The Dow Industrial Index just posted its best October monthly return in the index’s 126-year history after recording three straight quarterly losses, its longest quarterly losing streak in seven years. The 14% monthly return was also the index’s best monthly return since 1976[1]. Could the Dow Industrial Index’s strong October return suggest an end to the current bear market?
The month of October has developed a reputation of being a bear market killer. The S&P 500 index has bottomed in October more than any other month during prior bear markets. After closing at a new bear market low of 3,577 (roughly 25% below its January 2022 high), the S&P 500 is up just over 5% (as of November 2, 2022). Market technicians and strategists have pointed to several data points indicating extreme fear and capitulation which could signal a market bottom.
- The Bank of America Fund Manager Survey for October indicated investors have nearly 6.1% of their portfolios in cash, the highest amount since 2001.[2]
- During the first week of September, institutional traders bought $8.1-billion worth of put options and less than $1-billion in call options. The net short hedging was at a record level and three times more than in 2008.[3]
- The American Association of Individual Investors (AAII) conducts a weekly survey of investors to gauge if they are bullish, bearish or neutral. The survey has been conducted since the 1980s. The October 13th survey indicated the percentage of investors bullish was 20.4%, one of the 60 lowest readings in the survey history. Additionally, the ratio of bullish to bearish investors (bull-bear spread) was among one of the lowest readings in the surveys history at -35.6%.[4]
Investors are clearly apprehensive towards allocating capital to risk assets in this environment, and evidence of this fear is reflected in investor positioning and sentiment.
So, has the market bottomed or is this just another bear market rally? While these data points are helpful, it’s too early to declare the October low as the bottom. The market is laser-focused on inflation and the impact of the Fed’s restrictive monetary policy to bring inflation down to its two-percent objective. While headline inflation may have peaked, it is still uncomfortably high which means the Fed will continue to raise rates and reduce its balance sheet until it is confident inflation will return to its goal. Until the Fed signals it is finished raising rates, it will be difficult for the market to rally amidst inflation and interest rate uncertainty.
Below are some potential headwinds and tailwinds impacting the market over the near term.
Major Market Headwinds
The Fed has embarked on one of the fastest interest rate hiking cycles in the past 35 years and views failure to increase interest rates high enough to ease inflation as a larger risk to the economic system versus raising rates too much. The Fed is on pace to raise interest rates over 450 basis points by the end of the year with plans to continue rate hikes into 2023. Although various sectors of the economy are showing signs of slowing down from the COVID supply shocks and stimulus sugar high, the full impact of Fed tightening have not yet been entirely realized. Fed interest rate hikes generally take 12 to 18 months to fully impact the economy. The Fed started raising rates in March 2022 with an initial 25 basis point increase. Based on its market lag, the March rate hike may not have its total expected impact until March of 2023. Since the first interest rate hike, the Fed has raised rates an additional 375 basis points and has suggested it’s terminal rate could go up to 5% or beyond, if necessary. The restrictive effects from the Feds swift actions will reverberate throughout the economy in 2023 and probably into 2024 which could weigh on both corporate earnings and the stock market.
Corporate earnings have remained resilient in this environment as businesses continue to navigate through both supply and labor shocks, higher input costs, rising dollar, inventory issues and shifting consumer preferences from goods to services. Amidst the wide variety of issues, corporate earnings through the first half of 2022 were up 8.9%[5]. Analysts predict earnings to end the year up 6.3% and anticipate earnings to increase 6.3% in 2023[6]. Some strategists believe earnings expectations still need to be revised lower for the fourth quarter and 2023 to account for declining future economic growth. A slowing economy could be a major headwind for corporate earnings that could drive the market lower.
Other concerns that have the potential to drive the market lower is escalation of Russian aggression in Ukraine and selling pressure from seasonal tax-loss harvesting at the end of the year. Market returns have generated a lot of unrealized losses for investors. Over the next few months, investors will look to implement tax-loss harvesting strategies to realize losses to offset current or future gains which may add downward pressure to the market through the end of the year.
Potential Market Tailwinds
If inflation has peaked, it could be a good omen for equity markets. Jim Paulsen with Leuthold Group analyzed all major inflation spikes 6% or greater over the past 100 years. The US has experienced seven such spikes since 1920. During each of the seven inflationary spikes, the market essentially bottomed after the annualized inflation rate peaked. Inflation peaked in June at 9.1% and decreased to 8.2% in September[7]. As of November 2nd, the Cleveland Fed Inflation Nowcasting estimating October headline CPI will be 8.05%[8]. Although not significantly lower than September, it’s a step in the right direction and a sign of inflation easing. Inflation trending downward would be a welcome relief for the Fed and would allow the Fed to consider reducing the pace or pausing interest rate hikes. Actions to either slow or halt interest rate hikes would help stabilize bond yields and reduce risk in the stock market.
