“The two most powerful warriors are patience and time.” – Leo Tolstoy
“You can’t predict. You can prepare.” – Howard Marks
July is historically one of the best months of the year for investors. July 2022 did not disappoint with the stock market indexes we follow producing solid gains for the month, with the MSCI Emerging Markets being the lone exception. The bond market also rebounded for a solid positive gain for the first time this year. Commodities were just about flat, as was the US Dollar Index.
All data as of 08/01/2022, Source: Wells Fargo Investment Institute. [Wells Fargo Investment Institute, Inc. is a registered investment advisor and wholly-owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.]
The stock market is an interesting beast. Most of the time it is trending. Most of the time the trend is up. Sometimes – like the first half of this year, the trend is down. Fortunately, the downtrends have historically much shorter than the bull market uptrends.
In retrospect it is easy to see when the market has turned higher or lower.
In real time it’s much more of a challenge.
After half a year of negative returns it feels good to (finally) be able to report on positive gains for the stock market. It also leaves us with a dilemma. Market trends aren’t straight lines. They are wiggly (to use a technical term) in nature. Sometimes they can fool you into thinking the big picture trend has changed, when it has not.
The big move higher in the month of July could be the end of the bear market … or not. Today we will try to answer the question of where the stock market may be headed in the coming months.
Where are we Now?
There has been a lot of talk about an economic recession since our last update. More specifically, there has been an ongoing debate about the definition of a recession, are we in one right now, and what does this mean for stocks.
Honestly, we have basically ignored the whole argument.
The economy has slowed down – which is what matters – but companies are managing around the slowing economy and elevated inflation – which also matters. Earnings have continued to hold up after a stellar 2021. Have earnings been perfect? No. But that is to be expected.
We all are living in a world that continues to normalize. Corporate America included. Be it the retailers adjusting to new purchasing trends, airlines trying to manage the surge in summer traveler, or the home builders dealing with slowing demand, the world we live in is evolving back to something like what we had in 2019.
Taking a look at the S&P500, for the first time this year we see some positive developments. After bottoming in mid-June, the S&P500 enters August with what looks like the start of an uptrend. It is also is at a price level – 4130 – that lines up with both the early-June price consolidation and a Fibonacci retracement level.
Uptrends, of course, come in a variety of lengths. Some last for weeks. Others last for years.
Chart #1: www.stockcharts.com
While this all looks good, we need to remember the stock market is a market of individual companies that get priced over time on the earnings produced. It is also influenced by other markets.
Bonds – and the interest rate markets – influence how equities trade for a number of reasons. Foremost, an increasing interest rate environment will lower growth prospects for a number of sectors. Real Estate Investment Trusts (REITs) and utilities are two examples of this.
Interest rates will also affect the valuation investors are willing to place on the stock market. Generally speaking, the higher rates go the lower multiple investors are willing to pay for companies. Growth stocks are more affected by this than value stocks.
The bond market – and interest rates – do not always act as common sense would suggest. Since the beginning of 2022 the yield on the 10 Year US Treasury Bond has more than doubled at its June peak. This makes complete sense given the aggressive rate policy from the Federal Reserve Bank (The Fed) that has been deemed necessary to combat high inflation.
But here’s where it gets interesting …
On July 27 the Fed raise short term rates 0.75%. Eleven days prior, the yield on the 10-year US Treasury bond peaked at 3.47%, ending the month at 2.67%. That peak in rates came the day prior to the bottom for the S&P500.
Maybe more important in our view, the decline in rates appears to have completed the reliable Head-and-Shoulder technical pattern, suggesting LOWER not higher interest rates.
(Note: The head and shoulders pattern is thought of as one of the most reliable technical price pattern. It appears when the price of a stock (or other tradable asset) increases to its top and then drops back to where it started its uptrend. The price then descends back to the initial base after rising beyond the previous high to produce the “nose.” The stock price then rises once more, but only to the level of the formation’s first, first peak, before falling once more to the base or neckline.)
Chart #2: www.stockcharts.com
The other significant stock market influencer is the US Dollar. This year the strength of the US dollar has become a real problem for the US stock market. Many of the largest companies in the S&P500 and NASDAQ indexes get a large percentage of their earnings from global operations. The stronger the dollar, the fewer dollars received when converting earnings in Euros, yen, Pence, or other foreign currencies, diluting reported earnings. This is an issue companies mentioned in their 1st quarter reports (Barron’s).
The problem only got worse in the 2nd quarter as the US dollar broke above the range that has held since 2015, reaching the 108 area during the month of July. This is an important level as the index hasn’t been this high for almost 20 years! A break above the 108 level would suggest a move higher to the 120 level, and more pain for reporting multinational company earnings.
The good news for stocks is that the US Dollar Index ended July well off the highs. We believe it is more likely the dollar will return to the range it has been in for most of the last 7 ½ years than it is to trend higher.
Chart #3: www.stockcharts.com
The Case for a Stronger Stock Market
There are a number of really good reasons to believe that the worst of the bear market is behind us. On the economic front, the supply chain issues that caused so many headaches in 2021 are receding, inflation has likely peaked, and we have had two quarters of GDP declines. Commodity prices are now suggesting 4-5% headline inflation and global shipping rates have been cut in half as delivery times get back to normal.
