Bear Market May Take Short Summer Vacation

If this week turns out to be anything like last week for US equities, it’ll feel like the bear market is over.

Weary investors should relish any such respite — it won’t likely last. Q2 earnings are right around the corner and although you wouldn’t know it from analyst estimates, US corporate profits are almost surely headed for a reckoning of some kind.

On the inflation front, the Fed wants proof. They may take some solace in falling breakevens and other market-based indicators, but officials are clear: They need several months of declining sequential inflation prints. Peak inflation means peak inflation. It doesn’t mean peak breakevens or peak Bloomberg Commodity Index or peak Fed pricing or peak University of Michigan inflation expectations. It means an actual, sustained decline in MoM CPI and/or PCE.

But in the very near-term, a combination of lower yields, the pre-earnings summer lull and, this week, rebalancing flows, could give the appearance of a burgeoning bull.

“The bear market is likely not over although it may feel like it over the next few weeks as markets take lower rates as a sign the Fed can orchestrate a soft landing and prevent a meaningful revision to earnings forecasts,” Morgan Stanley’s Mike Wilson said Monday, after explaining why, in his view, the bear market will eventually resume.

Wilson’s comments on the prospects for an extension of last week’s bounce were notable in the context of remarks from JPMorgan’s Marko Kolanovic who, in a June 24 note, suggested the S&P could rally 7% this week. In the figure (below), the purple bars denote weeks when rebalancing flows may have contributed to upside.

This week’s rebalance “is important since equity markets were down significantly over the past month, quarter and six-month time periods, hence the various rebalance frequencies reinforce each other,” Marko said, adding that impaired market depth (i.e., low liquidity) means any such flows could be magnified.

“In addition to the lower rates and oil prices helping support the belief in a soft landing, there is still some equity demand from pension funds that need to rebalance at the end of the month/quarter this week,” Morgan’s Wilson wrote. The bank’s quants project as much as $30 billion in related demand for global equities, with as much as $20 billion for US shares.

Wilson called that “a substantial amount” which, if coupled with a bid from retail investors, “could carry equity prices higher before Q2 earnings season begins and the revisions arrive.”

He also noted that it wouldn’t be unusual to see stocks retrace a substantial portion of recent losses. Such bounces aren’t uncommon during bear market rallies, especially drawdowns where a recession is possible.

Wilson sees as much as 7% of additional upside from last week’s close in the event the rebound persists. That’s consistent with Kolanovic’s estimate of near-term upside although I’d be remiss not to note that JPMorgan’s view on the outlook for US equities differs materially from Morgan Stanley’s house view in some respects.

Wilson was (very) keen to emphasize that any rally wouldn’t constitute the end of 2022’s malaise. Earnings estimates, he reiterated, will likely “have to come down,” but in the meantime, Morgan’s equity team is “being realistic about the viciousness of bear markets and their ability to confound all market participants at times, even the bears.”