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  • The S&P 500 is 9% below September 12th's high and 13% below mid-August's peak.
  • Multiple indicators could reach levels historically associated with short-term bounces next week, and sentiment, a contrary indicator, is poor.
  • Risks remain, but Doug Kass is slowly increasing his net long exposure.

The S&P 500 has been marching downward since mid-August because investors increasingly realize that core inflation, excluding volatile energy and food prices, is remaining stubbornly sticky, forcing the Federal Reserve to ratchet up, rather than back, its hawkish rhetoric.

Yesterday’s increase to the Fed Funds rate – the rate at which banks lend to one another – marked the third consecutive 0.75% increase. Rates have increased 3% this year to a range of 3% to 3.25%; unfortunately, more increases are likely. The CBOE FedWatch tool now puts us on pace for 1.25% in additional increases by the end of December and, potentially, more increases early next year. This is an increase from previous expectations. For perspective, the Fed’s dot plot, a table showing each member's expectations, put rates at a median of 4.4% by year’s end, up from 3.4% in June. Furthermore, their expectation is for rates to be 4.6% in 2023, up from 3.8% in June.

Given rising rates correlate negatively with stock valuations in discounted cash flow models, it’s little wonder investors have been selling. However, stocks don’t fall (or rise) in a straight line. Market sentiment is getting lousy (again!), and contrary indicators are beginning to suggest stocks' recent slide could be setting up another bear market rally soon.

Oversold indicators are aligning

In “Let's Brush Up on the 3% Rule as We Pen a Thick Line on the S&P Chart,” Top Stocks’ Helene Meisler consults her favorite overbought/oversold tools for clues. She writes:

“The 30-day moving average of the advance/decline line is set to get oversold midweek next week. Two weeks ago, it was still hovering at the zero-line. It entered this week at -200. It now stands at -330. In May, it got to -500, and at the Covid lows, it was at -600. Based on the math behind the indicator, I think it gets to a good oversold condition next week.”

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This indicator averages the number of advancers minus decliners over the previous thirty days. It shows that poor breadth (more decliners) is increasingly displacing better breadth over the past month. As the line sinks, odds of a relief rally driven by short covering and bargain hunting increase. The advance/decline line for shorter periods is also getting overstretched. Meisler says of her 10-day oscillator, “My own Overbought/Oversold Oscillator is finally coming back down as well. I expect it will be back to an oversold condition midweek next week as well.”

Meisler’s also paying attention to the ratio of stocks making new lows, volume, and contrary sentiment indicators, including investor surveys.

Back to Meisler:

“The Volume Indicator is at 47%. It, too, should get oversold (low 40s) sometime next week…The Investors' Intelligence bulls have fallen to 30%. That is four points higher than the spring low and down from 44% in August. The bears have not risen much, though. They reside at 31.4%, whereas they were 44% in June. But the bulls have surely pulled in their horns.”

In “This Contrarian Indicator Has Only Been More Bearish 5 Times in the Last Decade,” Real Money’s Guy Ortmann writes, “The data, in our opinion, are now suggesting the probability of some pause or possible bounce from the recent weakness.”

Ortmann highlights the following indicators for his opinion:

“The McClellan Overbought/Oversold Oscillators are oversold with the NYSE very oversold (All Exchange: -98.26 NYSE: -110.01 Nasdaq: -90.51)...The percentage of S&P 500 issues trading above their 50-day moving averages (contrarian indicator) dropped to 15% and is now on a bullish signal…The Open Insider Buy/Sell Ratio lifted to 66.1% but remains neutral…Importantly, the detrended Rydex Ratio (contrarian indicator) (see below) remains in very bullish territory, dropping to -2.99, a level that has only been exceeded five times in the past 10 years as the typically wrong leveraged ETF traders now have extremely leveraged short exposure.”

Ortmann reminds us these conditions need to be confirmed by price, but technicians aren’t the only ones thinking there could be an upside move in the cards soon.

In his Real Money Pro diary today, Doug Kass explains why he’s slowly been increasing his net long position to 29% from 24%. He writes:

“As someone who is starting to see the glass as being more half empty now, the Fed's pronouncement is defining what might be the end of a hawkish era and not the beginning.

To me, we have already seen a lot of discounting. The time to be concerned about The Fed was late 2021 -- when I did, see my 15 Surprises for 2022 -- and not in late 2022, after the damage to the capital markets has largely transpired…Yesterday's downturn took the S&P Index slightly lower... 10 handles or only -0.25% below the low end of my projected balance of year trading range forecast. Remember, precision, as I have repeatedly written, is not intended…I am slowly and incrementally embracing the drop in equities - for the reasons mentioned in my Diary this morning and over the last two weeks - as an opportunity for capital gains…if you are an investor with an intermediate view like myself, opportunities are, arguably, accumulating - as potential reward vs. risk is improving.”

A potential rally off the low end of Kass’ expected trading range has him increasing long exposure, but that doesn’t mean his bet will pay off immediately, or people should toss caution to the wind. After all, he’s only 29% net long.

The Smart Play

In addition to the indicators previously mentioned, the volatility index (VIX) has increased to the high end of its range over the past three months, and the put/call ratio, a measure of bearish put trading to bullish call trading, reached 1.2 today. Also, 61% of respondents to this week’s American Association of Individual Investors’ survey are bearish about the next six months, the highest level since March 2009, when the S&P 500 put in its Great Recession low.

Those contrary indicators suggest some relief, but they can get increasingly oversold and stay oversold for a while. Meisler’s math puts her indicators in bounce territory next week, not necessarily this week. There’s art’ associated with interpreting data like this. Price action must confirm these readings for conviction.

Overall, bear market relief rallies are common and come in different sizes. As a result, they can be powerful and enticing, like the S&P 500’s 19% rally from mid-June to mid-August. Or, they can be smaller and faster, like its 6% move up earlier this month. Regardless, bear rallies fade near resistance levels because of sellers trapped at higher prices eager to ‘get out flat.’ For this reason, approach them cautiously, like Kass.

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