SPY: Why The Stock Market Likely Hasn't Bottomed

Samuel Corum

History Shows That Sharp Rallies Are Common In Bear Markets

Stocks have staged a furious rally off of the June lows, with the S&P 500 (NYSEARCA:SPY) rallying nearly 13%. The index is now down less than 14% for the year. Are investors out of the woods? Maybe not. Past cycles show that bear market rallies of 10% or greater are common, but as long as the structural issues driving the bear market are not solved, these rallies have ultimately failed.

For some context on bear market rallies:

2000-2002: The Tech Wreck

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The S&P 500 saw rallies of 19%, 21%, and 20% before bottoming in 2002, and nearly gave back a 21% rally in early 2003. Ultimately, stock valuations continued to fall as many investments made in the late 1990s and early 2000s turned out to not justify the valuations paid in the boom years.

2007-2009: The Global Financial Crisis

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Similarly, 2008 saw a rally of 12% in the spring/summer after Bear Stearns failed, but before investors realized the full extent of the crisis in late summer and early fall. Then there were rallies of 18% and 24% during the chaotic trading that autumn before markets bottomed in the early spring of 2009.

2022-Present: The Pandemic Everything Bubble?

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The S&P 500 rallied 11% in March for no clear and convincing reason and now has rallied a bit less than 13% (note that this graph predates the current rally by a couple of weeks). If you believe that the fundamentals for stocks justify the previous all-time highs, then stocks are at a discount. But, if like me, you believe that there are structural problems with the US and global economy that have yet to be addressed, then the current bear market is playing out like the past two big ones, despite the 13% rally in stocks.

Why Are Stocks Going Up So Much?

For one, Q2 earnings were not as bad as feared. But this is not as good as it seems at first glance. The U.S. consumer has been resilient despite inflation-adjusted household earnings falling another 1% in June and 4.4% over the last year. There’s evidence that consumers are spending down the savings built up from the pandemic despite warnings of a slowing economy. However, real incomes can’t fall while spending rises forever, flashing a clear warning signal going forward. The US economy meets the classic definition of a recession, posting two consecutive quarters of GDP decline. I’ve previously written that booming post-pandemic profit margins in the S&P 500 are not sustainable for these reasons, and believe earnings will need to decline somewhat from 2021 levels.

Second, the market is not taking the Fed seriously. Powell gave a very hawkish press conference last week but in my opinion, he made an unforced error by incorrectly referring to the current cash rate of 2.5% as “neutral.”

A cash rate of 2.5% is neutral if inflation is at 2%, but core inflation is roughly 5% annually. Ex-Treasury Secretary Larry Summers came out shortly after to slam the remarks. Powell’s musings sent stocks skyrocketing into the closing bell and up nearly 5% in two days. Fed speakers have since come out to walk back that statement, and there’s no real evidence that this is the official position of the Fed.

Not Neutral (Bloomberg)

The market is currently pricing rate cuts from the Fed when inflation hasn’t even peaked. For this to happen would likely imply a serious recession and a likely collapse in corporate earnings, which would not be positive for stocks. Another huge contradiction!

The market is deluding itself by thinking that bad news is good news and that the Fed will do QE to bail them out when inflation is crushing middle-class Americans. Bad news is bad news. Ironically, everyone seems to think that the Fed will cut rates and do QE to bail out stock and real estate speculators. However, no one really wants them to, whether it’s the White House, voters, or even investors who just want to see the economy function normally. Everyone is more or less on the same page that the Fed needs to do whatever is necessary to get inflation down, but the credibility of the Fed is so tarnished by now that they’ll have to hike much more than they would otherwise. In the end, this will cost the US Treasury more money in interest than a strongly credible Fed would have. I believe that the Fed will get inflation down because they have a broad mandate from the public and the White House to do so, but for this to happen, the current expectations for rate hikes are not enough. Unlike the infamous 2018 Fed pivot, there’s no Trump shouting at Powell on the phone this time around (and note that when Trump did this, inflation was below the Fed’s target).

To these points, markets are reflexive. A key way that the Fed fights inflation by raising interest rates and doing QT is by tightening financial conditions. This means that stock valuations fall, bond yields rise, and credit spreads for junk companies rise. But over the last month, stock prices have shot up, bond yields have tanked, and credit spreads have narrowed. The grand irony here is that the more the market believes that the Fed will bail them out and refuses to price interest rate hikes, the less likely the Fed is to actually do it and stop hiking.

A key idea of the 2010s bull market was TINA. TINA stands for “there is no alternative.” But now, we have a Fed that’s publicly committed to getting inflation down and hiking rates by 50 bps or more per month, TINA has become TIA. There is an alternative. Cash now pays 2.5% and is likely to be paying 4% or greater by year-end, risk-free. I Bonds offer a similar but better opportunity for investors willing to hold at least a year.

