This Market Rally Could Be A Bear Trap!! Here’s why……

After a really tough first 6 months of the year, the stock market has been in rally mode, rising over 9% within the last 30 days.  It’s left investors anxious to participate in the rally to recapture the losses that were incurred in the first half of the year.  Our guidance to clients, while there are plenty of bobbing heads on TV talking about “buying the dip” and trying to call the “bottom” in the market, this could very well be what we call a “bear trap”.   A bear trap is a short-term rally that baits investors into thinking the market has bottomed only to find out that they fell for the trap, and experience big losses when the market retreats to new lows.

The 4th Bear Trap In 2022

 If the current rally ends up being a bear trap, it would actually be the 4th bear trap so far in 2022.   

The green boxes in the chart show when the rallies occurred and the magnitude.  Notice how the market moved to a new lower level after each rally, this is a common pattern when you are in a prolonged bear market environment.

So how do you know when the bear market is over and the new sustainable bull market rally has begun?  It’s actually pretty simple. Ask yourself, what were the issues that drove the market lower in the first place?  Next question, “Is the economy making MEANINGFUL progress to resolve those issues?” If the answer is yes, you may in fact be at the beginning of the rally off of the bottom; if the answer is no, you should resist the temptation to begin loading up on risk assets.

It's Not A Secret

 It’s not a secret to anyone that inflation is the main issue plaguing not just the U.S. economy but economies around the world.  Everyone is trying to call the “peak” but we did a whole video on why the peak doesn’t matter.

 The market cheered the July inflation report showing that headline year over year inflation dropped from 9.1% in June to 8.5% in July.   While progress is always a good thing, if the inflation rate keeps dropping by only 0.60% per month, we are going to be in a lot of trouble heading into 2023.  Why? As long as the inflation rate (the amount prices are going up) is higher than the wage growth rate (how much more people are making), it will continue to eat away at consumer spending which is the bedrock of the U.S. economy.  As of July, wages are growing at only 6.2% year over year.  That’s still a big gap until we get to that safety zone.

Understand The Math Behind The CPI Data

While it’s great that the CPI (Consumer Price Index) is dropping, the main CPI number that hits the headlines is the year-over-year change, comparing where prices were 12 months ago to the prices on those same goods today. Let me explain why that is an issue as we look at the CPI data going forward.   If I told you I will sell you my coffee mug today for $100, you would say “No way, that’s too expensive.”  But a year from now I try and sell you that same coffee mug for $102 and I tell you that the cost of this mug has only risen by 2% over the past year, does that make you more likely to buy it?  No, it doesn’t because the price was already too high to begin with.

In August 2021, inflation was already heating up.  The CPI headline number for August 2021 was 5.4%, already running above the Fed’s comfort level of 3%.  Similar to the example I just gave you above with the coffee mug, if the price of everything was ALREADY at elevated levels a year ago, and it went up another 8.5% on top of that elevated level, why is the market celebrating?

Probability of A 2023 Recession

Even though no single source of data is an accurate predicator as to whether or not we will end up in a recession in 2023, the chart that I am about to show you is being weighted heavily in the investment decisions that we are making for our clients.

Historically an “inverted” yield curve has been a fairly accurate predicator of a coming recession.  Without going into all of the details of what causes a yield curve inversion, in its simplest form, it’s the bond market basically telling the stock market that a recession could be on the horizon.  The chart below shows all of the yield curve inversions going back to 1970.  The red arrows are where the inversion happened and the gray shaded areas are where recession occurred.

Look at where we are right now on the far right-hand side of the chart. There is no question that the yield curve is currently inverted and not just by a little bit.  There are two main takeaways from this chart, first, there has been a yield curve inversion prior to every recession going back to 1970, an accurate data point.  Second, there is typically a 6 – 18 month delay between the time the yield curve inverts and when the recession actually begins.

Playing The Gap

I want to build off of that last point about the yield curve.  Investors will sometimes ask, “if there is historically a 6 – 18 month delay between the inversion and the recession, why would you not take advantage of the market rally and then go to cash before the recession hits?”  My answer, if someone could accurately do that on a consistent basis, I would be out of a job, because they would manage all of the money in the world. 

