After a very strong month in July, with the S&P 500 up ~9%, strongest performance since November 2020, we are advising clients to take a precautionary approach to August due to remaining economic and and mid-term election uncertainties.

It is good to see that when the market became cheap (15x forward earnings at the lows in June), investors piled in with confidence. However, after the face-ripper rally in July, we are now back to 18x forward earnings for the S&P 500, which is neither here nor there. We think 18x forward earnings is fair value, which means investors need to be positioned for both downside and upside risks.

For downside risks, there are plenty. What drove us lower for the first half of 2022 still remain: high inflation and a Fed that is hawkish to fight inflation at the expense of the economy. On the inflation front, we actually have not seen the inflation numbers peaked, yet the market is trading as if inflation has peaked. If the next CPI data comes out hotter than expected, it would not be surprising to see the market takes a substantial leg lower. If the inflation data shows that inflation has peaked, this would only confirm what the market is currently pricing in, meaning there's not much of an upside surprise to be had. 

On the Fed's front, market is currently pricing in as if the Fed is towards the end of its tightening cycle. We are forced to think that this is too bullish of a call to make, or in simpler terms, we don't want investors to think the Fed is your friends at this moment. 

At this point we have not only the Fed to deal with but also the midterm elections. Current predictions have the Republicans winning thirty seats in the House, which would give them a majority in both houses and pretty much end anything President Joe Biden wants to do. That could make the Democrats go crazy during the perceived time that they have left; they can really go nuts against the banks, the oils, and the drug companies. 

The abovementioned factors, plus the historical/ seasonal trend of market turbulence in August-September (these two months are historically and seasonally challenging for stock market) make us believe that we will have a rocky two months ahead. We advise investors to trim positions that have seen outsized gains from the low, de-risks their portfolios and sit with plenty of cash on hands. We will tell you when the S&P Oscillator, our favorite indicator of market sentiment and direction, becomes oversold which signals the time to buy again. Right now the S&P Oscillator is very close to being overbought, which means we have to be net selling.

We think the S&P 500 will come in for a re-test, maybe not of the 3700-low we saw in June, but at least the 3900 level. For us to continue to be on the bullish side for H2 2022, we need to see the S&P 500 make higher highs and lower lows, something the smooth black arrow below indicates. 

What are we doing to our portfolio? For June and July, when we believed the market was very oversold and valuation was very attractive, we were positioned to deliver 2 times daily movements of the S&P 500. This means on a day that the S&P 500 moves up 1%, our portfolio on average moves up 2%, and the opposite direction is true. The result was that in July, while the S&P 500 moved up 9%, our portfolio moved up 16%. We weren't able to deliver 18% (2x 9%), but 16% is a very good outperformance that we will take any day. However, moving forward, we want to reduce the portfolio's volatility level, ideally to match the market's movement (portfolio should move down 1% when the market moves down 1%). We would achieve this with a combination of short trades, hedges and cash positions. We do this with the hope that when the time is right again, we can bring our exposure up to double the market's movement. We want to remind subscribers that we're still outperforming the S&P 500 to date.