Last week, we noted that it would not be uncommon for the market to retest recent lows. That is what happened on Monday morning before rallying sharply off that level. However, that rally was short-lived as President Trump’s “Liberation Day” on Wednesday afternoon liberated the market from its previous three-day gains. We will discuss the impact of that announcement further in today’s commentary, but let’s start with just the technical backdrop.
First, the bad news is that the tariff announcements were far worse than expected, causing a sharp drop in the market. Second, calculating the “Liberation Day” tariffs was deeply flawed, causing markets to reassess rapidly the impact on international trade and earnings.
The good news is that the tariffs were far worse than expected. That gives the market room to start looking for some optimistic outcome, relitigating the tariffs through negotiations or reassessing potential overreaction.
On Friday, the market was not expecting China. Rather than coming to the table to negotiate, China responded with a reciprocal 34% tariff on the U.S. plus export controls on rare earth metals needed for technological production. China is playing “hardball” in negotiating tactics with Trump.
This was a smart move from a negotiating standpoint by China, allowing President Xi to open tariff discussions from a point of strength. However, without some resolution to the extraordinary tariffs, the market will remain in turmoil for quite some time.
From a technical view, the market is now testing the next critical level of support. Last week, I stated the following:
“The following chart lays out the most probable retracement levels if such occurs. Using the October 2022 lows as the starting point for the bull market rally, the market recently completed a 23.6% retracement of that rally. A continuation of the correction will find support at the following levels:”
- The recent lows are around 5500. (That level was violated)
- Immediately below that is the 38.2% retracement level at 5134 (Is being challenged)
- Lastly, the 50% retracement level at 4816 should hold, barring the onset of a fiscal event or recession.
That 38.2% retracement level, using the bull market from October 2022 lows, was tested on Friday, with the market closing slightly below the 5134 level. Given the deep oversold condition, the market should be able to find some support at this level and muster a short-term rally next week.
However, there is a downside risk to 4816, which would be a 50% retracement of the bull market rally. Any positive announcements over the weekend could spark a relatively robust reversal rally, given the more than three-standard deviation gap between where the market closed and the 50-DMA.
As I noted last week, we strongly lean toward the potential of the markets beginning a more extensive corrective process, much like in 2022. However, we don’t suggest “panic selling” the market on news-related events. Even with the onset of tariffs, which certainly increases the risk of a recession, the market will have intermittent rallies.
As noted last week, nothing in the market is guaranteed. Therefore, continue managing risk accordingly, but for the next few weeks, if not months, we are now in “sell the rally” mode until the markets find equilibrium. When that will be, we are uncertain, so we continue to watch the technicals, make small moves within portfolios, and reduce volatility risk as needed.
Let’s examine the “Liberation Day” tariffs and their potential impacts on earnings and the 2022 scenario.
The “Liberation Day” Tariffs Weren’t What The Market Was Expecting
Much is being written about the tariffs, so I don’t need to go into great detail. However, a couple of things matter and likely matter a lot. The first is that how these “reciprocal tariffs” were calculated was deeply flawed. Had these tariffs been truly reciprocal, where Japan tariffs U.S. rice by 700%, and we tariff Japanese rice imports by 350%, the market would have likely responded much less drastically. However, that is not how these tariffs were calculated. Per CNBC:
“It didn’t take long for market observers to try and reverse engineer the formula — to confusing results. Many, including journalist and author James Surowiecki, said the U.S. appeared to have divided the trade deficit by imports from a given country to arrive at tariff rates for individual countries.”
This is incredibly important. A trade deficit is NOT a tariff. Those are two very different things, which is why the tariffs announced by the Trump Administration on Thursday appeared incredible. Furthermore, that methodology doesn’t necessarily align with the conventional approach to calculating tariffs.
It would imply the U.S. would have only looked at the trade deficit in goods and ignored trade in services. For instance, the U.S. claims that China charges a tariff of 67%. According to official data, the U.S. ran a deficit of $295.4 billion with China in 2024, while imported goods were worth $438.9 billion.
When you divide $295.4 billion by $438.9 billion, the result is 67%. Therefore, the Administration then divided that deficit by 50%. The same math applies to the rest of the countries on the list.
However, as noted by CNBC on Friday, Trump’s tariffs and actual tariffs are very different. This is why the market has had such a visceral reaction this past week.
“The formula is about trade imbalances with the U.S. rather than reciprocal tariffs in the sense of tariff level or non-tariff level distortions. This makes it difficult for Asian, particularly the poorer Asian countries, to meet US demand to reduce tariffs in the short-term as the benchmark is buying more American goods than they export to the U.S.
Given that U.S. goods are much more expensive, and the purchasing power is lower for countries targeted with the highest levels of tariffs, such option is not optimal. Vietnam, for example, stands out in having the 4th largest trade surplus with the U.S., and has already lowered tariffs versus the U.S. ahead of tariff announcement without any reprieve.” – Natixis
The problem with this approach is that there are countries with which we should have a trade deficit for various reasons. For example, we may import certain materials or products from a country we need for manufacturing or production that far exceed the imports they buy from the U.S. That is not necessarily bad, but that country is now being punished economically for a situation that was not necessarily of “ill intent.”
