The release of US inflation data on Tuesday last week triggered the biggest one day move down in stocks since June 2020. The S&P 500 closed down 4.3%, the Nasdaq lost 5.2%.
Just looking at the inflation data, it’s hard to see why markets would be so negatively surprised. Inflation rose +8.3% YoY for July, down slightly from June’s reading but higher than the consensus expectation of +8.1%. A 0.2% difference between the expected rate and actual rate of inflation in July seems an odd reason for the biggest move down in stocks for more than two years.
Looking at what markets had been doing in the lead up to this announcement is instructive here. Before last week, stocks hit their lows for 2022 in June. Since then, we have seen broadly lower levels of market volatility and some strong short-term moves up in many stocks. From the lows of June to the recent high of mid-August, the S&P 500 recorded a +17% move up. Over the same period, the Nasdaq increased +23%!
The rally in stocks started to convince many that this was the beginning of a new bull market cycle.  The further we went without re-testing the stock market lows seen in June, the stronger the case seemed to become that the new bull market cycle had begun.
We have remained more cautious since June, taking the view that we’re yet to be convinced a new bull market cycle is here.
A ‘dead cat bounce’ is a phrase used in professional finance to refer to a short-lived recovery in asset prices following a decline. Often, downtrends in asset prices will be interrupted by short rallies up in the price. The term ‘dead cat’ comes from the idea that even a dead cat will bounce if it falls far and fast enough.
Was the rally in shares, which started in June, a dead cat bounce? In other words, a short-term rally but only as part of a continued broader market move down as part of the 2022 bear market cycle?
A good framework is to think about what is needed for a sustained bull market in stocks. Bull markets need legs. In other words, no structural bull market has ever existed without some major factor (or set of factors) driving it. This could be, for example, supportive policy from central banks, it could be a strong improvement in the economic outlook, it could even be a new technology which has convinced many of soon-to-be-realised productivity improvements.
In the case of this current market cycle, we identify three factors which could support a new bull market cycle. A combination of one or more of any of the following would, we would argue, signal the next bull market cycle is imminent: (1) a fast move down in inflation back to pre-Covid levels, (2) a strong inflection upward in economic data, (3) a pivot in central bank policy.
All three of these will, eventually, happen. But we are not currently seeing any of them. This then, leads us to, at the very least, suspect, that the rally in stocks since June is unlikely to have legs, with little to sustain it. We likely have further to go in this bear market cycle before it is over.
The silver lining here is that lower prices offer much better entry points for long-term investors. On a previous episode we talked about periods in markets when ‘good news = bad news’. For long-term investors, when bad news in markets results in sharp moves down in prices, this is, in a way, good news for un-allocated cash which can be put to work with a lower entry price (and thus higher expected returns). Averaging in to market cycles, with a focus on buying high quality assets at lower prices, should reward patient investors through this, and any future short-term market declines, or dead cat bounces!

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