The illusory appeal of bear market rallies

Bear market rallies do not come draped in a banner saying “this is a bear market rally, please disregard”. 

Instead, these head-fake moments of levity in otherwise gloomy stock market conditions are often hard to distinguish from the real thing.

Over the summer, some investors learnt the hard way (again) that this can be painful, when they grabbed the wrong end of the stick from comments by Federal Reserve chair Jay Powell and ran with it.

Global stocks jumped in July after the vaguest hint from Powell that the Fed might slow down its rate rises. Mix in some short-term funds folding on negative bets and suddenly we had a near 8 per cent rally in the MSCI Global index that started to look like a serious positive turn in the mood in a punishing, terrible, no-good year for money managers. It turned out to be a fleeting summer fling. The Fed had not had a change of heart after all, and the beatings will continue until morale improves.

Now, with a certain grim predictability (markets never rise or fall in a straight line after all) we have been through the motions all over again. Global stocks put in a pretty decent 7 per cent climb in October. But this time, it really felt like a halfhearted effort. Even those jumping aboard thought it was a bit daft.

Michael Wilson, chief US equity strategist at Morgan Stanley and one of the more prominent bears on the street, was one of them. Wilson is of the view that the S&P 500 will sink to 3,000 in the event of a recession, some 20 per cent below where we are now, as part of his “fire and ice” theme. (First, the fire of soaring bond yields knocks the speculative fervour out of stocks, then bad corporate earnings in a souring economy provide the ice.)

“Two weeks ago we turned tactically bullish on US equities,” he wrote. “Some investors felt this call came out of left field given our well-established bearish view.” But, he said, this was mostly a tactical move “based almost entirely on technicals rather than fundamentals, which remain unsupportive of many equity prices”. 

The rationale: “oddities” in chart patterns were “too much to ignore” — those who believe in the predictive power of long-term moving average prices and the like had a real treat in mid-October; bearishness had become too much of a consensus trade; and “the seeds have been sown for a sharp fall” in inflation next year. “We realise that going against one’s core view in the short term can be dangerous, and maybe wrong-headed, but that’s part of our job,” he said.

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He’s right. If you can’t beat them, join them, temporarily at least. Trevor Greetham, head of multi-asset at Royal London Asset Management, also hopped along for the ride in stocks, but doesn’t expect to stay there. He says he unwound his negative bets on stocks and ended up, unusually, “slightly long” of the asset class. But he rather drily adds: “I expect to go underweight again.”

So what drove the ascent? The answer is somewhat depressing, given the adage that the definition of insanity is doing the same thing over and over again and expecting different results. It appears to have been expectations for a much-vaunted so-called pivot from the Fed, in which it cools, abandons or outright reverses its tough-love rate rises. The hunt for the pivot has been this year’s equivalent to the hunt for Big Foot. Every time pundits think they’ve found the elusive beast, it turns out to be a central banker in a suit saying “but the inflation”. 

In fairness, some of the smaller central banks have wobbled slightly of late. The Bank of Canada, for instance, plumped for a surprisingly small half-point interest rate rise at the end of October. This helped to stir speculation that the Fed might also show restraint, particularly while economists and asset managers fret over where the next big market accident might come from in this new tight-money era, after the spectacular UK meltdown in late September.

Again with grim predictability, the Fed on Wednesday spoiled the party. It raised its benchmark interest rate by 0.75 percentage points again, as expected, and Powell did suggest further rate rises might be smaller. But he also pulled the step ladder from under climbing stocks by saying rates would probably end up at a higher place at the end of this process than previously thought.

In any case, those hoping that the lesser-spotted pivot could be the magic trick to turn stocks higher could easily end up disappointed. Yes, rising rates and rising bond yields have hurt stocks. A lot. But if rates fall to reflect a recession, does that necessarily mean stocks recover?

In addition, there’s the small matter of still surging inflation. “We’re not there yet,” said Alexandra Morris, chief investment officer at Norway’s Skagen Funds. “We don’t have a solid footing, and we’re not going to have one until we have some tangible evidence of inflation coming down. Powell is not going to stop.”

Asset managers have a huge amount of financial firepower stashed away in cash that they are itching to deploy. That means when the real recovery does start, it will be dramatic and lasting. October appears to have provided yet another mirage. It is worth exercising extreme caution next time around too.

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