Finding the end of the bear market of 2022 (Survivor Series Part 2)
Looks like half way in an intermediate rally.
As I type this, beyond expectations, the broad markets are rallying.
All of a sudden, from doom and gloom, now even houses like Morgan Stanley is saying that the rally has more legs, even up to 10% more. Where were they a week ago?
Well, combined with the 10% bounce from the lows, another 10% bounce would like a 20% bounce. That's as good as an intermediate rally to me.
However, a couple days before the actual lows got bounced from, I was already alerting the the ground was ripe for an intermediate bounce. Here's a snippet of the last few posts I did.
I warned on Oct 13 that the "Rubber Band was stretched" and prime to snap back to a mean reversion.
In this post, I will do two things.
The first, perhaps for my own self, I want to document all the statistical signs that were warning us not to go with the bearish crowd and hold off on going short. So that when the next intermediate cycle bottom comes again we can have a sense of what to look for. Part of what I share was from the earlier posts, and I add some new ones.
Why do I think we were / are primed for an intermediate rally despite many classic recession indicators were hit? (Inverted yield curve, inflation still high, news of how people are struggling with food and rent prices, stress in the credit markets especially the pound, bonds more or less still selling off.)
All of these factors tell us we are in a bear market.
However, sometimes markets sell off so much that valuations become so cheap that any glimmer of hope will cause a brief surge in prices because in a sense, some stocks are selling at recession prices even before an official recession hit. As we speak, there are companies that are still beating expectations!
For an intermediate rally to have legs, there must be some cause for "hopium", a feel good story to bouy retail investors to get back in until the deteriorating fundamentals make its way into earnings. I think there are at least two now.
The first is the FED starting to sound less hawkish, they are to discuss if they are overtightening in the next FED meeting next week. At the same time, Morgan Stanley analyst Michael Wilson said in a note to clients that rates in the bond market "are poised to come in" as he contends that recent action in fixed income has created a situation where "the back end of the bond market" is now offering "real value for the first time since early 2021." This means that there could be price support for long-dated bonds, and bullishness for bonds also means bullishness for stocks in this part of the cycle.
The second is that this quarter is "saved" by companies reporting good earnings.
Here's a quick snapshot from investing.com.
The big banks kicked off earning season with big beats. We also say J&J, NFLX, United Health, ICM and AT&T smash earnings estimates. At least for this quarter, there is a chance for this trend to continue as more companies beat expectations.
OKAY, at least we have anacdotal evidence that the rally has some legs.
Before I continue, let me show you a couple slides I did months ago. I drew this up in the middle of May 2022! Both the 1st and 2nd objectives of the head and shoulders breakdown in the middle of May were hit.
So it seems like this type of set up is in play...
What were the signs for an intermediate rally before the news became favorable?
The Stretched Rubber Band
The rate of change of margin debt had an extreme reduction, usually signaling the sell-off was too fast and needs to mean revert.
The 20-day moving average of small trader put/call ratio also hit such bearish extremes that tend to signal ripe times for a bounce.
The Smart/Dumb money indicator also show SM is very optimistic while DM is pessimistic. Such extremes usually lead to intermediate rallies.
Large traders are hedging aggressively!
Traders are spending big premiums to hold a short position. The last time it was this extreme, it was the intermediate bottom just before the ultimate bottom in 2009.
The Manufacturers' New Orders for Durable Goods is a leading economic indicator. But it's the spread I am look at...
When it starts to turn down, it usually signals a recession.
Although it seems that most everyone is expecting this to collapse, it hasn't yet done so, although it can be argued that tightening monetary policy might eventually collapse this...
... but it hasn't happened yet.
The % y/y changes tend to be correlated to the stock market performance.
There is a dislocation between the MNODG and the stock market y/y change.
Put another way, the stock market has been dropping as though we are in a recession although we haven't felt the full effects of it yet.
if we take the spread between the two, we find we are at elevated levels seen Dec 1994, March 2003 and Nov 2008.
Here are the historical spots in the S&P500 during the month when the spread hit that extreme.
Even though Nov 2008 wasn't the ultimate bottom (that happened in Mar 2009), it still lead to a pop in the market that lasted 6 weeks that took the SPX from 800 at lows to almost 950 at highs, some 17%+ gains before collapsing due to the credit crisis.
We are on a seriously strong long-term support.
Look at the last 20 years. Every time the $SPX hits the red line, save for a sudden disaster like the COVID crash of 2020, there is ALWAYS a bounce even if it eventually gives way. See 2008. Best case scenario, it's 2011 and a recession is staved off. Worse case scenario, it's 2008 and eventually we drop lower.
Canaries in the coal mine.
In many cases, before there is a recovery in the big indices, there can be very specific stocks that can recover first. Here are the two that I mentioned in "An intermediate bottom in the S&P500 now?" dated Oct 4, 2022, a week before the bottom.
"1a) There are many stocks that have plumetted so much already, they are already trading at recession prices based on valuation. These stocks are like canaries in that they are more sensitive to traders and are smaller cap stocks. Some havecapitulated and are showing signs of accumulation. Here are two examples: ..."
Notice that September plunge?
FRG actually isn't doing that badly at all. They are still quite profitable. But they decreased their guidance a little. They are trading at 6x FW PE and 10% dividend rate. Their debt is manageable at 3x net debt to EBITDA and they plan to reduce it more. This company owns different franchises in the US and has a good track record of good acquisitions that are cash flow rich. I won't go more into details, you can read it here.