Investor sentiment has plunged this year. While not sounding like a positive for the stock market, it really is bullish. Markets tend to bottom when sentiment is at low levels.
Company earnings have been outperforming the economy in the second quarter. Expectations had been extremely negative. This earnings strength, combined with the drop in the stock market has moved valuations from elevated to much more attractive levels.
Strength in the mega-cap stocks – particularly the few with trillion-dollar market caps – have been moving higher on positive earnings reports. Without the largest companies participating it is hard to come up with a scenario in which the stock market indices trend higher.
Finally, the short-term technical strength we mentioned earlier is a positive.
The Case for Continued Stock Market Weakness
Just as we see a number of positives for the equity markets, we see reasons to believe markets could continue to struggle. The largest issue we see for the stock market is rising short-term interest rates. Expectations as we write this are for an additional ½% to ¾% at the September Fed meeting. While this could change, it is not the most likely outcome. And as we mentioned previously, higher rates aren’t good for the stock market, a rise in short-term rates without an increase in longer-term yields would likely damage and already weak economy.
Which speaking of the economy, issues that are unfavorable include rising unemployment claims data, housing weakness, and the leading economic indicators.
Finally, bear markets can give false signals that they are over with feel-good rallies. The long-term technical picture isn’t great at this point. Not surprising, given the current rally is only 6 weeks long, but still a risk factor.
Final Thoughts
“Suckers” rally or a real market bottom? This is the million-dollar question, right?
The honest answer is nobody knows if it is or not. There are times where we can say with reasonable confidence that the markets are turning or about to turn. This is not one of those times.
What we do believe is that the key to market direction will be inflation and the economy. While we believe that we have moved past peak inflation and the economy has clearly slowed, we do not make decisions on interest rates, the Federal Reserve Board does. How they proceed with interest rate policy at their next meeting, we believe, is the key.
Federal Reserve Board Chairman Powel has very bluntly stated on many occasions that they are data dependent in their decision-making process. If we are wrong and inflation doesn’t look like it is easing and the economy is stronger than the GDP numbers indicate, policymakers will have every reason to increase rates. In this scenario, we feel it is likely that the stock market would act negatively.
On the other hand, if the data shows falling inflation and a weak economy, The Fed will have good reason to either raise 25bps or “pause” rate increases at their next meeting. This outcome would likely be positive for stock prices.
Because of this, all eyes should be focused in on The Fed and the next decision on interest rate policy. Continued aggressive action on rates would likely lead to falling stock prices. A small or no rate increase at the next meeting should be positive for the overall stock market.
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Asset allocation and diversification are investment methods used to help manage risk. They do not guarantee investment returns or eliminate risk of loss including in a declining market.All investing involves risks including the possible loss of principal invested. Past performance is not a guarantee of future results.
Index returns are not fund returns. An index is unmanaged and not available for investment.
Dow Jones Industrial Average: The Dow Jones Industrial Average is a price-weighted index of 30 “blue-chip” industrial U.S. stocks.
S&P 500 Index: The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market value weighted index with each stock’s weight in the Index proportionate to its market value.
S&P Midcap 400 Index: The S&P Midcap 400 Index is a capitalization-weighted index measuring the performance of the mid-range sector of the U.S. stock market, and represents approximately 7% of the total market value of U.S. equities. Companies in the Index fall between the S&P 500 Index and the S&P SmallCap 600 Index in size: between $1-4 billion.
S&P Small-Cap 600 Index: The S&P SmallCap 600 Index consists of 600 domestic stocks chosen for market size, liquidity (bid-asked spread, ownership, share turnover and number of no trade days) and industry group representation. It is a market value-weighted index (stock price times the number of shares outstanding), with each stock’s weight in the index proportionate to its market value.
MSCI World Index: The MSCI World Index is a free float-adjusted market capitalization index that is designed to measure global developed market equity performance.
MSCI EAFE® Index: The MSCI EAFE Index is designed to represent the performance of large and mid-cap securities across 21 developed markets, including countries in Europe, Australasia and the Far East, excluding the U.S. and Canada.
Bloomberg Barclays U.S. Aggregate Bond Index: Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based measure of the investment grade, US dollar-denominated, fixed-rate taxable bond market.
NASDAQ Composite Index: The NASDAQ Composite Index measures the market value of all domestic and foreign common stocks, representing a wide array of more than 5,000 companies, listed on the NASDAQ Stock Market.
Russell 2000® Index: The Russell 2000® Index measures the performance of the 2,000 smallest companies in the Russell 3000® Index, which represents
Technical analysis is only one form of analysis. Investors should also consider the merits of Fundamental and Quantitative analysis when making investment decision. Technical analysis is based on the study of historical price movements and past trend patterns. There is no assurance that these movements or trends can or will be duplicated in the future.
Stocks offer long-term growth potential, but may fluctuate more and provide less current income than other investments. An investment in the stock market should be made with an understanding of the risks associated with common stocks, including market fluctuations.
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