Well, it seems that the ball game is over, and the bulls have clearly won. Inflation is dead, the Fed should be easing anytime soon, the expected recession has been averted, forward profits expectations are surging higher, valuation levels are now untethered and should rise to all-time highs, and the issue in both the Banking industry and Commercial Real Estate areas are finally behind us. A powerful, broad-based equity bull market is beginning that should take us to over 5000 before year-end. I guess the Wayne’s World Mega happy ending is actually happening. Pardon my ongoing sarcasm, but I could not help myself.
Today, the equity market continued surging higher on the back of the CPI data release and as we head into the big June options expiration on Friday. Despite this upward thrust, my work still suggests the following — 1) Yes, inflation is coming down, but the core at 5.3% remains sticky and still needs lots of work to get it down to the Fed’s 2% target; 2) June does indeed look like skip by Chair Powell and Gang as I have written this for the last month or so; 3) Importantly, however, a skip is NOT likely an all-clear sign that the Fed is done and that any easing is imminent; and 4) the odds for the next Fed action still favors a hike and that the central bank is still a long way away from being able to declare victory over inflation. Thus, investors need to remain wary of further optimism on this front and be mindful that expectations are likely to change at some point during 2H23, which is likely to create headwinds for the overall equity market.
With that being said, let’s shift away from pure macro this note. I did my monthly deep dive into my 4000 single stock U.S. universe to see what was going on with the earnings revisions at the ground level last week. As I mention quite often, I find it so valuable to leave macro at the door every once in a while, and really get into the details at the single stock level. With that being said, the biggest takeaways for me after doing my deep dive this month are (more details later in this note): 1) WEAKNESS; 2) Earnings are not collapsing, but forward profit expectations remain too high and still need to be lowered; 2) Economically sensitive stocks look to be the most at-risk; 3) Larger cap stocks generally look better than Small and mid; 4) Lots of single stock divergences intra-sector and intra-sub-industry, which for me means idiosyncratic/stock picking is important and will add value to one’s portfolio results.
Can the equity market go up despite what this analysis shows? Yes, it can, but if you look historically there are some caveats around my affirmative response — 1) in short-term periods of oversold or excessive bearish sentiment, equities can bullishly diverge from unfavorable earnings revisions; 2) however, over longer-term periods and once the oversold condition has been alleviated, the answer is really NO. 3) Unless an actual Fed easing cycle is imminent and ultimately this will cause the earnings revisions to show more strength. The bottom line here is to bemindful of what you own, what you may be buying, and what the earnings revisions look like for your key exposures because the backdrop still does not look like the beginning of a new broad-based bull market.
In my monthly ERM email that I sent out last week, which went out to over 600 clients who receive a customized portfolio analytics update, I asked a question to get some feedback from readers. I asked what was more likely to happen first 1) S&P 500 gets to 4500-4800 or 2) S&P falls to 4000-3800. The voting results were exactly 50/50. So, no clear view from my readers. Based on what I have been hearing in clients calls, I am not surprised. I have been writing for a couple of months that I don’t hear any excessive optimism or pessimism in my interactions.
Indeed, there have been some favorable macro developments that have occurred, and some unfavorable issues that continue to linger. I have tried to acknowledge the positive developments by taking my uber bear scenario off the table back in February, and also shifted away from a totally defensive sector positioning to a barbell that included a bias towards Large Cap, High Quality, Secular growth areas and had upgrade Tech and Comm Services and certainly deemphasizing Smid, Lower Quality, and Cyclicals in February to reflect this view.
These changes in February were the direct result of my earnings revisions work making extreme negative lows for all of the magnificent seven (Tech/AI Related/AMZN), as well as the flow through to the sector 8-panels, and not a real shift in anything macro that I was seeing at that time. The setup for a bounce and relative outperformance in these areas/names was quite clear based on my ASM indicators, regardless of whether the AI buzz had happened or not. We can always debate if the speed limit to the upside has been appropriate or not, but the outperformance was going to happen based on my analysis.
Since February, there has been a large divergence between the weighted S&P 500, which has been dominated by the Magnificent 7, and the equal-weighted index. As the chart below shows, the former is up 5% and the latter is down 5%. Again, not surprisingly based on my work, and it clearly reflects what the earnings revisions were signaling. The bottom line here is that the divergence will likely remain until there is a clear shift in the relative earnings revisions between the two groups, notwithstanding some tactical price-only moves to relieve overbought/oversold readings.
Big Divergence Remains
Staying on the earnings topic a while longer, let me state again, corporate profits are not collapsing, but at the same time they are anything but strong and improving. My work says investors should be aware of the growing divergences for earnings forecasts that the magnificent 7 are causing. Let’s first look at the coming 2Q23 earnings season that will begin in mid-July because there seems to be some misinformation or confusion when I speak with clients. It is easy to see why, but one needs to dive into the specifics.
The below charts are what the bottom-up consensus is forecasting for the upcoming 2Q23 earnings season. There have been some who have commented revisions have stopped falling, and technically they are correct. However, the devil is in the details. On the far left, one can see that the estimates and yr/yr decline in growth both bottomed out in my 5/19 weekly data update. Diving deeper, the middle column of charts shows that there has been a 400bps increase in the expected yr/yr growth rate for the Magnificent 7, and a solid reason why the stocks are outperforming. Importantly, however, when looking at the S&P 500 without this small group the estimates for 2Q23 continue to fall and now stand for an over 10% yr/yr decline in OEPS, which is nearly 200 basis points lower than where they stood in mid-April.
