A few clouds on the horizon; Equities down, rates and bonds mostly stable. Correction/consolidation likely to persist for another week. Europe treads water vs US; Nasdaq 100 best market of the week. Continue to be positive on equities, even if the market does feel extended (Nikkei 225 and Nasdaq 100 in particular) and prone to consolidation/correction, and neutral on bonds.
Major market events 26th – 30th June 2023
Highlights for the week
Mon: DE IFO Business Climate.
Tue: US Durable Goods Orders, US Consumer Confidence.
Wed: AU CPI, IT CPI, US Goods Trade Balance.
Thu: JP Retail Sales, AU Retail Sales, SW Interest Rate Decision, DE CPI, US GDP, US Initial Jobless Claims, Fed Chair Powell Speaks.
Fri: JP CPI, CN Manufacturing PMI, UK GDP, DE Retail Sales, CH Retail Sales, FR CPI, EU CPI, EU Unemployment Rate, US PCE Price Index.
- The writing was on the wall – equities were so extended that a pause seems mandatory. We have another week in June, and I still think that the markets are due for consolidation after a great ride – they should catch their breath. Losses were felt across the board, but it is telling to note that the best market was – once again – the Nasdaq 100, fuelled by the recent frenzy about AI and how it will impact productivity and the economy. (For my part, I can testify that Bard has been an admirable assistant in providing valuable data for this report, in a way that Google itself can’t). So for the last week of June – before we restart with earnings reports for 2Q23 – we are in a bit of a limbo, before economic data, the Fed, and earnings bring us back to reality.
- Growth trumped value once again, continuing its run of having greater relative strength. The Nikkei 225 was almost the worst market for the week, but still retains – by a wide margin – the best returns of the year of all major markets excluding the Nasdaq. The retracement should be monitored carefully, but it is quite possible that there is ongoing an epochal change in how the Japanese savers manage their money with a possible shift out of JGBs and into Equities. Even a small increase in equity weightings would mean a lot for the market. To be clear: while I would not buy Japan at these levels, I would not short it either. If you would like to follow the strong liquidity which has been pouring in, please be careful and have tight 2-3% stops. I still think it’s probably best to stay on the sidelines, at least until the next BOJ meeting on July 27-28. If the economy continues to perform well, I think the JPY will continue to weaken (which in turn will be a positive for the economy) – look after your hedges!
- The S&P 500 was the best market for yet another week and has a positive technical picture pointing to more upside. There is an ever-growing consensus – 71.9% – according to the CME FedWatch tool – for another 25bps hike in July, and another one might well follow in September or November. It must be mentioned that the Fed has categorically excluded the possibility of rate cuts in 2023 and the equity market seems to have digested that as well. European markets are in a more complicated position: for starters, the ECB is well behind the Fed in its quest for the terminal rate (as is the BOE), and needs a sustained performance of broader equities (not technology) to go higher still. Should it manage to reach its previous high set in July 2007 (4524.45) and make a breakout above that level it would signal another leg up for equities.
- The Fed, as mentioned, is likely to raise rates by 25bps in July after pausing in June. The CME FedWatch tool market is pricing a 71.9% probability of another 25 bps hike in July, luckily excluding, for the time being, a 50 bps hike – which would be a tail risk. There is growing consensus that the current level of rates is at a restrictive level for the economy, and therefore Governor Powell could continue to keep it at the same level for the rest of the year to further tame inflation, which he and other board members have acknowledged is still too high. After having gone past the rates tantrum, the baton passes on to the economy, which so far has performed admirably, despite the tough environment. In 2H23 it is expected that the economy will meet a more benign rate environment, although we need to see if earnings will indeed trough in 2Q23 and whether they will bounce in the back half of the year. It is important to see if bottom-up forecasts for both 2023 and 2024 continue to be cut or, at some point, manage to find their feet. It is also very important to check if the 7 leading companies (MAGMA – Microsoft, Apple, Google (Alphabet), Meta, and Amazon. plus Tesla and Nvidia) continue to perform in line with 1Q23 and if there is an expansion of breadth (which would be very important for the market) and a follow through to other companies.
- 1Q23 earnings reports are slowly tricking in, being in between the end of 1Q23 and the beginning of 2Q23. We will get another glimpse of performance in calendar 2Q23 from Nike on Tuesday, which will be closely watched. (Nike is reporting its 3Q23)
Checking up on the economy: the good
The ‘good’ points to more sustained growth and no recession, albeit at the cost of higher rates (the ‘higher for longer’ moniker that is soon becoming a mantra), even though expectations for rate cuts are slowly being shifted to 2024. There does seem to be a change in the narrative though, at least according to what is being priced by the market, with rates becoming less of a concern and the economy’s performance becoming more of a concern. Introducing the Atlanta Fed GDPNow estimate for 2Q23, which at 1.9% would account for very solid growth, revised higher from 1.9% previously. As before, there is a meaningful difference between this forecast and the consensus for Blue Chips; at some point, they will have to converge. It is good and notable to see that these are in positive territory and that they have been improving (=no recession) in the last two months or so, with the Blue Chips consensus moving towards 1%.
