Is the selloff done, or more pain to come?

Last week, the market took a thorough beating, offering investors an utterly disappointing price action. The only good news is that main indices as well as many individual stocks are now deeply oversold. This condition has preceded market rallies since October ‘22, as professional and retail investors have lightened up on equity allocation. Given the very negative levels of investor sentiment and oversold technical conditions, the possibility of a counter-trend rally is noteworthy.

There are 2 main drivers for the market currently: the conflict in the Middle East and earnings results. So far, both of these factors have put market participants in risk averse mode, as companies have been unable to drum up optimism about their growth prospects. From a fundamental perspective, P/E ratios have reverted to the cycle median and EPS has consolidated. Revenue growth continues to decelerate, albeit slowly.

Before discussing fundamentals, let’s take a look at the technical picture:

SPY Analysis (standard technical)

From a purely technical perspective, SPY, the benchmark ETF for what we call “the market” has almost reached an important inflection point at the $409 M-Trend support. Since the technical channel has a negative slope, our stop-loss system will take a violation of $409 on a weekly basis as a reason for cutting equity exposure to 0%. Upside remains at $431, where the R1 level resides, with the 50-DMA just above it at $435.

Stocktrader Almanac does a good job of displaying the odds facing investors currently:

“What’s the history when turmoil grips the planet in October, heading into the Best Six Months of the year? Since WWII, there has been an ongoing war or international conflagration going on practically all the time. Things have come to a head in October many times, with several happening in the Mideast. Current events in the Middle East are especially tense.

We’ve tried to pinpoint the Recent High related to the crisis and then the nearest Subsequent Low around October. We included the nearest Crisis Low, the Q4, Year, Best Six Months, and Next Year % Changes.

We find ourselves today at a similar crossroads with the Hamas attack, Israel’s reaction and unrest in Mideast and on the world stage. If this situation can be contained the market will likely rally sharply. If it drags on or escalates that will likely negatively impact the market.”

The result of their analysis highlights both the upside available if current worries turn out to be overblown, as well as the need for managing risk via stop-loss levels in case the market goes south. Results for 2024 appear highly binary: while the average return from similar scenarios is 1.7%, none of the outcomes is in the single digits, both positive or negative. The range is wide: -38.5% to +26.3%.

On fundamental grounds, we would like to remind our subscribers that we publish 3 scenarios in every quarter. Our late august analysis reveals 3 price targets and ensuing probabilities for the year ahead. For the negative case, we will worsen the outcome on purpose, in this analysis:

• Positive Outcome: 50% odds of SPY reaching $482 (17.3% upside)

• Neutral Outcome: 40% odds of SPY reaching $450 (9.57% upside)

• Negative Outcome: 10% odds of SPY reaching $360 (-12.3% downside)

The weighted average Price Target for these fundamental scenarios comes in at $457. When we apply a 7% historical Compound Annual Growth Rate to this Price Target, the fundamental chart of SPY looks like this:

SPY Analysis (Fundamental Adjusted Chart)

When we look at the market through this lens, we can see that fundamental support comes in a bit lower than our technical analysis suggests, at $403 instead of $409. What this means in practice is that many trend following systems will be inclined to sell “into a hole”, disregarding the fact that the market has acted in a “range trading” pattern in the last couple of years.

To be clear, Signal Sigma automated models are also guided by trend following principles, and have been rather ineffective at navigating the current range trading environment. That’s why it’s important to bring our own analysis to the table and understand the market action through a more meaningful and complete lens, such as fundamental analysis.

Also helping the fundamental picture, P/E ratios for the S&P 500 have reverted to a cycle median (see Market Fundamentals). While these can obviously get cheaper down the line, (see the covid crash and December 2018), it proves that the “average stock” is not “expensive”.

More on the “average stock”

Using our Stock Screener instrument, we can garner some additional information about the top 493 market cap companies (excluding the “magnificent 7” from the S&P 500: AAPL, AMZN, TSLA, GOOG, MSFT, NVDA, META). For this group, average 1 year returns are negative (-0.12%). Free Cash Flow yield is 4.18%, below the 1-year treasury bond. And the combined, equal weight chart looks ugly, to say the least.

S&P 500 stocks without the leadership of the top 7 best performing companies are now at June 2022 lows. This signals both an opportunity, as well as a technical issue if this trend does not reverse fast.

From a Z-Score perspective, we can see that large caps are “catching down” to the rest of the stock universe, a welcome development as long as the entirety of the market does not collapse. What we would like to see during the next advance is the average stock managing to “catch up” to the SPY, signaling an improvement in breadth.

In theory, the S&P 493 has an average 25% “distance to analyst Price Target”. This is consistent with Stocktrader Almanac’s observation at the beginning of this article.

Our Trading Strategy

Behavioral bias is the #1 cause of poor returns and faulty decision making. If anything, our analysis system is designed to bring objectivity and harness data science in order to combat our irrational (and human) behavioral mistakes. Among several, we’d like to highlight a couple of biases which are currently at work today:

• Loss Aversion – The fear of loss leads to a withdrawal of capital at the worst possible time. Also known as “panic selling.”

• Herding– Following what everyone else is doing. Which leads to “buy high/sell low.”

• Media Response – The media is biased to extreme optimism / pessimism to sell products from advertisers and attract view/readership.

Currently, our analysis suggests a reflexive rally into the end of the year is more probable than not. We shall perform another fundamental review of the market at the end of November and issue new scenarios and price targets. Until then, get ready for an eventful week: Apple, AMD, Palantir, and a host of other companies are reporting earnings and will greatly impact traders’ psychology. The Fed sets interest rates on Wednesday, and a pause in widely expected. Non-Farm Payrolls data is set to be released on Friday, wrapping up yet another pivotal week.

Bulls will hope for a successful break of the 200-DMA, to the upside. For now, we are in no rush to exit positions, as downside should be contained. If risk needs to be reduced, other (better) opportunities will eventually arrive.

Periods like this are never fun or pleasant. But we need to trade the market that we have, not the one that we want. We know that the stock market never goes straight up or down, and avoiding psychological mistakes is of paramount importance in volatile times.

Sometimes, it’s better to turn off the news, and just focus on risk management. Remember that investing is never easy. A well-thought-out strategy, on a longer-term timeline, and an ability to stick to your discipline can get you closer to your goals. If you need help with any of that, get in touch!

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!