4Q22 EPS misses are punished far less (-1%) vs 3Q21-3Q22 avg (-2% to -3%) suggesting lots priced in. YTD equity gains >5% (day 25) signal gains into YE (16 of 17 times) median gain 26% since 1950.

We publish on a 3-day a week schedule:

– Sun eve / Mon am
– SKIP MON
– Tue eve / Wed am
– SKIP WED
– Thu eve / Fri am

Half-full has been a better strategy YTD than Half-empty

Stocks have been soft over the past week as markets debate the trajectory of inflationary pressures, particularly wages. But even as Fed/inflation narrative is debated, since the start of 2023, the S&P 500 is up >8%, something that has happened only 4 times since 1950. And there are only 17 instances (of 73 years) where YTD gains thru 25 trading days are >5%. These are shown below:

• Of the 17 instances, markets gain from day 26 to YE 16 of 17 times
• Median full year gain is +26%, with median gains day 26 to YE of +16%
• This implies S&P 500 is ~4,800 by YE, inline with our target and far higher than Street Consensus of 4,000. In other words, it will be an “exception” if equity markets weaken
• There are those who say earnings are the next “shoe to drop” but EPS estimates been falling for many months already. So, what arguably matters more is how are stocks reacting to EPS results.
• As our Quant Strategist Adam Gould notes, companies missing results in 4Q22 are falling ~1%, compared to an average decline of -2.5% to -3.0% seen 3Q21 to 3Q22. So investors are punishing misses to a far less extent.
• The two best performing sectors YTD, Comm Services (+17%) and Discretionary (+16%) have the largest negative revisions into 4Q22 results (only Financials worse). And again, highlighting a lot of the bad news of 2023 EPS is getting priced in. This doesn’t mean EPS falling is good, but this does show lots are priced in.
• Next week, the key data point will be January CPI released on 2/14 (8:30am ET) and we expect Core CPI to come in below Street consensus of +0.4% (vs +0.3% Dec). The over-arching story on inflation is that rising downside risks are as arguable as upside risks. And the “inflation risk” premium should be fading from markets and if such is the case, VIX should fall and this should support valuations.
• Moreover, 34% of the CPI basket (weighted items) is in outright deflation, well above the 50-yr average and this crossover took place in Oct 2022. That is when inflation decisively started to fall. This is similar to Oct ’82 when this figure crossed above 30% and marked the end of that inflation war.
• In the shorter term, the strong January gains arguably pulled forward some return in Feb. This is something we wrote about earlier this week. And this is consistent with the view by Mark Newton, Head of Technical Strategy, who sees stocks peaking near-term and consolidating into March.

STREET ADAGE: “If the market doesn’t make sense, respect the price action”

For the most part, the equity gains YTD have been met with skepticism and warnings of “bear market trap” by most pundits and strategists. Recall, the Street nearly universally warned equities would struggle in 1H2023, with many predicting a decline to 3,200 or lower.

But as the above analysis shows, market internals are speaking a far different story.

• if the equity markets defy one’s framework, it might be time to revisit the “narrative”
• the bond market implies inflationary pressures are fading quickly
• in fact, our Head of Technical Strategy, Mark Newton believes US 10-yr could fall below 3.3% and even as low as 3% by YE.
• our base case has been US inflation peaked in mid-2022 and has been tanking since Oct 2022.
• thus, the rally in equities reflects the anticipation of the inevitable course correction coming from the Fed.

INFLATION: Jan readings for U Mich Inflation, CPI and PPI coming in the next week

There is a lot of incoming inflation data in the next week or so:

• 2/10 10am ET: Feb U Mich 1-yr inflation Street +4.0% vs 3.9% Jan –> we think 3.9% lower
• 2/14 8:30am ET: Jan Core CPI Street +0.4% vs +0.3% Dec –> we think +0.3% or less
• 2/16 8:30am ET: Jan Core PPI Street +0.3% vs +0.1% Dec –> no view

The over-arching story on inflation, in our view, is that structural inflationary pressures are abating quickly. Take a look at the % of items in deflation:

• 34% of CPI basket is in outright deflation, well above the 50-yr avg of 30%
• This is similar to Oct ’82 when this figure crossed above 30%
• This tells us that disinflationary forces are widening as energy, goods, food and other components are in disinflation

EPS: Two best performing sectors YTD had worst EPS revisions

One of the most frequent questions investors ask us is when will the bad news on EPS get priced in?

