5 things need to happen before the market turns around

Around the pandemic lows in 2020, I wrote that even though the virus will get worse, “it doesn’t mean the stock market has to go lower.” I remained bullish throughout the strong run but turned cautious in mid-December 2021 for two main reasons: The market technicals were breaking down and the Fed became increasingly hawkish. I’ve been defensive since then and maintained a high cash position for my clients.

In order for me to feel more confident about a sustained, new uptrend, and increase my exposure to equities, I need to see five things happen.

1. Improvement in Growth Stocks

The main factor I use to judge the health of the market is the price action of growth stocks. I screen the market every night looking for solid fundamental companies building strong technical bases. The more stocks I find, the more bullish I am on the markets, especially if these stocks come from a broad number of sectors. For example, the main reason I turned positive around the 2020 lows was that my screens produced tons of growth stocks in sectors such as Software, Semiconductors, Medical Products, and Biotech. Right now, there’s almost nothing looking good in the growth area. The main stocks that are working are commodity related and cyclical names. There’s nothing wrong with that, but I prefer to see money being put to work in “risk-on” sectors, and small and mid-cap stocks to tell me that large institutions are backing a new uptrend.

2. The Fed to change their hawkish stance

Around the pandemic lows, the Federal Reserve created an incredibly accommodative environment for equities. They not only kept interest rates at near-zero, but they also provided tons of liquidity by purchasing more treasuries in the six weeks following the pandemic than they did in the nine years combined from 2009-2018. They continued this accommodative stance with $120 billion in monthly bond purchases. However, in December of 2021, this all changed. They began talking about ending their bond buying program, raising rates in 2022, and possibly reducing their balance sheet.

The Fed is planning their first quarter-point rate increase at their upcoming meeting on March 15-16, and there will likely be subsequent, gradual increases later this year. I don’t think they will do the five to six hikes that many are expecting, but either way, investors need to be patient before this new rate-hiking cycle ends, or at least until the Fed pauses their hawkish rhetoric.

3. Institutional Buying to Resume

The big institutions control the market. That’s why it is so important to learn how to interpret what they are doing so you’re not fighting the trend. So far in 2022, they have been selling stocks, and every countertrend rally has been short-lived. In order to see a sustainable uptrend, we need consistent signs of big volume coming into the market on the up days. So far, all the bounces have been low-volume, short covering rallies that you would normally see in a correction. Again, patience will be required before this pattern changes and investors have the wind at their back.

Chart provided by MarketSmith.

Chart provided by MarketSmith.

4. Sentiment to reach extreme bearishness

Analyzing sentiment is important because the market tends to fool the majority. There are many sentiment readings/surveys in the market, and I prefer to look at them collectively. They are definitely starting to escalate in bearishness, but they are not at the extremes I have seen near prior market bottoms. Keep in mind that the market is a master manipulator. It convinced people for so long to buy the dip, and when market participants were finally convinced that we would never have a meaningful correction again, the market changed character. It might take a while for this brainwashed mentality to change.

5. A resolution with Russia and Ukraine

Tensions between Russia and Ukraine need to ease. It’s amazing how many times geopolitical tensions arise when the market goes into a correction. It’s almost as if the market becomes vulnerable and then bad news adds fuel to the fire. I don’t want to overthink the macroeconomics, but the domino effect of higher oil and food prices will clearly weigh on consumers. It will take time for prices to come down but some clarity that progress is being made will remove one big uncertainty from the minds of investors.

If I can offer any words of encouragement, they are that things can change quickly. The market is a discounting mechanism and tends to trade on what will happen six to nine months from now. In other words, although the news might get worse and inflation is likely to be around for a while, the market will eventually factor this in and turn around.

When this happens, there will be tremendous opportunities in growth stocks that will appreciate rapidly in price. It happens every time, but no one knows whether it will be three weeks from now, three months from now, or somewhere in between. It’s possible that it could take longer but I’m confident that the second half of this year will improve. Just stay defensive until we see these five signs start to form and wait patiently for market conditions to improve.

I can be reached at: jfahmy@zorcapital.com

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