Another bear market rally started last week and stocks gained 6%.
The rally started for a few reasons:
1. The markets were oversold and investors pessimistic.
2. Quarter-end rebalancing flows by US pension funds.
3. Good news about inflation. The University of Michigan’s gauge of inflation expectations dropped to 3.1%, and commodity prices fell.
The third reason is particularly important because high inflation has been a principal reason for the poor performance of the markets this year. If inflation falls, central banks can become less aggressive, bond yields can fall, and stocks can rise.
We would ignore this rally if it was simply based on flows, sentiment and technicals. Since it has the fundamental story about falling inflation behind it, though, it could run a little longer. As a result, we decided to increase the allocation of the portfolio to stocks last week.
This increased allocation is only a tactical position. Macro momentum remains negative whether you look at retail sales, the housing market, consumer confidence, or durable goods orders. The Conference Board LEI, which aggregates a number of these leading indicators into one score, has turned negative on a 6-month rate of change basis. This has frequently preceded recessions in the past.
Due to the negative macro momentum, our base case is that the current rally will end in July, the bear market will resume in August, and the market will only be able to bottom durably in Q1-Q2 2023. No opinion should be held too strongly, however, so investors should remain alert for further good news about inflation, which would lower bond yields, improve the housing market and consumer confidence, and perhaps even allow the economy to avoid recession (though that is a long shot).
𝟮𝟬𝟮𝟮 𝗽𝗲𝗿𝗳𝗼𝗿𝗺𝗮𝗻𝗰𝗲 𝗬𝗧𝗗
To try to benefit from the rally, new positions have been opened in the Utilities $XLU sector. $SRE (Sempra Energy), $D (Dominion Energy Inc), $FE (FirstEnergy Corp), $EVRG (Evergy Inc) and $VST (Vistra Corp) are from the US and $NG.L (National Grid) is from the UK. The portfolio also contains one new Financial, $ALLY (Ally Financial Inc) . We are cautious on the Financials sector in general because of the negative macro momentum, but $ALLY is oversold and according to the Fed’s recent stress test would survive a severe recession without issues.
Overall, the portfolio has a non-cyclical, defensive bias, which we expect to maintain until we see evidence that the economy has turned a corner.