Please read the Disclaimer before reading this article.
At the end of June, I wrote an article on why I remained bearish on risk assets.
Since then, I've primarily shared technical updates on my Twitter feed without really explaining the fundamentals behind the decisions I'm making. In this article, I want to elaborate on the fundamental views underpinning my trading decisions.
Please not that this is a strategic, not tactical view. If I'm fundamentally bearish, this doesn't mean I'm short all the time.
Bear market rallies
We've seen multiple bear market rallies this year. At the end of July, I started shorting the one that started in the middle of June. I was a bit too early but my analysis proved correct and I closed my short position on September 23th (see here).
The market bottomed in the middle of October and we've seen a new rally in stocks, which recently, I started to short again (see here).
The timing of my shorts is clearly based on technical analysis. But you need more than just technical analysis. There are a lot of very popular accounts that have tried to call the bottom in the market based on several technical signals that had a great track record in the past.
Let's take the breadth thrust for example. As the following chart shows, this indicator has an excellent track record in identifying when the bear market is over. In fact, it never had a false signal since the 1970's.
It's a signal I will be using as confirmation when I think we are close to a sustainable stock market bottom.
Source: Ed Clissold, NDR
However, the signal triggered (together with a lot of other sentiment and overbought/oversold indicators) but I kept adding to my shorts. Why was I ignoring it? Because context matters. The macro environment in which we are operating is of crucial importance.
When bulls were partying in the middle of August because they thought the bottom was in because all the indicators were flashing green lights, I tweeted (see here) that I was ignoring these signals because the fundamentals were not supportive. Historically, all these breadth thrusts took place during a Fed easing cycle. Since we were still in a Fed hike cycle and because once the market is in a correction, the market never bottoms before the Fed is done hiking (see here), I ignored these signals.
Technical analysis is a great tool. However, too many people use it on a standalone basis. You need both technical and fundamental analysis. (I wrote an article on this before, see here.)
Fundamentals supporting the bearish case
So, which fundamentals am I using to remain bearish on stocks?
I came into 2022 with a bearish view on risk assets. An article I wrote in January 2022 was called: 'Risky 2022 ahead? What are the leading indicators telling us?'
In June, I reiterated my bearish fundamental views in the following article: 'Risk-off environment remains intact.'
I urge you to read those two articles to get a complete view of my thought process.
In this article, I'll write about the fundamental picture we need to see to be confident that a stock market bottom might be close.
There is some kind of view in the market that peak inflation will be bullish for stocks. It's not difficult to understand where this view comes from. The declining stock market in the first part of the year was completely caused by a decline in valuations, caused by rising interest rates, which were caused by rising inflation.
So, the logic goes, a peak in inflation will support valuations and the stock market in general. I understand the logic but I've proven in detail why this is wrong both on historical and theoretical grounds. I'm not going to explain this again in detail in this article. You can read my previous article (see here) and this Twitter thread (see here).
So, if it's not peak inflation that we need to see a market bottom, what is it?
Another popular view that a lot of people seem to hold is that we need a Fed pivot.
The Fed needs to stop raising rates (I call this Fed pivot I) or the Fed needs to start cutting rates (I call this Fed pivot II) for the market to bottom.
If we look at the following chart, we can see in the top panel the S&P500 (blue line) together with recession periods. In the bottom panel, we can see the Fed funds rate. Vertical red lines indicate a Fed pivot I when the market didn't bottom and continued to decline. Vertical green lines indicate when a Fed pivot I indicated a stock market bottom.
What do you notice about this graph? All the green lines, when a Fed pivot I was accompanied by a stock market bottom, as the bulls are arguing for now, were never followed by a recession.
All the red lines, when a Fed pivot I didn't help the stock market, were followed by a recession.
When the Fed pivoted in 1989 and 2006, the market rose because the recession took some more time to arrive. In all other cases, when the market was already in a downtrend and a recession was near, the market started to decline very soon (2000) or just continued its decline (1969, 1974, 1981).
Since we are already in a decline, the question is the following: will a Fed pivot I result in a stock market bottom (like in 1966, 1984, 1995, 2018) or will the market continue to decline.
As explained above, the answer depends on whether or not the economy will enter recession.
Not every rate hike cycle leads to a recession. However, every rate hike cycle accompanied by food & energy price spikes does lead to a recession.
In fact, as the following chart shows, every recession we've seen was a combination of rate hikes and energy shocks.
