I am sure everyone was quite happy when Friday ended last week after the sharp move lower in the U.S. equity market. All 11 Sectors (GICS L-1) were down over 2% and the underperformers all fell over 6% with my recently downgraded again Industrials and Material among the worst four areas. At the stock level, only 25 names posted gains. Hence, the selloff was quite broad based on an absolute level.
The main drivers were the hot CPI data release on Tuesday and the post-market negative earnings preannouncement by FedEx (FDX), which should not have been surprising to my readers as I have been writing regularly about a hawkish Fed and their resolve about fighting inflation and that the forward profit outlook for corporate America remains too high, especially Cyclicals. Coming into the week, bullish forecasters and optimistic traders were beating the drum for the early Dovish Fed Pivot and that earnings cuts don’t matter because everyone knows they are coming, and that the fundamental capitulation took place at the June low, which my work does not support either.
As I am writing this note, two questions are hitting me after a full week of speaking with clients:
- Is the market finally waking up to the likely reality that the Chair Powell and Company are far from becoming dovish and that the negative earnings revisions cycle that I have been forecasting for months has much further to go before max pessimism is reached and that it matters (a lot)?
- As thrown out a couple weeks ago, are we at a point where good news is bad (more Fed and tighter policy) and that bad news is bad (slower economic growth, weaker corporate profits, and no immediate Dovish Fed Pivot)?
From my analysis, the domestic economy is clearly slowing down. Supporting this takeaway is that the “hard data” has been weakening as the Bloomberg U.S. Macro Surprise index (ex. Survey data) has fallen to its worst level since mid-2019. As a result of this weakness, the Atlanta Fed has cut its 3Q22 GDP outlook quite a bit. I must wonder how much the relative strength of U.S. retail spending is being backstopped by the 30% increase in credit card debt over the past four months, among other forms of credit, and how long will the U.S. consumer be willing and able to keep spending with the FOMC looking to slow the labor market?
Furthermore, when looking at economic growth projections for 2023, the outlook for several key areas around the world have been consistently falling. According to a Bloomberg survey of economists, the outlooks for the U.S. and Euro area/U.K. have been declining. If this has been and remains the case, then why aren’t the earnings revisions for domestic companies even weaker than what they have been thus far during the year? Add in the fact the U.S. dollar continues to be quite strong being up over 20% from its January 2021 low and 17% higher year-over-year, and my analysis shows not only a high probability that forward profits expectations still need to fall from current levels but that they will likely need to overshoot and reach maximum pessimism before the ultimate S&P 500 price low is reached.
As we are at the early parts of the earnings confession season, which normally peaks the first two weeks after the calendar quarter ends, the warnings from more cyclical companies have begun and there will likely be a higher number this year. Below are a few examples:
- Huntsman (HUN) resided in the red in the wake of cutting Q3 22 adj. EBITDA view and added it has been impacted by the persistent and extraordinary European energy costs – HUN is the third chemical company to cut guidance this week after DOW and EMN.
- International Paper (IP) was softer following a sell side downgrade, who pointed to decelerating orders and an inventory glut in the industry.
- Nucor (NUE) prelim. Q3 EPS view was cut to between USD 6.30-6.40 (exp. 7.97) amid considerably lower steel mills earnings.
- Dow (DOW) gave poor guidance, where Q3 EBITDA view was short of expected and expects approximately USD 600mln lower Q3 net sales and Op. EBITDA between USD 70-90mln.
As we get closer to the upcoming September FOMC meeting, there is likely to be some noise and hopes that a glimmer of dovishness may present itself, which tactical investors view as a catalyst to try and start another trading rally. However, my key indicators are still unfavorable, the corporate share buyback window is closed, and as we go through the ongoing confession season moving towards the 3Q22 earnings season, it appears that the tug for the S&P 500 is still to the downside. Thus, I am still viewing tactical bounces as bear market rallies that will likely fail and advise not to chase them.
I am introducing a change to my forecast in today’s note that I have been hinting at for several weeks. I have been calling for the S&P 500 to reach my next downside target of 3600-3500, and that the probability of a lower target range was rising but not at a level that I would officially announce. Well, my research now says it is time to state that 3200-3000 is now a range that needs to be recognized as a potential downside target area. It is not being elevated as my base case but continues to rise in likelihood and in the coming months may become my official forecast. So, I remain unfavorable on the U.S. equity market.
