FLASH COMMENTS:
I guess the bear market is over.
The DJIA just posted its best monthly return since January 1976 (+14.41%), its second-best month since 1936, and its best October as Chair Powell will trade in his talons for a white dove costume during his post-Halloween FOMC press conference, as inflation is ready to plummet and labor slack is surging, which will lead to a powerful upward shift in P/E multiples rising back to over 20x and expectations for reaccelerating forward profit growth. Well, as nice as that may sound, my work suggests that the mega-happy ending from Wayne’s World remains a lower probability scenario.
If the commentary following the upcoming two-day FOMC results in a dovish interpretation or explicit comments about slowing the pace of hikes/pausing, which I have some skepticism about, my work suggests that this would not actually be bullish despite the possibility of the equity markets initially rallying on the news. Why do I think that? The combination of my key indicators, deep discussions with my economics sources, and my own read of the macro tea leaves suggest that potentially slowing the pace of hikes or pausing will only open the door for the Fed to extend the rate hiking cycle for longer and higher, which would likely raise the ultimate terminal rate to 5.5-6.0% and pull up 10-yr yields as well.
Quite frankly from my perspective, there has been scant evidence to suggest that the battle against inflation and creating labor market slack has made enough substantive progress to even start contemplating any major shifts in policy let alone specific implementation and timing. So, where are we then?
- Earnings continue to slowly weaken, and forward expectations still look too high as maximum negativity, as captured by my proprietary S&P 500 ASM indicator which is still falling, has not been reached yet.
- Forward P/E multiples still look rich in a world of elevated inflation, rising interest rates, geopolitical instability, a hawkish Fed, and economic uncertainty.
- Despite domestic consumer spending broadly holding up, my analysis suggests that it is fragile, and weakening is on the way, especially with Fed’s intention to contain wage growth and create slack in the labor market.
As I continue to have a full docket of client interactions every week, I am getting a lot of feedback on my calls as to what investors are thinking. From my perspective, it is clear that clients with a more fundamental and strategic focus are communicating their concerns for the equity market. However, it is my view that their portfolios and cash levels do not reflect the same degree of bearishness. When having interactions with more aggressive tactical accounts, the overall level of negativity is relatively less, but still a clear majority voice concerns while their portfolios don’t synch with the same level of bearishness.
The biggest pushback I still get is that everyone agrees that the forward expectations for profits are still too high and that they will need to be lowered. Thus, the coming negative estimate revisions do not matter because they must already be priced in by markets. There are some mixed views on if inflation will likely be sticky or ready to fall like a stone, but it’s clear that my view that the terminal Fed funds level is likely to be higher than approximate 5% consensus target gets a good amount of skepticism. Another popular point of dispute is about the ongoing negative sentiment, bearish positioning, and the bullish seasonality. Well, my indicators signal that a good portion of the recent oversold condition that was present at the October low has been worked off and has considerably less fuel to support a sizable extension of the recent tactical equity bounce. So, to call THE market bottom being in place and for significant additional gains for the S&P 500 from here will likely require another catalyst to keep things in place.
Although it seems like many of the 2022 bears have claimed some degree of victory and have shifted their forecasts for additional upside, my work still has not flashed any supporting signals to allow me to change my longstanding forecast that considerable downside risk remains and that strategic investors should remain patient and use any additional upside to sell into, reposition, increase hedges, or reload on shorts. Tactical folks can continue to try and navigate the wiggles, but even on that front my aggressive tools only shifted from unfavorable to neutral at the October low, which is the only tactical bottom during 2022 where they didn’t both flip to tactically favorable. With that being said, one metric (HALO-2) is actually at a positive extreme and likely to have a bearish negative inflection over the next week or two. So, I continue to advise caution even if the equity market moves higher on perceived dovishness by Chair Powell on Wednesday afternoon.
Reiterating Key Assumptions:
- Headline Inflation has peaked.
- The U.S. economy is decelerating not collapsing, and fears of slowing have not reached their maximum level. The labor market remains resilient and is not yet showing any definitive signs of decelerating let alone contracting.
- Forward expectations for corporate profits are too high and most certainly will need to be lowered, especially names that are more sensitive to cyclicality.
- My work suggests that there has neither been a price nor fundamental capitulation yet, but they will both likely happen at some point in front of us.