In addition to “peak inflation,” favorable historic trends may provide stocks with some much-needed support. Since 1950, stocks have had one-year positive return averaging 14.7% following a midterm election. Furthermore, stock market returns tend to struggle during the first two-years after a new President enters office. Following midterm elections, the second half of the presidential cycle tends to be better with the third year in office having the best average annualized return of 20%[9]. We could very well see more volatility in the market, but seasonal trends may help the market rally from its October low.
Chart. Stock Market Returns following Midterm Elections since 1950
Source: LPL Financial
Conclusion
Frankly, it’s too early to declare the market has bottomed. The issues driving volatility in the market will be resolved overnight and will take time to settle. The Fed and inflation remain front and center of the market narrative. Until inflation is under control and the Fed can ease its hawkish policy stance, the market expect the market to remain volatile.
The average bear market decline (defined as market decline of around 19% or more) since 1950 is 30.3% with an average recovery from the market bottom of 19 months[10]. If we manage to avoid a recession, the average decline is 23.8% with a recovery from the market bottom of just over 7 months[11].
The S&P 500 Index lowest closing price decline this year was 25% in October. A lot of bad news has been priced into the market. The economy could potentially go into a recession in the next 12-24 months which is why it is important to maintain a long-term investment horizon. Based on the November 2nd closing price, the S&P 500 Index is down 22%[12]. If it takes the S&P 500 one-year to return to its high, it would be a 28% return. If it takes two-years, the annualized return is 13%. If it takes three-years, the annualized return is 8%. If it takes four-years, the annualized return is 6%. While this current bear market is difficult, the significant decline in prices helps boost expected future long-term returns.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
Stock investing includes risks, including fluctuating prices and loss of principal.
[1] Saul, Derek. (31, October 2022). Dow Closes Best Month In 46 Years As Investors Shake Off Fed’s Ghouls. Forbes. https://www.forbes.com/sites/dereksaul/2022/10/31/dow-closes-best-month-in-46-years-as-investors-shake-off-feds-ghouls/?sh=35616be099cb
[2] Elbahrawy, F. (18, October 2022). BofA Survey ‘Screams’ Capitulation With Rally Set for 2023. Bloomberg. Retrieved from https://www.bloomberg.com/news/articles/2022-10-18/bofa-survey-screams-capitulation-with-rally-set-for-early-2023?sref=0NCA5RSF
[3] SentimentTrader [@sentimenttrader]. (2022, September 7). https://twitter.com/sentimentrader/status/1567594385864261632?lang=en
[4] AAII Staff. (13, October 2022). AAII Sentiment Survey: Optimism Pulls Back Closer to Historical Levels. https://www.aaii.com/latest/article/22605-aaii-sentiment-survey-optimism-pulls-back-closer-to-historical-lows
[5] Butters, John. (28, October 2022). Earnings Insight. https://advantage.factset.com/hubfs/Website/Resources%20Section/Research%20Desk/Earnings%20Insight/EarningsInsight_102822.pdf
[6] Butters, John. (28, October 2022). Earnings Insight. https://advantage.factset.com/hubfs/Website/Resources%20Section/Research%20Desk/Earnings%20Insight/EarningsInsight_102822.pdf
[7] Paulsen, Jim. (12, September 2022). The LOW is In… Because The HIGH Is In. Leuthold Group
[8] Federal Reserve Bank of Cleveland. (2, November 2022). Inflation Nowcasting. https://www.clevelandfed.org/indicators-and-data/inflation-nowcasting
[9] Smith, George. (5, October 2022). Midterm Year Seasonality Swings Favorable for Stocks. LPL Financial Research. Midterm Year Seasonality Swings Favorable for Stocks | LPL Financial Research (lplresearch.com)
[10] Detrick, Ryan. (23, May 2022). What Happens After A Bear Market Starts? Four Things to Know. LPL Financial Research. https://lplresearch.com/2022/05/23/what-happens-after-a-bear-market-starts-four-things-to-know/
[11] Detrick, Ryan. (15, June 2022). 7 Things To Know Now That The Bear Is Here. LPL Financial Research. https://lplresearch.com/2022/06/15/7-things-to-know-now-that-the-bear-is-here/
[12] Based on S&P 500 Index closing price on November 2, 2022