July was a rip roaring month with the SPX gaining about 9%. I pointed out last post that due to the acute pessimism that existed at the time, combined with reluctant longs on the sidelines, the market was ripe for a vicious rally. I labeled such a rally as a counter trend rally i.e. bear market rally. Time will tell if that ends up being the case or if this is the start of a new bull market. I also suggested such a rally could take us to SPX 4000-4300. Well, here we are. How did we get here? It was primarily a function of lower long bond yields due to easing of inflation pressures and a quasi pivot from the Fed. Basically, the Fed suggested that they feel they have done most of the heavy lifting when it comes to hiking as they believe short rates are now at the long term neutral rate of 2.5% and going forward any future rate hikes will "depend on the data" . This gave the market some relief that the Fed won't end up over tightening. Some Fed officials including former ones like Larry Summers are trying to piss all over this rally stating that the Fed is not even close to being done. Well, with the 10 year bond yield at 2.7% it's saying otherwise. There's an abundance of indicators showing deceleration of inflation. Add this one to the list.
The market is still pricing in the Fed to continue to hike rates into December taking the fed funds to 3.25%. I will take the under on that given falling inflation pressures and weakening economic data with 10 year bond yield at 2.7% which is on the brink of inversion with the 90 day T-bill rate - this yield curve indicator has been the most reliable of the yield curve inversions when it comes to predicting recession. As I mentioned last post, we're in a technical recession which was officially confirmed last week. I don't give a rat's ass if this is considered a "real" recession or not. All I care about is what lies ahead....that's what always matters when it comes to the markets. Future looking indictors suggest at the very least, a major slowdown is ahead. Once again these hawkish Fed heads are going to look like idiots by failing to see the writing on the wall, preferring instead to look in the rear view mirror.
Sentiment during this big July rebound was for the most part showing wall of worry behavior. Equity Fund flows were -$21 Billion for the month, NAAIM exposure was sub 50%, AAII sentiment continued to show more bears than bulls and put/call ratios were elevated. In prior failed rallies this year, fund flows and put/call ratios indicated FOMO. AAII equity exposure - one of things I have pointed out as a holdout - declined very modestly from 64.5% to 64% in July despite the big rally. The fact that it didn't go up is bullish contrarian behavior, but I still want to see this exposure get down to about 60%. Earnings season was pretty good overall. Tech has been showing relative strength and earnings misses have for the most part, been handled well by the market. All of this is a bullish change in character for the market, indicative of a wall of worry having taken shape. But there's some holdouts (there usually is). Bitcoin has rebounded pretty much in lock step with the market and the VIX is in the low 20s. Another thing that's a concern is China's economy. I've read how they are having to dealing with 2 debt crisis - one at home with real estate and one abroad with their belt and road plan. They have been showing economic weakness despite latest attempts to stimulate. There's been calls for a Chinese economic collapse for over a decade due to to overbuilding in real estate. If China collapses it would be massively bearish for commodities as they are the largest marginal buyer in a lot of cases. It would also no doubt create turmoil for global equity markets - at least temporarily. In the long run however, it would make the US an even more dominant market force and US equity markets would benefit accordingly. I've never believed in the hype that China was going to be the next superpower overtaking the US because of their autocratic government and corruption. How are they going to attract foreign investment flows with such a heavy handed autocratic government which is becoming increasingly heavy handed by the day it seems. They also have a huge demographic problem as does Europe. So, it seems to me that in the long run the US is going to continue to dominate markets...but I digress. The other major concern is the further inversion of yield curves across the board with the most reliable 10 year - 90 day just about set to invert and very likely would invert should expected rate hikes continue. This is suggesting recession. It would need to be a mild one for a happy ending to take place.
So what do we do here now? Where do we go from here? In recent posts I showed charts and contrarian indicators that have shown we hit extremes which have marked major market lows in the past but I have also pointed out that certain things suggesting the bear market is not over yet. The action we have seen in July has been bull market-like action in that it has been largely not embraced It has also been accompanied by declining energy prices and bond yields - the unwinding of the 2 things that were responsible for the bear market starting in the first place. Obviously, this is only just a month's action and this bullish wall of worry behavior could crumble and turn to FOMO behavior quite quickly. I think it's probable that if the June low was THE low, we are going to have a trading range environment until the fall. The market is now ST overbought so let's see what happens in the next few weeks. If the market doesn't totally fall apart it would be yet another positive change in character.
For the markets to have a happy ending it will have to look like this: The economy slows down or even mildly contracts in the coming months shy of the point of massive layoffs and sharply declining profits. This mild downturn creates enough disinflationary pressures to allow the Fed to call off future expected hikes - a true Fed pivot. Here's the deal though...the market will probably sniff out this happy ending before it actually happens just like it always does. The longer you wait for confirmation, the higher the price you will have to pay to get in the market. It's quite conceivable the July rally is the beginning stages of the market starting to sniff out the end game for this Fed rate hike cycle with a positive resolution. Bears will vehemently dismiss this is nonsense and claim this is just an oversold bear market rally. The bearish narrative is that profit contraction and layoffs are the next shoes to drop. We shall see how this plays out. Keep an open mind and let the market do the talking. I will say this...despite some holdouts we have seen enough pessimism to suggest a major low may have been put in but it's tenuous at this point - we need to continue to see fund flows stay negative or flat and I would like to see bitcoin decouple. Let's assume for a moment that we're in a new bull market. There's a few ways this could play out. The rally continues in a V shaped fashion like it did at the Covid lows or we have a drawn out base building period like we saw in the lows of 2011, 2002-2003. I think it's likely that we will get such a base building period if the bull case is to playout.
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