New Bull or Bear Market Rally?

Podcast Intro:

From LPL Financial, welcome to Market Signals.

Jeff Buchbinder:

Hello everyone, and welcome to the latest edition of LPL Market Signals. Jeff Buchbinder here, your host for today with my friend and colleague Lawrence Gillum our Fixed Income Strategist. Lawrence, how are you today?

Lawrence Gillum:

Oh, couldn't be better, Jeff. I appreciate the opportunity to hop back on the podcast and talk all things fixed income.

Jeff Buchbinder:

Love it. We'll certainly have a lot of fixed income. I won't let you have the stage all to yourself though, because we have certainly a lot of excitement in the equity world as well. So, we'll be somewhat balanced, but certainly we'll take advantage of your fixed income expertise here. And with so many people focused on the Fed that is certainly a more interesting topic maybe than it sometimes is. So, let's get right to it. We've got a great show for you today. We have three key topics. The first question is the one that many of you're asking, it's, is this the start of a new bull market or a bear market rally? We're up about 17% off the lows in the S&P 500, and based on some technical indicators, our view is that it's probably more likely the start of a new bull.

 

So, we'll talk about that. Second, peak inflation is not mission accomplished. We certainly think we've hit peak inflation but that certainly doesn't mean the Fed's inflation fight is over. And then lastly here, again, tapping into Lawrence's expertise on fixed income, are credit markets pointing to a soft landing. So, let's get right to it. It is August 16, as we record this. First question, new bull or bear market rally. So, I'm showing here on the screen, the last few bull markets with the bear markets marked in red. Just to show you kind of where we are here on the question being, has this bounce, which is pretty big, 17%, does that mean the bear market is over? In other words, will the market retest the prior lows? Right? Will we go up 20% before we go back down to those lows in June?

 

You know, our answer to that is probably bull, but keep in mind that bear market rallies can actually be really powerful, and they can last a while. In fact, this data comes to us from our friends at Strategas. The average bear market rally is 32 trading days, right? So that covers about a month and a half and encompasses a 15% gain in the S&P 500. So, you know, we've had a little more than 32 trading days in this current rally, not a lot more. And we got a little more than 15%, right? We got 17. So, you know, it's a little stronger than the typical bear market rally, but not totally out of that realm, right? So, bottom line, this could still be a bear market rally. That's certainly possible. So, Lawrence, we talked about this in the Weekly Market Commentary.

 

Two key technical achievements for the S&P 500, number one, the 50% retracement. Now I priced this chart Friday midday, and it didn't, you know, we closed higher. So, you know, I don't have the latest value on the S&P 500. We're more like 4,300 now. But nonetheless, the key is we crossed that 4,232 number, which was the 50% retracement of the bear market lows. So, my question for you, Lawrence, is the market getting too excited about that inflation data from last week? Because certainly that was, you know, the big driver of this you know, the last few points of this move to get us over this key technical indicator.

Lawrence Gillum:

It's possible, you know, the inflationary data did come in kind of below expectations. So that was a good reprieve from some of the previous inflationary prints that we've seen. I think a bigger story, and this is certainly your domain, but I think the bigger story is just the earnings have come in better than expected for a lot of these companies too. So, you know, we think a lot of this retracement is justifiable.

Jeff Buchbinder:

Yeah, that's a good point. No doubt the earnings season has been better than feared. So, there's a lot of pessimism coming in. We have a slide on earnings here a little bit later. It's a big week for retail, so earnings season is not over, but it's very close. So, you know, the good news here is that when, you know, coming off of major lows, when bear markets retrace more than 50% of that big decline, the bear markets always end, right? Since World War II, 13 out of 13 times, this retracement has signaled the start of a new bull. Now, that doesn't mean that you're not going to see some volatility, right? And so, you know, over the next few months, history would tell us that maybe we'll have a modest gain and probably a little bit of choppiness. There's certainly a lot of bears out there.

