As an important preamble, I want to make sure that everyone is up to speed on my most recent thinking on my bearish stock market outlook...proof the bear is here...how much lower will we go...and a basic trading plan to profit on the way down while preparing to buy bottom when the time comes, asserts Steve Reitmeister of Reitmeister Total Return.
Now let’s pick up the conversation from there...
Low rates are the oil that lubricates the economy to run faster. That is why lowering rates is the number one tool of the Fed to help the economy during times of turmoil.
That is because in a lower rate environment it becomes more and more attractive for businesses to borrow money to expand their businesses. That is why we often call the steps by the Fed to lower rates; “accommodation” as it accommodates a faster-growing economy.
So what happens when you start doing the opposite...when there is less accommodation?
I think you know the answer. The opposite happens.
That’s because borrowing becomes less attractive. And thus less money circulates through the economy which equates to less spending and lower economic activity. But the more you ratchet up lending rates...the more likely you are to kill off borrowing which leads to recession.
The reason to not get bullish right now is that we are still too early in the process to squeeze excess valuation out of stock prices. That process normally takes 13 months to unfold with an average drop of 34% from the previous highs.
Yes, every bear comes in different shapes and sizes. But when we discuss what comes next you will appreciate why there is more time and more downside to come.
At this stage, all we have done is all we have seen is share prices drop and a deceleration in the economy (bordering on recession). But still, Wall Street analysts have not yet trimmed their earnings outlooks for the future.
When they do that...then immediately valuations for stocks go up. And that increased valuation will also have to be removed before the bear market is over.
Let’s break that part down because it’s not intuitive on the surface. Right now, Wall Street analysts are still predicting $231 in earnings per share for the S&P 500. At today’s price level of 3,821 that equates to a PE of 16.4.
Yes, that is more reasonable than the 21.4 peak PE for stocks back in January. But it is still above the historical average of 15.5. And typically stocks go well below the historical average in the final stages of the bear market cycle before the next bull emerges. So even without any forthcoming lowering of earnings estimates, stocks are still a shade too elevated to call it bottom.
Now let’s say that Wall Street analysts finally get the memo that indeed this is a recession coming and start the process to lower future earnings estimates. Well, the average recession comes with a 26% reduction in earnings outlook. I would guess this one will be on the milder side. So let's go with a 20% reduction.
That would bring down estimates from the current $231 to only $185. Given today’s closing price, that would have PE ratcheting back up to 20.7.
Your eyes do not deceive you. Valuations will have basically gone back to nearly the starting line like when we were at peak levels forcing investors to drive down prices to get PE more in line.
Note that this idea of lower EPS is not really hypothetical. Nick Raich of EarningsScout.com gave this somber note yesterday morning: “Here is the bad news: Our research indicates that 2H 2022 S&P 500 EPS expectations are likely to be cut by -15% to -25%.”
To be clear, Nick worked with me for many years at Zacks Investment Research, where we focused on earnings trends. And now he is considered one of the foremost experts on earnings trends getting him on CNBC, Bloomberg, and WSJ on a regular basis.
This means when he talks about earnings...you should listen.
The point is that as the bear market rolls on the pendulum will keep moving farther and farther towards fear. That will mean that investors will have to squeeze down the PE to more reasonable levels that would encourage more value investors to step forward thus starting the bottom fishing process which begets the next bull run.
Now, look at the totality of what we just discussed. If indeed there is a recession coming (which looks more and more likely by the day...heck, even Cathie Wood admitted as much) then it is too early to call the bottom pointing out the falsity of the recent rally.
Another way to think about this...the average bear market last 13 months. It takes time to work it all out of the system with a series of plunging to new lows...hefty rallies that make you question if a bottom has been found...and then tumbling to yet lower lows.
Right now we are almost at the six-month mark. No, it won't magically last exactly 13 months. But I think you appreciate that process to squeeze out excess valuation is not yet done which is why we keep our bearish bias in place. And why I am not getting suckered into joining rallies like this recent one that seemed impressive only to get back on the selling track this week.
Right now there are only two paths to making money. And no cash is not one of them unless you would like to lose 8% a year to inflation. What you need to do is...
Short stocks as the market heads lower (for which we have four attractive positions).
Short bonds as rates rise thanks to high inflation and hawkish Fed (for which we have two attractive positions).
This strategy pumped up our portfolio by +2.06% Tuesday while the S&P 500 tumbled by 2.01%. And now imagine how well we will do as stocks continue on their downward path likely towards 3,000 when we will start talking about some bottom fishing.
Portfolio Update
I know you were questioning my sanity as the market ripped higher last week. Even closing above the bear market territory of 3,855. However, I was so sure of the above outlook on the market that I did not lose a wink of sleep. Gladly it did not take long for the bear market to get back on track with profits accumulating in our portfolio.
As noted above...we kind of only have two types of positions. So let's talk to them like a group this week.
Shorting Stocks (HDGE, HIBS, SBS, TWM): This group stunk up the joint last week as stocks bounced mightily from the bottom. And today we got our just rewards for staying firmly convicted to the bear market premise.
As stated many times over HIBS can be our best friend or worst enemy. That Jekyll & Hyde perspective was on full display the past few weeks. However, if indeed we are on a crash course towards 3,000 then we want HIBS on the books a good while longer. But yes, it will be the first short we toss overboard when we are getting ready to bottom fish for the next bull run.
New entrant HDGE showed today why it is on board. Market down only -2.01% and yet it rallied +2.79% on the day. That is a pretty good excess return for a 1X ETF.
Shorting Bonds: The ten-year now sits at 3.18% when it was pushing 3.5% not that long ago. That is because bond investors are seeing how the next cards will be served up with Fed crushing the economy with higher rates leading to lower rates in the future. That is why longer-term rates like the ten-year are starting to retreat.
RISR still could benefit from the Fed raising short-term rates which played out just fine today with a tidy little gain.
But the pick of the litter is shorting junk bonds with SJB which climbed +1.13%. This is the one to watch as the recession fear grips investors and rates soar on these “junky” companies.
Closing Comments
Bull markets are easy for investors. Close your eyes...pick a stock...and it is likely to go higher.
Bear markets take a bit more thought...and a lot more patience. But if you understand the nature of the bear it can be tamed. Indeed we seem to be doing that now...and I likely suspect it will take another three months to play out.
Then we can get back to thinking about the easy, breezy bull market environment.
