(Please enjoy this updated version of my weekly commentary published August 11^th, 2022 from the POWR Stocks Under $10 newsletter).

Over the last week, the S&P 500 (SPY) is up a little more than 1%. Like much of this bear market rally, the advance has been broad-based. One observation is that more junky stocks are leading, while higher-quality ones are lagging.

This is another piece of evidence supporting the bear market rally thesis and that this move is more about sentiment and positioning rather than a sea change in fundamentals

Equally important, the S&P 500 retraced exactly 50% of the drop from the January highs to the June low at today’s high. Then, we dropped lower the rest of the day.

This price action probably whetted the appetite of bears, as it looks like a textbook, blow-off top and a ‘sell the news’ situation, given the soft PPI number which precipitated the gap up higher.

So, this is something to watch given that we are 71% long, and I’m intently focused on not giving up any of our head-earned profits. As noted earlier, the focus is now on cultivating our gains, and it would be prudent to accelerate this with a break below 4,100.

Bull Market vs Bear Market Rally

[This is a reprint of a comprehensive, deep-dive into the bull vs bear topic with some edits given this week’s developments and more pertinent information for the POWR Stocks Under 10 portfolio]

First, let’s just note a couple of things: The market has done a 180 in terms of mood over the last 2 months. It’s yet another reminder that ‘sentiment follows price’.

At the lows, the prevailing narratives were sky-high inflation, a breakdown in growth stocks, a hawkish Fed, and a looming recession that was going to culminate in a significant decline in earnings.

After more than six months of triumph for the bears, they are on the retreat and rethinking their priors due to a nearly 20% rally for the Nasdaq and 15% gain for the S&P 500 (SPY) since the mid-June low.

This is clearly the longest and most sustained rally in 2022 and is different in a qualitative and quantitative sense than previous advances in 2022. This has also coincided with a better than expected earnings season and economic data which undermines the recession narrative and increases the odds of a ‘soft landing’.

In addition, we had extreme levels of bearish sentiment, high levels of fund managers holding cash, and very low levels of stock ownership, specifically for tech stocks. Given these developments, it’s a good time to delve into some individual issues to help us answer the million-dollar question.

Inflation

Possibly the most potent bearish threat facing the market in 2022 is inflation which kept creeping higher, reaching a level above 9% in the last month that hasn’t been seen in decades. High inflation means a hawkish Fed and higher short-term rates which is particularly negative for financial assets.

After all, why would investors take risks in terms of borrowing money or buying stocks if the risk-free rate of return is sufficiently attractive.

Adding to this risk were energy prices. These were climbing higher, entering 2022 but accelerated due to the Russia and Ukraine crisis. Nasty side effects have included soaring electricity prices and broad-based gains in oil, coal, natural gas, etc.

The issue is also conflated with national security and politics which means that the US and EU are willing to absorb these higher prices in order to oppose Russia’s incursion into Ukraine.

There doesn’t seem to be a resolution to the conflict between Russia and Ukraine, but there are some positive developments in terms of inflation. Leading indicators are pointing lower. Supply chain issues are being sorted out with retailers now discounting prices due to excessive inventories.

Auto production is returning to full capacity and the housing market has slowed in a major way. Most importantly, there is relief in terms of lower gasoline prices. But, the recent inflation report does increase hope that it has peaked.

This is consistent with what we have observed with leading indicators and second-derivative measures which are forecasting a sharp decline in inflation. And as we have learned, this is a clear-cut catalyst for higher stock prices especially if the economy stays resilient.

Growth Stocks 

Growth stocks have been kind of a leading proxy for the market. Many of the frothiest, peaked in the spring of 2021, while others topped later in the year. This was well before the broader market which topped in January of this year.

Interestingly, the inverse took place recently as many growth stocks bottomed in mid-May and made a higher low in mid-June, even though the indices and most stocks made lower lows in June.

Currently, growth stocks have been the strongest performers during this rally. One reason is that moderating inflation is leading to lower rates which puts a bid underneath growth stocks. The other is that these stocks were heavily shorted which means that shorts are being squeezed.

