After the longest string of weekly losses since the dot-com crash, Wall Street is finally back on an upswing . . . but traders are understandably reluctant to cheer until we know more about whether this is the start of a new bull run.
Nobody wants to fall for a fake rally. And when you’ve endured a few empty bounces that ultimately left loyal shareholders chasing lower and lower bottoms, confidence is unusually low.
So my question is a simple one. It’s what everyone on Wall Street is going to spend this weekend pondering.
Has the knife stopped falling? Is it safe to buy stocks again?
Bounce After Bounce
Yes, the S&P 500 looked technically oversold last Friday when the market briefly slid into formal bear territory for the first time in the post-COVID era. But a week before that, it flashed “oversold” too . . . at 1.2% above last week’s low.
Before that, stocks bounced off oversold levels in April . . . and twice in March . . . and February. The S&P 500 even hit what I’d consider severe oversold levels back in January, when it became clear to everyone that the Fed was going to start getting serious about interest rates.
Sure, the market surged close to 9% from that bottom. It felt great at the time. But over the four months that followed, stocks gave up every inch of that rebound and then dropped another 10%. If you bought the bounce and held on for the long haul, you’re almost as frustrated as everyone else in Buy And Hold Land.
Until this week, people who like to buy good stocks on the dip and own them “forever” have gotten nothing out of the experience beyond the giddy feeling of pouring money down a hole. Not one glimmer of light at the end of the tunnel that didn’t turn into a train coming down at full speed.
And while long-term bulls know how to be patient, we also like a little short-term validation that we’re on the right track. An uninterrupted string of losing weeks doesn’t feed confidence at all. It only makes us overthink our decisions . . . and usually decide that the rewards of staying in the market just aren’t worth the headache right now.
After all, nobody knows how far a knife can fall until we’re sure it hits the floor. Unless you’re extremely acrobatic, the safest time to pick it up is when it’s stopped falling.
That’s the danger inherent in the bear market rally or what we sometimes call the dead cat bounce. It’s a gruesome metaphor, but it reflects what happens sometimes on Wall Street when securities that are falling fast enough temporarily reverse direction and go UP before hitting bottom.
The Bear Bounce Decoded
And that’s more a matter of market physics than psychology. There’s no human impulse to pause the selling and buy a few shares . . . no tangible catalyst that suddenly makes a company attractive again.
Shifting statistics actually send all the signals here. Traders who look for these signals know that the statistical world rarely tolerates extremes in either direction for long. It takes a lot of energy to keep a depressed stock falling.
When the statistics bend too much for probability to support for long, we say a stock is “oversold.” The clock is ticking before the price makes at least a temporary move back toward statistical normality . . . the default state. At that stage, if the stock can’t hold its historical levels, it becomes clear to everyone that what we were watching was only a statistical glitch in a downward trend.
In other words, it was only a bear market rally. Sometimes these bounces can be extreme in their own right, lasting for weeks or even months and creating their own internal statistical currents. Active traders like us know what to do: buy as close to the near-term bottom as you can, sell the near-term peak.
Repeat that process and you’ll make money even when the market as a whole goes nowhere but down. And you’ll know the larger trend when important signals start flashing.
First, you’ll want to see a pattern of rising peaks or at least rising bottoms. We have to see that energy is building up beneath a stock or the market as a whole. It gets harder and harder to push through the floor. It gets easier to push through the ceiling.
While we’ve gotten healthy hints in that direction lately, I have to say the pattern isn’t clear yet. Today the S&P 500 managed to push past last week’s high, but until we see a confirmed bottom above last week’s low, it’s all just noise.
Ironically, wary traders need to see the market go down as far as it can before we can trust it to keep going up. Until we see that, all our recent progress will feel a little illusory . . . untrustworthy. Fake.
Not Enough Fear
And of course, there’s no guarantee the next downswing won’t crack the floor and take the market all the way back to early 2021 levels if not lower. That’s at least a 9-10% relapse from here.
Personally, I think the odds of a relapse are more likely than an easy rebound. Investors have talked a lot about recession but have yet to really bend too far in the direction of fear.
