A Stock Market in Denial

Investors in the U.S. stock market are living in a state of denial. To be sure, the S&P 500 advanced nine days in row for the first time since 2004, and it has bounced 14% off the early April low, investors are wishing away the trade tsunami that is about to hit the economy. As I write this, the west coast ports are shutting down, bringing with it layoffs among dock workers and truckers. That malaise will soon spread eastward. 

Consumer confidence remains in the toilet. Thus, it is no surprise that year-over-year same store sales for McDonald’s, Chipotle, and Starbucks are down. Indeed, domestic airline travel is down, and foreign tourists are staying away from America in droves. On the business side, save for the Magnificent 7, capital spending plans are plummeting. Although the recent employment report for April was better than what I would have expected, my guess is that it will turn out to be the last good report we will see for quite some time. As a result, my March forecast calling for a recession starting in the current quarter still stands. (See: https://shulmaven.blogspot.com/2025/03/the-recession-of-2025.html ) 

Investors remain in denial that the postwar global architecture of the past 80 years is in ruins. (See: https://shulmaven.blogspot.com/2025/04/regime-change-end-of-economy-as-we-have.html ) To me this means that all of the old rules of thumb concerning the economy and the stock market are no longer valid. Simply put, we are entering a new world with unknown economic and geopolitical   consequences. In a nutshell, the world has become a much riskier place.

For those who believe that the U.S. will win the trade war with China, I have a few words of caution. According to the “Sinocism” newsletter, the domestic Chinese media are portraying the trade war as a “protracted war.” The members of the Chinese Communist Party know full well that the term “protracted war” harks back to Chairman Mao’s 1938 pamphlet calling for protracted guerilla warfare against the Japanese aggressors. That war lasted for seven years. Further, Thucydides taught us 2500 years ago that nations go to war for “honor, fear, and interest.” To China the trade war with the United States is a matter of honor.

The bottom line is that soon the denial phase of the current bear market will soon turn to anger as investors realize that the Trump tariff policy will bring with it higher prices and reduced output yielding a stagflationary recession. When that realization crystalizes, the S&P 500 will breach the April low before too long.

Stock Market Correction or Bear Market?

 I certainly haven't covered myself with glory this year. My recession call in May, just ahead of a 5% GDP quarter is damning. (Shulmaven: Has the Recession Arrived?) Nevertheless with the S&P 500 now down a touch over 10% from its July 31st high, a correction has been signaled. Perhaps more troubling, notwithstanding the fact that the index is still up 7% on the year, the equal weighted index is down 6%, meaning more stocks are down than up. Just as in the early 1970's nifty fifty market, the leadership has been extraordinarily narrow. Indeed with the onset of a middle-east war we have yet again another parallel to the 1970's. (Shulmaven: Roaring 20's or That 70's Show)

To me my biggest concern is that the S&P 500 is still down 14% from its 4797 all-time high set on January 3, 2022. It can be argued, that just like in the 1970's, we are now in a structural bear market that began almost two years ago. If that is the case, the rally this year could be characterized as one of the biggest head fakes of all time. It remains to early to make that call, and a big tell will be whether or not the broader stock market rallies next month with the abatement of mutual fund tax selling.

A Change in the Weather: Is the Summer Rally Over?

 After advancing four straight weeks taking the S&P 500 up 17% of its June low, socks retreated 1.3% in the past week. However, beneath the surface the damage was far greater with the leading edges of the bear market and the recent rally falling by a far greater amount. For example, Cathy Wood’s Ark Innovation ETF is now off 13.5% from its recent high and Bitcoin, the poster child of the bull and bear market, is down a similar 12.5%. As we noted previously crypto currency has been deeply embedded in both the bull and bear cycles. (See:  Shulmaven: The Crypto Crash and the Bear Market in Stocks)

 

When we wrote two months ago, we thought the bear market was entering its “anger phase.” (See: Shulmaven: The Bear Market Enters the Anger Phase ) It seems that lasted for only about a week as stocks embarked on the previously discussed 17% rally. For awhile it seemed that all anger had left the market as high valuation money losing companies led the charge and the “meme” stock mania returned in near full force.

