What Makes a Market Bottom?

What Makes a Market Bottom?

In both pieces this week we discuss the common confusions around “what makes a market bottom” and how to use the usual feelings associated with them to make better investing decisions, while sharing some key indicators that one can use as well.

Five Things You Should Know

1. Equity Markets – were higher this week with U.S. stocks (S&P 500) up 5.77% while international stocks (EAFE) rose 7.44%.
   
2. Fixed Income Markets – were mixed with investment grade bonds (AGG) down -0.28% while high yield bonds (JNK) rose 1.93%.
   
3. Fed Begins Hike – for the first time since 2018 the U.S. Federal Reserve decided to raise interest rates this week by a quarter point and outlined a roadmap that would see 6 additional hikes before year-end. Chairman Powell struck a hawkish tone and vowed that the Fed will do everything in its power to curb rising inflation and an over-heated labor market. It was also announced the Fed will soon begin reducing its balance sheet of bonds it has been purchasing, although no plan has officially been put in place.
   
4. China Changes Tune – following a massive downturn in Chinese equities that saw over $1.5 trillion erased from markets across two trading sessions, China’s government vowed to embrace policies that will boost economic growth and support financial markets. They also discussed measures to help add stability to China’s stock exchange and support overseas share listings, something the country has shown disinterest in in the past.
   
5. Key Insight – [VIDEO & ARTICLE] In both pieces this week we discuss the common confusions around “what makes a market bottom” and how to use the usual feelings associated with them to make better investing decisions, while sharing some key indicators that one can use as well.

Insights for Investors

Intro - “This doesn’t feel like the bottom”

I hear this type of comment quite frequently … near market bottoms. What should the bottom “feel like?”. My impression from these conversations is that people believe they should be seeing the proverbial light at the end of the tunnel, and their “feelings” come from the fact that things appear pitch black.

If you really think about it, wouldn’t the feelings associated with times when things seem like they can only keep getting worse actually be indicative of things bottoming? Can you point to much on March 23^rd, 2020, right as national shelter in place orders were occurring that told you that was the bottom, other than everything felt awful?

By the time you can see the path forward, the market is long ahead of you. Don’t ask me how, but that is a proven historical fact.

The usual pattern goes:

1. Market is Near a Bottom – “Things are awful I should get out”
2. Market begins new ascent – “Ok, the market is up a bit but it’s just a head fake”
3. Headlines Trumpet a Return to New Highs – “Fine, things do seem to be improving/good I’ll get back in now”
4. Market experiences another normal correction – “Dang, I knew I shouldn’t have gotten back in, get me back out”

And that is how you “buy high/sell low” and never get the returns you hope for.

Investments only give you the returns you want if you give them the time they need.

Resisting “Peer Pressure” was the Smart Call in High School, and Still Is as an Investor

“Everyone else is doing it” … can be a powerful emotional and social pull. And yet it rarely is a wise one.

On a related note, I can’t tell you how many times someone tells me about a friend that is “in the know,” and their “big” call. However, I can tell you that with few, if any exceptions, their prognostications never come close to materializing.

Furthermore, if you have ever experienced such a conversation, did it ever strike you as odd that most people’s “big calls” are usually quite pessimistic in nature? Where are all the “it’s going to be better than you expect” calls?

So, what are all the “cool kids” saying today? As is typical during a market correction, sentiments and outlooks are pretty dire.

On the consumer sentiment front, JPMorgan noted that “Consumer sentiment is often regarded as a key driver of consumer spending, since consumers might hold back on purchases in anticipation of a worsening economy or their own personal finances. However, for much of the pandemic, consumer spending remained robust amidst somber sentiment … For investors, it’s also interesting to note that troughs in consumer sentiment have typically preceded great equity returns, as we show in the chart. Of course, confidence is not the only piece of the puzzle, as returns will also be driven by fundamentals and valuations. However, history does suggest that panicking when people don’t feel great is usually a losing investment strategy (emphasis added).”

Continuing our theme of watching investor sentiment as a contrarian indicator, consider the following update from the folks at Bespoke. Echoing the above advice to fade popular sentiment, they point out that:

“The one silver lining to the cloud of bearishness hanging over the market is that some of the best market returns tend to follow periods of depressed market sentiment. With the continued volatility in markets, the war in Europe, and the chaos in commodity markets, investor sentiment remains very bearish.

As shown in the chart below, our composite net bullish sentiment indicator, which blends readings in the AAII, II, and NAAIM surveys, remains right near is recent lows and at levels that are essentially comparable to the trough in sentiment seen at the COVID crash lows.

Besides the fact that net bullish sentiment is depressed, it has been at these levels for several weeks. The net reading has been below the 10th percentile for five straight weeks and seven out of the last eight. To put that in perspective, during the COVID crash, it was only below the 10th percentile for four consecutive weeks.”

They continued by sharing that, “The table below breaks down forward returns of the S&P 500 following various ranges of net bullish sentiment, and while one and three month average returns when sentiment is below the 10th percentile are rather pedestrian, average returns six and twelve months later have been better than average.

