The ongoing tug-of-war that I have been discussing since the beginning of the year seems to have tilted towards “all is good.” Smooth sailing ahead. The banking crisis has been averted. The Fed will have to end its hiking cycle and return to accommodation. The economy and corporate profits will withstand any challenges and remain resilient while inflation keeps falling right to the magic 2% target without any further policy action required. Crush the VIX and aggressively shift back to higher-multiple Technology and other growth-related areas because a new bull has started.
So, sounds reasonable, right? Pardon my sarcasm. I am going to keep my intro comments on the shorter side in this note because not a lot has changed in my work.
Yes, at the margin, my longstanding view of higher for longer for the Fed and an ultimate 5.5-6.5% terminal rate range may need to be tweaked lower. Importantly, however, my work still suggests the markets are underestimating Chair Powell and Gang’s resolve to fight inflation, and that the probability for the return of easing is likely not going to happen without explicit and worsening banking contagion.
Forward profit expectations are still too high based on my analysis and, until more negativity is discounted, the S&P 500 has limited upside potential. On a relative basis, valuation levels have once again tried to expand as market interest rates have fallen, which makes sense to some degree, but they never became significantly cheap in the first place. Hence, my research does not show the overall market being attractively valued with the S&P 500 above 4000.
Inflation is still a problem and the fight to get it back to the Fed’s 2% yr/yr target is going to be hard fought and likely take time. Also, while it is elevated, it keeps the probability of easing and other outright stimulative central bank policy actions less likely.
The economy is still being resilient with small cracks beginning to show, but the lack of widespread labor market weakness is likely going to complicate the ongoing debate about what the Fed is ultimately going to do. My work suggests that domestic growth is headed for a shallow recession and then an extended period of sluggish growth, which will not resemble the more V-bottom recoveries that we have seen quite often over the last two decades.
With all that being said, when one only looks at earnings revisions at the single stock level, there are some interesting things that are occurring. Most of the favorable names that are flagging in my ERM model have some commonality — higher quality, larger cap, and secular growth. There are some classic contrarian ideas that are beginning to show up, and I continue to flag $INTC as one that investors should not miss. The areas of risk clearly seem to be in lower quality, smaller cap, and economically cyclical areas.
The below are my updated macro/market thoughts:
- Labor market strength remains resilient but will need to show signs of weakening to help reach the 2% inflation target.
- Core CPI ex. Housing, which has been flagged by Chair Powell as one of his key metrics, has rolled back up, which is not supportive of stopping the inflation fight.
- I have been in “the Fed is higher for longer” camp and the terminal rate reaches 5.50-6.5%. Although my research shows there is more work to do in the inflation fight, I might likely have to lower my expectations in the coming weeks.
- I still have the view that a premature pause raises the probability of higher terminal rate and does NOT lower the odds.
- NO EASING — Despite the recent problems in the banking industry, my view remains that the Fed keeps the ultimate terminal rate unchanged for an extended period. Chair Powell reiterated today that a return to easing is NOT in the Fed’s base case. …
- 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.
Bottom line: My work continues to signal danger.
The ongoing levitation higher by the S&P 500 appears to be driven by investors that now appear to have no signs of fear, with the VIX getting crushed from its mid-March high near 29 to a reading today below 20. Also, the fixed income market seems to be pricing in Fed eases at the same time.
The domestic banking system has apparently been saved so investors should have no fear, and despite this we should also be expecting Chair Powell to lose his talons and turn back into a dove. It is a nice story, but my work does not support it. Thus, the current market expectations will likely need to be readjusted again just like what happened in February following the January dovish hopes that grew to unrealistic levels.
Thus, I maintain my negative view on the equity market and urge caution to investors. Based on my research, there is still a significant amount of risk for equity investors, and it is advisable to remain vigilant and patient. I continue to recommend using tactical countertrend rallies as an opportunity to raise cash, reposition, increase hedges, and increase short positions, given the uncertain and volatile market conditions.
For investors who must be fully invested or focus on relative performance, my analysis indicates that a barbell strategy of cash, defensive positions, and select secular growth names will outperform. My earnings revision work suggests that cyclical areas are likely to face significant downward estimate cuts, as I have previously forecasted. Therefore, investors should focus on idiosyncratic and high-quality single stock names with cyclical exposure.
