What Our Clients Are Talking About Behind The Scenes

At the start of last week, I released my updated sector recommendations (Sectors Update) and Whispers (Previous Whispers) where I continued to suggest that my work had not been supporting the sustainability of the bounce that started at the late May low near 3810. That low was breached this morning. Last week was challenging for equity investors as two of my concern areas, inflation/hawkish Fed and estimate revisions heading lower, reared their ugly heads.  The start to this week wasn’t any prettier.

During this week, I have been immersed in doing my monthly deep dive into my 4,000 U.S. single stock database looking at every respective company’s ASM indicator, which is my proprietary earnings revision metric, and flagging what the overall ERM model is flagging as favorable. 

Let me get the big message out right up front – the earnings revisions have clearly begun a very negative shift.  There is only one way to describe this month’s review — U-G-L-Y.  The number of absolute negative revisions is at a low level and rising, but the percentage of names with negative sloped ASMs is large and still broadening.  For the optimists, I am sorry to say this process looks to still be in the early stages and the weakness is likely to persist for at least another 1-4 months, at minimum. 

Confirming this view, the profit backdrop is weakening and there is more to come at the company level. We had negative earnings preannouncements from Target (TGT) round two, Intel (INTC -0.70% ), and DocuSign (DOCU 1.31% ), to name a few, that provided some insights into the health of Corporate America.  In my opinion, there will be many more before the 2Q22 earnings season begins during the second week of July. 

Last Tuesday, Target announced it is cutting prices to offload some of its excessive inventory, but that the consumer was holding up OK.  Not to be critical of management, but the cynical side of me finds this statement a bit hard to believe, and even if it is spot-on, my analysis strongly suggests that consumer spending is likely to deteriorate as we move forward.  Outside of retail, Intel also made comments regarding the economic environment, and stated their read was that there was a dramatic weakening over the past month, and that this was a headwind for earnings. The company’s CFO added that customer demand and component supply issues were “much worse than we anticipated.” In addition, DocuSign, a beneficiary of pandemic demand patterns, missed earnings and was down more than 20% in Friday trading. Several analysts lowered their outlooks and price targets on the name, and one stated that the company’s “core growth story is now essentially over.”

These are only some of the first shoes to drop but, as stated above, my work suggests they won’t be the last. Now that we have the earnings season behind us, the equity market will be driven mainly by macro/inflation/Fed headlines and negative pre-announcements until we once again ramp back into earnings season mode.

I have been writing a lot about my expectations for an earnings revisions cutting cycle that has begun and will get worse, but at the risk of being boring to my readers I am going to include it again today.  In my view, this is one of the most important points to keep on your radar screens for both your overall risk exposure and for positioning, as my analysis strongly portends that there is still a lot of unfinished business to the downside for the market.  Hence, I want to reiterate once again that my ASM indicator for the overall equity market has just fallen below zero, and over the last 30 years when this happened the average S&P 500 decline has been 18% (median down 10%) over an average of five months.  Barring a sudden change in the geopolitical backdrop that would cause large declines in energy and other commodity pricing, I don’t see how these negative earnings revisions can be avoided unless markets pull off a Houdini-esque escape from the Chinese water torture cell.

Bottom line: There is still downside ahead. The lowering of earnings expectations and associated downgrades are only in the early stages. My deep-dive analysis of my proprietary model has shown a lot of weakness and it is much harder than normal to find anywhere to hide in this market. There are places that are relatively better, but few areas show an absolute positive outlook. I reiterate my next downside target of 3,600 to 3,500. The hot CPI print only strengthens my thesis that the Fed will remain hawkish and will likely be going higher for longer, even if they eventually must slow their pace and must pivot. 

Be careful and position for more possible downside with the understanding that my expectation for a high-quality buying opportunity will likely present itself, but it is still on the horizon:

• Monetary policy is still moving towards tightening—the recent CPI print and persistence of high energy prices, only makes the Fed’s mission harder.
• An equity market decline based on fears of economic slowing and negative earnings revisions to the forward outlook are only in the early phases.
• It is NOT yet time to shift positioning to the “other” side.
• The important shift from Value back to Growth is close.

MAIN CLIENT ISSUES

• How bad will the earnings revisions cycle be?  What are my expectations for S&P 500 OEPS?
• The ongoing interest on 1) will a new low need to be made on the S&P 500?, and 2) is it time to shift to Growth from Value?
• What is 8-panel saying about Energy sector?  Is it buyable here?
• Anything else that looks buyable here? 

SPECIFIC CLIENT QUESTIONS

• How does Friday’s hot CPI print affect your thesis and thoughts on US equities?
• What are your thoughts on the upcoming Russell rebalance at the end of June?
• What stocks stood out as relatively favorable during your monthly deep dive single stock ERM review?

MY ANSWERS

• How does Friday’s hot CPI print affect your thesis and thoughts on US equities?

In my view, it only supports the forecast that I have been discussing for months.  Also, and no disrespect to others who have a different take, inflation is still a major issue and the evidence for peaking is weak, at best.  Indeed, it will come down eventually and when it does it could fall quickly, but it is still a negative for markets.  There is no way around it.

