Why the markets could drift lower before bottoming

In our last blog post, we mentioned that the markets are at the trigger point between two scenarios.

Scenario 1 where there is no recession, and the war is Russia slowly resolves itself with no extra hidden surprises for the market. In this case, we said there would be a consolidation and the lows of the year won't be taken out. We gave it a 45% chance.

Scenario 2 where the lows of the year are taken out, and "ideally" the broken technical pattern goes to a natural target point before recovering. Here, the bull market is still structurally intact and we might have a shallow recession including more downside surprises. We gave this a 55% chance.

Both scenarios assume we are not in a bear market. Refer to this post https://www.quantzombie.com/single-post/will-we-go-into-a-bear-market-because-russia-quantzombie-market-outlook-mar-21-2022

for our webinar to explain how the major signals that precede bear markets are not quite signaling it yet (but it close), so we think there should at least be 1 more "last hurrah" before a full blown bear.

As we are now consolidating on support again, I get a chance to analyze deeper what is going on in the market during this consolidation. To summarize my findings, I would say that I guess the odds of scenario 1 vs scenario 2 is about 40:60.

Technical analysts will simply say we are in a support zone and so it will like bounce from here. They will have a buying strategy, like buying it now, but selling it if price drops below the support zone.

But here at QuantZombie, we go a few steps further.

I won't be writing all of my analysis, but just enough to make a case.

I've spent many years trying to develop heuristics for myself of how to gauge is a major bounce is coming. If you've been reading our posts, you know that we pre-empted the last 2 bounces on the SPX on both 24 Jan and 24 Feb a few days before. We basically said, "if there is going to be a bounce, it will happen later this week." Both times they did.

What I see today is slightly different from what I saw in the last two bounces from a market analysis point of view. A Deeper Look into the Market at these Support Levels.

Looking at the Head and Shoulder pattern and that we are on support is basic.

We cover this and a whole lot more in our "no-so-basic Basic Technical Analysis" section of our complete QuantZombie Investment Analysis++ course - including probabilities of where prices can go if broken which is not included in the many "basic" courses I went for when I was younger. E-mail me if interested. Here's a little of we talk about in the "more-than-advanced Advanced Technical Analysis" section.

We try to disect the various sectors and market participants in the market to see patterns within patterns.

Here, we see that a chart of S&P500, every time the XLF (financial ETF) new lows was above 20% for the first time in 60 days and a summary of performance results by Sentimentrader.com. This means that 20% of stocks covered in the XLF hit new 60 day lows. It measures a "shock" to the investors to the finance sector.

Just an eyeball look shows you that when this first happens in a downtrend, either it's in a bear market, or, if it is still in a bull market (which macro and technical indicators say) there can still be more weakness before a turnaround.

So, odds are, there is like more weakness ahead in the short term than strength, but how much more?

By the way, this is a "Quant" way of looking at the market. It's based on actual statistics.

Here's where technical analysis is an art and science.

Look at scenario 2.

If there is enough weakness to break the neckline, then there is around a ~55-60% chance that the price will get into the 3700-3900 range. See Thomas Bulkowski's Encyclopedia of Chart Patterns.

This somewhat corroborates that whenever the XLF exhibits such behavior, there is a little more weakness to go if in a bull market.

The next question to ask is, if price actually gets to 3700-3900, will there be enough "firepower" to start an intermediate reversal? (By intermediate, I mean weeks to months)

Most likely.

Now we take another way of looking at the market - sentiment.

This is the Smart Money / Dumb Money indicator by Sentimentrader.com. It's very useful.

Notice everytime the Smart Money is about 0.7 (very optimistic) and Dumb Money is below 0.3 (very pessimistic), the "soil" becomes fertile ground for a reversal. It doesn't mean there will be a reversal straightaway, but think of it as a powder keg for buying is there and all we need is some kind of catalyst to cause a buying explosion.

We are at the margin of very optimistic, but not as optimistic a month or two ago.

But guess what? If indeed there is going to be more weakness in the short term, and if the SPX is going to drop to 3700-3900, it is highly likely for Smart Money to reach 0.8.

This sentiment look, corroborates with the Quant look which corroborates with the Technical look that corroborates with macro look (that we are still in a bull market but with a major correction).

By the way, even if indeed we are in a bear market but don't know it yet, if price gets to 3700-3900, it is worth playing the rally, even if it is a bear market rally.