Source: Blue Chip Economic Indicators and Blue Chip Financial Forecasts
Following up on another bullish forecast for world GDP growth, Goldman Sachs (which is more positive than competitors on US GDP growth) forecasts Global GDP to achieve 2.5% real growth in 2023.
Source: Haver Analytics, Goldman Sachs Global Investment Research
An analysis by Bank of America, going back almost 100 years, has identified very strong 10-year annualized rolling returns for US large-cap stocks, of as much as 12.6%.
Source: BofA Global Investment Strategy, Global Financial Data, Bloomberg
Checking up on the economy: the bad
Let’s start with this chart with a very useful reminder: earnings do not survive recessions. So we absolutely must avoid one if we are to thrive. While the debate is very much alive and the jury’s still out, there are some continuing signs that the economy is in trouble and likely to fall into a recession. One of such signals, the US LEI, continues, as it has for some time, to signal a recession in the next 12 months. Introducing some new, very bearish forecasts from Morgan Stanley which see S&P 500’s earnings cut from $195 to $185 (bottom-up consensus: $221; top-down consensus: Goldman Sachs $224, J.P. Morgan $205, Bank of America $200). Should such a scenario (which would include a rather severe recession) come true, the market would undoubtedly be under much pressure, hammered by a powerful double whammy of a hit on its multiple and its earnings.
Source: The Conference Board
Another worrying signal is the lack of breadth in the US Market, as the ‘magnificent 7’ have practically driven all of the S&P 500’s performance so far this year. This does draw a parallel with the dot.com bubble in 1999-2000. While the performance of such stocks has been admirable, and may well continue to be so in the case of constructive 2Q23 earnings reports, it would definitely be much better if other companies and sectors would contribute as well.
Source: Goldman Sachs Global Investment Research
Checking up on the economy: the ugly
Valuation certainly isn’t cheap. It is even less so considering such appealing yields, particularly on the short end. This has led some to speculate that the current P/E is unsustainable. The current forward P/E of 18.8 is higher than the 5-Year average of 18.6 and the 10-Year average of 17.4. Hence earnings are of paramount importance. It is true that the market is expensive, but it much depends on the outlook for earnings in 2H23. If the economy can continue to perform, it would seem feasible to see the market trading around such multiples, perhaps with a slight compression due to the better results reported.
The staggering performance of the Magnificent Seven (MAGMA + Nvidia and Tesla) was in part fuelled by the AI boom, as these are the companies most exposed to this trend. This has, in turn, inflated their market capitalization, and increased their valuation to as much as 30x earnings. While this is far away from the excesses of the dot.com boom (with Cisco Systems trading at 100x forward revenues (!)) it is enough to raise eyebrows. Should any of these falter (and if one does, it might trigger a falling domino effect), then the index, with its ‘engines’ out, would fall precipitously. Watch out!
Source: Goldman Sachs
Goldman Sachs has done a comprehensive study of many different methodologies to value US stocks, and all of them look expensive. We should definitely not expect a multiple expansion in the future. It is possible that we might continue to trade on a multiple of 19x earnings, but it’s those that should drive the market (and lower the multiple) going forward. The chart below is sending us a message: there’s no room for error.
Source: Goldman Sachs Global Investment Research
Sentiment and what the market is telling us
The Fear and Greed Index made it back into Greed territory, ending the week with a reading of 77, down from 82 last week, This is another reason which brings me to approach the next week with a bit more caution.
Source: CNN Business
The lagging AAII Sentiment Survey saw an increase of neutral positions this week, even though the bulls are still in the relative majority. I share their constructive view on equities, despite any weakness that there might be near term.
Source: AAII Sentiment Survey
Finally, an update from the Fear & Frenzy index, which is clearly reflecting the excitement for the major indexes run of 1H23. Probably near term the market has to consolidate a bit more, before continuing its climb as earnings for 2Q23 come in.
Source: True Insights
What are the Flows telling us?
In a year of rising rates, money market funds continue to lead, buoyed by the great interest rates paid by the US Government and others. Cash is king.
Source: Datastream, Haver Analytics, EPFR, Goldman Sachs Global Investment Research
Profit taking in tech with the largest outflow in 10 weeks – probably justified by the fact that the market has to take a breather at this point. The 4-weeks Moving Average however is in positive territory.
Source: BofA Global Investment Strategy, EPFR
The forward 12-month P/E ratio for the S&P 500 is 18.8x, up from last week’s reading of 18.5x, which is above the 5-year average at 18.6x and the 10-year average at 17.4x. The present, bottom-up level ($221.17) is hovering around Goldman Sachs’ top-down $224 forecast, but it did manage to reverse its course after 1Q23. As we have been going down steadily for a while, I just wonder if at some point down the year the US Corporates will find in them what it takes to reverse this trend, as forecasted to happen in the back half of the year.