 

In fact, this data comes from Sam Stovall at CFRA. After these 50% retracements, historically, the average gains over the next one, two, and three months are 1%, 3%, and 2%, right? So, you know, you're higher, more likely than you're lower but modest gain. So, we probably need a little bit of digestion here. And we may need a little bit of a pullback. So, the next technical achievement for this market is shown here. We broke above the 50% retracement and we broke above the 90% trigger for percentage of S&P 500 stocks over their 50-day moving averages. We have seen this trigger hit at other major lows, essentially signaling new bulls. Similar story to the last indicator. Just some examples of when we triggered, and you can see this on the chart for those of you watching. The spikes to over 90% don't happen very often, but when they do happen, they're typically shortly after major lows.

 

So, some of the times, you'll remember certainly some of these periods April 2010, right? Coming out of the 2009 lows, which certainly we all remember, we got the trigger then. Coming out of the October 2011 lows, remember that was the whole Greek debt crisis, which essentially was a bear market. Stocks were down very close to 20%. So, we got this 90% breadth surge then. When you have a lot of stocks above their moving average, that shows a market that has a lot of breadth to it, which is a positive indicator about the near term. We also had one in April 2016 coming out of that oil and China crisis in late 15. And then 2019, February 2019, coming out of the, basically a Federal Reserve crisis, Lawrence, so you remember well in late 2018 too many hikes and the market threw a temper tantrum.

 

And we ended up coming out of that. I know the low was Christmas Eve coming out of that bear market. It was basically a bear market, down close enough to 20%. And we rallied up off of that, got the signal. And then the last one I'll highlight is June 2020 coming off of the lockdowns, that low. So, these breadth surges tend to happen fairly infrequently, but at really good times. And this suggests that we are indeed starting a new bull market. But again, it doesn't mean that there won't be any volatility. In fact, coming out of the 2011 lows we did have a 10% correction in early 2012. So, this could look like that. Certainly, we all know there's a lot of work that the Fed has to still do on inflation. So, that's that really, really interesting looking at some of these signals.

 

Now, by the way, not only is the inflation fight not over, but we have a lot of geopolitical risks certainly to consider that have the potential to push this market lower. And there are still a lot of folks out there who think that we didn't have enough panic in June to put in a major low. We don't agree at LPL Research. We don't think that's necessary at this point. We got close enough, but there's certainly folks on the other side of the fence that could push this market down. So, let's go to our next segment. And this is where I'm going to rely on you, Lawrence, a lot. You know, talking about what the Fed, you know, how the Fed is going to react to the inflation numbers that we just got or the inflation numbers we're about to get.

 

So, the question here is, well, that's not really a question. It's to point out that peak inflation is not mission accomplished, right? We got the peak, it appears, we're pretty confident that the peak in inflation is in. But the key question, and there's your question, how long will it take for inflation to come down? So, we've got some charts here on inflation, Lawrence. The first one comes from our Chief Economist, Jeffrey Roach, actually a couple from him. Durable goods prices lead the way down. This just shows again, the great CPI number that you know, we've made some progress here, no doubt, in bringing inflation down. But that services number, you know, that's the one that's going to be a little bit tougher to bring down. Do you think, you know, you think services have just got to hang in there and then we can rely on durables to bring inflation down, or is that not enough?

Lawrence Gillum:

Yeah, I mean, and certainly echoing what we've heard from our Chief Economist, Jeff Roach, I mean, we have seen durables roll over and price increases start to wane. Non-durables is likely the next shoe to drop in these inflationary prints. But yeah, to your point, services is likely going to stay higher for longer. You know, we've talked about supply chain disruptions, and that certainly was an issue on the durables non-durables side, on the good side. Services, it's more about just attracting enough people to fill these positions, these open positions. And until we get, you know, an increase in the labor market and getting additional people back into the labor market, you know, we could see these service prices continue to stay higher than what we've seen historically.

Jeff Buchbinder:

Yeah, certainly there's a little bit of a sign of stability in services, but you know, these are sort of longer duration prices, right? In many cases you know, rents, for example, wages for service jobs, for example, right? These things are going to be stickier. So, that just plays into the narrative that there is going to be I mean, it's going to take some time for inflation to come down.