It’s not enough to price in 100% odds of the worst case scenario. Wall Street needs to surrender. We need the market to rise in the face of worse-than-worst-case scenarios. In other words, we need real relief . . . the sense that we were ready for the end of the world and the world simply refuses to end.
We’ve seen the VIX surge beyond 30, which is ordinarily considered extreme and tends to be as serious as volatility gets in a true bull market cycle. Here, in a world still healing from the pandemic dislocations, racked by supply shocks and staring at a hawkish rate outlook, I think it’s more likely that the VIX goes up before it goes down.
In other words, we aren’t out of this yet. When we see volatility recede to normal levels (say below 20) without spiking again, we’ll know that this is a little more than another fake rally.
And of course, not all stocks will move in perfect synch. Some have already hit bottom and are becoming attractive to long-term investors. Others are in the throes of a short squeeze and are only being bought by bearish traders who want to cover their negative positions.
Defensive havens now look overdone. I saw the other day that the utilities are trading at 20X future earnings . . . and these companies almost never grow faster than inflation, much less the broad economic expansion rate.
Utilities at 20X earnings and at best 3% growth are not attractive. You don’t see Warren Buffett grabbing them now.
But you do see Buffett putting money to work in sectors like energy. If you can’t think of any havens against oil shocks, Big Oil is your natural friend.
Until we’re sure the banks can weather the Fed’s moves, Big Finance is a dicier bet. Even Buffett has been selling names like Wells Fargo (WFC) as earnings across the sector decline. While the banks are doing a little better than expected, they’re still having trouble with cutting off their Russian business . . . and clouds of angst around U.S. consumers.
For me, if you want a play on rates, go high-tech and pick up PayPal (PYPL) or even old-fashioned Visa (V). Both melted down early this year, but V bottomed out (higher highs, higher lows) in March.
PYPL is earlier on its journey but has farther to recover. And behind it, a bunch of “fintech” upstarts like, well, Upstart (UPST) are looking increasingly constructive.
UPST has that pattern of higher lows I want to see. If it can clear $52 in the current upswing, I wouldn’t be shocked if it hits $90 by the end of the summer.
The Bear Case
How bad can it get? In the grand scheme of things, I’m not convinced the bulls will regain their nerve until the S&P 500 gets back within sight of its pre-COVID high . . . or even starts testing closer to its COVID declines.
That’s nearly 20% down from here and a dizzying 31% from the record peak the market gave us just a few short months ago. That number looks huge, but put it in context of the last few wildly erratic years and nothing is quite so abnormal any more.
Two years ago, the economy was looking tired. The market was overbought. Earnings across the market were starting to stall. That’s the kind of world the pre-COVID high reflects.
Then the world shut down. The Fed unleashed free money to prevent a 2008-style crash. Companies adapted. The world kept turning and earnings kept flowing.
Now the Fed is taking the free money away. We might not need to go all the way back to late 2019 levels, but that’s definitely the kind of gut check that will show us what today’s investors are really made of.
Aren’t stocks worth more than they were in late 2019? Absurdly enough, I think they’re worth at least 10-15% more, based on inflation in the meantime making everything, including world-class companies, carry a higher cost.
Factor in earnings growth in the meantime and stocks actually seem relatively fairly valued. Every quarter we avoid a recession makes them worth more. But we need investors to really believe that before we see a rally that holds.
What do you believe in? I’ve been happy hanging out in consumer staples . . . and energy . . . and dynamic little stocks that are already changing the face of the post-COVID era. The linchpins of the economy aren’t breaking. They’ve bent a little here and there, but so far, the future looks at least as good as the past.
And once you have those bases covered, long-term investors crave long-term growth stories. You can’t beat inflation unless you lock in dividend yields of at least 3-4% and probably 5% right now.
By definition, that’s what economic linchpins are all about. They’re mature. They aren’t growing fast. They’ve already built vast markets and now dominate their fields. I’d argue that Apple (AAPL) and Microsoft (MSFT) are on the verge of becoming just that kind of company.
And in that scenario, I wouldn’t buy either unless I could lock in a 3% yield. You don’t want to know how far they need to drop for that to happen . . . but one day, they’ll either come up with higher shareholder payouts or else drop to those levels. Other names will take their place.