Financial conditions tightened since early Feb on "hot" data, softer expected Feb inflation + jobs offsets and reinforced "data dependent" Fed not "data reactive"

This has been a rough few weeks for equity markets, with the S&P 500 falling 5% from recent highs. There are many skeptics who are now “top calling” saying the dominant bear trend is resuming. But as our clients know, this is not our take.

• the “seasonal” payback of strong January seems to be playing out and as Mark Newton, Head of Technical Strategy at Fundstrat, notes, the S&P 500 is at critical support.
• and as the “rule of 1st 5 days” shows, equities are in the midst of the payback period, but should emerge in the coming week or so.
• and this softness follows tightening of financial conditions as Jan jobs and inflation were hotter than expected.

The best way to see the FCIs, or financial conditions, is look at three metrics below — VIX, 10-yr and USD.

• all 3 have moved in an adverse direction since early Feb
• Mark Newton believes the cycle is turning for yields (10Y) and if such plays out, this is support of stocks finding a bottom.

SEASONAL INFLATION: Jan PCE likely “hot” following CPI and PPI, but Feb likely softer

We think Jan PCE deflator (inflation) coming out 2/24 will be “hot” but that is not surprising. After the CPI and PPI readings.

• but as “tireless” Ken notes, head of data science research, at Fundstrat
• inflation breakevens (expectations) have an odd seasonality
• inflation expectations seem to be stronger early in the year Jan and Feb
• why? we have no idea
• but this means markets anticipate higher inflation = tighter financial conditions
• as we enter March, this is expected to ease
• read as easing FCIs = good

SEASONAL JOBS: Jan was possibly fluky strong?

Similarly, look at the jobs forecast by Morgan Stanley economists:

• They note the particularly strong Jan jobs is the outlier
• they expect Feb jobs and thereafter to soften
• this is reduced inflationary pressures, if right = easing FCIs = good

FED STUDY: Most inflation of 2021-2022 was COVID-related = transitory = data dependence, not reactive

Lastly, the FRB published a study this week looking at the “demand reallocation shock” of COVID-19. And as their study notes:

• the majority of the surge in inflation was likely due to pandemic drivers
• as much as 3.5% of the rise, or the bulk
• what does this mean? inflation drivers are arguably transitory
• and more reason for Fed to become data dependent
• as we noted earlier this week, of the 14 hiking cycles since 1970, 11 were data dependent Feds and those saw equity markets generally rise

2023 EPS: Are estimates bottoming?

The bear argument remains estimates will keep falling. But as noted in prior reports, EPS estimates bottom after markets bottom. And as 4Q2022 earning season wraps up, we see signs of a possible bottoming:

• 6 of 11 sectors are seeing a possible flattening of EPS expectations as shown below
• Technology, Comm Services, Industrials, Energy, Financials and Healthcare

Since 1930, equities bottom 11-12 months before EPS bottoms.

• if 2023 plays out
• EPS estimates bottoming in 2023, maybe now?
• that gives stronger credence Oct 2022 was the low
• that remains our view

STRATEGY: VIX matters far more for 2023 returns than EPS growth

Our data science team compiled the impact on 2023 equity returns from variables:

• S&P 500 post-negative year (2022)
• the varying impacts of
• VIX or volatility
• USD change
• Interest rates
• EPS growth
• All of the 4 above, positive or negative YoY
• Data is based on rolling quarters and summarized below

The surprising math and conclusions are as follows:

• most impactful is VIX
• Post-negative year (rolling LTM)
• if VIX falls, equity gain is 22% (win ratio 83%, n=23)
• if VIX rises, equity lose -23% (win ratio 14%, n=7)
• I mean, this shows this all comes down to the VIX
• EPS growth has little impact
• If EPS growth is negative YoY (likely), median gain +14.8% (win-ratio 70% n=33)
• If EPS growth is positive YoY, median gain is 15.5% (win-ratio is 78%)
• Hardly a sizable bifurcation

As the scatter below highlights, we can see the sizable influence of the VIX. Even in all years, the VIX is a key factor:

• in our view, if inflation falls sharply
• and wage growth slows
• Fed doesn’t have to cut, but this is a dovish development
• we see VIX falling to sub-20
• hence, >20% upside for stocks

And as shown below, EPS growth has a somewhat important correlation, but hardly as strong as VIX changes.

• the difference in median gain is a mere 70bp (positive vs negative) post-negative year
• the importance of EPS growth is stronger in other years

STRATEGY: Financial conditions should ease in 2023, driving higher equity prices. Technology, Discretionary and Industrials levered to easing FCI

The “base” case for 2023 should be below. That stocks gained >1.4% in the first 5 trading days, and this portends strong gains for the full year:

• Post-neg year + up >1.4% on first 5 days
• Day 5 to first half median gain is 9.5%
• Full year median gain is 26%, implies >4,800 S&P 500
• 7 of 7 years saw gains.

Those 7 precedent years are shown below.

• the range of full year gains is +13% to +38%
• so, this is a VERY STRONG signal
• the two most recent are 2012 and 2019
• we think 2023 will track >20%

The path to higher equity prices is discussed above:

• core inflation falling faster than Fed and consensus expects
• wage inflation is already approaching 3.5% target of Fed (aggregate payrolls)
• Fed could “dovishly” leg down its inflation view
• allowing financial conditions to ease
• bond market has already seen this and is well below Fed on terminal rate

BASE CASE: The “maths” for what to expect in 2023, post a “negative return” year (2022)

Question: how common is a “flat” year? Our team calculated the data and it is shown below:

• since 1950, there are 19 instances of a negative S&P 500 return year. In the following year,
• stocks are “flat” (+/- 5%) only 11% of the time (n=2)
• stocks are up >20% 53% of the time (n=10)
• yup, stocks are 5X more likely to rise 20% than be flat
• and more than half of the instances are >20% gains

So, does a “flat year” still make sense?

As shown below, these probabilities are far higher compared to typical years:

• since 1950, based upon all 73 years
• stocks are “flat” 16% of the time vs 11% post-negative years — BIG DIFFERENCE
• stocks are up >20% 27% of the time vs 53% post-negative years — BIG DIFFERENCE
• see the point? The odds of a >20% gain are double because of the decline in 2022

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