It could be very difficult for Powell and the Fed to tame inflation without causing an economic slowdown.
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Like Winnie the Pooh in the Hundred Acre Wood, investors have lived with the naive worldview that everything will be all right. That kind of thinking can you get mauled in a bear market.
The Nasdaq Composite is already in a bear market, and the S&P 500 is likely to do the same, even if it hasn’t met the precise definition of a 20% drop just yet. The index, after all, has fallen 14% from its January all-time high after dropping 0.2% this past week, while nearly half of the stocks within it have declined at least 20%, as their valuations contract and their earnings decelerate.
It’s the kind of selloff that, in the past, would have sent investors shuffling into the market to buy their favorite stocks, knowing that no serious harm would come to them. But “now, any strength that transpires in equity markets is being used as an opportunity to sell, a clear sign that the path of least resistance remains to the downside, unless proven otherwise,” writes David Rosenberg, chief economist at Rosenberg Research.
Nowhere was that clearer than in the reaction to this past week’s Federal Open Market Committee meeting.
The Federal Reserve didn’t surprise anyone when it raised interest rates by a half-percentage point and announced the details of how it would wind down its balance sheet. And it didn’t get much reaction to the announcement, either. It was only when Fed Chairman Jerome Powell said that the central bank doesn’t plan to raise interest rates by three-quarters of a point that the market took off, with the S&P 500 finishing up 3%, its largest gain since May 18, 2020.
Even then, that felt a bit off. A half-point is still a half-point, and Powell’s comments about the “neutral rate”—neither low enough to boost the economy nor high enough to hurt it—being 2% to 3% seemed awfully low, given the current pace of inflation. Dennis DeBusschere, founder of 22V Research, observes that some macro investors put the neutral rate as high as 4%, and that most believe it will be very difficult to tame inflation without causing an economic slowdown, despite Powell’s goal of a “soft or softish landing.”
DeBusschere’s conclusion: “Nobody believes what Powell said Wednesday.”
That was clear on Thursday, when the stock market gave back those gains, and then some. It wasn’t all about investors reconsidering the central bank’s monetary-policy stance; though, with the 10-year Treasury bond’s yield rising back above 3%, that was probably part of the problem. So were economic data that showed worker productivity tumbling and unit labor costs soaring 11.6%, bad news for an economy struggling with high inflation.
Even Friday’s mixed payrolls data—the 428,000 jobs added beat economists’ consensus forecast of 396,000, but the labor-force participation rate refused to budge—was taken as a signal to sell both stocks and bonds. “The Fed has more work to do, and the market knows it,” writes Michael Darda, chief economist at MKM Partners.
In fact, it seems as if we’re now in an environment where good news is bad news, and bad news is bad news, which ultimately could turn into good news. That’s not as crazy as it sounds. Frank Gretz, technical analyst at Wellington Shields, notes that bear markets end when everyone who needs to sell has sold, and that happens only when investors have reason to sell. “Bad news induces selling, and getting the selling out of the way is how lows happen,” Gretz writes.
Sentiment also suggests that we’re getting closer to that point, says Lori Calvasina, head of U.S. equity strategy at RBC Capital Markets.
The American Association of Individual Investors sentiment survey had found the percentage of bullish respondents declining to just 16.4%, before bouncing to 26.9% for the week ended on May 4. But CFTC positioning data had still shown a lack of capitulation among pros. And the Cboe Volatility index, or VIX—the market’s fear gauge—though high at 30.19, is below its peaks of the past decade.
For Calvasina, that signals a market probably in the throes of a growth scare, like those of 2015 and 2018, but that still could have more downside, with the S&P perhaps falling to 3,850. “We think the data continue to paint a picture of extreme fear and a contrarian opportunity for longer-term investors, even though there is scope for further movement/more downside in the very near term on some gauges,” she adds.
Still, bear markets don’t end because we want them to. Usually, something happens to change sentiment, and four things could fit the bill, says Louis-Vincent Gave, CEO at Gavekal Research: The Fed gets dovish, oil prices collapse, the rallying dollar falls, or assets get so cheap they’re irresistible. “If such developments do not unfold, there are few reasons to think that this year’s trends…will change,” Gave writes.
Until they do, it’s better to be an Eeyore than a Pooh.
Write to Ben Levisohn at Ben.Levisohn@barrons.com
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