US Strategy Weekly: Liquidity Crisis

Looking for a 90% Up Day

There are several extremes appearing in technical data that suggest this bear market is nearing, or already in its final phase. However, few bear market lows are quick or V-shaped. This is particularly true when the low precedes, or is accompanied by, a recession. And we think this one is. Most bear market troughs resemble a checkmark or a W-shape and take weeks or months to complete. In short, we believe it is much too late to be bearish, but we would not be too hasty to re-enter the equity market.

Although the equity market has declined to a level that could generate a short-covering rally, we believe the resistance at SPX 4100 may be a formidable hurdle. This can be seen in the charts of the indices on page 8. The late May rally encountered resistance at the 50-day moving averages in each of the popular indices. And though the last two weeks have generated a number of downside gaps that are likely to be filled in the near future, the 50-day moving average, now at SPX 4102.46, could prove to be a hurdle once again.

And as we noted last week, it would be prudent to wait for a solid 90% up-volume day accompanied by volume that is well above average, before adding to portfolios. Strong volume and at least a 10 to one positive breadth day would be a pivotal sign that panic selling is exhausted and that buyers have come back to the marketplace with conviction. This is particularly important since recent trading sessions have included worrisome signs of a liquidity crisis.

Liquidity Crisis – The Source

The liquidity crisis is not equity-centric and may stem from the volatility seen in the cryptocurrency market. Bitcoin (BTC – $20,825.00), the bellwether of the cryptocurrency market, has seen a 75% decline from its high. The world’s most-traded cryptocurrency, fell from nearly $69,000 last year, to $17,776.75 over the weekend, which led to forced liquidations of many large leveraged bets. Some crypto analysts have been worried about a complete capitulation of the market, particularly after Celsius Network, a private company, and a popular cryptocurrency lender, froze customers’ accounts last week leaving its customers unable to withdraw or transfer funds.

More than $2 trillion has been wiped from the crypto market since its peak last November, according to Yahoo News, and since money is fungible, losses of this size often create a liquidity crisis in the broader securities markets. What is noteworthy is that a liquidity crisis is not unusual at the end of a bear market, and in fact, is another sign that we may be nearing the finale of this cycle. Nevertheless, a liquidity crisis can be vicious. It is completely disconnected from economics, fundamentals, and technicals, and is simply a massive de-leveraging wave.

Again, there are reasons to be optimistic for the second half of the year, but this is still a dangerous time, and it is wise to be cautious.

Recession Talk

In our opinion, it is good news that market watchers have become obsessed with the prospects of a recession. Some economists even agree with me that we may already be in the middle of a recession. This is another ingredient that has been missing for a washed-out market. On the other hand, we have yet to see earnings forecasts come down. That may be the last and final phase of this bear cycle. But analysts tend to be trend followers and rarely identify turning points, so cuts in earnings estimates may not appear until the third quarter.

Similarly, there is good news in investor sentiment indicators. Last week’s AAII readings of 19.4% bulls and 58.3% bears were the third week in which a combination of less than 20% bulls and more than 50% bears has appeared since April 27, 2022. Prior to this string, there were comparable single-week readings on April 11, 2013, and January 10, 2008; however, neither of these readings coincided with a market low. The 4-week AAII bullish reading of 19% on April 27 was the lowest since 1990 and the bearish 52.9% reading of May 18 was the highest since the March 5, 2009 peak of 70.3%. These are some of the most extreme readings seen in years and according to AAII, equity prices tend to be higher in the next six and/or twelve months following such a combination. See page 11.

Recession Watch

Inflation is an insidious problem that eats into household consumption and also erodes corporate profit margins. For example, the charts on page 3 display the difference between nominal and real retail sales. May’s retail sales were disappointing but still rose 8.1% YOY. However, after adjusting for inflation, real retail sales fell 0.4% YOY. Year-over-year real retail sales have been negative for three consecutive months, which suggests that second quarter profits for many retailers may decline from first quarter’s weak results. The weakness in May sales was centered in autos, appliances, and nonretail stores. Gains were seen in necessities such as gas and food. For the month of May, sales from food and beverage stores, food service and drinking places, and gasoline stations totaled 34% of total retail sales. This was actually less than we expected but remember that retail sales measures merchandise and does not include necessities such as housing and healthcare expenses. See pages 3-4.

The NAHB Housing index has been declining every month this year and in May it hit its lowest level since the pandemic shutdown in early 2020. Existing median home prices, however, reached a cyclical high of $414,200, up 15% YOY. Unfortunately, with prices and mortgage rates rising rapidly, this means many prospective buyers will be priced out of the market. Note that in May single-family existing home sales were down 8.6% YOY. This decline may steepen in coming months which is unfortunate since the housing sector typically represents 15% to 18% of US GDP. See page 5.

Rates for a typical 30-year mortgage, which were hovering just above 3.1% at the beginning of the year, are now close to 6%. And rates are apt to go higher as the Fed continues to raise the fed funds rate. Investors are focusing on the Fed’s “terminal” fed funds rate which the consensus expects to be near 4%. But, with inflation currently at 8.6%, this still equates to a negative (i.e., easy) fed funds rate, which means the Fed may need to lift rates even higher than 4% to really curtail inflation. See page 6. When we look at the history of inflation and the fed funds rate it becomes clear that whenever inflation reaches 4% YOY, a recession has always followed. More importantly, history shows that it often takes more than one tightening cycle and more than one recession to truly reverse an inflation cycle once headline CPI exceeds the 4% YOY level. See page 6. In short, we may not see a buy-and-hold cycle in equities for a very long time.

Gail Dudack

Click to Download