Notable Events on our Weekly Watchlist:

Monday: Durable Goods Orders

Earnings: GRPN, OXY, WDAY, ZM

Tuesday: N/A

Earnings: TGT, ADT, AAP, A, AMC, AZO, CELH, FSLR, RIVN, ROST

Wednesday: ISM Manufacturing

Earnings: DLTR, JAZZ, KSS, LOW, NIO, OKTA, SNOW

Thursday: EU Inflation / Unemployment

Earnings: AVGO, BBY, COST, DELL, VMW, ZS

Friday: ISM Non-Manufacturing PMI

Earnings: N/A

ETFs to watch: SPY, XLY

On shaky footing

Last week, the decline in the equity markets finally started to unfold. We were already anticipating this consolidation move for a couple of weeks, and after struggling at the 417 level and triggering a couple of “fake” BUY and SELL signals, the market has now reached support.

We are adjusting SPY’s CAGR with a -10% value, and setting its price target to $345 for this analysis. It represents our “base case” expectation for this year’s overall price trajectory, by discounting an economic “soft landing” or shallow recession.

SPY Analysis

As always, the financial media finds a narrative to fit the technical setup. Totally disregarding the fact that markets were egregiously overbought to begin with, last week’s slump is attributed to inflation data and Fed hawkishness.

Of course, as we have repeatedly stated over the last couple of weeks (and even months), sticky inflation and a hawkish Federal Reserve are not really surprising factors. At current prices, SPY has a 9.57% return potential to our fundamental “no recession” Price Target of $435. This is much better than last week’s offering of just 6.7% upside, especially when compared to the 1-year risk-free treasury yield of 5.05%.

However, the key metric on any investor’s mind should be risk, not reward at this point. If the market cannot hold support and bounce convincingly from these levels, bears will take charge. We will have the confirmation that the Mean-Reversion environment is still in play, and we would be inclined to buy at $350, near the lower trend-line. There is a -11.8% possible decline to that level.

Economic data and recession scares

Ever since 2004, (the year that Google starts showing Trends data), recession searches show a similar pattern. There is an initial peak in interest, as growth slows, yield curves start inverting, and economists appear on TV and in social media warning everybody of impending doom. Dire prognosis don’t happen as fast as everyone expects, and the “recession” subject looses traction in the collective mind.

While a couple of months ago, one could clearly make the case that “everyone was bearish”, now that is no longer the case. Many Wall Street banks have already upgraded their year-end Price Targets for the S&P500, with Morgan Stanley’s Mike Wilson noting:

Therefore, the investing mentality gets complacent once again, and the cycle repeats. In order to track the aggregate progress of S&P500 companies, we have built the Market Fundamentals Instrument, which we will review below, as Q4 results get factored in.

Trailing TTM P/E Ratios

P/E Ratios have contracted considerably, as the Fed has started raising interest rates. They are now hovering near the 13-year median of 22. This leads us to believe that the market is currently close to fair value, but not exactly “cheap”.

Net Margins

Net Margins have contracted to below cycle trend-line. There is still a decent amount of declining ahead, as margins are some of the most historically “mean-reverting” series in finance.

Earnings Per Share

EPS has started a meaningful decline. From cycle top to cycle bottom, we would estimate we are 33% “there” in terms of reversion. We would only need to see a 50% progression in this decline in order to begin fundamentally adding to equity exposure. Stocks usually start climbing well ahead of EPS bottoming. However, we are maybe 1-2 quarters away from this cycle mid-point, as this data is very slow moving in nature.

Inventory Turnover

Even after accounting for hot retail sales, we can plainly see that consumers are simply paying more for the same amount of “stuff”. Company inventory remains historically bloated. We expect to see more margin pressure, as discounts need to be pushed through retail chains. This will eventually lead to lower inflation, with company profitability getting hit.

In order to mitigate that margin hit, many companies will focus on “efficiency”, in order to shield a hit to EPS. That will inevitably translate into headcount reductions down the line (more than what we are currently getting). When that slack hits the labor market, the Fed will have a good excuse to pivot and lower rates. Because the transmission and reporting mechanism is so slow (we are looking at charts with data reported at the end of Q4 after all), there is an increased possibility the Fed will be late with its response, having already overtightened financial conditions.

Our (Market Internals, Overbought/Oversold Instrument) will come in handy, if the “mean-reversion” trading environment persists. We would be inclined to buy at the low end of the range, when and if we eventually get there.

We are also keeping an eye on Dollar Transaction Volume (from the same instrument) in order to assess liquidity conditions. We would NOT like to see high volume confirm the current correction, in order to get more constructive here.

Takeaway

While our fundamental view, derived from historical outcomes in these types of conditions is leaning bearish, we are not committed to any particular outcome. The moment we “choose a side”, there is an increased possibility our analysis and decision making will become biased.

You may have noticed that “news” and “opinions” are not part of our Process. Price action is, however, and we need to respect the overall direction of the market.

We are at an important juncture for equities, with 2 possible short-term outcomes:

• We either get a solid bounce from current levels, with a MACD BUY signal triggering above the M-Trend level ($398), that will result in us being buyers;

• Or we get a breakdown, and return to “range-trading”; in this case, we will wait for panic to set in, and buy at the lower end of our trading range (around $350 on $SPY);

That’s it, there is no third option. Combining technical analysis with fundamental analysis makes things easy for us. We just need to execute when the time is right. We will keep you posted via trade alerts.

Andrei Sota