Lawrence Gillum:

Yeah, and that's the point that we've made all along is that peak is one thing, and this goes back to your mission accomplished slide. You know, we all expected a peak in inflation to, you know, show up here, you know, soon. But that doesn't mean that inflation is going to get back to that 2% target over the next year or two. It's going to take time before we get back into those 2% levels. So, we're excited that we've seen, you know, for all intents and purposes the peak, but the Fed and the inflation data has a long way to go to get back to normal.

Jeff Buchbinder:

Yeah. So, as you know, Lawrence, the Fed did say they'd be more comfortable with a little bit higher inflation to kind of offset that long period of lower inflation. So, you know, should the market really focus on 3%, you know, is that kind of a victory? Or do you really think, you know, the Fed needs to be tight until we get down closer to two?

Lawrence Gillum:

Yeah, they've said recently that they want to get back to that 2% target and not just the Fed Chair, Jerome Powell, it's been other members of the Federal Reserve Open Market Committee. I tend to agree with you though, that I think that getting back to 2% in short order is going to be challenging, especially given the service prices. So, maybe they do declare victory at, you know, two and a half, 3%. You know, their original mandate is it wasn't, the 2% construct was put in place, I think by Bernanke you know, years ago to kind of anchor inflation expectations because they were worried about deflation or disinflation, right? So, they included that 2% target recently. So, and their mandate, it doesn't specify 2%. So. I think that there is some flexibility around that number. And I do think that they could declare victory a little earlier than going all the way back to 2%.

Jeff Buchbinder:

Yeah, certainly the market may have gotten a little ahead of itself in, you know, cheering a pivot because we have a ways to go before we get that, or, you know, cuts in 2023, market's probably getting a little too excited too soon, I think we can all agree. But, you know, there's more good news I'd say in this and that indicators that we follow that reflect supply chain gluts are getting better, right? There's, you know, there's a Federal Reserve, I think it's out of the Federal Reserve of New York indicator of supply chain pressures. And then we have you know, evidence that producer prices are coming down, right? That was a two-part surprise. Good news last week, right? Better than expected CPI and PPI. And producer prices, as you're seeing here, do tend to lead to downward pressure on CPI when they fall.

 

And that's indeed what happened. So, the CPI probably needs to play some catch down to the producer prices, so to speak, which is certainly good news. Of course, we all care about inflation for the obvious reason. It's, you know, eroding purchasing power. But we, you know, as market watchers, I think we probably care more about it just because of what it means for the Fed. So, you know, and Lawrence, not only are we talking about the Fed in terms of, you know, rate hikes, and I know you and the team think we're going to get maybe another point, possibly less, but maybe another point of rate hikes this year. But, you know, people often forget that they're also shrinking the balance sheet, right? With quantitative tightening. So, explain to our listeners what that means and how much of an impact that could have.

Lawrence Gillum:

Yeah, so I think this is going to be a bigger story throughout the rest of this year, early next year, as the Fed continues to wind down its balance sheets. So, as we can see on the screen, the Fed has been a big purchaser of Treasury securities and mortgage-backed securities. To help support those markets, they grew their balance sheet up to about 9 trillion. And they've recently announced that they're going to start to let some of these bonds as they mature, roll off their balance sheet in an attempt to reduce the size of their balance sheet. The Fed is just not comfortable with the footprint that they have in the Treasury market or the mortgage-backed securities market. They want to slowly remove themselves from those markets. So, the Fed is letting $30 billion in Treasury securities roll off its balance sheet every month, and 17 and a half billion in mortgage-backed securities roll off their balance sheet each month until September, where they're expected to increase those amounts by twice as much.

