Following last week’s two-day S&P 500 swoon when bad economic news was bad news for stocks, the index rallied nearly 4%, led by the most shorted stocks, unprofitable highly shorted tech names, and some chatter that investors were returning to mega-cap Tech into Monday’s close. With the equity market moving up and dovish hopes increasing, the pressure has certainly shifted away from the optimists to the less bullish/hawkish forecasters, which includes yours truly.
As I interacted with clients over the last two weeks (and my calendar has been quite full), there seems to be two main camps:
- If a client is generally an optimist over time, more accepting of technicals, flows, and positioning, with a more sanguine view for the path of monetary policy for the FOMC, they seem to be quite confident that the low in equities is definitively behind us and a strong rally is in store for 2023. They are dismissive of nearly all negative points and the main argument is — “everybody knows that and it’s already been discounted.”
- The other camp are investors that, over the years, have shared a more balanced view between bullish/bearish, that are more driven by looking at idiosyncratic company fundamentals, longer time horizons, generally have less turnover, and in this group, there is certainly an above-average amount of confusion about the day-to-day market action as well as some of the bullish macro assumptions. I have been and continue to remain in this group.
Since I am more process-oriented and need to have my objective indicators flash reversal signals before I make major changes to my views, I find the recent market action in equities as well as the Fed expectations priced into the fixed income markets both interesting to watch and quite puzzling. Either something different is happening, as my key tools are NOT flashing bullish signals and my less objective analysis and thoughts concerning the macro environment are off base, or the ongoing equity levitation that originally started at the October low is nearing its ending point and has just been another confounding bear market rally.
When I go through my indicators and my many long heated discussions with colleagues, my trusted experts, and clients, I just can’t get to the uber bullish outlook. UGH! I would relish an opportunity to make a big change in view and attempt to lead a bull charge. Importantly, however, my key points that first made me bearish last year, which were my hawkish Fed view (higher for longer) and that forward earnings were too high and would cause a negative earnings revisions cycle, are still in place. Based on my process, it’s quite challenging to flip to bullish until at least one of these two factors flashes a contrarian reversal signal.
Let’s start with the profit backdrop. I have discussed that the absolute level of reports for the 4Q22 earnings season would likely not be a disaster relative to expectations that have been falling for nearly two quarters. My analysis suggests that the announcements of the companies that have reported their results of what has ALREADY happened (i.e., backward looking) have been OK when compared to the lowered expectations that the bottom-up community was forecasting. As shown in the table below, the companies that have reported are exceeding their respective estimates at the time of report by 3.5 percentage points, which is well within the long-term range of 3-5%. If every company going forward reports exactly in line, which is a conservative assumption, the final result will be for a 4.6% decline yr/yr, and nearly down 9% if the outsized impact of the Energy sector is excluded. Pretty strong, right? (I’m being sarcastic here.) And this decline in yr/yr profits is BEFORE the U.S. economy has truly begun to slow, as 4Q22 GDP growth is still being forecasted to be 3.5% when using the Atlanta Fed GDPNow estimate as of 1/20/23.
When turning to the forward guidance provided by Corporate America’s management following each company’s report, the outlooks have been quite weak and keeps the sequential quarterly deterioration in place, which I have been writing about for several months.
Yes, every company has not been all gloom and doom, but my analysis of the earnings reports shows that the lowering of future expectations has been broad-based across the early reports in Financials, more cyclical related areas, and even the reports tonight from MSFT and TXN. My work shows this is just the start of the profit declines, and it is definitely NOT priced into markets.
When I look at my oft-mentioned ASM indicator for the overall market (not shown), it is still in the downtrend that began during 4Q22, and has been highlighted many times since it fell through its all-important zero line in April 2022. My view remains that this key metric will reach its extreme bottom BEFORE the bottom in the equity market occurs.
S&P 500 — 4Q22 Earnings Season Results as of 1/23/23
The below are my update macro/market thoughts
- The first quarter is likely to see a tug-of-war each month as the inflation data will show continued declines that will fuel the hopes of the optimistic doves only to get a dose of hawkishness because of labor market resilience. While this is going on, the expectations for forward profits will be under downward pressure.
- My research continues to suggest that the battle with inflation is headed in the right direction, but as year-over-year readings fall, continued declines will get more challenging – something that is not fully appreciated by investors. This, combined with the absence of definitive weakening in the labor market, is why I continue to see the Fed path as higher for longer and still am targeting 5.25-6.0% as the most likely terminal rate with a high bar for flipping back to accommodation.
- In my view, earnings revisions and forward profit expectations matter. A LOT. Yes, other factors including falling inflation, a shift in Fed reaction function, and falling VIX are also important, but do not underestimate the signaling of my ASM indicator for the overall market as it has bottomed BEFORE every major bottom since 1990. Ignoring this will likely not lead to an optimal outcome.
- Valuation multiples are still too high and need further adjustments before equities become compelling again.
- Based on this, I am still advising clients to be careful, cautious, and patient as considerable risk remains.
Bottom line: My work continues to signal danger.
The continuation of a weak earnings season, the slashing of forward guidance, slowing domestic growth, and a Fed that will likely crush the market’s dovish hopes and voice displeasure with the dramatic loosening of financial conditions in the weeks ahead are likely to throw cold water on bullishness.
Although the current equity bounce could try to move a bit higher, my key indicators still strongly signal that is a bear market rally that will fail. My tactical tools are extended and suggesting that the immediate upside potential is limited at best, and a resumption of the move lower is nearing.
Thus, I continue to advise NOT to chase oversold bounces and to use the upcoming failure just like the late March and August S&P 500 tops that made lower lows by raising cash, repositioning, increasing hedges, or reloading shorts. I am still forecasting a break of the October 2022 equity lows, and a decline that heads towards 3200-3000.
For investors that need to be fully invested or to focus on relative performance, my work continues to show that a barbell approach of Defensive non-cyclicals and some select Secular Growth names will have the most relative winners going forward as more cyclical related areas will get the brunt of the downward estimate cuts over the next 3-6 months. For cyclicals, I still recommend single stocks to outperform other cyclicals for your exposure. Most of them are higher quality, as poor operators and management teams will likely not have any get-out-of-jail-free cards coming from any new stimulus for quite some time.
