- The economy is floundering, yet stocks are rallying.
- Stocks are a leading indicator, so they often sniff out good news early.
- Pros remain heavily bearish in the futures market, and money supply remains historically high.
- Zweig's Fed indicator could shift to neutral from bearish as early as March 2023.
The market has made tremendous progress since mid-June’s “hide-under-the-desk” low. The S&P 500 has been up 18% in the past two months, and the technology-laden Nasdaq has gained nearly 24%. Those moves are eye-popping considering that over rolling 10-year periods, stocks' historical compound annual return is about 6% over the past 100 years, according to CFRA.
The index returns caught many by surprise, given how poorly the economic data has been. U.S. Gross Domestic Product has fallen in the past two quarters, and things aren’t improving.
The Empire State Index collapsed yesterday because of a sharp decline in new orders. Today, China surprisingly cut interest rates to stimulate its economy. We also learned housing starts dropped 9.6%, and building permits fell 1.3% in July. The data has hardly been reassuring, but stocks have still enjoyed their best rally this year.
The disconnect between economic news and stock prices may seem like a head-scratcher, but stocks are forward-looking. Historically, they bottom before a recession is over when the economy is weakest, and earnings growth is lousy.
In “Getting in the Right Position Is What Matters Most Right Now,” Real Money Pro’s Carley Garner discusses why it’s essential to keep an open mind about what happens next for stocks.
“Markets are forward-looking, which often means the next market move is the least obvious one. Although pessimism is at historical highs, it might be that speculators that wanted to be short have already sold, and investors that wanted to reduce risk exposure have already liquidated. If so, regardless of noticeable fundamental headwinds, the stock market can continue to go higher as the very bears betting against the rally contribute to its magnitude via short covering. Similarly, long-term investors who liquidated near the June lows are likely regretting their decision and starting to chase prices higher.”
Undeniably, the sentiment was terrible in June. Professional investors were taking on the least risk in portfolios since the Great Recession, and individual investors were decidedly bearish. On June 22, only 18% of respondents were bullish in AAII’s weekly sentiment survey, a significantly low level of optimism. Furthermore, the put/call options ratio, a measure of bearish put trading to bullish call buying, was 1.3 in mid-June, a level of pessimism that’s been a good entry in the past for those who bet against the herd.
In short, as Garner suggests, everybody who wanted to sell had sold, leaving long-term buy-and-holders, speculators, and computer models the only ones left in the building. This setup provided fuel for any hint of optimism to spark a rally, and that rally has been supported ever since by short covering, trend-following algorithms, and short-term traders who bow at the altar of price.
That narrow participation suggests the rally’s only sustainable as long as the music keeps playing. A longer-term rally needs widespread institutional buying, and they’re primarily absent given anemic trading volume. Eventually, those who need to cover will have covered, leaving the market at risk of selling off. Under those circumstances, it wouldn’t take much to cause speculators and computer programs to change their tune.
However, everybody is aware of that risk. Stocks tend to punish the masses, so if everybody expects the market to fall dramatically, perhaps it won’t. Instead, it may be a stretch of shallow retreats to uptrends and horizontal supports, constructing a series of higher lows.
Back to Garner:
“We don't think there is room for being complacent regardless of your positions or opinions. The reality is the market could continue to climb the wall of worry. Here are a few arguments for a continuation of the upswing beyond what most consider to be reasonably possible.
Speculators? They're Already Short:
According to Friday's release, the large speculator category of the Commitments of Traders report issued by the Commodity Futures Trading Commission was holding a net short position of about 244,000 futures contracts. But if you use the data that combines futures and options positions, the net short position is near 300,000 contracts. This is a historically lopsided holding; we have only seen speculators this bearish on a few occasions. The first was in the fall of 2011, and the other was in May 2020. Each of these oversized short positions occurred a few months after the market bottomed and likely added fuel to the fire on the upside as traders unwound the overcrowded short positions throughout stunning melt-ups.
Money, Money, Money
The Federal Reserve embarked on a quantitative easing journey during the financial crisis and doubled down on that policy to fight the Covid-shutdown. The result has been a massive increase in the amount of money circulating in the economy. The goal of QE is to increase asset prices by increasing the money supply; the final objective is to artificially keep interest rates low and the wealth effect high (people tend to be more confident in their finances and spend more when their home value and stock portfolio are performing well). While the Fed has recently begun the process of quantitative tightening, it is in the early stages of the procedure, and it has merely stabilized the money supply, not reversed it. Perhaps this is a sign that there is still too much money chasing too few assets. If so, both stocks and bonds could melt up together as investors seek places to park money.”
Garner notes that pros playing the futures and options markets (green line in the chart above) are still heavily tilted toward bearishness. So, while the put/call ratio has improved and sentiment survey results aren’t as pessimistic as they were, many could get caught flat-footed if stocks power through resistance at the 200-day moving average. She points out that despite all the browbeating about quantitative tightening, the Fed’s balance sheet remains overstuffed, so money is still sloshing about in search of assets to own.
Furthermore, Garner suggests in her article that although economic data is bad, it’s not nearly as bad as in previous years when stocks also surprisingly soared. For instance, stocks rallied when the global economy was closed for business during the pandemic, and banks were under massive distress in 2009.
Where does Garner think stocks could go from here?
“I would not say I was bullish; in fact, if resistance near 4,400 holds, I believe things could get ugly fast. Yet, I'm keeping an open mind about the potential of an upside breakout. All of the signs are there to suggest it is a real possibility. In fact, I believe it is more likely than a reversal back into the bear market. If portfolios are short (not as exposed to stocks as they should be) and speculators are short (short futures or stock), the most motivated market participants will be those buying because they have to, not because they want to. One must never underestimate the ability of the market to cause the most pain to the highest number of people; a melt-up would do just that.”
The Smart Play
The market reflects optimism that bad data will ultimately be good news because it will force the Fed to the sidelines. Historically, stocks put in their best returns when the Fed is easing rather than hiking. We’re still a ways away from that happening, but remember, stocks look forward rather than backward.
We’ll likely get at least another 0.50% interest rate hike in September. Additional increases could be data-dependent, though. For example, if unemployment creeps up (employment is a lagging indicator) and inflation continues decelerating, the Fed could take a wait-and-see approach. If so, the negative impact of rate hikes should fade in 2023. For consideration, Martin Zweig (the inventor of “don’t fight the Fed”) removed the negative effect of rate increases in his model after six months. That means if September is the last increase, his Fed Indicator will return to neutral in March 2023.
Overall, if you’re an active investor, this isn’t a time for complacency. Use stop losses to play defense in case we stall. Nevertheless, it pays to sell the first half of bear and buy the second half. Since I believe we’re closer to being in the second half than the first half, I think it's best to buy pullbacks to support levels for upside in 2023 and 2024. Of course, stocks won't trade in a straight line, so spread buys across multiple tranches and avoid margin so you don’t get forced out by margin calls.