 

So, 60 billion in Treasury securities, and 35 billion in mortgage-backed securities every month. And again, in an attempt to reduce the size of the balance sheet. This is an experiment that's only happened one other time and it didn't really go great. We talked, you showed earlier about 2018-19 where we did see some upward pressure on spreads and yields and downward pressure on equity prices because of the tightening that went too far that time. So, this is a, again, an experiment that's only happened one other time, it didn't work out well. So, there is some doubt that the Fed can actually remove itself from the Treasury securities market or the mortgage-backed securities market completely. Right now, the Fed is the primary liquidity provider for the Treasury market. So, and we know that the Treasury market arguably is the most important market in the world.

 

So, as they remove their footprint in there on those markets, we could see additional volatility. So, it is something that we're going to continue to watch and pay attention to. You know, I personally doubt that they're going to be able to remove themselves completely from the Treasury market, just given the importance of that market and the poor liquidity that we're already seeing in that market with the Feds participation. So more to come over the course of this rest of this year, and certainly into next year as the Fed proceeds with balance sheet runoff.

Jeff Buchbinder:

Yeah, I saw a stat I thought was interesting, Lawrence. This is from Bank of America. They actually said quantitative tightening through 2023 is worth 7% on the S&P 500. So, you know, from current levels, stocks will correct. Pullback 7% just based on QT alone. That, I mean, that seems like a lot <laugh>, but certainly you know, a lot of folks try to compare the QT to a rate hike, right? And, you know, I don't know what you think, but maybe, maybe this QT plan could be the equivalent of a half a point hike. I don't know, maybe a little bit more. What do you think about that?

Lawrence Gillum:

Yeah, there's a lot of uncertainty within the Federal Reserve itself actually, in terms of the amount of tightening that would take place by reducing the size of its balance sheet. I have seen the 50 basis point hike equivalency for the reduction of the Fed's balance sheet. I've also seen, you know, 25 basis points or a full percent. So again, this has only happened one other time. So, I think, you know, the Fed doesn't even know what to expect in terms of reducing the size of its balance sheet. And I think that's one of the main reasons why they want to remove themselves from these markets, because there's just a lot of uncertainty with how this plays out as they extricate themselves from these markets. But yeah, 25 to 50 basis point rate hike in terms of financial conditions tightening sounds about right, according to some of the research that they've put out recently.

Jeff Buchbinder:

Yeah, there's no doubt this is tightening. And there's no doubt that rate hikes coupled with balance sheet reduction, increase the risk of a policy mistake from the Fed. So, this is certainly something we'll have to watch really closely and probably, I mean, based on, you know, the fact that they've never done this before and there's doubt as to whether they can even pull back from the Treasury market, they're going to go very slowly, slowly and carefully. Some of you may remember the famous Janet Yellen quote, this will be like watching paint dry <laugh>. So that is not very exciting.

Lawrence Gillum:

Another, just one other comment real quick on just balance sheet reductions. Sure. It's not just the Fed, it's also the ECB, the Bank of Japan. They all experimented with this quantitative easing. Certainly, the Fed is further along in trying to reduce the size of its balance sheet, but as you know, if the ECB is able to reduce its balance sheet as the Bank of England is able to reduce its balance sheet, certainly the Bank of Japan, we think is probably going to be in these markets for, you know, a long time, if not forever. But again, these are kind of coordinated global monetary tightening that could impact you know, the global growth prospects. So, again, it is going to be an interesting thing to watch over the course of the rest of this year and next year, because you know, these are experiments that haven't gone great previously. And now we're having a lot more central banks trying to remove themselves from these markets. So, interesting times for sure.

Jeff Buchbinder:

Yeah, no doubt. So, let's continue with the bond market theme. And I'll pose this question to you, Lawrence, is what are the credit markets saying about soft landing prospects? I know I've seen some of your work recently pointing to the improvement in the credit markets that has accompanied this equity market rally. So, you know, here we have a chart of credit spreads. What are they telling us?

Lawrence Gillum:

Yeah, so we have seen credit spreads tighten over the past, you know, say six weeks, particularly in the high yield corporate credit markets. Just as a reminder, we tend to look at the high yield corporate credit markets as that canary in the coal mine. You know, high yield markets, the returns are you know, asymmetrical in that there's a lot of downside and not a lot of upsides. So, these high yield credit markets tend to be you know, first movers if macro events are expected or if economic slowdown is on the horizon. So, it is comforting that we are seeing credit spreads tighten. We did see a lot of widening or yields and spreads higher at the beginning of this year. But as the concerns or threats of an economic recession have kind of dissipated or waned over, you know, recently, we certainly don't think there's going to be a recession over the next six months.

