October 31, 2022 | Allio’s Chief Investment Officer, Raymond Micaletti, discusses recent market moves, institutional sentiment, and how the Fed could react next.

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As of Friday’s close, S&P 500 futures were 12% off their post-CPI low (October 13) and 7% higher than they were on the morning of October 21st, when Nick (‘Nickileaks’) Timiraos, the Fed’s designated mouthpiece at the Wall Street Journal, released an article (on option expiration Friday, right before the Fed’s quiet period) saying the Fed was aware it needed to step down the pace of its rate hikes after its November 2nd meeting.

Thus, a reasonable question to ask is whether we have seen at least a short-term bottom?

Many signs point to that being the case, but there are still some potential pitfalls.

On the plus side, the market’s behavior after the September CPI report (released on October 13th)—plunging to new lows early in the morning, then rallying strongly off the low—was reminiscent of a so-called “bear trap.”

To that point, in Stock Market Blueprints, Edward Jensen talks about how “mass money” institutions need bad news—and thus high-volume panic selling—in order to buy without moving the market. 

In other words, markets bottom on bad news. And we’ve had a rash of bad news in recent weeks.

Earnings have not been salutary, especially mega-cap tech earnings. But mega-cap tech (with the exception of Apple) is down anywhere from 30%-75% since 2021. Thus, disappointing tech earnings might be the proverbial bad news that draws in longer-term institutional investors—who may be intrigued by tech valuations that are now somewhat in the realm of reason (e.g., META 11x P/E) as compared to last year’s untethered-from-reality valuations.

On the technical front, while the S&P 500 and Nasdaq 100 made new lows in October (relative to June), fewer individual stocks were making new lows—suggesting strength under the hood. Notably, the Russell 2000 index did not violate its June low. 

In a recent 10-day period, equity indices saw three days with greater than 90% upside volume, an occurrence that in the past has tended to be indicative of market bottoms.

With respect to cross-asset relationships, Ethereum, viewed by some as a leading indicator of liquidity, never got close to its June low (1000) when equities retested and violated their June lows this October. It is now sitting at 1600 (up 33% in the last two weeks). 

Dollar relative sentiment is bearish and falling even deeper into bearish territory (making it unlikely that it will reverse to being bullish anytime soon)--a falling dollar (it peaked in September) would likely be a tailwind for equities.

10-year real yields are close to registering negative momentum (which, coupled with bearish dollar relative sentiment, would likely be a boon for gold, silver, and mining stocks, as well as equities in general).

Extreme bearish sentiment in equities is another reason we may have bottomed in the near term. Not only have we seen exceptionally bearish point-in-time sentiment readings, we have also seen depressed sentiment for an exceptionally long period. For example, the 50-week average of AAII bullish sentiment is at an all-time low—it’s never been lower than it is right now (going back to 1987).

Of course, when individual investors are bearish, institutions (as alluded to earlier) tend to take the other side of the trade. And that’s what we are seeing. Institutions are substantially more bullish than individuals. And while not infallible, institutions (in the aggregate) tend to get the market’s direction right more often than not.

One potential interpretation of institutional bullishness is that perhaps institutions understood the Fed never wanted to raise rates—that the Fed was happy with (and even desirous of) mild inflation. Only when inflation became a political liability did the Fed begin to act.

But knowing that it wouldn’t be able to hold rates higher for longer without destabilizing markets and bankrupting the U.S. government, the Fed, out of weakness (in our view), resorted to hawkish jawboning in a desperate attempt to tighten financial conditions in the short window it had to raise rates. (In this vein, Neel Kashkari has been particularly cartoonish in his statements.)

Institutions may have seen through that ruse and began loading up (in June) when retail and speculators took on extreme short positions.

Now, it appears the winds have shifted to where falling asset markets may be the political liability du jour rather than inflation, as oil and gasoline have gone sideways for 8 months while retirement accounts have plummeted (and we’re a week away from a midterm election).

Indeed, a potential worst-case scenario for the Fed might be if they were to continue hiking rates, slamming the brakes on the economy in the process, but not making much headway on inflation. That could dent the Fed’s aura of being able to control markets, not to mention create widespread contempt for the institution from all corners of society. 