In summary:

1) Macro tells us we are still in a bull market, however, there are lots of uncertainties. Jobs are good. Earnings are decent.

2) Technically, we are ON support and on a head and shoulder's neckline. Either we bounce off now, OR, if we indeed breakdown, the 3700-3900 region becomes the " natural" or "median" place for a reversal to start.

3) Sentiment wise, Smart money IS optimistic, but not as extremely optimistic the large reversal a month or two ago. This means that on a probability way of thinking about it, buying good stocks now IS still "cheap" sentiment wise (you will likely make money in 6 months), but perhaps not as cheap as you could perfectly get it. But getting "perfect" is difficult, of course; although, we have the privilege of getting it right many times, including the 2009 and 2020 major bottoms. However, we don't get it right all the time, because the markets are about probabilities. Just because there could be a 70% chance of a bottom doesn't mean you get it at that time... it could happen later or earlier.

4) Quant wise, looking at the XLF's behavior and how the broad markets follow implies a little more weakness.

Market Summary Conclusion : Markets are anxious. S&P500 is consolidating on support. Dumb money are depressed. Smart money is optimistic, but could be more optimistic. Supports favor bounces (at least for the short term) than breaking through, however, angles like the XLF telegraphs that even in a bull market a little more weakness is more likely.

This means it is probably in your favor to start nibbling on certain stocks, and dollar cost averaging if it drops lower. If you are agressive, then you will hope that the markets really does breakdown into the 3700-3900 zone before buying. However, in all likelihood, if you buy certain stocks now, you will likely make money in the next 6 months.

HOWEVER, every market regime as a charactor and that charactor should inform you of what stocks are "favorable" and what aren't. So, you can further protect your alpha by selecting particular stocks.

So what stocks under these market conditions?

So here is what I suspect on what is informing the markets selling down.

Not all of it is FED tightening or war in Ukraine.

FED tightening brings us a little closer to recession, as also the commodity price increases due to Ukraine and the supply chain issues with COVID. More recently, there is fear about a rise in COVID and hospitalization cases in the US and some mutation (again).

A big factor is the shift in valuation mindset of tech: I think we are still in a bull market, but anything stock that is "expensive" gets punished, especially growth stocks, tech and big tech. The narrative on P/S ratios for world changing stocks has finally been eroded (I was bearish on those 1 year ago and people laughed at me). As it's obvious that FED is going to be raising rates to 3% by next year, valuations matter even more. We have a war in Ukraine that still isn't resolved, placing more uncertainty on commodity prices as well as letting our imagination wander if the war will escalate. This makes valuations even more demanding.

As I noticed, the only a few types of stock exhibit relative strength and can withstand the "buyer strike" in this market. They have to be of cheap valuation, at least less than 12x PE or P/FCF, have little to no debt, be in a position with financial flexibility and willing to reward shareholders with dividends or share buybacks, and they have an earnings profile that is somewhat predictable (some what defensive).

For example, shipping stocks had earnings going through the roof and were giving out a run rate of 20% dividends, however, there is great uncertainty of their earnings because of shipping rates. Their business is heavily dependant on shipping rates. So, you can't just rely on P/E because you might be buying the stock at the shipping cycle rate high, you have to have some expertise in where you think shipping rates will go, then build a DCF based on their earnings in the next few quarters and years. Not that many people know how to do that.

Our top stocks like ET and VST have great relative strength compared to shipping stocks, why?

Because not only did they return back at least 12-15% investment back to shareholders through dividends or share buybacks, their business model was defensive and predictable. Both ET and VST's earnings are not significantly dependant on economic gyrations. A case in point.

If you look at ET's earnings when oil price was at a 10-year low at around $30 during 2020 and look at ET's earnings a year later when oil price recovered, the difference was ~10%. They earn money by fixed contracts moving oil from fields to export stations. Hence, most of their fees are fixed. VST's (a private utility) cash flows fluccuates a little more (+/- 15%ish y/y) due to how they hedge fuel prices, but it's not as sensitive to economic cycles as everyone needs to use electricity. In other words, it's easier to trust management guidance because 80% of their earnings are predictable 1 year out.

So when they are so cheap that you are getting 12-15% shareholder value yield, there is a high chance this will continue.

Remember, in a buyer strike, or if funds are selling, both VST and ET are NOT market darlings, meaning that less funds hold them. ET only recently got on the "top idea" list this year, but for the years prior, people hated it.

