What now?

I penned this in my 2022 outlook on the markets, "In conclusion, the data points to a mixed bag and has something for everyone. The bears can highlight tapering and volatility while the bulls can point to continued momentum. Our best guess is the first half will be more volatile than normal with multiple pullbacks." So far 2022 has started off in a high volatile one way market down. Yet, is the current sell off still within the normal distribution curve for pullbacks? The current correction has already eclipsed the minor 5% intra-year drop from last year. But it still remains well within the normal average. According to JP Morgan the average intra-year drop for the S&P 500 is 14%. 

 

I think the big difference this year is the volatility of the market that have produced wild swings in both directions. A tweet from Ryan Detrick sums this up. 

A recent Bloomberg article highlighted the recent action was very reminiscent of prior volatile bear markets.

By Lu Wang
(Bloomberg) -- That was some ride U.S. stocks just took.
The Nasdaq 100, along with the rest of the market, turned
on a dime in the middle of its worst selloff in two years and
vaulted back into the green, erasing a loss of nearly 5%. The
move was the latest in a series of heart-stopping turnarounds
that have dogged markets amid rising tensions around Federal
Reserve policy.
Days like Monday are not unprecedented. But when they’ve
come, it’s been at times that are not remembered fondly by
equity bulls. Today’s move was the biggest of its kind since
Jan. 8, 2001, in the middle of the come-down from the dot-com
bubble. Most of the other similar moves occurred in the three
years that crash took to play out, with a few others coming in
the heart of the 2008 financial crisis. 
The table below shows the past instances where the Nasdaq
100 erased an intraday decline of bigger than 4%. 

Date |Intraday Loss |Close
1/24/2022| -4.94| 0.49
11/13/2008| -4.76| 6.48
10/23/2008| -4.84| 0.17
10/16/2008| -4.18| 5.52
7/15/2002| -4.55| 2.02
6/26/2002| -4.19| 0.44
6/14/2002| -4.61| 0.28
10/12/2001| -4.04| 0.29
2/23/2001| -4.78| 1.16
1/8/2001| -5.15| 0.6
10/26/2000| -4.87| 1.92
8/3/2000| -4.25| 3.82

Lastly, a great blog from Dr. Brett Steenbarger shows why the current environment has been so difficult for some many traders. His last paragraph sums it up perfectly. 

"We're due for a bounce" is not a substitute for a rational assessment of markets and their possible outcomes.  No amount of trading psychology techniques can substitute for knowing what you're doing when you put capital at risk.  People who tout their "passion for trading" most often need to trade and that leads them to take undue risk.  Far better to have a passion for good bets.  If you know that broadly oversold markets move a lot on average, the smart bet is to shorten your time frame, reduce the volatility of your returns, and find short-term bets that pay well without a scary downside.

The character of the market has certainly changed over the last few months and has been exasperated since the start of the year. It remains in a high volatility regime as the market gets more oversold. When the dust settles and the selling is exhausted there will be an abundance of opportunities on the upside. Trying to time it is almost impossible and why I remain very cautious in this tape as I expect volatility to remain elevated and a choppy trading environment. I am prepared for all scenarios and continue to adjust as new information arrives.

 

 

 

What's in store for 2022

As we embark on 2022 many market pundits are putting out their yearly predictions. We always find these more entertainment and theater rather than actual advice because the honest truth is, no one has any clue what the future holds and the market doesn't care about my opinion. Frankly there are always issues to worry about: Omicron shutdowns, new variant, supply chain glitches, labor shortage, school closures, higher inflation, rate increase cycle, Mid term elections, military conflict, etc. Our investment philosophy isn't predicated on predicting the future but rather reacting to current data. We use current and past data to help shape a thesis for potential outcomes in a scenario analysis manner. Then when events and conditions change we adjust our positioning and risk accordingly. The old adage sums it up perfectly, "the only constant in life is change".

With that said, to look out to next year we need to first assess what has actually taken place in real time. 2021 provided great returns across the asset class spectrum for everything except gold and treasuries. Jurrien Timmer from Fidelity sums this up in his table of investment returns.

Even as the general market provided health returns there was plenty of churn under the surface. Remarkably, the average Nasdaq drawdown from YTD highs is a whopping -42%.

Cathie Wood has taken a lot of heat this year as her Ark funds have under performed. But a simple ratio chart of the ARKK ETF to the SPY shows how dramatic the selling has been in high valuation growth names. ARKK peaked in February and has drastically under performed the S&P since then. Currently it is more than 50% of it's YTD high. 

 

Most of the destruction in high beta growth can be attributed to the pivot from the Federal Reserve to speed up the tapering process to fight inflation they let get out of control. A tweet from Puru Saxena highlights how expensive stocks have lagged all year when plotted against the Fed's balance sheet.

This begs a bigger question. What is the impact from QE on the markets. Clearly quantitative easing has been a tailwind to the S&P. However, the reversal of QE (tapering) that reduces liquidity in the economy seems to be a headwind. The following two charts from William O'Neil touch on this.

On top of that the Fed's actions have historically triggered greater volatility. 

 

The following two charts increase the likelihood for the potential for a more volatile environment next year. Low volatile years like 2021 are historically followed by more volatility.

The presidential cycle doesn't do any favors either. The first three quarters are weaker than normal heading into the mid term elections.

 

One of the biggest market concerns is the rate of inflation and the pace of interest rate hikes from the Fed. However, should we be scared of rate hikes? Bespoke has great data on this. What I found most interesting was, "as shown, the broad market tends to do poorly in the first three month of a tightening cycles over recent year, bu longer-term that's a buying opportunity as forward returns average 7.1% (86% positive) over the first six months follow a rate hike."

Ken Fisher validates this theory that the market shouldn't be spooked by rate hike cycles. Outside of the mid 70's stagflation, equity returns have been positive during rate hike cycles.

Some more data points in the bull case shows how strength begets strength. One of our favorites Ryan Detrick shows what happens after big up years in the S&P 500. The average return next year is 11.6%.

Another interesting stat lies in the fact that 2021 was a unique year. It was only the 5th time in history going back to the 1920's that the S&P finished up double digits three years in a row. We looked at what happened the 4th year after three straight double digit years. The returns surprised us.

Year	Yearly Return
1942	12.43%
1943	19.45%
1944	13.80%
1945	30.72%
1949	10.46%
1950	21.56%
1951	16.46%
1952	11.78%
1995	34.11%
1996	20.26%
1997	31.01%
1998	26.67%
2012	13.41%
2013	29.60%
2014	11.39%
2015	-0.73%
2019	28.88%
2020	16.26%
2021	26.89%
2022	?
Average 4th Yr Returns	17.11%

In conclusion, the data points to a mixed bag and has something for everyone. The bears can highlight tapering and volatility while the bulls can point to continued momentum. Our best guess is the first half will be more volatile than normal with multiple pullbacks. But as the supply chain gets worked out after Omicron dies down that should help inflation ease. Tapering should be done by the first quarter and we should have the first rate hike behind us sometime in the first half. That could set the stage for a second half rally as pent up demand comes on board and a strong finish once the Midterms are behind us. As I said in the beginning, the market doesn't care about my opinion. That is why we prefer to see how the tape reacts to new information and we'll adjust accordingly. 

Happy New Year!