Given the challenging market, I wanted to quickly provide and update on my research. As a reminder, I recently made a hard shift away from my longstanding bullish view in mid-March and I have been pounding the drum ever since on my new unfavorable forecast.
The earnings revisions backdrop, which had been one of my key supports for what was my medium term constructive view, began to weaken during my March deep dive ERM review and the May analysis that was done this week shows that it continues to broaden.
First, it was only negative inflections, “less good”, but my key proprietary revisions indicator is clearly revealing that the deterioration is spreading, and now more and more names are heading towards the southern hemisphere as accelerating absolute cuts are now beginning. I have been talking a lot with clients about my expectation that all things cyclical are at risk of estimates cuts going forward that will likely play out over the next 1-3 months, at minimum.
My work suggests the combination of a hawkish Fed, elevated inflation, slowing growth, rising interest rates, strong USD, continued geopolitical tensions, and an expected analyst profit cutting cycle are creating significant headwinds for the US equity markets.
With risk premiums also rising, I am reiterating my unfavorable view on equities, and I have said previously if there were a definitive downside price break of 4000 for the S&P 500 that I would target 3600-3500. Hence, with 4000 having been breached, I am expecting more downside.
Bottom line: Be careful. Despite the possibility of an oversold tactical bounce at some point, my key indicators are weakening and nowhere near negative extremes, which suggests considerable downside risk remains. Based on my work, I have the following conclusions:
- The extent of Fed hawkishness and their resolve to stay the course is NOT priced in.
- Despite recent equity market weakness and several sentiment indicators suggesting high levels of pessimism, we are NOT near a bottom yet.
- The equity decline thus far has been about rising risk premiums, compressing valuation multiples, and the selling of over owned areas and stocks.
- A decline based on fears of economic slowing and negative earnings revisions to the forward outlook is only in the early phases.
- It is NOT time to shift positioning to the “other” side, and importantly oversold tactical rallies are expected to fail.
MAIN CLIENT ISSUES
- Fed policy and how hawkish are they really?
- Is the bottom here?
- Have Tech and other Growth names fallen enough?
- How to position?
- What is actually being discounted?
SPECIFIC CLIENT QUESTIONS
- If inflation is peaking will that signal that the correction is over?
- Are you concerned about the housing market? Are the stocks buyable yet?
- As the equity market is down, the U.S. dollar higher, and financial conditions tightening hasn’t a lot of the work already been done for the Fed?
- Besides the pure defensive areas of Staples & Utilities, what are some areas or stocks that look relatively interesting based on your proprietary earnings revisions indicator?
MY ANSWERS
Q: If inflation is peaking will that signal that the correction is over?
NO.
If the headline inflation numbers do indeed peak and rollover, it will likely not suggest the correction is over.
First, the Fed has been quite clear in my view that they want to see the TREND in inflation coming down, which I am interpreting as 3-4 consecutive months not just a one-month rollover.
Second, the Fed has also been quite vocal about slowing what several speakers have described as “unsustainably hot”. It is my view that clear slack in the labor market will have to be apparent as well as definitive signs that wage pressures are abating.
Third, when inflation does start to slow, the economy is likely to be weakening, which will then be negatively impacting analysts forward profit expectations.
Bottom line: It is my view that it is overly simplistic to think that a peak in inflation by itself will be the ultimate signal that the equity correction is over. In addition, it is my belief that investors still do not fully appreciate that the Fed will have more resolve to stay on its inflation fighting mission than at any time over the past decade. Yes, I do believe they will ultimately have to relent, but it will take a few steps longer than current expectations. Lastly, THE bottom will likely be the result of either capitulatory selling, extreme negative earnings revisions, or both.
Q: Are you concerned about the housing market? Are the stocks buyable yet?
YES, to some degree, and NO, it is too early.
I am worried that activity levels will begin to slow as housing affordability and higher mortgage rates begin to hit the housing market. With that being said, inventory levels are quite low, and this should mitigate any major problems hitting the industry.
The stocks of the builders are seeing negative earnings revision readings when looking at our proprietary ASM indicator. Despite the stocks being awful relative performers since their early December peaks, any tactical bounces are likely to fail as our key metrics suggest that there is unfinished relative downside for housing and related stocks.
Bottom line: The housing market is likely to see slowing sales activity, but the expected weakness should be manageable and should not become a repeat of what occurred during the Financial Crisis. I will look for the ASMs for the stocks to make extreme lows before warming to the group.
Q: As the equity market is down, the U.S. dollar higher, and financial conditions tightening hasn’t a lot of the work already been done for the Fed?
YES, financial conditions have tightened, but this is the first bout of inflation in several decades and it is my view that further tightening will be needed for the Fed to feel it is credibly fighting inflation.
Investors and forecasters are searching high and low for evidence that the Fed ratchet back their hawkishness and that a bottom in the equity market is imminent. When looking at my key analytical tools, this appears to be a lower probability scenario. This process of Fed tightening, getting inflation under control, slowing the domestic economy, lowering forward profit expectations too far, and readjusting the equity market to compelling levels is likely going to take some time.
Granted, a sharp equity selloff or the Fed breaking something could possibly accelerate the process, but without those my research would suggest that things will need to play out over weeks and months not days.
Bottom line: Be patient. This is likely going to take longer rather than shorter. Adding to the challenging backdrop will be the likely oversold rallies that occur as they may be sharp and put the unfavorable forecasts like mine under pressure. Importantly, my research is indicating that they will likely be short duration and fail into overhead resistance levels. A new bull market and an amazing buying opportunity is coming, but it is likely still on the horizon.
Q: Besides the pure defensive areas of Staples & Utilities, what are some of the areas or stocks that look relatively interesting based on your proprietary earnings revisions indicator?
We have been asked quite a bit to forget about any of our macro thoughts and just to use our indicators to show what is looking relatively favorable.
The areas and stocks below come from my deep dive review of the S&P 500 using my ERM model and my key earnings revisions metric.
- Energy
- Aerospace & Defense
- Airlines
- Environmental & Facilities
- Travel/Vacation related
- Large Cap Biotech
- ADBE, WDC, T, CMCSA, FB, TWTR, AMCR, RSG, WM, MRK, CME, CB
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