PRO-II(EYEs) Indicators Suggest Short-Term Bounce

We have not reviewed our PRO-II(EYEs) indicators in a while because there were mostly caution signals, and we generally cover those with our macro comments each week. The lower the risk level, the higher the opportunity. While we think the hawkish policy (fiscal and monetary) shifts developing are in the early innings, our tactical indicators are flashing at least a short-term rally potential from these levels. The thing with these types of indicators are that we never know with certainty until well after the fact, but the indicators are at the most opportunistic levels since the early days of COVID. The negatives in front of us are clear. There is always something on the geopolitical front to concern investors like Russia-Ukraine. These geopolitics matter for a few days/weeks but are mostly noise. Yes, geopolitics can influence earnings and global growth. Especially if it can change the price of energy markets that impact everyone.

What really matters are fundamentals of earnings and what investors are willing to pay for them. This changes in a rising inflation and slower growth environment. But is likely the positive in the next few weeks as well as an FOMC mindful as always of financial conditions (read S&P 500 volatility) that likely tries to calm the markets with this week’s policy announcement. High P/E stocks should be sold on rallies, while good value (low P/E, P/B) stocks should be bought on weakness.

We want to highlight are several key factors pointing to a potential oversold bounce. The relationship of current volatility to future volatility (i.e what is being discounted). The front month VIX futures is trading at a premium to VIX futures one quarter from now. We are also seeing next months VIX futures trading at a parity with VIX futures 2 quarters from now. In the chart below, when the blue line (current VIX futures) moves above the one quarter out VIX futures (red line), we typical see a trading low point. The lower chart measures their relationship by way of standard deviations. Typically, a move above 2 standard deviations suggests we are close to a low point. Not necessarily “the” low point. The acute nature of the COVID shock caused an 8 standard deviation event. This decline is not about a black swan event shutting down the world economy. More normal type declines in 2018 and 2019 are better benchmarks to compare with.

From a sentiment perspective, the American Association of Individual Investors (AAII) weekly survey shows that bearish sentiment relative to bullish sentiment is at an extreme low. This also can be a strong indication that a low point is close. Of note, sentiment can swing wildly and can remain depressed for a while.

Finally, but not conclusively, the weekly overbought-oversold relative strength index (RSI) shows a major bearish divergence and is pointing lower. It’s not yet at the extreme of 2 standard deviations, but it rarely gets that low. We can also see for the first time since COVID shocked the world in early 2020, the S&P 500 is testing its 200-day average, which is closed below on Friday.

There are more indicators pointing to a near-term trading low (like most of the breadth indicators), but there is also clear evidence of a cyclical trend change in monetary and fiscal policy, which suggests that while traders can always buy the dip, trend investors may want to start to sell the rip. We covered some hedges in portfolios on the test of the 200-day for the S&P 500 and the September low for the QQQs last week. We think earnings and the Fed calm markets this week, but expect the highs for the year could already be in and investors are more likely to sell rallies until we get a better idea how hawkish the Fed may need to get. That Fed put is still there, but inflation complicates their ability to be too dovish. That put is at least a few quarters away at the earliest and possibly 5-10% lower for the S&P 500 and more for the high P/E stocks. For now, earnings should be good, so they better not disappoint on their outlooks in the next few weeks.

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