5 Red Flags that Preceded the 2022 Bear Market
Latest piece in the series. Last week was: Here’s The Long-Term Performance of the S&P 500.
Now let’s look at some Red Flags.
No two bear markets are identical, but they can often rhyme. With that in mind, I wanted to highlight some things that stood out to me in the lead-up to the current 2022 bear market in an effort to help others identify potential red flags in the future.
I will be the first to admit, I did not come into the year short — nor was I quick enough to flip short. Years of a buy-the-dip mentality had me stuck in my old ways, searching for a bottom instead of paying attention to the little red flags I had accumulated on the back of an old envelope on my desk.
Simply put, we hadn’t had a true bear market or a lasting bear market in more than a decade and even though a few red flags had piled up, I wasn’t ready for the seismic changes we felt in January.
For those that like watching instead of reading, I will try to do a video recap on this soon. I encourage you to sign up so you’ll get that notification when it’s ready (and to get more stories like this in the future).
Red Flag No. 1 — Growth Stock Bifurcation
A couple of weeks ago in early September, I did a webinar with MrTopStep — aka Danny Riley — a good friend of mine and my partner at The Opening Print.
In that webinar, I talked about what I expected in the fourth quarter and what went wrong in the lead-up to this year. I will include some of those slides going forward.
In late 2020 and coming into 2021, we had an insane move in growth stocks, crypto, SPACs, EVs, etc. It was madness. But then in January/February 2021, we had that huge blowoff top and these names were decimated.
I’m going to go by rough numbers here, but it seemed like half of growth stocks never made new highs again. The other half made big rallies and got close to or made news highs.
Despite the stock market pushing to new all-time highs in November, just a handful of growth stocks made news too. They were names like SHOP, AMD, TTD, NVDA, SNAP, etc.
This is called bifurcation — or “the division of something into two branches or parts.”
Essentially, there were the haves and the have-nots in the growth world. There was a disconnect; a break.
It was the first clue and it ran under the radar because many traders discarded them as “junk stocks that are and were overvalued.” And because some of them continued to trade well — especially the well-known ones — everyone thought it was okay.
Red Flag No. 2 — The Nasdaq and Russell Tip Their Hand
You can ignore growth stocks, but it’s not easy to ignore the Nasdaq and Russell. Simply put, the Nasdaq and the Russell are the “risk-on” indices of the four main US indices, while the S&P 500 and Dow Jones are less risk-on.
Equities are equities, but there’s a big difference between buying Walmart and J&J vs. a handful of small caps, right?
All four indices hit temporary highs in November, but the S&P and Dow went on to make new highs.
Look at the Nasdaq vs. the S&P:
Now look at the Russell vs. the Dow:
I mean, holy cow, there is some serious divergence there!
Specifically, the Russell was really getting dogged at the start of the year. On top of that, notice the stark bearish diligence in the RSI reading for S&P and Dow (top of the chart), as these measures were not making new highs at all, even though the respective indices were.
These two charts and four indices highlight the clear “risk-off” attitude among equity investors…it was a shadow bear market at work.
Red Flag No. 3 — Inflation
This next image is going to make you ask yourself how in the world you missed the coming freight train. It’s okay, a lot of us did. I did too. Because the stock market continued to power higher and brush off the situation, “we followed price higher.”
In reality, many of us were asleep at the wheel just like the Fed was.
Inflation was running warm in Q3 and heating up in early Q4. But by November and December we were north of 6% and pushing 7% and that was a red flag that everything was not okay.
I’m a price action guy, not an economist. But the Fed was calling inflation transitory. They underestimated what inflation was going to become and because of that, they ignored it despite all those green arrows on the chart above.
Finally, they gave us a measly 25 basis point hike in March. For comparison, September marked the third straight FOMC meeting with a 75 basis point increase.
Red Flag No. 4 and 5 — Fighting the Fed & Fighting a War
The crazy part? After the Fed meeting on March 15/16, the S&P actually rallied all the way back up above 4600.
Still though, too many investors were in a buy-the-dip mentality, thinking that’s what they were supposed to do. After all, that’s what had worked for the last 12-or-so years.
The rally in March made it so that the index was less than 4% below the all-time high. That’s even as the S&P rallied above ~4600, which has become a key pivot in the first quarter.
Now though, buyers were fighting two headwinds that combined to create a bigger problem: Russia invaded Ukraine. Not only did that create immense geopolitical uncertainty, but it threw supply chains into disarray and drove energy and commodity prices through the roof.
It was, quite literally, like throwing gasoline on the fire.
The other red flag? Now we had a hawkish Fed and one of the most well-known rules in trading is don’t fight the Fed!
While its token rate hike of 0.25% isn’t exactly enough to spook the doves, it should have been evident that the Fed would need to be much more aggressive to fight inflation — particularly with the Russia/Ukraine development.
Again, we’re not economists and when we — or at least when I — get too into a “predicting state,” I tend to overthink and that tends to hurt my results.
Forecasting what inflation would do or how the Fed would react seems to step on the logic of “price first, everything else second.” But combined with price action, the market was telegraphing the reality: We were in a bear market.
The “risk-on” assets — all the way from high-growth stock to the Russell 2000 — were showing various signs of distress and/or lagging the S&P months before the true selloff was on our doorstep.
Inflation was raging, while prior support was becoming resistance. A war was breaking out and the Fed was turning hawkish.
All of these things should have combined to get investors out at S&P 4500+.
The long-term performance of the S&P doesn’t lie, but that doesn’t mean we should buy blindly, hoping and praying that everything works out even in the face of so many clear red flags.