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The Consumer Price Index (CPI) unexpectedly rose 0.4% in September after a marginal increase of .1% in August. The S&P 500 had declined for six straight sessions leading up to this report, which meant that any shred of positive news would propel markets higher.
Unfortunately, the hotter-than-expected CPI print led the S&P 500 to open DOWN over 2%, which was to be expected. Then the craziest thing happened: It ended the day UP over 2%!
An intraday move of this magnitude is extremely rare. According to Bespoke Investment Group, it was only the fifth time in the history of the SPY, an exchange-traded fund that tracks the S&P 500, that it opened down 2% or more and closed the day up 2% or greater. That kind of intraday move is mind-boggling, especially as the CPI data came in worse than expected!
This begs the question of whether markets hit bottom or experienced another bear market rally. When markets rally on bad news, some view that as a potential sign of a bottom. The assumption was that while CPI remains high, it likely has peaked, with the worst now behind us. Interest rate hikes take months to work their way into the economy, so the thinking that inflation will start retreating seems very plausible.
Bear Market Rallies
It’s common for stocks to rally significantly multiple times during bear markets. As a reminder, a bear market is when a broad market index (e.g., S&P 500) drops by at least 20%. As we know, markets don’t go up or down in a straight line but instead experience heightened volatility during these stretches. Bear market rallies tend to be in the 5% to 15% range and can occur in a matter of days!
Truth be told, markets would be better served by slowly grinding higher, as that shows more conviction. The violent upswings are generally attributed to short covering, which ends pretty swiftly. Let’s take a look at some of the past bear markets:
During the 2007-2009 Global Financial Crisis, there were 12 instances in which the S&P 500 rallied between 5% and 24% before finally bottoming.
During the 2000-2002 Tech Bubble, there were eight instances in which the S&P 500 rallied between 5% and 21% before finally bottoming.
During the 1973-1974 Inflationary Period, there were nine instances in which the S&P 500 rallied between 5% and 21% before finally bottoming.
Source: Moneyshow.
This tells us we should expect more volatility. Unfortunately, markets don’t bottom overnight, and waiting it out takes time and patience. Many rallies will be short-lived and frustrating, but this is part of the bottoming process.
The chart below shows that markets declined by -34.7% during the “average” bear market and took two years, on average, to recover. We have experienced a few bear market rallies this year and will likely see a few more before bottoming.
According to Ned Davis Research, a 30% rise in stocks for more than 50 days, or a 13% gain for more than 155 days, is the start of a new bull market. While nothing is guaranteed, history has shown this to be a pretty accurate statistic.
The longer the bear market, the less confident investors become, which often leads to more selling. By now, we can acknowledge that we were spoiled for much of the last decade. Central banks provided an ultra-accommodating monetary policy that helped push their goal of asset price inflation. This is precisely why the phrase “Don’t Fight the Fed” gained so much traction.
The same phrase holds today, but in the opposite direction, as the Fed is laser-focused on raising interest rates regardless of how much volatility comes with it. Investors are left wondering if the Fed is making another policy mistake and overcompensating for their lack of action in 2021.
Bond Market Volatility
I am of the opinion that equity markets will not bottom until bond market volatility subsides. But for the bond market to find a bottom, the Federal Reserve has to indicate their willingness to pare back on aggressively raising interest rates. Right now, that seems unlikely until inflation shows more concrete signs of abating.
The chart above shows that bond market volatility spiked from a near 14-year low in late 2021 to its third-highest reading since 2008! This level of volatility is abnormal and partially explains why it is having a hard time finding a bottom.
On the surface, I understand what the Federal Reserve is attempting. They want to show they are serious this time and won’t flinch in the face of volatility. The problem is many markets, such as the housing market, have trouble functioning properly when rates rise on this magnitude.
Many bond sectors are as attractive as they’ve been since the Global Financial Crisis, but investors hesitate to allocate capital as interest rates keep rising. If volatility increases much more, I firmly believe the Fed will be forced to be more flexible in their mandate. The effect of higher interest rates could be offset by “policy overshoot,” an economic hard landing, or outright recession. I suspect the Fed's flexibility will take place at the end of the first quarter of 2023.
Things feel uneasy right now as both stocks and bonds are down. The typical market “hedges” of gold, silver, and cryptocurrencies are also deep in the red. While it doesn’t feel like we’ve reached panic yet, it feels close. Many unknowns still exist, and I suppose inflation could get worse—but things could just as well get better, as hard as that may be to believe right now.
Bear markets are never enjoyable, but the good news is they always eventually end.
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