I often am asked the following question: “When do you expect the market to bottom out?” My answer is almost always some derivative of the following: “Predicting market bottoms is a fool’s errand. We will know when the market bottom has arrived a good three to six months after the fact.” That said, I do have some opinions on what the necessary criteria for supporting a market bottom. Here is a list of my market bottom criteria:
1 – An end to a monetary tightening phase
2 – A material level of underinvestment in equities
3 – A measurable high level of volatility translating to unusually high levels of fear
4 – A stable economic environment that can result in an economic expansion phase
5 – An end to a period of political uncertainty
At first light it may appear that the bottoms list is somewhat wishful. The basis for seeing equity markets bottom out is predicated on the following simple logic: when you run out of sellers to push stocks lower you are setting up for a period of equity appreciation. In the last year we have been treated to mostly terrible news regarding our portfolios. We have seen bad government policy lead to an inflationary cycle. We have witnessed a hot war in Europe disrupting global commodity supplies and threatening to severely hamper European economic growth. We continue to live with a zero covid policy in China which strains supply chains throughout the globe. And we have lived through the fastest pace of monetary tightening since the early 1980s. If you consider what we have lived through over the last year one wonders how we could possibly bottom out in such an environment? The answer is based on the age-old concept of understanding what an equity investment truly means. A stock price is composed of all the future cash flows of the underlying company rolled into the price of a share today. The current price is theoretically supposed to include all the expectations for that company for the rest of its existence. The reason that stocks have sold off quickly is because all that negative stuff has changed investors’ expectations on the value of future cash flows. People must expect earnings to struggle to grow or even to contract. This is the recipe for an equity bear market. When investors begin to expect earnings to expand again, I would expect the prices of stocks to increase again. At the end of the day, it really is all about earnings expectations.
Returning to our bottoms criteria list, let us analyze each one in reverse order. The 5th condition for a market bottom is an end to political uncertainty. In 27 days, we will have political resolution in the US government as the midterm elections will be behind us. Most political analysts expect that either the House of Representatives or the Senate will flip over to the GOP, resulting in a two-year period of political stalemate between President Biden and Congress. Markets tend to like it when political power in Washington DC is divided. Passing bills will become rather difficult, and that can be translated into political stability. I am not suggesting that the path over the next 27 days will be smooth. In fact, I expect some goodly bit of social unrest leading into and out of November 8th. But what I am relaying to you is that the political advertisement game of dodgeball will finally be behind us. If you reside in a hotly contested election district you probably are looking forward to the day when those pesky political ads and those annoying telemarketing pollster calls/texts cease to invade your life. Not to worry my friends, that day is coming, and it is November 8th.
The 4th criterion for establishing a market bottom is a stable economic environment. Right now, it seems that every time you flip on the CNBC or Bloomberg channel you are inundated with disappointing inflation data. Yet if you look under the data hood you will find that the situation is not as bad as you may be led to believe. Yes, inflation is running rampant when looking at the headline figures. Just this morning the CPI surprised to the upside with a reading of 8.2% in the headline number. When looking at the core CPI, which strips out volatile food and energy components, we saw a higher than expected 6.6% annual rate of inflation. But when I peruse the data, I am beginning to see some early signs of inflation abatement. We know that the rapid rise in interest rates has all but shuttered the housing market. I expect that to translate to lower prices over the next several quarters. Owners’ Equivalent Rent (“OER”), which comprises nearly 24% weighting in the CPI and nearly 40% in the core CPI, continues to print large monthly increases. But once the lower home prices are entered into the OER equation we will begin to see that portion of the CPI number rapidly return to more sanguine levels. Home prices are already flattening out or even contracting across the country as buyers are no longer able to afford the lofty home prices given the near 7% mortgage rates. If you were to exclude OER from the core CPI you would have only seen a monthly increase of 0.2% and translating to an annualized pace of 2.4%. But why should we ignore OER? The simple answer is that it is a completely fictitious number. It is sort of defined in the following way: if you own a home but were forced to rent one instead of living in your home, that would be the theoretical level of inflation for renting instead of owning your home. It is what economists invent when they must attach a number to the price of a product that does not readily transact. The other major problem with this silly OER number is that it is based on outdated data of rents over the last year. Rental contracts are only negotiated once per year, so the rental data is based on rental contracts that were signed months ago. This is an extremely lagging indicator. To sum up my thoughts, I see ample evidence in the data that would suggest that inflation is already downshifting towards a lower trajectory.
