Stocks Have Rebounded Big in a Short Time History Shows Market Momentum Should Continue

Markets show glimmers of optimism – What is needed for a sustainable rebound?

Although volatility remains elevated, markets demonstrated glimmers of optimism last week as we make our way through the fourth quarter. Notably the S&P 500 is up now over 4.0% since the beginning of October, which historically tends to be a tough month for market performance ¹ . Nonetheless, for markets to mount a sustainable rebound, we would likely need to see certain conditions in place, including moderating inflation and Treasury yields peaking, neither of which are fully confirmed yet – but we may be getting closer.

What drove the positive sentiment early last week?

Third-quarter earnings results are largely meeting or beating expectations

While it is early in the third-quarter earnings season, thus far we have seen several bellwether companies report revenue and earnings that were above analyst expectations. About 20% of S&P 500 companies have reported third-quarter results, and about 73% have exceeded earnings forecasts, above the average of 70% ¹ . Perhaps a common theme in earnings season so far has been that U.S. consumers remain resilient, despite looming economic headwinds. We have seen this theme with big banks like J.P. Morgan, Bank of America and Goldman Sachs all highlighting solid consumer spending and low delinquency rates. In addition, companies across several consumer end-markets, including Netflix, United Airlines, and Procter & Gamble, have all beat earnings and noted resilient household demand ¹ .

However, while earnings in the third quarter ending September 30 may be solid, keep in mind that higher interest rates tend to impact the real economy with a lag impact. We would expect that earnings would continue to soften in the quarters ahead, particularly 2023 estimates. While we have seen some downward adjustment to 2023 earnings growth rates, analysts may mark these down more meaningfully as we head toward year-end. Nonetheless, with equity markets down over 20% this year, some or most of this markdown in next year's earnings may be reflected in the indexes already – and markets may start to look beyond the bottom to a potential rebound ahead.

Markets may have rebounded from oversold conditions

At the end of September and early October, there was also mounting evidence that investor sentiment had become very low, and markets were perhaps oversold. This showed up in surveys like the AAII bull-bear sentiment indicator, which reached the most pessimistic sentiment since 2008. In addition, the monthly Bank of America Fund Managers survey indicated that investors were holding the most cash since 2001. This extreme pessimism tends to be a contrarian indicator for markets and can set up markets for an oversold bounce, which is perhaps some of what we saw early last week. Nonetheless, while these rebounds may be temporary, they can at times mark capitulation in sentiment and pave the way toward establishing more sustainable rallies.

Figure 1. The AAII bull-bear sentiment ratio fell to extremely pessimistic levels earlier this month

^{Source: The S&P 500 is an unmanaged indicator and cannot be invested in directly. Past performance is no guarantee of future results.}

This chart shows the AAII investor sentiment survey and select stock market returns. Stock market returns are generally positive when sentiment is bearish and used as a contrarian indicator.

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What would we need to see for a more sustainable rally?

First and foremost, inflation would need to moderate consistently

Perhaps the key to a sustainable rally, in our view, still lies in inflation coming down. Central banks around the world, including the Federal Reserve, have indicated that they will continue raising rates (which can disrupt equity and bond markets) until they see clear and consistent evidence of inflation moving lower. Last Thursday's CPI inflation reading was hotter and more broad-based than expected, providing little support for a pause in the Fed's aggressive rate-hiking campaign. However, while CPI inflation remains elevated, we continue to see some cooling in the underlying fundamentals of inflation. Measures like inflation break-even rates, ISM prices-paid surveys, and supply-chain pressure indexes, among others, are all easing. This provides some support that inflation dynamics may start to moderate more meaningfully in the months ahead.

This week we also saw housing data that showed considerable weakening. The impact from higher rates has been most acutely felt in interest-rate-sensitive parts of the market, housing perhaps being the biggest among them. Mortgage rates in the U.S. have moved rapidly higher, now over 7.0% for a 30-year mortgage ¹ . Meanwhile, last week the NAHB homebuilder sentiment index fell to 46, its lowest since 2020. And mortgage purchase applications also continued to decline last week, now at the lowest levels since 2015. Perhaps the silver lining for investors is that over time we would expect this weakness in housing to show up in lower shelter and rent components of core CPI, which have thus far remained elevated.

Figure 2. Housing sentiment and demand is weakening as mortgage rates climb in the U.S.

