Downside targets on the S&P500 and stocks to accumulate on pullbacks.

Hi everyone! Your friendly neighbourhood market timer is back.

Key Takeaways for last week:

• The S&P 500 closed at 3,900.86 after the highest CPI reading since 1981 and the lowest University of Michigan consumer sentiment reading of all time. The VIX closed at $27.75.

• All sectors were down except for Staples which was essentially flat. Discretionary, Technology and Financials led to the downside, all losing more than 3%. The 10-yr rose to 3.154%.

• The US is to end COVID testing requirements for international travel. COVID cases are rolling over in Northeastern states.

• Gasoline was one of the biggest contributors to the high CPI reading. There doesn’t seem to be any immediate relief for high energy prices given the ongoing conflict in Ukraine.

Recently, lots more pundits calling for higher probability of recession, especially in the next 1-2 years. The last printed inflation rate still looks high, increasing the likelihood that the FED might continue to tighten rates into a recession. But what do the markets internals look like?

Recall in our earlier posts, we said that further downside was likely, and the 3700-3900 zone and the 3400-3550 zone on the S&P500 will be the high probability zones for accumulation.

This meaning that even if we are in a bear market, these are the major support zones to look at. A major bear market rally is likely to occur between these two zones.

"Ideal" looking major bottoms occur with some kind of nice pattern, a rounded cup, a double bottom... or a sharp capitulation into a major support zone and quick recovery. Will the next intermediate bottom look like this? Maybe, maybe not. However, I want to share the probability that an intermediate bottom may occur if we go through the 3700 region and into the 3500 region.

Note that I am not saying at this point if the next rally is for sure a bear market rally or the start of a longer market recovery, I am looking at market internals, comparing it with the narrative in the story market and building a probable scenario based on my experience of when an intermediate rally is favorable. By intermediate rally, I mean weeks and not days.

1) Sentiment Trader's Macro model combines 11 diverse economic indicator to determine the state of the U.S economy and declined 27% in the month of May.

When this happens historically, the S&P500 showed flat to slightly negative returns and a coin toss on the win rate across almost all time frames.

The key word here is "slightly".

This is because usually when recession actuality becomes obvious, the markets usually would have discounted maybe half of it by then. The S&P500 has already dropped by about 20% since the start of the year, which is already discounting a moderate recession. Although the macro model reading is bad, it can occur in a recession and also not in a recession. But the last time it happened, it signalled the second half of the COVID recession. This feeds into the bearish sentiment.

History does imply higher chance of weakness versus strength. A "slightly" more weakness would also push the S&P500 into the accumulation zones between 3700-3900 and 3400-3550. 2) The recession narrative in the mainstream is strong and getting stronger. Lots of people who are not even in the financial investment or analysis industry are saying it. This means I would love to see more extremity in sentiment to counter it. The insider buy / sell ratio is at good but not great levels, but not as extreme as the COVID bottom or bottoms of the last few major corrections. However, they are almost there. If the sell-off continues closer to the 3500s on the S&P500, there's a good chance it will hit that extreme.

The same goes for the Smart Money / Dumb Money confidence.

It signaled a good short term bottom 2 weeks ago, but now we are declining again and is not as extreme as I would like it to be considering there is a recession narrative going on now. This also implies higher chance of downside first before upside.

However, statistics on this indicator shows that at the present levels, it suggests an excess return of 1.8% over the next 2 months. In other words, good but not great. Cheap, but perhaps not cheap enough based on the pessimism out there.

3) "Panic" selling is occuring in the tech space.

Some might say tech is a coincident indicator or slightly leading of the whole market.

The XLK Component Correlation shows the degree to which all the stocks in the index are trending similarly. When the reading is high, it suggests that investors are dumping stocks indiscriminately.

Indiscriminate dumping is one of the signs of a bottom making.

Below, you will that when the correlation is as high as it is now, it's usually towards the 2nd half of a major sell off. It means we are closer to the end than the beginning of a sell off.

Being closer to the end also puts us towards the bottom fo the 3700-3900 and if not, then the 3400-3550 zone.

