The first half of 2022 has undoubtedly been a rough one. The S&P 500 has declined by roughly 20% over the first 6 months and various other assets such as bonds, real estate, and cryptocurrencies have not faired any better. Historically, we’re looking at the worst first half of market returns in over 100 years. This may be shocking but after the decade of returns that nearly doubled historical averages, simple factors like mean reversion must come into play at some point.
Why are we falling?
“Why is the market crashing?” is a question you hear a lot as a financial professional. It’s much more complicated than it might seem, however. See there are many factors at play during a market correction or in this case, a bear market. Things such as fundamentals, technicals, market structure, and market sentiment play a large role in determining where a market moves in the short, medium, and long term. The one factor that trumps all others at certain times is market fundamentals. Fundamentals can be looked at as the underpinning for all other market activity. Fundamentals not only include company-specific information such as revenues, growth rate, profit margin. But they also expand into the greater economic picture such as macro-economic data, monetary policy, and fiscal policy. See technical analysis can be most useful in the absence of a fundamental change to the market picture. This was exactly the case from the lows in March 2020 to the market top in late 2021. The fed made a big move in March 2020 which coincided with the lows of the market. They decided to drop interest rates to zero and begin quantitative easing (QE). QE is the process in which the fed stimulates the economy by buying government bonds and artificially lowering interest rates, often compared to giving a person steroids or drugs. It feels great in the moment, but what about the come down? Well, our economy rode the high into late 2021 when the fed said “no more steroids for you”. By no accident, this was the market top. This pattern is the overwhelming dictator of market movement on a long term basis. So now that the fed has not only stopped buying government bonds but actually began to turn around and sell them? The market is throwing a fit. The technicals play a big role in day to day action which is irrelevant to most investors. These technicals are processed by algorithm and other high frequency traders that control the minute to minute action in the market. If things are going down, they will continue to cascade because of these algorithms until there is a greater fundamental factor that changes the direction of the market.
What needs to happen for the fed to change course?
Of course, this is an impossible question to answer. But we can use scenario analysis to identify possible outcomes. The first scenario would be a long and unchanged rate of inflation, this would be due to a strong labor market and the continued strength of the US consumer. This would give the fed room to continue rate hikes until inflation starts to dissipate and the consumer begins to roll over due to price increases decreasing their purchasing power. The next scenario would be the economy falling into a recession. This would be accompanied by a decrease in job growth and therefore give the fed room to stop rate hikes and the market would likely react positively to that. In fact, the market historically bottoms approximately halfway into a recession and gives great returns in the second half of a recession. This is of course because the market is a forward pricing mechanism that typically looks 6-12 months in the future. If the market sees an economic recovery in the future, prices won’t wait and will appreciate greatly ahead of that recovery. So far the market has had lows around 24% from the high, which is pricing in a moderate recession. Although recessions are painful for families and individuals, they are a normal part of the economic cycle and have historically led to higher margins for the largest companies. The stock market is filled with the biggest companies that can fight inflation by increasing prices, and increasing margins by automating jobs. This is the main reason you have to be invested in the market, it provides protection against the rapidly growing big business portion of the economy and allows you to participate in that growth. Regardless of what happens in the rest of 2022, it will be a good idea to have some exposure to these companies which will continue to grow revenues, profits, and margins over the long haul.
What’s next?
Over the next few months, I will be keeping my eyes on a few things that could be a good indicator of whether the market may have found a bottom, or if we have more room to drop. For one, and the most obvious factor is technicals. I will be watching to see if we make a new low in the indexes like the S&P, Nasdaq and Dow. Without a new low, we will slowly form a base that will act as resistance and give us a good chance of producing outsized returns in the future. Second I’m keeping an eye on the CPI and PPI data. Although these can be lagging indicators they are certainly 2 of the main data points the federal reserve analyzes to make their decisions. Apart from these two numbers, we can look at individual commodities like oil, copper, wheat, and more to see if they begin to rise again which would increase inflation in the future. Furthermore, I’m looking for softness in the corporate earnings picture. We know company profits should be slowing, due to inflation and supply chain issues but the question is by how much? If the pressure on margins is less than wall street expects, stocks will likely drift higher on the “bad news” during earnings season. Keeping an eye on these important factors will give you insights to know whether there is a potential bottom near or if we are going to continue seeing new lows.
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