There has been a small shift in client sentiment over the previous week or two that has come out during my client meetings (yes, finally seeing people in person again) and zoom calls. A small number of clients have shared that they are beginning to hold their nose and are starting to put money to work as the S&P 500 keeps falling and frustrating the forecasters that keep calling for rallies and bottoms.
I was a bit surprised, but the logic is if one looks out 12-24 months from today the stocks they are buying will likely be higher. Thus, they don’t want to miss the beginning of the new bull market. At the highest level under that specific set of criteria — looking ahead 12-24 months (end point to end point) — I do not necessarily disagree.
Importantly, however, my work is still clearly unfavorable and not much has changed in my key indicators over the last couple of months. Therefore, considerable downside risk remains based on my research and I am unable to make a high conviction, compelling case to ring the bell and advise investors to aggressively shift back to risk on and more offensive positioning.
In fact, I am quite concerned about the potential outcome of the upcoming CPI data release this Thursday. The doves and more optimistic forecasters have a view that being long into the event is an attractive set up. Respectfully, my work shows quite a different negative potential outcome.
This is not an outright forecast, but I do want investors to be on full alert for the potential scenario: 1) Core CPI comes in hot to the upside; 2) Market does not like that and shifts expectations for the Fed to 100bps for November and for December while also pushing out easings; 3) Equity markets decline begins to accelerate into the 10/21 option expiration; 4) The analyst community recession fear level finally begins to rise more noticeably and they go to work on lowering forward profit expectations. Think it can’t happen? Go back and revisit what happened during December 2018. The S&P 500 sharply fell nearly 17% into 12/24. It is not exactly the same set up, but is a perfect example of how expectations can shift quickly and equity markets sharply decline in a short period of time.
My advice is to take a minute and consider this potential chain of events and how you would react if the situation did unfold in a similar manner. Maybe I am becoming too bearish and am just looking for outcomes that would be confirmatory. The early influence of Byron Wien on my thought process when I was a young analyst still sits with me and thinking outside the box.
Be alert. And I will gladly eat my words next week if CPI comes in tame and the market makes another attempt to rally.
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 is not in place yet, and my next downside target area is 3200-3000. NOTE: sharp downward capitulatory price action 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: The equity backdrop remains tenuous and despite a high degree of pessimism and bearishness I am actually hearing more clients saying they are starting to hold their nose and are putting money to work. If one is looking out 12-24 months, I have a hard time challenging that view, BUT my work is still strongly suggesting that the S&P 500 still has considerable downside risk as my key indicators remain unfavorable. Hence, if you hold this view, I recommend only nibbling not aggressively buying (gobbling).
Yes, some metrics are oversold. Yes, some analytical techniques are signaling some degree of selling exhaustion. Yes, this could lead to tactical bear market bounces. However, I strongly advise NOT to underestimate the powerful combination of earnings that need to be lowered (not discounted by markets), valuation multiples that are still adjusting lower, and the all-important Rule #1 — DO NOT FIGHT THE FED.
For positioning, my work continues to suggest 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
- What were the main conclusions from your monthly earnings revisions deep dive into the S&P 500?
- Has your ASM indicator for the overall S&P 500 reached maximum pessimism yet?
- What are your most aggressive tactical indicators saying?
What were the main conclusions from your monthly earnings revisions deep dive into the S&P 500?
The earnings revisions backdrop continues to deteriorate as expected. The number of favorable names keeps following and is at the lowest level since the COVID low in April 2020. This has been the case for the last five months as the bleed continues.
There is finally some early evidence that the analyst community is starting to acknowledge that the profits of cyclical areas are too high, as I saw signs of cutting. Importantly, however, there is still much work to do before peak negativity is reached (fundamental capitulation), which will be an important bullish contrarian signal.
Why is fundamental capitulation important? My research shows that since 1990 this has been a critical prerequisite for the equity market to put in a sustainable investment bottom (i.e. THE BOTTOM).
I will reiterate once again that this process is likely to persist for at least another 1-4 months, at minimum. Thus, patience will be needed if my analysis comes to fruition.
- Favorably standing out as relatively interesting based on earnings revision trends:
Health Care — Equipment, HMOs, Biotech, Pharma, and Life Sciences (showing some early signs of life). Sadly, there is not much that stands out from an absolute perspective.
- Unfavorable and look quite vulnerable based on earnings revision trends:
Too many to mention, but Cyclicals still look weak, and more is to come. Growthier areas and names look close to bottoming or in early signs of recovery.
Has 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 of 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?
In my last Whispers, I commented that my key metrics had rolled up and that another tactical rally would likely start AND my expectation was for another short cycle. Thus, I stated that chasing was not advised. As expected, HALO-2 and V-squared did weakly rollover quite quickly, which is signaling a strong tug lower as the equity market is unable to bounce when oversold. Tactical risk has considerably risen going into the main event of the week — the Thursday morning CPI data release — as my aggressive tools are once again falling.
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 both declining again suggesting that the bear market continues to have huge influence. Some have seen the lack of the S&P 500 price dramatically breaking down early this week as a positive. My work suggests quite a different conclusion with the equity market unable to rally more than a few days when it is oversold. I would remind readers that some of the worst down days in market history have occurred from oversold levels and the combination of my tools falling, forward earnings that likely need to be lowered, and the Fed clearly decisive about its inflation fight could lead to sharp downward capitulatory selling action. I am quite concerned about how the market might react to a hot core CPI reading on Thursday. Be on high alert for potential extreme price action heading into the 10/21 option expiration.