Recession Lessons

I have been in the investment industry since 2002.  I experienced the end of the tech bubble bust, the Great Recession of 2008/2009, Eurozone Crisis, and 2020 COVID recession. I have learned a number of valuable lessons with regard to managing money prior to and during those recessions that I’m going to share with you now:

1.  It’s very very difficult to time the market.  By the time most investors realize we are on the verge of a recession, the market losses have already piled up.

2. Something typically breaks during the recession that no one expects.  For example, in the 2008 Housing Crisis, on the surface it was just an issue with inflated housing prices, but it manifested into a leverage issue that almost took down our entire financial system.   The questions becomes if we end up in a recession in 2023, will something break that is not on the surface?

3. Do not underestimate the power of monetary and fiscal policy.

The Power of Monetary & Fiscal Policy

I want to spend some time elaborating on that third lesson.  The Fed is in control of monetary policy which allows them to use interest rates and bond activity to either speed up or slow down the growth rate of the economy.   The Fed’s primary tool is the Fed Funds Rate, when they want to stimulate the economy, they lower rates, and when they want to slow the economy down (like they are now), they raise rates.   

Fiscal policy uses tax policy to either stimulate or slow down the economy.  Similar to what happened during COVID, the government authorized stimulus payments, enhanced tax credits, and created new programs like the PPP to help the economy begin growing again.  

Many investors severely underestimate the power of monetary and fiscal stimulus. COVID was a perfect example.  The whole world economy came to a standstill for the first time in history, but the Fed stepped in, lowered rates to zero, injected liquidity into the system via bond purchases, and Congress injected close to $7 Trillion dollars in the U.S. economy via all of the stimulus policies.  Even though the stock market dropped by 34% within two months at the onset of the COVID crisis in 2020, the S&P 500 ended up posting a return of 16% in 2020. 

Now those same powerful forces that allowed the market to rally against unsurmountable odds are now working against the economy.  The Fed is raising rates and decreasing liquidity assistance.  Since the Fed has control over short term interest rates but not long-term rates, that is what causes the yield curve inversion.  Every time the Fed hikes interest rates, it takes time for the impact of those rate hikes to make their way through the economy. Some economists estimate that the delay between the rate hike and the full impact on the economy is 6 – 12 months.

The Fed Is Raising More Aggressively

The Fed right now is not just raising interest rates but raising them at a pace and magnitude that is greater than anything we have seen since the 1970’s.  A chart below shows historical data of the Fed Fund Rate going back to 2000. 

Look at 2004 and 2016, it looks like a staircase. Historically the Fed has raised rates in small steps of 0.25% - 0.50%. This gives the economy the time that it needs to digest the rate hikes.  If you look at where we are now in 2022, the line shoots up like a rocket because they have been raising rates in 0.75% increments and another hike of 0.50% - 0.75% is expected at the next Fed meeting in September.  When the Fed hikes rates bigger and faster than it ever has in recent history, it increases the chances that something could “break” unexpectedly 6 to 12 months from now.  

Don’t Fight The Fed

You will frequently hear the phrase “Don’t Fight The Fed”.   When you look back at history, when the Fed is lowering interest rates in an effort to jump start the economy, it usually works.  Conversely, when the Fed is raising rates to slow down the economy to fight inflation, it usually works but it’s a double edged sword.  While they may successfully slow down inflation, to do so, they have to slow down the economy, which is traditionally not great news for the stock market.

I have to credit Rob Mangold in our office with this next data point that was eye opening to me, when you look back in history, the Fed has NEVER been able to reduce the inflation rate by more than 2% without causing a recession.  Reminder, the inflation rate is at 8.5% right now and they are trying to get the year over year inflation rate back down to the 2% - 3% range.  That’s a reduction of a lot more than 2%.

Stimulus Packages Don’t Work

In the 1970’s, when we had hyperinflation, the government made the error of issuing stimulus payments and subsidies to taxpayers to help them pay the higher prices.  They discovered very quickly that it was a grave mistake. If there is inflation and the people have more money to spend, it allows them to keep paying those higher prices which creates MORE inflation. That is why in the late 70’s and early 80’s, interest rates rose well above 10%, and it was a horrible decade for the stock market.

