Is a Market Crash Coming?
In the last blog post we covered some of the bullish arguments for a strong recovery later this year instead of a market crash.
A still lower corporate tax rate overall, strong balance sheets, very low unemployment heading into a slowdown and market indices holding long-term trendlines are some of the bullish arguments.
Now lets take a look at the bearish arguments from a technical and fundamental standpoint. And how we will know if we need to be on guard for a real market crash in the months ahead.
Is a Market Crash Coming?
During an interview recently, one expert talked about how a more than 20% drawdown on the S&P 500 actually increases the risk for a 20% to 30% move below the recent lows in the near future.
This is true and is a reflection of how economic and rate hike cycles often play out.
Fortunately, the chances of a 50% to 60% crash on the S&P 500 are now a little less than 50/50 based on this cursory research. However, we have to prepare for anything when trading with the right strategies.
How Bear Markets Historically Play Out
In the last blog post we discussed how a long-term bear market starting this year may not be just 1 large correction but 3 to 5 large corrections over 1.5 years or more with each correction taking the market below the prior low.
So why did we say this?
Well, historically this is how long-term bear markets have played out in the US market. This was true of the 1929 crash, dot com crash, 1969-1970 bear market, and 2008 crash and most of the long-term bear markets over the past 50 years.
These long-term bear markets were not just 1 large correction over 5 to 6 months but 3 to 5 large corrections over 1.5 years or more. The last 2 corrections are when you tend to see the larger market crash.
But lets talk about the fundamental reasons for a long-term bear market first.
The Seeds of a Big Bear
Its hard to think of a worse scenario then the one we saw heading into 2022. Accelerating inflation, more inflationary events likely in the near future, a Fed suddenly turning hawkish, more regulation taking hold, increasing geopolitical risk and the effects of stimulus beginning to fade with no new stimulus in sight.
The trigger of most recessions is an ever tightening labor market generating more inflation and demand destruction with the Federal Reserve increasing interest rates to combat the inflation for fear of a wage/price spiral and far worse problems. The higher interest rates take many months to make their impact on the economy.
Due to the pandemic and the possible Ukraine invasion, the Fed held back from tapering bond purchases and delayed plans to reduce the balance sheet and hike rates. After over a decade of not being able to generate any inflation, the Fed and Washington pushed the envelope further during this crisis.
They finally pushed things over the edge into an inflationary environment. An environment that is sometimes tough to tame historically.
The Fed was left with the unfortunate dilemma last November of either spelling out what they really needed to do and causing a market crash immediately or taking their time to become more and more hawkish.
They waited for the market to regain traction before suddenly lifting interest rate expectations in a step by step fashion so far in 2022. Not good for investors and traders but probably the better thing to do given the circumstances after not at least tapering last year.
Buying the Rumor and Selling/Covering the News
Its important to understand that its the signaling that triggers the market response rather than the actual rate hikes or balance sheet changes themselves. This is where the “Fed does not really matter” advice can hurt traders. The market starts to move on the signaling and often moves in the opposite direction once the hiking or cutting of interest rates is near completion or fully priced in.
Keep in mind that the Fed raised interest rate expectations through signaling multiple times already right after the market regained traction again after they were hinting that the expectations for late this year and next year were now at their final destination.
So how do we know they will not do it again? Some experts say that another 1% to 2% higher interest rate expectations should lead to a 10% to 15% drop in the market averages.
All we know at this point is that commodity prices have pulled back for now but the CRB commodity index is still above a rising 200 day moving average. Many commodities are still in a long-term uptrend. A break of that uptrend could just signal that the economy is weakening faster.
Bear Markets and the Fed
Every bullish confirmation signal this year has been met with higher inflation and/or increased rate hike expectations from the Fed soon after. The timing from the Fed was impeccable it seems to take the bulls to the cleaners who thought a correction was behind us. This caused a sharp resurgence in selling and new 52-week lows for the major indices.
As we said last time, its been the worst first half of a new year in five decades. The worst for bonds in more than 200 years.
The important lesson to take away is that sometimes the Fed is going to send mixed signals and raise interest rates gradually over months even after signaling that they probably will not go further.
It Paid to Trust Inflation Instead of the Fed
So sometimes you have to trust inflation numbers more than the Fed.
Some say the Fed really has 3 mandates. Stable prices and full employment are two. The third is to not trigger sudden market crashes which can affect the other 2 mandates.
More than 15% or so off the S&P 500 within a couple weeks could potentially cause instability in the financial system so they do not want to signal something that will likely trigger that. 15% lower over a month or more is fine but the sudden large drops in the market are a concern for the Fed.
