Market Outlook (20 June 2022): Preparing for further downside AND buying the intermediate bottom?
Hi gang, before I go further into a very comprehensive deep dive into the market internals i want to remind you that I don't give direct financial advice. This is because every person has his own risk-reward tolerance, his own timeframes, objectives, leverage etc. Some people want to DCA, some are traders, some want to have a long bia investment fund but market time some of the time. Because of that, I cannot give anyone direct advice to buy or sell. However, I can and will give ideas about the markets, analysis and data so that you can make a much better informed decision for your situation.
For some reason, I felt compelled to spend a large part of the weekend to do a deep dive into the market internals, because I thought it may be timely for some of you. Something in my spirit compelled me. I actually spend over 12 hours doing this and haven't even slept yet... it's actually 9:17 am as I type this. I will be reducing my posting significantly in the next couple weeks / months and will only come out if I feel something very important or opportunistic has occured. I've been neglecting some other important aspects to my life and need to refocus, especially on health and also my writing ministry (I'm writing a Christian book about Victory through a two decade long Abyss).
So that being the case, given last weeks unprecidented selloff, this long post is to answer the questions:
1) where could we be in the market cycle?
2) Is there a buyable intermediate bottom coming soon?
3) what can we say about some of the different pockets in the markets?
4) How are the market internals differing from other major corrections in the past?
Because of how long this post is, I am going to start with my conclusions and then put supporting data after.
1. The largest destruction of wealth in history. The first time you see such unrelentless selling, it’s likely not quite done yet. Simultaneously, it also implies short term selling exhaustion and increased probability of an intermediate bear market rally bottoming process.
2. Inflation will get better – Sooner or later. If too late, FED tightening likely lead to prolonged recession (some small caps are fairly valued, and large caps still overvalued if history is a guide). If sooner, higher probability of a soft landing (some small caps are likely oversold, and large caps are almost fairly valued).
3. In terms of sentiment and technicals, a little more downside (-5% to -10%) will cause SM/DM as well as the weekly RSI to have an extreme reading making it highly probably for a potential intermediate bottom. The weekly MACD hasn’t turned up yet, so we do have downside bias but a bottom could be close so could start to turn soon. If market continue to drop or even capitulate, we might hit those extremes readings, starting a bottoming process beginning possibly by the end of June and into July! We see hints of nascent optimism through sentiment, breadth and key insidering buying from key companies.
1. Short Term Traders: should prepare for two possibilities that we might have a soft landing, or that we might be only at the halfway point of further weakness (in time and price). However, either way, even if you believe more downside ahead, do note that we are close to extreme oversold levels and that short covering and value investors tip toeing their way back might cause an intermediate rally.
2. Look out for capitulations. If the market capitulates, look for reversal signals.
4. Large Caps are discounted for an average recession. Small Caps are discounted for close to severe recessions. This implies a couple ideas:
1. Longer term investors: If you are Dollar Cost Averaging Monthly, you should definitely continue for the long term is favorable at these levels. (SPX is already down 20%, the average severe recession drawdown is -38%, so you are DCAing into what is the bottom half of the drawdown.)
2. Speculative Value investors: Can looks for crash valuation small caps that are potential acquisition targets. These might still get you a return even in a bear market as they have catalysts outside of the market buyer strike to realize their value.
3. Uncertain Investors: should either do emotionless investing with rules like: 1) Dollar-Cost Averaging. 2) Using major moving averages to gauge the general direction of the stock market… stay out if price is below the major MA, get in if above. You might miss the absolute bottom, but you stay out of a lot of trouble on downsides being longer than expected.
5. Extra: In a recessionary environment, growth stocks can be favored over cyclical stocks. Some growth stocks might get a boost, however, in an uncertain weakening economy, fundamentals, earnings visibility and cheap enough valuations to compensate for recessionary uncertainty become even more important to keep a stock in your portfolio.
I include this chart 10 days ago in our earlier post before the markets melted down further.
