The atypical action of 2022’s Midterm market continued during May. For most of the month, it looked as if May would maintain its title as the second-worst market month during a Midterm year. Through the first three weeks, all the major market indices were down more than -4.5%, a painful drop coming off the worst April we have seen in decades. Thankfully buyers finally started entering the market over the last seven trading days of the month, reversing losses and pushing the Dow Jones, S&P 500, and Russell 2000 out to small gains. Only the Nasdaq, the weakest performing index all year, posted a loss for the month.
Considering the position of the market for most of the month and the historical weakness expected in May during midterm years, ending the month with small gains, for the most part, seems like an impressive market victory. And while all the major indices remain down for the year, the action underneath the market in May was the most constructive we have seen since early last fall.
In Case You Missed It
If you missed it, we put out a research note two weeks ago explaining the massive moves we have historically seen across the market after the lows get put in during a midterm market year. While down markets are never pleasurable, history shows that the period after "The Midterm Low" gets put in, has led to the best buying opportunity over the four-year Presidential Cycle. Below is a link to the research piece we sent out:
“I know but one lamp by which my feet are guided, and that is the lamp of experience. I know of no way of judging the future but by the past”
- Patrick Henry
A Note on Inflation
The Case-Shiller Home Index recently showed double-digit price increases year-over-year but is now showing signs of moderation. Many other economic data points are showing that we have passed peak inflation, but are still at elevated levels. We are still feeling the pain when we fill up at the pump. While inflation remains near its highest levels in the last 40 years, we see both core and headline inflation data rolling over when we look at the PCE Index. The PCE Index, known as the Personal Consumption Expenditures Index, the Federal Reserve’s preferred measure of inflation, posted another month of decelerating data. Both core and headline data were down by 30 basis points over the last month, marking the second consecutive monthly decline for the index since mid-2020.
We welcome any decline we can get in inflation, but we continue to expect that inflation pressure will still need several more months to work through the system. The most important aspect of the PCE data, other than seeing it decline, is that it should allow the Fed to become less aggressive with interest rates moving forward. Good for risk assets.
A Note on the Fed
After raising rates 50bps and outlining the details of their balance sheet runoff in May, the Fed will meet again in June with an eye toward another 50bps increase. As we said last month, there were roughly 10 Fed rate increases already priced into the market, so a 50bps move in June should have little effect on the overall market. While we continue to expect the Fed to raise rates in July, the question is quickly becoming how much further the Fed will move up rates at future meetings?
Along with the PCE Index, several different data sets point to the Fed becoming less ‘hawkish’ or less aggressive moving forward. When we subtract short-term 6-month yields from both the 2-year and 5-year yields, there has been a significant decline in this curve over the last two months, signifying that the Fed will be less aggressive moving forward. Looking at the longer-term curve between the 6-month and the 10-year yield, we see evidence that the Fed’s tightening has eaten into long-term growth expectations.
Finally, when we look at Eurodollar Futures, they show that the Fed will finish raising rates a year from now but that the Fed will have to start cutting rates in June of 2023. These data points paint a picture of the Fed becoming less aggressive with rates moving forward. Although you will continue to hear the Fed saying that inflation is the biggest threat to the economy, we feel this is their attempt to save face after being so wrong for so long about inflation. No matter what they are currently saying, several indicators show us that the Fed will be much less aggressive in policy changes moving forward. Good for risk assets.
Whether it is a midterm year or any other year in the Presidential Cycle, June is historically one of the weaker months for the market. Over the last 70 years, June has traditionally been a flat month for both the Dow and S&P 500, with slightly better performance by the Nasdaq and Russell 2000. While not much is expected for the month, the continued improvements we see in internal market data lead us to believe that any significant pullback during June should likely represent the ultimate low for the midterm market. This is our base case view and we are advising clients to be prepared to deploy any cash targeted for long-term investing.
S&P 500 Money Flows - May was the strongest month for our daily S&P 500 money flow data since January 2019. Money flows rose 16.77% in May, closing out the month at 54.49%. Traditionally, money flows will front-run price action. Money flows on the S&P bottomed out on January 24th at 21.56%. Today, we are higher by more than 30%, yet the actual price of the S&P 500 is roughly 10% lower today. Seeing such strength in our daily money flow numbers provides us a high conviction that stocks are becoming quite attractive at these levels and institutional money is starting to notice.
Bond Market Liquidity - Along with the strength we saw in S&P 500 money flows in May, it also was the first time we have seen liquidity in the bond market in almost a year. May was the first positive month for the total bond market since July last year. It has been a rough number of months for any investment tied to interest rate movements. But we have seen a notable, positive change in bond performance recently. The last two weeks of May produced some of the most significant moves higher in price and volume for fixed-income investments. This was especially true for investments that are more susceptible to a lack of liquidity, many of these names traded near-record volume over the last couple of weeks. Liquidity in the bond market is an enormous positive going forward.
For the first time, in what seems like a year, there is an upside risk to the market. With liquidity rushing back into the bond market over the last few weeks and the massive divergence between money flows and price action, we are much more confident in the market finding its footing than at any point this year. We have also seen the US Dollar run into resistance, steeping of the yield curve, and even seeing several growth equities put in higher lows. Data points are forecasting a return to normality in the market. Only the Fed could derail the market at this point.
We would view any significant pullback in June as an opportunity to get even more bullish. However, there is a good chance we have already experienced the bottom in stocks for the year when the S&P 500 briefly touched bear market territory (-20% off highs) on May 19th and subsequently rallied off that level before the close.