In the U.S. we have become accustomed to recessions that are painful but short.  The COVID Recession and 2008/2009 Housing Crisis were both painful but short because the government stepped in, lowered interest rates, printed a bunch of money, and got the economy growing again. However, when inflation is the root cause of our pain, unless the government repeats their mistakes from the 1970’s, there is very little the government can do to help until the economy has contracted by enough to curb inflation. 

Is This The Anomaly?

Investors have to be very careful over the next 12 months.  If by some chance, the economy is able to escape a recession in 2023, based on the historical data, that would be an “anomaly” as opposed to the rule.   Over my 20 year career in the industry, I have heard the phrase “well this time it’s different because of X, Y, and Z” but I have found that it rarely is.  Invest wisely.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Will The January Market Selloff Continue?

The markets have experienced an intense selloff in the first three weeks of 2022. As of January 21st, the S&P 500 Index is down over 7% for the month.  There are only a few times in the past 10 years that the index has dropped by more the 5% in a single month.  That begs the questions, “After those big monthly declines, historically, what happens next?” Continued decline? Market recovery?  We are going to answer that question in this article

 The recent selloff has also been widespread.  The selloff in January has negatively impacted stocks, bonds, crypto, while inflation continues to erode the value of cash.   It has essentially created a nowhere to hide market environment.  As of January 21, 2022, the YTD returns of the major indices are:

 S&P 500 Index: -7.7%

Nasdaq:                -12.0%

Small Cap 600:   -8.5%

Agg (Bonds):      -1.7%

Bitcoin:                 -24.1% 

In this article I’m going to cover:

• What has caused the selloff?

• Do we expect the selloff to continue?

This Has Happened Before

How many times has the S&P 500 index dropped by more than 5% in a month over the past 10 years?

 Answer:  4 times

 February 2020: -18.92%

November 2018:  -5.56%

December 2015:  -6.42%

July 2011: -10.40%

Next question: How many times did the S&P 500 Index post a positive return 3 months following the month with the 5%+ loss?

 Answer: ALL OF THEM

 Mar 2020 – May 2020:     16.7%

Dec 2018 – Feb 2019:    9.5%

Jan 2016 – Mar 2016:          8.6%

Aug 2011 – Oct 2011:         4.0%

Don’t Make The Jump In / Jump Out Mistake

There is no doubt that the big, swift downturns in the markets bring fear, uncertainty, and stress for investors but all too often investors let their emotions get the better of them and the lose sight of the biggest economic trends that are at work.  The most common phrase that I hear from investors during these steep declines is:

“Maybe we should just go to cash to stop the losses and then we can buy back into the stock market once the risks have passed.”

The issue becomes: when do you get back in?  Following these big temporary sells offs in the market, it is common that the lion share of the gains happened before things feel good again.  Investors get back in after the market has already rallied back, meaning they solidified their losses and they are now allocating money back into stocks when they have returned to higher levels.   

We accurately forecasted higher levels of volatility in the market in 2022 when we release our 2022 Market Outlook video.   It is also our expectation that with inflation rising and the Fed moving interest rates higher, the selloff that we have experienced in January, will not be the only steep selloff that we are faced with this year.  Before we get into the longer- term picture, let’s first look at what prompted the January selloff in the markets.

What Caused The Market Selloff in January?

There are a number of factors that we believe has caused this severe selloff in January:

 COVID Omicron cases have surged

• The Fed’s more hawkish tone

• Rising interest rates

• Tech sector selloff

• COVID investment plays unwinding

• Loss of enhanced child tax credit monthly payments

While that looks like a long list, at the risking sounding like a broken record, if you go back to the Market Outlook video that we released in December, all of these were expected.  It’s only when unexpected events occur that we then have to shift our strategy for the entire year.  Let’s look at each of these items one by one:

COVID Cases Have Peaked

One thing that caught the market by surprise over the past few months is how contagious the Omicron variant was and how many cases there would be. This caused the recovery story to stall as safety measures were put back into place to control the spread of the most recent variant.  The good news is it looks like the cases have peaked and are now on the decline. See the chart below:

It's a little tough to see in the chart but the blue line represents the number of confirmed COVID cases. If you look all the way on the righthand side, as of January 20th, they have dropped dramatically. The 7-day moving average has dropped by about 100,000 cases.   This trend supports our forecast that the economy will begin opening up again starting in February.  We expect the reopening trade story to be part of the market rally coming off of this tough January for the markets.

