The stock-market rebound sits on a shaky foundation

The comparison with the last three big bear markets provides some similarities, but also some important differences. Since I am often accused of being a permabearer, let’s start with the analogy, thinking this rally might be sustainable.

The first is that the biggest loser becomes the biggest winner. In 2002, 2009 and 2020, the best performing areas became the worst or worst in the early stages of the rebound, and vice versa.

That’s exactly what happened this time, with technology, especially the beloved unprofitable and barely profitable tech stocks from Cathy Wood’s ARK Innovation ETF, moving from disappointing losers to the rest of the market. ARK Innovation lost 44% in the three months prior to March 14 – and much higher than last year’s high – followed by an extraordinary 29% recovery in 14 trading days.

Energy stocks did just the opposite. After leading the market with a gain of 35% in at least the first three months, they rose only 4% as the worst-performing sector.

The second is that the low was driven by emotion, not just fundamentals. Certainly, the fundamentals were of great importance: Russia’s invasion of Ukraine caused oil prices to skyrocket, helping to stockpile energy. The Federal Reserve’s swift turn triggered one of the biggest selloffs in Treasuries of all time, raising bond yields and hurting stocks whose profits are too distant in the future.

But the mood of investors was very bad, which usually happens at low levels. Bears outnumber bulls in a survey by the American Association of Individual Investors and newsletters seen by Investor Intelligence. As hedge funds cut investment in riskier assets, and institutional and individual investors eventually began selling stocks, mutual fund flows turned negative.

The mood changed two weeks ago and began to improve, which contributes to a natural recovery, even if the fundamentals remain at risk. Every major low has been marked by serious sentiment and the idea that the stock is too risky right now.

There are significant differences though, which make me doubt the durability of this boom.

The first is that, usually at low levels, fundamentals appear to be moving in the right direction, not just sentiment. In 2020, the government and the Fed intervened. In 2009, Citigroup was rescued. In 2002, the market smelled an economic recovery (although it was too early, and after a strong rally, the market fell to nearly 2002 lows by March 2003, before the bulls took charge).

This time the fundamentals are moving in the wrong direction. Oil prices hit their lowest level since March, ahead of Thursday’s news that the US would release strategic crude reserves, and the Fed, if nothing less, has become more stringent. Bond yields are rising, and real yields, linked to inflation, are also up. Neither of these should augur well for the stock market.

The second is that the type of rebound is strange, as the sell-off itself was unusual. Cheap-priced stocks generally suffer the most when the market hits their lows, because they are most vulnerable in an economic downturn, and because they are the least investors’ willingness to own. In the reversals of 2002, 2009 and 2020, the Russell 1000 price index fell far more than growth stocks in the three months prior to the low, beating them strongly in the first 14 trading days of recovery.

This time it’s the growth stock that fell hardest, and had the biggest rebound. On a fundamental level, it makes sense that growth stocks took a hit this year because they are most at risk of higher bond yields. It also made sense that Price did much better, as it included many banks that should have benefited from higher interest rates and energy companies that benefited from the price of oil.

But the growth fundamentals actually took off as the stock corrected, so the case for the rebound of technology and growth to be sustainable should be that they sold even more than the fundamentals. It’s true that valuations are very low, but development and technology are hardly the kind of deal that would justify carving out the bottom of the market. S&P 500 growth fell below 23 times 12-month forward earnings in March, up from nearly 30 times in January last year. Cheaper, but not cheap: This only took the valuation back to where it was just before the pandemic, while bond yields are now much higher than they were then.

Third, the reversal seems to be perfect (see chart) across all stocks. If things would have changed in real life or even in bond yields, such fluctuations could be traced. They haven’t, which makes me suspicious.

Oh, and even before GameStop’s announced stock split this week, without any news, the following has doubled since.

On balance, I don’t think March 14 is likely to mark a longer-term low for the market, but I am less confident than usual, as sentiment is such a powerful force on stock prices.