Returning from Orbit

From March 23, 2020 Volume Analysis Update..

In the March 23, 2020 edition of Volume Analysis, a time of tremendous market turmoil, I described the market and the Federal Reserve’s quotative easing actions as such:

"Given the strong health of the economy and the strength of market internals prior to the decline, I believe all this aforementioned stimulus may act as rocket fuel when the market eventually turns, transforming the clouds of uncertainty into rays of hope. Blink and you will likely miss the run up.”

At the time, the S&P 500 was 2237 and was in one of the fastest declines of historical record. The vast majority of Wall Street analysts were predicting doom and gloom, focusing on the pandemic and the looming economic shutdown. Meanwhile, I was focused on the S&P 500’s “VPCI V Bottom capitulation signal” and was among the first analysts at the time focused on what would become the rocket analogy of the stock market. Earlier this year the S&P 500 surpassed 4800, a 115% increase since the call on March 23, 2020.

With these same events in mind, this new series is entitled “Returning from Orbit”. The Federal Reserve’s rocket has since overshot its orbit causing increasing inflation while providing a speculative paradise for risk assets. Now how shall the Federal Reserve return the economy back to post pandemic normalcy? While the launch is the most exhilarating part of the journey, the reentry is often the most dangerous. In returning a rocket back to earth, the first step is “de-orbit burn”, slowing the rocket down below its orbital speed. Once the rocket is slowed, gravity takes over and the spacecraft plunges back into the atmosphere. While the atmosphere slows the spacecraft further, it also creates heat which could destroy or damage the craft. Landing a rocket from space is not like landing an airplane. Landing from space needs to be just right. Yet, there are many variables to calculate such as potential craft damage during reentry, weather, drag and weight. Likewise, the economic re-entry may continue to be a treacherous journey as well.

In efforts to tame inflation and bring the markets back to normalcy, the Federal Reserve will soon begin a rapid reversal of the stimulus previously infused into the economy. The Fed has two primary tools to “slow down the rocket”. One of these tools is to raise rates while the other is balance sheet reductions. Some believe the Fed may use both. The last time they attempted this was the “Powell Pivot” in 2018. Those “pivot” actions did not turn out so well for the markets. Will the Fed be able to orchestrate a soft landing or will there be damage landing the “ship”? We will not wait to see but rather trust our leading indicators to dictate our market positioning.

Thus far we have referenced two dates in comparison to today - December 2018 and March 2020. The current AAII sentiment data shows the lowest number of bullish individual investors (only 19.2% bullish) since December 2018 and March 2020. Both prior times represented good times to enter the market. Also, Investor Intelligence, a measure of the sentiment of market advisors, is also at its lowest point since March 2020 (chart 2 below).

Although, both sentiment indicators show a low number of bulls, neither sentiment indicator shows an extraordinarily high number of bears. When there are a high number of bears, it may mean that investors have already sold out, a bullish indication. You can see in the graph below that the last two times bears have outnumbered bulls, it has represented a positive inflection point in the market. Although not completely there yet, this data seems to be suggesting that bad news may already be largely built into equity prices.