FLASH COMMENTS:

With the S&P 500 once again trying to rally from a tactical oversold condition, the following bullish chatter and hope is resurfacing:

The Fed about to signal something less hawkish.

There has been fundamental capitulation and future earnings cuts do not matter.

The bottom is in because the S&P 500 was not able to definitively break below 3600-3500.

Excessive negative sentiment and bearish positioning will propel us higher combined with a bullish election cycle and fourth quarter seasonality

My work still does not support the views from above and my four counterpoints are the following:

The Fed may have to do MORE than what is currently priced in, which is out of consensus and certainly not priced into the equity market, which is an incremental new and developing view.

Earnings DO matter and based on my analysis most certainly shows that the negative earnings revision cycle has further to go to reach max negativity.

THE bottom is NOT in, and considerable downside risk remains for the U.S. equity markets.

Yes, there is a degree of bearishness that could support countertrend tactical rallies and is probably my biggest worry point for my longstanding unfavorable view as we move into the historically favorable seasonal period into year end.

Although there is a lot going on, my main two bearish points remain in place — 1) A hawkish Fed, and 2) Forward earnings remain too high, which is leading to a negative earnings revision cycle that has not reached its trough.

My work and discussion with my inner circle of economists leads to my view that the Fed is unlikely to suggest before year end that there will be pause. Yes, at some point this will occur, but it remains my expectation that it will take longer, which will certainly be a disappointment to the forecasters with a more sanguine view on the inflation fight and that Chairman Powell and Gang are losing their resolve. In fact, not only am I reiterating that imminent dovishness is low probability, but I am also growing MORE concerned that the market’s view for the fed funds terminal rate of around 5% may end up being too LOW. I can certainly say that this outlook of MORE Fed policy gets push back, which only more supports my thoughts that it is not priced into equity markets and would be quite bearish.

Why am I worried ?

The first has to do with inflation. Yes, headline inflation and more goods related items appear to have peaked and are rolling over. However, what about using other techniques to analyze inflation? Are they showing any definitive signs of slowing?

Without getting too deep in the weeds, I went through some alternative measures of inflation from a few of the Regional Fed Branches (Atlanta, Cleveland, and Dallas) and their techniques using “Sticky Prices” and trimmed mean show that inflation is still rising. Now, the goal here is not to debate the merits of different types of inflation, but to simply illustrate that it does not seem clear cut that the Fed’s ongoing battle against inflation is really showing any definitive results. In addition, the calls for inflation to sharply decline before year end that prompts the FOMC to signal that there has been enough evidence to pause seems lower probability to me.

Atlanta Fed — Sticky CPI* is still rising

Note for more on the Sticky CPI (More Details)

Cleveland & Dallas Fed — Trimmed Mean CPI** is still rising

Secondly, Chair Powell and nearly every other Fed speaker has emphasized the need to create slack in the labor market, and despite the recent rollover in the recent headline JOLTS release, there has been scant evidence that any meaningful progress has been made on this front. In my view, investors should keep a keen eye on the weekly initial jobless claims, which are shown below. If they don’t start moving higher and rise above the range of the last year, it will likely diminish the likelihood of a potential pause in the current policy tightening cycle.

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.
Despite recent statement by some forecasters, 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: My work remains quite unfavorable, which continues to be the underpinning for my longstanding pessimistic view on the U.S. equity market. The backdrop is still shaky and despite a high degree of pessimism and bearishness. Thus, strategic investors should continue to be vigilant and view tactical oversold bounces as opportunities to sell into, raise cash, increase hedges, or reload on their shorts. Tactical traders can attempt to play the wiggles while my aggressive tools are favorable, but even here I advise be fully alert and ready for bounces to be short duration and smallish magnitude.

Admittedly, there are some metrics that show that the equity market is oversold, and some analytical techniques are signaling a degree of selling exhaustion. These factors very well could contribute and be catalysts for tactical bear market rallies. Nevertheless, I continue to strongly advise NOT to underestimate the powerful combination of forward 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.

