The first week of March has been filled with the same “tug of war” action that typified the months of January and February, which I began discussing in my first Whispers of 2023. The two-day short squeeze rally following non-voting Atlanta Fed President Bostic’s comments last Thursday has reversed quite violently this week on Chair Powell’s two-day testimony in front of Congress, as well as the job data that is not showing clear signs of deterioration. When I take a step back from this headline noise, my work suggests two things that are quite clear to me — the data is not supportive of dovish Fed hopes, and the equity market is still in a state of denial with the S&P 500 remaining near 4000.
To quickly show support for my view, let’s look at a few simple charts below. The bond market’s volatility expectations metric, called the MOVE index, has been noticeably rising since early February, while equity volatility as shown by the VIX has been FALLING. This positive inflection in bond volatility began in earnest with the reemergence of a potential 50bps Fed hike by Fed speakers Mester and Bullard, which I had flagged on 2/15 as a rising possibility BEFORE it occurred. During this roughly one-month period, Fed expectations have gone from a June pause (terminal rate under 4.9%) and 70bps of easing by January 2024 to 5.70% terminal rate and only a small easing by January next year, which still looks to be too dovish. In my mind, that is a dramatic reversal, and it appears to be reflected in investors’ bond-volatility expectations to some degree. Importantly, however, the expected volatility for equities is still near the lowest levels in over 10 months. Yes, there could be lots of reasons why this is happening, but it does seem to suggest that the equity market has not fully priced in the new reality, which may even get worse over time. Based on my key indicators, it is just a matter of time before things come back into alignment and the equity market properly adjusts to my longstanding view of the Fed is higher for longer. Hence, the remainder of 1H23 will likely be a challenging period for equity investors.
Updating my Fed view. Before going into what I am hearing during my client interactions, I wanted to make a small change to one of my macro assumptions that I mentioned last week might be coming. After diving into my key macro indicators, my work does suggest that I should raise my longstanding 5.25-6.0% terminal rate assumption range to 5.5-6.5%.
With that being said, I do want to acknowledge all the unhappy feedback I got over the past week from readers telling me that I am way off the mark, but without going into details here, my analysis still strongly points to an ongoing and challenging inflation fight that is going to take time. In addition, we still have a domestic labor market that remains stubbornly healthy, which will need to show signs of slack to ultimately get inflation back to the 2% target as repeatedly stated by Chair Powell. Thus, I remain firmly in the “Fed is higher for longer” camp, but this is likely to be a bumpy journey over the next 6-12 months where policy expectations may very well get priced in, priced out, and priced back in again.
My client interactions continue to center around three main areas:
- The S&P 500 is holding up around the 4000 level (i.e., technicals are supportive)
- Struggling with non-technical-related evidence and the case to flip aggressively to bullish
- Clarity on the state of earnings and revisions
In nearly every client meeting during 2023, I have heard “the S&P 500 is holding up quite well” or “the charts look supportive.” Interestingly, these statements have been accompanied by two distinct emotional states: 1) accounts that are more tactical or open to technical-analysis techniques are somewhere between neutral to constructive on the outlook for the equity market; and 2) investors that are more strategic and influenced by macro and idiosyncratic fundamentals, who communicate feelings of frustration, confusion, and are neutral, at best, to negative on their forward expectations for overall equity performance. Most meetings have a lot of back and forth trying to flush out the key drivers for both bull and bear cases for equities. I would say that the conviction level for most is average, at best, and is skewed towards the low end of the scale.
Now, I look at charts and certain technical indicators just like nearly everyone else, but they are not a big part of my process, which is more centered on profit-cycle analysis and earnings revisions. My historical research shows that on one hand, when one looks at shorter and shorter time frames, positioning, sentiment, and technical tools can be quite effective at identifying tactical opportunities in markets. On the other hand, however, for the probabilities of a sustained equity move in either direction to considerably rise beyond shorter-term periods, there likely needs to be something more than these nonfundamental factors to drive the trend for longer. For example, it will be hard for a stock to keep moving higher if its forward profits outlook is deteriorating at an accelerating rate or the high likelihood that the overall equity market struggles to stay in the black when central bank policy is restrictive and is still aways from shifting back towards accommodation.
My bottom line is, if one takes technical analysis tools off the table, it is difficult based on my research to make the case for a sustainable and significant equity move higher. Indeed, to achieve a surging equity market, it is my view that one would need an expectation of higher forward earnings and a return to valuation multiples that approach 20x. At this time, I cannot make the case for either based on my indicators. Consequently, for me, that leaves either an equity trading range environment or unfinished business to the downside, and with the 2-yr treasury and short term yields near 5% risk-free, it sure looks like equities have some competition for investor funds.
When switching to what is going on with corporate profits and earnings revisions, there are two points that are facts — current earnings are NOT collapsing and revisions to forward expectations are now falling at a slower pace. Where it gets less clear is, are those points bullish, bearish, or it is hard to tell right now?
When looking at all my historically reliable indicators that forecast the future path for earnings, I continue to have the following conclusions: 1) YES, the data is marginally supportive from a tactical perspective; and 2) the recent “less bad” readings are only a respite that will likely roll back over and ultimately make a lower low as shown below in my updated ASM indicator for the overall S&P 1500.
As a result, it is my bottom line that with the Fed likely to be higher for longer it is quite difficult to forecast that overall market ASM indicator is beginning a new favorable cycle that historically provides strong support for a nascent bull market. If one of these factors changes, I will have to reevaluate the new data and possibly temper or switch my current unfavorable interpretation.
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 5.50-6.5%.
- 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: Although there has been a lot of movement in the day-to-day macro news and in market related price changes, my bigger picture views have not changed very much.
Indeed, my research continues to signal that I retain my ongoing bearish view and that the countertrend equity market rally that began in October is likely over. The more recent economic data has shown that the decline in inflation is going to be a hard fought battle, especially with the labor market readings still showing little signs of deterioration, which has dramatically reversed what were unrealistic dovish Fed hopes that grew into early February. The market is now pricing in a terminal rate of 5.70%, which is within my recently raised target range of 5.5-6.5%.
My analysis shows that despite the fixed income market adjusting its expectations to reflect the shifting winds the current price level of equities still looks to be reluctant to acknowledge the evolving backdrop. On the corporate profits front, the resilient U.S. economy staying out of recession has led to earnings being a bit “less bad”, but I remain skeptical that this occurrence is anything but a pause in downtrend that still needs more time to reach its final low.
My works portends that the “bull base” for now is the continuance of the S&P 500 trading range of roughly 4200-3950, and more likely that additional downside risk at least reaches the October 2023 low near 3500. On the journey lower, there will likely be numerous tactical trading opportunities.
As a result, this continues to leave the S&P 500 risky for equity investors and supports my ongoing view that strategic investors need to remain 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.