The Bull-Bear

Not all bears are alike.

Take the American black bear, for example. They’re typically shy, somewhat affable and, generally speaking, will choose berries, roots, grass and various sorts of insects over your leg when they’re hungry. Grizzlies, on the other hand… well, suffice to say that “avoiding a conflict is easier than dealing with one,” as the Interagency Grizzly Bear Committee euphemistically puts it, on an informational page.

On Wall Street too, there are different sorts of bears. Some are proudly incorrigible. Like SocGen’s Albert Edwards. On the other end of the spectrum are reluctant bears, who only acquiesce on a delay, once evidence of adverse market conditions becomes irrefutable.

Earlier this week, in the August edition of the bank’s monthly Global Fund Manager survey, BofA’s Michael Hartnett described himself (and, by extension, the bank’s Savita Subramanian) as a “patient” bear. A few days later, in his weekly, Hartnett distinguished between two other sorts of bears: The pragmatic variety and the dogmatic variety.

Dogmatic bearishness of the strictest sort doesn’t show up in sell-side research, but occasionally, the fundamentals deteriorate such that adopting some version of dogmatic bearishness can make sense until conditions improve. Even that’s tenuous, though. In the post-Lehman world, rapid deterioration in the fundamentals (or even the prospect thereof) is almost always met with a monetary policy response. As such, being dogmatically bearish based on poor fundamentals was almost always the wrong trade in the era of ZIRP, NIRP, LSAP and forward guidance. The worse the news, the better for risk assets given the assumed response from the benefactors with the printing presses.

Hartnett suggested that pragmatic bearishness may now be a better approach based on a number of arguments he attributed to a hypothetical “cyclical bull.” To be clear, it’s not so much that BofA believes in the tenets of any cyclical bull case. Rather, it’s that the arguments for such a case are plausible enough to make pragmatic bearishness preferable to dogmatic bearishness.

He couched the bull case in his “4 Ps” framework, the same framework he’s used to make the bear case. The 4 Ps are price, positioning, policy and profits.

As for “prices,” the “destruction in the first half was epic,” Hartnett said, noting that government bond returns were annualizing a -33% loss, the worst since 1865. The figure (below) is a snapshot from June 30.

Bonds rebounded in July. The outlook is uncertain, but H1 is a tough act to follow when it comes to poor returns.

As remarkable as the visual (above) is, I’d note that one can use data from the same source to produce even wilder charts. In an effort to convey the anomalous nature of this year’s first-half losses for government bonds, a few banks leveraged numbers from California-based Global Financial Data, which builds indexes by appending historical records to more conventional series. On one such index, benchmark US debt suffered its worst start to a year since 1788, the year before George Washington assumed the presidency.

Of course, what made the first half so vexing was the simultaneous drawdown in both bonds and stocks. Hartnett noted that in real terms, the S&P “retraced its entire COVID bull market,” as did almost half of the index in nominal terms.

The figure above (which, like the bond chart, is a snapshot of where things stood at the end of H1) casts considerable doubt on the “stocks as an inflation hedge” narrative. That story might be a better fit going forward, but it didn’t pan out during the first half.

Hartnett summarized H1 2022: The bear “was an utter brute.”

The point is just that it can’t get a lot worse. There’s no need to “knock on wood” or resort to any other superstitious rituals. We’ve had a pandemic, a war, an inflation crisis and the worst government bond rout in more than 200 years. If it gets much worse, you won’t be worried about your personal finances.

So, that’s the “price” in the bull case version of Hartnett’s “4 Ps.” As for the “positioning,” he wrote that although there’s been no sign of capitulation in flows to equity funds, there has indeed been an exodus from credit, which is now reversing. US IG funds took in another $3.5 billion over the latest weekly reporting period on Lipper’s data (figure below).

It was the biggest haul since January and marked a third consecutive weekly inflow. Note that prior to August, IG funds suffered 18 straight weeks of outflows, the longest such stretch on record.

“Smart money follows credit, not stocks, and in credit there was genuine capitulation,” Hartnett said. He cited EPFR data, noting that for every $100 in inflows to credit funds since January 2021, $84 has come out. That figure for global equity funds is just $2.

That leaves “policy” and “profits.” The path to a policy pivot goes through lower inflation, and since everyone generally agrees that the odds of headline price growth receding are good (notwithstanding the clear and present danger of more energy shocks), the question is whether “services inflation quickly follows goods inflation lower,” as Hartnett wrote. That’d be bullish to the extent it could push CPI below 4%.

As for profits, Hartnett suggested that some bulls might believe a recession can be avoided, especially in the “era of government bailouts.” “This year, politicians [are] panicking and subsidizing consumer spending on energy, oil and gasoline everywhere from San Francisco to London to Berlin, no matter what the long-term climate consequences,” he wrote.

On that score, I’d note that although I personally believe some such subsidies are necessary for a variety of reasons, from a dispassionate perspective, the read-through of such spending is plainly inflationary to the extent it forestalls the kind of demand destruction central banks are actively trying to achieve.

As ever, it’s a delicate balancing act: Central banks need an economy that’s strong enough to withstand aggressive policy tightening, but not so strong that it offsets the very same tightening.

You can draw your own conclusions — decide what kind of bear you are, and which interpretation of the “4 Ps” you prefer. As of mid-August, there were a lot of “bull-bears” out there. Funds previously positioned for the worst caught flat-footed and forced to chase the rally higher, strategists struggling to reconcile bearish year-end targets after a 21% rally in the Nasdaq, and so on.

For whatever numbers are worth, BofA noted that the average S&P gain during 43 bear market rallies since 1929 is just over 17%, with an average duration of 39 trading days. The current rally, prior to Friday’s options-inspired fireworks, was 17.4% over 41 days. So, “textbook,” as Hartnett put it.