Tangled Up In Capitulation   

I lived with them on Montagüe Street
In a basement down the stairs
There was music in the cafés at night
And revolution in the air

–Bob Dylan, “Tangled Up In Blue”

Stocks have witnessed a very robust comeback over the past week, and almost under the radar, the Nasdaq Composite has climbed more than 10% over the past month. The S&P 500 and Dow Industrials also have done well, up some 8% and 6.8%, respectively, in the past month. 

So, why the recent rebound in stocks? After all, the Federal Reserve is still hiking interest rates, inflation is still at a four-decade-plus high and the economic data on growth is beginning to show its recessionary colors.

Well, one reason why is that market sentiment is just much too bearish right now, and we know that because some of the best market sentiment indicators are all tangled up in capitulation. 

In this morning’s Eagle Eye Opener, my “secret market insider” astutely pointed out that capitulation, or what he calls “extreme pessimism,” is rampant among investors right now, and that this is traditionally a contrarian signal that predates a big rebound in markets. 

Let’s take a look at an excerpt from this morning’s Eagle Eye Opener, as it will do all of the explanatory heavy lifting…

The S&P 500 closed above the 50-day moving average for the first time since April and traded to a three-week high, as the rally from the June lows continues to gain steam. This is easily the most bullish price action we’ve seen from stocks since March.  

Importantly, there are “reasons” for the rally. Markets have firmly seized onto the hope that we are close to 1) Peak inflation, 2) Peak Fed hawkishness and, as a result of the first two, 3) Peak U.S. dollar strength (which should ease pressure on earnings if the dollar decline continues).  

The “hope” for these peaks is founded on the following: 1) Commodity price declines, 2) The University of Michigan Consumer Sentiment survey falling back below 3.0% for the first time in months, and 3) A drop in the price indices in the Empire Manufacturing survey.  

Notably, this hope flies in the face of what is typically more important data points such as the Consumer Price Index (CPI) (40-plus-year high), the Producer Price Index (PPI) (11% gains yoy and climbing), and massive recession risks in Europe and the United Kingdom courtesy of surging energy prices, following the Ukraine war (which would further weigh on the euro).

Point being, while I very much appreciate that markets are always forward looking and are constantly pricing in “what’s next,” normally there’s a bit more actual evidence underwriting market optimism. Put differently, hope combined with some favorable motion from some second-tier data points isn’t usually enough to cause a solid rally (or at least the most solid one we’ve seen in a few months).  

But there is one ingredient that’s helping to fuel this rally despite the lack of actual fundamental progress: Extreme pessimism.

Yesterday, Bank of America released its monthly fund manager survey, and their conclusion was clear: Investors are so bearish it implies capitulation. Some highlights (or low lights) of the survey include:

• Recession expectations the highest since the pandemic, and before that the 2008 financial crisis
• Stock allocations are at their lowest since 2008
• Cash is at its highest since 2001
• Growth and profit expectations are at all-time lows
• The most risk-averse behavior is occurring since October 2008

This extreme pessimism has combined with the hope of the aforementioned peaks to spark the best rally we’ve seen in months — and it raises the question as to whether markets have become so pessimistic that perhaps it will lead to a bottom before we get actual, real improvement in fundamentals (remember inflation keeps getting worse every month, as do Fed hiking expectations and earnings warnings — we haven’t seen an actual “low” in any of them yet).

Certainly, that’s a possibility. But before anyone focuses on the fact that sentiment is so low, I’ll provide this reminder:

• The S&P 500 kept falling until March 2009  
• Levels cited in the Bank of America survey implied capitulation was all in 2008
• The S&P 500 fell from 1,161 on October 1, 2008, to 676 on March 9, 2009  

The point here is that sentiment bottomed out in these indicators in late 2008 because the Fed passed Trouble Asset Relief Program (TARP) and was coming to the rescue, but that didn’t stop the economic or earnings destruction already underway.

Right now, no one is coming to the rescue. The Fed is about to hike rates again by 75-100 basis points and there’s another hike after that is coming in September (and probably more after that).

Markets are rallying on the hope that a big inflection point with the Fed is looking likely in the coming months, but there’s no real proof it’s actually going to happen in the coming months!

To be clear, I’m not a perma-bear and I’m not trying to pooh-pooh the best price action we’ve seen in months. I enjoy watching my personal account on days like yesterday a lot more than most days of late, and I very much hope a bottom is in. Moreover, I very much hope I’m wrong being skeptical.  

I do want to continually point out that, from an economic and earnings standpoint, we have not even really started to feel the impact of the soon-to-be, 200-plus basis points of tightening that’s occurred since March. For reference, over the past two decades it’s taken the Fed years to raise fed funds 200 basis points. This time they’ll do it in essentially 4 1/2 months, and that will combine with quantitative tightening hitting full speed at the end of the summer.  

While I hope markets have bottomed, and I hope extreme pessimism can result in capitulation, it’s my job to point out the underlying factors behind market moves, and the bottom line is neither the economy nor corporate earnings have felt the full brunt of Fed tightening.

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So, there you have it, an outstanding explanation of not only why this market’s extreme pessimism might lead to more buying ahead, but also a tempered analysis of the factors that may prevent this latest buying trend from continuing in the near future. 

If you’d like to get analysis like this every trading day, before the market opens, then I invite you to check out the Eagle Eye Opener, today. For just a few dollars a week, you’ll be equipped with the same analysis that Wall Street pros use to make key market decisions. And after reading it, you’ll really know what’s making this market go. 

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A Little Something on Choice

“Today, I choose life. Every morning when I wake up I can choose joy, happiness, negativity, pain… To feel the freedom that comes from being able to continue to make mistakes and choices — today I choose to feel life, not to deny my humanity but embrace it.”

–Kevyn Aucoin

In every moment you have a choice. The choice is to recognize that moment and embrace it, or to let it overwhelm you and control your thoughts and therefore your emotions. Well, today I choose to feel life, and to embrace my humanity — and it’s something that I recommend you do every moment. 

Wisdom about money, investing and life can be found anywhere. If you have a good quote that you’d like me to share with your fellow readers, send it to me, along with any comments, questions and suggestions you have about my newsletters, seminars or anything else. Click here to ask Jim.