Part of the bearish argument is that rate hikes work on a lag. You may get a relief rally once the market expects the Fed to pause soon but the affects of the rate hikes will not hit the economy hard until around 6 to 12 months after they raise rates.
Just a Bear Market Rally?
But now we have seen a stronger bullish market signal in June once signs appeared that inflation was peaking and the Fed will soon do what they need to and pause in the months ahead.
This time around a bullish confirmation signal was met with inflation numbers only slightly higher than expected with a sharp drop in commodity prices in July which will likely mean lower inflation numbers released in August. Also, the Fed did not raise interest rate expectations significantly within a few weeks after the bullish market signal nor another leg higher in bond yields.
This led to 2 big trading opportunities on top growth stocks above their 200 day moving average.
Bear Market Earnings Plays
We found both ENPH and SWAV for subscribers of the daily alert during the first sustained bear market rally this year. Both stocks are among the best growth stocks in the market. 2 stocks that were in a large double bottom with handle pattern.
Both stocks reached our entry trigger price soon after we featured them and soared about 25% higher from there within a couple weeks. More importantly, both stocks held a 1.5% stop below our entry trigger price.
This is key to successful trading. Identifying the stocks, fundamental factors, technical factors and market conditions that are ideal for holding a tight stop-loss on a quality growth stock that are much less likely to be halted and open 40% lower as is too often the case with recent IPOs and penny stocks.
In a prior blog post on how to find a great swing trade we talk about all the factors that lead to an ideal trading opportunity using our strategies. It worked again to a tee once market conditions met our criteria.
Bear Market and Earnings
So far, we are seeing earnings come in better than feared in Q2 with total forecasted 2022 S&P 500 earnings holding up well. Decent earnings growth for the S&P 500 overall is still expected for 2022 and 2023. At least for now.
However, earnings in the energy sector are making up for the decline in earnings for the rest of the S&P 500.
We will be watching earnings estimate revisions in the weeks and months ahead and watching closely to see how jobless claims data trends.
How to Trade Long-term Bear Markets
We always want to trade the market we have and not the one we expect or want. Meaning if the market is in a sustained bear market rally, we trade long. If the market is showing signs of going into another correction from the recent swing high then we favor shorts.
Other bearish setups become more exciting during the third and fourth leg lower during a long-term bear market which tend to be much larger legs lower. Until then, we just trade like most corrections and sustained market rallies during a long-term bull market.
However, its good to know that if we get a second large leg lower ending at least 5% to 10% below the June lows we should get prepared for the large third and fourth leg lower after another sustained bear market rally that often lasts just a couple months or so. These third and fourth legs involve a market crash and can be tremendous buying opportunities once we see signs that the selling is exhausted and margin calls finally subside.
What We are Trading Now
Ideal technical patterns on good growth stocks or stocks with big beats and rising estimates in long-term uptrends continue to do well. ON, MCK, CNC, COST and others have reached our entry price and made real nice moves for subscribers. Subscribers were able to take some profits and raise their stops on the remainder.
The biggest gains, of course, came from the top growth stocks like SWAV and ENPH mentioned above. You can see the explosive double bottom breakout from SWAV below shortly after we featured it to subscribers. Its now formed an earnings flag.
Chart courtesy of StockCharts.com
In the weeks ahead, we want to consider only the ideal opportunities. Top growth stocks with all the fundamental metrics we want to see and great consolidation patterns. Or, UPOD stocks with rising estimates that are very reasonably valued. Top earnings flag breakouts with a catalyst will be on our menu. We are seeing some real nice ones for the weeks to come.
Short Term Swing Trading Strategies Favored for Now
I’ll explain more about this in the next blog post where we will talk about past long-term bear markets and any similarities to how 2022 is playing out in more detail.
We’ll also talk about the perhaps soon to be infamous “50% retracement rule” of bear markets and how its pretty controversial to say the least.
We’ll also look at a better rule to know that we are in the clear or are more likely heading for a real long-term bear market that could be a more than 50% drawdown from the highs on the S&P 500 rather than a “50% retracement rule” leading to new highs quickly.
If its a long-term bear market and are heading for a more than 50% haircut off the highs, we want to work and save more to have extra cash to invest if that happens for long-term investments. For our swing trading accounts, we want to focus on the best strategies to earn money during the crushing third and fourth leg lower in a long-term bear market where you often see a real market crash and which can be very profitable using the right strategies.
In that environment, we want to be ready with our best short and put option strategies when trading.
But that will be discussed in the next blog post along with how we will know if we are entering a strongly bearish trading environment where they will be the preferred strategies.