It Could Be The Start Of A Bull Market... Or Not

With the global economy holding up pretty well, and stocks moving like it’s 2021, the question on everyone’s lips seems to be: is this the start of a new bull market or is this just a tricky old bear market rally, destined to crumble? So let’s take a look at the bull market thesis and the bear market one – and I’ll tell you where I stand. Plus, I’ll give you some pointers on how to play this market with caution.

What’s the bull market thesis say?

Price action is strong

The S&P 500 recently blasted above its previous downward trend line and above its 200-day moving average (Russell wrote all about it here). That kind of decisive move didn’t happen in past bear markets, like 2001 and 2008. So that suggests this move could be the real deal. And if there’s one thing that investors don’t like, it’s missing out on the upside, so the recent rally could spark new demand and push prices higher.

Central banks are taking it easy (at least for now)

Central banks in the US, UK and Europe all hiked interest rates last week. But each one nodded to the fact that, with inflation now in retreat, those hiking cycles wouldn't go on much longer. That doesn’t mean upcoming data won’t influence what these central bankers do next, but as long as inflation keeps falling, the Fed might be able to focus again on the broader economy.

The economy’s holding up better than people feared

The global economy has remained surprisingly resilient to the Fed’s aggressive rate hikes. And now, with China’s reopening, a warmer winter in Europe (which has taken the sting out of the energy crisis), and a still-strong US consumer, the outlook for global growth has been brightening. Some people are even arguing that the slowdown is already behind us. If that’s the case, and if sales growth resumes and companies can preserve their margins over the next few quarters, earnings could even beat investors' expectations.

There’s still a lot of excess liquidity in the system

Financial conditions were already incredibly loose in 2020, but they reached levels never seen before during the pandemic crisis. (And that’s without taking into account the massive stimulus measures that governments adopted.) So, sure, the Fed’s been hiking rates, but not by enough to remove all the liquidity from the system. What’s more, with central banks now likely to stop tightening conditions, another wave of liquidity could push stocks higher.

What’s the bear market thesis say?

The pain (for the economy and earnings) may be yet to come

Interest rate hikes take time to filter through to the real economy, and their impact is felt across different sectors in a sort of sequence represented by the acronym “HOPE”. US housing (H) and new orders (O) have both collapsed, and companies’ profit (P) is showing new weakness. According to the framework (which I explained in detail here), profit will likely take a more significant hit next, followed by employment. With all the excess liquidity in the system and with the savings buffer people accumulated during Covid lockdowns, the sequence might be taking more time than usual to play out.

The Fed might not “save the day” here

Investors are betting that inflation will go back near the Fed’s 2% target, that growth won’t collapse, and that the Fed will cut interest rates. This combination is extremely unlikely. If the Fed lowers rates any time soon, it would probably be because of some kind of shattering blow to economic growth and employment, which wouldn’t be good news for stocks. And, to throw a little more cold water on this theory, if growth proves to be robust, then core inflation might make an unwelcome comeback and force the Fed to go back to hiking rates again.

Valuations are still pretty rich

New bull markets tend to be born when valuations are dirt cheap. Now, stocks are certainly less outrageously priced than they were a year ago, but they’re far from dirt cheap. With other asset classes like bonds now providing attractive yields, you could argue that valuations will need to be a lot less expensive to really draw a rally-driving crowd.

This is just a short-squeeze

Bear markets are notoriously difficult to trade because they’re punctuated by sharp, short-lived rallies that can reach high double-digit returns on occasion. They tend to start with a short-squeeze and rally in low-quality stocks – as has been the case so far. With positioning back to normal and investors now generally feeling greedy again, it’s going to take a real improvement in fundamentals to bring stocks higher. Any weakness in the rally, on the other hand, could quickly swing the momentum the other way.

What can you take from all that?

With so many crosscurrents out there, the range of possible outcomes is almost unprecedented. And that makes it truly difficult to have a strong conviction either way. Your best bet then is to keep an open mind and adjust your view if and when the facts change. It’s all about having strong opinions, weakly held, as the saying goes.

Personally, I remain cautious about stocks, even though the resilience of the economy and strong market price action have reduced my conviction that a hard-landing was inevitable. I think investors are still too optimistic about a soft-landing, no-recession scenario and are underestimating the risks of other possibilities, like a comeback in inflation that could force the Fed to hike rates again or a deeper-than-expected plunge in economic activity. Any hints toward those scenarios could lead to a sharp change in the market’s narrative and a repricing in stocks. Put more simply, I acknowledge the bull case, but the risks-rewards just don’t appear attractive to me at these levels.

What does all this mean for your portfolio?

Now’s not the time to bet the house on any one scenario. Don’t go all-in on stocks, but don’t go all-in shorting them either. Try to diversify your exposure across regions (China, Europe, and emerging markets look like interesting long-term bets right now), styles (consider growth stocks, sure, but also quality and value stocks), and across asset classes (adding some US Treasuries, gold, other commodities, and US dollars should bring balance to your portfolio).

With volatility back to more attractive, subdued levels, another interesting option for more advanced investors could be to use options to either participate in the rebound (via “calls”) or protect your downside (via “puts” or the 1:2 structure I explained here).

Last but not least, it’s probably still a good idea to hold some cash – particularly since you can park it at an attractive rate right now. With the macroeconomic picture still so uncertain, there are likely to be new opportunities ahead, and you’ll want to keep some powder dry for when it happens.

Stay safe out there.