What Our Clients Are Talking About Behind The Scenes

Bottom line: My work has not and still does not support the recent bounce attempt by the S&P 500 as “the bottom” that is sustainable and long duration.  Quite the contrary, my key indicators continue to weaken and suggest that a cycle of estimate cuts is in the early innings and will grow stronger over the next couple of months, at minimum.   Thus, I am reiterating my unfavorable view on equities, and I continue to target 3600-3500 as my next downside target.

The tug to the downside is likely to return, as the multitude of challenges that I have been discussing for the equities markets remain unresolved. Based on my analysis, investors should be using any remaining equity strength to sell into, increase hedges/shorts, and up exposure to defensive areas.

Be careful and position for more possible downside with the understanding that an epic buying opportunity will likely present itself, but it is still on the horizon:

• Monetary policy is still in the process of tightening — recent comments show even the most dovish committee members are not irking to reverse course on rate hikes or QT 2.
• An equity market decline based on fears of economic slowing and a negative earnings revisions cycle is still my base case and still in the early phases—this may be exacerbated further by the U.S. dollar strength over the last year, which is now up nearly 15% yr/yr.  
• It is NOT time to aggressively shift positioning to the “other” side and, based on what my indicators are showing now, oversold tactical rallies are anticipated to fail.
• Expectations for a great buying opportunity are still at a high level, and investors should be starting to identify candidates for their wish list (FYI — be on the lookout for my new single stock publication that should be out before the end of the month).   

Higher level positioning recommendations 

• Although the current bounce off the May low could drift higher, my work suggests it will fail and downside risks remain. 

• Growth is likely to have one more short duration underperformance leg left that lasts days/weeks once it starts and NOT months.  It will likely occur while 10-yr yields once again rise above 3% and DXY rises to over 105.    

• Value is lining up to be the leader to the downside during next overall market decline as estimate cuts hit cyclicals the hardest. 

• Stock selection continues to slowly rise in importance.

• Be opportunistic and ready for a higher quality entry point when forward looking indicators suggest that the reward/risk set up is highly in our favor.

MAIN CLIENT ISSUES

• Growth versus Value?
• Have long rates peaked yet?
• Earnings expectations are too high
• Should Energy still be a large part of a portfolio?

SPECIFIC CLIENT QUESTIONS

• What did Fed comments signify this week?

• Do you think that the USD strength is priced into the earnings estimates?
• Any thoughts on the upcoming Russell rebalancing and Energy weights going down for Value managers and rising for Growth managers?

MY ANSWERS

Q: What did Fed comments signify this past week?

The Fed means business on inflation. Don’t underestimate their resolve and the potential for QT to lead to issues for investors. 

Some of the most dovish members of the FOMC continue to send starkly hawkish signals and are determined to see inflation much closer to the target than the current elevated readings.  The way we read the Fed tea leaves, the recent messaging has not made any effort to prepare for a pause in hikes, let alone flipping back to easing.

A key part of most bullish theses by forecasters is that the Federal Reserve will be proactively willing to slow or reverse its policy actions on the first signs of either inflation peaking, labor market cracking, economic growth decelerating, or lower equity market prices.  Granted, this has been the case post the Financial Crisis and there seems to be an inherent dovish bias amongst the members of the FOMC.  Importantly, however, the Fed has their work cut out for them and, until energy prices come down, their policy tools are not perfectly suited for their battle.  Indeed, the current bout of inflation is its most credible threat in a quite some time and erring on the side of patience may not be an option for policy makers in either their credibility or to actually reach their goals of getting the genie back into the bottle.

Bottom line:  There will be a point when a Fed pause/reversal will provide the bulls with a solid reason to get aggressive again.  With that being said, it is still my view that Powell & Company will show more resolve than the policy makers have had for quite some time, which ultimately leads to either something breaking or problems for equity investors.  Regardless, I will likely be hesitant to jump on every data point that may provide a glimmer of hope for an end of the tightening cycle.  My data suggests that things will likely take some time to play out for inflation and economic expectations to slow enough, which will also be accompanied by forward profit expectations for Corporate America being lowered.  How long is the question that I don’t have a high conviction answer to, but I think days/weeks is too short and that quarters is too long. 

