fter several turbulent months that resulted in a market correction of over 20% and two consecutive quarters of negative GDP, investors are convinced we’re in a full blown recession. But while the correction seemed persistent through 1H22, one has to consider that at least for the S&P 500 this is a blip in the uptrend that began in 2009. However, two-quarters of falling GDP growth hasn’t bothered the market, which has remained more or less flat through the summer months. 

And with Powell set to speak after weeklong meetings with other central bankers at the Jackson Hole Economic Symposium, we’re taking a look at the case for a bullish rebound and a policy taper. The case can be made by looking at the unusual strength of the US dollar, the effects of changing interest rate velocity, and inflation. We believe that equities could continue to rise after a smaller correction. 

So why is the Dollar so strong? The dollar index rose over 7% to date, beating the Euro for the first time in decades. This is not due to some unprecedented dollar strength, but instead to weakness relative to two constituents of the dollar index: The Euro and the Japanese Yen, which account for over 70% of the index.

Historically, Japan had the lowest inflation of any developed nation ‚Äď if anything, it had too low inflation ‚Äď a problem that the late prime minister Shinzo Abe tried to solve. Thus, the Bank of Japan (BOJ) has had interest rates at negative 0.1% for the last 6 years.

The European Central Bank (ECB) hiked only once, with July inflation at 8.9%. This presents a disconnect between inflation and monetary policy rarely seen throughout history. The problem is the different debt structures of countries that were carried over into a joint monetary system.

US public debt is mainly at a federal level, and Federal Reserve policy decisions do not significantly impact individual states like ECB decisions in the Eurozone. It is not surprising that divergence between the actions of the FED, ECB, and BOJ created such a dollar rally.

Despite inflation ticking higher in June at 9.1%, the topping prices of commodities in June showed that the inflation should subside, which was proven by the latest CPI print. Inflation in the US is more spread out between the demand and supply side, which is more controllable with monetary policy than the pure supply-side inflation in Europe.

A new study from the Fed points to demand shock as responsible for 60% of inflation
Source: St. Louis Fed

The Fed has no reason to cause a deep recession or crash the stock market; in the past, Chair Powell proved reluctant to do so. The market would likely celebrate a policy reversal, flipping sentiment and pulling in more cash from the sidelines. 

Meanwhile, retail investors might not be aware of the correlation shift between the Federal Funds Rate (FFR) and the 10-year yield since the Fed initiated quantitative easing in 2008. The correlation has been positive since then, with FFR rising and pushing the 10-year yield higher. However, the correlation between the 10-year yield and equities also remained positive over the decade.

BoFa fund manager survey says: Recession is now concensus
Source: Bank of America

We have a few reasons to be bullish. Yes, the latest Bank of America fund manager survey showed market sentiment is the worst it has been since April 2020 and March 2009 ‚Äď with an overwhelming number of managers expecting a recession.

And, there are record low growth & profit expectations, cash levels are the highest in a very long time, and equity allocation is the lowest since 2008. But if inflation tops out soon, where would the cash go?

For the fifth time in a decade, the S&P 500 corporate insider buy/sell ratio has flipped to a heavy buying zone. Previous instances were in 2011, 2016, 2019, and 2020 and a market rally followed each one.

S&P 500 Insider Buying Ratio
source: JP Morgan Equity Research

While up for debate, analysts like Robert Balan argue that aggregate central bank balance sheets lead the stock market. According to these models, G5 aggregate expenditures lead risk asset prices by 2.5 years, pointing to an S&P 500 bottom already in place.

A yield curve inversion is also a relatively reliable predictor of market turmoils, but it is a leading indicator by 5-6 quarters. Aggregate government expenditures look favorable for 2H2022 and 1H2023. However, they point to a weakening market in 2H2023, aligned with the yield curve inversion as a leading indicator.

The S&P rallied 13.75% in 3Q2022, and chasing the market doesn’t make sense from the risk-reward perspective. Instead, we should look for signals from volume and implied volatility that indicate pullbacks. 

S&P 500 hits daily resistance multiple times
Source: TradingView

Notice the falling volume that repeats at the beginning of this year when the market topped at 4,800 before falling 12%. The index also hit a 200-day moving average convergence point with the falling trendline connecting two highs from this year. Meanwhile, implied volatility shows the VIX is approaching a near-term trough with a potential spike in volatility coming soon. This increases the odds of a market correction. 

In general, the market appears to be ‚Äúfine‚ÄĚ moving into 2023, but investors should be careful not to chase superfluous trends. Many signals could be a red herring. The odds of a 5-10% pullback before 4Q2022 are high enough to wait for that opportunity, as the technical and physical outlook all point in that direction.¬†

Inflation has likely peaked, but this trend needs further confirmation from the Producer Price Index (PPI), and the stickiest components of the CPI. This would support further US Dollar strength, especially if the US is able to tame inflation before other countries with a different policy approach. This would also make US equities more attractive to foreign investors. 

Aug 26, 2022

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