Last week was a very busy week! Frustratingly, it ended pretty much flat after the mother of all short covering rallies in the closing minutes of Friday’s trading session.
I say "frustratingly" because I held onto more growth-oriented positions until Friday waiting on a bounce. When it did not appear the bounce would occur at these levels (see March 2020 decline for reference), I decided I had better cut bait and sell out of many of them.
Not ideal timing, but I did add back a little of that exposure on Monday for a trade post the short covering rally.
So where do we go from here?
Over the weekend, I listened to advisors and managers make the case for the Fed to capitulate and markets to reverse higher all the way to the opposite extreme of the Fed is trying to crash the markets. I honestly can say there is no general consensus!
So, we turn to the charts, they can sometimes help when the markets appear confused and there is no clear path forward.
Above is a 4-hour chart of the S&P 500 Index. What you will notice on this chart is the market is bouncing but within what we call a Bear Flag (the area between the two dotted back lines).
What does a Bear Flag typically mean?
It usually is a continuation pattern that in this case could resolve itself lower.
If we took the recent all-time high of 4,818.62 and subtracted the recent low of 4,222.62, we get 596 S&P 500 points or roughly 600 if we round. If we then measure 600 points lower from the top of the Bear Flag pattern (estimated at 4,500), that gives us a rough target of 3,900 on the S&P 500 or another 13% lower.
Top to bottom this would give us a 19-20% correction. I think this is a real probability in the coming weeks.
Now the disclaimer – this is just a guess. Anything could happen from the Fed getting dovish to seven rate hikes, as Bank of America is now forecasting over the next two years.
I will say this, the next four months will likely be very volatile!
I expect there is a great deal of pressure on the Fed to deal with inflation, even if it ends up being transitory. This could mean they lean towards a larger number of rate increases and risk pushing the economy to the brink or into recession.
It will be a delicate balancing act; one the Fed usually gets wrong historically as you can see below!
So hold onto your hats, this one could get interesting!
Let us know if we can help.
The Year That Was
Happy New Year to all our readers! 2021 was a fabulous year if you invested almost entirely in names, such as Apple, Microsoft, Nvidia and Tesla in 2021! Here is their performance relative to the S&P 500 index.
You can see that they all outperformed the S&P 500 index for the year on a relative basis.
Otherwise, the S&P 500 index (in red) ruled the day, because of those four names, and an end of the year rotating bear market in many other names that wreaked havoc in other indexes.
The Year Ahead (What is to Come – Possibly)
2022 stands to be a more challenging year than 2021! However, let’s remember a couple of things that recent history has taught us.
Here is the U.S., the Federal Reserve has started to taper the purchase of treasury securities and plans to raise the Fed Fund rate starting in mid-2022, which would usually have the effect of lowering demand for our U.S. treasuries and raising interest rates. This is exactly what has happened with short-dated bonds, but longer dated bonds are still trading in a consolidation range, possibly signaling that the bond market thinks the Fed is too late and that inflation is already moderating (remember deflation usually follows inflation). The increase in the rates of short-term bonds is why the Barclay’s Aggregate Bond Index lost -1.77% in 2021.
Despite the constant negative news and bear market predictions, we think there is a decent chance that the overall market continue higher. Here is why?
The S&P 500 index RSI is trending above 70 (top indicator, circled in green). When this indicator is above 70, it tends to stay above for 14-15 months on average and lead to strong gains of more than 24% on average. Given the current run above 70 on the RSI, we can project another 3-4 months of positive to sideways market returns and +3.33% based on the historical averages. This is the average, and it should be noted that the longest such run since 1997 was 27 months in 2013-2015 and this resulted in a market gain of more than 39.1% over that period. We believe it is possible, we stay above the 70 RSI mark for much of 2022. Of course, that is just a guess and certainly past performance is never a guarantee of future performance!
The other reason? Fed tapering and rate increases don’t cause Bear Markets. Policy errors, such as raising rates too much or too fast, cause Bear Markets.
As you can see below, when the U.S. Federal Reserve has raised interest rates in the past (the orange line), the S&P 500 index has continued to climb. It is only when rates went too far, and the Fed starts to flatten or reverse rate hikes that the market falls. If you look at the three historical periods of rate increases, below, you had roughly a year in which the markets rose, and rates also increased in each case. The Fed does not plan to start raising rates until mid-2022 and this is why we think 2022 could be volatile but generally positive return year.
Now the disclaimer. Not every index may rise. Many such as non-U.S. markets could struggle over the entire year. To us it looks like non-U.S. markets are oversold, could rally higher and then resume their struggles, but this is pretty tough to forecast.
We are still advocates of broadening diversification, but 2022 could prove another year of narrow leadership. It might not be until 2023 that a Central Bank policy error occurs, and diversification finally works to narrow losses, but we can save that for another post.
This information is for educational purposes only. Please do not rely on this forecast nor trade based on it. Past performance is not indicative of future performance.
The S&P 500 Price Index is a capitalization weighted index of the 500 leading companies from leading industries of the U.S. economy. It represents a broad cross-section of the U.S. equity market, including stocks traded on the NYSE, Amex, and Nasdaq.
The S&P MidCap 400 Index, more commonly known as the S&P 400, is a stock market index from S&P Dow Jones Indices. The index serves as a barometer for the U.S. mid-cap equities sector and is the most widely followed mid-cap index. To be included in the index, a stock must have an unadjusted total market capitalization that ranges from $3.2 billion to $9.8 billion at the time of addition to the index.
The S&P SmallCap 600 Index (S&P 600) is a stock market index established by Standard & Poor's. It covers roughly the small-cap range of American stocks, using a capitalization-weighted index. To be included in the index, a stock must have a total market capitalization that ranges from $700 million to $3.2 billion at the time of addition to the index. As of 31 December 2020, the index's median market cap was $1.26 billion and covered roughly three percent of the total US stock market. These small cap stocks cover a narrower range of capitalization than the companies covered by the Russell 2000 Smallcap index which range from $169 million to $4 billion.
The MSCI EAFE Index is designed to represent the performance of large and mid-cap securities across 21 developed markets, including countries in Europe, Australasia and the Far East, excluding the U.S. and Canada. The Index is available for a number of regions, market segments/sizes and covers approximately 85% of the free float-adjusted market capitalization in each of the 21 countries.
The MSCI Emerging Markets Index reflects the performance of large-cap and medium-cap companies in 27 nations. All are defined as emerging markets. That is, their economies or some sectors of their economies are seen to be rapidly expanding and engaging aggressively with global markets. The MSCI Emerging Markets Index currently includes the stocks of companies based in Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Kuwait, Malaysia, Mexico, Pakistan, Peru, Philippines, Poland, Qatar, Russia, Saudi Arabia, South Africa, Taiwan, Thailand, Turkey, and the United Arab Emirates.
The iShares Core U.S. Aggregate Bond ETF seeks to track the investment results of an index composed of the total U.S. investment-grade bond market.
The federal funds rate refers to the target interest rate set by the Federal Open Market Committee (FOMC). This target is the rate at which commercial banks borrow and lend their excess reserves to each other overnight. The FOMC, which is the making body of the Federal Reserve System, meets eight times a year to set the target federal funds rate, which is part of its monetary policy. This is used to help promote economic growth.