- THE equity market bottom is not in place yet, and my next downside target area is 3200-3000. NOTE: sharp downward capitulatory price action that takes the S&P 500 below 3500 may cause me to shift my view and start putting some money to work.
- My work still suggests selling rallies and not buying dips.
Bottom line: Notwithstanding the many reasons proposed by the bulls on why the equity market has bottomed and is poised for a healthy thrust higher to either the old highs or above, my work has not yet flashed any signals to support any sustainable optimistic forecast. Granted, there will be attempts to bounce from time to time, but the key indicators in my research are still signaling that downside risk clearly outweighs upside potential and investors still need to be cautious.
The adjustment process for the economy, inflation, forward profits, and valuation levels still needs more time and work to be done to reach readings that shift the risk-reward ratio back to reward for strategic investors. I have no doubt that it is coming, but the speed at which it arrives appears to be on slower the side and thus requires some degree of patience.
Hence, I am still advising that bounces should be viewed as bear market rallies that will likely fail and should be used to sell into, reposition, raise hedges, and reload shorts. Any tactical gains or outperformance for now is just the side show while the MAIN EVENT of pivoting for THE bottom is still in front of us.
GENERAL CLIENT QUESTIONS/CONCERNS/TOPICS
- A lot of confusion about why the equity has rallied as much as it has and the timing of future Fed policy adjustments.
- Accounts are beginning to see some idiosyncratic differentiation showing up after companies post their 3Q22 earnings results, and my work is seeing early signs as well.
- What is wrong with FAAMG? Is it done? Does it change my view that clients should still tilt toward Growth and away from Cyclicality?
SPECIFIC CLIENT QUESTIONS
- How is Health Care looking using your ASM and HALO indicators for the sector?
- Has the earnings season impacted your ASM indicator for the overall S&P?
- What are your most aggressive tactical indicators saying?
MY ANSWERS
- How is Health Care looking using your ASM and HALO indicators for the sector?
The sector has both a favorable and rising ASM indicator (see top chart below) as well as a rising HALO. Importantly, neither metric is near a positive extreme suggesting that further outperformance is expected for Health Care, for which I continue to recommend an above benchmark weighting.
- Has the earnings season impacted your ASM indicator for the overall S&P 500?
NO, it is still falling as companies have been lowering their forward guidance as expected and forward numbers continue to fall. Importantly, this key metric still does not appear to have reached maximum pessimism, which suggests that downside price remains for the index.
Well, the earnings season has come close to my expectations, which were absolute numbers OK, some high-profile misses, and conservative to weak forward guidance. Some have asked — where is the disaster? I have not been looking for any waterfall declines or collapse in the profitability for Corporate America, but I have been forecasting that results would be weaker than 1H22 and that forward outlooks would also be lowered more than earlier this year. As far as my analysis is concerned, we are right on course and still headed to the same destination. The ASM indicator for the index continues to fall and still has further to go to reach a zone where we can look for a positive inflection, which would be an important contrarian bullish signal for the equity markets. Why? Historical analysis has shown that EVERY major equity market bottom was PRECEDED by an extreme trough in the index’s ASM indicator, which measures the rate of change in analysts’ estimate revisions. So, to be clear, it does NOT show when analysts begin raising, but when their activity turns “less bad” (i.e., rate of downside acceleration has slowed as shown by a flip from negative to positive slope). Thus, it continues to appear that more work needs to be done and once a negative extreme is reached and there is a second derivative an important bullish signal will be flashed. Stay tuned.
- What are your most aggressive tactical indicators saying?
My most aggressive tactical tools remain mixed with HALO-2 having reached a positive extreme, which is a contrarian bearish signal, while V-Squared has slowly been rolling up. The October low was the first bottom during 2022 where both indicators did not confirm the start of a tactical rally. With HALO-2 about to roll over, these tools will likely remain mixed and diminish the potential for significant upside gains until they both bottom again.
My highest-frequency and most aggressive tactical tools for looking at the S&P 500 price action — V-squared (orange line top chart) and HALO-2 (purple line bottom chart) are still mixed with HALO-2 peaking and V-squared unimpressively trying to move higher. In my view, the setup is not compelling for a major upside move from current levels. In fact, once HALO-2 rolls over again, the bias will be neutral to negative. If playing the wiggle for more, my work advises a lot of caution.
