FLASH COMMENTS:

The oversold condition that I wrote about in my last note was combined over the weekend and this morning with some rumor and hope that the FOMC is about to cave in and end its inflation fight. No disrespect to the doves/bulls, but everything I look at suggests this is highly unlikely.

Why do I have this view? I am reminded by my main economic sounding board (SR) that 1) the U.S. economy is not broadly cratering; 2) core inflation is still high and will likely be a challenge to move lower; 3) the labor market still has shown little to no signs of weakening. He shared with me that in his view every inflation cycle has symptomatic credit issues, but currently there does not appear to be any systemic credit landmines out there. Going deep into the inner workings of the machine known as the global financial system and fixed income market is outside my area of expertise, and I value my circle of experts as they have been incredibly helpful and right over the years (thanks as always, SR). With that being said, my thoughts when looking into these areas seem to be aligned.

Yes, there have been some rumblings in the fixed income markets and the Bank of England recently did react quite quickly to stabilize the U.K. Gilt market. In addition, some former Fed employees that are now employed on the Street have commented that if the U.S. Treasury market ran into similar issues because of a lack of liquidity that there will be some actions the Fed would likely try to implement to alleviate the problems.

Importantly, however, the key takeaway of this type of potential central bank action is the Fed would NOT be capitulating on their inflation fight and NOT be shifting back to the accommodative policies that investors have gotten used to for the last twenty plus years. Maybe I have this wrong and will have to reactively flip my bearish view at higher equity price levels, but my work continues to give me close to zero reason to think otherwise.

Switching back to a topic that I am more well versed; the forward profit backdrop continues to weaken. As mentioned last week, we remain in the earnings preannouncement period until mid-October, which also runs concurrently with the share buyback blackout period. This is important because most of the corporate news will be negative and the probability that we have seen the last high profile “confession” is quite low. It would not be surprising if more than one major company that impacts investor sentiment still needs to negatively preannounce, raising profit concerns for the broader market. This would likely help nudge the analyst community to start revisiting their forward outlooks more aggressively.

My work still strongly suggests that earnings cuts will matter and there is more work to be done until we have OVERLY discounted all the bad news that Corporate America is facing. So, if you are going to play this bounce despite my warnings, be careful.

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.
Forward expectations for corporate profits are too high and most certainly will need to be lowered, especially names that are more sensitive to cyclicality.
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, either a clear test of the June lows near 3600 or my new 3200-3000 outlook are my targets to potentially become more constructive.
My work still suggests selling rallies and not buying dips.

Bottom line: Despite what appears could be the start of another tactical bear market rally, I continue to reiterate that the S&P 500 still has considerable downside risk as my key indicators remain unfavorable.

Overall, my research still suggests the risk/reward ratio certainly favors betting on a below-average bounce. In addition, unless we make fresh lows for the year in the coming weeks October will NOT be the “bear killer” others are looking for, but rather more like a respite before moving lower. Could the bounce make 3800-3900? Sure, but the downside risk is still substantial. I can see scenarios where the S&P 500 ends the year at a higher level than where we are now, but unless the critical contrarian bullish signals that I am looking for appear then downside potential should remain the focus.

For positioning, I am going to reword my conclusions after several client calls this past week, but there is no substantive change. I am recommending a mix of both defensive non-cyclicals (I was calling this defensive growth) and offensive Growth, relative to Cyclicality even though tactically offensive Growth may still have some bumps as interest rates try to push higher. My indicators suggest relative underperformance is an opportunity to raise exposure as the bigger risk remains weaker profits from areas that are cyclical.

SPECIFIC CLIENT QUESTIONS

Is THE bottom in?

Do you think that the elusive Dovish Fed Pivot is now a certainty?

Is it time for strategic accounts to finally buy dips?

Have I flipped from bearish to bullish?

Are the forward profit expectations for Corporate America still too high and need to be lowered?

Is inflation still well above the Fed’s comfort zone and is their resolve to win their fight the top priority?

Is the labor market still too tight, which is a concern that Chair Powell and Crew have voiced repeatedly during 2H22?

Is there still considerable downside risk for the U.S. equity markets?

Should investors still use tactical oversold rallies as opportunities to sell into, reposition, increase hedges, or reload their short bets?

If one was a more aggressive account and had a trading focus, would you be more open to participate in the bounce that occurred this morning? Do you see this move achieving 10-15% upside?

Has your ASM indicator for the overall S&P 500 reached maximum pessimism yet?
What are your most aggressive tactical indicators saying?

MY ANSWERS

Is THE bottom in?

Do you think that the elusive Dovish Fed Pivot is now a certainty?

Is it time for strategic accounts to finally buy dips?

Have I flipped from bearish to bullish?

Based on my research and my read of the macro environment, the answer to all these questions is a high conviction NO.

Are the forward profit expectations for Corporate America still too high and need to be lowered?

Is inflation still well above the Fed’s comfort zone and is their resolve to win their fight the top priority?

Is the labor market still too tight, which is a concern that Chair Powell and Crew have voiced repeatedly during 2H22?

Is there still considerable downside risk for the U.S. equity markets?

Should investors still use tactical oversold rallies as opportunities to sell into, reposition, increase hedges, or reload their short bets?

When using my key indicators and read of the macro environment, the answer to all these questions is a high conviction YES.

If one was a more aggressive account and had a trading focus, would you be more open to participate in the bounce that occurred this morning? Do you see this move achieving 10-15% upside?

This is a bit harder for me to answer. I would say yes I’m more open, but my work says the magnitude and duration of the bounce are likely to be on the shorter/smaller side with the probability of 10-15% being quite low. Thus, my analysis suggests the reward/risk is still skewed to more downside and suggesting the attractiveness of this bounce is low.

Is your ASM indicator for the overall S&P 500 reached maximum pessimism yet?

NO, it is still falling and appears to need more time to make its bottom, which would be an important signal that we have OVERLY discounted the future weakness in corporate profits.

The ASM metric for the overall S&P 500 continues to work its way lower as I have been expecting since early April. As I have written over the past several months, this is critical for identifying THE bottom in the equity market. 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 the 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?

As discussed last week, both of my aggressive metrics were at negative extreme levels, which suggested that within a couple of weeks another oversold rally attempt would likely begin. Well, they flipped this morning, and the bounce will likely run until they once again rollover. 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.

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) both have positively inflected today and are signaling that another tactical bear market rally is upon us. Although any negative extreme could run its full course back to positive extreme, which is our contrarian signal to flip back to unfavorable, I am expecting another short cycle so be alert for short and small. Ultimately, the rollover of these critical tools is when I will once again return to tactically bearish and sync up fully with my longstanding medium term bearish outlook.