In recent commentary we have tackled why it's a bear market, asserts Steve Reitmeister of Reitmeister Total Return.
And how much lower stocks should go. Even the reasons behind the circuitous path that stocks take to find the eventual bottom.
This last part is interesting as we wind our way into the Q2 earnings season. During bullish times, these reports often provide the catalyst for the next leg higher.
Unfortunately, this time around it may do the exact opposite as Wall Street has been late to acknowledge the recession. Thus, if a higher than usual percentage of companies show weak results and lower guidance for the future, then that will give investors ample reason to hit the sell button once more, pushing stocks to new lows.
Let's talk about that and our trading plan in this week's market commentary...
Earnings season is always important. But this time it takes on special meaning as investors are concerned that recent economic weakness will show up in these reports. If true, then get ready for the next leg lower as reports roll out in July.
As noted last week, the average recession brings with it a 26% reduction in the earnings per share for S&P 500 (SPX) companies. This is a big part of why share prices come down. Some of that is already reflected in the current sell-off in anticipation of this move...but certainly not all of it.
Let me repeat some of the math from last week so you appreciate why valuations will be too high once the revisions take place and why it points to further downside.
“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.”
This gets us back to the notion of how low do stocks need to go to properly squeeze out an excess valuation to attract investors back for the next bull run?
Previously, I predicted that the bottom of this bear market will be a tad more than the 34% average decline. Perhaps 40%. Not because I am expecting a worse-than-normal recession. Rather it is because valuations got higher than normal in the low rate environment and that excess needs to be trimmed out.
Another way to put it is to say that everyone got drunk on stocks during the last bull market party. And now we are dealing with the morning-after hangover.
3,180 = 34% decline from previous peak of 4,818.
3,000 = 37.7% decline and an interesting spot of resistance for stocks to battle over.
2,891 = 40% decline.
Now let’s square up these previous predictions of where stocks head against the valuation reduction story for earnings.
I suspect that stocks will have to get to around 15-16 times the reduced earnings estimates of $185. That creates a fair value range of 2,775 to 2,960. That prediction lines up pretty nicely with what I shared above.
Now we have two different ways of looking at where the bear market low should be and they are lining up pretty well. But here is the sad part. No matter how much we want the market to act in a logical order...it will not!
Meaning that just because we have made logical predictions of where stocks could go...there is nothing written in stone that it will play out this way. Thus, it requires a more flexible strategy of when to take profits and when to start buying up for the next bull run.
My sense is we should start taking some profit on our short positions around the 34% decline level (3,180). Especially the highest beta short positions. Maybe even a touch before.
Because I sense there will be a long battle over 3,000 ensues, and it indeed could be bottom, then start getting back to a hedged portfolio by balancing out our short positions by bottom fishing in some stocks that should soar in the early stages of the next bull market. Like cyclical stocks (energy, chemicals, materials, etc).
Yes, we are a little ahead of ourselves, but good to have a plan in place to figure out why stocks will likely head lower. And thus when to start taking our short stock profits off the board and switch into an offensive mode for the re-emergence of the bull market.
For now with a closing price of 3,831 today...there is likely ample more downside to come. And yes, broad weakness in earnings reports this quarter would certainly be a logical catalyst to get us moving down to test those lower levels.
Our portfolio with four diverse inverse ETF positions is well-positioned to profit from this environment. The same goes for our two trades on higher rates that both wound up in the plus column today too.
Since the start of June, this plan has worked wonders for us as we enjoyed a tidy gain while the S&P 500 is down a whopping -7.28%. So you can imagine how much more impressive it will be if indeed we have another 10-20% more downside til we find the bear market bottom.
Portfolio Update
I know you were questioning my sanity as the market ripped higher last week. Even closing
Shorting Stocks (HDGE, HIBS, SBS, TWM): The reason to have four different flavors of inverse ETFs is because of sector rotation. That being the market does not move as a whole in lockstep. Rather there are groups that outperform and underperform on any daily/weekly/monthly basis. Thus, having a diversified group of inverse ETFs gives us the best chance to be in enough of the right groups to enjoy the gains we are expecting.
HDGE and HIBS are the biggest wild cards sometimes offering the best results...sometimes the worst like today. The key is how they produce over time which I am monitoring closely. All in all, these positions are paying the bills as the market falls. Now the key is figuring out when to take profits. The market commentary above gives a good plan for how that will unfold.
Shorting Bonds: We were right to get out of PowerShares UltraShort Lehman 20+ Year Treasury ProShares 2x Shares (TBT) as it is nearly 10% lower than where we sold. Gladly FolioBeyond Rising Rates ETF (RISR) and ProShares Short High Yield -1x Shares (SJB) are faring much better since then and will keep on board as long as conditions are favorable. Here too when it is time to take profits on our inverse ETFs it will likely also be time to take profits on these positions.
Closing Comments
Our nets are out to catch profits as the market falls. That seems like the easy part now. Figuring out the bottom will be the trickier task. Gladly we are ahead of the curve thinking about how that could unfold...thus like our odds to deploy those strategies to our benefit when the time comes.
For now, just let short stock and bond profits accumulate in our portfolio as this bear market winds its way to the bottom.