As for the 3rd and 2nd criteria for bottoming, I will combine those into one precondition. The increased volatility and market swoon of both stocks and bonds has inspired many investors to cut their risk profiles in favor of cash. For the most part, 2022 has seen nearly every asset class perform negatively. This has forced investors to park their money in cash, as investors are underweight exposures to both equities and bonds. When I consider a shift in investor sentiment, I like to ask the following question: are there additional sellers lurking in the shadows waiting to dump their stock and bond holdings? My sense is that investors are at extreme levels when it comes to their cash holdings. Moving forward it may very well be difficult to find new sellers in these markets. In a recent polling by Bank of America, they found that investment managers are sitting on their highest cash percentages since October 2001, immediately after the 9/11 attacks. In addition, 68% of fund managers are now expecting a recession in 2023. This is extreme caution the likes of which we have not seen in the better part of 40 years. Market bottoms usually occur around periods of extreme pessimism. The negativity seems almost entirely baked in the proverbial cake. For example, some governments in Europe have begun handing out iodine pills to offset the effects of radiation in the unlikely event the Russia Ukraine War goes mini-nuclear. I assure you that a tiny iodine pill will have nearly no effect to offset large amounts of radiation spillover, but a fear of nuclear action is clearly taking root in Europe. I could only imagine how big of a rally the stock market could see if the R-U War were to come to a resolution.
And finally, the most important piece of the puzzle is the Federal Reserve and their aggressive inflation busting campaign. The FOMC has endlessly communicated that they will stop at nothing until they are convinced that inflation is moving materially to a level that is more sustainable. Powell has beaten the drum to its breaking point about having to be restrictive to lower the demand side of the equation to balance the economy. The message has been received, as any data that appears like solid growth or inflation is met with relentless selling of both equities and bonds. Yet, for the first time this week, a Fed speaker began floating the idea that monetary policy tightening works with a lag, and that the Fed may reconsider the aggressive rate hiking warpath that they have embarked upon. It is this writer’s opinion that the FOMC will have to strongly consider their exit strategy before too long due to the potential economic damage that they may inflict should they slam on the brakes a bit too forcefully. The moment job losses begin to mount it will be the signal that the inflation story is fast resolving. The time for a cessation of Fed rate hikes is fast approaching. And sure, they will inform us that they intend on keeping rates elevated and restrictive for a long time. But my sense is that once the shoe begins to fall and inflation quickly cools off, the Fed will be considering bringing rates to a more neutral state. As I wrote in my market update on September 13th, “my economic crystal ball is telling me that by the end of 2022, the Federal Reserve will be ready to pause the rate hike cycle. They are keenly aware that monetary policy works with a lag of 6-18 months. The fruits of their rate hikes will be felt sometime in the spring of 2023. Chairman Powell will most likely signal the tightening pause by December 2022. By then I suspect short term rates will be approximately 4.00-4.50%, the yield curve will be properly inverted, and nearly $1 trillion would have rolled off the central bank’s balance sheet. This should be ample ammunition to attack inflation. And once inflation begins to move lower … well … we are going to wish we had more stocks in our portfolios.” I am going to stick to my guns on this one: the hiking cycle will probably be ending in 2022. Indeed, the Fed may warn us that they intend to keep a keen eye on inflation and are ready to pump the brakes even further. But by then the brunt of the previous rate hikes will begin to bite, and I suspect Powell will be singing songs of steady as she goes for the balance of 2023.