Why This Stock Rally is a Bear Trap
A bear trap is a false signal in the market that suggests a sudden reversal in the price trend is about to occur when in reality, the price will continue to decline. Investors will think the market has bottomed out and start to buy, only to see the price continue to fall.
The stock market for the first half of 2022 has been one of the worst on record. The S&P 500 fell over 24%, and many other indexes like the Nasdaq fared even worse. The Covid 19 lockdowns in China and the war in Ukraine were the main reasons for the market crash.
We have seen a sudden and sharp rally in the stock market in the last few weeks. The S&P 500 has jumped over 17% from a mid-June low. This has led many investors to believe that the market has finally bottomed out and is now ready to start a new bull market.
However, there are several reasons to believe that this rally is nothing more than a bear trap.
The War in Ukraine is Far from Over
The war in Ukraine is one of the main reasons why the stock market crashed in the first place. It doesn't seem like any progress has been made in terms of peace talks, and the fighting appears to be as intense as ever.
If anything, it seems like the situation is getting worse. Shelling by both sides has not subsided in recent weeks, and there is no end in sight to the conflict. Mediated peace talks have failed, and it doesn't look like they will be successful soon. This major risk factor could easily make the stock market tumble again.
High Cost of Labor As Inflation Reduces
The Federal Reserve raised interest rates by 0.75 in July to combat runaway inflation. This was the second consecutive month interest rate hike, making it one of the most aggressive measures to fight inflation in years.
With the rate hike, the market saw a massive rally that has got some investors thinking that the market has bottomed. However, this couldn't be further from the truth.
The falling inflation does not necessarily mean the bear market is over. According to Morgan Stanley strategists, businesses will face the challenge of reducing prices and high labor costs, leading to lower profits. The net effect is that the reduction in profits will cancel out the drop in inflation, resulting in no real change for the economy.
According to July's job report, over 528,000 new jobs were created, which means businesses are still spending heavily on labor. This is not sustainable in the long run and will eventually lead to lower profits and another stock market crash.
Another factor is that inflation is dropping at a rate of 0.60% per month. This slow pace of decline means inflation will remain elevated for some time, which will continue to pressure consumer spending and corporate profits.
A Recession Is Still Likely
Although we're not yet in a recession, the risk of one happening is still relatively high.
According to a recent study by Allianz Life Insurance Company of North America, about 66% of Americans believe that a recession will likely happen in the next year. This is up from 48% a year ago. With spending power already constrained, another economic downturn would be devastating for the stock market.
In addition, many economists believe that we are close to a recession. According to UBS' probability model, there is a 40% chance of a recession happening in the next 12 months. UBS foresees a consumer-led recession, with a slowdown in spending as has been the case for the better part of this year.
A recession would be disastrous for the stock market and is a major risk factor that investors must be aware of.
What Next for Investors?
The stock market is a risky place right now, and investors need to be very careful. Although there has been a recent rally, many risks could still send the market crashing again. We're likely not yet at the bottom, and caution is still warranted. A bear trap is a genuine possibility.
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Alpesh Patel OBE