"Certainly a Possibility." 

 

Those were the words of Federal Reserve Chairman Jerome Powell during testimony to the U.S. Senate banking Committee on Wednesday, June 22. Investors took his warning in stride, instead of plummeting. That may indicate markets are ready for another relief rally.

 

Powell thought the U.S. economy was strong enough to roll with the Fed's punches of higher interest rates, and a shrinking balance sheet without too much trouble. It was the outside factors — the Ukrainian war, China's COVID-19 policy, and supply chain problems — that complicate the outlook. Avoiding the "R" word was largely out of the Fed's control, he said, "it's not our intended outcome at all, but it's certainly a possibility."

 

Granted, it wasn't as if fears of a recession were a new concept among investors. For the past few weeks, as the Fed made clear they were pursuing an even more aggressive series of interest rate hikes to combat inflation, investors began to worry that the Fed's action might tip the economy into recession.

 

This fear has weighed heavily on stocks in various hot sectors like energy and materials, which have fallen considerably in price. Oil has dropped from $123 a barrel to almost $100 in the last two weeks with energy stocks falling faster and further. Natural gas prices have also dropped substantially, despite the actions of Russia to cut off natural gas to the European Community.   

 

Defensive stocks in areas like utilities, health care, consumer durables, and telecom were bought instead. As were U.S. bonds, which are sending yields lower. That makes sense. If the U.S. does slip into recession, there will be far less demand for energy and other commodity inputs to fuel economies. In recessions, investors usually hide out in higher yielding areas where hefty dividends support stock prices in areas which people need, (not want) to purchase.

 

I pay attention when investors receive bad news (such as a potential recession forecast from the Fed), and the markets hold in there as they did this week. After all, Chair Powell had two days of testimony in front of Congress and plenty of opportunities during the Q&A sessions to tank the markets, but that didn't happen, even though he was no less hawkish in his forecast. That leads me to believe that the markets may have discounted the worst — for now.

 

Rest assured, I still believe we have a lower low in front of us sometime before the end of September. But that does not mean we can't see a face-ripping rally of 10 percent in the short-term. As a contrarian indicator, the AAII Sentiment survey, which measures bullish/bearish sentiment among institutional investors, just registered the 25th lowest bullish and its sixth highest bearish sentiment reading in its history.

 

Many traders are expecting just that kind of event to occur over the next week or two. There are several technical reasons that make bounce higher a high probability. There is the rebalancing of funds by large institutions (bonds into equities) that occurs at the end of a quarter after severe selloffs. Many hedge funds are ending the quarter net short and will also need to rebalance.

 

There will also be the usual flow of new funds into pension plans that will need to be invested. Finally, a huge number of put options will expire at the end of the month. They will need to be either liquidated or rolled over to a future month. This could set the markets up for another oversold bounce.

 

We have had several of these rallies thus far in 2022. The S&P 500 Index gained 6 percent in four trading days, 11 percent in 11 days, and 8.7 percent in 9 days, while losing 19 percent overall. Bear market rallies typically get back 70 percent of the losses of the prior move lower with over a quarter of the rallies gaining back over 100 percent.

 

Bill Schmick is the founding partner of Onota Partners, Inc., in the Berkshires. His forecasts and opinions are purely his own and do not necessarily represent the views of Onota Partners Inc. (OPI). None of his commentary is or should be considered investment advice. Direct your inquiries to Bill at 1-413-347-2401 or email him at bill@schmicksretiredinvestor.com.