Will This Week's Rally in Stocks Last?

This week looks like it will end as the first positive week of the month for the major stock indices after all three posted their biggest weekly losses of the month the week before. That has led to some people to say that maybe, just maybe, we have found a bottom for stocks, as the reversal of a drop usually follows one last big push down. As I have said several times recently, I do believe that now is a good time for those with a long-term outlook to start to average in any available cash, but I still believe there is a good chance that we may see at least one more push lower before we really turn.

The reasoning behind that comes down to a simple question: what has all the selling been about? If you believe that it was just a big correction to an up move that got a little overdone, then it is easy to think that a retracement of somewhere around twenty percent would be more than enough to set up a strong bounce back.

If, on the other hand, you think that the move was a response to a fundamental change in conditions for all businesses, and that stocks therefore needed a complete reset to reflect those new conditions, then it is the periodic rallies, not the drop itself, that look like corrections to the upside within a sustained and unfinished move downward.

The latter seems to me to be nearer the truth than the former. The move down started because inflation really took hold, but it wasn’t inflation itself that made traders and investors sell: It was the response to it. The Fed, somewhat belatedly some might say, decided that their focus should shift from promoting growth to controlling inflation. That meant reversing long-standing policies of easy money and low interest rates. Slowing economic growth isn’t an unfortunate side effect of that policy change -- it is actually the desired outcome, and if that isn’t a change in fundamental business conditions, I don’t know what is.

The most powerful influence on the U.S. economy, the Federal Reserve Bank, is actively trying to create conditions that are bad for stocks and have really only just started that process. No real recovery in the stock market is possible until that changes. However, if the last few years have taught us anything about Jay Powell’s Fed, it is that once they commit to something, they stay committed. They continued with ultra-low rates and asset purchases, not just until the jobs market recovered, but until it went the other way, creating a full-on labor shortage, so why would you think that they are going to stop raising rates after just three hikes and with inflation data showing an 8.6% increase in prices last month?

With a fundamental influence as powerful as that, technical analysis has only limited use but, even there, this rally can be seen as a bearish sign in some ways. Elliott Wave Theory is a form of technical analysis that is rooted in the observed behavior of traders in response to changing conditions in the past, which makes it more useful than more esoteric technical theories in predicting the effect of changes now. It is based on the fact that periods of heavy selling always contain small bounces on the way down as some sellers take profits, but they are limited rallies that just add fuel to the selling pressure. Elliott observed five “waves” in that pattern; down, up, down, up, down.

If you look at the chart for the S&P since the beginning of this most recent move down back in March, you can see that four of those five waves are evident. They also, so far, follow the classic Elliott pattern, with the drops becoming steeper and the rallies becoming shorter. That points to a likelihood that within a few trading days, the market will turn again and drop sharply to a level well below the 3836.87 low.  

I’m sorry to be the bearer of bad news, but both the fundamental outlook and technical picture make it look as if this week’s rally, as welcome as it has been, is really only a pause in the drop, and that there is more bad news to come.