 

Nevertheless, under the surface all is not well. The great bond rally that took 10-year yield down from 3.48% in June to 2.60% in early August has reversed with the yield closing at 2.99% on Friday. Further the market seems blind to the fact that inflation is not quiescent. As of July, the CPI is up 5.4% from the start of the year and by December, using some very modest assumptions, it will still be up 6.5% on a year-over-year basis. Similarly, with the core CPI is up 3.7% thus far this year, it more than likely than not, it will close out the up around 6.3%. 

Further you have to remember that if the CPI were calculated on the same basis as it was in the 1970’s, inflation would have peaked in the 12%-13% range, not the 9.1% reported. With data like this, the Fed will continue to tighten policy making it more likely than not, the terminal funds rate will exceed 4% and we have yet to see the full force of its quantitative tightening program which will start in a few weeks. That action will double its balance sheet shrinkage from $45 billion/month to $90 billion/month. We will learn much from the Fed this week when Chair Jay Powell delivers his remarks at the annual Jackson Hole Conference.

 

So just as summer turns to fall, the recent rally is likely over, and the anger phase of the bear market will resume. My guess is that we are heading for a retest of the June lows. Only then will we move to the final acceptance stage of the bear market.

The Bear Market Enters the Anger Phase

On Friday with the S&P 500 down 2.9% on the day and off 18.7% from its all-time high on January 3^rd, the bear market entered the anger phase. Similar to the Kuber-Ross stages of grieving, bear markets have three phases: denial, anger, and acceptance. With the release of the May CPI data which disclosed that headline inflation on a year-over-year-basis increased by 8.6% and core inflation rose by 6%, markets could no longer deny the fact that a broad-based inflationary process is now underway. (See: https://shulmaven.blogspot.com/2022/01/way-too-complacent-about-inflation-and.html) Further with the all-important housing component lagging economic reality, the inflation we are now experiencing will have a long tail.

 

In response to the data the yield on the 2-Year note popped to 3.07% and the 10-Year yield hit 3.17%, just shy of its recent high. Put bluntly the bond market is now signaling that the Fed Funds rate is well on the road to, at least, 3.5%. That along with quantitative tightening could very well trigger a recession in 2023. Time will tell whether or not a recession pans out.

 

Nevertheless, in the anger phase of a bear market, the stock market will shoot first and ask questions later. It is my guess that stocks will quickly fall below the intraday low of just above 3800 on the S&P 500 making a bear market official to those who mindlessly invoke the 20% rule to define a bear market. As we have written before, it is obvious that we have been in a bear market for some time. (See: https://shulmaven.blogspot.com/2022/05/we-are-in-bear-market.html)

 

The anger phase of a bear market can either be short or long, but it is usually severe. That will ultimately give way to an acceptance phase which can grind out for years. Again, as we have previously written we are likely to be in a new 13-year cycle that will be characterized by a long and drawn-out trading range. (See: https://shulmaven.blogspot.com/2022/05/the-useconomy-is-entering-new-thirteen.html )

We are in a Bear Market

Forget about what the financial press said on Friday and Saturday with The Wall Street Journal headline of May 22 screaming “S&P 500 Briefly Dips into a Bear Market.” The story below the headline noted that on an intraday day basis the S&P 500 was trading 20% below its all-time high reached on January 3. There is nothing magical about a 20% decline defining a bear market. In the 1990’s while I was Chief Equity Strategist at Salomon Brothers, I helped popularize the notion that a retreat of 20% by a broad market average constituted a bear market. A 20% decline was not a hard and fast definition, but rather a rule of thumb. There is little difference between the 18.7% decline on Friday’s close and 20%.

 

Further evidence that we are in a bear market is that the Dow Jones Industrial Average has decline for eight weeks in a row. The last time that streak happened was in 1932. The S&P 500 has declined for seven weeks in row, the first time that happened since 2001. Needless to say, both 1932 and 2001 were bear market years. Just to note a bear market is also defined as a sustained drop in stock prices from its recent high.