Note that the chart I drew is not exactly how I think it will go, but this is a "natural configuration" where the 3700-3900 zone and 3500 zone are signifcant consolidation zones (I won't go into detail why, but its more quant and experience on my understanding of the fundamentals than technical), and if the charts go "ideally", we might get an intermediate bounce from the 3500 level if it gets there. The 3500 zone also doubles as strong support technically. I don't ever use technical supports alone for investment decisions, but I see other factors confluencing at might intersect at that level, strengthening the probability of a bounce there. So in other words, if you had put a gun to my head and force me to guess where the markets would go based on all I observed so far and based on my experience, I would have drawn that. Longer term, whether we break new lows or stay above really depends on FED policy, the persistance of inflation and the rate of eleviation of supply constraints.
This estimation is still in play.
The largest destruction of wealth in history. The first time you see such unrelentless selling, it’s likely not quite done yet. Simultaneously, it also implies short term selling exhaustion and increased probability of an intermediate bear market rally bottoming process.
Historic Bout of Selling Pressure: It's like Tale of Two. •Over a 7-day stretch, 5 days saw more than 90% of stocks decline, a first since 1928. The FED’s tightening and being “behind the curve” was the popular narrative to blame. Two implications can be simultaneous: 1) That a longer bear market can be in the cards. 2) But selling to this level tended to be exhaustive, increasing the probability of a short-term / intermediate term bottom.
Yield Curve looks to invert soon after a brief touch on Mar 2022: coupled with more headline news of non-transitory inflation if the 10-yr yield doesn't increase much, a couple more hikes of the FED funds rate will almost certainty cause a lengthy period of yield curve inversion.
The FED usually drops rates into a weak economy or it tightens rates in an overheated economy. What we have is atypical, hiking rates into a weakening economy primarily caused by supply-side constraints.
Historically, once the yield curve is confirmed to be inverted, a bear market tends to get "invited" 6 months to 1.5 years later, if history is a guide. Considering we are already in a bearish market, this could mean "lengthen" the time of the bear market. Simulataneously, could the markets have overshot to the downside, pre-empting a recession months before the size and duration of the recession is clear? (S&P500 already down -20% vs average major recession drawdowns of -38%)
Measuring Bear Market Downsides.
Usually when there are bear markets without a recession (soft landings), the average downside is 24% and the median duration is about 6 months. This is pretty close where we are now (down 20%).
When there are bear markets in a severe recessionary cycle, the average downside is 30% and the median duration is about 12 months. The worst of which was the GFC starting 2007 which had a max drop of almost 57%.
The markets have already priced in a bear market with no recession, or the threat of a recession but with a soft landing in regards to the S&P500.
However, this time round, the S&P500 seems to be given a historical premium compared to the other midcap or smallcap stocks.
Recession Markets FW PE: Severe Recession Max Pullbacks:
Large Cap stocks are still “expensive” compared to historical bear markets, but some Small Cap stocks are almost at severe recession prices.
Russell Value stocks trading at 2009 crash valuations and almost at 2020 COVID crash valuations, however, this value is likely a skewed because of a part of Russell Value are oil/inflation stocks that are indeed trading at <5x fw PEs, at least for this year. But what about 2 or 3 years out?
All bear markets acompanied by major recessions ended with PEG ratios < 1. This measure implies that the ratio has 20% more to drop before being at "crash extreme". It gives a range of downside should we reach the maximum pessimism of the average major recession / major correction.
In terms of sentiment and technicals... bottom possibly soon but not quite yet!
... a little more downside (-5% to -15%) will cause SM/DM as well as the weekly RSI to have an extreme reading making it highly probably for a potential intermediate bottom. The weekly MACD hasn’t turned up yet, do we do have downside bias but know that a bottom could be close. If market continue to drop or even capitulate, we might hit those extremes readings, starting a bottoming process by the end of June! We see hints of nascent optimism through sentiment, breadth and key insidering buying from key companies.
