Skip to main content
  • Doug Kass believes stocks are more likely to fall than to climb from current levels.
  • Stocks face stiff resistance, increasing the risk of poor economic and earnings data derailing them.
  • Use strength to prune low-conviction stocks to upgrade your portfolio.

Active investors require different skills to succeed than those firmly in the buy-and-hold camp. Instead of a strong constitution enabling one to stay firmly on course to long-term gains, active investors need to be able to “lean into the wind,” continuously adjusting exposure based on their assessment of evolving risk to reward.

Recalibrating judgments to create and execute portfolio strategy (plan trades, trade plans) isn’t easy, especially when it means going against the crowd. It’s tough to stand your ground against an onslaught of verbal arrows. Yet, that’s what Real Money Pro’s Doug Kass regularly does.

Last year, he tilted bearish when everybody else was bullish, exposing him to more than his fair share of body blows. Similarly, he pivoted net bullish earlier this summer when everyone was hiding under the desk, convinced stocks were heading to zero. Now, he is stepping back into the fray, writing “We May Be Approaching Another Important Top in the Market” this week.

Are short sellers about to get their revenge?

The rally since the mid-June lows was impressive but not uncommon. As I noted earlier this week, the NASDAQ’s 23% run-up was in line with the average gain notched in bear market rallies during the Great Depression and Internet bust.

Undeniably, the move up in stocks caught many flatfooted. In June, Bank of America’s survey of professional investors showed fund managers were taking the least risk since the Great Recession, the put/call ratio (a measure of bearish put trading to bullish call trading) was significantly above 1, the volatility index was north of 30 (arguably, an extreme), and few stocks were trading above key moving averages. Poor sentiment proved to be very bullish; however, those measures no longer provide the same level of support.

For example, Kass writes, “In June, only 2% of the S&P Index components traded above their daily 50-day moving averages. We are now back to 86% of the S&P Index above their moving averages!”

Indeed, the rally has repaired a lot of damage to stocks. My overbought/oversold indicator measures the percentage of institutional quality stocks trading over 5% above or below the 200-day moving average. In June, only 6.5% of 1,600 highly-liquid stocks were 5% or more above the 200-day. Today, 18.6% of stocks pass that test.

Notably, the run-up has moved the major market indexes back up to the down-trending 200-day moving average, a key line in the sand many investors use to determine if the market is healthy (above it) or unhealthy (below it). Often, the 200-day moving average provides support on the way down and resistance on the way up. Since we’ve moved very fast off the lows, it wouldn’t be surprising if some investors fade strength at the 200-day moving average (or near it, which is why I use a +5% and -5% band around it).

Back to Kass:

“Indeed, the swiftness and size of the rise in equities last month have recently driven the markets back to valuation levels that concern me - reducing the general attraction of equities and posing the risk of more negative outcomes for stocks…Investor expectations and sentiment, so dour six weeks ago, are now elevated. An oversold market in June has become overbought on every measure we look at as market strength is being bought. Short positions are being aggressively covered, and fear of the return of capital has quickly morphed into the fear of missing out ("FOMO").”

In “At a Standstill,” Top Stocks Helene Meisler suggests a bull/bear tug of war is afoot. She notes:

“New highs did not expand, so there is no change there. And we remain overbought…My best guess is that we need a pullback and another rally. How many are really dying to turn bullish with the indexes at their 200-day moving average lines/resistance? A pullback would give folks the feeling of "ah," we’re no longer overbought, we’ve backed off the 200 daily moving average…Like letting the air escape from a zipper bag.”

If short-term overbought at 200-day resistance results in a pullback, many stocks that made big moves, such as heavily-shorted and high-beta stocks, could see prices fall meaningfully. Support levels exist below, but the steep slope created by the rally means many need double-digit declines to reach them.

Kass says he recently had lunch with long-time friend Lee Cooperman, the billionaire investor who founded Omega Advisors in 1991. Cooperman is similarly concerned that stocks may have run too far, too fast. According to Kass, Cooperman “sees S&P fair value at about 18x projected EPS of $230/share - which equates to about 4140. However, if we get a recession next year, profits can drop to $180/share, using a 20x price-earnings multiple yields 3600 on the S&P Index.”

The S&P 500 is 4268, above Cooperman’s fair value target, suggesting that stocks aren’t nearly as attractive as they were a couple of months ago. Sure, stocks can remain overbought and oversold for longer than anybody expects. Still, earnings aren’t likely to offer much support to valuation targets like the one suggested by Cooperman.

