless job to determine the ultimate lows in the financial markets, it is important to maintain defensive allocations and ample cash equivalents. The next phase of this business cycle will be profit misses and/or lower profit guidance in this upcoming quarterly earnings season. It will then be followed by a quicker deterioration in labor conditions which at that point will cause the Fed to pivot, thus creating a bottom in economic conditions. Given how quickly this has unfolded, we expect this cycle to flush through much faster than we have seen in previous cycles. We are monitoring our data models closely. Please do not hesitate to contact me with any questions or comments. Best, Andrew H. Smith Chief Investment Strategist
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