The Fed’s Hawkish Tone

It's the Fed’s job to keep inflation under control so the economy does not overheat.  Inflation has been running at rate of over 6% for the past several months and going into 2022, the Fed telegraphed making 3 rate hikes in 2022.  After the Fed’s January meeting, an even more hawkish tone was found in those meeting minutes, suggesting that more than 3 rate hikes could be on the table this year.  This caused interest rates to rise rapidly which hurt both stocks and bonds in January. 

 But let’s take a look at history. The last time the Fed started raising rates was in 2016.  Between 2016 and 2018, they hiked the Fed Funds Rate 8 times. During that two-year period, the S&P 500 was up 15.8%.  The lesson here is just because the Fed is beginning to raise rates does not necessarily mark the end of the bull market rally. 

Rising Interest Rates

Interest rates rose sharply in January which put downward pressure on both stocks and bonds.  Investor often have bonds in their portfolio to offer protection when the there are selloffs in the stock market but when interest rates are moving high and the stock market is selling off at the same time, both stocks and bonds tend to move lower together.  The yield on the 10 Year Treasury jumped from 1.51% on December 31, 2021 to 1.86% on January 18, 2022. That does not sound like a big increase but in terms of interest rates that is a huge move in 18 days. (In percentage terms, over 23%) 

 We do expect interest to continue to rise in 2022 but not at the concentrated monthly pace that we saw in January. 

Tech Stock Drop

Tech stock took a big hit in January. The Nasdaq is down 12% in the first three weeks of 2022.  In the 2022 Market Outlook we talked about tech stock coming under pressure this year in the face of rising interest rate and a lesson from the 1970’s about the “Nifty Fifty”.    These tech stocks tend to trade at higher valuations. Interest rates and valuation levels tend to have an inverse relationship meaning if a stock is trading at a higher valuation level (P/E), they tend to be more adversely affected compared to the rest of the market when interest rates move higher.

COVID Investment Plays Unwind              

In January, stocks that were considered “stay at home” COVID plays, like streaming, home exercise equipment, and electronic document providers experience large corrections.  Here are some of the names that fall into that space and their performance YTD as of January 21, 2022:

Netlfix:                 -33%

Peloton:               -23%

DocuSign:            -23%

Now that the United States has reached a level of vaccinations and positive COVID cases that would suggest that we are at or close to herd immunity, there seems to be a higher likelihood that future COVID variants may not cause extreme economic shutdowns that supported the higher valuation level of these “stay at home” investment strategies.

Loss of Child Tax Credit Payments

Since the Build Back Better bill did not pass in December 2021, the $300+ per month that many parents were receiving for the Enhanced Child Tax Credits stopped in January.  While those monthly payments to families were only meant to be temporary, it was highly anticipated that they were going to be extended into 2022 with the passing of the Build Back Better bill.   Not having that extra money every month could slow down consumer spending in the first quarter of 2022.

Do We Expect The Selloff To Continue?

No one has a crystal ball but I would be very surprised if we do not see a recovery rally in the markets over the next few months.  I think people underestimate the amount of money that has been injected into the U.S. economy over the past 18 months.  If you total up all of the COVID stimulus packages over the past 18 months, they total $6.9 Trillion dollars. Compare that to the TARP Stimulus package that saved the banks and housing market in the 2008/2009 recession which only totaled $700 Billion.  A lot of that stimulus money has yet to be spent due to supply change and labor constraints over the past year.

 It's our expectations that the supply chain, which is already showing improvement, will continue to heal as we move further into 2022, which will give rise to higher levels of consumer spending and in turn, higher corporate earnings.  

 Inflation will be the greatest risk to the economy in 2022, but if the recovery of the supply chain causes prices to stabilize and consumers have the cash and wages to pay these temporarily higher prices, the bull rally could continue in 2022.  But again, it will be choppy.  The market could experience numerous corrections similar to what we are experiencing in January that investors may have to hold through, especially as the Fed begins to announce interest rate hikes later this year.  We expect patience to be rewarded in 2022.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.