This is not to say that our trade partners have ZERO trade barriers on the U.S.; they do; however, they are not at the level that Trump presented yesterday.
However, I think Peter Tchir summed it up best:
“That is such a weird calculation that it is incredibly difficult to figure out a starting point for negotiations.”
Whether you agree with Trump’s “Liberation Day” tariffs is irrelevant to the expected outcomes on the market. As shown, the impact on earnings expectations matters to investors going forward, as it is a function of the valuation that investors assign to those earnings.
As Liz Ann Sonders from Charles Schwab (NYSE:SCHW) noted:
“”I think what we’re likely to see fairly soon is a re-rating of the probabilities of recession. It would not surprise me at all if we see those notched up. At the very least, we’re going to see further downward pressure on 2025 estimates for company profitability. The path of least resistance for earnings is significantly down from here.”
With that, we agree.
The Impact On Earnings – The Only Thing That Matters
Despite the market turmoil caused by the “Liberation Day” tariff announcements, what matters going forward is where Wall Street lands concerning earnings and valuations. As noted last week:
“With the economy slowing, earnings growth rates are unlikely to maintain current levels. We have already seen a rather sharp reduction in estimates for Q1, particularly over the last month. We suspect that those downward estimates revisions will accelerate somewhat heading into the Q2 reporting season.”
We will enter the Q1 earnings reporting season on Monday. The chart shows the history of revisions for the Q1 reporting period. You will see that estimates for Q1 have fallen from $226.54/share when the estimates were first released to $217.99 in March.
Also, it is notable that estimates declined from $226 to $217 between August of last year and now, reflecting slower economic growth rates. As we enter Q2, we expect a more profound revision to earnings estimates between now and year-end. Goldman Sachs recently published its downwardly revised forecast for this year, with a range of multiples attached.
You will notice that the recession scenario of $220/share has become a reality for Wall Street analysts. However, on December 20th, 2024, we published our forecast for 2025, and we explained our reasoning for $220/share was likely. To wit:
“While the bullish prediction is possible, that outcome faces many challenges in 2025, given the market already trades at fairly lofty valuations. Even in a “soft landing” environment, earnings should weaken, which makes current valuations at 27x earnings more challenging to sustain.
Therefore, assuming earnings decline toward their long-term trend, that would suggest current estimates fall to $220/share by the end of 2025. This substantially changes the outlook for stocks, with the most bullish case being 6380, assuming a roughly 4.5% gain versus every other outcome, providing losses ranging from a 2.6% loss to a 20.6% decline."
The issue going forward is the assignment of the valuation multiple that Wall Street is willing to pay. The market has already been in a valuation reversion process since March, and this week’s sell-off has only depressed that valuation multiple further. However, if the recession risk increases due to the onset of tariffs, analysts will make more drastic cuts to those estimates.
So far, that has not been the case yet, but it is likely only a function of time. While estimates have been pared back recently, that $220/share level identified by Goldman is where the long-term economic growth trend of earnings exists.
Notably, with the market selling off sharply this week, valuations have started the valuation reversion process. In the last month, valuations fell from 22.5x to 18.5x forward earnings. While the long-term average is closer to 16x earnings, the reassessment of forward earnings suggests a potential for further valuation reversion.
This brings us to our conversation from Tuesday, in which we discussed the idea that the market’s performance in 2022 may be the “playbook” for this year.
The 2022 Scenario
I can not stress enough the importance of paying attention to the direction and trend of economic growth. Over the last 12 months, we have written numerous articles explaining the relationship between economic growth and inflation. For example, in “Paul Tudor Jones,” we explained why his call for higher interest rates was unlikely to be correct. To wit:
“The current surge in inflation, and ultimately interest rates, was not a function of organic economic growth. It was a stimulus-driven surge in the supply/demand equation following the pandemic-driven shutdown. As those monetary and fiscal inflows reverse, that support will fade. In the future, we must understand the factors that drive rates over time: economic growth, wages, and inflation. Visually, we can create a composite index of GDP, wages, and inflation versus interest rates.”
That lack of monetary support has now arrived as economic growth rates have weakened. With the economic drag from tariffs added, Wall Street economists are slashing economic growth forecasts heading into Q2.
That decline is primarily linked to a reversal of U.S. exports due to those “Liberation Day” tariffs. While Trump hopes tariffs on goods exported to other countries will raise hundreds of billions in revenue annually for the U.S., reducing domestic exports will markedly slow economic growth.
Don’t dismiss the importance of that data. Exports account for nearly 40% of corporate revenues. Therefore, if such a decline manifests itself, it will show up in reduced earnings growth, which is not yet accounted for in Wall Street’s earnings estimates.
That reversion in earnings estimates would likely be akin to 2022 rather than the drastic drop seen in 2020 as the entire U.S. economy was shuttered. If we enter another corrective period like 2022, given some of the same technical similarities, there is a decent “playbook” to follow despite substantial differences.
