There is no way to know yet if the recent rally in stocks marks a turning point for the market.  Was it “smart money” buying or a “fools rush in” kind of rally?  We will not let a market bounce blind us to the underlying fundamental, fiscal, and monetary conditions.  Rising and falling markets are always accompanied by periods of counter-trend movement.  For example, the 1973-1974 bear market had two 10% rallies, two of 8% and two of 7%, each snuffed out.  It took 20 months before the low was reached.  In the midst of the financial crisis in 2008, there was a 15% rally that quickly fizzled.  So the recent 8% rally off the May 20 low doesn’t mean we are out of the woods.

In order to do an objective review of current market conditions and prospects, it is important to consider the evidence put forward by both bulls and bears before coming up with a conclusion.  Here is what we know about both sides of the argument:

The Bull Case (we have hit bottom)

  • The economic backdrop may be slowing but the economy is not.
  • Forward earnings estimates continue to rise.
  • Corporate insiders are making purchases. Insiders do well with buying and selling their own stocks.
  • Investor sentiment is still very negative (contrarian signal).
  • Money flows into equity ETFs have resumed – $26 billion the week of May 25th.
  • Bespoke Investment Group writes that only about 10% of stocks are overbought, and almost half are still oversold.
  • According to some leading economists, including well-respected Ed Yardeni, the Fed will raise the inflation target to 4% (from 2-3%) if necessary to avoid a recession.
  • Goldman Sachs Chief U.S. Equity Strategist David Kostin says a recession is not inevitable but stocks are priced as if it were. Leveraged fund positioning appears to have taken profits on shorts, and retail speculation has declined.
  • Citigroup Strategist Scott Chronert says volatility will move down the single stock path. Market sentiment is hitting extreme pessimism.

The Bear Argument
(this is a bear market rally)

  • The Fed tightening cycle has just begun. It is too early to know how restrictive conditions will get, and over what timeframe.
  • We may not have seen peak inflation. Gasoline and food prices continue to rise, for example.  On Friday the CPI report for May will be released.
  • The war in Ukraine will likely exacerbate already high commodity price inflation.
  • We have not had capitulation when investors give up and sell washed out stocks to avoid further pain. Ned Davis Research writes that to confirm a bottom we need multiple 10:1 up volume days without a 10:1 down volume day in between.  Selling pressure has to change to persistent buying pressure…we have not seen this.
  • Profit margins are rolling over due to both supply chain issues and higher costs.
  • Consumer confidence is plunging despite a strong jobs market and healthy consumer balance sheets.
  • Leading economic indicators may be rolling over (but it is too early to confirm).
  • Eight valuation indicators that have proven best at predicting 10 year stock returns, inflation adjusted, stand at more than twice the average valuation of bear market bottoms seen in the past 50 years.
  • The first leg down this year was due to the prospect of tighter monetary policy. The second, slower economic growth.  Will the next leg down result from faltering earnings growth expectations?

In our view, the negative fundamentals listed above outweigh the positives, with the lack of capitulation a big concern.  We expect further weakness ahead although we also recognize a lot could go right to limit further downside.  But we think this correction/bear market will continue a while longer.

In this market environment there is still work to do even if an investor stays fully invested over a cycle (like Clearview).  First, tax loss harvesting makes sense for taxable investors.  We are taking losses (where appropriate) and buying attractive replacement securities.  There are plenty to choose from.  Second, there is an opportunity to upgrade portfolios.  We are replacing our least favorite holdings with high quality stocks that are now selling at very reasonable valuations.  Just as investors confused great companies with great stocks on the way up, they will likely avoid bombed-out stocks on the way down that happen to be great companies.