This May Be The Stock Market’s Biggest Bull Trap In 23 Years

The S&P 500 (SPX) caught a bounce as rates fell and the dollar weakened to start last week. However, after a slew of economic data throughout the week, which was supportive of a higher for longer monetary policy to remain in place, the bear market rally will likely fade, sending the S&P 500 lower to continue its August pullback and back to the 4,100 over the next couple of months.

The rally from mid-March to mid-July may be one of the most incredible bull traps since the 43% Nasdaq 100 surge in the summer of 2000. A trap driven by a fantasy narrative of inflation melting, allowing the Fed to cut rates and ease up on monetary policy as the US economy glides to a soft landing. While there may be some early signs that the economy may be starting to soften, it is still too strong and resilient and far from getting the Fed to change its projected restrictive monetary policy path.

Rates

Once again, the stock market thinks bad news is good news because traders can’t help but think that the Fed will be coming to the stock market’s rescue at the first sign of slowing growth. The “bad news” started on August 23, following weak preliminary PMI data points across Europe and the US, which sharply lower nominal rates.

Then, this past week, weaker Job opening data (JOLTS) and a weaker-than-expected ADP job report, despite massive upward revisions for July, sent rates down again. But Thursday, the as-expected core PCE data point and the hot PCE Core Services ex-housing data helped to see rates stabilize and then move higher on Friday following the stronger-than-expected non-farm payroll number and hotter-than-expected ISM manufacturing report.

One can find evidence of some economic softening if one searches hard enough. However, the data remains robust and suggests that the market will likely continue the previous trend of pushing rates higher on the back of the yield curve and piling back into the dollar. After all, economic models such as the Atlanta Fed GDPNow and the Bloomberg Nowcast suggest that real GDP estimates for the third quarter hardly budged following the onslaught of data.

This would suggest that 10-year and 30-year rates continue to power higher and probably move back up to the upper end of the ranges set before the August 23 move lower and potentially higher.

Dollar Impacts

Additionally, the better-than-fear economic data will continue to support the dollar. The dollar index retraced all of its losses following the weaker-than-expected JOLTS data and moved back to its highs as of September 1. From a technical standpoint, the dollar index could push higher to around 106 in the short term and may eventually run to about 111. I discussed this in a recent TV interview on the FOX Business channel’s Making Money with Charles Payne.

Many investors fail to realize how important the dollar is to the stock market and what a strong dollar does to stock prices. It makes US exports less competitive abroad, weakening revenue and earnings growth. Additionally, it will tighten financial conditions, removing leverage from the system. With the addition of China, the sum of the balance sheet of the G5 central banks in dollar terms has been moving lower. Part of this move is due to the dollar strengthening. This liquidity is highly correlated with the S&P 500 over time, making it extremely important, and the recent deviation is eye-popping.

This creates a problem for equities investors because big moves like those on August 29 give the impression that all is clear, and the worst of the August pullback is behind them. But in reality, the move higher in the S&P 500 on Tuesday was driven by a weaker dollar and falling rates, coupled with a negative gamma regime in the equity market due to the positioning of the options market. The dynamics created a massive rally as dealer flows had to buy the index as it rose, and this rally is likely to unwind in the days to come.

The complexity that may also be a significant factor is the recent surge in oil prices, which has risen to $86 per barrel, and means that CPI swaps are pushing up the inflation outlook for the next few months as gasoline prices rise.

Expectations for CPI in August have risen to 3.6%, September has increased to 3.4%, and October has grown to 3%. These don’t sound like meaningful moves, given where inflation rates were last year at this time. However, these CPI expectations may only rise if oil prices continue to climb. The longer the headline stays above the Fed’s 2% target, the longer the Fed will have to hold rates higher, with increasing risk of the Fed’s needing to do more.

Yes, Fundamentals Matter

This will complicate things because almost the entire rally in the stock market has been driven by multiple expansion, and not due to improving fundamentals, as the PE ratio of the S&P 500 has risen from around 18.1 on March 24 to approximately 20.8 as of September 1. If the index’s multiple were to contract back to 18.1 times 2023 earnings estimates of $217.26, the index would be back to trading at 3,930.

This brings us back to the dollar because the move higher in the PE has been driven primarily by easing financial conditions, which directly ties to the dollar’s weakening value. So, should the dollar continue to strengthen, this should lead to further multiple contraction. The stronger dollar could also lead to lower S&P 500 earnings overall due to FX headwinds.

The combination of high rates and a stronger dollar, coupled with rising oil prices, is likely to make things difficult for the stock market for the balance of the year, as price retraces to lower levels, and financial conditions tighten, that likely lead to a revisit to 4,100 over the next couple of months, which could end up being more depending on where things stand after that, leaving bulls stunned to find out that fundamentals and macro trends actually do matter.