Here's another canary, it's a M-REIT. M-REITs are traded by people with itchy trigger fingers. Because in theory, they own lots of leveraged assets, when drastic changes occur in the economy, there might be harsh writedown to their assets, which happened in 2020 during the COVID crash.
The potential bottom formation for RITM was key, why? Because the present sell down is because of overtightening of interest rates. M-REITs are notorious for being affected by such big tightenings. So, if they find support, it may be an early show that the appetite for selling is slowing down, and that we've hit value territory. To give context, M-REITs tend to trade close to their book values. The book value of RITM is about $12. The price at this time was in the $7s. A 40% reduction in book values?! Isn't this already recession prices?
Breadth Indicators were all diverging...
1.New Highs and New Low spreads improving.
2.Bullish Percent $SPX improving.
3.Number of S&P500 stocks above 200 MA improving.
4.Number of S&P500 stocks above 50 MA improving more.
5.Yield between high yield bonds and risk free improving.
6.Relative strength between the Russell 2000 and S&P500 improving.
These signals don't always happen, but when they do, it usually favors an intermediate rally.
Fund managers raised cash to levels that signalled intermediate bottoms.
These were some of the stats that caused me to feel an intermediate rally was very possible, all we needed was some catalyst. The FED even contemplating to slow down the tightening of rates could be one of them, especially if coupled with decent earnings/earnings that beat expectation of prime companies.
On the longer term, we are NOT out of the woods of a bear market yet...
SO THIS MEANS THAT IF THE 200 WK Moving Average of the $SPX fails, especially one news that the FED is going to continue tightening, it's wise to have a "risk-off" mentality.
To keep my analysis simple, whenever yield curves are inverted or close to inverted, it signals caution.
In the last 20 years, every time the yield curve is inverted, a bear market starts 6 months to 1.5 years later. Given that rates have been tightening the fastest in history, it's no wonder the markets have been trading off as though a recession is given!
So how do we know when a major bottom is coming?
1) Bonds must recover first.
A basic idea is to understand the intermarket interactions in an idealized economic cycle.
Where are we right now?
We are possibly in late expansion, early contraction. Or, stage 6 leading into stage 1.
Stage 6 is when all asset classes, stocks, bonds and commodities fall.
However, remember that more than one possible reality can exist at once. If the FED choses to continue their plans, then they have planned to finish this sell off cycle to the end. If they chose to pivot quickly, this cycle might be temporarily reversed. However, assume that damage in the economy has already been done and the viscious cycle set and we are in further pain in the stock market (if this happens, it will happen when stocks finally report decreasing earnings and decreasing guidance).
If the stock market finally finished the intermediate rally and breaks below the long term support of the 200 week moving average, then a big indicator is that you should see the BOND market recover before the STOCK market recovers.
To put this another way, here's another chart. Here, the asset classes average performance over the a couple of cycles were estimated.
In a FED driven recession, Bonds will usually recover first before Stocks do.
The below is the $SPX with the US 10-year treasury yield and commodity index.
Decreasing bond yields means increasing bond prices.
When in recession, stocks are weak, but bonds tend to drift higher in price.
Then, at major bottoms, there is usually a quick spike in bond prices.
Every cycle is different in terms of median bond yield per cycle and the rate it increases and decreases but the general principle holds.
Especially in a FED driven recession, in order to have macro factors supporting a bull market, bonds must recover first. If bonds are still plummeting, and yields increasing, it is difficult to have confidence in the stock market on the longer term.
So what are bonds doing now?
The TLT, the 20+ Year Treasury Bond ETF is still being sold down as of today!
However, it is very oversold on the daily! And, if it reverses and does an intermediate rally, a reversion to the mean at around 104, that also lends ammo for an intermediate rally to stocks.
If we look at a weekly chart of the IEF, or the 7-10 year treasury bond ETF, it's also oversold... to the weekly.
Here's the chart in terms of yield.
This means that on the short term, it's possible for bonds to rally, giving relief to stocks! Everytime the 10-year yield gets overbought to the weekly, there tends to be be some kind of reversal, even if it's short term. I think that at these levels, where the 10-year yield is a 4%+, the best since 2007, it won't be too long for value hunters to get some. Of course one could argue that in 1999, the 10-year was 6.5%... so who knows?
However, for a major bottom, we need to see a sort of bottoming pattern based on momentum and we don't have that yet.
So until we see some sort of recovery in the bond markets, odds are to be cautious on the stock market in the longer term.
I hope this post helps by showing you some things you can look out for to find intermediate bottoms before they occur, and also, to give some points of view to find the absolute bottom.
Well, what do we do if on the longer-term the classic signs are still "risk-off"? The problem is that the market is tricky and these days tend to subvert expectations. As they say, every cycle is different.
I definitely don't see enough signs we have hit the absolute bottom, but I see signs we are in an intermediate rally that might have some legs to year end, and some stocks are already at recession prices, so averaging in these slowly over the next few months is possible. People with weak hearts can stay away.
In my next post, I might share some more signs to look out for in major bottoms; as well as a proprietary indicator that can help gauge sentiment of risk-on or risk-off. This will because even more important going forward, because as you get towards major bottoms, it becomes more volatile, AND, there will be stocks that will look very cheap.
Everyone take care!
God bless you.
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