Following the weaker-than-expected October inflation report, stocks rallied on the hope that the Fed “pivot” sooner rather than later. As we recently discussed, a “policy pivot” is not necessarily bullish, but rather suggests that market action will be more bearish. That is:
“This leaves only two trajectories for monetary policy. The first option is for central banks to pause rates and allow inflation to run its course. This would potentially lead to a softer landing in the economy, but would theoretically anchor inflation to higher levels. The second option, and the chosen one, is to raise rates until the economy falls into a deeper recession. Both trajectories are bad for stocks. The latter is substantially more risky as it creates an economic or financial “event” with more severe results.
While the US economy has absorbed tighter financial conditions so far, that doesn’t mean it will continue to do so. History is pretty clear on the results of higher rates, combined with a rising dollar and inflationary pressures.”
the “monetary policy conditions index” measures the 2-year Treasury rate, which affects short-term borrowing; the 10-year rate, which affects longer-term loans; inflation that impacts the consumer; and the dollar, which impacts foreign consumption. Historically, when the index has reached higher levels, it has preceded economic downturns, recessions, and bear markets.
Not surprisingly, the tighter monetary policy conditions become, the slower economic growth tends to be.
The bullish expectation is that when the Fed finally makes a “policy pivot” Such will put an end to the bear market. However, while that expectation is not wrong, it may not happen as quickly as the bulls are expecting.
In particular, the Monetary Policy Conditions Index suggests more bearish action is likely before the next bull market cycle can begin.
Outlook remains bearish for now
Investors are facing a bear market for the first time in more than a decade. This is something that many investors in today’s stock market have never witnessed first hand. However, it has been a challenging year on many fronts, given the huge number of negative days and increases in daily volatility.
However, we caution that this could be the case in 2021 when we discuss that “Low volatility begets high volatility.”
“Hyman Minsky argued that financial markets have inherent instability. As we saw in 2020-2021, asymmetric risks increase in market speculation during an abnormally long bull cycle. That speculation eventually results in market instability and collapse.
We can visualize these periods of “instability” by examining the daily price swings of the S&P 500 Index. Note that long periods of “instability” regularly lead to “instability.”
(I’ve updated the chart to the present.)
While periods of high volatility eventually go away, the down period for stocks is ultimately tied to the monetary conditions present in the economy at the time. If we invert our Monetary Conditions Index and compare it to the annual price changes of the S&P 500 Index, the correlation becomes apparent.
Unsurprisingly, with the Federal Reserve aggressively raising rates and the US Dollar Index rising in 2022, monetary conditions are extremely tight. This suggests that until those monetary conditions reverse, the market will continue to trade within a downtrend. This is because, as should be evident, tighter monetary conditions reduce corporate profits and profit margins.
The strong dollar is only problematic for companies with foreign sales, which account for nearly 40% of corporate revenue. However, added to that risk, higher borrowing costs, wages, input prices and the ability to maintain margins in a slower economic environment becomes extremely difficult.
So it should come as no surprise that stocks will need to trade lower again next year to adjust for slower earnings growth.
7 rules for navigating the final leg of a bear market
While anything is possible in the short term, complacency has quickly returned to the market. Investors are very optimistic that the Fed will turn around and start the next bull market. However, there are numerous reasons to remain aware of the risks.
- Earnings and profit growth estimates are too high.
- Deflation will be more frequent
- The Fed will continue to raise rates.
- The economic data will surprise in lowers it
- Consumer spending will slow.
- Excess inventory will affect manufacturing.
- Valuations remain high by many indicators.
- The risk of a credit-related event is increasing.
Then what do you do?
We remain bullish on the markets due to share buybacks, seasonality and bullish sentiment. As we have said repeatedly, the market could go as high as 4000 to 4100 by the end of the year. However, as we enter 2023, we remain concerned about broader macro risks and the risk that the Federal Reserve “to break something” raising rates too high. This keeps us cautious, so we continue to reiterate the importance of standing firm and focusing on managing portfolio risk.
- Move slowly. There is no rush to make drastic changes. Doing anything in a moment of “panic” tends to be the wrong thing to do.
- If you are overweight stocks, DO NOT try to fully adjust your portfolio to your target allocation in one move. Again, after significant drops, people feel like they “must” do something. Think logically about where you want to be and use the rally to adjust to that level.
- Start by selling laggards and losers. These positions were dragging performance as the market rose and were leading the way down.
- Add to sectors or positions that are performing with or exceeding the broader market if you need risk exposure.
- Move the stop-loss levels to the recent lows for each position. Managing a portfolio without stop-loss levels is like driving with your eyes closed.
- Be prepared to sell on the rally and reduce overall portfolio risk. You will sell many losing positions simply because you overpaid for them to begin with. Selling at a loss does NOT make you a loser. It just means you made a mistake.
- If none of this makes sense to you, consider hiring someone to manage your portfolio. It will be worth the extra expense in the long run.
Everyone approaches money management differently. Our process isn’t perfect, but it works most of the time.
The important message is that this bearish cycle will end and the next bullish cycle will begin.
Remember, if you “run out of chips” beforehand, you are out of the game.