 

You know, maybe 2023 is a higher probability. But as we've seen, those economic conditions kind of moderate and things kind of you know, improve, we have seen spreads tighten and high yield spreads have moved lower five of the last six weeks. So, I'm not willing to say that the credit markets are signaling the all clear signal but they are moving in the right direction in terms of saying that, you know, the economic conditions aren't as scary as they were say, you know, six weeks ago.

Jeff Buchbinder:

Yeah, when I see this chart, I immediately, you know, think of the financial crisis, right? And just how much of a credit crisis that really was <laugh>. And so, you know, this is nothing like that, right? We're not worried if a company is still going to exist tomorrow, this is not that at all. And so, this is a more normal credit environment. Here I am the equity guy talking about credit, which is dangerous, but this it seems like a more normal credit market, at least that's what, Lawrence, you've told me. And that tells me that you know, at least translating over to the equity side that you know, that 23 and a half percent correction or bear market that we got is probably all we need. And that suggests to me that, you know, the economy could avoid a recession.

 

Soft landing is still possible. I mean, we're still at 50/50 for the next year. Now based on the latest data and the trajectory, we might take those odds of recession in the next year down, but, you know, we're still 50/50. There's still a chance of recession, certainly we acknowledge that. But the credit markets are telling us a soft landing is possible. And certainly, the jobs data and the consumer spending data recently is telling us a soft landing is still possible. So, positive signal here and you know, hopefully those credit spreads continue to narrow and tell us you know, corporate America's still in good shape. So, let's go to our last segment here about, you know, the week ahead. And this is really all about retail this week. So, I know, Lawrence, you're happy that your kids are back in school.

 

So, you probably already did some damage at these various retailers or others for back to school. I did a little bit of that this weekend and well it's continued into this week because of course we have online shopping. So, we get a ton of retail reports. We already got a couple here, Home Depot and Walmart, were generally well received, especially Walmart this morning. And we'll get Lowe's, we'll get Target, we'll get a number of others. So, not only is it back to school shopping season, but it is earnings season for retail. And remember this was a tough spot last quarter, right? We've gotten a few profit warnings from Walmart, Target and others dealing with inventory problems. The transition away from the pandemic to reopening and then back to something more like normal has been very tricky for these retailers to manage.

 

And of course, the inflation putting cost pressures and from a number of different directions have made, and supply chain problems have made this a very tricky environment for retailers. So, it's just been, I mean, frankly, I think you've heard probably if you've been following some of the comments out of retailers this earnings season that you've heard a number of them say this is one of the most difficult environments they have ever seen. It certainly has been. So, this, you know, those types of challenges, right? Supply chain, cost pressures, slowing economic growth, inflation eroding purchasing power of consumers, the challenges and geopolitics, the challenges go on and on and on. And yet this earnings season has just really been normal. It's almost as if none of those things are even happening because companies delivered their typical upside estimates, have delivered their typical reductions, right?

 

On average earnings fall, earnings estimates fall a couple points during earnings season. That's essentially what's happened. We've gotten the upside, you know, we started at maybe 4%, now we're at six and a half, this is FactSet data. Some actually have higher numbers. It depends on how you adjust for operating earnings versus GAAP accounting earnings. Some shops, very reputable shops, widely used data sources are saying more like eight, eight to 9%. So, whatever numbers you want to use, the earnings season was really good. And the reason has been revenue. We had about five percentage point upside surprise in revenue this quarter. So, that to me, in addition to just managing costs, well the upside to revenue to me is really the big story this earnings season. So, Lawrence, I know you probably don't follow this as closely as I do, but any observations about the earnings season and you know, maybe what it might mean from kind of a credit perspective?