Wide Scale Insider buying hasn't been as high as major corrections in the past, however, there has been some recent CEO buying in some interesting companies begs further questions if the pessimism in the markets are overblown (at least until the economy shows to deteriorate). For example, NLY is a M.REIT whose book value will decrease with rising interest rates. The CEO buy $1M worth of stock when the stock capitulated. Has the market oversold these counters by overestimating the damage due to rising interest rates? Although there is still lots of insider selling and not enough wide scale buying, I find these key insider buyings "interesting" especially at this time.
A look at fund statistics also show the ground is ripe for some kind of mean reversion from extreme levels.
Fund managers are at extreme levels of pessimism. They have almost +2 standard deviations of cash % vs historical and about -1.7% standard deviation of equities % level (and tech) vs historical.
This simultaneously could imply both a reaction to a weakening economy down the road, but also short term exhaustion in selling.
Funds make up a big part of the entire market. If they have excess cash on the sidelines, it only takes a little good news for that cash to come back to the market.
The theorectical price has reached it's technical objective from the Head-and-Shoulders pattern breakdown. When a price objective is hit due to the market phenomenon of symetry, historically, an exhaustion of the trend usually starts, prompting a consolidation zone to "reconsider" where the price should be going. Another way of saying it is that according to Bulkowsk's Encyclopedia of Chart Patterns, you can say that the price objective on a major pattern breakdown is the close to the median probability of downside before some kind of counter trend rally. Experienced traders will look to short cover, or look for reversal signals around this area.
A Reminder on the Technicals. WE are on a downside bias. Any intermediate rally should be taken as a counter trend rally unless a game-changer in the fundamentals occur.
As I mentioned before, in my first couple of years as a trader, I discovered a couple of rules to help me get out of trouble. The first is that if I had no strong fundamental conviction in the markets, if the price was above the BLUE line I considered it a bullish regime and would look to buy dips, but if the price was below the BLUE line, I consider that something significant had changed about the markets and economy and assume the cycle had turned bearish.
We are below that blue line now. Technically speaking, I would say we are in a bear market or that the price action is preempting a recession that isn't here yet.
Some traders I know will not even think of longer-term buying UNTIL the price recovers above the BLUE LINE.
At the same time, the RED LINE is historically very strong support and has been the absolute bottom for all major corrections in a longer bull market. In the last 20 years, it was the INTERMEDIATE BEAR MARKET RALLY during the 2008 GFC causing a bounce of +10% before economic deterioriation forced further downside. Could it do the same again soon?
The only time the price broke straight through the RED LINE without any bounce was during the COVID shock bottom. However, I argue we are in a slow boil towards a potential recession which was different from the visceral panic of wondering how much of the world would be locked down due to an unknown pandemic.
Being below the BLUE LINE on the S&P500 price chart, coupled with flattened interest rates that "welcomes" corrections and the probability of further profitability downgrades to certain companies and employment imply we might continue to slow boil into a bear market with a severe recession (average downside -38%).
However, it may take longer to reach there and we may have overshot to the downside based on what is known today.
Some green shoots of optimism are appearing and we are reaching technical zones that a ripe for counter trend rallies. Combining this with close to extreme levels on sentiment, and interesting insider buying... it would be wise to look for buying signals especially if the price drifts lower, and especially if there is another round of capitulation. Even if there is futher downside from -20% on the SPX to an eventual ~ 38%, it won't happen straight away and intermediate rallies can occur especially if the macro damage is relatively far from being confirmed yet.
In terms of valuations and investing, large caps are not at crash valuations, but some small caps are close to crash valuations. In a weakening but far from crash macro environment, some small caps can make potential buyout targets that can still make good reward-to-risk even if we eventually get into a recession. If you choose to speculate on these (or invest), I wouldn't bet the house and would diversify into a few. I would also consider keeping cash available in case the rest of the market (or your long-term stocks of choice) gets cheaper into crash territory.
Refer to the TL:DR Conclusion at the start of this post for a more detailed conclusion.
Stay Safe everyone.
God bless you all.
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