Also, in a buyer strike, no one wants to buy stocks... so where do the buyers come from?

In the case of ET and VST, it comes from themselves.

VST announced last year they were going to buy 40% of their marketcap in 4 years time, because of their predictable cash flows and low valuations. ET hasn't done any agressive share buybacks yet, but they recently hit a point where they can start because they finally reduced their debt to their target levels this year. Instead ET increased value by increasing their dividend payouts twice this year, once by 15% then another 14%.

Both ET and VST are defensive WITH secular tailwinds.

The push for EV will only increase demand for electricity. Good for VST.

The push for more natural gas means the US is going to export more natural gas... exporting more natural gas means more volumes flowing through pipes. Good for ET.

Both of their earnings will not be affected by COVID cases or periodic shutdowns of companies, but only if the world shuts down again and there is a full market meltdown.

Of course, ET and VST will only marginally benefit from these trends compared to actual EV companies or actual natural gas producers, but at least they are benefiting from them. This means their earnings shouldn't shrink but have support going forward. Can you see the difference between ET's and VST's dividend (that will likely increase going forward) compared to a shipping company's dividend at the top of the cycle?

Why were ET and VST's valuation so good? Because the market's narrative for the last 3 years was all about new technology and the death of crude oil. And, very few funds were talking about utlities AT ALL. When I look at the major investment banks guidance as well as "gurus" on YouTube (many of them just copy what the investment bank thesis is), all of them simply ignored utitlies by saying they were boring and you can't make much money from them. That's so funny to me because this year, the markets are down 12% to 20% to 50% depending if you are SPX, semis, or "growth" but ET and VST are up 25-30% not even including healthy dividends.

The point is that cash flow matters when things get tough.

Suffice to say, ET and VST are the stocks you should be accumulating on small pullbacks.

Another stock to consider at these prices, is X (US Steel) that I will be writing more about in future.

Note that X (steel producer) is different from the defensive ET and VST. ET and VST have somewhat constant earnings that are likely to increase slightly y/y. X's earnings explode with high steel price and drops a lot with low steel price, however, the great valuation at the moment makes me think a speculative bet is worthwhile. In other words, X is the new "tech growth stock", at least for a few quarters because you have to use your imagination how much money its going to earn this year and next.

I encourage you to read their management transcript and earnings presentation this quarter. Yes, the company is dependant on steel prices, but just on management's guidance for this year and next, you can do a DCF and see that it's really undervalued. More importantly is this statement by management, "What I think is most exciting is our progress on our stock buyback. Right now we know the stock price is too low and buybacks are the best way to return capital to stockholders. And good timing, I just received here an update that we completed our first $300 million authorization and are beginning our $500 million authorization now. So as I mentioned in my remarks, we expect the pace of our buybacks to materially increase in the second quarter."

Think about this: right now they have a $500M buyback in place. They plan to "materially increase" the pace of their buybacks. They're earnings are likely going to be at least $3B this year. Their marketcap is at 7.8B. They are at low debt levels of <1x EBITDA.

Not only do they believe they are undervalued, they will be buying more of their stock next quarter and I will not be surprised if they increase their buybacks and dividends too.

Remember, in a buyer's strike where nothing is good enough to buy, companies in great position to buy significant amounts of their stocks can buck this trend. This happened with ET and VST, and X has just started too.

So, ET and VST are probably at the mid-point of the market realizing their value and X is speculative value and has alot of positive catalysts going for it this year, although steel prices will likely normalize lower by 2024. Yet, even with those 2024 earnings estimates by SeekingAlpha, that's a fw 10x PE, which is still cheap... and a lot of money is going to get returned to shareholders in the meanwhile. But, because X is more "speculative", it might be wise to trade it technically. By the way, we recommended to look at X at our previous blog post while it was at 27, citing 37 as a possible target price. It hit $37 and then retraced with the recent market weakness. Because X is "speculative" because it's dependant on steel prices that can swing, the price of X is not as tethered to obvious value like ET, as such, it might be wise to use technical analysis to determine a buy point. A convenient one to use is when the MACD finally cuts upward, it's there yet.

So that's all for today. We got a market look. Where the markets might go and where the high probability buying points are. We also got why certain stocks ourperformed and an encouragement to take a look at X.

Cheers.

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