What underpins the current bear market rally?

The weaker-than-expected print in the October US Consumer Price Inflation (CPI) data, which came in at 7.7% (not seasonally adjusted) versus an expected 8.1% in early November, prompted a strong rally in US and global equity markets amid positive sentiment.

Since then, a plethora of US Federal Reserve (Fed) governors such as Christopher Waller warned investors against getting too optimistic over one inflation report and pointed out that the Fed needs to see whether the recent decline in US inflation is indeed the beginning of a downward trend and, if so, how it is going to adjust its monetary policy accordingly.

Waller also said that the US Federal Reserve “still got ways to go” with interest rate hikes whilst acknowledging that the Fed may slow the pace of rate increases in the coming meetings.

The market is currently pricing in a 50-basis point rate hike on 14 December, followed by successive 25 bps hikes early next year.

Can the US equity bear market rally last until year end? What about 2023?

With the upcoming long Thanksgiving weekend in the US, trading volumes are likely to diminish which could lead to another spike in volatility being seen late this week or early next week.

If US equity indices were to gradually slide further in the course of this week and continue to do so with relatively low volatility, such as was the case for most of last week, another high volatility move to the upside might lead to the traditional Christmas rally taking place earlier than usual.

Such a move would catch most investors off guard since sentiment is beginning to look less positive amid resurging Covid-19 infections in China and several areas imposing curfews to control outbreaks, once again stifling that country’s economy.

Historically speaking equity markets tend to rally at some stage during the month of December, however, helped by US 401k retirement plan inflows into equities towards the end of the year.

S&P 500

The S&P 500, for example, has so far risen to 4,042, close to the 200-day simple moving average (SMA) at 4,053, before it slid to last week’s low at 3,904.

Should this level be slipped through, the early October low at 3,807 may be revisited over the course of the next couple of weeks. Provided that the next lower early November low at 3,696 isn’t being slipped through, though, the October bear market rally uptrend remains intact. This is because a series of higher highs and higher lows on the daily chart would in this case still be seen.

A, by most market participants currently unexpected, rally above last week’s 4,042 high would push the mid-September high at 4,155 to the fore, around 5% higher than where the index is currently trading.

In this scenario the late May and August highs at 4,203 to 4,215 and perhaps even the August peak at 4,325, close to 10% above current levels around 3,950, may be reached in the first quarter of 2023 before the bear market re-asserts itself and possibly takes the S&P 500 to below this year’s lows at 3,491 to the February 2020 pre-pandemic high at 3,397.

Dow Jones Industrial Average

If a similar scenario were to play out for the Dow Jones Industrial Average (Dow) it may first of all slide in the upcoming days, especially since its recent high at 34,010 has been accompanied by negative divergence on the daily Relative Strength Index (RSI), and perhaps reach the 200-day simple moving average (SMA) at 32,420.

As long as the next lower early November low at 31,711 doesn’t give way, however, the October-to-November uptrend remains intact and thus the possibility of the current November high at 34,010 being bettered in early 2023.

In this case the August peak at 34,285 is also likely to be exceeded with the 35,000 region being reached before the index is expected to drop once more on a probably worsening economic outlook in the next quarter. During 2023 the Dow may then drop as far as the 50% retracement of the entire pandemic bull market at 27,580.

Nasdaq 100

For the Nasdaq 100 the technical picture looks less rosy than for its peers in that US technology stocks have taken a beating this year with the index having recently failed ever so slightly above its 11,918 to 12,069 resistance area, consisting of the early September low and 21 September high, and at present trading at close to -30% year-to-date, versus -17% for the S&P 500 and less than -8% for the Dow Jones Industrial Average (as of 21/11/2022).

A slide towards the 55-day simple moving average (SMA) at 11,459 seems to currently be at hand and perhaps the index will slip all the way back towards the early October 11,039 low before recovering into year end.

Provided that the Nasdaq 100 remains above its key 10,603 to 10,433 October and current November lows, an eventual rise to above last week’s high at 12,084 may still ensue by the first quarter of 2023. If so, the mid-September high at 12,902 would be in the picture, together with the June peak at 12,942.

Once the current bear market rally has run its course, however, and a fall through this year’s low at 10,433 has occurred, probably in early 2023, the pre-pandemic February 2020 high at 9,752 may be back in the frame.

Why the current bear market rally is likely to run out of steam in early 2023?

The Fed’s commitment to reduce US inflation back to its (2%) target, something which in the past has taken on average around five years, highlights the risk of a significant contraction in the US economy being seen in early 2023 which would most likely have a detrimental effect on earnings and drive down equity prices once more, probably to below this year’s lows.

Furthermore, stock allocation at the recent equity indices lows in October were relatively high at over 60% and cash allocations relatively low at below 25% when compared to previous bear market lows when the former was closer to the 40% mark and the latter, cash allocation, shot up as high as 40% in investment portfolios, the exception being the rapid Covid crash with an around 55% stock allocation.

The data suggest that we haven’t seen any capitulation in US equities yet. Since some kind of capitulation or extremely negative market sentiment usually accompanies bear market bottoms, it is likely that the recent rally in equities is exactly that, a strong rally in a long-term bear market and not the beginning of a bull market.

With the majority of major economies around the world either being close to or technically in a recession, another rout in stock market performance is thus likely to ensue next year, especially if earnings begin to disappoint.

Having said that, this doesn’t exclude another 5%-to-10% rally in US stock indices (from current levels) being seen by the end of the first quarter of 2023 before the bulk of the probable 2022 to 2023 bear market rears its head.