4) In terms of other measures, it's getting close to bearish extremes but still negative momentum.

The relative performance of the Russell and S&P500 can be a early warning signal of impending trend change. Prior to the SPX drop starting in 2022, the Russell was very much underperforming. For a market bottom to occur, it is good to see the Russell stablize and improve.

We are starting to see a small green shoot, but it's too early to tell.

The Put/Call ratio is at short term extremes, but not at the extreme levels of a major bottom.

The VIX are at levels of short term bottoms, but not major bottoms.

The AAII Bull to Bear is very pessimistic... which tells us that we are likely in the ending half of all sell-off, it can't pinpoint more than that.

It's been a long time since we've been in the bottom half of the weekly MACD. The MACD does imply we are somewhat oversold, but the momentum is down, and at the very least, we need to see the BLACK LINE of the MACD turn up. Good news is that the last time we got so negative was at the bottom of the COVID crash, it will not surprise me for the MACD to turn up in the next couple weeks.

Also, Small-caps have improved in the last month and along with growth rallying vs Value, this is thought to be an important part of a market bottoming process. Sentiment remains quite negative and has gotten worse this past week, though no capitulation. Increasingly, this might not be needed if everyone is searching for it.

On Youtube, you already see videos like this:

Then such gloom and doom becomes mainstream, the bottoming process is here, at least on the intermediate level. Where were these guys even 3 months ago?

When I see these pundits annoucing doom and gloom on the mainstream level, I usually train my mind to look for capitulations or buying signals.

CONCLUSIONS:

At the beginning of the year, we said that 2H22 will perform better than 1H22. We think this is still very probable. (With such a bad 1H22, how could 2H22 be worse?)

Sentiment is negative, downside momentum still exists, BUT there are some green shoots... although the green shoots are too small at the moment. The Russell relative strength seems to be stablizing, small caps improving, growth stocks (a measure for risky money) slightly rallying vs value. However, there isn't that "capitulation" yet which I love to see, but this might not happen if everyone is searching for it, or if the capitulation occurs in small pockets of the market.

Based on various probablistic takes, I would say that if the price of the S&P500 hits the major support zone of 3350-3550 and the above indicators hit those extremes, that would be the equivalent of getting dealt a hand of AA in texas-hold em poker in terms of reward-to-risk for an intermediate bottom. I would be looking for buy signals at these points.

Those with liquidity might want to take this chance to buy stocks on the cheap.

However, not all stocks. Some stocks are still quite "expensive" or have too much "uncertainty" in this environment.

Some Candidates for Accumulation.

I am not saying these are all the good stocks available or that you have to get these, but showing examples of stocks that have a better chance of withstanding the quadruple threat of prolonged inflation (wont get crushed by high material costs), an economic recession (cash flow need to be defensive and not pegged too much to the economy). high interest rates (won't get crushed by debt) and a bear market (valuations need to be <12x PE on average in the foreseeable future - sorry big tech).

More importantly, these stocks have "their own story" and have their own way of increasing their share price in the face of a buyer strike (which occur in bear markets).

These would be the type of stocks I would consider buying on big dips if the market indiscriminately sells.

Defensive Value

1) Energy Transfer (probably the cheapest Midstream Oil)

Their cash flows will not be overly impacted by recession. Most of their revenues are fixed fee contracts and NOT directly proportional to the price of oil (that can drop significantly in a recession). Their forward PE is 8x. (Cheap for a midstream) Debt is relatively high at 4x net debt to EBITDA, but likely to be reduced and managed because of predictable cash flows. Longer term catalyst includes Lake Charles LNG exporting where they already got a contract for delivery to China.

Catalysts would be when they increase their dividends, it will make dividend investors buy the stock. They pay $0.80 annually now, but they used to pay $1.20 historically before the COVID crash. They are in prime position to raise the dividend going forward.

