In the latest post, we pointed out a pattern indicating upcoming pain for the Nasdaq Composite following the meme stock fiasco. This conclusion is consistent with our view that the overall market will experience some turbulence in the coming days. After a ~15% off the year's low, the market is facing some very tough macro-economic, fundamental valuation and technical resistance.

On the macro-economic front, the market has been talking about a pivot from the Federal Reserve. Per CME FedWatch Tool, the market expects a 0.50% interest rate hike in September, a 0.50% hike in November, and a 0.25% hike in December, taking interest rates to 3.5% by the end of the year. Compared to the previous 2x 0.75% interest rate hikes in June and July, expectations of smaller increases towards year's end assumes the Federal Reserve is happy with the trajectory of inflation. Recall, July's Consumer Price Index indicates a slow-down in inflation (up 8.5% year-over-year compared to up 9.1% year-over-year in June; and flat month-over-month). While this indicates inflation may have peaked, it doesn't mean inflation will come down to the Fed's target of 2%. As such, the Fed could continue to be hawkish, raise rates more than the market is currently pricing in. In short, the market is currently trading as if inflation will come down and the Fed will slow down interest rate hikes. However, we have yet to have evidence of inflation coming down.

Moreover, in addition to unusually large interest rate hikes, the Federal Reserve has just begun the largest Quantitative Tightening program in history. We argue that the effects of this has not been seen in the economy. In the past earnings season (reporting Q2 2022), companies reported earnings that were not as terrible as expected, but also were not good. In aggregate, S&P500 companies are beating earnings estimates by 3.4%, which is below the five-year average of 8.8%. On a year-over-year basis, the S&P500 is reporting its lowest earnings growth since Q4 2020. What's worrisome is that Q2 earnings season lapped April - July, when the Fed had just started to raise interest rates by small increments, and Quantitative Tightening had barely begun. If the earnings are already weakening at the beginning of the Fed's tightening campaign, it is reasonable to expect much worse to come at the height of the tightening.  

Additionally, from now until November there will be the mid-term elections, in which many Democratic seats in Congress will be up for the Republicans to grab. Expectations are for the Republicans to gain control of the House and the Senate, meaning in the next last two years of Biden's presidency, nothing can get done. Actually, this outcome is favorable for the stock market. However, usually, election season usually comes with some volatility.

On the valuation front, the S&P500 is now trading at about 18x 2022 earnings, close to the 10-year average. It is very hard to argue for 20x, which was the multiple in 2020 and 2021, because money was essentially free during those years. However, given the possibility that we have not seen the worst of the monetary tightening campaign, we think there is higher probability for multiples to compress (lower) rather than expand (higher).  

Lastly, on the technical aspect, the S&P500 has encountered resistance at the 200-day Moving Average (red smooth line), which is a major technical overhead resistance that the index has to overcome. Historically, when the 200-day MA is sloping down such as it is currently, when the price approaches this level there would be major resistance. Unless there is a fundamentally positive news (such as substantially lower inflation and/or strong earnings), we believe this overhead resistance continues to be a challenge. Additionally, prices are approaching the upper trendline resistance (black trendline). Taken together, it is reasonable to expect worsening of price action ahead.