Market Musings 261122: A second head-fake, or a real bull trend this time?

Market Musings 261122:
A second head-fake, or a real bull trend this time?

It is tough to tell the difference between a bear market rally and a new bull market…

SUMMARY

• Long-term interest rates decline, boosting stocks and bonds
• Financial conditions are more supportive for stocks
• Stock buybacks should accelerate into year-end
• Stock market indices hold above key moving averages
• Value stocks still look attractive versus Growth
• Healthcare and Biotech is a new leading sector

How to tell between a bear market rally, and a new bull market?

Stock markets have rebounded sharply over the last few weeks. The average US and European large-cap stock has recovered 12-14% since the end of September. At this point in time, the UK FTSE 100 index has now recovered to flat for the year (+3% once dividends paid are included), while both Eurozone and US stock market indices remain around 155 lower than at the start of this year.

A double-digit rally for US + European stocks since end-September

Source: tradingview.com

However, the question many investors have in their minds today is the following:

”Is this just another bear market rally as we saw in June, or is this the beginning of a new bull market trend?”

Arguments for continued pessimism

There are many reasons for believing this is just a bear market rally. After all:

• we are in recession,
• inflation is still very high,
• central banks are still raising interest rates, which will drag on the economy, and
• companies are still seeing earnings forecasts being reduced, as they are more and more impacted by the slowing economy.

Which is of course natural. So far, these don't really sound like classic conditions for a new bull market in stocks.

The counter-argument for a true market recovery

However, we should remember that most new bull markets are born in the midst of extreme pessimism, like a phoenix rising from the ashes.

So let's look at some of the evidence in favour of a more positive reading of the current rally.

First of all, financial conditions are improving. These financial conditions include:

• tighter credit spreads in the corporate bond market,
• lower levels of market volatility in the bond and stock markets, and
• improving liquidity for instance, measured by the TED spread or broad money supply.

Secondly, long-term bond yields are falling. So the cost of financing at least for governments is starting to come down.

UK, US and German 10-year bond yields all fall

Source: tradingview.com

This translates across to valuations for stocks. The lower long term bond yields fall, the higher valuations can be. Of course, the very sharp rise in bond yields over the last 12 months has been a major reason for the fall in stock market valuations.

In fact, if you analyse the fall in stock markets over this year so far we can argue that this has been much more driven by a compression of valuations rather than falling earnings. As corporate earnings haven't really fallen that much yet at an aggregate level.

Thirdly, pessimism remains pretty widespread. So far in this latest stock market recovery, we've seen a lot of so-called “short covering”. That is professional investors who are reducing or selling the hedges that they had put on to protect their stock market portfolios at the institutional level, for instance, by selling futures or by buying put options.

November fund manager survey: still prefer safety of cash to equities

Source: Bank of America

There is evidence that institutional investors and hedge funds have been reducing the so-called short positions and thus driving the market up, because effectively they're having to buy back these short positions. But this is not truly evidence of renewed optimism, given that their positioning is still leaning away from stocks and instead towards cash.

A fourth support for a continuation of this positive trend in markets are stock buybacks, particularly in the US.

US share buybacks at highest in history

Source: Yardeni Research, S&P

We know that the number of announced stock buybacks is at a record level in the US for this year. But that's just announcements. If we talk about the number of stock buybacks actually completed, we have to remember that companies generally are not allowed to buy stocks during the blackout period around results. So now that the quarterly results season has drawn to a close, we should expect the stock buybacks to continue to support the markets through consistent buying by the companies themselves.

Dow Jones Indices expects the pace of US stock buybacks to have slowed in Q3 2022 to $214.7 billion — down from $234.6 billion a year earlier — but a rebound is expected in the fourth quarter as companies race to beat a new 1% tax on buybacks that comes into force in 2023.

And I think the final piece of the puzzle which we should not forget, is the US dollar. The US dollar has been incredibly strong against pretty much all currencies, particularly the yen, the euro, and the Chinese renminbi for most of this year.

