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  • Stocks and bonds fell sharply in September.
  • Sentiment indicators suggest a rally in stocks is near.
  • The risk that a rally could falter is high because of financial system instability and geopolitical uncertainty.

The stock market performed terribly in September to finish a lousy quarter. The numbers? The S&P 500 and NASDAQ fell 9.3% and 10.5% during the month, resulting in third-quarter and year-to-date declines of 5.3% and 4.1%, and 24.8% and 32.4%, respectively.

If you were among the many with a healthy allocation toward Treasuries this year, you’ve similarly been disappointed.

Substantially higher yields because of Fed Interest rate increases means bond prices have fallen dramatically. For example, the iShares 1-3 year Treasury ETF  (SHY)  and IShares 20+ Year Treasury Bond ETF  (TLT)  fell 1.3% and 8.4% in September, bringing their year-to-date returns to losses of 5.1% and 31%, respectively.

Last month’s ruthless selling likely has you wondering what’s next for the markets. Can they find their footing and rally, or does more pain await? There’s good reason to believe stocks could rally soon; however, how long that rally lasts may depend on the Federal Reserve.

The bullish argument

Stock prices hate straight lines, so the sharp decline last month may set the stage for a bear market rally.

In “We Should Rally in Early October,” Top Stocks’ Helene Meisler notes that poor sentiment and contrary indicators, including her oscillator of advancing stocks minus declining stocks, suggest the rubber band has been stretched too far. That may indicate stocks are due for a bounce, even if it isn’t long-lasting. She writes:

“We know sentiment is sour. Let me count the ways: Investors Intelligence bulls at 25%, American Association of Individual Investors bears over 60% for two consecutive weeks, the National Association of Active Investment Managers exposure now at 10, the put/call ratios zooming ever higher, the ISE Equity call/put ratio falling under 1.0 for two consecutive days, and even the Citi Panic/Euphoria Model moved into Panic two weeks ago. The Daily Sentiment Index (DSI) for the S&P 500 is back to single digits at 9 and Nasdaq is at 10…

We also know the market is oversold. Last Friday's decline didn't even manage to take the Oscillator to a lower low. We know that Nasdaq's new lows have been contracting with Friday's reading one half of what they were a week ago and one-third of what they were in May…

My view has not changed as I still think we should rally in early October. But if you are looking for the low of the bear market, we'll need bases for that, something that we don't have.”

Meisler’s opinion is similar to Real Money Pro value investor Paul Price. In “The Bad News and the Good News Heading Into Q4 2022,” he reinforces that flashing contrarian sentiment signals are particularly notable because they coincide with investors pulling the plug on investments and heading to cash. Price writes:

“Investor sentiment readings are near all-time worsts. That has always proven to be a true contrary indicator in the past…"mom and pop" investors always being wrong at key turning points. A glance at the equity fund flow numbers proved that true once again during August and September this year. Individual investors were net buyers right at the August rally peak before selling out billions of dollars at much cheaper prices in the 45-days or so since. When those fundholders start demanding billions in redemptions from their equity mutual funds the managers of those have no choice but to sell into weakness to get the money to send them. That only exacerbates the declines. What is the bottom line from all this? Stock prices have almost completely detached from their fair values…Get ready for what should be a tremendous recovery as we progress through the strongest three months of the calendar based on decades of stock market history.”

According to data compiled by Barron’s and money flow watchdog Lipper, September’s weakness resulted in weekly outflows from equity funds over the past month totaling $10.6 billion. Similarly, weekly average outflows from taxable bond funds flipped to negative $2.3 billion, and only money markets saw average weekly inflows, rising to $3.6 billion. For now, rising money market balances reflect mounting investor fear, but historically, big cash balances support higher asset values. Why? Because that cash is only temporarily being sidelined. Once things “look better,” mom-and-pop investors usually reallocate back into risk assets. In short, Main Street investors often sell low and buy higher rather than buy low and sell higher.

