The market has moved down somewhat quickly in the first half of the year, and while many of the downside catalysts remain unchanged, it’s important to remember that the market doesn’t go up or down in a straight line.  Bear market rallies can be equally as vicious as the downward moves.  

The most interesting question now is: what will the shape of the market be for the back half of the year?   Let’s assume for a moment that the S&P hits our downside target of 3250 sometime in early Q4.  That’s ~500 points down from here (or ~13%).  That doesn’t leave us room to have even two months like we just had in June (where the market was down -8.38%.)  Unless, of course, the market has some vicious upswings in-between them both.  An alternative to big upswings could be that the market chops sideways for a while before taking another leg down.  The third implied possibility here is that we’re simply wrong and that the bottom is already in for this downturn.  

We’re having a hard time finding conviction for a major bear market bounce soon because it’s hard to find anything to be excited about.  This same lack of conviction is also why we can’t rule it out: moves are often the most extreme when sentiment and positioning is all on the same side of the trade.   We’re only one CPI print, jobs report, or unexpectedly dovish Fed action away from a big short-covering rally.  So, while our base case is probably the choppy action that slowly moves lower, we’re keeping our eyes open for an unexpected rally based on a news catalyst as it wouldn’t take much.

Among experts, there’s been some discussion about how orderly the selling has been so far this year.  We noted in May’s letter how the VIX was declining without a commensurately strong rally in markets.  This compression of volatility has a second order effect that many may not be considering: even if they saw this coming, participants in the market may not have been as well hedged as they hoped.  If they bought put options many months ago, they would have experienced meaningful theta burn (eg., the decay in the time-value of the option) without the implied volatility in the option increasing enough to make up for it.  This means that even hedged participants may come under pressure in the months to come.  Is orderly selling destined to lead to disorderly selling?  Quite possibly; time will tell. 

 We’ve been presaging a macroeconomic quadrant flip from inflation to deflation, which hasn’t come to pass yet.  Applying this lens, it’s particularly interesting to look at the commodity complex.  Have precious metals, industrial metals, and more recently, natural gas, started to sniff out this upcoming regime change? Their recent sharp drops suggest so.  If they (and we) are right, then there will be more damage to come there.  

Finally, from a sector perspective, we’re left asking ourselves where the next down leg comes from.  Some of the smallcaps have drawn down 80%+ and are now trading at relatively reasonable valuations.  Is that the sector we’ll see bottom first?  For the higher quality companies, our guess is yes.  Some of the companies that have drawn down a lot are still relatively richly valued from a P/E perspective and we wouldn’t be buying those dips quite yet.  It appears that the industrials haven’t fully gotten the deflation memo yet; so that’s where we’d be the most wary right now. 

All told, the market has been moving down in line with our expectations for most of the year.  We think the pace of decline is going to slow, and even potentially be accompanied by some fake-out rallies.  If the pace of change does, in fact, slow down, then we’ll need to re-evaluate our call for a much higher SPX by EOY after the Fed does its inevitable about-face.  While it could get pushed out into Q1, we’ll wait for the data to confirm that and reiterate our downside target of 3250 on the SPX and our EOY target of 4450.

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