Why Stocks Might Have Hit a Bottom of Sorts

Photo by Magda Ehlers from Pexels

What are the key facts

  • Stocks have been in a frenzy swing ride higher since hitting rock-bottom back in March 2020 on Covid-19 pandemic fears.
  • The SP-500 Index has more than doubled from 2200 to 4800 in the same period, propped up by unprecedented monetary and fiscal stimulus.
  • The combination of stronger economic activity on the back of increased vaccination rates and pent-up-demand from lock-downs, coupled with significant supply-side bottlenecks, has sent inflation spiking to record levels. Core personal consumer expenditures (PCE), the price index closely followed by the Federal Reserve (‘Fed’), showed an increase of 4.9% in December compared to a year ago, and has been the highest gain since 1983.
  • The Fed has been signaling a less accommodative policy may be appropriate, including tapering its asset purchases and hiking interest rates. In its January 2022 FOMC statement it is mentioned that:

‘With inflation well above 2 percent and a strong labor market, the Committee expects it will soon be appropriate to raise the target range for the federal funds rate.’

  • Stocks have hovered into correction territory starting into early 2022, with the SP-500 dropping by more than 10% in January, led by a correction in the technology sector.

Macros and fundamentals

  • A Modest level of inflation — hence the Fed inflation target of around 2% — is considered healthy for economic activity and stocks tend to benefit, while also providing a good hedge for rising prices as opposed to other asset classes like cash and bonds. Significant increases in the rate of inflation are generally negative for stocks, particularly as the increased costs of production erode margins and earnings potential. Recent inflation figures have proven more persistent than transitory, while several corporations have increasingly expressed concerns about inflationary pressures building up. We are, therefore, in an environment of rising inflation which should act as a headwind for stocks.
Source: Factset
  • Interest rates are determined by central banks via their policy rate in the short term, and economic growth prospects in the long term. Since the Fed is mandated with maintaining stable prices while achieving full employment longer term, it is the most influential player in setting the trend for interest rates. Lower rates favor the expansion of credit and economic growth. On the contrary, higher rates tend to be contractionary as the cost of borrowing increases, margins reduced, and valuations are reduced as price multiples are discounted at higher factors. In view of the recent FOMC statement, and expectations of rate hikes starting as soon as March, we are in an environment of rising interest rates which should act as a headwind for stocks.
  • Economic growth, as measured by GDP, is expected to grow by 4.0% in 2022, down from the 5.6% growth expected in 2021, but still above the US economy’s long-term trend growth rate (Source: Factset). We are therefore in an environment of strong economic growth which should act as a tailwind for stocks but at a rate that may be reaching a plateau.
  • The labor market and related employment statistics are important indicators which tend to be highly correlated with economic growth. As the labor market gets stronger, spending, and investing in the economy and markets increases in a feedback loop fashion. When strength becomes overwhelming though, then labor conditions are so-called to be tight. Any additional boost simply just feeds into wage inflation, and not necessarily related to productivity and economic growth. The below chart by Factset draws some very interesting conclusions — there is approximately half a person unemployed per job opening! The enormously tight US labor market conditions are almost certain to support economic growth and push inflation higher.
Source: Factset
  • Earnings are the bottom line of a corporation. Increased economic activity, favorable credit conditions, and benign inflation contribute positively to the earnings growth of a corporation. We are currently in a situation where corporate earnings are still growing, albeit at a slower pace, which should still be acting as a tailwind for stocks. In view of the headwinds from rising inflation and interest rates, earnings will be the key determinant of valuations going forward. Earnings will have to keep growing for stocks to maintain the bull run, everything else kept constant.

Technicals

Looking at a 3-year chart of the SP-500 index, it is evident that the long term picture hasn’t changed dramatically despite the January sell-off. Yes, the 200-day moving average (blue line) has just been tested for the first time since June 2020, but it seems to have worked like a rubber band containing the drop. The recent correction on the SP-500 index still remains that — a correction in the vicinity of 10%, and not a bear market.

SP-500 Index, Source: Barchart.com

Market Sentiment

Market sentiment data provide a framework for analyzing market participants’ emotions and expectations about future outcomes. One popular example is the Volatility Index (Vix — aka ‘fear index’). Another example is the CNN Fear & Greed Index, a composite contrarian indicator about market sentiment. Based on the current reading it is indicating ‘fear’ and hence it seems more likely than not that stocks are, at least at this juncture, climbing a wall of worry — a vote of confidence for the bullish camp.

Source: https://money.cnn.com/data/fear-and-greed/

To sum-it-up

We are still in a bull market. The January 2022 sell-off has taken a toll — some well known companies, especially tech, have more than halved in value. Some will even repeat the halving process several times till they go bust. Most of the decent companies though, with good cash flows and business models are likely to recover and offer true bottom-fishing opportunities.

Paradoxically, the biggest risk facing the stock market today may be in fact its very own strength.

Disclaimer: All views are strictly personal and intended for education purposes only. Under no circumstances can information in this article be considered as advice, investment or otherwise, nor can it be considered as a solicitation to trade in any securities. You should consult your personal adviser for any financial matters. The author cannot be held liable for any adverse impact due to any action or inaction by anyone as a result of consuming this information. All rights reserved.

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Spyros Ierides, CFA

Spyros Ierides, CFA

Sharing thoughts on financial markets, personal investing and self development.