2022-06-18

The Case for a Rally and Then?

The Bank of America Bull & Bear Indicator hit 0.0 on Friday. Below are the other readings of zero.
Only one reading didn't come at a major market low: July 2008. All the others, with the exception of 2015 that saw a higher low in January 2016, saw major low within two months of the signal triggering. 

July 2008 is the most comparable signal because of the length of time into the signal. The 2002 signal came well into a bear market. The other signals came in a sharp, short correction. The only similar signal is July 2008.
The pieces are in place for a big rally. First, sentiment is extremely negative. Put buying was heavy on Friday. I don't see very many bulls out there. The only people I see talking about a rally are bears who are long for a rally already or want to get long. The fuel for a squeeze is in place. 

Bear markets have big rallies, but there hasn't been one yet. The prior ones were 10%, roughly two week blips in the decline. We are overdue for one by both the 2000 and 2008 bear market examples. Here's 2000. There was a roughly six month drop from September 2000 (the S&P 500 Index is barely off its March high in late August) into a March 2021 low. There are a couple of 10 percent rallies along the way, but otherwise almost continuous selling for six months. Sound familiar?



Macro Catalysts

I'm confident that oil is done going up for now, barring some surprise geopolitical situation. I expect oil will decline with a stock rally and decline more if stocks keep falling. As soon as crude gets below $95, energy will start cutting the monthly inflation numbers. Not necessarily headline, but the month-on-month numbers will come down. We could quickly be a situation with say, 0.4 percent monthly, which annualizes to 4.9 percent inflation. 

The Atlanta Fed's GDP Now model is currently at 0.0 percent. Economic data is weak and weakening. The way CPI is calculated, inflation reading will stay elevated via the real estate calculation, but other parts of it could come down quickly. This will trigger falling bond yields. 

Ukraine is a wildcard, but anything positive there or with Russia sanctions will be bullish.

The main negative I see from here is what I suspect will be a very weak earnings season.

What Comes Next

This part is speculative, a thinking exercise rather than a hard prediction because nobody knows the future. 

Take off your consumer hat right now and put on your finance or trader hat. Ten-year inflation expectation are falling. I see a potential H&S topping pattern that targets to 1.6 percent if the higher blue horizontal is broken. I don't want to overcomplicate this, but suffice to say, I think the Federal Reserve might cease hiking rates around 2 percent if inflation comes down fast. July might even be the last hike. If you want to open your mouth here and say, "but inflation!," shut it. We don't care if inflation is really higher or not, we only care about what the market thinks, has priced in and how it will react. Ditto the Fed. 




The neutral rate of inflation is a theoretical level that is sort of like "Goldilocks" for the FOMC. Below they are accommodating, above they are restrictive. The current neutral rate for the Fed is around 2.5 percent. Right near the 10-year inflation expectations. 

The Fed hiked the Fed funds rate 75 basis points to 1.50 percent last week. The 10-year IE fell 25 basis points in one week, a combined 100 basis point move. They are about 100 basis points away from neutral right now if we use that as a neutral rate. Assuming they do at least 50 basis points and inflation expectations come down at least another 25 basis points, they will be a quarter point away from neutral. If inflation keeps falling, they might be done. They could pause at the September meeting.

What's the scenario for a deeper bear market? One is deflationary collapse. The Fed keeps hiking even as deflation rages. The other is they pause or reverse too early and trigger much higher commodity prices and much higher interest rates. A continuation of the current bear market.

The bull market scenario involves a much faster collapse that leads to restarting QE or at least rate cuts, that then later triggers the rise in commodities. This would be a repeat of the same trap we've been in since 2008. It could go on for many more cycles before it finally ends the bond bull market for good.

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