One year later, for example, the S&P 500 averaged a gain of 14.3% with positive returns 81% of the time. Of the ten different deciles shown, no other decile has a better average return.”

Updates to two other charts we love (institutional cash and advisor sentiment respectively, show that we are experiencing points that again are quite typical of the bottoming process for risk markets.

The last point regarding “soft data” and historical trends we’ll share this week relates to typical market patterns during mid-term election years. As you can see from the chart below, market weakness is quite common during mid-term years, with an average intra-year decline of around 16-17%. However, as we touched on last week, the key to what an investor does with that information depends very much on where they put their focus.

Importantly, does such information and “red” numbers instantly induce panic for you, or do you take the extra second to look to the right of those red numbers to take in what typically happens over the next twelve months?

Markets of late have currently resided near the typical drawdown levels today, and while the future cannot be known, history would strongly suggest now is not the time to give up, with an average rebound gain of over 30% similar periods.

Lest all that Feelings Talk Seem to “Fluffy” for You…Some Data

Cash doesn’t sit too long on the sideline, it needs/wants a home and a return. Therefore, one of the most important questions investors can ask is, what are the most relatively attractive assets that money is likely to flow to?

During such periods of stock market drawdowns and volatility, the easy answer seems to be “anything but stocks!”. But such sentiment is about fear and recent price action, not about facts and what likely lies ahead.

Analyst Brian Gilmartin, noted this week that not only are earnings revisions trending higher, but on a relative basis the current earnings yield for the S&P 500 is very attractive on a historical basis as well.
He stated, “In fact the S&P 500 earnings revisions this week were mostly positive and continue higher:

• The forward 4-quarter estimate rose to $226.46 from last week's $225.60 and 12/31/21 forward estimate of $216.14;
• The PE after the 2.44% decline in the S&P 500 this week is 18.5x
• The S&P 500 “earnings yield” jumped to 5.39% this week, expected given the benchmark drop, from 5.21% last week.”

For those of you not familiar, people look to the earnings yield of the stock market (earnings per share divided by average price) to compare to the current Treasury Yield. The higher yield is considered the more attractive long-term investment, and right now we are sitting at a pretty historically high spread favoring equities over treasuries. Keep in mind this is not a market timing tool.

What May Lie Ahead

Market “bottoms” are better thought of as processes, not singular points in time. So, have we bottomed? I have no idea.

Technically, there is a very solid technical floor, as we’ve told you before in our February 23^rd trade alert, around 4050 and another around 4200. Those seem to be holding which is why we’ve previously put some cash back to work.

And while the situation in Ukraine is tragic, as is the Fed’s logic in thinking they can raise rates seven times this year, there is reason to be far more optimistic than what is “popular” these days.

To that end, analyst Tom Essaye, summarized his outlook (which we largely concur with) by stating, “Bottom line, the market is resilient, and we think that’s important, and we could see a solid rally if we can just get some good news. But there remain numerous headwinds on the markets and as a result we continue to view the S&P 500 is a 4,600-4,300ish band as long as the Fed isn’t too hawkish, the Russia/Ukraine conflict doesn’t expand to NATO, and there are no other material negative surprises. Tactically, we continue to favor value, defensives, and low-volatility ETFs … and cyclical sectors, as they should withstand higher yields and slowing growth more than tech and higher-multiple parts of the market (we think that dynamic is here).”

While we wait for this to play out, we continue to collect our high-income streams for clients that buy them time and of course consequently “peace of mind.”

If that isn’t you, now is not the time to panic, but when things start to “feel good” again, remember how you’ve felt of late and commit to finding a better way.

Lastly, when people are feeling bearish/negative, the “scary” what-ifs begin to fly from all sides and one that has made the rounds in various forms over the last few years, is that China will “crash” the U.S. economy by selling their Treasury holdings en masse. Brian Wesbury recently addressed these concerns in a great piece we thought we’d share below.

We hope you all are enjoying the games, and if you’re in Spokane, are doing so with us down at the return of our March Madness Event today!

Have a wonderful weekend,

Tim and the team at TEN Capital

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Will Russian Sanctions Lead China to Sell US Debt?

To view this article, Click Here.

Brian S. Wesbury, Chief Economist
Robert Stein, Deputy Chief Economist
Date: 3/7/2022

Russia's invasion of Ukraine led western nations to impose the most draconian economic sanctions in the modern era. The Russian stock and bond markets have collapsed, along with Russia's currency, the ruble.

Many investors fear that China, which has always wanted control of Taiwan, will use the mayhem of the moment to take it. Obviously, this would create even more uncertainty and mayhem, but China is more involved in global finance than Russia. The West's response to Russia has not gone unnoticed, but many fear that even if China doesn't invade, it may preemptively sell its roughly $1.1 trillion in US government debt to avoid financial retaliation. The fear is that this will cause US interest rates to soar and the US economy to suffer.

We think this fear is unwarranted. Yes, inflation and Fed tightening are likely to push up rates in the next few years. This is what the markets should focus on, not a Chinese sell-off of US Treasury debt, which would have little impact.

First, total US debt is roughly $30 trillion. If China sold all its debt, it is only 3.6% of all outstanding US debt. A shock to the system maybe, on the day it happens, but just a temporary shock, not a death blow.

