Caution Advised Amid Downside Risk

With the first two months of 2023 now in the books, the year has started like a classic Rocky movie that has massive reversals.  The evil dovish/bullish bad guy, Clubber Lang or Ivan Drago, comes out for the opening bell during round one in January and totally pummels hawkish/bearish Rocky.  Our hero Rocky barely looks like he will survive and make it through the round.  Well, in true fashion, the Italian Stallion not only valiantly makes it to his corner for a recharge, but he comes out swinging and dominates round two during February.  The crowd is sitting on the edge of their seats and do not have a high degree of confidence about what the final outcome will be. 

Who is going to win?

When bringing this back to the equity markets, all of my client interactions have focused on what is the true underlying trend — 1) the battle with inflation has been won, the Fed is lower for shorter, and the beginnings of a new bull market have already occurred in October/January; or 2) inflation is coming down but it’s going to be a long hard fought battle, the Fed is higher for longer, and we are still in midst of an ongoing bear market as experienced in February.  There continues to be a lot of heated debate both internally and externally about where the macro and equity markets are headed.  Well, that’s what makes a market as investors and analysts use their own respective tools, insights, and experiences to drive their views. 

For readers, I certainly tipped my hand into which camp I remain in by casting the bad guys as being the dovish/bulls in January and the hero, good guy as the hawkish/bearish Rocky who emerged in February.  My work continues to suggest that the January move, and to an even bigger extent the rally off the October low, in equities that was largely built upon dovish Fed hopes was a fake out.  Based on my work and recent data releases, my longstanding view on inflation and where the Fed is going seems to be coming to fruition.  Indeed, I had kept my 5.25-6.0% terminal rate range expectations on the board even when it was looking implausible during January, and now I am evaluating if my right tail needs to be raised to 6.50%.  I know a more dovish forecaster/investor is shaking their head and likely thinking this is crazy, but YES, it needs to be explored.  More on this after I have completed my deep dive. 

Another topic that has been getting some increasing attention by investors during the last couple of weeks is corporate profits and the possibility that they are bottoming.  During February, a few things have helped bring this to the forefront:

1. The 4Q22 earnings reporting season that has been underway and has shown that the profits for Corporate America are not collapsing;
2. The domestic economy has remained resilient and the immediate start of a recession has not occurred; and
3. A chart has been circulating on the Street that shows that the equity market tends to bottom six to nine months BEFORE the absolute level of S&P 500 OEPS, which is an accurate representation of this historical relationship. 

Since I do a lot of work with earnings and revisions, I think it is important to address this issue as this is a critical piece of the puzzle to determine which scenario plays out for equities through year end, and possibly into 1H24.  Yes, there has been some data that could cause one to liberally infer that a trough has been reached for profits.  Being an analyst that attempts to identify second derivative inflections in nearly all my indicators, I understand and empathize with this interpretation under normal circumstances.  With that being said, when I look at my work on earnings revisions combined with my macro view, I am quite confident that the recent respite in the decline in forward earnings expectations is only a pause and not a beginning of a new powerful uptrend, which would be contrarian bullish if I am wrong and it is indeed bottoming.  As the character Dollar Bill is known for saying on the television show Billions, “I am not unsure in my view.” 

Let’s dive into this a bit.  I have written quite often over the last year about the overall estimate revisions for the broad market using an indicator that I call Analyst Sentiment Measure (ASM).  To summarize my past comments, the ASM indicator for the equity market broke below zero in late March 2022, which historically has been a 100% accurate signal for negative equity returns until it makes an extreme low, and was likely to head south for the 6-9 months that was the average duration of the previous six declines going back to 1990.  I have made an ongoing case that the ASM indicator has bottomed out before every major equity bull market over the last three decades, and that I was expecting the same to happen in the current cycle.  A positive inflection from an extreme low would likely be a critical signal that the bear was nearing its completion.  As shown below, the ASM indicator does show that it has technically stopped falling.  From my perspective, this looks more like a short duration pause rather than the start of a powerful reversal that is going to fuel a new bull market, and my forecast that it needs to fall further is still confidently in place. 

