This Market Rally Could Be A Bear Trap!! Here’s why……
After a really tough first 6 months of the year, the stock market has been in rally mode, rising over 9% within the last 30 days. It’s left investors anxious to participate in the rally to recapture the losses that were incurred in the first half of the year. Our guidance to clients, while there are plenty of bobbing heads on TV talking about “buying the dip” and trying to call the “bottom” in the market, this could very well be what we call a “bear trap”. A bear trap is a short-term rally that baits investors into thinking the market has bottomed only to find out that they fell for the trap, and experience big losses when the market retreats to new lows.
The 4th Bear Trap In 2022
If the current rally ends up being a bear trap, it would actually be the 4th bear trap so far in 2022.
The green boxes in the chart show when the rallies occurred and the magnitude. Notice how the market moved to a new lower level after each rally, this is a common pattern when you are in a prolonged bear market environment.
So how do you know when the bear market is over and the new sustainable bull market rally has begun? It’s actually pretty simple. Ask yourself, what were the issues that drove the market lower in the first place? Next question, “Is the economy making MEANINGFUL progress to resolve those issues?” If the answer is yes, you may in fact be at the beginning of the rally off of the bottom; if the answer is no, you should resist the temptation to begin loading up on risk assets.
It's Not A Secret
It’s not a secret to anyone that inflation is the main issue plaguing not just the U.S. economy but economies around the world. Everyone is trying to call the “peak” but we did a whole video on why the peak doesn’t matter.
The market cheered the July inflation report showing that headline year over year inflation dropped from 9.1% in June to 8.5% in July. While progress is always a good thing, if the inflation rate keeps dropping by only 0.60% per month, we are going to be in a lot of trouble heading into 2023. Why? As long as the inflation rate (the amount prices are going up) is higher than the wage growth rate (how much more people are making), it will continue to eat away at consumer spending which is the bedrock of the U.S. economy. As of July, wages are growing at only 6.2% year over year. That’s still a big gap until we get to that safety zone.
Understand The Math Behind The CPI Data
While it’s great that the CPI (Consumer Price Index) is dropping, the main CPI number that hits the headlines is the year-over-year change, comparing where prices were 12 months ago to the prices on those same goods today. Let me explain why that is an issue as we look at the CPI data going forward. If I told you I will sell you my coffee mug today for $100, you would say “No way, that’s too expensive.” But a year from now I try and sell you that same coffee mug for $102 and I tell you that the cost of this mug has only risen by 2% over the past year, does that make you more likely to buy it? No, it doesn’t because the price was already too high to begin with.
In August 2021, inflation was already heating up. The CPI headline number for August 2021 was 5.4%, already running above the Fed’s comfort level of 3%. Similar to the example I just gave you above with the coffee mug, if the price of everything was ALREADY at elevated levels a year ago, and it went up another 8.5% on top of that elevated level, why is the market celebrating?
Probability of A 2023 Recession
Even though no single source of data is an accurate predicator as to whether or not we will end up in a recession in 2023, the chart that I am about to show you is being weighted heavily in the investment decisions that we are making for our clients.
Historically an “inverted” yield curve has been a fairly accurate predicator of a coming recession. Without going into all of the details of what causes a yield curve inversion, in its simplest form, it’s the bond market basically telling the stock market that a recession could be on the horizon. The chart below shows all of the yield curve inversions going back to 1970. The red arrows are where the inversion happened and the gray shaded areas are where recession occurred.
Look at where we are right now on the far right-hand side of the chart. There is no question that the yield curve is currently inverted and not just by a little bit. There are two main takeaways from this chart, first, there has been a yield curve inversion prior to every recession going back to 1970, an accurate data point. Second, there is typically a 6 – 18 month delay between the time the yield curve inverts and when the recession actually begins.
Playing The Gap
I want to build off of that last point about the yield curve. Investors will sometimes ask, “if there is historically a 6 – 18 month delay between the inversion and the recession, why would you not take advantage of the market rally and then go to cash before the recession hits?” My answer, if someone could accurately do that on a consistent basis, I would be out of a job, because they would manage all of the money in the world.
Recession Lessons
I have been in the investment industry since 2002. I experienced the end of the tech bubble bust, the Great Recession of 2008/2009, Eurozone Crisis, and 2020 COVID recession. I have learned a number of valuable lessons with regard to managing money prior to and during those recessions that I’m going to share with you now:
It’s very very difficult to time the market. By the time most investors realize we are on the verge of a recession, the market losses have already piled up.
