Caution Advised: Negative Considerations May Not Be Priced In

The ongoing equity market levitation is looking like the path of least resistance is moving up, but today’s much anticipated FOMC meeting may throw a monkey wrench into the works.  While the S&P 500 has been surging during January, the debate between the Doves/Bulls and the Hawks/Bears remains quite heated. 

If one only looks at the easing of financial conditions, the dovishness that has been priced into the fixed-income markets, and certain technical analysis techniques, the ongoing rally makes some sense.  Quite frankly, if my tools had picked up on this dramatic shift in these factors, I would likely have tempered my bearishness somewhat, at least in the short term. 

Interestingly, the Doves/Bulls are dismissing a lot of negatives for the equity market by saying they are either already fully discounted, they don’t matter, or the “Market is always right”.  Well, my work suggests that some negative considerations may not be priced in, and they should not be ignored. I have been discussing for several months that the outlook for corporate profits is too high, and will need to be lowered, and they matter, which I will once again discuss later in the note. On the topic of “the Market is always right”, I am generally in agreement with this statement, but it is clearly not a 100% truism as Mr. Market has had some horrific misses that should not be just forgotten about.  

Let’s look at how Mr. Market did with discounting financial conditions over the last five years.  As shown below, I have included both the current period divergence between financial conditions and the Fed Funds rate (left chart — financial conditions vs Fed Funds) and 4Q18 when six to eight Fed hikes were priced into the fixed income markets and financial conditions considerably tightened, which contributed to the S&P 500 falling nearly 20% from the start of December to the day before Christmas only to suddenly and violently reverse (right chart — financial conditions vs SPX), which was a HUGE miss.   

My only point here is that despite strong shifts in market perceptions that lead to violent short-term moves in the equity markets at either the index level or causes sector/stock rotations do NOT always mean it is a done deal. Based on my work and my read on the Fed, I remain skeptical that the backdrop is one that suggests a new bull market has begun and the equity markets are off to the races. 

Coming into 2023, the S&P 500 was a bit technically oversold after a weak December and the lack of a Santa Claus rally, which suggested that the likelihood of a tactical bounce attempt would not have been surprising.  However, as financial conditions eased and equity participants were emboldened by the three strong Treasury auctions last week, equities markets surged, but I question both the quality and sustainability of the move. 

Why do I feel this way?  

First, when looking at the top two sectors thus far during 2023 — Comm Services (+15%) and Consumer Discretionary (+14.2%), the top intra-sector performers are an interesting list of names as shown below.  The only names in either sector that have favorable ASM readings, which is my proprietary earnings revisions metric, are the Casino-related names within Discretionary (WYNN, CZR, and MGM, which have been favorable for at least the past two months).  So, 20 names were strong price performers during January, and 17 look unfavorable in my work.  

Second, the rally has been fueled by short covering, and according to one bulge bracket firm a bucket of the most shorted stocks was up a staggering 19% during January.  So, not the best leadership.  In addition, if one deciled the S&P 500’s 2022 performance and then looked at their 2023 performance, the results clearly show that the worst deciles during last year have been the best year to date, while the best groups have been 2023’s laggards (chart below).  When this type of almost linear reversal occurs, it raises my eyebrow, especially if none of my key indicators are flashing bullish signals.  

January 2023 S&P 500 Performance — A Mirror Image of 2022

During 2H22, there was a good amount of chatter about excessive bearishness and that the equity exposure for institutional investors was quite low.  So, looking at several different data sets and diving into the data, I developed my new Equity Exposure Indicator in 4Q22 and introduced it in a publication at that time.  As shown below, this proprietary indicator did flash contrarian extreme low exposure readings last year in both June and October.  The late December/early January readings never reached an extreme low level, and currently have risen to near the long-term average.  This does not suggest that investors are now overly bullish or that the equity market can’t keep moving higher, but a lot of fuel has been spent to get us to current levels.  This could be a helpful indicator to keep an eye on as we move forward to help gauge positioning outliers. 

