Welcome back to Cook's Kitchen where we break down the market's "inner dialogue" with Behavioral Economics!

In late August, I told members of my TAZR Trader portfolio why stocks were expensive and we could expect better bargains on the horizon.

Well, stocks are under pressure again after a strong summer rally off of the bear market lows made in June.

Strategists like Mike Wilson from Morgan Stanley are calling for new lows because his research says that earnings estimates are still vulnerable to further downward revisions.

And that makes the stock market expensive in his team's view.

In today's video, I share details of that view and tell you how I plan to navigate these potentially rough waters by looking at an undercover metric big institutional investors use to evaluate when the stock market is cheap or dear.

Wilson the Bear: Stocks 15% Too Expensive

Here's what I wrote to my subscriber group in late August when we went to a 60% cash position...

TAZR Traders

On Monday, we trimmed profits in three positions to reduce risk and raise cash: CDNS, MDB, and CRWD.

This brought our CASH position to over 60%.

While we were doing that, Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley, was busy recording his podcast "Thoughts on the Market."

His analysis remains pretty consistent: earnings estimates are still too high for what he believes is coming -- and that means stocks are still too expensive until we know we've hit the earnings trough next year.

His argument is worth understanding because many fund managers may choose not to fight it using too much capital. And that means the path of least resistance is down -- especially now that the Fed "pivot" trade is over and those hopes are dashed.

Here is the link to the 4-minute broadcast and an excerpt from transcript...

The Increasing Risks to Earnings

After the Fed's highly anticipated annual meeting in Jackson Hole has come and gone with a very clear message - the fight against inflation is far from over, and the equity markets did not take it very well. As we discussed in this podcast two weeks ago, the equity markets may have gotten too excited and even pre-traded a Fed pivot that isn't coming. For stocks, that means the bear market rally is likely over.

Technically speaking, the rally looks rather textbook. In June, we reached oversold conditions with breadth falling to some of the lowest readings on record. However, the rally stalled out exactly at the 200-day moving average for the S&P 500 and many key stocks. On that basis alone, the sharp reversal looks quite ominous to even the most basic tactical analysts.

Wilson goes on to describe why being bullish on stocks is so challenging. First, he addresses the valuation question using the two major inputs of the Price/Earnings ratio: 10 year U.S. Treasury yields and the Equity Risk Premium (ERP).

"Simplistically, the U.S. Treasury yield is a cost of capital component, while the Equity Risk Premium is primarily a function of growth expectations."

The ERP is all about how much excess return investors want over the Treasury yield to justify the risk of buying the S&P 500 vs the risk of buying "risk-free" Treasury securities.

If you go to a great educational website like Investopedia to learn about ERP, even there you'll get a long-winded explanation with lots of math.

But I consider it my job to make this simple and easy to understand.

Basically, we just want to flip P/E on its head for the S&P 500.

If we start with a basic P/E for the S&P 500 of 4,000 (the index level) and divide it by a calculated 12-month forward EPS of $240, we get 16.7X.

Now, we take those same numbers and flip them into the inverse.

That means that we take projected earnings of approximately $240 per share and divide it by a current index level of say 4,000.

That equates to an "earnings yield" of 6%. That's a decent return over 10-year Treasury note yield over 3%.

But is it enough if it's perceived that rates are going higher and corporate earnings might be going lower?

That's the $1 million question, indeed.

Wilson goes on to explain that typically, the ERP is negatively correlated to growth. In other words, when growth is accelerating, or expected to accelerate, the ERP tends to be lower than normal and vice versa...

"Our problem with the view that June was the low for the index in this bear market is that the Equity Risk Premium never went above average. Instead, the fall in the Price/Earnings ratio from December to June was entirely a function of the Fed's tightening of financial conditions, and the higher cost of capital.