To further this point, I am providing the ASM indicators for the S&P 500 cap-weighted, the S&P 500 x Magnificent 7, and the S&P 1500 equal weighted. As I have been discussing the last several weeks, the S&P 500 revisions have been the strongest driven by the Magnificent 7, and they get weaker once they are excluded, and even weaker as we go down the cap scale into the S&P 1500 equal-weighted. Furthermore, please note that all three are rolling back over, which has been another key development that I have been forecasting and discussing. My expectations are still that the weakest economic quarters are still in front of us and that there is unfinished business to the downside in these metrics. If this occurs, the upside potential for equities is certainly impacted and more likely spells trouble. So, I advise paying close attention to where the revisions are improving and beware of the areas that are still deteriorating.
Estimates Revisions are looking tired. Are they about to start falling again?
So, what’s an investor to do? Well, my work continues to support a barbell approach of some traditional defensive areas and some Large Cap, Higher Quality, and Secular growth areas and continue deemphasizing Smid cap, Lower Quality, and Cyclicality.
The Energy sector continues to slowly move towards a potential upgrade and for longer-term investors the Financials (Banks) seem too early to aggressively raise weightings. Importantly, as I have been discussing all year, beneath the surface stock picking/idiosyncratic selection is gaining in importance and relative investors have a nice opportunity to add alpha by looking at the trees and not the entire forest.
The below are my updated macro/market thoughts:
- Broad labor market is clearly not flashing, which keeps the Fed’s inflation fight challenging.
- Core inflation readings are not falling at the same pace as before and have caused some uncertainty about their path in the coming quarters, which lowers the probability of the market’s dovish Fed expectations.
- I remain in the Fed is higher for longer camp and my forecast for the terminal rate is still 5.25-6.25%.
- NO EASING — Despite the recent problems in the banking industry, my view remains that once the Fed does pause it will likely keep policy unchanged for an extended period. I expect Chair Powell to reiterate this at the upcoming May FOMC meeting.
- The weakest quarters for the U.S. economy are still in front of us. It looks headed towards a shallow recession, and then an extended period of sluggish growth.
- Corporate profit expectations remain too high and need to be lowered as there are strong headwinds.
- Importantly, the immediate upside potential for the S&P 500 equally weighted still appears limited, at best, while considerable downside risk remains for equity investors. Despite being tactically overbought, my work suggests that any pullback in the AI/Tech leadership will likely be a dip in an ongoing uptrend that should likely last till their ASM indicators rollover.
- From a positioning standpoint, economically sensitive areas/names are looking the riskiest based on my key indicators while secular growth ideas look relatively favorable.
- Single stock opportunities are sparse, but they are slowly increasing. The general theme is higher vs lower quality and larger vs smaller cap.
GENERAL CLIENT QUESTIONS/CONCERNS/TOPICS
- Most of the main client questions and issues have remained quite stable over the last 4-6 weeks.
- Despite the S&P 500 cap-weighted index still moving higher and now near 4400, there remains a reasonable amount of distrust about the ongoing equity rally.
- Investors remain skeptical that the tone is still uber bearish as highlighted by competitor trading desk commentaries, and nearly everyone wants to know what I am hearing about sentiment from others.
- I still am not hearing any excessive amounts of bullishness or bearishness. More about confusion, frustration, and lack of conviction.
- Where to be looking for new ideas and how to position continue to be the dominant discussion points during my client calls.
- There were some large (i.e. managers with mega AUM) value investors that have started nibbling on banks and energy as they don’t have the conviction that their respective bottoms are in, but they are beaten up and look interesting from a longer-term perspective.
- There is still a lot of interest in what is happening with forward earnings expectations.
SPECIFIC CLIENT QUESTIONS
Do you have any more detailed takeaways from your monthly dive deep into the U.S. universe using your single stock ERM model?
Any single stock names standing out?
- Energy is getting closer, but still needs time. I am expecting a potential upgrade before the end of year if the data does what I think.
- Regional Banks also look too early based on my ASMs. As of now, I am targeting 1H24 for a potential upgrade, but will be alert for doing it sooner.
- Economically sensitive names continue to look at risk as their numbers do not reflect my projected slowdown in the economy.
- The only cyclicals outside of the secular, growth, Tech, AI-related areas that broadly look favorable using my earnings revisions work are as follows: Construction Materials, Building Products, Airlines, Rails, Cruise Lines, and Exchanges with Financials.
- Within the growthier areas, Semi Equipment/Chips are quite mixed — some names are favorable and some quite weak. Software is the same. Importantly, the strongest earnings revision readings are coming from Tech/AI related.
- HC and Staples have some names and look relatively better than most cyclical areas.
Single stock names outside the groups mentioned above that are favorably standing out based on earnings revision trends:
- Energy — EQT 0.68%
- CD — AMZN 1.41% and TSLA 10.19%
- Staples — COST 1.47% , WMT, MNST -1.78% , and CHD 0.54%
- HC — ISRG 0.59% , ZBH, BIIB -1.27% , and EXAS 1.74%
- Financials — BRK-B 0.46% /B and SPGI
- Tech — TYL, FTNT 1.92% , MSFT 0.51% , NOW 0.65% , AMAT 1.46% , KLAC 1.37% , AMD 4.05% , INTC 0.68% , NXPI 2.40% , and QRVO 0.93%
- Misc — NWS 0.96% , LYV 2.04% , NFLX 0.89% , GOOGL 1.05% , META 0.87% , and PLD 1.56%