Equity Positioning is no Longer Excessively Bearish

The below are my updated macro/market thoughts:

• The first quarter is likely to see a tug of war each month as 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 remain 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 is not fully appreciated by investors.  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% (YES, this is correct and YES, it is now way out of consensus) as the most likely terminal rate with a high bar for flipping back to accommodation. 

• In my view, earnings revisions and forward profit expectations still 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. 

Bottom line:  My work continues to signal danger, and as the S&P 500 keeps drifting higher the reward/risk ratio is moving more and more away from reward.

The continuation of a weak earnings season, slashing of forward guidance, slowing domestic growth, and a Fed that will likely crush the dovish hopes and voice displeasure with the dramatic loosening of financial conditions in the weeks ahead is likely to throw cold water on bullishness. 

Although the current equity bounce could try to move a bit higher, my key indicators still strongly signal that it is a bear market rally that will fail.  My tactical tools are extended and suggesting that tactical upside potential is limited, at best, and a resumption of the move lower is nearing.

Thus, I continue to advise NOT to chase oversold bounces and to use the upcoming failure just like the late March and August S&P 500 tops that made lower lows.  I am still forecasting a break of the October 2022 equity lows. 

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 likely 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.

GENERAL CLIENT QUESTIONS/CONCERNS/TOPICS

• Confusion comments are still the most common view expressed by clients.

• Most of my interactions have shared that they have been using the ongoing equity market bounce to trim unwanted legacy positions with limited buying in favorite longer-term names. 

• What stocks should I be keeping a keen eye on? 

• Is LC Tech buyable or is it done for a while? 

• What areas are most at risk if my bearish outcome occurs? 

SPECIFIC CLIENT QUESTIONS

• Has the earnings season improved since last week?

• Are there any bottoming signs in the ASM indicator for the overall S&P 500?
  • What are your most aggressive tactical indicators saying?
    

MY ANSWERS

• Has the earnings season improved since last week?

NO.  The results are coming in at down 1.8%.  I continue to suggest that investors look at things without the Energy sector that is skewing the overall figures as it is projected to grow 65% yr/yr this quarter.   The ex. Energy results are down 5.6%.  The final results are projected to be down 4.6% (ex Energy down 8.9%) if we assume that all remaining companies will report inline, which historically is a conservative assumption. 

Based on my read on the forward guidance that has been provided by Corporate America’s management, the picture for the forward outlook is weakening.  There can be debate on whether earnings matter or not (My view is — THEY MATTER A LOT!), but my takeaway from both the earnings seasons and the revisions (see next page) is that the profit backdrop is anything but healthy.  In addition, expectations need to be lowered. 

• Are there any bottoming signs in the ASM indicator for the overall S&P 500?

NO.  After a 1-2 week pause, it is once again falling and has not yet reached its maximum negative reading, which would be an extreme low.  It is unusual to have aggressive Fed easing priced into markets without the ASM signaling capitulation has historically been driven by rising fears of significant economic slowing. 

Is this time different?  Can we have our cake and eat it too (150-200bps of easing without fears of economic slowing and declining profits)?  It is always possible, but something looks out of sync.  If the revisions don’t have a strong move lower on growth concerns, the odds of the Fed returning to accommodation would be quite low based on my work. 

• What are your most aggressive tactical indicators saying?

My most aggressive tactical tools have been quite mixed since the October 2022 low in the S&P 500 and have not had confirming extreme contrarian readings, which has suggested that a strong reversal in either direction was unlikely.  Thus, the strong up move in the S&P 500 during January was both unexpected and unusual.  Yes, they both made midcycle reversals during the first week of the year that historically have led to small magnitude and short-duration bounces.  They remain in conflict and tilt towards tactical upside being limited, at best.  I am on full alert for bearish rollovers, which could happen over the next week or two. 

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