Weekly Preview / September 26
Notable Events on our Weekly Watchlist:
Monday: N/A
Earnings: N/A
Tuesday: Durable Goods, New Home Sales
Earnings: BB, CALM, PRGS
Wednesday: Various Fed Speakers
Earnings: PAYX, THO
Thursday: EU Inflation Expectations
Earnings: BBBY, MU, NKE, KMX
Friday: Caixin Manufacturing PMI, EU Inflation, Personal Spending / Income
Earnings: CL
ETFs to watch: SPY, XLY
No Fed pivot in sight takes markets to extreme oversold
Last week recorded abysmal performance for virtually all asset classes except the US Dollar. The Fed hiked interest rates by 75bps and Jerome Powell clearly stated that there would be no chance of a “pivot” any time soon as financial conditions need to be restrictive in order to bring inflation down to 2%. In the aftermath of the FOMC announcement, markets started to price in a more aggressive policy path, with a terminal interest rate of 4.5% - 4.75% by March 2023, up from 3.94% before the announcement.
The Fed also slashed growth projections, upped unemployment estimates and kept inflation expectations elevated through 2023 to a larger extent than market participants were expecting. This led Goldman Sachs to issue a downgraded year-end price target for the S&P 500 on Friday:
“In a recession, we forecast earnings will fall and the yield gap will widen, pushing the index to a trough of 3150. Our economists assign a 35% probability of recession in the next 12 months and note that any recession would likely be mild given the lack of major financial imbalances in the economy. As we previously outlined, in the event of a moderate recession, our top-down model indicates EPS would fall by 11% to $200.
For context, a 34% peak-to-trough decline in the S&P 500 index during a recession would only be slightly worse than the historical average of 30%. We see two risks that would create a more dramatic sell-off in equities during a recession. First, if inflation concerns were to limit the degree of monetary or fiscal policy support and interest rates did not fall, it could lead to even lower valuations or even larger economic and earnings growth declines than we model. Second, concentrated sector weakness, such as Information Technology in 2001 and Financials in 2008, could lead to an even sharper earnings and price decline.”
The research note added fuel to the selling, pushing all risk positions to extreme levels of oversold. Given the broad nature of the selloff, there was no place to hide, except cash and short positions. In equities, our system will not allow long positioning due to the fact that all support levels have been breached.
SPY Analysis
This tells us that the technical setup is starting to align to the more bearish fundamentals underpinning the market. While Goldman’s estimate of $200 EPS for SPY is lower, we believe it is still optimistic. We would like to highlight the Q2 Earnings Preview Article from July 15 published on Signal Sigma:
“Our own analysis suggests that the 12 month EPS for the S&P 500 could drop by 20% from $207 to $165. Using this assumption and the median trailing P/E ratio of 21, we get a “fair value” estimate of 3465, close to Wilson’s target, and 8% lower from yesterday’s close. A word of warning: price reversions can be brutal, and often times drop below the median level. Using the -2 Standard deviation trailing multiple of 16.75, the (very) bearish scenario could take the S&P down to 2763.”
This leaves the market in a tenuous position: close above 3940 to determine trend following systems to chase a rally, or drop to the 3000 area in order to elicit fundamental buyers to step in. Friday’s close has pushed all equity factors below -1 Absolute Z-Score, and below -2 Sigma Score (with the exception of the Momentum factor).
Factors Overview / Sigma Scores and Z-Scores
While there are a couple of relative out-performers (MTUM, DIA, IVE), virtually all sectors are now extremely oversold, as indicated by a negative sigma score below -2. We do not expect this to last very long - a reflexive rally would not be surprising in the next couple of weeks.
However, we would use that rally to further hedge the Sigma Portfolio and rebalance positions. There are certainly some very interesting bargains on the horizon, and I still expect our discretionary positions to outperform the broad market. What we do not want to do is fight the Fed, which is tightening financial conditions at the most aggressive pace in recent history:
The risk of a Fed policy mistake is getting closer by each rate hike
Source: https://www.chartr.co/
We would also like to reiterate the view from last week:
At some point during the next 6 months, we fully expect a “flight to safety” narrative to give a boost to bond prices. Our next important “BUY” will probably be bonds, not stocks.
Takeaway
With the markets getting very oversold and deviated to the downside, there is little reason to add to short positions right now. We will leave the Sigma Portfolio as it is, and use any reflexive rally to the 3900 - 4000 area in SPY to raise cash, and add to short exposure. It is possible to get net-short at that juncture as well.
At tomorrow’s rebalance, all Signal Sigma models will be mainly in cash.
Andrei Sota