To The Moon

The sentiment is at a low, some sentiment indicators cannot fall any further. Sentiment indicators are relatively good for determining a bottom in the stock market, much better in any case than for determining a top. Negative sentiment is much more contagious than positive sentiment and therefore highly clustered. These situations are usually relatively short-lived, whereas positive sentiment can last for a longer period. Anyone who had invested on the basis of sentiment indicators in the past twenty years could almost always have done so at the bottom.

Against such a strong track record, there seems little else to say but that this time it is different, a dangerous statement in the financial world. But things are indeed different this time than in previous corrections. Since 1928, there have been a total of 15 bear markets (a decline of 20 per cent or more) on the S&P 500 and in four of them the decline was limited to not much more than 20 per cent. In all four cases, the decline was halted by central bank intervention, something we now refer to as the Fed put. The difference with those four times is that inflation was not a problem then, so the central bank had room to manoeuvre, but now inflation is causing intervention to come at the expense of fighting inflation.

One of the reasons that sentiment is so poor is the rapidly changing and therefore unpredictable policies of central banks. Last week, the Fed raised interest rates by 75 basis points, a quarter more than expected a week ago. The next rate hike is likely to be another 75 basis points. An even bigger surprise was the Swiss central bank's increase of 50 basis points. Not only the step is surprising, but also the moment at which. For the Swiss, their own currency is usually too hard versus the euro, a reason to synchronise monetary policy with the euro. But the ECB will only raise interest rates in July, and by 25 basis points as well. Only in September will the ECB raise the interest rate by another 50 basis points. The Swiss are choosing to anticipate this. The ECB sees inflation rising above 2 per cent in the coming years, so it has to put pressure on economic growth. The tricky thing is that inflation is largely caused by things the ECB cannot control, such as higher oil prices. Moreover, the risk of the eurozone splitting up increases when interest rates rise.

This fragmentation risk became visible in recent months in the rising interest rates on Italian government bonds. The ECB is working on a new 'anti-fragmentation' instrument to reduce the higher (borrowing) costs of the weaker eurozone countries. The measures are not yet concrete, but it should soon be a package of more than 200 billion to buy bonds from weaker member states. The other member states would have to allow this. With Italian and Spanish elections next year in the offing, a new stream of refugees, high inflation and a high probability of recession, the risk of fragmentation in the eurozone is currently underestimated.

The more structural core inflation in the United States is probably around four per cent and that is too high. However, the Fed believes that this inflation rate is temporary, that we could be at 2.4 per cent by 2024, but that would require a deeper recession than the slowdown that the Fed is now targeting. The Fed's rate would then have to go to 4 per cent anyway. After the adjustment last week, we are moving in that direction, but we are not there yet. A good indicator is when the yield curve inverts.

Another problem for central banks is the stubbornly high price of oil. Despite all the negative news about the oil price, the oil price remains high. The supply-side problem has not been solved yet and stocks are still being reduced. And now the Chinese economy is gradually opening up more. 

Forward-looking economic indicators show a clear weakening, but the indicators measuring current activity are holding up well. There is a risk that the Fed will steer too much on the latter indicators and thereby cause a harder landing than is actually needed. Forward-looking indicators suggest that earnings valuations will come under pressure. On balance, the economic news is too good to assume that inflation will decline. For that to happen, there would have to signal that wages are rising less sharply, that US growth is slowing down further or that, for example, credit spreads are rising sharply (preferably together with a VIX above 40). None of this seems to be the case yet, so it is too early to say that the market is 'clean'.

If history is to be used to determine when this decline will end, it will be on 19 October 2022 (coincidentally, 35 years after Black Monday) with the S&P 500 at 3000. 

Pinning down the exact bottom is, of course, a hopeless task. Normally, the start of a recession is a good entry point (we are not there yet), because so much bad news has already been discounted. Historically, returns after the start of the bear market are not so bad, although the current bear market looks like a merger of the 1973 (oil shock) and 2001 (dot-com bubble) bear markets.  

There are still excesses in the market that are likely to disappear only gradually. This creates risks, but also offers opportunities.