What Our Clients Are Talking About Behind The Scenes

Equities have rallied and have continued to hold at higher levels following the lower-than-expected CPI report from last week and the follow up downside surprise from PPI that came out earlier this week.  A lot of more tactical and mechanical related funds were caught offsides, and a short covering surge has occurred.  Now that a bounce attempt has once again begun and with the bulls getting reenergized the question is now — How high and how long?

The bulls have spun quite an interesting set of assumptions that keeps the rally holding the S&P 500 above 4000 and rising to levels not seen since the beginning of 2022. 

• High cash levels by institutional funds, positive seasonals, and equity positioning that is on the lighter side create enough tailwind to power the S&P 500 to significantly higher levels. 
• The inflation battle has been won and Chair Powell and Crew are about to announce a pause in their tightening cycle.
• Forward earnings cuts don’t matter as they are already discounted.  
• Or better yet, we will have a Goldilocks scenario where interest rates are falling, the economy avoids a major recessionary slowdown, profits surprise to the upside, and valuation multiples have nowhere to go but higher. 

My work still does not support such an optimistic outlook, or the assumptions likely needed to suggest that downside risk and lower equity prices are off the board.  Granted, the fact that the inflation data was softer than I was expecting does keep me on alert that my views are under heightened scrutiny. 

Let’s discuss a few points that have come up during client interactions and to put into some context how extreme the market action has been since the recent CPI data was released. 

Fed expectations have fallen quite a bit.  Following Chair Powell’s post-FOMC press conference, several metrics gauging forward rate expectations peaked and have fallen quite dramatically.  In fact, they have plunged 25-50 bps, and some have commented that using 1yr-1yr OIS that the over 50bps decline was one of the largest easings in financial conditions in the last 20 years (ie., roughly two Fed CUTS).  And although Vice Chair Brainard was interpreted as being on the dovish side during an interview this week, several other speakers have remained hawkish and in line with Chair Powell’s recent comments.  Indeed, Fed President Mary Daly emphatically stated that “Pausing is off the table right now. It’s not even part of the discussion”.  Like the bear market bounce attempts that occurred earlier during 2022, it would seem that a continued fall in interest rates would be needed to sustain additional equity gains.  My work suggests that the upcoming data releases may not support this outcome, and that the unwelcome surprise is still that the Fed may have to do MORE (higher terminal rate) rather than less.  

Short squeeze/covering.  On Thursday alone following the explosive up move in equities following the CPI release, there was a very clear pattern of performance as shown below.  The worst YTD performing decile was up nearly 10% while the two top YTD performing deciles were only up 2%. 

And if we look at things a slightly different way by examining how the most shorted names performed, we see that they had a four-day gain of roughly 18% as of Tuesday’s close (shown below).

In my opinion, based on these two simplistic charts and information, the bounce has clearly been heavily fueled by tactical funds covering short positions.  Further supporting this view is that in the discussions I have had with my Street contacts, many of the important equity trading desks were seeing heavy short covering AND strategic long only accounts selling into the strength.   I know some will see this as a contrarian positive because of the skepticism, but when my indicators are unfavorable, I interpret this is powerful confirmation. 

Earnings outlooks still look too high/negative earnings revisions.   My main indicator for the S&P 500 for estimate revisions is called ASM (Analyst Sentiment Measure) and it is still falling as I have been discussing since early April.  Importantly, it does not yet appear to have made its final extreme low (see chart below), which in my view is an extremely critical occurrence to switch back to being strategically bullish.  I will reiterate yet again that this process is likely to persist for at least another 1-4 months, at minimum.  Thus, patience will be needed if the historical relationship between the ASM indicator reaching max pessimism is consistent with previous six major bottoms since 1990.  REMINDER — Why is fundamental capitulation important?  My research shows that since 1990 the ASM indicator has made its extreme low BEFORE the S&P 500 makes its FINAL bottom in all six periods.     

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.  
• And because so many have commented, I do not necessarily like being bearish and am not rooting for a negative outcome.  I am eagerly awaiting an opportunity to turn full bullish again like I did in March 2020, but my work and key indicators are not yet flashing the signals that will cause a shift.

Bottom line:  The current rally could very well have some more work to do as bearish sentiment, high cash levels, positive seasonals and tactical technicals, corporate share buybacks, and CTA buying could help fuel the S&P 500 higher.  Importantly, however, my analysis does not support the conclusion that the bear market is over, and we have begun a new sustainable bull market.  Hence, despite the attempts to bounce from time to time, my key indicators are still signaling that downside risk clearly outweighs upside potential and investors still need to be cautious. 

I will once again repeat that 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.  Patience will be needed, but the payoff will be a great opportunity to get high-quality stocks at lower prices that will likely have a longer duration move higher. 

So, 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 to 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.

SPECIFIC CLIENT QUESTIONS

• What are the main observations from your earnings revision deep dive and ERM review into your 4000+ single stock U.S. universe?
• Any areas/single stock names that are standing out?  
• What are your most aggressive tactical indicators saying?

MY ANSWERS

• What are the main observations from your earnings revision deep dive and ERM review into your 4000+ single stock U.S. universe?

The deep dive continues to show that the earnings revisions backdrop is still deteriorating as expected.  The number of favorable names is still falling and is at the lowest level since the COVID low in April 2020.  This been the case for the last seven months as the bleed continues. 

To build on last month’s comments, there is a slow increase in the estimate behavior which shows that the analyst community is starting to lower profits of cyclical areas, but they still look to be too high.  Crucially, however, there is still much work to do before maximum negativity is reached (fundamental capitulation), which will be an important bullish contrarian signal once it happens.

• Any areas/single stock names that are standing out?

Health Care — Equipment, Biotech, Pharma, and Life Sciences (showing some early signs of life).  Sadly, there is not much that stands out from an absolute perspective.  

Staples — had some interesting names pop up this month (WBA, SYY, HRL, MDLZ, MKC, CLX, PG, STZ, MNST, PEP, CAG, GIS, LW, SJM).

Energy — has seen some improvement and it was broad-based. 

Technology — is still weakening, but lots of things are getting close.  I can see a point in the next 2-4 months when this will be a fertile area to find compelling ideas. 

• What are your most aggressive tactical indicators saying?

My aggressive metrics are in divergence with V-squared rolling over at its downtrend line and HALO-2 elevated but still drifting higher.  Hardly compelling readings to expect a high probability extension to the ongoing equity market rally.  I will be looking for the next rollovers that will once again synch the tactical with my longstanding unfavorable medium-term view.  Strategic accounts should follow the same strategy that I have been reiterating all year — sell into the strength, reposition, raise hedges, and reload shorts as this rally may be your last chance.