Market insights and analysis

By Jerry Wagner

The major market indexes finished higher last week. The Dow Jones Industrial Average gained 4.9%, the S&P 500 Index rose 4.7%, the NASDAQ Composite climbed 5.2%, and the Russell 2000 small-capitalization index picked up 3.5%. The 10-year Treasury bond yield rose 20 basis points to 4.222%, sending bond prices lower for the week. Gold futures closed at $1,656.30, up $7.40 per ounce, or 0.45%.

Stocks

The S&P 500 Index continued its rally from the low it reached on October 12. Within a week of that date, the bears made three attempts to breach the 25%-loss level on the S&P 500 Index’s close. But the closest the Index’s loss got to that level for the current bear market was 24.9%. This rare triple bottom should provide support for a while—at least for a bear market rally or perhaps the ignition of a bull market.

Several bullish indicators are signaling a double-digit bear market rally (at least). We have had extreme sentiment readings. These are at historically low levels and have led to positive price moves in the past. Internally, both advancing issues and advancing volume have climbed in a manner that has always led the stock market higher.

Finally, we have had a classic new low divergence, often seen at bear market bottoms. As you can see in the following chart, the number of companies hitting new lows was less at the time of the October bottom than when we hit the June bottom, signaling underlying strength in stocks.

It is too early to tell whether this will be anything more than a tactical bear market rally. Both the March and April rallies had excellent technical underpinnings but were ultimately overwhelmed by downward momentum and economic macro view, causing a resumption of the bear market.

Much hope is being pinned on the present earnings reporting season to sustain the current rally in the short run. This seems likely.

Analysts have been steadily lowering their forecasts for earnings since the end of the last quarter’s earnings reporting period. As a result, the hurdle that firms have to jump over to “beat” estimates is very low. And these “beats” can move stock prices higher.

So far, 76% of the 68 companies in the S&P 500 that have reported have beaten the analyst estimates for both earnings and revenue growth. This is higher than the historical averages. We’ll see if that can continue. The next two weeks will see the largest number of firms reporting.

Regardless, we cannot ignore that, on a broader strategic basis, the outlook is not good. We remain below both the 50-day and 200-day moving averages. The intermediate trend of the market points solidly lower.

As we have been saying since July, the economy is in a recession. Watch our Turnkey Strategy Webinar: Q3 Review, presented by me and our Director of Research and Senior Portfolio Manager, Jason Teed. In it, I explain why I came to that belief. In addition, I show that the stock market tends to fall more during recessions and that the declines last longer.

But this week is likely to see a blip in the recession prognosis. The third-quarter GDP will likely show a gain (a 2.9% gain is forecast)—a sharp contrast to the declines in the previous two quarters. If Thursday’s (10/27) reported number equals or exceeds that estimate, the initial reaction is likely to be positive. The market may quickly reverse, however, as investors consider the impact on monetary policy.

The Federal Reserve has been aggressively raising interest rates trying to stem the fiscally induced inflation ravaging our nation at rates higher than most of our trading partners in both the developed and undeveloped world. Any positive GDP number, let alone one that matches or exceeds the estimate, is likely to provide the Fed with perceived political cover to continue their present campaign.

The current rally has been fueled by speculation that the Fed may ease its hawkish policies. Friday’s Wall Street Journal suggested that this may be happening. This is based on the fear that the Fed may be going too far too fast, resulting in severe wounds to the economy—not the “soft landing” it has been aiming for so far. A hint from the GDP report that the economy remains strong may counter this thinking.

At the same time, the farther the reported GDP number is below the estimated GDP, the more likely the dovish point of view on the Fed may surface and increase the budding speculation of an early end to the Fed intervention. This would spur the stock market higher.

Back to the issue of the recession. Will a positive third-quarter GDP number end the recession talk? I doubt it.

Economic reports continue to flood in suggesting further weakness ahead for stocks. Last week’s reports on manufacturing (both Fed missed estimates were to the downside) and the housing sector (fifth straight month of declines) point to worse days on the horizon.

I fear that the market still has not fully discounted the depth and duration of this recession. As I have been saying, this is likely to be a double-dip recession (i.e., a recession that begins with GDP falling, sees some relief from a positive report or two, and then grinds lower again), like we saw in the early 1980s.

We wrote a lot about inverted yield curves earlier this year. At the time, a few of the accurate predictors among the possible long- and short-maturity duration pairs were signaling a recession. Now they number almost 50% of the total. Whenever the current level (46%) has been reached in the past, a recession has occurred. To back that up, The Conference Board’s recession probability model is now registering a 96% chance of a recession.

