Equity markets will do what they want to do in the short term. Many wise investors have stated over time that one should not get mad at markets if they move against you. I agree, but to be honest, the recent price action has me frustrated and a tad puzzled.
What has me scratching my head?
- My research has not budged at all over the last five months. In fact, my key indicators have become even more unfavorable.
- My ongoing view that the Fed would likely remain laser-focused on inflation and stay in motion for higher and longer was only confirmed by Chairman Powell’s post-FOMC press conference that was as clear and hawkish as I can remember over my career.
- Forward earnings still look too high. When looking at the level of operating earnings forecasted as shown by the bottom-up consensus of the analyst community, the 2023 outlook for the S&P 500 is roughly $235. When looking through both the company-level data and my preferred top-down analysis, I keep coming up with a range of $210-215, which would confirm that 2023 OEPS cuts are likely still coming.
- Indeed, when looking at forward estimate revisions using my proprietary ASM indicator for the broad U.S. equity market, it continues to weaken as I have been forecasting since the end of 1Q22. Importantly, this key metric has not yet reached a critical extreme bottom, which will be a bullish contrarian signal once it is reached. Importantly, every major equity market low since 1990 has been preceded by a max pessimistic reading and a subsequent positive inflection.
- The equity market does not look cheap based on my valuation work and the ongoing P/E multiple adjustment that began during 1Q22 appears like there is further to go to reflect the current environment of elevated inflation, higher interest rates, a hawkish Fed that remains in motion, geopolitical instability, and uncertainties regarding the future path of the domestic economy. Quite simply, it seems inconceivable that the fair value P/E multiple should not be considerably lower than where we started the year.
- As I have written over the last couple of months, just doing the simple index level projection using NTM OEPS and a fair value multiple makes it quite challenging to make significantly higher price forecasts for the S&P 500. If one has significant upside price targets for the S&P 500, then using the current consensus forecast of $235 (fyi – nearly every client I speak with agrees that this figure is too high), a multiple of 17x to justify today’s price level of 3828, and a roughly a 21x reading to get back to the old highs. Based on my research, I would have a challenging time making a case for 17-21x unless something changed in the current backdrop. With the long-term average P/E multiple range for the S&P 500 between 12-16x (yes, there were periods outside this range under specific conditions), the new 2023 fair value target range for the S&P 500 would be 2820-3760 and that is using $235 for NTM OEPS, which is most likely too high. This is all without going into a deep dive into operating margins and how they are likely to have some reversion to the mean and move lower as they reached all-time highs during 2021. So, if you are bullish, what are you more optimistic on, earnings or multiples?
- When I look at my aggressive tactical tools, they remain unimpressive. Early during 2022 at the S&P 500 tactical trading lows, my metrics flashed signals that countertrend bounces were likely. But clear tactical bullish signs were absent at the October low and remain mixed. They are not yet flashing an immediate failure of the equity market rally, but they are hardly endorsing additional gains to 3950-4100 as a high probability outcome either. These tools have been quite reliable over the years and my reading is that the ongoing rally is tenuous at best, and despite the possibility that it could make further upside progress there is scant evidence to suggest sustainability.
What about the other side Brian? Does anything catch your attention? What are your bullish clients saying?
- Yes, I still hear and observe that positioning and cash levels are reflecting some degree of negativity which could lead to rallies. This remains one of my biggest concerns for my ongoing unfavorable outlook for the equity market.
- Another point that continues to surface in client meetings is the view that the continued hawkish Fed rhetoric does not matter because they have the inflation forecast wrong. The argument goes that the central bank is using lagging data and is not reflecting more real time and new data sources that are showing signs of inflation pressures diminishing and that the policy actions have already broken the back of inflation and that a sharp decline is about to begin. Some are expecting the upcoming CPI data release to be an important shot across the bow as it will be a noticeable down-surprise. My work keeps me skeptical and assigns decent odds the reading may once again come in hot.
- And the recent bullish support is that the presumed Red Wave is supportive of immediate higher equity prices. From a market perspective, I would agree that the low-probability scenario of the Democrats holding both houses would not be market-friendly. However, I am not quite convinced that having the Republicans take one or both houses really changes much, and its ability to push the S&P 500 sustainably and significantly higher is unlikely. Granted, taking one house by the GOP will certainly take off the board any additional fiscal stimulus, but at the margin, my analysis doesn’t suggest that this is an important bullish outcome as the Fed will still be fighting elevated inflation and interest rates still moving higher.
During client interactions, the breakdowns of bears/bulls between strategic and tactical investors remain quite the same. Clients with a longer-term outlook, fundamentally driven, and only able to turn the ship one time from cautious to optimistic are still mainly cautious and are looking for better entry points during 1H23, but there is a small percentage that they are becoming bullish. When shifting the focus to tactical investors that are more amenable to price action and technical, there are more that are short-term favorable, but it is still well below 50%. I would generally say there is a sense of frustration over what most would call perplexing market action and the day-to-day leadership.
So, at the risk of being overly stubborn and not openly embracing the favorable story that is being communicated by the bulls, I remain concerned that there remains considerable downside risk for the equity market as my key indicators have not flashed any signals that have preceded nearly all major market bottoms since 1990.
Reiterating Key Assumptions:
- Headline Inflation has peaked.
- The U.S. economy is decelerating not collapsing, and fears of slowing have not reached their maximum level. The labor market remains resilient and is not yet showing any definitive signs of decelerating let alone contracting.
- Forward expectations for corporate profits are too high and most certainly will need to be lowered, especially names that are more sensitive to cyclicality.
- My work suggests that there has neither been a price nor fundamental capitulation yet, but they will both likely happen at some point in front of us.
- THE equity market bottom is not in place yet, and my next downside target area is 3200-3000. NOTE: sharp downward capitulatory price action that takes the S&P 500 below 3500 may cause me to shift my view and start putting some money to work.
- My work still suggests selling rallies and not buying dips.
Bottom line: My analysis does not support the sustainability of the ongoing equity market rally following the October low, which was originally based on oversold conditions and the hopes for a dovish Fed. The bullish story continues to morph, but my earnings revisions dominated process is still quite unfavorable. When expanding my analysis, I don’t have any of my preferred metrics flashing bottoming signals, and there is still my ongoing view that Chairman Powell and the Gang will end up going higher for longer. Thus, despite the attempts to bounce from time to time, my key indicators are still signaling that downside risk clearly outweighs upside potential and investors still need to be cautious.
I reiterate that the adjustment process for the economy, inflation, forward profits, and valuation levels still needs more time and work to be done to reach readings that shift the risk-reward ratio back to reward for strategic investors. Patience will be needed, but the payoff will be a great opportunity to get high-quality stocks at lower prices that will likely have a longer duration move higher.
Therefore, I am still advising that bounces should be viewed as bear market rallies that will likely fail and should be used to sell into, reposition, raise hedges, and to reload shorts. Any tactical gains or outperformance for now is just the side show while the MAIN EVENT of pivoting for THE bottom is still in front of us.