By Cory McPherson | January 2022
The stock market has not gotten off to the start in 2022 that many anticipated. After such a smooth ride in 2021, with any dip in the market being bought, no dip has been bought yet to start 2022. So far, the S&P 500 index is down 7.73% to start the year, as of the close on 1/21. A market correction is considered to be down 10% or more from its recent high. In 2021, we saw zero days with the market in correction, and are fast approaching one to start 2022.
It seems many of the risks we saw in 2021, especially in the second half, are starting to be realized and possibly priced in. Leading the fall has been the growth areas of the market, mostly in the technology sector. We started seeing rotation at the end of 2021, with more defensive areas of the market seeing accumulation while the growth areas that had led since March of 2020 were starting to decline. We did begin building a cash buffer in most of our portfolios at the end of 2021 and to start this year because of what we were seeing underneath the market.
We had some of our indicators that we follow turn negative over the weekend and are following those indicators by reducing risk in our portfolios. We now have multiple short-term indicators negative, and an intermediate-term indicator now negative. Our long-term indicator that we follow remains positive but has weakened substantially over the last few months and we continue to watch it closely. The short-term indicators can move quickly, and if we see the market bounce then they could spend a short amount of time negative. A counter-trend rally from here is a possibility with some of the oversold conditions we’re seeing. But the question would be if any rally would have the legs to get the market out of its downtrend that started at the beginning of the year and get it back on track. If not, then the market would continue to be under pressure, and any rally would eventually be sold. On Monday, 1/24, the market went for a wild ride. The Nasdaq index at one point during the day was down over 4% yet finished with a positive gain. The S&P 500 index also was down substantially during the day, but was able to rally and finish the day positive. This is typical of times of high volatility, and we could continue to see wild intra-day swings in the market.
Another troubling sign to us is the S&P 500 index falling below the 200-day moving average. After not being tested at all in 2021, it was breached on Friday, 1/21. The chart below shows the 200-day moving average with the red line. You can see, even with the rally seen on Monday, 1/24, it remains below the red line. We want to see it rally back above that line and stay above it with any test.
The question becomes are we entering a bear market or is this just a simple correction taking place. With our indicators starting to flip negative, we’ve been proactive and reducing risk but not completely giving up on the market either. We’re prepared for any possibility depending on what our signals tell us and what the charts say. We believe investor sentiment would need to be reset if we do enter a bear market, before seeing a real bottom. We’ve all seen signs of excess in the stock market since it began its recovery from the COVID crash of March 2020. Many folks in the market now have only been investing since that time, and have never experienced a real correction, let alone a real bear market. Market bottoms typically don’t happen until bearish sentiment peaks, and that isn’t something that happens overnight and would take time. We aren’t calling for a bear market, are just prepared for one.
Risks Piling Up
Many of the risks we’ve outlined recently are still present, and it seems more could be on the horizon. The biggest risk we felt going into this year was with the Federal Reserve, and their plan to tighten policy and begin raising their benchmark interest rate. That’s been the biggest factor to the rotation we’ve seen out of high growth areas of the market, especially in smaller sized technology companies that have relied on ultra-low interest rates and easy monetary policy.
With Fed meetings this week, we’ll see if they give any indication on plans for interest rate increases and ending their quantitative easing program. While the Fed is not supposed to be worried about what the stock market does day to day, we’ll see if the recent volatility and drop in the market causes the Fed to rethink their plans for 2022. It is believed by many that the Fed will hike interest rates 4 times this year. Jamie Dimon, CEO of JPMorgan Chase, made a prediction of even “six or seven” rate hikes this year. It could be hard for the Fed to even get to 4 though if the market remains under stress and growth in the economy slows. A pivot by the Fed in 2022, similar to Q4 2018, remains a possibility. It depends on how aggressive they become to try and tame inflation. High inflation obviously continues to be a risk, and how it affects Fed policy. For much of 2021, the stock market ignored inflation concerns, even as the CPI increased at levels not seen since the 1980’s. We could also see political pressure on the Fed mount with mid term elections happening later this year and affect some of the decision making.
One risk many weren’t seeing in 2021 was the risk of a recession in the economy. While the chances of a recession this year may be low, parts of the market seem to be getting worried. The bond market for a while has been flashing a warning signal, as long-term rates on the U.S. Treasury yield curve have not risen as much as short-term rates. With that you are beginning to see the yield curve flatten, meaning you aren’t getting paid a much higher percentage of interest to hold a Treasury bond for a longer time period (more risk) compared to a shorter time period. Typically, you’ll see the yield curve flatten and even invert months before a recession in the economy begins. It seems the bond market is worried about a Fed policy error, of hiking interest rates into a slowing economy. We’ve also seen small cap stocks begin to enter bear market territory this year. Small caps are typically much more sensitive to economic conditions and are also being affected by rising interest rates.
While all the economic concerns for the market are rising, there are also geopolitical concerns rising at the same time. It seems relations with both Russia and China are at extreme lows. Russia could invade Ukraine at any moment. It will be interesting to see if China takes any action in regard to Taiwan after the 2022 Olympics. Throw in problems with Iran, and it doesn’t seem like the world is on very good footing. If any of these issues turn into a military conflict, it could have a drastic effect on the markets.
With the start to 2022 almost 1 month in, it’s become clear this year won’t be like the previous one. We continue to let our indicators and the charts guide our decision making. We’ve become much more cautious with what we’re seeing, but will be ready to deploy cash and reposition portfolios as indicators change. Risks affecting the market continue to rise, and we’ll see if the market can eventually get back to climbing that wall of worry.