If that's true again, then improving seasonality could encourage them to buy back into stocks and bonds. Typically, October and November are particularly strong performing months during mid-term Election years. Furthermore, returns between November 1 and April 30 have trounced from May 1 through October 31 since 1950. According to the Stock Trader's Almanac, a $10,000 investment in each period in 1950 would have grown to $1.01 million or $12,623, respectively. That track record is a pretty compelling reason to tilt bullish soon.

The bearish case

The potential for a bounce doesn’t necessarily signal an ‘all clear’ for stocks. As Meisler said, bottoms are usually built on bases (sideways trading that can last months or longer), and there aren’t many of them.

In “Charting the S&P 500: A Bridge Too Far,” Action Alerts PLUS co-Portfolio Managers paint a still-risky picture of where the index could be heading. They write:

“The weekly chart below shows a break of the June lows, plain as day. The channel we drew in a couple of months back is still in play, and a test to the lower band would be a push down to 3300 currently, but ultimately 3000…The relative strength on the weekly has rolled over, and to show the strength in volatility, the Bollinger bandwidth is rising, as is the ulcer index. The Traders Dynamic Index (TDI), previously discussed here, at the bottom, crossed and started rolling over in August; this has been on a sell signal since. And notice the purple bars in the price window and the bearish SAR (big arrow). This tells us the trend is down, and it is very strong…Oversold readings are here now, but that is not a reason to buy. Remain cautious [emphasis mine].”

CHART-Street-Smarts-JS-100322

That bearish backdrop is similar to what Real Money Pro’s Bret Jensen wrote in “My Prediction for the Fourth Quarter: Pain.” Jensen says, “I wish I confidently could say stocks are now oversold, and the fourth quarter will bring a nice rebound to help close out 2022 on a more hope-filled note. Unfortunately, that is not my view. I have been consistently bearish throughout this year and remain so as the last quarter of 2022 commences. There are myriad reasons for concern around the markets and the economy right now.”

Among those reasons are that an overly aggressive Fed, alongside increasingly hawkish global Central Banks, could break something, and inflation could reignite this winter if Russia recaptures lost ground in Ukraine and embargoes on Russian fossil fuel to Europe continue.

We saw what “something” may break could look like when a free fall in UK bonds forced its government to buy long bonds last week to stabilize pension funds and insurers who were facing margin calls. Russia’s recent mobilization of additional forces and annexation announcements show it remains committed to its War in Ukraine.

The risk of a system-wide negative event is also on the mind of Real Money Pro’s Peter Tchir. In “Bond Market Liquidity: Even I'm Concerned,” Tchir writes:

“I've seen a lot in almost 30 years of trading debt instruments, and liquidity is at one of the more precarious levels I've seen. My biggest fear is that the gut-wrenching, illiquid trading in bonds gets worse and exposes cracks in the entire market structure. There is concern that is happening, and that concern is increasingly well founded…My expectation is the final lows of this bear market occur with a big risk-off trade (bonds do extremely well, while stocks get hit hard). I think we have another everything rally before then. Be safe, be careful. This is risky.”

The Smart Play

The odds of a short-term rally are good because sentiment is poor, but the durability of a bounce remains a big question. Will a rally be similar to June, when the S&P 500 rose nearly 20% before stalling in mid-August? Or will it be like early September, when the index climbed about 6% before rolling over?

You could construe that level of uncertainty alone as bullish. However, investors shouldn’t ramp leverage and hope to hit a home run. Bear markets can last a long time, and the Fed’s not showing signs it’s ready to “blink” in its inflation battle. As you can see in the following table, included in Martin Zweig’s Winning on Wall Street (1997 edition), positive returns can be hard to come by when the Fed is bearish (raising rates).

fed indicator.jfif

Intermediate-term investors are facing the most challenging decision currently. Short-term traders can rein in short exposure and increase longs, similar to what Real Money Pro’s Doug Kass has been doing in his daily trading diary. Meanwhile, long-term investors can use bear market prices to lower average costs, knowing that they have decades for the market to work its compounding magic. In the medium term, however, the crystal ball is very hazy. So, if you’re in the intermediate-term camp, overweighting cash, using stop losses, and avoiding margin until there’s more clarity remains smart.

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