What's The Playbook Here?

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Markets are a little bit in no man's land after crashing hard on Monday at the open and then fighting back to recoup a good chunk of the gains over this last three trading sessions.

In this article, we will lay out a mental framework based on what we expect to be the most likely scenario of where things go from here, and how we will trade based on that scenario. If the real-world results differ from our assumed scenario (which they certainly will, at least in part), we can and will make adjustments accordingly.

But having a working mental framework in this market can help give us a leg up over most traders, investors, and commentators who seem totally lost on what to do right now.

Here's the short of it:

• Markets are flattish to up from here through September as the Fed waits till its next official meeting to start cutting (we stay cautious but long).
• Markets rip higher and there is a blow-off top sometime around the September meeting when the Fed actually cuts for the first time (we'll try to capitalize on this without getting too cute).
• Markets drop 15-20% in the 6-12 month cutting cycle following the September meeting, leading to fears of a widespread US recession (we'll be ready for this, having raised cash and adding shorts in the aforementioned blow-off top).
• When markets get really ugly and everyone is certain of a recession, we'll get aggressively long and buy our favorite AI and Robotics stocks which will propel the next leg higher as the Fed signals an end to the cutting cycle.

That big 6.5% drop in the Nasdaq on Monday pre-market brought some fear back to the market that it hadn't felt in quite some time. It revived all of the talk of recession and even a potential financial crisis that we'd heard ad nauseam circa 2022.

The 13% drop in the Nasdaq in three weeks (which is not a crash folks) even had quite a few commentators calling for an emergency rate cut before the Fed's September meeting.

Despite the correction in the markets, there are lots of good data points and anecdotes that show things really aren't all that bad. According to Factset, this quarter 78% of S&P 500 companies have reported a positive EPS surprise, 59% reported a positive revenue surprise, and the earnings growth rate for the S&P 500 was 11.5% y/y (which is the highest y/y growth rate since Q4 2021).

This mixed bag of an economy/market has most mainstream players (media, investors, governments, the Fed) lost right now.

This closing paragraph from a WSJ article yesterday discussing how a recession might happen is a perfect example of this:

Each succeeding sentence in that closing paragraph essentially offers a counterpoint to the sentence that preceded it. It's a good example of how the lack of a clear mental framework leads down a road of never-ending circular logic.

As investors and traders, we have to look past the noise and avoid the circular logic that is entirely unhelpful for us.

So here's our playbook for the next few months given that we are almost certainly entering a Fed cutting cycle.

First, we don't think that the Fed will cut at an emergency meeting in advance of the scheduled September meeting. Yields and equities are highly correlated right now (meaning investors are fleeing to bonds and selling their stocks, and vice versa).

Bond yields dropped a lot coming into the Fed meeting last Wednesday and kept dropping before bottoming with the markets Monday morning. We think yields probably stabilize around here, and the markets with them. As the possibility of rate cuts gets pushed out to September, we think the markets are probably flat to slightly up from here. Thus, we will maintain our "cautious" stance with respect to the markets, but stay pretty much net long.

We expect to see some headlines like this before the September meeting:

"Bloomberg: Bond Market Drops As Fed Unlikely To Cut Until September Meeting."

As we get closer to the September meeting, we expect the markets will probably rally in anticipation of the cuts they so desperately want. When the Fed does finally cut, without getting too cute here, we think there will probably be a chance to make some good money on the upside as tech stocks and probably even the Russell 2000 (IWM) have a blow-off top.

"CNBC: Russell 2000 Looks To Set New All-Time Highs As Fed Cuts For First Time In Almost Four Years."

We think within a few days of the rate cut, markets resume the sell off and we might get some real pain for the next few months. The market will be thinking that the US is heading into a recession and the Fed is late to the game. We think we could see a 15-20% pullback during this three-six month time frame to close out the year.

We'll see something like this:

"Fox Business: Economists Place 70% Chance For US Recession in 2025."

But toward the end of the year, once nearly everyone is committed to the idea of an impending US recession, and further market deterioration, we will finally likely get the pitch to go aggressively long. About that time, the Fed will indicate that it's shrinking its balance sheet after cutting rates 100-125bps for fear of letting inflation out of the bag.

Most people will doubt that the rally is sustainable, and we'll see headlines like this:

"Fortune: Morgan Stanley's Mike Wilson Says "I Was Right, We Are Finally In A Recession, Don't Believe This Rally."

That indication of an end to the new cutting cycle will help put in a bottom in the markets. From there, we'll just ride the AI and Robotics Revolutions as they propel us to the next level higher. We'll be back to some headlines like this:

"CNN: Investors Look For The Next Nvidia and Tesla With These Ten Promising AI Stocks."

We think this scenario is the most likely and also the most ironic. There are already plenty of market players that are giving up on the promise of the AI Revolution, and think the big tech companies are spending too much on CAPEX currently. When the market crashes in anticipation of the US recession, it will be totally ironic that the efficiency gains of the AI Revolution start to make a real impact just about the time that everyone is 100% sure we are heading into a recession.

Obviously, we could be wrong on any and all of this. But this gives us a playbook to work from going forward. If/when things change, we'll update this framework.

But for now, let's stick with our favorite longs, and stay cautious through most of August, but be ready for a rip higher sometime around the September meeting.