What the Recent Sell-off Tells Us and What’s Next?

(Please enjoy this updated version of my weekly commentary published January 20, 2022 from the POWR Stocks Under $10 newsletter).

First, let’s just recap the past week:

Basically, the market has been sliding lower with little relief. Over the past week, the S&P 500 is down by 3.2%, the Russell 2000 is down 6.5%, and the Nasdaq is lower by 4.4%.

During the early parts of the selloff, weakness was concentrated in tech/growth/froth. Now, it’s starting to affect the broader market.

This isn’t totally surprising given that fund managers might be forced sellers of these stocks especially if people start pulling money out of their accounts especially with growth/tech so over-owned and overvalued.

For investors and traders, the obvious questions are whether we are at the start of a major correction or is this the end of a dip?

The latter argument certainly has merit. In fact, since the stock market bottom on March 2020, being bullish with this type of intense selling, fear, and extreme levels of oversold has been extremely lucrative.

But, I still can’t shake the feeling that this is more of a correction rather than a dip.

Here’s Why I Think These Bearish Conditions Could Persist

For the sake of clarification, dips last for days, while corrections go on for weeks. Corrections tend to see selling across the board, meaning there are little to few places to hide, while dips are more like market rotations which means weakness is confined to specific stocks and sectors.

The Fed is Out of the Game

So, the major reason to think that we could go lower is that we no longer have the Fed as a backstop with its pivot towards battling inflation. There’s unanimous consensus across political parties and various branches of government that inflation is the biggest threat.

It's why President Biden’s approval ratings and specifically approval ratings on the economy is plunging despite historical strength in so many categories like household savings, wages, and labor market.

So, the Fed is intent on removing liquidity to ensure that inflation subsides and prevent it from becoming entrenched. The Fed is so big and powerful that anything it does have massive repercussions.

Think about the Fed’s determination to not let the economy slide into deflation at the onset of the pandemic. They fueled a massive bull market that resulted in pockets of froth and excess speculation.

The Fed was OK with this consequence given its larger purpose of preventing a freezing up of the financial system like what happened in 2008. In fact, one could argue that the absence of such speculation and froth would be an indication that the Fed hadn’t been as aggressive as it could have been.

I think, we are in the same situation. The Fed is now focused on bringing down inflation. At this point, the stock market is of a tertiary concern for the Fed.

Just like speculation and froth were a byproduct of its largesse, profit-taking and a market correction are byproducts of its hawkish stance, especially if we encounter some sort of “growth scare” or an underwhelming earnings season.

To recap, I believe that previous instances of market weakness were self-contained to being more like “dips” because of the implicit Fed backstop. With that no longer being there, I think the odds of a correction are increasing.

Inflation is Getting Worse

We’ve constantly been tracking inflation and favored positions that would do well in an inflationary environment like energy and materials.

There were some glimmers of hope a few months ago with shipping rates plummeting, auto production improving, and ports getting unclogged.

Unfortunately, omicron has wrecked those plans. While, omicron has been much less severe, many countries are pursuing a zero-covid policy with little concern of the secondary and tertiary effects on the various supply chains and transportation channels that it affects.

Therefore, everything is going in the wrong direction. Shipping rates are up, used car prices are increasing, and order times for semiconductors is also increasing. Basically, omicron is unleashing another inflation pulse through the system.

Another negative is that energy prices are not going down like other assets, mainly because of the buildup on the Ukranian border with increasing odds that some sort of invasion or “incursion” is likely. While, a major conflict is unlikely, energy prices are going to stay elevated as long as this continues.

Rates Will Keep Moving Higher

The major implication of a hawkish Fed and rising inflation is that rates will keep moving higher. Thus, we’re also deprived of another source of market stability or a “short-circuit”.

What happens in many market sell-offs is that you have stocks go down, while bonds go up which pushes rates lower. At some point, rates get so low that money starts moving back into equities that are doing buybacks, paying generous dividends, or benefit from lower rates. In essence, it’s almost like a short-circuit that protects the market on the downside.

This circumstance is still intact, but I don’t think it will meaningfully trigger until equities fall much lower… again due to the Fed’s major focus being inflation and the removal of liquidity from the financial system.

Market Commentary Summary

In summation, the market is moving lower and is oversold by many measures. Although, some vicious bounces are going to be likely, I see this as the beginning of a multiweek correction.

As noted in last week’s commentary, this environment necessitates a more cautious strategy in terms of exposure, risk management, and profit target and today’ moves were certainly in that vein.

However, it’s also important to reiterate that on the other side of this correction will be incredible opportunities and gains. The key is to preserve our financial, mental, and emotional capital so that we are able to fully participate and take advantage.

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All the Best!

Jaimini Desai
Chief Growth Strategist, StockNews
Editor, POWR Stocks Under $10 Newsletter

SPY shares were trading at $444.12 per share on Friday morning, down $2.63 (-0.59%). Year-to-date, SPY has declined -6.49%, versus a % rise in the benchmark S&P 500 index during the same period.

Jaimini Desai has been a financial writer and reporter for nearly a decade. His goal is to help readers identify risks and opportunities in the markets. He is the Chief Growth Strategist for StockNews.com and the editor of the POWR Growth and POWR Stocks Under $10 newsletters. Learn more about Jaimini’s background, along with links to his most recent articles.

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