GENERAL CLIENT QUESTIONS/CONCERNS/TOPICS
- Why are the equity markets acting so well despite what appears to be a challenging operating environment?
- The number of outright bears has fallen, but I still talk to a low number of outright bulls. Most are neutralish and focusing on positioning and single stock names.
- More questions about single stock names and comparing them versus others in the same space.
- Most are not optimistic about the operating outlook for the banking industry, but few are overly concerned about direct contagion. I do not hear worries about a severe credit crunch, but the consensus is there will likely be at least a marginal negative impact for credit.
- What is my ASM indicator showing for the broad-based estimate revisions trend?
SPECIFIC CLIENT QUESTIONS
- Are you seeing anything interesting within the Energy sector?
- At the sub-industry level (GICS L-4), is there a clear intra-sector contrarian long/over and under/short within Industrials?
- Your ASM line was showing signs of stabilizing. Has that continued or has it rolled back over?
Are you seeing anything interesting within the Energy sector ?
YES. My work is getting closer to a potential upgrade of the overall sector, but it isn’t quite ready yet. So, I will be keeping a close eye on this area, and I expected that an upgrade will likely come before 3Q23. On an intra-sector basis, my key indicators are suggesting looking into E&P for new exposure and getting smaller within Oil & Gas Equipment.
When taking a deep dive look within the Energy sector using both my proprietary ASM metrics and HALO, an interesting dichotomy appears at the sub-industry level (GICS L-4). In the charts below, I have included the relative ASMs for E&P (left side) and for Equipment (right side) versus the sector, as well as their respective relative HALOs. My work shows that E&P has had weaker relative revisions (top left chart) and has been an underperformer (low left chart). While Equipment has been the better intra-sector performer (lower right chart), which has likely been helped by its strong and rising ASM indicator (upper right chart) that is now getting extreme.
Bottom line: E&P looks more attractive versus Equipment as one looks forward 6-12 months.
At the sub-industry level (GICS L-4), is there a clear intra-sector contrarian long/over and under/short within Industrials?
YES. On an intra-sector basis, my key indicators are suggesting looking into Rails for new exposure and getting smaller within Electrical Equipment.
My sector work has been suggesting that one of the areas at risk is Industrials, which is why I have been below benchmark. However, I have received a lot of questions asking to dive deeper within the sector looking for relative attractiveness. Based on my tools ASM and HALO, there appears to be a nice set up for investors. In the charts below, I have included the relative ASMs for Rails (left side) and for Electrical Equipment (right side) versus the sector, as well as their respective relative HALOs.
My work shows that E&P has had weaker relative revisions (top left chart) and has been an underperformer (low left chart). While Equipment has been the better intra-sector performer (lower right chart), which has likely been helped by its strong and rising ASM indicator (upper right chart) that is now getting extreme. Bottom line: Rails look more attractive versus Electrical Equipment if one looks forward 6-12 months.
Your ASM line was showing signs of stabilizing. Has that continued or has it rolled back over?
NO, it appears to be headed lower again. It had been going sideways, which is not the norm over the nearly three decades that I have data. At this point of the cycle, there would historically be a sharp and persistent move lower as analysts’ fears about a growth slowdown would be rising. It has been my longstanding view that the ASM indicator for the overall market needs to fall to somewhere near the red box annotation. Once that occurs and there is a positive inflection, an important prerequisite for THE final equity market bottom would finally be in place. It appears additional time is needed, and the Street has to become much more negative on forward profits. Stay tuned.
What are your preferred aggressive tactical indicators showing your most aggressive tactical indicators saying?
My most aggressive tactical tools both rolled up on 3/13/23 and have been heading higher. They have not yet reached positive extremes, so the tactical push higher could have a bit more to go before finally ending. Importantly, the ongoing bounce is still within the context of a countertrend rally that should be used to sell into, raise cash, and reposition. The medium-term work still suggests that there is unfinished business on the downside, and I continue to target the October 2022 lows, as a minimum.