We FINALLY saw the stock market take a step back after a seeming non-stop 5 month rally. Many investment commentators point to the Fitch ratings downgraded of US debt as the primary cause. However, if we are being honest with ourselves….this self off was long overdue. The Fitch announcement was just a convenient excuse to hit the sell button for a while.

Friday was an interesting session worthy of note. The Government Employment Report seemed like a Goldilocks announcement. Not too hot…not too cold…just right helping the S&P 500 rise nearly 1% early in the session.

Yet as the day progressed those gains melted off the board leading to a -0.53% session. Even more interesting was the S&P 500 (SPY) closing below 4,500 and now probably on our way towards 4,400 (more on that in the Price Action section below.)

Even though we don’t like seeing red on the screen…this is healthy. That investors took the opportunity of an intraday rally to take more gains off the table.

On Monday we got a solid bounce back as investors have gotten into the habit of buying every dip the past several months as that strategy has paid off handsomely. What they didn’t know was a surprise announcement on Monday that Moody’s was downgrading their ratings on a slew of small to midsized banks. This reawakened the Risk Off sentiment from last week with more investors hitting the sell button in earnest on Tuesday.

This is the classic swinging of the fear/greed pendulum. The greed of the rally up to 4,600 was overextended. Simply conditions were not that pristine to keep rising. This left investors vulnerable to any bad news for which Fitch and Moody’s were reminders that the overall market may be ahead of itself.

Another reminder of this is on the earnings front. As we come down the homestretch of Q2 earnings season we find that earnings estimates for the future have been trimmed for the next few quarters. Adding those 3 quarters together points to virtually no year over year growth.

The weak earnings outlook is NOT GOOD FUEL FOR A BULL RALLY

Especially true when the S&P 500 is already at a PE of 20. That is not necessarily overpriced…but it is rather fully priced. Thus, to reasonably expect more upside you need better earnings growth prospects for the future to compel higher prices without overly inflating PE.

This is a long way of saying that now is a logical time for the runaway rally to end and for us to enter a healthy consolidation period to digest recent gains. And thus be more selective about the stocks that should advance from here.

So Why Still Believe in a Long Term Bull Rally?

Because the Fed is providing more hints of a “dovish tilt”. That gained steam with the speech from Harken of the Philly Fed where he stated that likely no further rate hikes are needed. At this stage they just need to give the current high rates time to sink in and bring down inflation further. Then start thinking about lower rates.

Plain and simple, the future lowering of rates is a tail wind for the economy that increases the odds of better growth prospects (what is needed to push prices higher). Knowing that is on the horizon is a reason to be more bullish now.

On top of that you have more business people feeling optimistic about the future. Here is the…

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