Are the bears done? Wednesday's 2% surge left the Dow Jones Industrial Average 20% above its October lows, meeting the common definition of a bull market.
Many investors remain in no mood to celebrate, with all the major stock averages as well as bonds still showing significant losses year-to-date, cryptocurrencies imploding, and consumers feeling the effects of high inflation amid recession worries. Markets reflected that skepticism Thursday. The major indices ended the day little changed as investors awaited a sign from tomorrow's jobs report.
Sentiment among individual investors remains decidedly bearish, according to the AAII investor sentiment survey, ending November with market bears above 40% and bulls below 25%. That's a contrarian indicator that suggests more people might warm to stocks, providing additional fuel for the rally. Here are some more reasons stocks might end a rough year on a high note.
- U.S. and global stocks have mounted impressive rallies since mid-October.
- The Dow Jones Industrial Average ended November up 20% from its low.
- Investor sentiment remains bearish even after it's improved over the past month.
- Cooling U.S. inflation in October raised hopes rate hikes are close to done.
- The job market and corporate profits have remained historically strong.
- China has eased COVID restrictions while Europe is addressing its energy crisis.
Inflation Is Receding
Federal Reserve Chair Jerome Powell stressed in a speech Wednesday that inflation remains high, with the Fed's preferred inflation gauge, the personal consumption expenditures (PCE) price index, up 6% in the past year. Nonetheless, the index rose less than expected in October, according to data released Thursday, as did the consumer price index (CPI), an alternate measure of inflation.
In October, core PCE inflation excluding food and energy rose just 0.2% from the prior month, a sharp decline from the 0.5% gain on the same basis in September. It's just one month, as Powell noted, but string together 11 more such months and you end up with annual inflation of 2.4%, not much above the Fed's 2% long-term target.
Supply-side pressures are also easing. The past year's inflation coincided with pandemic supply disruptions that have largely dissipated, and the spike in U.S. gasoline prices after Russia's invasion of Ukraine has reversed as well.
Just as importantly, the past year's inflation took place amid significantly lower interest rates as the Fed raised its benchmark fed funds rate from near zero in March to nearly 4% now.
As a result, some leading indicators of future inflation, such as apartment rents and port unloading queues, have recently declined significantly. What remains to be seen is whether services inflation can also cool while the job market remains historically strong.
The Economy's Still Standing
The Fed's rate hikes have helped stall U.S. economic growth over the first nine months of the year, and the fourth quarter is expected to show only a modest improvement. And as Powell reiterated Wednesday, the full effects of prior rate hikes haven't propagated through the economy quite yet, providing a sustained near-term headwind.
Still, recent action in stocks reflects a measure of relief about the rate hikes' toll to date. The labor market remains historically tight, with Thursday's initial jobless claims data confirming employers remain reluctant to cut staff with so many vacancies still going unfilled. As long as low unemployment and above-trend wage gains hold up, it seems unlikely that consumer spending, which accounts for two-thirds of U.S. GDP, will slow meaningfully. October's downdraft in spending was primarily driven by lower-income consumers hardest hit by the rising cost of necessities. Recent declines in gas prices should help on that score, as would a lower inflation rate next year.
Business spending has also remained resilient. Large, publicly listed companies are still enjoying historically strong profit margins thanks to price hikes on their products. S&P 500 earnings were up 9.2% year-over-year in Q3, and while Q4 is now estimated down slightly year-over-year there's a good chance it ends up showing a gain, since 70% of S&P 500 companies beat estimates in Q3. Last year, a wider measure of corporate profits claimed its largest share of domestic income since 1929.
Small businesses and tech giants alike have already laid off workers, and more may follow suit. The moderate slowdown to date in technology spending may grow more severe. But with Powell signaling the fed funds rate will peak near 5%, that potentially leaves the Fed with just 50 basis points of hikes after December. And the longer the economy escapes a sustained downturn the higher the hopes the Fed will manage to engineer a historically elusive "soft landing."
Momo, FOMO, and Career Risk
The market rebound from its mid-October lows provides stocks with plenty of short-term momentum. While the Dow has led the way, the S&P 500 has reclaimed its 200-day moving average, a widely watched trend indicator that capped the index's August rebound. If the S&P can sustain and extend this week's breakout into late December, it could convince more market participants that the 2022 bear market has ended.
This shot of short-term momentum poses a dilemma for fund managers, many of whom have had a tough year. Losing money in a bear market is the sort of thing that can happen to anyone. Underperforming one's competitors because you didn't ride the year-end rally hard enough presents a more potent bonus and career risk. Retail investors might also catch the fear of missing out fever if market gains continue.
Global Storm Clouds Lifting
Among the key risks to the global economy and equities markets this year have been the sharp slowdowns in growth in Europe and China. European economies have been roiled by the spike in energy and electricity prices on the continent following Russia's invasion of Ukraine. China has seen its growth rate slow dramatically this year, as the Beijing government ordered protracted and widespread lockdowns to limit the spread of COVID-19.
Now there's new hope on both fronts. Europe has overcome its historical dependence on Russian natural gas and sought to limit electricity market disruptions. While the continent is still expected to suffer a recession next year, recent growth indicators suggest the downturn might not prove as severe as previously feared.
Meanwhile, China was seeking an exit strategy from its Zero-COVID policy even before the strict quarantines became the focus of widespread popular protests last week. In the wake of the demonstrations, those efforts appear to have gathered steam.
While European resilience and China's change of heart don't eliminate the risks from further rate hikes, recession, and continued Russian aggression, they limit the downside. They have also caused a historically strong dollar to lose some of its luster over the last month, reducing inflationary pressures abroad.
Developed foreign markets outperformed the S&P 500 index in November. In the U.S., industrial, materials, and financial stocks have led the recent market gains. These are not sectors one buys ahead of a recession.
Sentiment Remains Subdued
The new monthly edition of the Investopedia investor survey shows readers are slowly warming to stocks against a backdrop of elevated risk aversion. The same trend is evident among professional investors. A variety of surveys indicate most market participants remain skeptical that recent market gains will persist, providing plenty of room for stocks to rise more if that sentiment shifts.
The Bottom Line
None of the above can guarantee the bear market is history. The delayed effects of prior interest rate hikes remain the primary risk to continued growth. But the fundamentals underpinning consumer and business spending remain in place for now, while many investors continue to discount the recent rally. That's a plausible recipe for further stock market gains over the short term.