Why is the Stock Market Rallying if We are Headed into Recession?
The answer lies in the psychology of the stock market.
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The Bottom Line
With a seemingly uncertain economic environment, the Federal Reserve raising interest rates, the US in a technical recession, corporate earnings often missing expectations, and inflation still at a 40 year high, why are we seeing such a dramatic turnaround in the stock market? This chart below shows just the last month in the market:
I threw the price of oil on this chart because, while not a perfect correlation and most likely not the sole cause of this rally, the price of oil coming down is significant. Plummeting oil prices could be a sign that inflation has peaked, for now at least. While in this chart the S&P 500 and Crude Oil have an almost perfect negative correlation in respect to month performance, this should be seen as a coincidence.
So why is oil coming down if we are worried about the supply? Why has the market turned into buying machine as of late? Is this sustainable? Let’s (try) to dig in.
What We Know
June 16th is the day the stock market “bottomed”, for now at least. Since then we have been on an upward march, and as of late, charge, up higher on every single major stock index. But why June 16th? The Federal Reserve.
On June 15th, the Federal Reserve rose interest rates 75 basis points for the first time since 1994, doubling the federal funds rate from 0.75% to 1.50%. This was a dramatic move in the fight against inflation, and signaled the Federal Reserve meant what they said. This would be the first of two 75 basis point hikes, which the market was expecting at this point.
The day after this increase, the market freaked out, in a sense. After a rally the afternoon after the Fed decision, the S&P 500 fell 3.31% the next day. This was due to just about every reason you can think of, including fears of recession. A good rule of thumb, if you ever need to explain why the stock market is down, the answer is probably uncertainty of some kind.
But after this huge sell-off on the Thursday after the FOMC meeting, it seemed like the stock market had priced in a recession, and it was time for the bond market to do so. How does this happen? You see a massive decrease in the yield of the 10-year treasury bond, and a less severe decrease or an increase in a shorter bond, like the 2-year treasury bond. When the 10-year yield and the 2-year yield invert, meaning the yield of the 2-year bond is greater than that of a 10-year bond, that is often a good sign that we are headed towards a recession. Well:
This chart shows the inversion of the 10-year/2-year yield curve. July 5th is the day the yield curve inverted, and it has stayed that way since. It was sent on this path by the Federal Reserve during their June 14-15th meeting, and isn’t looking to change soon.
On top of this, on July 28th, we got the Q2 2022 GDP numbers that showed that we have officially had 2 quarters in a row of negative GDP growth, signaling that we are in a technical recession. This has sparked much debate over whether this is a real recession or not, mainly because the unemployment rate is still historically low and the labor market is tight. Regardless, this confirmed that we are headed for a recession, or at the very least a significant economic slowdown.
So now I that I dropped a bunch of information, I can answer the “Why”?
Buy The Rumor, Sell The News
If you’re in the stock market long enough, one of the lessons you (hopefully) learn is that bad news isn’t what causes investors to sell, uncertainty is. We are witnessing an amazing example of that right now. For much of the first half of 2022, we had concerns of inflation, a war, a recession, everything under the moon. But the uncertainty around inflation is easing because of the Fed’s actions, commodity prices falling, and slowing consume demand. The day of the Russian invasion into Ukraine the market had one of the highest one day rallies in its history. The stock market was also green the day we found out we are in a technical recession.
Every day that a reasonable person would expect the market to fall, it was up, and sometimes very high. This is because once confirmation over a past uncertainty is achieved, it is no longer uncertain. Basically, even if what happened is bad, at least it has happened, and investors move onto the next thing. This idea gives the philosophy of “buy the rumor, sell the news”. If you’re buying when news comes out, you’re often too late.
Wrapping It Up
To bring it all together, I believe that the stock market has rallied because we have removed a lot of uncertainty from the market. We have also removed a lot of risk from the market, which happens when stock prices fall substantially. We know financial conditions are tightening, we know the economy might not grow this year, we know inflation is high, we know company earnings aren’t as good as in past years, but because we KNOW this things and aren’t worried about them in the future, this rally has been allowed to run up. The stock market typically bottoms before the worst point of any recession, so hopefully this is one of those cases.
It is impossible to determine if this rally will continue, or if we will go lower than the June 16th bottom. We know what we know and we don’t know what we don’t know, but one thing we do know is that the stock market is the ticket to long-term wealth, you just have to be along for the ride.