Stock market rebound proves the skeptics — including the 'Mystery Broker' — wrong

Published Sat, Oct 16 20219:20 AM EDT

The stock market answered the skeptics last week along a few fronts, first demonstrating traction by refusing to revisit its early-October low and then accelerating higher to break a six-week downtrend and retake some meaningful technical levels. After weeks facing down loud and persistent threats – stubborn inflation, rising yields, an energy shock, supply-chain chaos, legislative lethargy, a Fed eager to taper bond buying, flattening earnings projections and a potential Apple iPhone supply cut – the tape ran out of reasons to keep going down, at least for now, with the S & P 500 gaining nearly 2% for the week and closing to within 2% of the old record high. It's far from guaranteed that stocks will now decisively resume the relentless rally that preceded the Sept. 2 top, naturally. But for those of us who have been viewing the recent unsettled market as likely a routine shakeout to reset expectations and valuations, a kind of stress test that the bull market seemed to be passing , last week fit those premises reasonably well. The majority of stocks underwent double-digit corrections even as the S & P never sank more than 6%, cyclical sectors held their ground, credit markets never really flinched, bank stocks managed to rally on impressive earnings reports and investor pessimism had welled up on cue to offer a contrarian bullish message. Assessing Thursday's sharp climb in the market that pushed the S & P 500 back above its 50-day average, Renaissance Macro Research technical strategist Jeff de Graaf says strong but not overwhelming positive market breadth and volume made it "a good day, strong enough to kick off the seasonal rally, but not a game changer." Mystery Broker update One skeptic who was persuaded by the market action to turn more favorably toward stocks last week was the veteran financial advisor and longtime source known as the Mystery Broker. (His background and the history of his market calls can be found in this column from July .) In an update sent late Thursday night, after the S & P 500 had staged its best one-day rally in seven months, Mystery Broker backed off his call – first made in late April – that the index was headed for a deeper correction of at least 10%. He's now looking for a more typical fourth-quarter advance, perhaps deferring a real correction into early 2022. He caught the entire 90% S & P surge from the March 2020 low into this past April, calling it a new bull market and believing equities would quickly discount a peak in the Covid crisis and reopening of the economy. Yet he believed by April that overheated speculation into the first quarter in expensive and aggressive growth stocks, over-reliance on mega-cap Nasdaq names and vulnerability in leadership groups such as semiconductors would drive a broad retrenchment to correct valuation excesses and refresh the bull market. He missed about a 6% gain point to point, though at the Sept. 2 high the market was up 8% from when he turned cautious and two Monday's ago, at the recent low, the index was barely 2% above that level. Observing the recent pullback phase, he noted that the market had faced "multiple punches since early September, but few punches actually landed." Resilience against the litany of threats detailed above, a near-textbook technical bottoming effort, the start of a seasonally strong period that rarely fails to deliver when stocks are already up a lot for a year and a good flush in investor sentiment all feed into his call. He continues to prefer cyclical and financial stocks, as he has all year, and thinks big companies are far along in navigating supply obstacles and pushing through price increases. What's left to bear case? With seasoned market participants shifting from defense to offense based on the recent tenacity of the market in resisting would-be downside catalysts, it's worth asking where the bear case for stocks now lies. The most immediate focus of those looking for downside is probably the same cluster of issues in the air for months, only in more extreme form: The inflation, labor-shortage, supply-chain, energy-shock themes that persist and disrupt corporate profitability, force the Fed to tighten more quickly and drive a more disorderly rise in bond yields. It's probably no accident that last week's nice market bounce fed off a moderation in longer-term Treasury yields that were comfortable both to value and growth stocks, even as two-year yields shot to 17-month highs to price in a late-2022 Fed rate hike or two. Morgan Stanley strategist Mike Wilson has been warning of some version of this, a jagged mid-cycle adjustment period in which the S & P ultimately sheds between 10% and 20%: "The Fed tightens policy due to rising inflationary pressures and a hot labor market, rates rise and valuations compress 10-15%. The S & P 500 goes down by ~10% as earnings offset some of the multiple compression." The 20%-setback scenario is the same set of circumstances only combined with a sharp slowdown in U.S. growth. Wilson invokes the mid-cycle lulls in 1994 and 2004 as precedents for such a sequence. And slower growth along with a Fed seen as rigid in sticking with a tightening plan were also the combination that accompanied the 2015 and 2018 fourth-quarter market drops, two rare years when late-year strength was absent. All fair, though again income growth plus low household and corporate debt burdens are pretty good buffers against anything nasty in the economy, while history says the first rate hike in a cycle is typically seen as appropriate and rarely accompanies a major stock-market peak. For sure, inflation is unsettling consumers, as Friday's University of Michigan Consumer Sentiment report showed, with another weak headline reading near 2011 levels (a year with a near-20% market drop) and swelling concern over inflation. Still, household income growth has been so strong it's more than preserved spending power, retail sales last month were far stronger than expected and survey-based inflation projections aren't particularly prescient. For sure, it would seem that heading into 2022, there is some risk that analysts are expecting too much of companies' ability to defend and even expand profit margins. Bernstein Research showed S & P 500 margins projected to expand from already-record levels. Bears might also quibble with the idea that the rally last week was technically pristine and reflective of fresh real-money commitments to stocks. The market also had a comparable ferocious rebound last fall after an initial correction before rolling over again into the end of October. The S & P's climb Friday stopped just short of its mid-September high, and there are some hints that the once-unwavering retail-trader bid in stocks has faltered a bit over the past couple of months. Not exactly a damning indictment of a generally encouraging market bounce in an economy showing signs of reaccelerating. It remains a bull market and isn't particularly close to losing that status. Yet it never hurts to acknowledge two-way risk in an stock market whose gears have slipped a bit lately in a spring-loaded, fast-evolving economic cycle that has opened up a wider set of possible outcomes than we got used to over the prior decade.