The question of have stocks bottomed 2.0 builds on the work in Dispatch #16 & Dispatch #18. Our latest valuation and earnings analysis suggest that stocks have not bottomed, although bearish positioning provides room for a bear market rally. The US economy today is robust, but interest rate hikes take 12+ month to impact activity. We see earnings risks peaking in mid-2023 as the sharp interest rate hikes of 2022 bite. We would not be surprised by a Santa Claus rally in the coming weeks.
Dispatch #19 completed on November 11, 2022, focuses on this single subject.
Have Stocks Bottomed?
The timing of this edition of have stocks bottomed is similar to the summer edition (see Dispatch #16) as we are once again in a bear market rally. Markets rarely go straight down and bear market rallies can be furious. At Rockden, we focus positioning client portfolios for the long term where our macro background provides an edge. We continually test our thesis to make sure we are evolving as new data become available.
When judging a bottom in the equity market we look at three main things: Have valuations sufficiently corrected, corporate earnings trends and positioning/sentiment indicators. Let’s start with valuation and earnings.
S&P 500 P/E remain elevated despite drop
This historical S&P 500 P/E chart shows that we are off the frothy 37x P/E valuations peak of 2021. Yet, we are still not near the median SP 500 P/E ratio of about 15, and the chart shows that markets can overcorrect during bear markets. This data leads us to believe that we are closer to the bottom than the Covid top, but at a multiple of just under 20, there is likely to be further downside pressure to come. Earnings downgrades, as we discuss in more detail below, are just starting to accelerate.
S&P 500 CAPE (Cyclically Adjusted Price to Earnings) Ratio
Regular readers of The Dispatch will know that it was only a matter of time before we discussed the CAPE Ratio. The CAPE ratio uses the average of the last ten years of earnings and adjusts it for inflation. This provides a more accurate picture of where valuations stand relative to the business cycle. The median CAPE Ratio is just about 15. With S&P currently at 28x CAPE, this metric project substantial downside to median valuations. The CAPE ratio is likely to offer the most conservative entry point, however, we believe that company margins are likely to remain structurally higher due to ongoing market share consolidation. This should translate into the CAPE staying elevated relative to history.
Earnings Are Slowing
According Factset’s latest earnings update, 85 percent of the S&P 500 has reported 3Q earnings with 70 percent reporting a positive EPS surprise. On the surface this may sound like a positive, but if we dive a bit deeper, we can see that these beats come on the heels of significant downside revisions. The chart below shows the directional skew of earnings revisions over the last eight quarters. The last two quarters have seen estimate cuts accelerate into reporting season.
We see a high probability of estimate revisions staying negative and earnings ultimately falling YoY. For 2023, analysts’ consensus sees 5.6% earnings growth to 233.30 (index EPS). As this chart from BofA shows, the EPS has come off substantially since peaking this past summer.
Furthermore, energy has been a notable contributor to positive earnings growth. SP 500 earnings excluding energy is far worse as the charts below illustrate. Even energy has started to fade recently as crude has dropped below $100 a barrel.
Our valuation and earnings conclusions have not changed from the summer. Monetary policy works with a lag, and the interest rates hikes of 2022 will impact economic activity in 2023. The earnings risk is not a 2022 event as the economy remains robust today. It’ll be skewed to 2023 and 2024, and we have more earnings disappointments ahead.
Macro indicators point to future slowing
The Macro variables we track to monitor our expectations continue to point to further slowing, compared to highlights in Dispatch #18. Leading indicators are now pointing to a recession.
LEIs have reliable predicted recessions
Tightening conditions of the Fed’s Senior Loan Officer (SLO) survey also point to weaker earnings ahead. This is a tight correlation. It’s worth asking why analysts covering companies still see earnings growth. That’s often because Wall Street analyst projections hover around company guidance. In a highly financialized economy, where most of the CEO compensation is from stock options, there’s limited incentive to guide lower. Plus, companies have levers to move earnings from one quarter to the next, but they can’t delay a longer-term earnings slowdown.
Tightening standard at domestic banks points to weaker earnings
The SLO also predicts higher credit spreads, which is likely a contributing factor to lower earnings as financing costs rise at the margin.
Professional investors remain cautious
The one area that supports a potential rally is bearish sentiment. The Bank of America Fund Manager’s Survey shows institutional managers remain extremely bearish.
This positioning along with the need to repair poor YTD performance could well lead to a Santa Claus rally, which may have started following the favorable October inflation print. Markets also don’t have to worry about earnings until mid-January, which provides a reasonably clear road. The November CPI report is the one possible wrinkle, but these volatile markets could well post double digits upside by then. From our typical long-term approach, we’ll aim to participate in this bear market rally up to a point before expressing our cautious view. Expect Fed speakers to start to push back against rallying markets as that eases financial conditions. The key monetary policy transmission mechanism to cool the economy and inflation is financial conditions. This week, those conditions have eased rather substantially as WSJ’s Fed reporter tweets.
The ~ 17% rally from June to August was supported by a favorable July CPI report. Earnings were less of a headwind during the summer. Inflation has shown to have stochastic (random or up/down) path, and we continue to see risks of unfavorable data in the coming months. Earnings are clearly deteriorating, which will present a headwind that wasn’t a factor in bear market rallied YTD. Don’t overstay this current rally, and be careful thinking we’ve seen the lows already. Bear markets don’t typically end with a VIX in the mid 20s.
Stay safe and do reach out if you have any questions or comments about the material in this Dispatch.
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