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July 22, 2022

Why the Stock Market Rally Is a Mirage

Michael J. Donoghue
Why the Stock Market Rally Is a Mirage

US stock market bulls experienced a month of respite as major indices have rebounded from their mid-June lows over the following five weeks. The Dow Jones Industrial Average crossed above 31,800 on July 19th after finding support upon dipping below 30,000 in June, and the S&P 500 likewise nearly hit the 4000 level on July 20th after having touched 3650 in June. Even with mixed earnings reports and a surprise 50 basis point rate hike from the European Central Bank seemingly prompting US stocks to take a tumble intraday on Thursday, July 21, investors were treated to another ultimately positive day as indices closed higher. However, despite over a month’s worth of restored buying pressure, this recent indices-wide leap is likely not as optimistic as it seems. Let’s explore fundamentals as we discuss why the stock market rally is a mirage, as well as what investors could expect timeline-wise.

Why the Stock Market Rally Is a Mirage

USD Trade Complications

Although a soaring USD in the foreign exchange market enables American consumers to indulge in lower priced imported goods, the flip side is that it comes at a cost for many US businesses. For those corporations that have historically sold goods and services internationally, these prices overseas are now far higher than in years past, limiting foreign demand. Thus, a highly valued USD makes US exports (approximately 13% of US GDP) less enticing for trade partners, which can substantially limit revenue for these businesses in the US, disincentivizing potential investors by theoretically limiting their earnings and share prices. Considering that USD looks primed to continue its bullish trajectory into the near future, this could be bad news for US indices overall, and by extension GDP growth as well.

Why the Stock Market Rally Is a Mirage

Ill-Fated Consumer Demand

As is the case in every market or mixed economy, corporate earnings in the US are predicated on demand for the products and services that companies are selling. High inflation is happening in America because, as in much of the world, demand for products and services has significantly outpaced their supply; this has resulted in today’s uncomfortably high prices and a hot labor market, bolstering corporate profits to a degree.

However, this strong demand is quite unlikely to remain. Factors such as US employees’ wages and salaries failing to rise at the rate of inflation (with average hourly earnings having increased only 5.1% over the past 12 months, compared to 9.1% inflation), as well as a hawkish Federal Reserve intent on aggressively cooling the economy through raising interest rates, will impair consumer spending. This will mean less income for US businesses by extension, as well as far less money spent buying stocks speculatively as in recent years.

Why the Stock Market Rally Is a Mirage

Global Economic Conditions

Although the US economy is currently the largest economy in the world in terms of its $25 trillion GDP and vast net wealth, much of this growth has been due to its relationship with the global economy. By relying heavily on free trade agreements, as well as foreign direct and portfolio investment, markets in the US have been transformed by globalized supply chains and reinforced by an ongoing influx of new capital.

While this approach to prosperity ostensibly comes with benefits, such as cheap imported goods and huge financing possibilities, it also comes with liabilities, such as those we are encountering today. Globalized supply chains aren’t conducive to flourishing if the world’s economies are in a tailspin while supply is unusually limited. Likewise, US businesses can’t rely on buying pressure from foreign investors if these investors have less capital to work with themselves. Thus, the US stock market is in double jeopardy, as it must endure both global and domestic economic hardships.

Why the Stock Market Rally Is a Mirage

No More Deus Ex Machina Fed

The Federal Reserve, the central bank for the United States, has established a unique role for itself over the past fifteen years as the lender of last resort. During the financial crisis of 2008, as well as the pandemic-induced crash in 2020, the Federal Reserve undertook unprecedented measures to save the US economy through monetary stimulus. By implementing quantitative easing as well as low interest rates to escape recession via emergency expansion, the Fed made history by being willing to spend its way out of any economic crisis, stabilizing markets and causing stocks to rapidly appreciate in value.

However, with potential for recession and stagflation around the corner in the US economy, the Fed’s ability to play monetary savior is now severely restricted. With annual inflation over 9%, at 40-year highs, the Federal Reserve is forced to confront hyperinflation threats, even at the expense of consumers and businesses. The Fed won’t be able to rescue the markets with its usual dovish tricks because this time the contraction is of their own making, as a sort of necessary evil. This is incredibly bearish for US indices, because there will likely be no multi-trillion-dollar last-ditch effort to prop up corporate share prices this time.

Why the Stock Market Rally Is a Mirage

How Long Will This Last?

Unfortunately, it appears that both the US’ and the global battles against high inflation are just beginning. With the Federal Funds Rate currently hovering around 1.75% as inflation surpasses market forecasts, and the Federal Reserve reportedly considering a full 1% rate hike with many more hikes left to go, US indices are seemingly destined for a prolonged bear market. While it is virtually impossible to know when the stock market will hit bottom, with much disappointment for short-term bulls likely ahead, long-term investors can take heart, knowing that this can also mean myriad discounted buying opportunities over the next few years.

Key Takeaways

  • Despite a month-long rally for stock market indices, this buying pressure is likely not what it seems. In light of fundamental analysis, these gains seem to be a bout of false hope.
  • A US Dollar that is appreciating in value in the foreign exchange market makes sales difficult for American companies selling products and services overseas, limiting earnings and share prices.
  • Despite surging consumer demand and a hot labor market, between wages lagging behind high inflation and the Federal Reserve preparing an arsenal of rate hikes, consumer spending will soon likely be severely impaired along with speculative investing.
  • Because the US economy is so globalized, bolstered by cheap imports and foreign investment, American economic activity is quite tethered to global output. With many of the world’s economies in a tailspin, this could negatively affect US stock markets.
  • In response to both the 2008 financial crisis and the pandemic-induced crash in 2020, the Federal Reserve rescued the US economy with extensive intervention via expansionary monetary policy. This will likely not happen again soon, due to hyperinflation threats.
  • While it is impossible to discern exactly when US indices will hit bottom, it seems plausible that we are headed for a prolonged bear market. Long-term investors will be able to continue capitalizing on this downtrend accordingly.

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