Market Corrects Despite Decent Q2 Earnings

As we restart our market coverage after a well deserved summer break, we find equities in the midst of an ongoing correction process. For anyone who’s been paying attention recently, this should not come as a surprise. We’ve repeatedly stated that a lot of potential upside has been already priced in, as the S&P 500 index set record after record above 5.500. When a 1-year treasury bond offers a better risk-free return than the S&P 500, it’s clear that investors got ahead of themselves.

During bullish years, corrections happen fairly often. However, when corrections do in fact occur, it is not uncommon to see concerns about a “bear market” rise, especially as key technical levels get taken out. The following chart from RIA Advice shows just how large the drawdown of each year was, compared to its final outcome. Note that the median annual loss stands at -10%, while median returns hover just above +10%. Years that only have upside are rare. 2017 saw a gain of +19%, with only a -3% loss, and it was an anomaly.

All of this is to say that temporary losses and drawdowns are entirely to be expected within a bull market. Corrections reverse the excesses of the previous advance and it’s something that we must use to our advantage as investors. However - no matter how high the previous gains, investors and the media start to panic at the slightest hint of a market pullback. This leads to emotional trading decisions which turn out to be costly mistakes most of the time. In October 2023, many retail and professional investors were busy selling, when, instead, they should have been buying.

As Q2 Earnings Season gets close to its mid-point, the market is rewarding positive surprises less and punishing negative surprises more than average. This is symptomatic of a very high bar that needs to be passed by corporations, as their stock prices were already reflecting increased expectations. The blended earnings growth rate for the second quarter is 9.8%. This would be a great result if expectations were not higher.

SPY has not reached a new high in 12 trading days, and the current pullback is -3.87%. Within our 2-year analysis window, the average time to get back to all-time highs sits at 58 days and the 1 std drawdown is -5%. When we adjust the chart for our $582 price target and a 20% CAGR (which now seems far too aggressive given the actual EPS growth in Q2), we are seeing an expensive looking instrument with plenty of scope to correct.

The key technical level to watch for support is $532 (M-Trend), a price which would warrant some decent buying considering fundamentals. If $532 does not hold, our take is that a much larger correction is in the works, with downside all the way to $495 (-8.83% form current levels).

Critically, a pullback to $495 would be a great buying opportunity, as it would represent a -12% drawdown from SPY’s all-time-high of $564. As mentioned in the intro of this article, a -10% decline is absolutely normal in any given year. The abnormal part was the run-up in the first half of 2024.

Another critical point is that there is still enough bullishness on the part of investors that are currently “buying the dip”. Our sentiment gauge sits at 53/100, recording a “Neutral” reading. We want to be buying during “Extreme Fear” - and we are not there yet.

Our Trading Strategy

For now, this episode represents a healthy and normal correction within a clearly bullish trend. It would still be normal, even if the drawdown gets much larger. Also - this episode is not over just yet.

We would not be inclined to buy with both hands, but rather to manage risk using pre-set stop loss levels. Even if this means selling, stop levels still need to be respected. Most likely, the correction will go on for at least a couple more weeks, heading into the election. We will also have sharp rallies along the way, which could be used to lighten up on risk exposure.

There is no evidence currently of an exogenous event that would “derail” financial markets to a “financial crisis” style crash. Economic data, while weakening, is not recessionary. However, mainstream financial media and click-hungry commentators are quick to assume the worst. Now is a good time as ever to review our core investing rules:

1. Cut losers short and let winners run. Scale up into positions that work, and rarely vice-versa.

2. Set actionable goals. Decide the proper position sizing, Profit Taking and Stop Loss price for each position, when doing your investment planning. Do this when the market is closed. In the “heat of the moment”, during the live session, consult your pre-set plan. Use the Portfolio Tracker to monitor positions and risk.

3. Abstain from emotional mistakes. Emotionally driven decisions void the investment process. Use the Sentiment indicator to avoid buying in Greed and selling in Fear.

4. Never let a “trading opportunity” turn into a long-term investment. Until your thesis is proven correct, a position in your portfolio is “just a trade”. Many traders become “long term investors” when their positions under-perform. Refer to rule #1.

5. An investment discipline does not work if it is not followed. “Just do it” - easier said than done, but focus on the process rather than returns, and profits will eventually materialize.

6. “Losing money” is part of this game. You should not be investing if you are not prepared to take losses. Refer to Rule #2 to understand the risk you are taking.

7. Strive for a “70% win rate”. No strategy works 100% of the time. There’s no “magic bullet” when investing. However, doing research, managing risk and emotions can be practiced every day and will lead to successful outcomes given time.

We will resume our daily market coverage next week and share updates about the next generation version of the platform. Have a great weekend, everyone!

-Andrei

Signal Sigma PRO members will be notified by Trade Alert of any live portfolio changes (if subscribed). If you’re not on this plan yet, you can get a free trial when you join our Society Forum. If you need any help with your trading strategy (or would like to implement one on your account), feel free to reach out!