It’s also worth noting that ‘junk’ growth stocks with no earnings and high valuations are leading the rally, while more higher-quality growth stocks are lagging. This could be interpreted as a lack of institutional participation in the rally and validation of our short-squeeze thesis.

Recession + the Fed

In May and June, the calculus seemed simple. The Fed’s hawkishness and determination to crush inflation was going to result in a recession.

This scenario could still prove to be correct, but it’s clear that the economy is much more resilient than expected. This is evident with the recent jobs report which showed the US economy adding more than 500,000 jobs.

Additionally, the services segment of the economy expanded in July contrary to expectations. Finally, the hospitality & leisure segment of the economy continues to boom as indicated by earnings and economic data.

Earnings

Earnings are also inconsistent with an economy that is on the verge of a recession. Although, bears might counter by saying that Fed tightening is just beginning to impact the economy.

As Q2 earnings season nears an end, analysts are now expecting that S&P 500 (SPY) earnings will increase by 6.8%. This is better than the initial 4% estimate. It is true that the bulk of this earnings growth is coming from the energy sector as ex-energy earnings are set to decline by 1%.

Conclusion

I started off writing this almost 100% convinced that this is a bear market rally that will inevitably lead to lower lows. However, in putting this together and taking an objective view of the situation, I do think the bull case should be respected, but it hinges on one crucial development.

Basically, if inflation starts plummeting and continues to plummet, but the economy stays resilient, this could be sufficient cause for a new bull market.  In that case, this could be the nadir for earnings, and we could have a market with earnings growth and falling rates which would send stocks to new highs.

I think the possibility of this has gone from ‘implausible’ to ‘unlikely’ over the last 2 months based on leading indicators of inflation rolling over, while earnings have remained stable despite six months of tighter policy.

Another way to say this is that the economy is much less interest-rate sensitive than the market and most investors think.

However, just like the economy has proven to be more resilient than expected, something similar could happen with inflation. This would mean the Fed keeps hiking and economic growth would be choked off, leading to a more significant contraction in earnings.

This combination of higher rates and lower earnings would recreate the same dynamic that led to plummeting prices in the first-half of the year.

So, I remain in the bear market rally camp. Mostly, because I see growth rolling over and more damage to earnings.

At the same time, we have caught the bulk of this move and our portfolio is up more than 10% since the market bottom despite an above-average cash position and some defensive picks which have underperformed.

2 Paths to Ponder

Wanted to give a couple of quick notes on 2 potential paths for the market.

Lockout Rally vs Marginal Highs That Rolls Over

One is that this ‘lockout rally’ continues. These rallies are defined by bulls and bears both rooting for lower prices. Bears, for obvious reasons, and bulls, because they are underinvested.

Unfortunately, it’s in the market’s nature to disappoint and frustrate, so it stubbornly keeps climbing higher with shallow or quick dips that quickly turn into higher highs.

If this scenario is valid, we should see the market quickly get above today’s highs.

The other possibility was alluded to above. The market made higher highs by a marginal amount as we peeked above the previous highs in early June. No doubt, this development led to some algorithmic, trend-following, and technically-oriented traders covering shorts or even getting long.

But, this is often a head-fake and the last gasp of a bear market rally. In fact, we can see this exact occurrence in the March rally which ended with marginal new highs above the February highs.

The bad thing is that I don’t have much conviction either way. The good thing is that we will know pretty quickly which one is more likely.

If it’s the latter scenario then we can be slow and deliberate in our profit-taking and shift to a more neutral stance. And if it’s the former, then we will act with more urgency.

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All the Best!

Jaimini Desai
Chief Growth Strategist, StockNews
Editor, POWR Stocks Under $10 Newsletter

SPY shares were trading at $423.07 per share on Friday morning, up $3.08 (+0.73%). Year-to-date, SPY has declined -10.26%, versus a % rise in the benchmark S&P 500 index during the same period.

About the Author: Jaimini Desai

Jaimini Desai has been a financial writer and reporter for nearly a decade. His goal is to help readers identify risks and opportunities in the markets. He is the Chief Growth Strategist for StockNews.com and the editor of the POWR Growth and POWR Stocks Under $10 newsletters. Learn more about Jaimini’s background, along with links to his most recent articles. More...

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