Reiterating Key Assumptions:
- Inflation has peaked.
- The U.S. economy is decelerating, and fears of slowing have not reached their maximum level.
- Forward expectations for corporate profits are too high and most certainly will need to be lowered, especially names that are more sensitive to cyclicality.
- 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, either a clear test of the June lows near 3600 or my new 3200-3000 outlook are my targets to potentially become more constructive.
- My work still suggests selling rallies and not buying dips.
Bottom line: The S&P 500 still has considerable downside risk, as my key indicators remain unfavorable. Along the way down to my main downside target areas 3600-3500 and 3200-3000, there will likely be additional tactical oversold bear market rallies that should be used to either sell into, raise hedges, or reposition.
For positioning, I am still recommending Growth, both defensive and offensive, relative to Cyclicality even though tactically the area may be weak as rates try to push higher. My indicators suggest relative underperformance is an opportunity to raise exposure, as the bigger risk remains weaker profits from areas that are cyclical.
SPECIFIC CLIENT QUESTIONS
- So, you agree that headline inflation has peaked. Why are you still worried about the Fed?
- What are your most aggressive tactical indicators saying?
So, you agree that headline inflation has peaked. Why are you still worried about the Fed?
My work and my read of the Fed suggest that, despite goods inflation coming down services inflation will likely be harder to fight off. Chair Powell and Crew have suggested that cooling the labor market is needed. It appears that having the unemployment rate rise from 3.7% to between 5-6% is what the central bank is targeting. Thus, only focusing on headline and goods inflation moderating is only part of the story.
For most of my conclusions and recommendations, I use objective indicators and models. However, to answer this question, I must use a lot of what I think versus what my tools are saying. With being said, this is my thought process:
- Goods inflation falling.
- Services inflation will likely be more resilient as there is a larger labor component (fyi – also bigger part of the economy than the goods side).
- The Fed wants to create slack in the labor market and some FOMC members have commented that the unemployment rate needs to rise from 3.7% to 5-6%.
- If goods inflation does keep moderating, but the labor market does not show signs of weakening, the Fed will not declare victory.
- The bar to shift to outright accommodation is quite high. Slowing the pace of policy tightening and pausing are certainly incremental positives. Importantly, however, unless the equity markets have moved much lower because forward earnings have been dramatically cut, Fed slowing and pausing really does not provide strong enough tailwinds to offset the formidable macro challenges that are still present.
- So, 3900 and no outright easing does not make the equity markets attractive based on my work.
- Reaching 3600-3500 and no outright easing is relatively better but not overly exciting.
- If the S&P 500 fell to 3200 or lower on fears of a hard economic landing, which caused the forward profit backdrop to fall towards max pessimism (i.e., overshoot reality), and there are potential signs of the elusive Dovish Pivot, the backdrop for equities would likely be quite attractive for strategic buyers.
What are your most aggressive tactical indicators saying?
The positive inflections that we wrote about last week rolled back over early last week, which were well within my expected two weeks or less forecast. The indicators are falling and unfavorable, but since the previous bump was on the shorter side, they both are still near bottoming levels. The implications are it wouldn’t take much to flip them back to favorable and signal another attempt to start a bear market failing rally. For tactical investors, stay on your toes as the S&P 500 could move in either direction over the next week or so. Importantly, the message for strategic investors remains the same — don’t chase rallies and remain on alert for a better buying opportunity that is still in front of us.
My highest-frequency and most aggressive tactical tools for looking at the S&P 500 price action — V-squared (orange line top chart) and HALO-2 (purple line bottom chart) both rolled back over after being favorable for only a few days. Extreme indicator reversal signals have a typical life cycle of 2-4 weeks, but there is precedent for both shorter and longer periods. Normally, a truncated signal that only lasts between 1-7 trading sessions is followed by another shorter signal before ultimately flashing a signal that lasts towards the longer historical durations of 3-5 weeks. Hence, with the current signal negative, I am on the alert for a positive tactical reversal that would likely lead to another countertrend bounce attempt. With that being said, short cycle reversals also imply that the bigger trend (as shown by HALO which is negative) is quite strong and frequently leads to a powerful sell off. Therefore, the tactical backdrop is appears evenly distributed based on my indicators with the medium term still firmly pointed lower. Sell/hedge/reposition on any strength. Stay alert as our aggressive pivot point gets closer every day.