Risk Remains in Rangebound Market

The equity markets remain rangebound since 5/22, with varying performance across different indexes — some showing slight gains, others remaining flat or marginally down. However, it is crucial to recognize that the S&P 500 does not encompass the entire breadth of the equity markets. Beneath the surface of the headline benchmark index and the dominating mega-cap tech names, the average equity market reveals signs of weakness, aligning more closely with my forecast over the past six months.  Based on my key indicators and analysis, it is clear that we are not yet in a new bull market and have not fully escaped the challenges that began during 1Q22.

The inflation data released last week and the preliminary reading on May consumer sentiment were certainly not bullish in my view and are now providing additional worries on top of the ongoing problems in the regional bank space. The headline April PPI and CPI data may have revealed continued deceleration in the inflation rate from 2022’s peak readings, but the underlying details clearly suggest prices are remaining quite sticky on the way down, which has been my longstanding expectation. Indeed, the core CPI appears to be stabilizing in the 5% area, while some are pointing to the core PPI (ex-trade) starting to find a floor around 3%. 

In addition to these data, there was the 6.3% rise in unit labor costs recorded in 1Q23 and the modest upticks in both the one-year and five-year inflation expectations released in Friday’s latest Michigan Consumer Sentiment survey. The possibility of inflation finding a floor well above the Fed’s 2% inflation target while investors are also getting more concerned about economic growth is leading to stagflation worries.

Contrary to the optimistic sentiment prevailing in some circles, my research still does not indicate the beginning of a new bull market.  A couple of points to consider — valuation and historical equity drawdowns during recessions. 

Valuation.  If one simplistically looks at U.S. equity market capitalization vs U.S. GDP as shown in the chart below, which is one of Warren Buffet’s preferred metrics, this ratio has indeed moderated from its late 2021/early 2022 peak of over 2.0 and has fallen to roughly 1.6.  However, no bear market bottom since 1980 has ever been recorded with this metric still above 1.2.  Thus, if a new bull has begun, it would be the most expensive equity market starting point based on this indicator in the last 40-plus years. 

Historical equity drawdowns during recessions.  Since 1929, according to B of A, the S&P 500 had drawdowns of over 20% in seven of the last eight recessions, and in nearly all of them the largest decline for the cycle occurred during the recession and not prior to when they started (see chart below).  Hence, unless the recession will be retroactively backed dated at some point in the future to 2H22, which I do not believe to be likely, or if one does not think a recession will occur at all, the current period seems to be quite unusual thus far.  If my forecast is correct that the weakest economic quarters are still in front of us, history would suggest that there is still some pain to be had for the equity markets before shifting our attention to a new surging bull market.    

The Federal Reserve’s fight against inflation, combined with uncertainties surrounding future monetary policies, keeps the backdrop for equities challenging, especially as forward profit expectations remain too high and still need to be lowered as suggested by my analysis. 

With that being said, the domestic economy remains resilient despite signs of cracking and there is enough ambiguity in the day-to-day data releases and headline news to keep the tug-of-war between the bulls and bears heated and inconclusive for now.  The bulls continue to highlight the market’s toughness in the face of negative news, while bears point to the lack of a breakout and poor breadth of participation as signs of weakness.  Navigating the equity market amid such conflicting viewpoints becomes increasingly challenging and has led to a lack of a definitive S&P 500 price move in either direction. 

Last week, I did my monthly deep dive into my 4000+ U.S. single stock universe using my ERM model, which is heavily impacted by earnings revisions.  As I like to remind folks, I find this exercise so useful for seeing what is really happening at the tree level while at the same time shielding myself somewhat to the macro noise for a short period of time. 

The key high-level takeaways from this deep dive are similar to the previous month’s findings:

• Forward profit expectations are still unrealistically high and need to be adjusted downward.
• Economically sensitive stocks appear to be more vulnerable, given uncertainties surrounding the global economic recovery and potential policy shifts.
• Larger-cap stocks generally exhibit more favorable prospects compared to small and mid-cap stocks.
• Significant divergences exist within sectors and sub-industries, emphasizing the importance of diligent stock picking and recognizing idiosyncratic factors that can add value to portfolio results.