Q: Do you think that the USD strength is priced into the earnings estimates?

No.  Based on my earnings revisions work, I do not think it has been accounted for by the analyst community and will put some downward pressure on estimates for the next 4-8 weeks. 

The U.S. dollar is up about 15% yr/yr (see chart below) and this is certainly going to be a headwind to the profit expectations for Corporate America.  The announcement by Microsoft was the first high-profile sign that dollar strength is eating into many company’s earnings, which dovetails with my ongoing forecast for a negative earnings revisions cycle that is occurring and will likely speed up in the weeks/months to come.  Granted, in the bigger picture, having MSFT lower its next quarterly results by only $480 million is a smallish figure, but it does contribute to the likely erosion that will also come from a slew of other factors like input costs and labor costs. Slowing demand will provide strong headwinds for the overall equity markets as well.  

Based on my single stock ERM model that looks at the estimate revisions, which I call ASM, of over 4000 U.S. companies, it is my view that factoring in the impacts of a strong greenback has not broadly occurred, as I would hypothesize that analysts are waiting for guidance instead of aggressively making adjustments on their own. 

Bottom line:  Currency risk to earnings is yet another headwind analysts will surely be taking into consideration in the next month or two, which will contribute to a wave of downgrades for stocks. As I mentioned last week, the outcomes after similarly negative readings for my overall ASM indicator for the S&P 500 have portended weakness in equities for a median decline of 10% over five months, which would bring the index close to my next downside target of 3,600-3,500.

Q: Any thoughts on the upcoming Russell rebalancing and Energy weights going down for Value managers and rising for Growth managers?

Yes, Energy outperformance could come under some pressure. 

Admittedly, I am not an expert on the annual Russell rebalancing, so I am going to share some thoughts without any hard empirical evidence to back up my comments.

I had several managers last week of both Growth and Value ask me about the upcoming changes to the Russell weightings that impact managers who are benchmarked to those indexes. 

During the discussions, it was clear that the weighting for Energy is likely to rise in the Growth index and fall in the Value index since it has been such a large outperformer. 

So, when talking to my Growth managers, I asked them what their current weightings were for Energy relative to their benchmark weight.  Most told me they were OVERWEIGHT.  However, after the rebalance, they will likely be UNDERWEIGHT. My next question was: “Will you be buying Energy to get back to Neutral/Overweight?” I thought that was quite relevant considering how well the sector has done.   Every account told me — NO, they would NOT be buying energy.  

I also did the same round of questioning to my Value managers.   They told me they were also OVERWEIGHT right now.  After the expected rebalance, they would be WAY overweight because Energy’s weight is likely to be lowered in the Value index.  Most told me that they would likely have to be sellers because they didn’t want to go even further overweight. 

Now, when I put the two together, I am hearing active Value managers are likely to lower their upcoming Energy weights while active Growth managers are likely not going to be buyers.  Could this imbalance in flows finally create some headwinds for the outperformance of the Energy sector?  I need to do some additional digging on this, but I felt it was worth sharing and for investors to think about while I spend some more time investigating. 

Bottom Line: Energy has been a large outperformer since it reached its all-time relative low in November 2020.  It has been supported throughout by my proprietary 8-panel analysis, and it remains favorable today, which is why I have been recommending above Neutral positioning for over 18 months.  Yet, the key indicators that I look at are reaching historical positive extremes and are close to flashing some type of contrarian sell signal.  It is not clear if it will be a tactical or strategic signal.  In any case, I am full alert and looking for evidence that Energy is finally due for a well needed pause, at minimum, and the upcoming Russell rebalance should be on the radar screen.