• We know the simple answer is when EPS revisions bottom, investors will become more confident.
• We also know that there will be a crossover point where equities become less reactive to declining EPS forecasts. This happens 9 to 12 months before EPS estimates actually bottom.
• 4Q22 EPS results season suggests might be getting some clues we are nearing that turning point.
• The two best performing sectors YTD, Comm Services (+17%) and Discretionary (+16%) have among the worst EPS revisions. And Healthcare and Materials, which had positive revisions, are among the worst performing sectors.
• About 2/3 S&P 500 has reported 4Q22 results and those missing (32%) are getting far less punished as well. The sell-off is -1% in 4Q22 compared to 3Q21-3Q22 average of -2% to -3%. This is another sign that much of the “bad earnings” is priced in.

And as shown, about 2/3 of S&P 500 companies have reported and the EPS season so far is OK. 68% are beating estimates and the surprise magnitude is 1.9%. There are similar levels for top-line and overall revs are set to grow 5% in 4Q22 — not entirely bad.

• but with revenues up +4.7% nominally, is this telling us something about inflation?
• after all, shouldn’t S&P 500 revs reflect inflation?

EPS: Misses getting less punished = bad news increasingly baked in?

And as our Quant Strategist, Adam Gould, notes, the stocks missing EPS results are falling less than prior quarters:

• so far in 4Q22 season, decline for misses is -1% or so
• this is less than half of the -2.5% to -3.0% seen 3Q21 to 3Q22, suggesteing that a lot of bad news is priced in regarding earnings.
• conversely, those beating estimates are seeing similar gains.

But the trend in EPS continues to drip low as shown for the S&P 500 and 11 sectors below. The charts highlight the forecast for 2023 EPS and the baseline (100) is 4 months earlier.

TACTICAL: Feb shaping up to be tough month

In the shorter term, we think January borrowed from February. As shown below, in those years when markets are up >5% thru day 25 (like 2023), into month-end:

• win-ratio into month-end is only 53% and is lower than 67% for other months
• so, Jan strength borrowed from February
• but it doesn’t change the positive outlook into YE

Newton’s Take on Key Drivers

10-year Yields

Technically speaking the recent bounce in $TNX now looks to be approaching meaningful resistance.  This is based on a combination of Ichimoku cloud resistance, along with ongoing downtrend lines.

Given that the ongoing correlation with yields and stocks remains quite negative, any pullback in yields, for whatever reason, argues for stocks to push higher.

It’s right to monitor rates in the days to come.  However, I don’t anticipate an immediate push back over 3.80%.  Thus, this minor Treasury correction/yield bounce should offer opportunity, as I expect yields to turn down into the month of March.

Treasury yield cycles look bearish into late March.  This should coincide with yields pulling back further, and most bounces to translate into buying opportunities for Treasuries.

CFTC Sentiment in Treasuries has reached the lowest levels in nearly 5 years when examining CFTC net Non-commercial Treasuries positioning (see chart below) –    I view this as bullish for Treasuries to rally more, and rates should drop over the next couple months.

Any breach of 3.32% offers little to no support until 3.11% and then 3.000%, which is a huge psychological level.

2-year Yields

Consolidation in 2-year yields since November has done little to no real technical damage to yields but merely consolidated near the highs of the 1-year range.  Recent spikes in yields this past week look technically bullish, and I expect might lead to a coming test and breakout back above 4.799% which was the intra-day highs back in November.

While I expect this move should prove temporary, this does look to have the potential to carry 2-year yields up to a zone of resistance from 5.00-5.27%, which is a significant level marking former peaks back in 2006-7.

Given the slowdown in momentum on this recent stalling out in yields, any further escalation would likely result in negative momentum divergence, making a rate rise over 5.27% unlikely at this time.

