U.S. Stocks Have Biggest Daily Gain Since 2020 on Cooling Inflation

Many have been focusing on all of the concerns about rising inflation, rising
interest rates, supply chain issues, the war in the Ukraine, problems in Europe
and problems in China. Statements from Federal Chairperson Jerome Powell
projecting more interest rate increases into 2023 made many believe that the
outlook was just too uncertain to invest or expect stock prices to move
significantly higher.

However, stocks often react to what is expected to happen 6 to 12 months from
now, not on what is happening today. Investor behaviour had already laid the
foundation for a strong, long-term uptrend to begin. The cornerstone of this
foundation was the double bottom pattern investors formed from June to October.
This is a classic pattern to show that the selling has been exhausted after a decline
of 20% or more.

The first low is formed after buying comes in as fearful sellers unload their
stocks, bringing them down to attractive levels. This happens in the middle of
June, as you can see in the chart of the S&P 500 from WSJ below. Stock prices
then recover for a number of weeks. There is still a lot of uncertainty in the midst
of a bear market so the buying slows down as prices rise. This causes prices to
start falling again. The stress and pressure in the midst of great pessimism means
there are some who just cannot help themselves to give in to the temptation to sell.
They do not have the discipline to think about the longer-term so they get caught
up in day-to-day volatility. At a certain point, stock prices become attractive again
so buyers jump in creating another low that holds.

The second part of the foundation occurred when stock prices fell 2% on
October 13th and then closed with a 3% gain. This is called a Key Reversal Day.
The third part of the foundation is when stock prices continue to advance after the
Key Reversal day. When two distinct lows like this happen at least 4 weeks apart
within 4% of the previous low, it is a sign that the selling has been exhausted and
that a new uptrend has started. See the low on October 13th and the recovery since
then.

 

 

Last week’s Update explained that the Dow Jones Industrial Average (DJIA)
had the biggest monthly gain since 1976 in October with a gain of 14%. Today,
the S&P 500 jumped 5.54% while the S&P 400 Index of U.S. mid-sized
companies spiked 5.79%. The U.S. Banking Index ETF (BKX) also rose 5.75%.
The NASDAQ rose 7.35%. Daily broad-based gains like this are very rare! The
last time a daily gain like this happened was in April 2020, as stock prices were
recovering from the 34% decline due to Covid. If you recall, the S&P 500 was
back at record highs six months later.

Previous Updates have been informing you of how conditions were setting up
for a positive outcome just like this. Headlines in my Updates such as “A Surprise
Can Happen At Any Moment” on October 6th, “Stock Markets Are Like A Coiled
Spring” on October 13th, “On The Verge Of Lower Inflation And A Peak In
Interest Rates” on October 20th and “The Pendulum Is Starting To Swing Back”
on October 28th provided you with the evidence for what has been leading up to
the strongest monthly gain in the DJIA in 46 years and one of the strongest daily
gains today. The evidence was not my opinions. The evidence was how investor
behaviour compared to how investors have reacted during other major market
declines. The situation is always a little different but the human reaction during
serious market declines is very similar. This is because human nature has not
changed in thousands of years.

While there are limitless factors we can look at, two of the most important
factors for stock prices are interest rates and oil prices. Oil prices have declined
from a high of $124 earlier this year to $88, so meaningful progress has been
made towards making fuel more affordable. However, the Fed has continued to
raise interest rates by almost 4% this year to combat rising inflation. Inflation
rates were already coming down but investors seemed to want more evidence of
this to be confident that the Fed was near the end of the rate increases.

The price of many items peaked last March and have retreated since then.
March is only 4 months away now. Therefore, inflation could be significantly
lower in 4 months. Some very respectable experts have even warned that there
could be deflation early next year. An Update in early September explained how
26 out of 27 inflation indicators had just moved lower, suggesting lower inflation
all across the board. Today, investors got the news, which was the surprise I have
been writing about. Data was released today showing that U.S. inflation had
dropped for four months in a row and by more than expected. The rate fell from a
peak of 9.1% in June to 7.7% last month. The violent reaction to stock prices
today showed that this was the catalyst that can change investor’s perception from
the glass being half empty to the glass being half full. It wasn’t just stocks that
had exhibited a change in the mindset of investors. Bond yields had the biggest
decline since the Financial Crisis in 2009. The U.S. dollar fell sharply as well.
Shifts in investor sentiment like this are extremely important! The catalyst to
start a new bull market at the bottom of the Financial Crisis was when the large
bank Citigroup announced that they were going to report a profit for the quarter
on March 9, 2009. Stocks started a powerful 2-year rally that day. The inflation
news today could very well be the catalyst that creates more upside momentum in
this rally, taking prices back to new record highs again. Many did not believe
stock prices could move back to record highs so quickly after in Covid in 2020.
Don’t underestimate what stock prices can do in a growth cycle like this.