From my perspective, the key takeaway here is that the Fed is likely going higher for longer.  Yes, many are going to be sifting through the details of every inflation-related data release and at some point, a peak will be reached.  Importantly, however, it continues to be my view that the rollover is not going to signal an immediate change in the Fed’s game plan.  In my reading of the commentary by the FOMC, it is clear to me that a trend in the decline in inflation will be needed to make an impact on the forward policy path, and I am reminded by my economic sources that likely means 3-4 months, at minimum.  Yes, if something breaks along the way or causes energy and commodity prices to noticeably decline, Chairman Powell and colleagues may be forced to change course. 

Since it has been coming out after the CPI release, I do not think that a surprise 75-100bps move by the Fed will be coming next week.  However, I think the odds that Chairman Powell might comment that 75bps is back on the table are quite good. The question is how the market will react, regardless of whatever comes out.  Will the market see a potential 75bps return as bullish or bearish and, on the flip side, if it does not, how will the Bond Vigilantes behave?

No matter how this plays out, can the Fed come in and rescue markets on its white horse once we get to the point that fear rises?  But that is a discussion for a future note. 

Bottom line:  The Fed may ultimately reverse course but, as I have been saying for the last two months, markets have been underpricing the Fed’s hawkishness. Today’s print tells me that the bad news is far from fully baked into the equity market. Some experts now think 75 bps is back on the table and given the other headwinds for markets, my research has little evidence to see anything pushing Equities much higher before we get to my next downside target of 3,600-3,500.

• What are your thoughts on the upcoming Russell rebalance at the end of June?

After July 1^st, be careful when you hear forecasters use the style terms “Growth and Value”.  Ask the question, how are you defining them, and what areas/stocks are you putting into each category, because from a Russell basis, lots of names are being recategorized. 

This section has less to do with an actionable idea or to directly help you with your portfolio returns, but after it has come up a lot, I felt it would be worth mentioning in today’s note.  The reason for this is many names that are currently thought of as either Growth or Value will be redefined and put in the other bucket and after July 1^st, people who will still use those broad terms may actually be communicating different messages. 

So, what will be Growth and Value going forward?  Many Energy and other Commodity related areas are likely to be moved out of Value and into the Growth index.  On the other hand, there are lots of names that many consider Growth that will be moved into the Value index, and the biggest area to switch is likely Technology related. 

For example, one of my forecasts is for Growth to start outperforming Value in the near future.  This is using the current definitions that put Tech in Growth and Commodity Cyclicals in Value.  Now, my view that tech and other areas that have been considered Growth will begin to move into the relative leadership is likely not to change, but I may have to start saying that Value will outperform because they are in different buckets.  Is your head spinning yet? 

Bottom line:  As the summer progresses, be cognizant of the changing definitions of Growth and Value and watch how rebalancing affects these respective areas. For me, I will do my best to be as clear as possible on what my style message is, and as always I try to bring things back to sectors to avoid any confusion. 

• What stocks stood out as relatively favorable during your monthly deep dive single stock ERM review?

The number of favorable names is getting harder and harder to find in my work.  However, there were some and it was a hodge-podge of areas. 

The strongest absolute areas from an earnings revision basis by far were within the Energy sector, and what really caught my attention are names that I have liked for a while but are quite strong in Energy Equipment. Normally, my process takes me to contrarian ideas and avoids areas that have recently enjoyed prolonged stretches of outperformance.  With that being said, there are times when readings are so strong that staying with and adding to a momentum group still looks attractive, and this is one of those times.  Thus, with the dearth of favorable names, I am willing to raise exposure to the names below, despite my having upgraded them originally in November 2020.

• SLB 0.04% , BKR -1.34% , HAL -1.09%

Another area that the ERM continues to support is within Defense sub-industry in the Industrial sector. These names are generally less cyclical than their intra-sector peers and have a major idiosyncratic tailwind as the US defense budget, as well as the budgets of our allies, should grow at levels far above recent historical trends. The below companies have supportive estimate revisions trends:

• RTX 0.56% , GD 0.16% , LMT 0.10% , and NOC 0.29%

Staples has a fair number of names that have been historically seen as defensive and safe havens during periods of equity market weakness, and the names below look the most interesting, based on my key metrics.

• CPB 1.55% , KO 0.60% , PEP 0.97% , and PM 0.20%

Also, within Staples, there has also been some attractiveness within Brewers and Distillers & Vintners. These names typically have some recession-resistant characteristics and they’re coming off strong pandemic demand. Recent earnings reports have supported my model’s favorable readings.

• BF-B, TAP, and STZ

One of the other sub-industries that continues to stand out to me is the HMOs and big Insurers. Again, these names are traditionally recession-resistant and are a more defensive area of the market. 

• UNH, CNC 0.18% , and ANTM

Some areas of Travel and Leisure are beginning to weaken but I still see strength in BKNG 0.68% and LYV -0.04% . Another stock I see continued strength in is Uranium miner Cameco Corporation (CCJ -2.53% ).