Under 4.00% is necessary to call for a breakdown in 2-year yields which hasn’t happened and seems less likely in the short-run, technically speaking.

DXY

Minor stabilization has begun within an ongoing downtrend in the Dollar from last Fall.   While momentum has indeed picked up suggesting an eventual rise in the Dollar is likely, I don’t see this happening technically for the next few months.   DXY has meaningful overhead Ichimoku weekly cloud resistance and likely should turn back lower into March/April which should also coincide with yields dropping.   The break of the 103 level from 2020 which was thought to potentially offer support to DXY means that price trends and momentum remain clearly bearish from a structural perspective and stabilization/rallies will take time.

Technically I expect weakness down to 99 in DXY which would represent a 61.8% Fibonacci retracement zone of support.  Upon reaching that level, there could be a sharp rally that occurs during April-June timeframe, where Risk assets might consolidate a bit   (Note that the rally in risk assets directly happened since October with Dollar and yields moving lower.  If both start to move higher quickly, technically this could be a risk to Equities in the very near-term given current correlation trends, which don’t look to be breaking thus far.

I remain bearish on DXY for the next 1-2 months and also for the next 12-24 months, but suspect that a sharp rally could be approaching in Q2-Q3 that might be a counter-trend move, and then allow for additional weakness in DXY to unfold.

Dec 2023 Inflation breakevens

Short-term breakevens have begun to stabilize lately after having pulled back sharply to test a 50% retracement of the entire rise from 2020.  This area looks important, and recent escalation in B/E over the last month might persist in the short run, and could rise back to near 4.00% before falling further.

Overall, it’s tough to be too bullish on a big rise given the extent of the weakness since last year from the highs.  However, a counter-trend snapback does look quite possible over the next 3-5 months before B/E starts to rollover again and pullback down under recent monthly lows

MARKET STRUCTURE: Vast improvement in market structure – 5 SIGNALS now

Lastly, the S&P 500 has seen vast improvements in market structure. This is something that Mark Newton, our Head of Technical Strategy at Fundstrat, has been commenting upon. Take a look:

• on 1/9/2023, the “rule of 1st 5 days >1.4%” triggered
• on 1/12/2023, the trifecta of market breadth triggered, first time EVER since 1950 (see past reports)
• on 1/23/2023, the 3rd day S&P 500 close >200D, first time since Jan 2022
• on 2/2/2023, S&P 500 “golden cross” where 50D > 200D, first time since March 2022
• on 2/7/2023, S&P 500 closed above 50% retracement of entire decline for 2nd day

The list is growing to validate that internal market structure of S&P 500 is vastly improving.

STRATEGY: Technology is primary beneficiary of Fed “course correction”

The best way to play easing financial conditions, in our view, is owning Technology and even small-caps. As the charts below highlight, both $QQQ and $IWM are breaking out decisively

• IWM is more evident as the breakout was 1/11
• QQQ breaking out on a relative basis and just crossed above the 200D

And Technology remains a group where there are many down and out names.

• ~20% of Technology stocks in the broad market index Russell 3000 are >75% off their highs
• That means 1 in 5 technology stocks has been absolutely obliterated

And as shown below, there is a greater bludgeoning in Healthcare and Comm Services (which is essentially TMT).

Similarly, short interest has been rising in Technology. So this rally YTD has been met with investor skepticism and they are increasing their short selling of Technology. To me, this is fuel for further upside.

Technology largest beneficiary of easing FCIs and less correlated to PPI

The two big macro changes to impact 2023, in our view, are:

• easing of financial conditions, of FCIs
• easing of PPI, or easing of cost pressures for producers
• some sectors are negatively impacted by falling PPIs as this spells margin pressure

As shown below, Technology is arguably the greatest beneficiary of each:

• Technology at 88% has the highest correlation to easing FCIs
• and has less exposure to PPIs falling as margin correlation is only 28%

Moreover, Technology technicals seem to be improving:

• $QQQ relative performance of SPY broke above a key trendline
• and QQQ is now closed above the 200D for the first time since April 2022
• So the technical picture has flipped positive

