Just like that, the stock market’s good times are back. But investors have every reason to be deeply skeptical.
After weathering a miserable first half of the year, stock traders have become increasingly optimistic now that there are signs inflation may be peaking, and that the major recession some analysts have been predicting may not materialize.
Rapidly improving risk appetite has spread across virtually all sectors and segments, electrifying parts of the market that were among those most damaged in the downturn.
Big tech has staged an enormous reversal, with the Nasdaq Composite Index gaining 23 per cent over the past two months. Retail investors have scrambled back into growth stocks, which tend to be among the biggest casualties in a rising interest rate environment.
Even meme stock mania has come back to life, with Bed Bath & Beyond Inc. gaining roughly 180 per cent over the past few weeks, and AMC Entertainment Holdings Inc. rising by 75 per cent over the same time period.
At this point, many investors appear to be betting that the economy will remain strong enough to support corporate profits, but weak enough to tame inflation to a point where central bankers can back off of rate hikes.
“That something-for-everyone combination looks implausible,” CIBC chief economist Avery Shenfeld wrote in a note on Friday.
After a steady drumbeat of alarming consumer price data, the relief in financial markets was palpable this past week when the U.S. inflation result for July finally bucked the upward trend. After rising by 9.1 per cent in the 12 months leading up to the end of June, the year-over-year rise in the Consumer Price Index ticked down to 8.5 per cent last month.
Beyond that headline figure, there is little in the data to inspire a bullish market call. Much of the relief came from falling gasoline prices, which could head back up at any moment, for any number of reasons. Meanwhile, many measures of core inflation, which strips out volatile items such as food and energy, actually accelerated in July.
The combination of an improving global supply chain and falling commodity prices amounts to welcome relief to consumers on the goods side. But services make up roughly two-thirds of the CPI basket.
Martin Roberge, a portfolio strategist at Canaccord Genuity, wrote in a recent note that the main objective of the U.S. Federal Reserve is to tame inflation in services and wages, where price increases tend to be much stickier. As a result, the Fed and the Bank of Canada still have a long way to go before they have sufficiently cooled off the economy.
“As such, we expect a prolonged tightening and negative earnings revision cycle,” Mr. Roberge said.
That hardly seems like the makings of the next great bull market in stocks. It’s more likely that investors are witnessing a classic bear market rally – one of those periodic reprieves common in major stock market sell-offs.
“There’s nothing that’s going to test your convictions like a bear market rally that has some verve,” Sébastien Mc Mahon, chief strategist at iA Investment Management, said in an interview.
Some of the fastest and strongest market moves happen in the midst of broader corrections. During the market crash that followed the 1990s dot-com bubble, for example, the Nasdaq Composite Index saw three rallies of at least 40 per cent, none of which ended the bear market.
It can be tempting to buy into that kind of momentum, Mr. Mc Mahon said. Missing out on the early stages of a bull market can be costly. Already, the S&P/TSX Composite Index and the S&P 500 Index have recouped about half of the losses incurred through the first half of the year.
Often, the trap of a bear market rally will reveal itself through technical indicators – patterns of price and volume across individual stocks and broader segments of the market.
In a healthy uptrend, for example, one would expect to see sectors diverge from one another based on their specific prospects. But sectors such as technology, consumer discretionary and communications are still moving together quite closely, which is generally a sign of underlying stress.
“The technical factors you’d like to see to suggest this is a sustainable rally, we’re just not seeing them,” Mr. Mc Mahon said. “I think this is a bear market rally and we should retest the lows, and even go lower.”
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Tim Shufelt