Bear Market is Far from Over

ES1!
In the past six months, the S&P 500 has fallen from an all-time high of 4,818.62 to a fresh 52-week low of 3,636.82, down 1,181.8 points, or -24.5%.

Following a brutal week, the U.S. stock market rose on Tuesday, as investors weighed the Fed rate hikes amid rising fears of a recession. The Dow rose 2.15%. The S&P popped 2.45%, and the Nasdaq climbed 2.51% at market close. Has the stock market correction ended?

Let’s look at a 5-year chart. The previous peak of S&P 500 was 3,383 on February 10, 2020. It hit bottom on March 23 at 2,177, down 35.6%. Since then, the S&P has a great run for nearly two years, up 121%, with very little hiccup along the way. The new high was 40% above the pre-pandemic high.

After recent steep fall, the S&P is still 400 points above the pre-COVID peak, which, in my view, is our first support line. If recession fear materializes into a real one, the post-COVID dip will become the second support. I believe that the bear market is far from over.

My reasoning bogs down into two essential questions:
1. Will Government policies be effective in controlling the runaway inflation?
2. Will U.S. economic growth be sustainable at current high price level?

On March 16, the Fed raised interest rates by 25 basis points (bps). A second hike followed on May 4, for 50 bps. On June 15, a big 75-bps move upped the Fed Fund Rate to 1.50%-1.75%. Meanwhile, U.S. inflation continues to rise. In May, the official Consumer Price Index rose 8.6% year-over-year. The core CPI (all items less food and energy) was also at a record high of 6.0%.

While aggressive Fed tightening could reduce the excess money supply, it could not affect the record gas price, nor the supply chain bottleneck from China.

President Biden will try to convince the Saudis to increase oil production during his visit. However, we need to understand it is the best interest of OPEC to maximize oil revenue. High oil price is good for them as long as it does not cause demand to decline. Besides, if Biden can’t control his own bike, do you really expect him to get OPEC to fall in line behind us?

Removing the Trump era tariff could bring some relief to U.S. consumers. However, the extent of imported goods covered by tariff reductions remains unclear. From policy discussion to actual implementation, it would take months before we see price drops on store shelves.

In a nutshell, my answer is NO for the first question.

As to the second question, even if the Fed succeeds in bringing down the inflation, will the U.S economy sustain its growth momentum?

Take the $5 gas price for instance. For an average family with two cars, the consumption of 100 gallons a month is budgeted at $500, and it is $200 more than when gas was $3/gallon. Record gas price has already resulted in less driving and reduced trips to grocery stores and supermarkets.

A major impact of Fed rate hikes is higher mortgage payments for millions of homeowners. For a family with a $400,000 house and $300,000 mortgage, a 6.5%, 30-year-fixed loan will require $1,900 interest payment per month. This is $380 more than when the mortgage rate was 4.5%.

High energy and mortgage costs trickle down to every corner of American life. Even if inflation is tamed, at current price level, everything is too costly for the economy to function properly. We need to have deflation, starting with energy and housing, to avoid a recession.

With headwinds to the economy and massive overhang over the stock market, I’m not optimistic for the near-term U.S. economic outlook.

A short position in CME E-Mini S&P 500 futures is a way to express this bearish view. The December (ESZ2) contract may be a good one, considering both liquidity factor and time to allow major market-moving events to play out. At 3,788.00, each contract has a notional value of $189,400 ($50 times index value). CME requires an initial margin of $10,500. Futures contract is marked to market daily. For a short position, a decline of 1 index point will result in $50 gain in your account balance because of the $50 multiplier. Likewise, an increase of 1 index point means a $50 reduction in your account.

If you don’t want to deal with the daily profit and loss accounting, consider a Long Put Option on the same E-Mini S&P futures contract. For example, the out-of-the-money 3685-strike (100 points below market) is currently quoted at $9.00. To buy an option requires $450, again because of the contract multiplier of 50.

When is the good time to place the order? The next market rebound. Put premium generally gets cheaper following a price rise in the underlying futures.

Happy Trading.

Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.