^{Source: Bloomberg}

This chart highlights the relationship between homebuilder sentiment and mortgage rates. As mortgage rates have risen, sentiment has fallen as housing demand softens.

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We are also watching for Treasury yields to stabilize

We would also look for U.S. Treasury yields to peak and stabilize as a signal for a more durable market rally. Lower yields can support equity and bond markets, particularly the higher-valuation and longer-duration parts of the market, as they indicate lower discount rates and cheaper cost of capital for companies. For example, historically, in the 12 months after a peak in yields, bond-market returns have been positive by about 16% on average ¹ .

Figure 3. Historically, when Treasury yields peak, the bond returns rise in the following 12 months

^{Source: FactSet, Past performance is no guarantee of future results.}

This chart shows the relationship of bond returns after a peak in the 10-year treasury yield.

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The Fed narrative continues to be a driver of yields and broader markets

However, last week Treasury yields seemed to move on speculation around the path of Fed rate hikes. We heard from Philadelphia Fed President Harker, for example, that the Fed will continue to push rates higher given the "disappointing lack of progress in curtailing inflation." U.S. Treasury yields then rose to their highest of the year, with the 10-year yield reaching around 4.28%, nearly three times the 1.51% at the start of the year ¹ . However, late in the week the Wall Street Journal also reported that some Fed officials may be considering easing the pace of rate hikes to 0.50% at the December meeting, a very welcome first step towards a more gradual path of hikes for markets ¹ . In our view, the FOMC is carefully monitoring economic and financial conditions and is likely not keen on pushing the economy into an unnecessarily deep downturn, especially if underlying inflation is starting to slow. While Fed members may not want to signal any pause or pivot in their rate-hiking campaign prematurely, the Fed may be setting up to perhaps pause its rate-hiking campaign sometime in early 2023. And this would pave the way for a peak in Treasury yields, which historically occurs a couple months ahead of the final Fed rate hike.

Opportunities forming in equities and fixed income

As we potentially head into the final innings of the Fed rate-hiking cycle and perhaps closer to a peak in Treasury bond yields, we believe opportunities may be forming in the weeks ahead to position for a possibly more sustainable rally to come. We highlight a couple of trends in the equity market and fixed-income space that we see emerging. Of course, every investor and financial strategy is unique, and working with a financial advisor can help shape the best approach to navigating this market.

• In equities, there may be an opportunity to consider growth sectors in addition to value and defensive parts of the market. If Treasury yields do stabilize and ultimately move lower, this is a more supportive backdrop for growth sectors such as technology. Keep in mind that if economic growth slows, investors may be seeking growth in their portfolios as well. While defensive parts of the market, like consumer staples and health care, have held up relatively well, there may be an opportunity forming to complement these with quality growth investments that have underperformed dramatically during this market downturn.
  
• In fixed income, consider complementing shorter-duration bonds and CDs with longer-term investment-grade investments. While more recently investors have gravitated toward shorter-duration CDs or bonds with one- or two-year maturities, there may be an opportunity forming to complement these with longer-duration quality bonds. These bonds not only secure higher income for longer, but also may appreciate if yields do peak and eventually start to move lower. We favor investment-grade fixed income that aligns investors with highly rated government or corporate borrowers.

Mona Mahajan
Investment Strategist

^{Source: 1. Bloomberg}

Weekly market stats

Weekly market stats

INDEX	CLOSE	WEEK	YTD
Dow Jones Industrial Average	31,083	4.9%	-14.5%
S&P 500 Index	3,753	4.7%	-21.3%
NASDAQ	10,860	5.2%	-30.6%
MSCI EAFE	1,698	1.7%	-27.3%
10-yr Treasury Yield	4.23%	0.2%	2.7%
Oil ($/bbl)	$85.16	-0.5%	13.2%
Bonds	$93.82	-0.9%	-16.5%

^{Source: Factset. 10/21/2022. Bonds represented by the iShares Core U.S. Aggregate Bond ETF. Past performance does not guarantee future results. * 4-day performance ending on Thursday.}

The week ahead

Important economic data being released this week include GDP & inflation.

Review last week's weekly market update.

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Mona Mahajan

jimenezfesion.blogspot.com

Source: https://www.edwardjones.com/us-en/market-news-insights/stock-market-news/stock-market-weekly-update

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