Many experts said that the strong rally after March 2009 was just going to
fizzle out in a month or two. You can expect many to say that again now. There
have been many powerful one-day rallies in the midst of a long-term decline. So,
how do we know if this is just a rally in a bear market or the real McCoy? The
answer to that is very simple. The fact that the rise since mid-October and today
occurred after stock prices have traced out the classic double bottom pattern gives
us to be as confident as we can be that this bear market is over.

You may think that the Fed says they are still going to raise interest rates into
2023, so how can interest rates be peaking? In September 2021, most of the
members of the Federal Reserve Board of Governors forecast that there would be
no interest rate increases in 2022. Two said rates would increase by 0.25% and
one said they would rise by 0.5%. They have actually increased interest rates by
close to 4% so far this year with one meeting still left to go.

In spring, Powell said they would not raise interest rates by as much as 0.75%.
They have actually raised rates by 0.75% four times after that! After being on a
SAR team for 20 years, I have learned to pay a lot of attention to whom I can
trust. When I am hanging on ropes over a cliff in the dark, (we always have two
completely separate rope systems for redundancy that can each hold ten times the
weight on the line for safety) I want to know that the person controlling each rope
system is experienced and capable. I have been flying through the air hundreds of
feet off of the ground hanging from a rope 200 feet below a helicopter. I have to
trust the pilot, the machine and the SAR person in the helicopter who can release
the rope and drop me if the helicopter gets into trouble. I have to trust my
colleagues in many other situations as well. I have a hard time trusting someone
who has failed me or someone else when it really mattered. Thank goodness that
has almost never happened.

Consequently, when what the Fed has said has been completely different from
what they do, does it make sense that they will all of a sudden keep their word
now? Powell said he would keep raising interest rates in early December 2018.
After stock prices fell 20% by Christmas Eve 2018, in early January Powell said
he would base his decision on the data instead of a pre-planned strategy. There is
a pattern of behaviour all investors have to be aware of here. I have a difficult
time trusting what they say. So, if we cannot trust the Fed, who or what can we
trust?

The decision makers at the Bank of Canada and the Fed are not super human.
They are just men and women who have a lot of experience and knowledge about
how economies and markets function. However, there are many bond investors
who also have the same knowledge and experience. Therefore, bond investors
react to economic data in a similar way that central bankers do. This is why the 2-
year U.S. government bond has been a good guide for the future direction of
interest rates. The yield peaked for this bond peaked at 4.72% on Nov. 7th and
closed a 4.34% today, a decline of 0.38%. Please see the 1-year chart for this bond
from Y Charts below.

The current U.S. Fed Funds rate is at 4% now, suggesting that the Fed should
only raise rates by close to 0.25% to get close to the 4.34% level. The reason why
the headline on the October 20, 2022 Investment Update was “On The Verge Of
Lower Inflation And A Peak In Interest Rates” was because the oscillator for U.S.
bonds were completely oversold. This suggested that the worst-case scenario for
inflation was already factored into current prices. The white line is the monthly
oscillator going back 20 years. The red and green bars are the bond price. The
yellow arrow shows that the oscillator is as low as it has ever been. This is a sign
that bond prices are poised to rise, which means that interest rates are poised to
decline.

 

The completely oversold condition of bonds is a major reason why bond yields
dropped today. (Bond prices fall when interest rates rise and rise as rates fall.)
This means that interest rates could have already peaked in the bond markets. This
is important because many longer-term mortgage rates are based on what happens
in the bond market. The Bank of Canada and the Fed only control very short-term
interest rates.

Another major part of the foundation for a bull market to begin is investor
sentiment. Optimism has waned and pessimism has increased to the point where
bear markets have ended in the past. This is more evidence that the worst-case
scenario has been factored into current prices. Please see the chart from Investors
Intelligence on the next page.

The black line below shows the level of optimism. You can see that it recently
fell below the level it reached during the 20% sell-off in December 2018 and the
34% Covid sell-off in early 2020. Stock prices rose sharply right after those
instances. The reversal happened in January 2019 because Powell reversed his
stance a few weeks after the December 2018 low. Stock prices skyrocketed after
the Covid sell-off because of all the measures taken by central banks to lower
interest rates and add liquidity to the financial system. Quick responses by the Fed
meant that markets did not have to go through the double bottoming process to
form a low. This time, markets have been left to their own devices to deal with the
selloff. There has been no intervention. This is why a double bottom has been
formed this time and not in 2018 and 2020.

 

You can see that optimism has been returning from multi-year lows. This is a
positive development because it means that confidence is returning. In summary,
there is more and more confirmation that a new bull market started on October
13th. History suggests that this is an excellent time to invest cash and open
accounts if you are in a position to do that. Please feel free to call me if I can be
of any assistance. Have a good weekend my friend!

 

Lest we forget about the men and women who sacrificed so that we can live in
freedom today.

 

Image by Getty Images