For 2Q23 the blended EPS decline for the S&P500 on aggregate is -6.5%. If correct, it will mark the third consecutive quarter in which there has been an earnings contraction, and it will represent the largest decline since 2Q20, when it was -31.6%. The upward revision to 2Q23 earnings growth (-6.5%), has been surprisingly negative if compared to 31 Mar’s -4.7%; we won’t have much to wait for the actual results. Despite the concern about a possible recession next year, analysts still forecast a positive growth in earnings for the overall market in CY 2023 of 1.1% year on year, vs 1.1% on Mar 31, while revenue is forecasted to grow by 2.4% vs 2.1% on Mar 31.
With estimates now measured against the forecasts as of Mar 31st, there are very few differences yet. Of note, Information Technology’s growth is now positive, and greatly outstripping both earlier negative forecasts (of as much as -1%) and their Mar 31st previous reference.
The S&P 500 has its revenue growth estimates at 2.4%, level with last week’s. Financials are still leading the pack in terms of revenue forecasts. Information Technology revenue growth has been revised upwards to 1.4% from as low as 0.7% and is now level of the 1.4% recorded on Mar 31st. The sector seems to be doing better on the top than on the bottom line, perhaps signaling the reason for some of the layoffs.
Let’s take a look at EPS for 2023 and 2024, which last week had a downward revision. The forecast for 2023 has now been updated to $221.17 from last week’s reading of $221.66; while 2024 is currently forecasted to be $246.92, compared to last week’s reading of $247.31.
This is the detail for 2Q23. While the market might be more concerned about rates and recession than earnings at this point, the narrative is changing from rate risk to macro risk where earnings will be of paramount importance. While the negative revisions to 2Q23 are a bit troublesome, I’m encouraged by the fact that on a yearly basis, there have been small declines lately, which is remarkable considering the very limited breadth of the market. It is also well possible that earnings for 2Q23 will also surprise on the upside following a very positive 1Q23. Stay tuned.
Earnings, What’s Next?
The earnings season is now drawing to an end in its 1Q23 reports and a few 2Q23 reports are starting to trickle in. We will have another glimpse of 2Q23 (or at least the first two months of it) from companies that report a month early. Here’s a list of companies reporting this week. Highlights include Nike (Thursday, After Close).
Source: Earnings Whispers
Revenue growth estimates for 2024 are forecasted to grow by 4.9% (5.1% on Mar 31st) and earnings growth estimates for 2024 are predicted to grow by 11.7% (12.2% on Mar 31st), so the future looks to be bright. While we continue to debate whether the US economy will fall into a recession or not and what will be the peak rates for Fed Funds, we welcome the arrival of a new bull market for the S&P 500 (+20% from the October lows), near-term it is quite possible that we see a consolidation around current prices after such a big jump.
We are probably shifting from a monetary risk to a macro risk, where the performance of the economy is more important than what the Fed does. We should be mindful that the economy is probably just doing ok, even though passing the peak in rates will remove the overhang present on the market. If and when rates will diminish in importance, earnings (and top-line growth) will hopefully pick up their pace.
So the breakout happened, with both the S&P 500 and the Nasdaq 100 ahead of their previous Feb 2 highs. Next week will probably be sideways/down again, as the market consolidates and forms a base around current levels. Still, I tactically continue to suggest staying long on Equities, despite a possible consolidation/correction, as long as the S&P 500 and the Nasdaq 100 stay above their Feb 2 peaks (4,179.76 and 12,803.14 respectively). If those levels hold, it would open a new leg up for equities and for the market; if they don’t, we fall in double-top territory with the markets possibly revisiting their recent lows. Regarding bonds, the trajectory is that yields will eventually fall, albeit with a few bumps on the road, although given the new Fed’s forecast, we might have to wait until 2024 for that.
For the less volatility prone of you, it may make sense to take all opportunities to alter the weights of your asset allocation by increasing the weights of safety assets at the expense of more risky assets by lightening up in equities and reinvesting in bonds at attractive (approx 4%) yields. For those willing to look besides US treasuries, investment grade bonds (LQD ETF) could also be a good compromise: 1.2% pickup over government bonds for the safest part of the credit complex may still be compelling. 10-Year yields were turbulent last week, both in the US and Europe, though the ceiling should be near for both. For those wishing to keep their money in Equities with lower volatility, suggest switching to Japan as the company with the most stable outlook (the country with the more precise picture of rates at the moment) until rate perspectives become clearer in the US and Europe. They got a boost given the recent buy recommendation by Warren Buffett, and the oracle is very rarely wrong. So Japanese Equities are now investable regardless of the lower volatility derived by being the only nation in G7 not to raise rates in the current environment. Just watch out for the JPY – if the current strength in the economy and markets is to continue, you may want to hedge it as it will likely continue to slide (against all major currencies).
Happy trading and see you next week!
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