After facing a tumultuous first half of the year, investors have been greeted by a seemingly unexpected and strong rally from the June 16th lows of the market. Having erased more than half of the losses for the year, investors who had moved to the sidelines face the uncertainty of when to invest back into the market. Naturally, their emotions may be torn between the fear of buying at higher levels and the fear of missing out (aka. FOMO).

The reasons to be skeptical are valid. First, the global economy is highly fragile. China’s economy continues to weaken, plagued by on-and-off Covid related shutdowns. Second, geo-political risks are high as Russia continues to threaten a cold winter for the EU as they play games with pipelines and natural gas distribution. Third, stock strategist continue to fear that a recession will catch up to corporate earnings and hence continue to revise profit expectations lower. Fourth, the Fed continues to present commentary that indicates they will keep interest rates higher for longer. And fifth, valuations of the S&P500 are at 18X Forward earnings which is above the historical long term average of 16X.

We still define the recent move higher as a bear market rally. Although this phrase implies that the upswing is only temporal, investors should also recognize that all sustainable recoveries begin as bear market rallies. Since this leaves the possibility for markets to grind higher, we elect to stay invested but do not feel it necessary to be fully invested (aka. “all-in”). Instead, we would be enticed to increase our overweight in equities and will redefine the rally as a sustainable recovery when two fundamental milestones are achieved. The first is that the Fed must raise rates to at least 3%. This level would be very near the 3.25% - 3.5% target rate as signaled by the market. Achieving this level allows the government to become more data-dependent in their interest rate decisions. This is a far departure from the emergency catch-up mode of the Fed that brought automatic monthly rate hikes of notable magnitude. The second milestone is to have at least two consecutive monthly inflation prints (measured by Headline CPI) that further signals that inflation had peaked in June. Investors welcomed the first drop in inflation data this month and look forward to the second one next month. Overall, we feel that by mid to late September, investors will have a chance to redefine this rally as a recovery as the August CPI data and the next Fed announcement on interest rates will take place on September 13th and September 21st, respectively.

In the meantime, we focus on three fundamentals that we feel need to stay resilient to keep the recovery on course.

The first is the health of the consumer. Although many consumers have been hurt by inflation and soaring gas prices, they have generally remained resilient as most have been able to retain employment. With a near-record low unemployment of 3.5% and wage growth of 5.2% from a year ago,  the consumer, in a broad sense, has been able to survive these higher prices, which limits the severity of any potential recession.

The second is that corporate earnings need to remain healthy. The latest second quarter earnings came in much better than originally feared, with about 75% of corporations beating expectations. Although we expect higher interest rates to eventually cool consumer demand and earnings, a mid-single digit earnings growth in 2022 and 2023 will help keep PE valuations in check.

The third is that the economy (GDP) needs to show broad resiliency. Although some may point to the -0.9% annualized decrease in Q2 GDP print as concerning, the internal details of the GDP figure actually provide us comfort. As the chart below shows, the decline in GDP was led by slower residential investment and a tick lower in business investment alongside a smaller inventory build. This intuitively makes sense as residential housing has fallen due to a cooling real estate market, and companies held back production as their glut of inventory has been widely reported. Hence, we see this economic weakness as “healthy” in the sense that we are correcting a period of excess. In short, there was an excess in housing demand and an excess of inventory. Moreover, those weaknesses were offset by stronger consumer spending, which was boosted by spending on services, and exports increased due to easing supply chain constraints. Therefore, the US economy appears resilient and may be able to handle further rate hikes from the Fed.

Overall, we feel that this market is investable, especially for those with a time horizon of 18 months or longer. Although some investors may have missed out on the recent rally, we foresee opportunities to add to positions on market dips. These downturns could be driven by renewed inflation concerns that are reignited by the return of higher gasoline prices. The myriad of geo-political risks abroad and even the mid-term elections in the US may also fuel uncertainty. We remain cautiously optimistic that the Fed will be able to thread the needle and avoid a hard recession. Work with an advisor to review one’s portfolio and discuss upcoming entry points and possible levels to further add to equities.