STRATEGY: VIX matters far more for 2023 returns than EPS growth

Our data science team compiled the impact on 2023 equity returns from variables:

• S&P 500 post-negative year (2022)
• the varying impacts of
• VIX or volatility
• USD change
• Interest rates
• EPS growth
• All of the 4 above, positive or negative YoY
• Data is based on rolling quarters and summarized below

The surprising math and conclusions are as follows:

• most impactful is VIX
• Post-negative year (rolling LTM)
• if VIX falls, equity gain is 22% (win ratio 83%, n=23)
• if VIX rises, equity lose -23% (win ratio 14%, n=7)
• I mean, this shows this all comes down to the VIX
• EPS growth has little impact
• If EPS growth is negative YoY (likely), median gain +14.8% (win-ratio 70% n=33)
• If EPS growth is positive YoY, median gain is 15.5% (win-ratio is 78%)
• Hardly a sizable bifurcation

As the scatter below highlights, we can see the sizable influence of the VIX. Even in all years, the VIX is a key factor:

• in our view, if inflation falls sharply
• and wage growth slows
• Fed doesn’t have to cut, but this is a dovish development
• we see VIX falling to sub-20
• hence, >20% upside for stocks

And as shown below, EPS growth has a somewhat important correlation, but hardly as strong as VIX changes.

• the difference in median gain is a mere 70bp (positive vs negative) post-negative year
• the importance of EPS growth is stronger in other years

STRATEGY: Financial conditions should ease in 2023, driving higher equity prices. Technology, Discretionary and Industrials levered to easing FCI

The “base” case for 2023 should be below. That stocks gained >1.4% in the first 5 trading days, and this portends strong gains for the full year:

• Post-neg year + up >1.4% on first 5 days
• Day 5 to first half median gain is 9.5%
• Full year median gain is 26%, implies >4,800 S&P 500
• 7 of 7 years saw gains.

Those 7 precedent years are shown below.

• the range of full year gains is +13% to +38%
• so, this is a VERY STRONG signal
• the two most recent are 2012 and 2019
• we think 2023 will track >20%

The path to higher equity prices is discussed above:

• core inflation falling faster than Fed and consensus expects
• wage inflation is already approaching 3.5% target of Fed (aggregate payrolls)
• Fed could “dovishly” leg down its inflation view
• allowing financial conditions to ease
• bond market has already seen this and is well below Fed on terminal rate

BASE CASE: The “maths” for what to expect in 2023, post a “negative return” year (2022)

Question: how common is a “flat” year? Our team calculated the data and it is shown below:

• since 1950, there are 19 instances of a negative S&P 500 return year. In the following year,
• stocks are “flat” (+/- 5%) only 11% of the time (n=2)
• stocks are up >20% 53% of the time (n=10)
• yup, stocks are 5X more likely to rise 20% than be flat
• and more than half of the instances are >20% gains

So, does a “flat year” still make sense?

As shown below, these probabilities are far higher compared to typical years:

• since 1950, based upon all 73 years
• stocks are “flat” 16% of the time vs 11% post-negative years — BIG DIFFERENCE
• stocks are up >20% 27% of the time vs 53% post-negative years — BIG DIFFERENCE
• see the point? The odds of a >20% gain are double because of the decline in 2022

37 GRANNY SHOTS: Updated list is below:

The revised 37 Granny shots are shown below. The list is sorted by the most attractive (most frequently cited) to least. To be a “Granny shot” the stock needs to appear in at least two portfolios. The list of tickers and their respective themes is shown below.

Communication Services: $GOOGL, $META, $OMC

Consumer Discretionary: $AMZN, $GRMN, $TSLA

Consumer Staples: $BF/B, $KO, $MNST, $PG, $PM

Energy: $DVN, $EOG, $MRO, $OXY, $PSX, $VLO, $XOM

Financials: $AXP, $JPM

Health Care: $AMGN, $HUM, $ISRG, $MRK, $UNH

Industrials: $GD, $JCI

Information Technology: $AAPL, $AMD, $CDNS, $CSCO, $KLAC, $MSFT, $NVDA, $PYPL

Materials: $NUE

Real Estate: $AMT