Bottom line: The breakdown to new lows that I have been forecasting occurred, and it has opened a tactical opportunity for a recovery in the short term at least. Our more tactical strategies have been positioned to take advantage of this (see the discussion about our QFC Political Seasonality strategy below, for example). At the same time, the macro view is for more downward pressure in the intermediate term. Most of our intermediate-term strategies (for example, our Core and Classic strategies) have been positioned for just such an occurrence, with large allocations to cash, the U.S. dollar, and short and variable fixed-income instruments, as well as some inverse positioning.

Bonds

Treasury rates have once again reversed course. They bounced as they approached the 200-day moving average and have now surpassed the 50-day moving average that had provided some resistance.

The report of positive GDP numbers for the third quarter on Thursday is likely to spur yields still higher in the intermediate term. However, the same reverse psychology that I discussed above regarding Fed policy may change that forecast. A report that equals or beats estimates would likely send rates higher. A shortfall could send them lower.

Bond prices have fallen, reflecting the rally in yields (the movement and direction of bond prices and yields are inversely correlated). The long-bond (with a maturity of 20-plus years) ETF (TLT) is now at its lowest level since the Fed’s higher interest rate program was launched. It is down about 35% year to date.

The high-yield sector of the bond market continues to track stocks better than rates. It is down, but less than half of what the long-maturity Treasurys have experienced. Still, high-yield bonds, as reflected in the prices of the high-yield ETF HYG, confirmed the stock market’s fall to new lows, as the ETF also registered a new low on this down cycle.

With stocks recently rallying, high-yield bonds have also rallied. But notice that the rally has been much milder (not even exceeding the previous bottom, so far). This may be signaling further weakness in both stocks and high-yield bonds.

Gold

Gold continued its downturn under its 50-day moving average last week.

As has been the case all year, gold’s decline has been inextricably linked to the rising dollar. What little relief we got at last week’s end was based on speculation of a softening in the Fed’s aggressive rate policy, discussed above. When the market perception is that the Fed will stick to its guns, the dollar goes up and gold falls. When the perception reverses, the price action of both assets also reverses.

Gold could move up in price from here, at least until it reaches its 50-day moving average. This has been difficult for gold to cross, however. Similarly, the dollar is approaching its own 50-day measure, and that support has not substantially broken all year.

Flexible Plan Investments (FPI) is the subadvisor to the only U.S. gold mutual fund, The Gold Bullion Strategy Fund (QGLDX), designed at its introduction more than nine years ago to track the daily price changes in the precious metal.

The indicators

The short-term-trend indicators for stocks that we watch remain mixed but are turning more positive. Our very short-term-oriented QFC S&P Pattern Recognition strategy is 80% inverse to the S&P 500 Index.

Our QFC Political Seasonality Index (PSI) strategy has been fully invested for most of the October run-up in stock prices. It continues to be one of our top-performing strategies for 2022. At the close on October 24, however, it moved 100% into its defensive position, exiting stocks. It will remain defensively positioned until the close on October 31. The strategy is available separately and is included in our QFC Multi-Strategy Explore: Special Equities and QFC Fusion portfolios. (Our QFC Political Seasonality Index—with all of the 2022 daily signals—is available post-login in our Weekly Performance Report section under the Quantified Fund Credit category.)

The stock market embarks on the last 50 trading days of the year this week. Normally, that is a very bullish period. The average gain in the S&P has been 3.45%, with positive returns 79% of the time.

FPI’s intermediate-term tactical strategies are mixed. Classic is fully invested in its non-equity, defensive asset classes. The Volatility Adjusted NASDAQ (VAN) strategy is 40% inverse to the NASDAQ, the Systematic Advantage (SA) strategy is 60% in equities, and our QFC Self-Adjusting Trend Following (QSTF) strategy is positioned 100% inverse to the NASDAQ. VAN, SA, and QSTF can all employ leverage—hence the investment positions may at times be more than 100%.

At the beginning of May, our All-Terrain indicator, one of Flexible Plan’s Market Regime Indicators, registered a major change. Our Growth and Inflation measure began signaling that we were in a Stagflation economic environment stage (meaning a positive monthly change in the inflation rate and negative monthly GDP reading).

This could change with a positive GDP reading on Thursday (10/27). If so, we would move back to a Normal reading. The Normal stage (rising GDP and inflation) occurs about 60% of the time and is supportive of stocks, then gold, and then bonds. Gold has the greatest downside risk in this stage.

Our S&P 500 volatility regime is registering a High and Rising reading, which favors equity over gold and then bonds from an annualized return standpoint. The combination has occurred 23% of the time since 2003. It is a stage of higher downside volatility for stocks. The S&P 500 registered a maximum drawdown of over 49% during one of these regime stages, while gold’s maximum price loss has been over 30%.