"Compounding this challenge, the Equity Risk Premium fell sharply over the past few months and reached near record lows in the post financial crisis period. In fact, the only time the Equity Risk Premium has been lower in the past 14 years was at the end of the bear market rally in March earlier this year, and we know how that ended. Even after Friday's sharp decline in stocks, the S&P 500 Equity Risk Premium remains more than 100 basis points lower than what our model suggests. In short, the S&P 500 price earnings ratio is 17.1x, it's 15% too high in our view."

Wilson then describes the conundrum for investors as most remain preoccupied with the Fed, while he and his team have been more focused on earnings and the risk to forward estimates. In June, this led to the "bad news is good news" rally or as the index traded at 15.4X as many observers chatted about "better than feared" results.

Wilson then said in the podcast something that may have revealed his key bias to not be caught with his hand in "the Cooker Behavioral Economics jar"...

"Call us old school, but better than feared is not a good reason to invest in something if the price is high and the earnings are weak. In other words, it's a fine reason for stocks to see some relief from an oversold condition, but we wouldn't commit any real capital to such a strategy. Our analysis of second quarter earnings showed clear deterioration in profitability, a trend we believe is just starting. In short, we believe earnings forecast for next year remains significantly too high."

When you are more concerned with being right in the short-term than making money in the long-term, you can get your investing fingers slammed in the proverbial cookie jar.

Playing the Pendulum Swing of Common Sentiment

Investing in stocks is about the future of growth.

But trading the actual volatility for out-sized returns in a portfolio is about gauging the swings of greed and fear.

Or what I define more clearly as "the emotional extremes of optimism and pessimism."

So while I believe Mike Wilson is right about a lot of stuff, I also know he's being the ultra-Bear because he has to be for his clients and brand.

The good news is that most investors haven't been paying attention to him -- yet.

And that means that stocks will have another leg down as shattered bullish expectations wake up to reality.

But then, they will go too far down. And smart money will be buying the disconnect between doom and value.

That's what I'm looking forward to this month.

My Top Picks for the September Swoon

MongoDB (MDB Quick QuoteMDB - Free Report) : This is the young upstart database engine competing with Google Cloud, Amazon AWS, and Microsoft Azure. I'm surprised none of them bought this little monkey sooner. Their sales growth is off the charts at 36% this year and sustaining at 26% next year as the company makes the shift to profits. The stock got crush last week by over 30% with cloudy guidance. But it remains a Zacks #2 Rank as analysts have not lowered estimates and the average price target is well over $300.

CrowdStrike (CRWD Quick QuoteCRWD - Free Report) : This is the premier cybersecurity provider that specializes in "end point" solutions. This means what happens in mobile devices and the "edge" of the internet/cloud where connectivity depends on sketchy ISPs. We first bought this company at $50 and still love the upside here.

Cadence Design Systems (CDNS Quick QuoteCDNS - Free Report) : This Zacks #1 Rank is the premier provider of semiconductor design software that NVIDIA loves because it allows them to simulate every single iteration of the program. Even as NVDA stock gets hit on their lower growth expectations, Cadence rises because the orders for their platform service are in high demand as Semi builders have to plan out 2-4 years.

Bonus Ideas: Buy the SPDR Equal Weight Biotech Index (XBI Quick QuoteXBI - Free Report) and/or the Nasdaq 100 3X ETF (TQQQ Quick QuoteTQQQ - Free Report) by the first week of October.

Be sure to watch the video for the full details on the ERP math mechanics like this...

Short: How much investors want to be compensated in potential earnings ABOVE the risk-free rate

Long: We need a simple way to compare corporate earnings to the 10-year Treasury yield. Handy math is to flip the P/E for the S&P 500 index to give us an earnings yield and then subtract the risk-free rate.

But again, it's all about the direction of movement for both components AND the rate of change. I explain it in full detail in the video.

Disclosure: I own CDNS, MDB, and CRWD for the Zacks TAZR Trader Portfolio.

Kevin Cook cut his trading teeth in the trillion-dollar day of FX trading at the upper bank tier. Then he got trained by the top options traders in the "epicenter of probability" in Chicago at the CBOE and PEAK6. Now he runs the hyper-focused portfolio at Zacks called TAZR.