Fixing Structural Economic Issues Will Take Years

You can’t make a baby in one month by getting nine women pregnant.

-Warren Buffett

As Buffett reminds us, good things take time. The issues with the US and global economies are structural. For the last 20 years, these problems have been kicked down the road by running big budget deficits and reducing interest rates, but the ability of the government to continue to do this and get away with it is severely limited by inflation and high debt loads. Conservatives will tell you that we’re borrowing more money than we can comfortably pay back, while liberals will tell you that we’re trashing our planet and hollowing out the middle class. These criticisms are two sides of the same coin. The populist economic policies run by the last two presidential administrations were never going to work in the long run.

When countries get the big stuff wrong, standards of living have fallen for decades, even in politically stable countries. In US dollar terms, Japan’s stock market peaked in 1989, France peaked in 1998 (by the way, Buffett once won a big bet against France in the World Cup), and the United Kingdom peaked in 2007. Japan and Europe have widely known issues, but they’re no secret, and the current valuations of their stocks are much cheaper than US stocks.

The US now faces the same problems, ranging from demographics (plunging birthrates and Baby Boomers getting old) to runaway public debt, to a reliance on unsustainable business practices. I did a deep dive on these issues in my piece “Where Will The S&P 500 Be in 10 Years?” In this piece, I contrast the cold reality of debt, demographics, and previous policy mistakes compared with the potential for technology to help improve living standards.

The next couple of years will truly be the last good chance to turn things around. If they don’t, the government will be so behind the curve that they’ll have to raise taxes to shocking levels or default on the debt. Either would lead to a steep drop in living standards. What does this mean for stock investors? It means taxes need to come up, putting a lid on earnings growth over the next 10 years. Additionally, with the median retirement balance of Baby Boomers less than $100k and old-age and retirement looming, growth is going to be an issue. They won’t be able to work forever and Social Security isn’t meant to cover 100% of living expenses, so it’s not clear how this is going to play out.

The current reconciliation bill is a good example of what is needed to truly work to dig out from these sorts of long-term problems. The text of the Manchin compromise bill is surprisingly good. I covered the original reconciliation bill last year, which was full of hidden tax increases and junk like provisions for beauty salons, record companies, and Puerto Rican liquor. I skimmed the 700+ pages of the new bill and it’s remarkably free of pork. The new bill is a bit misnamed as the “inflation reduction act” because it’s going to take years to bring inflation down from the supply side, but it’s a solid bill. Betting markets indicate it has a roughly 65% chance of passing by early September and a 90% chance of passing before midterms.

If this weren’t an election year, I believe it would be a bipartisan bill. They’re raising corporate taxes by about $70 billion per year (the national income is something like $23 trillion) and using the money to make investments in dozens of energy projects, such as consumer solar, energy efficiency upgrades for consumers and businesses, utility solar, electric vehicles, biodiesel from agricultural waste, etc. At the same time, they’re planning to increase oil drilling in the Gulf of Mexico, meaning that we can export the oil for profit if we achieve quick gains in renewable energy. This helps the trade deficit. The healthcare provisions in the bill include cracking down on drug companies’ ability to charge Medicare tens of thousands of dollars per patient on speculative drugs and stopping the insulin hustle. Companies have used monopoly power to raise insulin prices by over 100x over time, but anybody who has taken high-school chemistry can make the stuff. Reforming a country tends to be incremental and takes years, not five weeks like bulls assume.

The point of all of this is that the issues at hand are deeply entrenched. The markets don’t believe the Fed will do what they need to do, and this is resulting in assets being priced in contradictory ways. D.C. is as dysfunctional as ever, but it appears that they’re going to put a down payment on digging their way out of the structural issues that we face and start the slow process of balancing the budget. And while stocks are lower than they were at the start of the year, paying a 13% higher price for a market that has the same structural issues it had a month ago does not appeal to me. Cash looks increasingly good here.

Key Takeaways:

  • Bear market rallies of 10% or more are very common in downtrends and don’t mean the market has bottomed, per se.
  • Earnings came in a bit better than expected for Q2, but the US economy and global economy appear to be in a recession now that stimulus has run out. This bodes poorly for earnings going forward.
  • The market is fighting the Fed and financial conditions have rapidly loosened over the last month. This actually makes it less likely that the Fed will slow down or stop rate hikes.
  • Investors now have a clear alternative to stocks in Treasury bills, which are likely to pay 4% or higher by the end of the year.
  • Markets are not giving enough compensation at current prices for the long-run challenges of demographics and government debt. I reiterate my fair value estimate for the S&P 500 of roughly 3200-3300. Stocks are roughly 20% overvalued at current prices.