Third Quarter Recap – State of the Market
The third quarter of 2022 is in the books. Catch up on what you missed
Stocks continue to be under pressure in 2022, as the S&P 500 fell another 5.3% in the third quarter to close at its lowest level since November 2020. It’s been all about the US Dollar this year, and the recent rally higher in the DXY presaged the latest equity market selloff.
At the end of September, though, the USD showed signs of weakness, reversing from its highs while stock prices continued to drop. That divergence is worth keeping an eye on – it very well could be signaling a light at the end of the tunnel for stocks.
This would be a pretty logical level for the Dollar to peak – or at least pause and take a breather. Take a look at the DXY running into the 161.8% Fibonacci extension from the entire 2015-2021 range. Prices respect these Fibonacci levels, so we probably should, too.
Currency pressures may subside, but with the Dollar 18% higher than a year ago, they’ll still be a major headwind for earnings this year. A strong USD hurts sales of exporters and negatively impacts the accounting translation of overseas earnings. That’s a big part of why analysts have lowered their estimates for annual S&P 500 earnings growth to 7% from 10% over the last 3 months.
The decline in earnings hasn’t negatively impacted valuations – the market’s forward P/E reached a multi-year low of 15x – but that’s only because stock prices have fallen even faster. Of course, this is nothing new. Stock prices always lead earnings, not the other way around. And if the S&P 500 briefly breaking its June lows was any indication, earnings estimates likely have more room to fall.
Consumer Discretionary was the top sector in the quarter, helped by strong performances from auto manufacturers and retailers. On a relative basis, it briefly pushed Discretionary back above its 200-day moving average. Now the group is struggling to absorb resistance from last summer’s swing lows.
Leadership could be shifting back towards Energy stocks as we enter the fourth quarter. On a relative basis, Energy is in a clear uptrend and successfully tested a major area of support over the summer.
The bond market continues to suffer through its worst calendar year in modern history. Ten-year Treasury yields rose to more than 4% in September, their highest level since 2010. The place investors have historically gone for safety has provided nothing of the kind, as rising yields have driven the US Aggregate bond index down almost 15% since December. On an inflation-adjusted basis, the performance is even worse.
Normally I don’t put much weight on round numbers as areas of support or resistance, but they seem to matter to the bond market. Four percent yields could offer support to bond prices and give investors a reprieve from the selloff.
The Federal Reserve started raising short-term interest rates with a 25bps hike in March. Since then, they’ve implemented a balance sheet runoff plan and raised the target Federal Funds rate to the highest level in nearly 15 years. It’s quite the shift from this time last year, when most Fed officials were still talking about transitory inflation and sub-1% rates until late next year.
The narrative has shifted from transitory inflation to a return of the Philips Curve. The Philips curve states that inflation and unemployment are inversely related – when unemployment is low, inflation will be high. During the years preceding the pandemic, many economists gave up on the theory as a useful model for the economy, and understandably so. From 2017-2019, unemployment fell from 4.7% to a 50-year low of 3.5%, but prices showed no ill-effects.
Now that inflation has returned, though, Philips curve believers are back. Two recent Fed studies – one from San Francisco and the other from New York – showed that wages and inflation have become increasingly linked. Powell is hoping the labor market will soften even more in coming months, crimping demand and curtailing prices.
In the latest Summary of Economic Projections from the FOMC, officials saw a median year-end Federal Funds target rate of 4.4%. They expect to hike rates to 4.6% in 2023, before cutting them to 3.9% by 2024. In doing so, they anticipate joblessness will increase from July’s low of 3.5% to 4.4% next year. Never has the unemployment rate risen that much outside of full-blown economic recession. For his part, Powell has stated on multiple occasions now that pain is inevitable. And he has no intention of using the Fed’s tools to soften the blow – at least not until inflation is under control.
Crude oil continued to decline in the third quarter, dropping below $80 per barrel for the first time all year. That’s still higher than it was at any point from 2015-2020. The 2018 highs should offer near-term support and could be the catalyst for a rally. The administration has also been rumored to consider refilling the SPR with oil prices near current levels, and further support could come from OPEC+ cutting supplies by 2 million barrels per day or more in coming months.
Gold broke below $1700 after flirting with the level for nearly 2 years. It looked like reversal from the multi-year uptrend that started in 2015. But just as quickly as things turned sour for the yellow metal, the winds shifted. What looked like a new downtrend looks more like a false breakdown today.
The clues were elsewhere in precious metals. Silver tends to just be a more extreme version of Gold – when Gold rises, Silver rises more, and vice versa. So it was interesting that Silver wasn’t moving lower when Gold prices faltered. Now, Silver is leading the way higher after its best day since 2008.
Here’s everything you might have missed from Means to a Trend in Q3
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