June 8, 2022
Good morning,
There is no better indicator of market performance over long periods of time than earnings and their growth. Earnings forecasting is the bedrock of fundamental analysis and is the most highly correlated factor to market performance over long time spans. However, over shorter time spans – not so much. For example, we commonly see weak market performance during peak earnings periods because investors intuitively know the earnings won’t grow indefinitely. Like fundamental analysis, there are time periods when technical analysis is highly predictive and others when – not so much.
There are huge time spans when sentiment (the emotional state of market investors) just doesn’t matter – it is balanced and stuck in neutral. Sentiment is important at extremes – extremely bullish sentiment is often found at market tops and extremely bearish sentiment is often found at market bottoms. Sometimes, sentiment can get so extreme, that it dominates trading and is the leading factor driving the change in market prices. In March, and again in May, sentiment reached extremely bearish levels. Pessimism reached an extreme, weakly held shares of stock were sold, supply overwhelmed demand, prices dropped and continued dropping until the selling abated – a bottom of some sort. With selling exhausted the market usually rallies and the market is said to be rallying on technicals – a term of art.
A week or two ago, we talked about the four common conditions of a bottom – oversold, rally, retest, and breadth trusts. Why the retest? Retests occur because fear is the strongest of emotions and pessimistic extremes (driven by fear) often get out in front of the fundamentals. After the deep bearish extreme is worked off due to a nice rally (April and the one we’re enjoying now), and strong technical influences recede, investors are left to look at the fundamentals once again.
The extreme levels of pessimism registered last month have now been worked off and are no longer a wind at the equity market’s back. What’s the fundamental backdrop now? China is likely coming back online and will be a positive to growth forecasts. Inflation is likely at or near its peak. However, the Fed has more tightening to do, and earnings forecasts will likely be reduced for the second half of the year in the coming weeks (end of June into July). Lower earnings forecasts now may be the fuel for a second half market rally but that might be putting the cart before the horse at this time.
It is entirely possible that all this is fully discounted into the market and S&P 3800 last month was a bottom never to be touched again. However, I suspect the more probable path for this market is more volatile choppiness, a test of the lows of some sort, and perhaps then fundamentals will have caught up with investor’s fearful emotions and a true upwardly trending market can resume.
Be well,
Mike