Along these lines, Larry Summers recently warned of a fiscal/monetary “doom loop” (i.e., higher rates leading to slower growth and less tax receipts but higher interest expenses, which blow out the budget deficit leading to more debt issuance, even higher interest expenses, and so forth). If the Fed tries to do QT into such a loop, the fabric of space-time might tear. 

If Summers is publicly warning about this, it’s a certainty it’s top of mind for Fed and Treasury officials , which makes the idea of a Fed softening quite plausible.

Further, bank regulators are considering letting banks count U.S. Treasury securities as cash reserves, which would free up banks to buy these securities and thus help stabilize the bond market. A stable bond market would likely support equities. 

Further to the point of Fed softening, Harald Malmgren, a well-connected and seasoned economist and geopolitical strategist, said to expect the Fed to begin transitioning to an inflation target of 3%-4%. When challenged by Lenny Dykstra (of all people!) that it would never happen, Malmgren replied that he doesn’t engage in  idle speculation–if he’s tweeting about it it’s because his friends in high-level decision-making positions are already discussing it. 

ZeroHedge had a similar tweet, saying the Fed, in pivoting to a 3%-4% inflation target, will say it can’t do anything about the supply side and thus will have to be tolerant of moderately higher inflation.

Thus, the bull case can be summed up as:

1. Markets and individual stocks may have recently bottomed on bad news (CPI, earnings)

2. Technical and breadth divergences suggest strength under the surface

3. Cross-asset relationships (dollar, real yields, cryptocurrencies) are supportive

4. Extreme bearish sentiment for a prolonged period

5. Institutions are more bullish than retail

6. Well-connected insiders are suggesting the Fed is softening its stance

In its totality, the bullish argument is formidable. But we don’t think we’re out of the woods quite yet.

What gives us pause is that we may be repeating the same pattern we’ve witnessed since late August—the market rallies (often strongly) into a major event (e.g., Jackson Hole, CPI, FOMC) only to have the rug pulled by the data or by Powell.

Two weeks ago, we speculated that the Fed might want to soften its rhetoric (but not its intentions) in the near term so markets would stabilize during the Fed’s quiet period, which would then allow the Fed to continue on its hawkish path without an imminent fear of breaking things. 

If the Fed’s hinted-at softening was only a tactical retreat, it’s worked perfectly so far.

Evidence that it may have been only a ruse surfaced this weekend, as Nick Timiraos—the WSJ reporter who supercharged the recent rally two Fridays ago—dropped an article this Friday evening stating that the Fed was concerned by the rise in the employment cost index; in essence walking back much of what he had written the week prior. He then appeared on Face the Nation Sunday morning explaining how the Fed can’t take the risk of letting inflation get out of control. 

Further, the S&P and Nasdaq have not yet cleared downtrend resistance. As we write this, they are both sitting at the downtrend line from the mid-August interim high–and we are again approaching a major event–the November 2nd FOMC meeting.

Still, we are a little more than a week away from the midterm elections and we wonder whether the Fed would intentionally talk down markets again so close to the midterms?

But if the Fed doesn’t pull the rug, the October CPI report (released November 10th) would likely be the next potential catalyst to reverse the recent rally. 

And while much has been made about positive year-end seasonality, it turns out that year-end seasonality during bear markets is actually quite poor. That is, markets tend to sell off into year-end when in the midst of a bear market. 

Thus, for us, until equities decisively push through the current resistance zone, it’s hard to feel confident about this rally given what we’ve seen over the last 8 weeks.

From a longer-term perspective, we believe U.S. equities will eventually move lower given their relatively poor expected returns at current levels. If inflation settles into a 4%-6% range, U.S. equities will offer flat to negative real returns over the next decade—unless they move substantially lower first.

How or when they get there, however, is anyone’s guess. 

If the Fed does soften its stance, it’s conceivable we have a strong rally first, perhaps back to the previous highs. But in that case, energy prices likely rise as well and that eventually would eat into growth, which would damage sovereign bond markets and we would likely reenact what we’ve experienced for most of 2022.

If, however, the Fed remains resolute and the Timiraos option-expiration/Fed-quiet-period article was merely a ruse to stabilize markets in the short-term, then we may move lower straightaway.

Wednesday should give us a little more clarity.