With the S&P 500 still lingering near 4100-4200, my work does not provide much, if any, evidence of significant upside potential from this level, which for me would mean at least 10-20% upside over 6-12 months.  Thus, I reiterate my views that investors need to continue to be mindful of downside risk potential, avoiding large exposures in my highlighted unfavorable areas, while being both vigilant and aware of potential single stock opportunities throughout what my indicators propose will be a rocky period going forward.

For relative investors, my research still points to relative attractiveness in classic defensive areas, some offensive secular growth stocks, and to generally favor high quality versus low, larger cap over Smid, and secular instead of cyclical. 

The below are my updated macro/market thoughts:

• Labor market strength may be waning somewhat, but signs of outright weakness and broad-based job losses are still not flashing, which keeps the Fed’s inflation fight challenging.
• Core inflation readings are not falling at the same pace as before and have caused some uncertainty about their path in the coming quarters, which lowers the probability of the market’s dovish Fed expectations.
• I remain in the “Fed is higher for longer” camp, and my forecast for the terminal rate is still 5.25-6.25%. I am keeping this under review for another lowering in the coming months if the fears of a credit crunch accelerate.
• NO EASING — Despite the recent problems in the banking industry, my view remains that once the Fed does pause it will likely keep policy unchanged for an extended period.
• The economy looks headed towards a shallow recession, and then an extended period of sluggish growth.
• 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 still appears limited, at best, while considerable downside risk remains for equity investors.
• From a positioning standpoint, economically sensitive areas/names are looking the riskiest based on my key indicators while secular growth ideas look relatively favorable.
• Single stock opportunities are sparse, but they are slowly increasing. The general theme is higher vs lower quality and larger vs smaller cap.

GENERAL CLIENT QUESTIONS/CONCERNS/TOPICS

• There remains a decent quantity of skepticism about the strength of the ongoing equity rally. 

• I still am not hearing any excessive amounts of bullishness or bearishness. 

• Investors continue to want to spend more time discussing how to position. 

• There were some value managers that have started nibbling on banks and energy, acknowledging that their respective bottoms may not be in yet. 

• There is still a lot of interest about what is happening with forward earnings expectations.

SPECIFIC CLIENT QUESTIONS

• What are the key points from your monthly single stock ERM deep dive update?

What are the key points from your monthly single stock ERM deep dive update?

• The earnings backdrop is still not collapsing.  It is melting away and the consensus needs to move lower.
• Despite the 1Q23 earnings season results, which were better than the consensus expected and in line with my forecast, the corporate profit environment is not improving.
• Economically sensitive names continue to look at risk as their numbers do not reflect my projected slowdown in the economy.
• Secular growth areas/names seem to mainly be in their respective lower right-hand corners and are at or near what looks like contrarian favorable levels. There are a lot of Tech areas, HC equipment, and higher-quality single stocks.
• The Energy sector continues to inch closer to an upgrade back to above neutral.

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

Tech — ADBE, FTNT, ORCL, TYL, MSFT, INTC

Health Care —BAX, BDX, BSX, DXCM, EXAS, EW, HOLX, ISRG, PODD, RMD, STE, ZBH, SYK, ALGN, XRAY, PEN, COO, DVA, HCA, UHS, WST, ZTS, and nearly the entire Life Sciences sub-industry continues to get close (DHR, ILMN, PKI, TECH stand out the most). 

Staples— SYY, COST, TGT, WMT, TAP, MNST, PEP, GIS, K, MCK, CHD, CL, CLX, PG, MO, PM, and CPB.

New names that got my attention:  CSX, VRSK, MA, and PLD.

Other large cap names that caught my attention —BA, HWM, LMT, RTX, GE, CMG, DRI, MCD, SBUX, YUM, and non-bank Financials (FIS, FISV, LNC, BRK/B, CBOE, CME, ICE, and NDAQ).

And for you contrarians, I continue to suggest revisiting INTC as it screens as one of the most interesting contrarian stocks in the entire universe. 

The Bank and related names still look awful and not yet finished, in my view. 

Unfavorable and looking quite weak based on earnings revision trends:

Too many to mention, and I continue to wave the warning flag for Cyclicals.