Something typically breaks during the recession that no one expects. For example, in the 2008 Housing Crisis, on the surface it was just an issue with inflated housing prices, but it manifested into a leverage issue that almost took down our entire financial system. The questions becomes if we end up in a recession in 2023, will something break that is not on the surface?
Do not underestimate the power of monetary and fiscal policy.
The Power of Monetary & Fiscal Policy
I want to spend some time elaborating on that third lesson. The Fed is in control of monetary policy which allows them to use interest rates and bond activity to either speed up or slow down the growth rate of the economy. The Fed’s primary tool is the Fed Funds Rate, when they want to stimulate the economy, they lower rates, and when they want to slow the economy down (like they are now), they raise rates.
Fiscal policy uses tax policy to either stimulate or slow down the economy. Similar to what happened during COVID, the government authorized stimulus payments, enhanced tax credits, and created new programs like the PPP to help the economy begin growing again.
Many investors severely underestimate the power of monetary and fiscal stimulus. COVID was a perfect example. The whole world economy came to a standstill for the first time in history, but the Fed stepped in, lowered rates to zero, injected liquidity into the system via bond purchases, and Congress injected close to $7 Trillion dollars in the U.S. economy via all of the stimulus policies. Even though the stock market dropped by 34% within two months at the onset of the COVID crisis in 2020, the S&P 500 ended up posting a return of 16% in 2020.
Now those same powerful forces that allowed the market to rally against unsurmountable odds are now working against the economy. The Fed is raising rates and decreasing liquidity assistance. Since the Fed has control over short term interest rates but not long-term rates, that is what causes the yield curve inversion. Every time the Fed hikes interest rates, it takes time for the impact of those rate hikes to make their way through the economy. Some economists estimate that the delay between the rate hike and the full impact on the economy is 6 – 12 months.
The Fed Is Raising More Aggressively
The Fed right now is not just raising interest rates but raising them at a pace and magnitude that is greater than anything we have seen since the 1970’s. A chart below shows historical data of the Fed Fund Rate going back to 2000.
Look at 2004 and 2016, it looks like a staircase. Historically the Fed has raised rates in small steps of 0.25% - 0.50%. This gives the economy the time that it needs to digest the rate hikes. If you look at where we are now in 2022, the line shoots up like a rocket because they have been raising rates in 0.75% increments and another hike of 0.50% - 0.75% is expected at the next Fed meeting in September. When the Fed hikes rates bigger and faster than it ever has in recent history, it increases the chances that something could “break” unexpectedly 6 to 12 months from now.
Don’t Fight The Fed
You will frequently hear the phrase “Don’t Fight The Fed”. When you look back at history, when the Fed is lowering interest rates in an effort to jump start the economy, it usually works. Conversely, when the Fed is raising rates to slow down the economy to fight inflation, it usually works but it’s a double edged sword. While they may successfully slow down inflation, to do so, they have to slow down the economy, which is traditionally not great news for the stock market.
I have to credit Rob Mangold in our office with this next data point that was eye opening to me, when you look back in history, the Fed has NEVER been able to reduce the inflation rate by more than 2% without causing a recession. Reminder, the inflation rate is at 8.5% right now and they are trying to get the year over year inflation rate back down to the 2% - 3% range. That’s a reduction of a lot more than 2%.
Stimulus Packages Don’t Work
In the 1970’s, when we had hyperinflation, the government made the error of issuing stimulus payments and subsidies to taxpayers to help them pay the higher prices. They discovered very quickly that it was a grave mistake. If there is inflation and the people have more money to spend, it allows them to keep paying those higher prices which creates MORE inflation. That is why in the late 70’s and early 80’s, interest rates rose well above 10%, and it was a horrible decade for the stock market.
In the U.S. we have become accustomed to recessions that are painful but short. The COVID Recession and 2008/2009 Housing Crisis were both painful but short because the government stepped in, lowered interest rates, printed a bunch of money, and got the economy growing again. However, when inflation is the root cause of our pain, unless the government repeats their mistakes from the 1970’s, there is very little the government can do to help until the economy has contracted by enough to curb inflation.
Is This The Anomaly?
Investors have to be very careful over the next 12 months. If by some chance, the economy is able to escape a recession in 2023, based on the historical data, that would be an “anomaly” as opposed to the rule. Over my 20 year career in the industry, I have heard the phrase “well this time it’s different because of X, Y, and Z” but I have found that it rarely is. Invest wisely.
About Michael……...
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
