I wanted to start this Whispers with a quote from Winston Churchill to put this last week’s most talked about topic into perspective:
You will never reach your destination if you stop and throw stones at every dog that barks.
You might be thinking, what are you getting at Brian? Let’s change “your destination if you stop and throw stones at every dog that barks” and replace it with “your investment goals if you stop and chase every oversold condition that happens in a bear market when the Fed is tightening.”
Everywhere I turn I am hearing or reading from either clients or forecasters that the U.S. equity market is oversold, there are excessive amounts of pessimism, defensive stocks are beginning to underperform, and the investors are overly fearing the resolve of Chair Powell and his inflation fighting Crew. The conclusion of course is to flip to bullish and put money to work before one gets left behind by an upward surge in equity prices.
Pardon my sarcasm and no disrespect to the bulls, but once again I am left wondering if I am missing something? My key indicators that have been flashing unfavorable and downside risk signals have changed very little over the last several months, and my hawkish view on the Fed has been confirmed by the recent Jackson Hole and post-FOMC guidance provided by the Fed Chair. So, I don’t see any real substantive changes that would cause me to change my overall market view or sector positioning.
To get a bit deeper into the details, my analysis of the earnings revisions for both the S&P 500 and the remaining names within the broader S&P 1500 Super Composite has been highlighting that the backdrop has been weak and getting weaker while the forward outlook for Corporate America will need to come down. I have written quite a bit about how my key ASM indicator for the overall U.S. equity market will likely need to reach max pessimism BEFORE the ultimate price bottom is reached, and as of my most recent update it is still falling and has not reached a level that would suggest the negativity was getting overdone. Once the ASM decline nears this important range, the clock will start ticking for the rate of change in cuts to positively inflect (less bad), which has historically been a major bullish contrarian signal. Thus, there is no support for bullishness on this front.
Furthermore, we will be in the earnings preannouncement period until mid-October, which also runs concurrently with the share buyback blackout period, and the likelihood that there will be a fair amount of companies that will “confess” their profit forecasts need to be lowered because of weakening demand, FX issues, and or input cost pressures are too high. It would not be surprising if more than one major company that impacts investor sentiment preannounces and raises profit concerns for the broader market. This will likely help nudge the analyst community to start revisiting their forward outlooks more aggressively.
Hence, the earnings news will likely only be bad for the next couple of weeks, and the Fed is unlikely to begin communicating any dovish signs for quite some time despite the rollover in goods inflation data, which suggests to me there are no get out of jail free cards out there for investors.
Yes, the equity market is oversold. Indeed, both of my aggressive tactical indicators, HALO-2 and V-Squared, are approaching negative extreme readings suggesting that another attempt for a short duration bear market bounce will likely occur over the next couple of weeks. Is this a reason to get excited? To put cash back to work? Reposition out of defensives and back into offensive cyclicals for the start of a new sustainable bull run? Well, according to my research, the answer is a very clear NO.
If/when the next countertrend bounce occurs, I continue to advise strategic investors to not chase, but use strength to sell into, to reposition, and/or raise hedges as considerable downside risk remains. An aggressive tactical account can attempt to get less short or try to capture part of any rally, but the tug of this market is lower so be careful as the surprises will likely still be on the negative side. The process of readjusting valuation multiples and forward profit expectations has been occurring all year, but my analysis still shows that there is work to do to OVERLY discount the current challenging macro backdrop.
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: I continue to reiterate that the S&P 500 still has considerable downside risk as my key indicators remain unfavorable. Along the way down to my main downside target areas 3600-3500 and 3200-3000, there will likely be additional tactical oversold bear market rallies that should be used to either sell into, raise hedges, or reposition.
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
- So, you agree that headline inflation has peaked. Why are you still worried ab out the Fed? (this is a carry over from last week as it was asked quite a bit — so, I am going to include it once again).
- What are your most aggressive tactical indicators saying?
- So, you agree that headline inflation has peaked. Why are you still worried about the Fed?
My work and my read of the Fed suggest that despite goods inflation coming down services inflation will likely be harder to fight off. Chair Powell and Crew have suggested that cooling the labor market is needed. It appears that having the unemployment rate rise from 3.7% to between 5-6% is what the central bank is targeting. Thus, only focusing on headline and goods inflation moderating is only part of the story.
For most of my conclusions and recommendations, I use objective indicators and models. However, to answer this question, I must use a lot of what I think versus what my tools are saying. With that being said, this is my thought process:
- Goods inflation falling.
- Services inflation will likely be more resilient as there is a larger labor component (fyi – also bigger part of the economy than the goods side).
- The Fed wants to create slack in the labor market and some FOMC members have commented that the unemployment rate needs to rise from 3.7% to 5-6%.
- If goods inflation does keep moderating, but the labor market does not show signs of weakening the Fed will not declare victory.
- The bar to shift to outright accommodation is quite high. Slowing the pace of policy tightening and pausing are certainly incremental positives. Importantly, however, unless the equity markets have moved much lower because forward earnings have been dramatically cut, Fed slowing and pausing really does not provide strong enough tailwinds to offset the formidable macro challenges that are still present.
- So, 3900 and no outright easing does not make the equity markets attractive based on my work.
- Reaching 3600-3500 and no outright easing is relatively better but not overly exciting.
- If the S&P 500 fell to 3200 or lower on fears of a hard economic landing, which caused the forward profit backdrop to fall towards max pessimism (i.e., overshoot reality), and there are potential signs of the elusive Dovish Pivot, the backdrop for equities would likely be quite attractive for strategic buyers.
What are your most aggressive tactical indicators saying?
As discussed last week, a short cycle roll over can often lead to large declines despite being in negative extreme territory, and the S&P 500 remains under pressure. Well, my indicators have reached levels where a tactical bounce can occur at any moment. So, it would not be surprising that another countertrend rally starts within the next couple of weeks. However, my message for strategic investors remains the same — don’t chase rallies and remain on alert for a better buying opportunity that is still in front of us.
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 fallen hard over the past week and are at readings that have historically led to a rally. I guess the bigger question is will V-squared have a major decline before positively inflecting while HALO-2 is already poised to flip. It’s time to be on full alert.