What Our Clients Are Talking About Behind the Scenes

During last week’s start to 2023, I spent a good portion of my time doing my monthly deep dive into my single-stock section model, which I call ERM, for the U.S. universe. It is useful to take a step back from the macro every once in while and devote more attention to what individual names and what themes may be flashing by looking at the trees and not the entire forest. 

Since the end of 1Q22, I have been commenting that the overall S&P 500 earnings revisions as shown by my proprietary ASM indicator were falling, and this was one of the main reasons I had flipped from bullish to bearish.  Additionally, during the remainder of the year, I wrote quite a bit about how this key metric kept deteriorating, and that making a final extreme low would be an incredibly important signal that an equity market bottom was finally at or near its final trough. 

The highest-level takeaways from my earnings revisions review at the single-stock level are as follows: 

1) Earnings expectations for 2023 still look too high; and

2) The aggregate analyst community has little to no fear about any significant economic slowing in their company outlooks. 

So, how does this reconcile with investor sentiment polls that suggest “everyone” is overly bearish? 

As I am now out of full earnings revisions mode and once again have my focus more balanced between macro, sectors, and stocks, my sense by looking at my indicators and speaking with folks is this:

1) Most clients talk between neutral to some level of bearishness

2) The positioning of most long-only strategic investors is NOT overly bearish, but cautious

3) As mentioned earlier, analysts in the aggregate are not fearful of significant economic slowing

4) My simple view of the options market is that there does not seem to be any noticeable demand for put protection, which suggests to me a lack of fear

5) Fixed income markets are pricing in Fed cuts during 2H23 despite comments from Chair Powell and Gang that are quite to the contrary. 

When adding in that valuation levels for the broader equity market do not look particularly cheap and attractive based on my work, the aggregation of all that has been mentioned doesn’t give me a warm, fuzzy, bullish feeling.  Granted, my next downside target zone of 3200-3000 may end up being too pessimistic, but I would have to make a lot of aggressive assumptions to get to a runaway upside equity market that does not seem like a high probability now. 

Switching gears to the January U.S. universe single-stock revisions deep dive, the following observations stood out the most: 

• Since March, every monthly review has shown that the earnings revisions backdrop was weaker than the previous month, and the January deep dive continues the ongoing trend.  The number of favorable names has fallen once again and is at the lowest level since the COVID low in April 2020.  Thus, the slow bleed continues, but it appears that fundamental capitulation still has not occurred. 

• Significantly, there is still much work to do before peak negativity is reached (fundamental capitulation), which will be a crucial bullish contrarian signal once it happens.

• Why is fundamental capitulation important?  My research shows that since 1990 this has been a critical prerequisite for the equity market to put in a sustainable investment bottom (i.e. THE BOTTOM).   

• I will reiterate that this process is likely to persist for at least another 1-4 months, at minimum.  Thus, patience will be needed if my analysis comes to fruition. 

• Favorably standing out as relatively interesting based on earnings revision trends:

Health Care — Equipment, Pharma, and Life Sciences — BSX, ISRG, SYK, MNRA, JNJ, LLY, MRK, A, CRL, MTD, PKI, and TMO. 

• Note that Large-Cap Biotech and HMOs are showing signs of weakening. 
• Staples— WBA, COST, MNST, CPB, KO, KHC, CL, KMB, EL, PM, and PG.

• Other large-cap names that caught my attention — Casinos and related, BA, CPRT, SBUX, BEN, BK, CB, RE, and IPG
• And for you contrarians, I strongly recommend revisiting INTC.  It may not be ready now, but it screens as one of the most interesting stocks in the entire universe. 
• Tech, FANG, and TSLA continue to deteriorate broadly.  I can see a point in the next 3-5 months when these names will once again flash as compelling long ideas. 

• Unfavorable and look quite weak based on earnings revision trends:

Too many to mention, but Cyclicals, which have been more resilient than I was expecting, are slowly cracking.  Growthier areas and names look close to bottoming or in early signs of recovery. 

The below are my update macro/market thoughts

• The first quarter is likely to see a tug of war each month as we expect the inflation data will show continued declines that will fuel the hopes of the optimistic doves only to get a dose of hawkishness because of labor market resilience.  While this is going on, the expectations for forward profits will be under downward pressure. 

• My research continues to suggest that the battle with inflation is headed in the right direction, but as year-over-year readings fall, continued declines will get more challenging – something that investors don’t fully appreciate.  This, combined with the absence of definitive weakening in the labor market, is why I continue to see the Fed path as higher for longer and still am targeting 5.25-6.0% as the most likely terminal rate with a high bar for flipping back to accommodation. 

• In my view, earnings revisions and forward profit expectations matter.  A LOT.  Yes, other factors, including falling inflation, a shift in Fed reaction function, and falling VIX are also important, but do not underestimate the signaling of my ASM indicator for the overall market as it has bottomed BEFORE every major bottom since 1990.  Ignoring this will likely not lead to an optimal outcome. 

• Valuation multiples are still too high and need further adjustments before equities become compelling again. 

• Based on this, I am still advising clients to be careful, cautious, and patient as considerable risk remains. 

For investors that need to be fully invested or to focus on relative performance, my work continues to show that a barbell approach of Defensive non-cyclicals and some select Secular Growth names will have the most relative winners going forward as more cyclical-related areas will get the brunt of the downward estimate cuts over the next 3-6 months. For cyclicals, I still recommend single stocks to outperform other cyclicals for your exposure.  Most of them are higher quality, as poor operators and management teams will likely not have any get-out-of-jail-free cards coming from any new stimulus for quite some time. 

Bottom line:  My work continues to signal danger.  Hence, I am still advising that oversold bounces should be viewed as counter-trend and that they will likely fail.  So, strategic investors should opportunistically use them to sell into, raise hedges, and reposition.  Tactical traders can play the tactical wiggles when signals are flashed by my aggressive tools (HALO-2 and V-squared), but know that any strength is likely a bear-market rally and keep an eye on the exit door. 

Before I sign off, I want to remind everyone of two things. 

First, I will be doing my 2023 Year Ahead Outlook this Thursday, January 12.

Second, I will provide my monthly FSI sector allocation update, which I usually release at the beginning of the month, within my upcoming outlook publication. 

Happy New Year, best wishes in 2023.