The market for April was about as far removed from its historical performance as anyone could have imagined. The price action was very similar to what we saw in January when "Fed talk" initiated market weakness, and then underwhelming earnings extended the selloff. Unlike January, the massive FAANG names that comprise so much of the S&P 500 weighting provided gas for the fire this month. The earnings results of Netflix, Google, and Amazon disappointed, which led to much of the overall weakness seen in the indices. April limped to its worst performance in several decades. The S&P return this month was the worst since April of 1970. While the Nasdaq, where most of the market damage originated, posted its worst month since the top of the Tech Bubble in 2000. Not wanting to go into much more detail, it was an April to forget; let's leave it at that.
Where We Currently Stand
We waited until after the Fed meeting held on May 4th to provide our outlook for May and the coming months.
On Wednesday, the Federal Reserve raised the Fed Rate by .50 bps, the most significant rate increase in more than two decades. Along with this rate increase, the Fed also announced that they would begin rolling off their balance sheet in June, meaning they would no longer reinvest bonds on their mature balance sheet. Both moves were more than expected, but one comment from Fed President Jerome Powell was not. Specifically, he stated that rate hikes of more than .50 bps at future meetings are not an option. The market took this news very positively, and the market rallied hard into the close. Fast forward one day, and the 'washing machine' market was back in force when an increase in first-quarter unit labor costs finally broke the 10-year yield above 3% and caused an immediate selloff across the board.
Here are our viewpoints on the current stance of the Fed:
At current levels, the market and much of the economy have priced in roughly nine Fed rate hikes for the remainder of 2022 and at least one hike in early 2023. One could say the Fed is late, which they are. But one could also say that the economy is excessively front-running expected future Fed action. For example, the move on the 10-year yield yesterday above 3% was the first time this level was breached since 2018. At that time, the Federal Reserve rate was 2.25%, and today that rate sits at 0.75%. You can say the same thing for the 30-year mortgage rate, which sits above 5% for the first time in a decade. These dramatic moves in long-term rates seem out of place compared to the current Fed funds rate. The Fed is moving much slower than what the market is pricing in.
Inflation, which was not a major concern of the Fed for much of the last two years, is now really the only concern for the Fed. The inflation we see today was created by a combination of variables. Examples include easy money policies due to Covid stimulus payments, a quantitative easing program from the Fed that went on for too long, supply chain issues related to shutdowns, high oil prices due to the Russian invasion of Ukraine, and higher rents due to a housing shortage. The question plaguing the markets is will the Fed become more aggressive to fight off high inflation, or will inflation begin to subside? Demand destruction will slow inflation, which we already see in many areas of the economy. So maybe the Fed might eventually be right on being slower in raising rates and allowing inflation to clear itself from the economy with a 'soft landing.'
Midterm Bottom on the Horizon?
The market has had difficulty handling everything that has been thrown at it so far this year. Still, it continues to fight as we are currently retesting the previous lows established earlier in the year. If the market fails to hold these current levels of support, then we would expect the correction to intensify further.
One crucial point to keep in mind is that when the correction finally bottoms and inflation begins to show signs of weakness, we expect stocks to resume their upward trajectory. We do not believe that the long-term secular bull market is finished, only that it is taking a breather. Midterm election years have historically generated significant market bottoms that have led to profitable outcomes.
A couple of points of interest:
Last week's American Association of Individual Investors (AAII) survey showed the lowest percentage of bullish investors since 1992. This survey also showed the most extensive spread between bullish and bearish investors since right before the massive market bottom in March 2009. This does not mean it will happen with the current market, but excessively one-sided readings in this survey have always occurred near a significant market bottom.
Historically, a midterm election year market bottom offers an excellent entry point for investors to become more aggressive. For example, over the last 27 mid-term election years (dating back to 1914), the Dow Jones Industrial has averaged a return of 46.8% from a mid-term year bottom to the high of the following year. The Dow returned 31.4% from the mid-term low in 2018 to its high in 2019. If you look at other indices, the returns are even better. Since 1974, the Nasdaq has returned 70.2% on average from the mid-term bottom to the index's top the following year. Right now, it's difficult to see the potential opportunity given the volatility of the current market, but better times are ahead.
Market breadth is already washed out. The charts below represent the number of NYSE and Nasdaq stocks above their 50- & 200-day moving averages. These are some of the worst readings we have seen since the Covid Crash, but all these indicators are at levels where bottoms have often been formed over the past several years. The most crucial aspect of these indicators is that they are not getting worse from where we were earlier in the year. So, while the price has been trending low, breadth has not been getting worse, a positive divergence.
As volatile as the market has been over the last two weeks, it's challenging to project where we will end the month. We know the current market is oversold, even more so after the previous few days. We can point to several data points and indicators in areas where the market has historically found a bottom, but when fear grips the markets all bets are off. Most of the 'important' earnings reports are now behind us and they were actually quite good results overall. But when bullish seasonal patterns do not work out as expected, as we saw in April, it is difficult to call "the" bottom. Developing a bottom takes time, and it can be stressful. But we are still optimistic that stocks will rally into year-end when it finally occurs.
The most significant piece to solving the current market turmoil is getting Treasury yields to stabilize and then retrace their massive run. Technically, the stock market is oversold, and Treasury yields are about as overbought as they have been since the top of the Taper Tantrum in 2013. Long-term yields are more disconnected from the Fed and their monetary policy than at any other time we can remember, a trend we think will start to change. We expect long-term rates to stabilize soon, which will help reduce overall market volatility and allow for a market rebound.
We are not out of the woods yet, but we are likely getting close. While May might not bring the final low for this market, we are still believers that stock prices will be higher 12 months from now. Any significant market weakness should be considered investable, especially if stocks fall another 10% from here. Because as we approach the fourth quarter, better known as the 'sweet spot,' we believe investors will be rewarded.