Lawrence Gillum:

Well, I mean, did you mention the headwind that the strong dollar also posed? I mean, we've seen the dollar appreciate pretty significantly relative to other currencies, so that's certainly been a headwind for some of these bigger companies out there that generate a lot of revenues outside the U.S. borders.

Jeff Buchbinder:

Very good point, yes. I mean, that's basically two to three points off of S&P 500 profits, and yet still companies have been able to hit their estimates for Q2, and then the guidance for Q3, frankly, has been pretty darn good considering all those challenges. So, we're calling earnings season a win. As, Lawrence, you pointed out earlier, that is certainly one of the reasons why stocks were up so nicely off the lows. And certainly, have a good chance, we think, to hit their estimates for the second half of the year now that they've come down. So, we're holding our estimates unchanged for this year and next year and feel pretty good about them, frankly especially after you know, the last few weeks. So, let's close it out by just talking about this week. I mean, we got some weak housing data. You know, it's been pretty obvious that the housing market was going to slow and it has certainly. What else do you want to highlight here, Lawrence? I mean, I guess the Fed minutes will probably get a lot of attention tomorrow.

Lawrence Gillum:

Yeah, and then, you know, firstly the retail sales number. We had our investment committee meeting yesterday and our Chief Economist, Jeff Roach, mentioned that Wednesday is going to be a good barometer in terms of economic growth. So, we do expect to see, you know, maybe stronger than expected retail sales numbers come in. So that could be market moving, particularly on the fixed income side. But yeah, to your point, the meeting minutes come out tomorrow for the July 27 meeting, it's probably too early to get any sort of hints about a September rate hike. But we will get some additional information on things like, you know, what the neutral rate of interest was as, you know, Chair Powell mentioned that at two and a half percent, they were at that neutral rate.

 

So curious to see the discussions around that. And then again, looking to see what sort of information they've talked about or can provide about just the illiquidity in the treasury market and this ongoing quantitative tightening that they're going to pursue over the next few years. So, I think it is going to be an interesting release of meeting minutes. And, oh, by the way, next week, and we'll have more of this next week, I'm sure, but they also have their annual you know, symposium out in Kansas City hosted by the Kansas City Fed out in Jackson Hole. So, that starts next week. So, you know, this week and next week are going to be likely some pretty interesting weeks as it relates to the Fed absent any sort of FOMC meeting.

 

So, there's a lot of information that's going to come to us outside of the normal channels starting tomorrow with these meeting minutes. And then we also have some speakers this week. You know, Esther George is a voting member. She's going to talk on Thursday. And then we have Neel Kashkari, who is interestingly, has been one of the most dovish Fed members on the committee. He's not a voting member, but he's certainly changed his tune and is now becoming one of the most hawkish members on the committee. So, we'll certainly pay attention to what he says. And then of course, you know, Tom Barkin on Friday. So, it could be an interesting week for Fed watchers like myself and our chief economist. So, you know, certainly a lot of information out there that could move bond markets this week.

Jeff Buchbinder:

Oh, Fed chat can move stock markets too, no doubt. So, thanks for that, Lawrence. I, you know, having grown up in Kansas City, if I was hosting a Kansas City Fed Symposium, I'd probably have it at a barbecue joint there, but, you know, Jackson Hole I've heard is really nice, so that works too <laugh>. So, we'll certainly be watching what we hear from the Fed, particularly Powell next week. And that'll probably be one of our main topics for the podcast in two weeks. So, certainly, we'll look forward to that. So, let's go ahead and wrap at this point. Thank you, Lawrence, for joining. I think for, you know, for those of you out there listening that think the bond guys are smarter than the equity guys, now you have confirmation after hearing from Lawrence. You know, it's, frankly, I think the bond market is usually smarter <laugh> than the equity market. They do more homework. So, I always pay attention to both. But even as an equity guy I'll admit that bond market signals can certainly be very insightful. So, thanks, Lawrence, for sharing your thoughts. Thanks everybody for listening or watching to another edition of LPL Market signals. We'll be back with you next week. We'll see you then.

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