It might be helpful to describe what is normally going on during historical earnings revisions cycles and compare the current macro backdrop and what you personally think how the next 6-12 months play out.  The typical down earnings revisions period is driven by a Fed tightening cycle that then leads to a rise in economic growth fears.  While that is happening, the analyst community begins to lower their forward profit expectations and ultimately capitulation.  This last sharp down move, or what I like to refer to as the “over discounting” of reality, starts the clock ticking on opportunity for investors because the earnings bar is set extremely low.  Now, to get the earnings revisions that are extreme negative, growth fears are normally high and increasing, which ultimately leads to a Fed easing cycle that occurs within a quarter.  However, before the return to accommodation occurs, some time usually passes and the absolute earnings revision keeps falling, but the rate of change diminishes and becomes “less bad”.  This positive inflection has LED equity market reversals and is an important contrarian bullish signal when it finally flashes. 

So, let’s look at where we are today.  It appears to me based on my research that one of two main scenarios is playing out — 1) the economy continues being resilient, inflation falls slowly, the Fed stays higher for longer, and the real economic slowdown that causes the last sharp downturn in earnings revisions is still in front of us (MY BASE CASE); or 2) the economy is now slowing enough to keep inflation on its path directly to two percent, and the earning revisions will start falling faster over the next couple of months.  I cannot support any case that suggests an immediate dovish Fed and that earnings have already troughed.  Thus, my work strongly suggests that forward earnings expectations and absolute levels have NOT yet bottomed out, and this is a major piece of my ongoing bearish case. 

The below are my updated macro/market thoughts:

• Fed expectations have dramatically shifted back to a more realistic hawkish stance, and as stated a few weeks back when this occurred, I would begin reevaluating putting my uber bear scenario of 3200-3000 back on the table. 
• Labor market strength remains resilient but will need to show signs of weakening to help reach the 2% end game. 
• The Fed is higher for longer and the terminal rate reaches 5.25-6.0%. I may need to RAISE my 6% high end target.
  • A premature pause raises the probability of higher terminal rate and does NOT lower the odds.
• NO EASING — Fed keeps the ultimate terminal rate unchanged for an extended period …
• Even though it appears less imminent, the economy looks headed towards a shallow recession.
• Corporate profit expectations remain too high and need to be lowered as there are strong headwinds. 
• Importantly, the immediate upside potential for the S&P 500 appears limited, at best, while considerable downside risk remains for equity investors. 
• Cyclicals are holding up, but my work says this is where the risk is growing the most.
• Single stock opportunities are sparse, but they are expected to increase.  

Bottom line:  My research suggests that my ongoing bear case is intact and that the countertrend equity market rally that began in October and got supercharged during the January shift to aggressive dovish Fed hopes, is likely over.  The terminal rate is now in the bottom end of my long standing 5.25%-6.0% range, and if the economy continues to be resilient, I may need to raise the right tail to 6.5%. 

The price level of equities has only marginally adjusted in February, and does not reflect my base case for the Fed and for corporate profits, which still appear to be too high and will need to be lowered.  

Additionally, my tactical tools that were signaling an elevated probability that an equity market reversal was imminent at the beginning of February have not yet reached negative extremes, which will likely be needed to signal that the next attempted short duration small magnitude rally was imminent. 

Thus, this leaves the S&P 500 risky for equity investors.  Hence, I am still advising being careful, cautious, and patient while being on full alert for potential opportunities that may present themselves during my expected challenging period. 

For relative investors, my work still sees attractiveness in classic Defensive non-cyclicals and some Offensive Growth areas.  I continue to be interested in the highfliers of the last cycle as some are still quite beaten up despite their respective 2023 bounces. 

GENERAL CLIENT QUESTIONS/CONCERNS/TOPICS

• Less confusion, but frustration levels remain high.

• More questions about my thoughts if the 10-yr yield can get above 4%, and if the U.S. dollar may keep rising. 

• Lots of discussion about the earnings stuff that I mentioned earlier. What is my ASM indicator showing for the broad-based estimate revisions trend? 

• Tech continues to be the most asked about sector, and Energy is second. 

SPECIFIC CLIENT QUESTIONS

• What Is your main HALO indicator for the overall market showing now?

What Is your main HALO indicator for the overall market showing now?

It has peaked and continues to fall, which has historically preceded periods of limited equity upside, and more often periods of downside risk. My longstanding less than constructive view for the S&P 500 is unchanged, and now with its HALO headed lower the countertrend bounce that began in October looks to be finished. The tactical outlook will remain unfavorable until this key indicator shows signs of its next bottom. Until then, risk remains elevated for equity investors.