But this is again reversing now that the US Federal Reserve central bank seems to be nearing its end of its interest rate hiking cycle, as US inflation seems to be finally on a downward trend.

The US dollar finally starts to reverse trend

Source: tradingview.com

So this level of support for the dollar should weaken. Remember also the dollar acts as a safe haven currency along with the Swiss franc. So that when markets are turbulent, and uncertain, investors do tend to retreat to these two currencies and to the US dollar in particular as the world’s premier reserve currency, as a safe haven from this turbulence.

Now that volatility is falling and stock markets are recovering along with bond markets, perhaps this value of the safe haven status is going to reduce.

Remember too that when it comes to valuation, the US dollar is probably the most expensive major currency in the world today based on long-term fair value models like Purchasing Power Parity (PPP).

Why do I talk about the dollar? Well, because when the dollar strengthens, it is usually because it's a safe haven trade. And that usually implies falling stock and/or bond markets. Now that we have rising stock and bond markets and lower volatility, the dollar is falling and that reinforces the positive momentum into stock and bond markets.

Should the US Federal Reserve stop raising rates in January next year, as is widely expected, this interest rate support for the US dollar will evaporate. This can be particularly good news for emerging markets finally, because they are historically very sensitive to the trajectory of the US dollar. They very much prefer a weakening US dollar to a strengthening US dollar, as a strong US dollar puts pressure on emerging market economies and also on companies that often borrow in US dollars.

Searching for evidence of a true recovery

So I think there are many good reasons to suspect that this is not just another bear market rally, but something a bit more substantial and long-lasting.

However, what is the evidence that we should be looking for that this is going to be the case?

I think looking at what the market tells us is probably a good start. For instance, if we look at the major stock market indices such as the FTSE 100, the Euro STOXX 50 or the S&P 500 indices, these are all now above or even well above their own 200-day moving averages.

Equal-weight S&P 500 and Euro STOXX 50 indices well above 200-day moving average

Source: tradingview.com

This is typically a good sign of an upward trend. What we are looking for are stock markets that are rising above their own 200-day moving averages.

Clearly we need to see that even in any stock market consolidation in the short term that these trends do not change, i.e. that the stock markets hold above these moving averages. Then I think that we can have renewed confidence that a longer lasting uptrend is in place.

Secondly, we should be looking for continued falls in long term bond yields. These long-term interest rates will be important in determining the fair market valuation for stocks and stock markets.

Thirdly, we should look for a relatively modest economic recession so that we don't see huge economic damage being wrought on the European EU or US economies. In this way, we can hope that the hit to company earnings will be relatively modest, even in 2023.

Conclusion: which sectors and stocks to focus on?

Finally, the question remains which stocks and sectors should we be focusing on? There are always some that do better than others.

At the moment, the clear momentum remains with a mishmash of more cyclical and more defensive sectors.

On the cyclical or value side of things, we should think about Oil & Gas, Mining and Financials, principally banks.

Bear in mind that value stocks remain historically very cheap versus growth stocks, in spite of the rally the value stocks have enjoyed so far. Of the cyclical value sectors mentioned above, the Oil & Gas sector today is the cheapest sector relative to its own long-run valuation history.

Global value stocks remain very cheap relative to their own history

Source: Robeco

Over the last few months in the defensive sectors, my focus has been much more on healthcare stocks. These are breaking out of the US, have strong long term demographic support in terms of growth and also in new US drug approvals for formerly poorly-treated conditions, and are seeing strength in a number of subsectors such as biotech for the first time in a long time.

Global healthcare sector rallies hard

Source: tradingview.com. Note, ETF quoted in euros

Biotech sector on the comeback trail

Source: tradingview.com. Note, IBT fund in GB pounds, SBIO ETF (in green) quoted in USD,

Have a great week,

Edmund