The Fed Bubble: A Technical View

There are a couple of widely accepted definitions of a correction and a bubble. Today I am going to offer a slightly different technical definition and observation based on longer term trends and deviations from those trends during market cycles.

If you overlay a 3 year moving average on a long term index chart, you’ll notice a couple of things. One of which is that normal market cycle corrections tend to respect this trend. The only events that don’t respect this trend are events that have caused long term bear markets. For examples, the chart above represents a 156 week (3YR) Bollinger Band, with this center line being a moving average and the upper/lower lines representing 2 standard deviations from the mean.

Examples: Respected the 3 year moving average (bounced near this price level)
• 2018 Correction
• 2016 Correction
• 2011 Correction
• Even the 2008 crisis found resistance here Q1-Q2 before entering a bear market
• Black Monday
• 1973 crash found resistance here Q3-Q4 before entering a bear market
• Most normal market cycle behavior over the last 40 years

Examples: Broke this 3 year moving average and entered into a bear market (These are the only examples going back to 1970)
• Covid crash (briefly on SP500)
• 2008 Financial Crisis
• .COM Bubble
• Early 1980s Recession (Interest Rate, Inflation, Oil)
• 1970’s Crash/Recession (Interest Rate, Inflation, Oil, Bretton Woods)

With these observations in mind, I am going to define a correction as a pull-back to a 3 year moving average, and a bear market as a run below the 3 year moving average. So, I am saying that a price converging on its average is normal correction behavior.

This is why this is concerning:

While most investors have been spooked by the current market cycle correction, the realty is that we are only a little more than halfway to a 3 year moving average pullback. And, based on the historical perspective of this long term trend, pulling back to it would NOT yet be entering into a bear market. In fact, bear markets have historically ended 2-4 standard deviations BELOW the 3 year moving average. At its peak in December, the Nasdaq 100 hadn’t deviated that far from the 3 year moving average since the .COM bubble, which led to a multi-year bear market during a time that we were NOT facing record inflation, when oil was cheap, and during a time where the Fed had room to move down the interest rate to stimulate a recovery.

So, what happens when we mix the market speculation frenzy of the .COM bubble with record inflation, a Fed that can only raise interest rates, and a large spike in the cost of oil (which could itself cause recession)? To add to the uncertainty, the pandemic could still find a variant that is vaccine resistant and did anyone pick up on what Russia was pushing on state media over the weekend? The cliff notes is that they are beating the WW3 war drum and televising what a simulated nuclear strike on Europe would look like.

So, where do these correction and bear market numbers exist today, if the market corrects as it has historically?

The 3 year moving average is another ~14% below the SP500’s price level today. 2 Standard Deviations below the 3 year moving average is ~44% below the SP500’s price level today. Or, for perspective, it is right around where the SP500 bottomed out during the covid crash in March 2020.

But fortunately, we aren’t seeing companies revert to that price level, right? I mean, the Fed Rate is only at 0.33%.

Actually, we are seeing companies revert to 2017-2018 price levels based on 1 or 2 choppy earnings reports. Case in point:
• NFLX: Trading today at the same levels it was in Q4 2017.
• PYPL: Trading today at the same levels it was in Q3 2018
• FB: Trading today at the same levels it was in Q3 2018
• TWTR: Trading in Q4 2018 ranges before Elon news
• JPM: Trading just above Q3 2018 price levels
• BA: Trading today at the same levels it was in 2015
• There are more.

So, what would happen if the indexes reverted to the price levels these large companies have been reverting to?

This would put the SP500 1-2 standard deviations below the 3 year moving average, or in bear market territory. It would represent over a 40% decline in today’s SP500 level. Over the past 50 years, that would be a decline that has only been caused by the 2008 financial crisis, the .COM bubble, inflation, the cost of oil and rising interest rates circa 1974.

So, what is going to happen?

In the absence of psychic abilities, here is some perspective: The indexes obviously have a long term upward bias. The reality is that the vast majority of time the market is not in a correction or bear cycle, and therefore the vast majority of the time it is trading above the 3yr moving average. There are also multiple ways that the price could revert to the 3 year average. If prices range sideways for an extended period of time, then the average will move up to the price level eventually. I would call that a soft landing. If we continue the downward trend that started in January, we could see the SP500 converge on the 3-year moving average later this year at a level around 3800. We are facing multiple head-winds with inflation, rising interest rates, the price of oil and war. Due to inflation and rising interest rates, bonds and the dollar are not risk-free short-term safe havens. We know bonds will lose value with rising interest, and the dollar will lose value with rising inflation. The point here is, take a look at the historical perspective and adjust your risk expectations accordingly.