GENERAL CLIENT QUESTIONS/CONCERNS/TOPICS

I have begun traveling again and seeing clients over the last several weeks, which combines with my usual busy week of zoom calls (Great, to see everyone!! I hope to reconnect with everyone face-to-face as soon as I can). So, I have had plenty of interactions with clients and have some observations to share along with my thoughts on their questions and other topics that have come up quite a bit.

Very few, if any, are bullish, but in my view, everyone is not uber bearish either.

The more tactical the account the more concerned and sensitive they are to the negative sentiment data and bearish positioning. A lot of time is spent about how far can the current bounce attempt run and can it last all the way until year end.

Strategic accounts with a more fundamental process have not been interested in the oversold rallies that have occurred during 2022 and are looking into 1H23 to get more aggressive. With that being said, more portfolio managers have expressed that they are seeing opportunities at current levels if they take a 12-24 month outlook and are looking to start putting money to work if/when the S&P 500 makes new lows and are not looking to pinpoint the ultimate bottom.

SPECIFIC CLIENT QUESTIONS

If you look at 2023 OEPS and valuation multiples, what target levels are likely?

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

MY ANSWERS

If you look at 2023 OEPS and valuation multiples, what target levels are likely?

Making some simple assumptions for 2023 OEPS and P/E multiple level, it is hard to forecast significant gains for the S&P 500 relative to current levels. So, one has to really think about forward profits and what should be the proper market multiple. When using my estimates, the index target is within my 3200-3000 downside price range.

Without going into a lot of details now, I wanted to pass along a quick analysis for investors to really consider when thinking about upside price targets. In a simplistic test, I am providing below a grid that includes 2023 OEPS levels and P/E multiples. Now, I know there are more sophisticated techniques and other things I can include here (i.e., risk premiums, interest rates, etc.), but let’s take a quick look and dive deeper in the near future. The current bottom-up S&P 500 OEPS estimate for the index is $249. As readers likely know, I have been quite vocal that the estimates are too high, but let’s assume they are accurate for now even though nearly every client I speak with agrees that they are going to come down.

To get back to the old S&P 500 high, let alone a new high, the P/E multiple for the index would have to be at least 20x. Let’s put that in perspective — The long-term average range for the S&P 500 since inception is roughly 12-16x with extreme periods that were either above or below. The few years from 2019-2021 the multiple spent more time in the range of 16-22x during the unusual period of low inflation, low interest rates, accommodative Fed policy, and peace. For now, I think it’s fair to say that that backdrop is no longer valid. So, let’s assume that the S&P 500 will likely trade within its normal range of 12-16x. Even if the earnings come in at $249, the target zone for the S&P 500 would only be 2988-3984 with 3486 using the midpoint 14x. With the current index price just below 3700, there doesn’t seem to be a lot of potential upside.

Now, using my current back of the envelope calculation of $217 for S&P 500 OEPS for 2023 (explanation on how this figure was derived in a future note) and the same P/E multiple range produces a target zone of 2604-3472 with 3038 using the 14x average. Phew, I hope I didn’t scare anyone with that range.

So, more discussion to come on this, but if you have a forecast that is for the S&P 500 to reach the old highs any time soon or higher, you are implicitly forecasting either higher OEPS or P/E multiple over 20x. I know there will be some pushback because this is quite simplistic, but I am presenting it as food for thought. More to come on this in coming notes.

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.

As we are starting to get the early reports for the 3Q22 earnings season, the ASM metric for the overall S&P 1500 continues to decline as I have been expecting since early April. Over the past several months, I have written extensively that making an ASM extreme bottom would be critical for identifying THE low 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?

My most aggressive tactical tools are now mixed and have been quite weak as one is falling while one may be trying to bottom. It hardly paints a bullish picture but is also not screaming bearish either. So tactically, the take is a lack of clear directionality seems evenly distributed with a slight downside bias, which is not compelling enough to even consider playing any tactical wiggle higher. Strategically, nothing has changed.

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 now mixed with HALO-2 falling and V-squared attempting to bottom. In my view, the setup is not compelling to make a tactical play in either direction that appealing, especially with all my medium-term indicators still unfavorable. Thus, I will be looking for the next tactical signal and continue to advise strategic investors to still sell rallies.