The Fed, Bottom Signals, and Timelines

Is there an end in sight? Let’s talk about it.

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Bottom Signals

In this post I want to spend some time looking backwards.

We’ve had several bear markets (and recessions) in the past, so for us to best understand where we might be in this one — we need to make comparisons.

Where are we?

The S&P 500 is now trading -18% off its late-December high. This decline is consistent with not only historical bear markets, but also the markets pricing in a looming recession.

Given there’s still a disconnect between some stock valuations and the underlying intrinsic value of companies — it’s obvious that we need to see the market completely price-in a recession happening before we see a bottom.

Above is an awesome graphic that shares where we’re stacking up in comparison to past market corrections — both with and without a looming recession.

The verdict?

We’re definitely beyond the -10% or so sell-off that come with the occasional bear market. The current sell-off of about -18% is approaching the “recession median” correction of -24%.

Additionally, the current market reversal we’re experiencing is already into its 4th month and approaching a duration only seen during recessions. As we look below — it’s very fair to assume things aren’t even halfway over yet. 

How do we know when we’re at the bottom?

I have no idea.

There’s no perfect algorithm that can conclusively determine that everything is over and we’re going back up up up. However, we can use historical data to begin to work backwards into calculating what the valuation multiples would look like.

Recessions and their compressions: P/E ratios

• 2000 Dot Com Bust: 26X to 14X

• 2008 Great Recession: 18.5X to 9X

• 2018 Rate Shock: 18.5X to 13.5X

• 2020 Covid Crash: 19X to 13X

• 2022 Covid Bubble: 23X to ~16.5X today

Today, we’re currently trading around ~16.5X forward earnings. If we look to past recessionary events and bubbles, we can see the “bottom” price to earnings ratio was around 13-14X.

Sure, we can look at the Great Recession’s 9X multiple — but I think that was a once-in-a-generation recession that doesn’t provide a perfect comparable for today.

This would suggest the S&P 500 has room to drop to (or below) 3,300 points — putting us where we were right before the Covid crash took place. This is about a -16% decline from where we stand today.

Below is a completely hypothetical illustration of what that might look like — with the bottoming taking place as we approach 2023.

Personally, I think that we’ll see at least one ‘dead cat bounces’ along the way — where many people will believe the end of the bear market has arrived and we are through the worst of it.

And that’s where things can get the ugliest.

Regardless of how we arrive there, the situation depicted above would put us at a total decline of -31% from late-December highs, just over the -24% sell-off “recession median” mentioned earlier. If we really do turn and bottom at the start of the new year, we’d be tracking at a total of 234 trading days for this correction (currently sitting at 94).

However, let’s not forget about analyst estimates

As we saw from Walmart’s earnings call last week (important takeaways here) — analysts are not accurately pricing in next year’s earnings. Things are changing at the drop of a hat, and there’s a lot to still be discovered and calculated.

When earnings estimates come down (due to margin pressure from inflation, or any other reason) the valuation multiple increases — think about it as a division problem, smaller denominator equals more expensive forward price to earnings ratio.

And as you can see below, more and more uncertainty around company earnings is upon us.

Historical indicators of market bottoms

Before we turn to the “what I’m doing with this information” part of the post — let’s quickly catch up on where our indicators are trending.

Historically speaking, market bottoms happen when these three things take place:

• Flight to safety

It’s obvious investors have become more risk adverse during this sell-off, but I think until we see a true flight to safety by both money managers and retail — there’s going to be continued volatility.

• Net new 52-week lows

This is the number of stocks on the NYSE that are trading at new 52-week low prices. Usually this number is higher (1,000+) before we see a true market bottom. We’re certainly on our way, but not there yet.

• The VIX hits 45

Generally speaking, the VIX (volatility index) is the way Wall Street keeps track of “fear” in the markets. Since the measurement was invented, there has never been a bear market bottom without the VIX hitting 45 first. 

We’re currently hovering around the ~30 range, having peaked at 36 in early-May.

What do we do about this?

Well, it’s simple.

If you’re like me and think we head lower — continue piling cash and / or deploy small amounts of it into free cash flow positive tech companies that have traded to pre-COVID lows (shown below).

• The median multiple for tech stocks is currently 6.2X forward revenue

  • This is -44% below pre-COVID levels in Feb 2020 

  • This is -20% below 5-year average (2015-2019)

  • This is -6% below COVID lows in March 2020

Maybe, but I’d argue probably not. The 10-year Treasury yield is around 2.7% right now and is on pace to eclipse 5% by the end of 2022. Also — don’t forget about the recession we’ve been talking about frequently, issues with the supply chain, war in Ukraine, and the possibility for the FOMC to raise rates more dramatically over time.

However, if you’re ready to begin accumulating (not a horrible idea) — here is a list of 13 tech companies who are not only free cash flow positive, but are running 20-30% FCF margins:

• Adobe (ADBE)

• Datadog (DDOG)

• Zscaler (ZS)

• Crowdstrike (CRWD)

• Atlassian (TEAM)

• ServiceNow (NOW)

• Veeva (VEEV)

• Dynatrace (DYNA)

• Autodesk (ADSK)

• Hubspot (HUBS)

• Workday (WDAY)

• Salesforce (CRM)

• Dropbox (BOX)

Personally, I’m doing a bit of both. Really stacking cash while nibbling at some favorites. More to come.

If you’re starting your investing journey or want to change to a cleaner, social-focused investing platform, consider visiting Public.com.

Disclaimer: This is not financial advice or recommendation for any investment. The content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice.