What Our Clients Are Talking About Behind The Scenes

Equity markets continue to struggle as my work has been suggesting.  The big events for last week were the FOMC meeting and the large quarterly option expiration that has added to the challenging increase in volatility. Last week, the S&P 500 traded between 3840—3636, which is just above my longstanding next downside target range of 3600-3500 and closed near 3700 as there is still a hope by some that a significant low has been reached.  Besides being oversold on some metrics and a handful of sentiment indicators flashing depressed levels, my work does not yet provide any compelling evidence that it’s time for investors to pivot to a full bullish view.   

The Fed’s June hike was 75 bps marking the largest hike since 1994 and continues to support my ongoing view that the FOMC is focused and serious to succeed in its inflation fighting mission.  Going into last week’s meeting, there was a lot of noise and debate whether the committee would go 50 or 75bps following the recent hot CPI data release and an article in the Wall Street Journal suggesting that 75bps was likely.  Would Chair Powell stick with his stated forward guidance, which he has commented many times is the Fed’s most effective policy tool, or was the news story a clear leak to give the market a heads up?  Practically speaking, the difference between the two outcomes on inflation in the immediate term is small, but the impact on the Chair’s credibility could be large.  In my view, Powell has created a perception problem of his own doing and it remains to be seen what the longer lasting consequences may be.  Following the meeting, nearly all Fed speakers continue to sound closely aligned that their fight to restore price stability was “unconditional.”  Even the historically dovish Fed Governor Kashkari stated that he could support another 75bps move in July.  All I can comment here is — WOW! 

Without trying to spend too much time around the Fed, I am quite puzzled as are other forecasters about Chair Powell’s comments that the domestic economy is on firm footing.  1Q22 GDP growth was negative, the Atlanta Fed Nowcast has fallen to 0% growth for 2Q22, real retail sales release showed a contraction, and the industrial production release was also unimpressive falling .1%.  What am I missing?  Based on my work, the economy is clearly decelerating under the weight of elevated energy/commodity pricing, elevated inflation, ongoing logistics issues, and rising interest rates.  Furthermore, I continue to expect that forward expectations have not fallen enough yet.  Yes, I acknowledge that this can take some time, but my indicators suggest that fears of a soft-landing recession will grow and ultimately evolve into concerns of an outright hard landing barring a sudden change in the backdrop surrounding energy/commodity pricing. 

It is my view that this will either run concurrently or influence the forward outlook for corporate profits.  As longer-term readers know, I spend a lot of time looking into the earnings and estimate revisions.  Based on my work, forward estimates from the analyst community are too high and will almost certainly have to come down.  In my opinion, this potential headwind being flagged by my tools is NOT priced into equity markets, especially in areas/stocks that are more cyclical and to some degree impacted by a strong U.S. dollar.  Granted, there are some who strongly disagree with this last statement and ask about my conviction level, but to quote one of my favorite TV shows Billions when Bobby Axelrod asks Dollar Bill his level of confidence — “I am not uncertain.”  So, I strongly advise keeping this on your radar screens along with my analysis of when my S&P 500 ASM indicator falls below zero that I have been discussing over the past several weeks ( Report Link ).

When diving deeper into which trees in the forest may be impacted the most, my ASM indicators at the sub-industry (GICS L-4) and stock levels show that the largest amount of suffering is likely to be in:

• Industrial Cyclicals
• Consumer Cyclicals
• Commodity Cyclicals

Bottom line: I continue to reiterate that my work strongly portends that there is still more downside ahead not withstanding the possibility of short duration failed rally attempts along the way lower.  A downward estimate revisions cycle has begun and remains in the early stages, which will be a strong head wind for equities to move higher until max pessimism is reached. 

As the S&P 500 nears what I have been describing as my NEXT downside target zone, my key indicators are signaling a high probability of having to introduce a new lower forecast.  Not only is the profits backdrop weakening, but the growing number of other macro issues that are on my radar screen is raising my concern level even further.  I am still working my way through things and will likely announce my new levels over the next couple of weeks. 

A couple of key takeaways here are that my work says there is more to come on the downside and its going to take time.  Hence, although there could be a short duration tactical bounce that could occur, I want to caution my work says THE low will likely need months to play out, but not quarters.  

Be careful and position for more possible downside with the understanding that my expectation for a high-quality buying opportunity will likely present itself, but it is still not on the horizon:

• Monetary policy is still tightening — Don’t Fight the Fed (yes, I know, but it is really appropriate now).
• An equity market decline based on fears of economic slowing and negative earnings revisions to the forward outlook are only in the early phases and is NOT priced into the market based on my work.
• It is NOT yet time to aggressively shift positioning on the long side. I continue to expect any rallies that occur will be of limited duration and magnitude.
• The important shift from Value back to Growth is close.

MAIN CLIENT ISSUES

• Are we at the equities bottom yet?
• How high can 10-yr yields rise?
• How high will the U.S. dollar get to?
• Are all your earnings worries priced in since sentiment and positioning are already bearish?

SPECIFIC CLIENT QUESTIONS

• What is going on with S&P 500 OEPS estimates for 2022?
• I am worried about missing THE bottom, and with oversold technical readings and sentiment/flow data already showing a fair amount of negativity, do you have any evidence to call a bottom?

MY ANSWERS

• What is going on with S&P 500 OEPS estimates for 2022?

When looking at S&P 500 ex. Energy OEPS, the analyst community have only recently begun to lower their forecasts for corporate profits.  My research shows that the bottom up consensus yr/yr growth rate, which stands at a yr/yr increase of 5%, will likely fall to a decline of  5-10%, at minimum. 

More clients are asking about the bottom-up consensus OEPS estimate for the S&P 500 and trying to figure out where they fall to and ultimately to use to forecast what the low for index price level might be.  In my view, we should be looking at the S&P 500 ex. Energy because that sector is really masking what core earnings are doing.  For perspective, the CY21 level was $207 and the current forecast stands at $217, or roughly 5% yr/yr growth. 

On the following page, I have included the historical readings for the S&P 500 ex Energy forward expectations for CY22, which begins in 4Q21.  The charts show that expectations for OEPS, Sales, and Margins were generally rising until the 2H21 and have only begun to decline during 1H22.  Interestingly, the analyst community is still raising their top line numbers, which I assume is reflecting the fact that these figures are not adjusted for inflation, which by definition implies falling margins. 

Based on my deep dive analysis into the entire S&P 500 universe at the individual company level, all four categories are too high and will need to be lowered as we move forward as shown by my red annotations.  My work strongly suggests that expectations will need to fall below $207, which was the CY21 actual, and will likely get to $185-195, or a 5-10% yr/yr decline, at minimum.  Relative to the normal decline in OEPS when the domestic economy falls to no growth or contraction this expectation is quite modest.  Barring a sudden downward shift in energy/commodity pricing, I am finding it nearly impossible to model how this can be avoided. 

Bottom line:  My work shows that earnings estimates for the overall equity market are too high and are going to have to come down.  In a study that I conducted going back to 1990, a negative earnings revision cycle that my work is flagging has always (six for six in prior occurrences) led to negative equity returns for the S&P 500 until the rate of change reached maximum.  Historically, this has taken five months on average and the average S&P 500 return was down 18% and the median was a decline of 10% ( Report Link ).

• I am worried about missing THE bottom, and with oversold technical readings and sentiment/flow data already showing a fair amount of negativity, do you have any evidence to call a bottom?

THE bottom ?— NO evidence.  A tactical bottom? Possibly. 

My preferred tactical indicator (HALO, top chart next page, blue line) for the S&P 500 has provided many significant tactical reversal signals since 4Q18, which all ended up rewarding investors. As a result, the model continues to be value-added and remains quite relevant. In my last sector update at the beginning of June, I commented that I expected that HALO would make another lower high, which I would view as quite bearish and forecast that it then makes a new low for this cycle.  Well, in the top chart on the following page, HALO did indeed rollover at a lower high and remains under pressure, which suggests that THE low is likely not in yet until this key indicator can bottom. 

With that being said, when looking even closer into the S&P500 by using my highest-frequency and most aggressive tactical tools — V-squared (bottom chart on next page, orange line) and HALO-2 (bottom chart on the next page, purple line) – which were extremely helpful in identifying many of the tactical trading reversals since 4Q17, both have fallen quite hard as I forecasted would occur at the beginning of June.  One is at an extreme low (HALO-2), which is a tactical contrarian bullish signal, while the other (V-squared) looks like it needs to fall further before it gets to its max negative reading.  Putting this together, a tactical trading low is rising in probability and could occur at any time within the context that it will be COUNTERTREND and will be expected to fail. 

Bottom line:  Remain cautious as my key indicators are not flashing that THE bottom is NOT here yet.  Combined with all the other evidence that I have been discussing, the two takeaways are 1) notwithstanding any tactical rally attempts, my key indicators say more downside is likely; and 2) the process of getting to THE bottom will take months and not quarters, and for those eager and hopeful bulls certainly not days/weeks. 

HALO Description – The proprietary Fundstrat Portfolio Strategy Halo Model is a multi-factor model that attempts to predict the forward 1 – 6 month relative performance of a group.  The goal is to help both strategic accounts better time their implementation strategies that would be consistent with our more strategic conclusions derived by our sector/sub-industry 8-panels as well as our stock specific Estimate Revisions Model (ERM), and to generate tactical ideas for aggressive trading accounts. 

The model has both momentum and contrarian characteristics.  When the blue line, which is the model, is trending, our proprietary tool is in a momentum phase, and our research shows a high probability that relative performance will mirror the slope of the line.  Importantly, because the model is built to oscillate, an extreme reading that inflects strongly suggests that a reversal in the most recent performance trend is likely to occur.

HALO-2  &  V-squared Description – The proprietary Fundstrat Portfolio Strategy V-squared indicator shown in the top chart (orange line) shows the ratio of VXV (the 3-month CBOE S&P 500 Volatility Index) and the VIX (the 1-month CBOE S&P 500 Volatility Index).  This tool is also useful for identifying aggressive tactical trading bottoms for the S&P 500.  

The proprietary Fundstrat Portfolio Strategy HALO-2 Model, which is the purple line in the lower chart shown above, is the raw tactical data behind our standard HALO multi-factor model described on the previous page.  It is useful for identifying aggressive tactical trading bottoms for the S&P 500.   

HALO still falling…

…HALO-2 and V-squared reaching areas that normally lead to trading bounces