In 2022, the Fed was hiking rates, inflation was surging, and economists were convinced a recession was on the horizon. As noted above, earnings estimates were revised lower, causing the markets to reprice valuations.
Today, the Fed is cutting rates as inflation is declining, but the risk of recession is again increasing as estimates are being revised lower. However, we must realize that the analysis can change quickly with the impact of tariffs.
As noted, while the latest economic data does not currently show evidence of a recession, economists are again raising their expectations for one year from now.
Whether they are correct or not is irrelevant; however, what is relevant are both expectations and the reality of earnings. The recent crack of the 200-DMA may be our first clue of a deeper correction IF economic data points to slower economic growth that further reduces forward estimates. As we noted previously:
“In March 2022, the market triggered the weekly “sell signal” as it declined. Notably, the market rallied sharply higher after the “sell signal” was initially triggered. This is unsurprising, as when markets trigger “sell signals,” they are often profoundly oversold in the short term. However, that rally was an opportunity to “reduce risk,” as the failure of that rally brought sellers back into the market. The “decline, rally, decline” process repeated until the market bottomed in October."
Given the confluence of events, including softening economic data, the “Liberation Day” tariffs, and still restrictive monetary policy, we suspect we have not seen the end of market volatility this year. However, it is crucial to remember that in 2022, it seemed like the market would not stop declining. However, it eventually did. The current correction process will end also, and when it is time to buy, you will likely not want to.
When It’s Time To Buy, You Won’t Want To
Is now the time to start buying? Given the technical and economic backdrop, we suspect the answer is no. However, that doesn’t mean there can not be vicious rallies along the way. After all, the market tends to do a great job sucking investors in just in time to pull the rug from beneath them. As shown in the chart above, we saw that several times during the 2022 correction process.
However, there is also an essential lesson in this analysis. Investors often forget that market corrections are positive as they allow you to make investments at a discount to their fair value. For example, the largest Mega-capitalization companies, which have been under the most pressure over the last two months, now trade at the cheapest valuation level relative to the S&P 500 over the previous 10 years.
That doesn’t mean you should go out and load up on the “Magnificent 7″ stocks today; however, the reversal process has cleared some of the excess over-valuation issues in these companies, but this is where “investing” becomes much more difficult.
As investors, we inherently know we should buy low and sell high. However, that is incredibly difficult during corrections due to our emotional bias of “loss avoidance.”
“Loss aversion is a tendency in behavioral finance where investors are so fearful of losses that they focus on trying to avoid a loss more so than on making gains. The more one experiences losses, the more likely they are to become prone to loss aversion.” – Corporate Finance Institute
That fear of further losses leads us to “sell bottoms” rather than “buy low.”
This is why we focus on factors such as investor sentiment, technical analysis, and the fundamentals of the companies we buy. We are not suggesting that this set of tools will allow you to buy the exact bottom of the market or sell the top; however, if our goal is to grow capital over time, these tools can help navigate volatile markets.
It won’t take much for the market to find a reason to rally. That could happen as soon as next week. At that rally, we suggest reverting to the basic principles to navigate what we suspect will be a more volatile market this year.
However, at some point, just as we saw in 2022, the market will bottom. Like then, you won’t want to believe the market is bottoming; your fear of buying will be overwhelming, but that will be the point you must step in.
Buying near market lows is incredibly difficult. While we likely aren’t there yet, we will be there sooner than you imagine. As such, when you want to “sell everything,” ask yourself if this is the point where you should “buy” instead.
How We Are Trading It
As noted, we expect a sizable rally soon. While such a rally will undoubtedly make investors more bullish on the markets, we will use that rally to reduce portfolio volatility until a more durable market bottom is identified. Furthermore, we are triggering an important weekly sell signal.
Still, the markets are simultaneously three standard deviations below their longer-term moving average, challenging the rising trend line from the October 2022 lows. Such oversold conditions typically precede short-term rallies, allowing us to reduce exposure to equities between 5500 and 5700. While the rally could be more significant, we will use those levels to begin risk reductions.
Our primary focus on this process will be:
- Reduce current positions by 1/4 to 1/2 of their current target weights.
- Increase cash levels
- Raise stop-loss levels on long-term positions.
- Sell positions that have technically violated previous support levels or exceeded risk tolerances.
- Add to positions that are positioned to benefit from further market stress.
Following those actions, we will continue to monitor and adjust the portfolio accordingly. At some point, the valuation reversion will be complete, allowing us to reconfigure portfolio allocations for a more bullish environment. When that event occurs, we will reduce fixed income, shift income allocations to corporate bonds rather than government bonds, and overweight equity allocations in portfolios.
However, that is a conversation we will have in more detail in the future. For now, market conditions remain uncertain. Preparing and adjusting strategies can help investors navigate volatility confidently. As technical indicators flash warning signs, a well-structured risk management approach will protect capital and preserve long-term gains.
I hope this helps.
Have a great week.