 

Indeed, if you look at the 29% decline in the NASDAQ Composite, the 27% decline in the Russell 2000 and the 21% decline in the Wilshire 5000; stocks as whole are deeply in bear market territory. Further the 50%-90% declines in a host hitherto high-flying and non-earning technology stocks reminiscent of the 2000-02 bear market and the break the SPAC stocks, a dubious Wall Street invention, the carnage is visible for all to see.

 

Further evidence of the bear market is the fact that recent market favorites such as large cap technology and consumer staple stocks were taken out and slaughtered over the past few weeks. Remember when the police raid a whorehouse, the good girls and the bad girls alike are taken in the paddy wagon.

 

Adding to the carnage is the collapse of the crypto currency market. Total global losses there are estimated at $1.5 trillion with some so-called stable coins rendered worthless. More than a few hedge funds were caught off-sides in this market which converted their losses in crypto currency into margin calls against their stock positions. Even legendary investor and longtime bull on Bitcoin Bill Miller on CNBC admitted to selling part of his position due to a margin call.

 

So, forget the headlines, the carnage all around us is obvious. How long the bear market will last and how deep it will be remains unknown. However, my guess is that we are closer to the end than the beginning in terms of price, but not necessarily of duration. My biggest worry remains that the stock market decline is signaling the start of a new thirteen-year economic cycle bringing with it heightened uncertainty. (See: Shulmaven: The U.S. Economy is Entering a New Thirteen Year Cycle )

 

The Defanging of the Stock Market

 

April has brought with it the defanging of the stock market where the hitherto invulnerable FAANG stocks crashed and burned bringing with it a full-fledged bear market in the NASDAQ Composite Index. FAANG stands for Facebook (now Meta Platforms) Apple, Amazon, Netflix, and Google (now Alphabet). From their respective 52-week highs Meta is down 48%, Apple is down 13%, Amazon is down 33%, Netflix is down an astounding 73% and Alphabet is down 23%. Taken as a whole the NASDAQ Composite is down 23%. The weakness in these five stocks which at one time accounted for nearly a quarter of the market value of the S&P 500 brought that benchmark index down 14%.

 

Market behavior of this type is reminiscent of the 1973-74 and the 2000-02 bear markets. In the 1970s the so-called Nifty-50 group of one-decision growth stocks which were trading at 50-60X earnings experienced declines in excess of 50 -80% during the course of the bear market. In the collapse of the 2000 dot.com bubble such stalwarts as Cisco, Microsoft, Intel, and Oracle (a group of stocks that I then characterized as “The Four Horseman of the NASDAQ”) which traded at multiples in the 80-100X range lost about three quarters of their market value. Indeed, just as today, the stock market was bracing for a tightening of monetary policy. Needless to say, the history is not encouraging.

 

There are, however, two distinct differences between then and now. First, from 1972-74 the 10-year Treasury traded in a 6-8% range and in 2000-02 it traded in a 5-6% range far higher than the current 2.9% yield. Second, with the exception of Netflix valuations are nowhere near as demanding with Alphabet trading less than 20X earnings, Apple at around 25X, Meta at a below market 14X earnings. As a result, even if Treasury yields rise to 4%, my sense is that the worst of the declines in FAANG and the market as whole are behind us.

 

To be sure, we could soon be looking into the teeth of a recession triggered by a very aggressive Fed and continued high inflation which would haircut earnings estimates across the entire market. We are sure to have a recession at some point, but I do not believe it is soon. Simply put the end of the pandemic is fueling a consumer boom and capex remains strong fueled technology and energy related spending of all types. Thus, it will take more than 250 basis points of tightening to break this economy. Of course, if we are in a rerun of “That 70’s Show,” all bets are off. (Shulmaven: Roaring 20's or That 70's Show)

 

As I wrote in February(https://shulmaven.blogspot.com/2022/02/the-unravelling.html), my sense is that we are in a structural bear market in bonds and in for a very volatile stock market. Whether or not the lows are in or not, I do not know, but the world will not look as bad in December as market participants feared last week. Net, net although 2022 will be a down year for stocks, the market will end the year higher than where it is now.