2) VST (probably the cheapest private utility)

Whether recession or not, everyone needs electricity. They already have a plan to grow earnings 5% a year simply as they change out their legacy energy generating units to renewables which have better economics. VST is able to predict their earnings to +/- 10% each year out and so their cash flows are also much more predictable than average. A new plus is that they took advantage of the recent highs in natural gas curves and locked those prices in. Giving more certainty, and a higher boast to earnings. They have affirmed 2022 adjusted free cash flow before growth of an average of $2.25B. Compare that to their market cap of 11B now.

No wonder they have a big share buyback plan going on that is estimated to be around 25% market cap in the next 3 years.

Both ET and VST will likely take selldowns if there are indiscrimate selling in the market, however, on the strength of their cash flows and valuation, they can have auto-catalysts to bring their stock price back up through dividend increases or share buybacks.

Notable mentions: 3) CMLS

Cumulus Media is a radio licensing company. Looking and projecting earnings is more difficult. However, they recently had a buyout offer at $15 which the company's directors rejected because they felt it was too low.

Their debt levels have dropped to the lowest in industry (3.5x net debt / EBITDA) and the company is confident to drop that level to <3x by the end of the year EVEN with the share buybacks! Management is confident in the cash flows. Because they felt they were in good position, with a great 1Q22 result and low valuation, they accelerated their share buyback program, buying back an estimated 10% of their market cap in a reverse dutch auction from their share holders at a minumum price of $14.50!

These actions give the market an idea of what the company is worth ($14.50 and more) and also gives investors alternative ways to realize gains even if the markets are bearish.

Of course, one can argue that radio business drops during a recessionary environment, but it is hard to know when exactly business will reduce their radio ad spend.

Investing in this company means you think the company is healthy to survive a recession and that either they will have another private buyout offer, or management is correct in their estimations of cash flow and will continue to buy back their stock.

4) Valuetronics

Finally, Valuetronics.

Simply put, I feel that Valuetronics has the highest margin of safety of all the stocks here. Not only do they have a fortress of a balance sheet with net cash that makes up 70% of their market cap. They are trading at an annual run rate of 12x PE now.

The market might not realize that many of their structural problems are now gone. Because of the US-China trade war, they lost some US business as Valuetronics has a major manufacturing site in China. However, they have recently finished building their Vietnam manufacturing site and have successfully courted 3 new ICE clients from the US to recognize mass production starting this year!

The only risk now is the uncertainty of when the weakening margins due to component shortage will abate, and perhaps a recessionary environment next year that may affect client orders.

However, if one does any sort of a DCF that includes their net cash, Valuetronics is insanely cheap. The only thing it lacks is that the analysts haven't yet upgraded their investment calls on Valuetronics.

Because of this, Valutronics share price might not be able to surge continually, and that recession fears may cause some selling.

However, the company has a big share buyback program that is worth about 20% of their entire market cap... and have been buying back shares at today's prices, between $0.51 and $0.535. The share price is about $0.53 today.

So, this this is a stock that didn't get to participate much the COVID crash recovery because of it's structural problems that recently got solved, which is why it is one of the stocks that are so cheap compared to many in the market today.

Investors in this stock might have to expect to be patient for the narrative to change about Valuetronics, but know that their downside is exceptionally limited, and they will get paid a super safe dividend of at least 4% while they wait.

This stock price might not go anywhere for the next few months, but there will be accumulation at these levels for sure.

Also, in a market that interest rates are going up, their net cash is a very big plus.

They will get a bump in earnings based on their fixed deposit, and they might become an EVEN more favorable manufacturer of choice because they can offer much better financial flexible terms to their clients.

For more information about Valuetronics, refer to our recent post: https://www.quantzombie.com/single-post/verdict-on-valuetronics-earnings-report-accumulate-it-s-cheap-and-bottoming

These are just stocks that give you an idea of what to look for. Do share your stock ideas that fit this type of mold. Large margin of safety. Good valuation. Cash flows. Not too much affected by recessionary environment. Have their own story or catalyst to unlock the share price even in recession.

Hope this analysis helps your planning in the next couple weeks.

God bless everyone! Stay safe!

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