Tactically Cautious, Remaining Medium Term Bullish

September has not been friendly towards equity investors. The Standard and Poor’s 500 Index has posted its first decline of greater than 10% for the first time since the 3/23 trough near 2,200. That level was not only the nadir for 2020 but also the lowest point for equities going back to 4Q16.

Although this is the first double-digit drawdown over the last six months, it is the fourth decline greater than 5%. And all other 5% declines represented dips and buy opportunities within the context of an ongoing recovery rally.

The most important underpinnings of our expectation for even higher highs for the equity markets are still very much in place. The Fed has clearly signaled it is on hold for an extended period and the favorable liquidity environment will not be interrupted. Interest rates remain near record lows which is supportive for equities.

The earnings revisions data, as shown by our proprietary Analyst Sentiment Measure (ASM), is still robust. It shows that the rate of change in the depressed future profit expectations, which were consensus in late-March and early-April, is still getting less bad for the universe of names within the both the S&P 500, as well as the S&P 1500.

Granted, some other factors have helped create some tactical headwinds for the equity markets over the past few weeks. Congress has been unable to pass another stimulus package which has muted recovery expectations. COVID-19 remains stubborn and cases have not fallen low enough to quicken the pace of normalization, despite the fact that hospitalizations and deaths are significantly below wave one peak levels.

Our preferred tactical indicator flashed its most recent caution/sell signal during the middle parts of Q3 and is yet to experience a positive inflection. Accordingly, our work suggests that investors should be tactically cautious and allocate within sectors supported by our work. This week we updated our most preferred and lest preferred sector lists. The results are as follows:

Most preferred: Consumer Discretionary, Technology, Industrials. Communication Services, and Materials rated better than neutral

Neutral: Health Care

Least preferred: Energy, Real Estate. Utilities, Consumer Staples and Financials were rated below neutral.

Relative to previous recommendations, Industrials and Materials were upgraded from Neutral to better than neutral and Financials and Energy lowered to below neutral.

Bottom line: The important drivers for higher equity prices are still in place. Our work suggests that investors should be tactically cautious and allocate additional equity exposure within the sectors supported by our proprietary research tools.

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