Back to Kass:

“The earnings season, though better than many feared, has still not been good as forward guidance has disappointed and has raised more questions about prospective trends in profitability…Q2 2022 S&P profits, excluding the contribution of the robust gains in the energy space, declined by 3.7%...Consensus corporate profit expectations are too elevated. Indeed, the pace of the rise in input costs will likely lead to an earnings recession over the next few quarters. The PPI (Producer Price Index) has now eclipsed the CPI (Consumer Price Index) for 29 straight months. As an example, last week's PPI rose by +9.8% compared to "only" +8.5% in the CPI. Input costs are outpacing the ability for corporations to pass on higher costs to the consumer.”

We’ve talked about this dynamic a lot. Real wages (wage growth adjusted for inflation) are negative, so companies are struggling to increase prices enough to offset rising input costs. Inflation is decelerating because of falling commodity prices, relieving some pressure, but other costs are stickier, including salaries. This stickiness is why the Cleveland Fed’s median and trimmed-mean CPI figures haven’t started dropping, despite the recent retreat in the headline and core CPI.

cleveland_fed_mediancpi

Absent job cuts (a lagging indicator), many companies will find maintaining the heady profit growth rates delivered in 2021 a challenge. Analysts are finally waking up to this point. Following Q2 earnings, third quarter and full-year earnings growth estimates for the S&P 500 have fallen to 5.8% and 8.9%, respectively, from 10.1% and 9.9% in July.

Back to Kass:

“I invest by doing what we view as correct and not necessarily by doing what is popular or consensus…Most investors find it hard to venture out in the herd…My market view is never based on price momentum - it is always based on our assessment and in the calculus of upside reward vs. downside risk…I have dramatically reduced my long exposure and have re-established a much more conservative portfolio construction…For the first time in a while, I am finding appealing short opportunities to complement my long holdings.”

The Smart Play

Markets don’t climb or fall in a straight line. They zig-zag up and down. Bear bottoms aren’t always “V-shaped.” They’re built over time as pops and drops shake out sellers and buyers to form more actionable bases.

For this reason, I’ve previously highlighted periods where I believe risk has climbed high enough to result in a sell-off, making it wise for active investors to reduce risk. I wrote It May Be Time To Sell Some Stocks on June 3 prior to the sharp sell-off through mid-June, and It Could Be Time To Sell Some Stocks on April 4, at the beginning of a major sell-off that lasted until mid-May.

Given that we’ve had a big run in a short period and are now into the thick of resistance, now could be another excellent time to sell some stocks.

For example, suppose you’re sitting on stocks with a broken thesis and questionable financials, well, then selling into strength to raise cash to buy higher-quality stocks makes sense. But, remember, the next bull market’s biggest winners aren’t likely the same as the last bull market’s winners.

If you’re unsure what to sell, try ranking your holdings from 1 (strongest conviction) to 5 (weakest conviction). Labeling your holdings as “forever” or “rental” mindset can also help. For example, high-quality stocks with secular tailwinds that you want to own for a decade or longer should fall into the “forever” camp, while stocks supported by catalysts or cyclical stories, such as commodities, should be considered rentals.

Buying pullbacks to support should pay off over the next year or two. However, a lot can happen along the way. Since some companies’ support levels are far below current prices, consider reducing margin to avoid forced sales if we dip, and take some off the top if a stock is too heavily-weighted in your portfolio.

My back-of-napkin charting shows solid resistance all the way from here to 4500 to 4600, which is 5.5% to 7.8% above where the S&P 500 currently trades. That’s not a ton of reward for a lot of risks, so if you’re an active investor, remember the idiom, “Pigs get fat, hogs get slaughtered.”

THUMB-Bear-Killer-JS-092322 (1)

Stocks: Will October Be Another Bear Killer?

October delivers historically strong returns during mid-term election years and bear markets.

THUMB-Oversold-Market-JS-092222

Is The Stock Market Getting Oversold?

A sharp sell-off this month has many oversold indicators suggesting a bear market rally is increasingly likely.

THUMB-Federal-Reserve-Stocks-JS-092122

The Federal Reserve Remains Stocks’ Enemy

The Federal Reserve increased interest rates by another 0.75% today, stiffening the headwind for stocks.

Stocks: Will October Be Another "Bear Killer?"

Stocks: Will October Be Another Bear Killer?

October delivers historically strong returns during mid-term election years and bear markets.

THUMB-Oversold-Market-JS-092222

Is The Stock Market Getting Oversold?

A sharp sell-off this month has many oversold indicators suggesting a bear market rally is increasingly likely.

THUMB-Federal-Reserve-Stocks-JS-092122

The Federal Reserve Remains Stocks’ Enemy

The Federal Reserve increased interest rates by another 0.75% today, stiffening the headwind for stocks.

THUMB-Housing-Stocks-JS-092022

It’s Still Too Soon To Buy Housing Stocks

Housing-related stocks have been punished this year, but surging inventory and dwindling demand mean they're still too risky to buy.