To The Moon

Summary

• "Whenever the market is going up on bearish news, you better be sure to have a long position".

• If one agrees with this statement, which I personally do, then there is overwhelming evidence on why stocks will continue to rally.

• The S&P 500 is not expensive, priced at a 2024 FWD P/E of about x16, implying a 6.3% earnings yield.

• The FED's hiking campaign has likely come to an end, and striking pessimism among investors implies more outstanding buying pressure.

• I am buying 105/115 %-moneyness call spreads with a December 10th expiration date, with the potential for a 5:1 payoff.

Huge green glass bull confronts red glass bear

$E-mini S&P 500 - main 2306(ESmain)$ There are undoubtedly some super smart arguments to be made on why the stock market should crash soon (at least these arguments may sound smart, because fear sells). But there is one fundamental rule in trading that overshadows all the analytical 'sophistication' of the bears:

Whenever the market is going up on bearish news, you better be sure to have a long position!

If one agrees with this rule, which I personally do, then there is overwhelming evidence on why stocks will continue to rally:

• (1) The FED is rising rates at record pace, but the markets keep pushing higher;

• (2) A recession is at the doorstep and earnings are contracting; but the markets keep pushing higher;

• (3) Regional bank stocks are crashing and doomster predict the next financial crisis, but the markets keep pushing higher;

• (4) the U.S. government may default on its debt, but the markets keep pushing higher.

Apart from all the named events pressuring sentiment, bears are frequently pointing out that the S&P 500 is valued expensively. Admittedly, the forward price-to-earnings (P/E) ratio of the S&P 500 has once again surpassed the 18x multiple, and the difference between earnings yield and corporate bond yields is at its narrowest point in almost a decade. But overall, I do not agree with the assessment that the S&P 500 is expensive. In fact, investors should consider that the recent earnings recession has likely ended in Q1 2023, and most companies will likely report expanding profitability again in Q2.

Referencing consensus expectations, I would like to point out that analysts are already predicting a rapid rebound in earnings growth, reaching a low double-digit pace by the end of the year. With that frame of reference, S&P 500 earnings for FY 2023 are now projected at close to $225 (see enclosed chart). Even more notable, expectations 2024 EPS are now anchored at $250, which would effectively price the S&P 500 at a one year forward price-to-earnings multiple of about 16x. Needless to say, a 16x multiple is below the historical average valuation of the S&P 500 benchmark, and the implied 6.3% earnings yield is materially higher than the 2 year treasury yield at about 4.3%.

S&P 500 2023 earnings estimates

In contrast to supportive fundamental factors, the market's positioning suggests a predominance of short positions, which could potentially create upward pressure on the market if there are positive surprises during the upcoming earnings season.

Needless to say, when stocks are heavily shorted (investors betting on the price to decline), a positive surprise or unexpected news can trigger a "short squeeze". This occurs when short sellers rush to cover their positions by buying the stock, causing a rapid increase in prices. The buying pressure from short covering can push stock prices up, even in the face of bearish news. Accordingly, as stocks continue to make gains, the army of bears will be pressured to cover their positions, which means more buying pressure from those who actually wanted selling pressure. Or as Morgan Stanley' Andrew Slimmon commented:

The longer the market goes without collapsing, the more tenuous it’s going to get for the bears ... The market extracts the biggest pain it can ... and the pain trade is higher.

Validating the thesis about bearish sentiment, Bank of America’s monthly positioning and sentiment survey a striking pessimism among global fund managers--a level of pessimism on par with sentiment during the financial crisis. Notably, this gloomy sentiment persisted despite stocks trading at levels that were near their highest points in 2023.

relates to Investors Most Pessimistic So Far This Year, BofA Survey Shows

Of course, I acknowledge that the FED's aggressive hiking campaign is pressuring market sentiment. But investors should not forget that the 'higher interest rate risk' has already materialized; and now, the risk is to the upside, as the FED is shifting towards a pause/ reversion. Only recently, on Friday 19th May, Powell commented on a conference in Washington:

... we’ve come a long way in policy tightening and the stance of policy is restrictive and we face uncertainty about the lagged effects of our tightening so far and about the extent of credit tightening from recent banking stresses ...

The financial stability tools helped to calm conditions in the banking sector. Developments there, on the other hand, are contributing to tighter credit conditions and are likely to weigh on economic growth, hiring and inflation

So as a result, our policy rate may not need to rise as much as it would have otherwise to achieve our goals

Looking at historical patterns, a rally appears to be on the horizon for the equity markets, if the FED indeed pauses/ reverts the hiking cycle. Based on evidence from eight previous monetary-tightening cycles, it has been observed that the S&P 500, after the final interest-rate hike, rallied by an average 13% in the following twelve months.

Equity rally post hiking cycle

Personally, I see the S&P 500 topping 4,500 by year-end, suggesting a reasonable x18 P/E multiple for FY2024 FWD. And that said, I am increasing my bullish positioning in the S&P 500 through 105/115 %-moneyness call spreads with a December 10th expiration date, as they have the potential for a 5:1 payoff if the SP500 benchmark closes at or above $4700.

Source: seeking alpha