All the rate hike cycles (1966, 1984, 1995, 2018) that weren't followed by a recession have one thing in common: there was no energy shock. It were also the only times when a Fed pivot I was bullish for the stock market.
Source: Michael Kantrowitz
Another variable we can look at is the unemployment rate which currently is still very low. As we all know, the unemployment rate rises during a recession.
What the rate hike cycles that didn't lead to recession have in common (besides the fact that there was no energy shock), was that the unemployment rate continued to decline after the Fed pivot I.
To get an idea what the unemployment rate will do this time around, we can look at some models.
As the following chart shows, initial unemployment claims lead the unemployment rate by about 5 months.
Thus, to know what the unemployment rate will do, we need to know what initial claims will do.
The housing market is an excellent leading indicator for unemployment claims.
Since housing accounts for 27% of investment spending and around 5% of the economy, it has a significant impact on the trajectory of the overall economy.
The following chart shows initial unemployment claims together with the NAHB housing market index as a leading indicator. As you can see, a weak housing market (indicated by a rising blue line) is followed by a rise in initial unemployment claims.
The current weakness in the housing market is a clear indication of the weakness to come in the labour market.
Is the model perfect? Of course not. In the mid-1990's for example, the weakening housing market (rising blue line) wasn't followed by a rise in initial unemployment claims and thus the unemployment rate.
However, in the mid-1990's there was no energy shock, just a Fed rate hike cycle. Now, both elements are flashing red warning signals.
To solve the problem of potential false signals by using the NAHB housing market index as a leading indicator for unemployment, I built a breadth model.
The breadth model shows the underlying weakness in the employment picture.
When the breadth model spikes, bad things tend to happen.
Below, I annotated the chart above to give some more clarity. The white arrows indicate historical episodes when the breadth model spiked to similar high levels as today. As you can see, the unemployment rate was already rising by then (1991 and 2002) or it was soon going to (1980 and 2008).
I also colored two periods in red. The first one is the 1995 rate hike cycle. The fed was raising rates and the housing market was weakening but the unemployment rate didn't rise since the breadth model didn't give a warning. There also was no energy shock. When the fed pivoted, stocks started to rise.
The same is true for the December 2018 Fed pivot. There was no warning signal from the breadth model and there was no energy shock. In 2018, there was also no warning from the NAHB housing market index. The result was that a Fed pivot led to a rising stock market.
Today, all three signals are flashing red.
Conclusion
Recession or not is the determining variable to anticipate the stock market's behavior around a Fed pivot I. Since the models I shared in this article are all indicating a recession is coming, it's clear to me that a Fed pivot I won't be bullish for stocks. (Other independent models from other analysts I'm following are indicating the same recession probabilities.)
One final note to close this article on. Isn't a recession already priced in? The Philadelphia Fed Survey of professional forecasters is indicating a very high expectation (in fact the highest number ever) off a recession coming in the next 12 months.
Why would a recession matter if everyone knows about it?
Two reasons.
Professional forecasters may know about it, but investors haven't acted on it yet. Sentiment is very bearish (sentiment data shows pessimism being as extreme as at previous market bottoms) but equity flows haven't gone negative yet. There is a difference between saying and doing. Investors are saying they are negative, but they haven't acted on it yet. Historically they act on it as well before we see a major market bottom.
The second reason is that equities tend to bottom with leading economic indicators when a recession hits. As long as I'm not seeing this, I'm not going to become bullish on the assumption that the market has priced certain things in. Is the market really that smart? The market is certainly forward looking on lagging economic indicators like GDP growth itself but I've never seen proof that the market is forward looking on leading economic indicators. The market is reactive.
Just one quick example. This year, the market had several very big up-days when inflation prints came in lower than expected. As I wrote earlier, declining valuations because of higher interest rates caused by rising inflation were the main reason for the decline in the stock market in the first part of this year. Thus, a lower inflation print was interpreted by the market as being bullish and the market rose sharply. But did the market anticipate these lower inflation prints? Certainly not, otherwise it would have risen before them, not on the day that the news was made public. How will the market react in 2023 when earnings will be much weaker than expected (see my leading indicators in my previous article) and when the unemployment rate will start to rise? Why is a recession already priced in but peak inflation wasn't? Clearly, the idea of things getting priced in by the market is too simplistic. The interaction between investors, economy, and markets is much more nuanced.
I'll write more on this when the time is ripe.
Thank you very much for reading my article.