I Warned You This Would Happen

Economic Status Board

This is why you read Filthy Rich, Dirt Poor. On April 27, I warned you that the S&P 500 was sending warning signs it would trade lower and told you there are three critical levels of support.

We’re now at level 2 (3850), and frankly, level 3 (3550) wouldn’t be surprising given that positive catalysts are still absent from the market and the economy.

It took the S&P 500 just 6 days to violate 4170 and collapse 9%. This is the chart I shared with you on April 27:

S&P 500In that issue (April 27), I discussed buying 27MAY22 SPY puts at 380 or 400 strikes.

S&P 500

I believe the S&P 500 has to retest that 3550 line of support before it hits a bottom and turns back higher.

Looking ahead to June expirations, I see the 340 and 360 range as the current trading volume area. That tells me the selling isn’t over and that this market has to retest the 3500 range to build support (or not).

Here are pre-market options prices as of Thursday, May 12 to buy Put options on the SPY (again, not a recommendation, but it’s information you can use if you choose).

S&P 500

Here Come the Crazy People

Now, my mother recently passed along some crazy rant: it was “end times” oriented and told people to sell everything (which is, frankly, stupid advice). I stopped reading after “S&P 500 to go to 800 points.”

The stock market isn’t going to zero.

This is NOT 2008-09; there are no conditions even similar.

Yes, we have continuous bad news – learn how to use it to your advantage!

This is a “fight or flight” stock market this year and probably next. We choose to fight.

Forward Valuations of S&P 500 for Reasonable People

Let’s look at which valuations can help us find a market bottom: The green highlight shows you where we are now (3900); you can see the “bottom” is roughly 3712 if there’s a continued deterioration in the forward multiple for 2022.

The one caveat at present is full-year S&P 500 earnings; if they remain on target for $225-$230, these levels should hold. If earnings expectations decline, say to $215, look at the change in S&P 500 levels:

 

Let’s look at $215 Full-Year Earnings impact, with the same P/E Multiples:

Notice how the green highlight moves?

What this gives, however, is a realistic range on the S&P 500 for 2022: 3547 to 4162.

Next Friday, we’ll look at 2023 levels and I’ll share with you why I think we’re already in a recession and why we’ll be out of it sooner than people think.

Economic Status Board: Dow Theory Turns Bearish

We’re running out of “positives” in the short term on the status board. A reminder here that in late March 2022, when we launched this board, none of the indicators were in the red. None. 

6 weeks. That’s how rapidly the economic outlook has changed.

Economic Status Board

Last week, the Thursday and Friday sell-offs pushed the Dow to a new weekly low which confirmed Dow Theory as bearish, something it has not done since 2018. This implies that market selling pressure is not finished (obviously, right?).

Earnings Season Highlighted by Weaker Margins

In the past, I’ve shared concerns about “margin compression” which is the reduction in profit margin by increased costs.

This past earnings season delivered a stunning example of margin compression and this, above all other noise, it what is driving markets lower.

Typical earnings growth runs at ~9.1% (a 10-year average).

This past quarter’s earnings growth is running at 4.9% – that’s a 53% reduction in net margin for S&P 500 companies.

Institutional Selling Absent Put Options

A little note crossed my email this morning: institutional selling is increasing without buying put options as protection. This is important to watch – it’s a worrisome development because institutional selling (and buying) triggers algorithms on Wall St.; those algorithms trigger other program trading systems which ‘follow’ the leaders.

On a stock chart, it’s called the waterfall effect; in algorithmic trading, it’s the same thing – it is an acceleration of selling pressure.

Now, about those put options: Typically institutions buy options as hedging or protection against their positions. What’s unusual about the last week of selling is the absence of increased options buying.

This you can see by following the VIX – with the rate at which the S&P 500 sold off last week and into this week, the VIX SHOULD be at higher levels.

But it isn’t. It is lower than the most recent high. Not easy to see but the recent high 34 was lower than the previous high of 36; and the current level of 32.5 is even lower. This is … unusual.

What Can You Do:

It is NOT all bad news (not yet); I still believe the following:

  1. The stock market never should have recovered from shut-downs/lock-downs as quickly as it did in 2020.
  2. The forward P/E on the S&P 500, when greater than 20.5 (as it was in 2020-21), is as close to a signal as you can get that the market is going to sell-off.
  3. BUT, a forward P/E approaching 16.5 is as close to a rally signal as you can get.

We’re closer to that 16.5 than we are the 20.5 which implies the market is nearing a bottom (technical bottom).

Forward earnings expectations are lower for Q2-2022 and higher for Q3 and Q4. I would anticipate continued selling throughout this current quarter as the ‘hunt for the bottom’ continues. But I see markets turning higher as we close 2022 and begin 2023.

A recession shock would of course change that outlook – but I think we’re already IN the technical recession.

Some rapid-fire thoughts.

If you’re an investor who is focused on portfolio growth, and you have at least a 2- to 5-year time horizon on stocks or funds you hold, this isn’t the time to panic (that time isn’t going to come either).

Instead, this is the time to evaluate what you hold: for stocks, do you believe in the long-term health of the company? Do you think the company will be worth more in 1, 2 or 5 years from now than it is today?

Are you willing to continue to invest in this company? If you are, then consider dollar-cost-averaging DOWN. That means buying shares at lower prices than you originally paid. This is not alway possible for investors. It depends upon available cash to add shares to your portfolio.

Here’s a simple example (using fake prices, ok?)

You hold 50 shares of GM with a long-term average price of $40 per share.

Assume GM is currently trading at $25.

You add 50 shares of GM at $25. This decreases your average price per share to $32.50.

That’s the mid-point between $40 and $25 ($15 divided by 2 = $7.50; $40 – $7.5 =$32.5)

Why would you do this in the midst of an ongoing market sell-off?

To decrease your break-even price and to put less pressure on your portfolio to outperform in the future.

For GM, in this hypothetical example, to achieve break-even for you would require the price of the stock to move 30% higher (from $25 to $32.50); as opposed to a 60% move at your original price of $40.

Next week, we’ll begin diving into stocks you know to help you evaluate whether or not they should remain in your portfolio.

Enjoy your weekend and stop worrying about the stock market. We’ll worry for you.

 

All the best,

John Hutchinson
Traders Reserve

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