Making Sense of This Confusing Market

With the possible exception of option sellers, pretty much everyone likes it when the stock market picks a direction and sticks to it. It’s frustrating, however, when the market grinds sideways or chops around, which it has done for the past year.

The month of April has also seen more than its fair share of sideways, directionless price action in mega-cap stocks. Yet, even as the VIX volatility index craters, the overriding sentiment among investors isn’t complacency, but mostly confusion.

On one hand, you’ve got a stock market that surged higher in March. Apparently, investors expect the Federal Reserve to cut interest rates this year. The Fed hasn’t provided any signals that it’s going to reduce the federal funds rate in 2023, but financial traders evidently expect the central bank to pivot nonetheless.

At the same time, the bond market is sending a signal that’s both bearish and bullish. A range of yield curves are inverted, so bond traders expect economic conditions to worsen, resulting in the Federal Reserve swooping in and cutting interest rates.

Then, you’ve got the FOMC meeting minutes stating that the Fed expects a mild recession later this year. Also, we’re about to start on a seasonally weak period for the stock market; remember the old rhyme, “Sell in May and go away, and don’t come back ’til after Halloween day.”

CBOE Volatility Index (VIX). Courtesy: Yahoo Finance

If volatility brings opportunity, then a lack of volatility can fray at one’s patience. It’s baffling and infuriating to witness the U.S. inching ever closer to a debt ceiling disaster, yet the market refuses to budge in either direction.

Meanwhile, it’s not difficult to find dour predictions and warnings. Finance professor Jeffrey Bierman sees technology and industrial stocks as “vulnerable to a 20% to 40% correction.” Furthermore, after Tesla’s dismal earnings report, Bierman stated, “There’s nowhere to hide, no diversification in this type of market. This is a black swan event.”

Speaking of Tesla, CEO Elon Musk expects “stormy weather” to continue in the U.S. economy for about a year or so. In a similar vein, Longview Economics CEO Chris Watling sees a recession coming, citing “pretty compelling” and “brutally bad” leading economic indicators, including inverted Treasury bond yield curves.

Another indicator worth mentioning is the NFIB business survey, which shows that lending standards are rapidly tightening. Thus, it will be more difficult for individuals and businesses to get loans, which doesn’t bode well for a U.S. economy that depends on borrowing.

Courtesy: @GameofTrades_

Charts like this should make any reasonable person want to exit mega-cap stocks completely. Yet, it’s wrong to assume that investors are reasonable as a whole; the madness of crowds can prevail for a surprisingly long time on Wall Street.

So, what’s going on, exactly? Sevens Report Research founder Tom Essaye has an explanation that’s as valid as any I’ve seen lately. Apparently, the stock market continues to grind sideways and higher because of the “pain trade.”

The idea behind the “pain trade” is that “The goal of the market is to extract the most amount of pain from the greatest number of people.” In other words, the stock market will frustrate as many people’s expectations as possible.

And so, the fact that practically everyone with a shred of rationality is pointing to an imminent recession, is exactly what’s allowing the market to climb the wall of worry. “That wide expectation of looming calamity, and the fact that it hasn’t come to fruition yet, has been a material contributor to equity resilience,” Essaye observed.

Moreover, “it’s made the pain trade higher as investors waiting for a decline that never occurred, and who are now chasing stocks higher as they remain resilient.” It makes sense in a twisted way, and it explains why the market generally doesn’t crash until no one’s expecting a crash.

This doesn’t mean you should ignore the fundamental facts that point to an economic downturn. Rather, the idea is to understand why the stock market contradicts reality and how you can take advantage of this odd phenomenon. While I’m bearish on the economy, I’m also not just putting all of my capital into a money market fund; as long as the “pain trade” prevails, I’m ready for any possible outcome.