US Strategy Weekly: A Week of Important Tests

This week is significant since it marks the heaviest five days of the third quarter earnings reporting season. It also includes the November FOMC meeting and October’s employment report and precedes the midterm election on November 8. Each of these issues has ramifications for the equity market, but in our view, earnings reports should have the biggest short- and long-term impact on stocks.

The Importance of Earnings

To date, third quarter earnings results are coming in lower than much-reduced expectations. Last week the Refinitiv IBES estimates for this year and next fell $0.87 and $2.86, respectively. The S&P Dow Jones consensus estimates, which are important since S&P follows GAAP methodology, fell $2.00 and $2.52, respectively. As a result, the respective consensus estimates for this year are currently $221.27 and $204.70, which represent growth rates of 6.3% YOY for IBES and negative 1.7% YOY for S&P. See page 8. The steady decline in earnings estimates is a concern because we believe bear markets bottom out when the outlook for valuation is improving, or at least hopeful. Unfortunately, assuming the Federal Reserve will raise interest rates this week and again in December, and since rising interest rates suggest a weaker economy in 2023, the outlook for earnings is not optimistic. As a result, estimates for 2023 earnings are probably still too high and one can expect more negative surprises in the quarters ahead. Earnings disappointments erode investor confidence over time. In the short run, this week’s battery of earnings reports could set the tone for whether there is hope for 2023 earnings, or if estimates are still too high.

Nonetheless, our skepticism on S&P 500 earnings is not broadly based. In fact, we have been in favor of recession-resistant sectors and seek stocks where earnings growth is most predictable. In general, the current economic environment favors value stocks versus growth stocks, and we have been emphasizing necessities such as energy, staples, defense/aerospace, and utilities. The utility sector has shifted from being an outperformer to an underperformer in the last month, but keep in mind that “performance” in utilities should not be measured just by price, but by total return. We have a neutral weighting on healthcare, however, since healthcare is another household necessity with pricing power, it should not be overlooked in our view. See page 13. From a historical perspective, bear markets tend to be a transition period for a significant shift in leadership. We believe this is true of the current market. Notably, S&P sectors labeled as “growth” have varied over the decades, but they have had one thing in common and that is that they have represented the highest earnings growth rates of all 11 S&P sectors. In the next few years, or at least until inflation has come under control, we believe recession/inflation-resistant companies will provide the best earnings and price performance and will outperform the S&P 500 index. In truth, energy has been the growth sector of 2021 and 2022.

A Fed Pivot

The Federal Reserve is expected to raise the fed funds rate from its current range of 3% to 3.25% to 3.75% to 4.0% this week. This would be the fifth interest rate hike in a twelve-month period and the fourth consecutive 75 basis point increase this year. It would also constitute an increase of 375 basis points in the last 20 months. This will certainly have a major dampening effect on economic activity in the first half of next year and it has already put the residential real estate market in a recession. We would challenge market pundits who are focused on whether a 50-basis point increase at the December FOMC meeting would constitute a “Fed pivot” and a key buying opportunity, because we believe this misses a very important point — a 375-basis-point increase in the fed funds rate in a mere twelve months is likely to trigger a recession in 2023. Again, there are many reasons to focus on recession and/or inflation resistant companies at this juncture, even though we would note that the best three-month period for stocks (November, December and January) has just begun.

A Critical Technical Juncture

Technical indicators are at an interesting and, in some cases, critical juncture just as important information from earnings, the Fed, economic data, and political elections loom on the horizon. The most important indicator this week is the 25-day up/down volume oscillator which is currently neutral with a reading of 2.61. However, this is surprisingly close to an overbought reading of 3.0 or greater. Since bear markets rarely reach overbought territory and if they do the reading is brief, there is the possibility of a turning point in this indicator. In sum, we will be watching the 25-day up/down volume oscillator very carefully in coming weeks.

And as the oscillator faces a potential turning point so does the S&P 500 index. A convergence of the  50- and 100-day moving averages at roughly SPX 3900 represents a key resistance level. If bettered, it would be a positive for the intermediate-term outlook and fall in line with the favorable seasonality that is typical of year end. If it proves to be resistance, it will confirm that the bear market cycle remains intact. See page 9. Nevertheless, the indices are not moving in unison, and it is worth noting that the DJIA is trading above its shorter-term moving averages and currently testing its 200-day moving average. The Russell 2000 is similarly close to its 200-day moving average. This divergence and relative outperformance of small capitalization stocks is favorable since the large capitalization stocks tend to be the last to fall in a bear market.

Economic Data

After contracting in the first two quarters of the year, GDP grew 2.6% (seasonally adjusted annualized rate – SAAR) in the third quarter. However, trade contributed 2.8% to the quarter as exports of oil & gas to Europe increased and a strong dollar translated into fewer dollars spent on imports. In short, these may be short-term influences and the domestic economy continued to struggle. See page 3.

Household consumption contributed less to third quarter activity than it did in the second quarter and consumer spending was disproportionately in services. Businesses slashed spending on structures and residential investment fell at a 26.4% annual rate. Residential fixed investment was the largest drag on third quarter GDP falling 1.4% (SAAR), followed by inventories which fell 0.7% (SAAR). Third quarter typically sees an inventory build ahead of the holiday season; however, real retail sales have been weak in recent months and retailers appear to be cautious. The one bright spot in the GDP report was a small decline in the GDP deflator from 7.6% to 7.0%. See pages 4 and 5.

In September, personal income grew 5.2% YOY and personal disposable income grew 3.2% YOY. But the true measure of household consumption is demonstrated by real personal income which declined 1.0% YOY and real disposable income which fell 2.9% YOY. See page 6. Yet despite a lack of purchasing power, personal consumption expenditures rose 8.2% YOY in September and grew 8.4% over the last three months. Not surprisingly, the savings rate fell from 3.4% to 3.1% in the same month. Overall, consumption may not be sustainable at this level.

Gail Dudack

Click to Download