Second, consider what's happened to our budget deficit the last couple of years. Right before COVID, the Congressional Budget Office estimated that the baseline deficits for Fiscal Years 2020 and 2021, combined, would be a two-year total of $2.0 trillion. Instead, due to COVID and related shutdowns, the two-year deficit totaled $5.9 trillion. That's $3.9 trillion in extra deficits over a two-year period. And the 10-year Treasury yield is essentially where it was right before COVID hit.

Third, the Federal Reserve shrunk its balance sheet by almost $700 billion (effectively selling debt securities) in 2018 and the first eight months of 2019. Guess what? Interest rates fell.

Fourth, even if rates were to rise, which looks likely no matter what China does, the US economy has rarely been as insensitive to interest rates as it is today. Due to underbuilding going back a decade, there are too few homes in the US. Even if mortgage rates go up, we need more new homes. Higher interest rates might mean a greater appetite for renting versus buying, but rental units have to be built, too. Meanwhile, auto sales are very low due to supply-chain issues. As those issues gradually get resolved, auto sales should increase even if interest rates go up.

Fifth, we anticipate another round of Quantitative Tightening starting mid-year that will eventually be more aggressive than it was in 2018-19, maybe reducing the balance sheet by $100 billion per month. If we're right, that would mean one year of peak QT by the Fed is even more debt being sold than all the debt China owns. And yet, the 10-year yield is still 1.8%. We know the Quantitative Tightening isn't an exact equivalent to China selling debt. But the comparison still puts the size of a potential China selloff in perspective.

Sixth, it's important to remember that China didn't buy our debt as a favor to the US; they bought our debt out of self-interest. Using Treasury debt to back up their currency makes people more willing to use the renminbi. If China's government sells its Treasury debt, that appetite for the relative safety of the dollar won't disappear and citizens in China could offset this sale by buying more dollar-denominated assets.

Seventh, and most important of all, we need to recognize that interest rates are a function of economic fundamentals and expectations about the future, not who is buying and selling how much Treasury debt on any particular day.

If China sells its Treasury debt, it's going to end up getting dollars in return. What will it do with those dollars? Swap them for a different currency...let's say Euros? Then whomever it swaps with will have the dollars. What will they do with those dollars? If China's sales of bonds drive up rates, whoever gets the dollars would likely turn around and buy US bonds. The result? No fewer dollars or bonds in the world.

The US debt that China owns is more problematic for China than it is for the US. Moreover, if China sells US debt because it fears sanctions, then it will likely sell European debt as well. In the end, it's not the US that has a problematic conundrum.

China invading Taiwan would be a horrible event. But the fear of China hurting our economy by selling our debt is overblown.


A Note on Ukraine

Looking for a local way to help Ukraine where 100% of donations go directly to the people there? Spokane Helps Ukraine has direct connections to three churches in Kharkiv, the 2^nd largest city in Ukraine, thanks to Spokane local business owner, Sergey Stefoglo, of Elite Construction.

Sergey, who was born in Ukraine and has lived in Spokane for around 25 years, has family and friends in Kharkiv. His brothers-in-law are fighting for their country and their wives and children have fled to Finland. Spokane Helps Ukraine is working with Sergey to get direct support to those on-site buying food and relief supplies for those still there. Please visit https://www.spokanehelpsukraine.org/ if you would like to learn more, donate and help.

Data, Just the Data

Data points this week included:

• U.S. Jobless Claims – fell by 15K to a claimant count of 214K for the week ending March 12^th. This is the lowest reading in over 10 weeks and the 4-week moving average has edged lower to 223K.
  
• U.S. PPI – producer prices rose 0.8% MoM in February and fell slightly from the month previous reading of 1.2%. Prices for goods expanded 2.4% – mostly due to gas rising 14.8%. Service prices were mostly unchanged, but on a YoY basis, producer inflation remains at 10%.
  
• U.S. Industrial Production – rose 0.5% MoM in February, which was slightly lower than the January reading of a 1.4% rise. Manufacturing output expanded 1.2% thanks to durable and nondurable manufacturing up 1.3% and 1.1%, respectively. The utilities index contracted (2.7%), but mining output bumped up 0.1%.
  
• U.S. Retail Sales – moderately bumped up 0.3% last month, which was significantly lower than January’s reading of a 4.9% rise. Sales at the gas pump rose 5.3%, while food and services increased 2.5%. Non-store retailer sales fell (3.7%) and health and personal care stores also fell (1.8%).
  
• U.S. Housing Starts & Permits – starts bumped up 6.8% MoM to an annualized rate of 1.79M in February – this is the highest reading since June 2006 and a complete turnaround after a (5.5%) decrease in January. Building permits contracted (1.9%) to an annual rate of 1.89M – lower than the previous month’s 16-year high.
  
• U.S. Existing Home Sales – plummeted (7.0%) to an annual rate of 6.02M and slightly below forecasts of 6.1M. This is the lowest reading in 6 months with inventory slightly rising to 870K. Median prices rose to $357,300, up 15% YoY.