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Iron Capital Insights

  • Iron Capital Insights
  • December 14, 2022
  • Chuck Osborne

Passing the Test

‘Tis the season. If you are a student, a parent of an exam-taking student, or young enough to remember being a student yourself, then you know what I mean:  It is time to finally open up that textbook and do a semester’s worth of learning in one caffeine-fueled all-night cram session. It is the pre-holiday ritual known as final exams.

The market has tests as well. This quarter we have rallied off of the September lows right up to the 200-day moving average. We hit that at the end of November, and since then have been negative. Getting over the 200-day moving average is a big test, and thus far the market has failed.

Some translation to English may be in order. The 200-day moving average is exactly what it sounds like:  Every day there is a value or price for the various market indexes. For this discussion we will use the S&P 500. Every day, one could look at the prices of the S&P 500 for the last 200 days and calculate the average price. The next day one could do the same thing, and the oldest day would fall off and the current day would be added. Then, one could place those 200-day average prices on a chart and see the trend of the S&P 500. Currently that trend is down, as we have been in a bear market. The trend will eventually move up, but for that to happen, the current price has to be higher than the 200-day average price.

What is the real significance of all this? Probably nothing, except there are enough believers in this kind of analysis to make it a self-fulfilling prophesy. Getting meaningfully over that average is the first step in a lasting recovery, and this is often the point where bear market rallies fail. So, will we pass the exam, or will we fail? The former moves us forward, while the latter does the same thing it did in school – it forces us to take our course all over again…down once more before rebounding.

So, which is it going to be this time? The Fed has a lot to say about that. They have now raised the Fed Funds rate by another 0.50 percent, which the market fully expected. They also raised their guidance for where they believe rates will end up (the so-called terminal rate) by 0.50 percent to 5.1 percent.

Interestingly, the bond market reacted to this change in guidance with a yawn., which tells me they do not believe the Fed. The 10-year Treasury is trading near 3.5 percent; in fact, the yield is down very slightly since the Fed announced its action. The bond market believes the Fed is going to overdo it, cause a more severe recession, and then have to reverse course.

The stock market is also yawning – it has lost interest in the whole inflation and interest rate story and moved on to the recession of 2023. The question, according to consensus, is not whether we will have a recession, but how severe will it be?

There are a few holes in this narrative. (We have become accustomed to narratives that have holes in them, but I digress.) In this case, the first hole is that the recession of 2023 would be the most anticipated recession of all time. Anticipated recessions have a way not happening. We could have a setup that is overly pessimistic, in which case the market would go up.

Let’s say that the recession does occur. Lots of pundits want to say that our two quarters of negative GDP growth this year wasn’t a recession, but no one can say we did not have a full-on bear market. If that was not in reaction to the recession that shall not be called a recession, then it must have been in anticipation of the recession of 2023. If that is so, then will a recession in 2023 cause yet another bear market?

It is possible, but it is not probable. My educated guess is that the best case for 2023 is things are far less bad than expected, the market passes the test, and we have a good year. The worst case is that we actually have the most-anticipated recession of all time, and while volatile, the market stays roughly where it is.

In the end, all-night cram sessions won’t likely get you many As, but C is still passing. As a doctor friend of mine once told me, “Do you know what they call someone who finished with a C average in med-school? They call him Doctor. (The hers get As and Bs.)”  We don’t need an A; we just need to pass this 200-day average test, and then we can move forward.

Warm regards,

Chuck Osborne, CFA
Managing Director