The Good News
According to NYSE volume statistics, recent trading sessions have included three significant 90% down days: April 22: 90%; May 5: 93%; and May 9: 92%. History suggests that these extreme downside volume readings usually come in a series and reflect underlying investor panic. The good news is that a series of 90% down days is also a characteristic of a late-stage bear market cycle. Unfortunately, there is no consistent pattern to how many extreme down days may occur; however, the first indication that selling pressure and panic is becoming exhausted is seen when a 90% up day appears. Hopefully, a 90% up day will be on the horizon.
As a result of recent extreme breadth days, the 25-day up/down volume oscillator dropped to negative 3.80 this week, its most oversold reading since April 1, 2020. But to put this into context, in March and April of 2020, the market was in oversold territory for 25 of 28 consecutive trading sessions and reached an oversold reading of negative 7.32 on March 23, 2020, the same day the stock market bottomed at SPX 2237.40. See page 8. In short, there is no telling how long selling pressure may last.
The other bit of good news has been sentiment indicators. The American Association of Individual Investors (AAII) sentiment survey was revealing two weeks ago when the survey showed 16.5% bullishness and 59.4% bearishness. This bearish reading was the highest percentage since the March 5, 2009, reading of 70.3%. This week’s survey results of 26.9% bullishness and 52.9% bearishness are also relatively extreme, and the AAII Bull/Bear Spread remains in positive territory. See page 10. Low bullish sentiment is typical of the end of a decline; therefore, investors should be wary of becoming too negative at this juncture.
Over the last twelve months, we have pointed out a pattern of sequential weakness in the popular indices. This trend can be seen in charts of the DJIA, SPX, IXIC, and RUT, in that order, where the declines from their recent peaks has been 12.6%, 16.6%, 26.9%, and 27.9%, respectively. What has been notable during this time, is that the Russell 2000 index has been the best forecaster for the overall market. It was an early leader at the top and it may lead at the low as well. We will continue to monitor these charts, but at present the RUT shows no signs of bottoming. See page 7.
Many investors are focused on the CBOE Volatility index (.VIX – $32.99) which has moved up from a recent low of $18.50 to a high of $35. The VIX is a measure of volatility, and it often spikes at the end of a bear market cycle, just like volatility does. But overall, we find the VIX to be an unreliable indicator since there is no level that actually defines a peak in volatility, and conversely, a low in prices. For example, at the end of corrections in 2010, 2011, 2015 and 2018, the VIX rose to levels in excess of 45. But it reached 85 at the 2020 low and 82 at the 2008 low. In short, the VIX would have to more than double from current readings to suggest the bear market cycle is over.
The Bad News
The bad news is that first quarter earnings season is not going well. Last week S&P Dow Jones lowered its 2022 S&P 500 earnings forecast by $2.45 to $225.06 and IBES Refinitiv lowered its consensus forecast by $1.14 to $227.60. Yet as bad as these reductions appear, consensus estimates are merely returning to where they were a few months ago. Nonetheless, we have noticed that several strategists are lowering their 2022 earnings estimates as first quarter earnings season is ending. As a result, my 2022 earnings forecast of $220 is no longer a downside outlier. This is important to keep in mind because valuation is an important factor at the end of a bear market cycle.
In most bear market cycles, earnings growth, or lack thereof, is usually an issue. We have expected this to be true in the current cycle as well. Regrettably, the fundamental factors that are most predictable today are inflation and short-term interest rates, both of which are rising. Rising inflation and interest rates are a drag on earnings, and we fear that analysts may have underestimated the impact.
April’s inflation data will be released this week and it could take a toll on the market. Some economists are calling for a deceleration in the pace of inflation, but we checked our files and found that if headline CPI were unchanged in the month of April, the year-over-year pace would still be 7.7%, down from 8.5%. Similarly, core inflation would be 5.6%, down from 6.5%. PPI would be 14.5%, down from 15.2% and PPI final demand would be 10.1%, down from 11.2%. In other words, we expect inflation will remain high and continue to be a problem for the Federal Reserve. Unless data suggests inflation is under control the Fed has been extremely clear on its intentions of raising the fed funds rate 50 basis points at each of the next five meetings. In sum, the fed funds rate could rise as high at 3.5% by the end of this year. If it does, it could be a huge drag on the economy and earnings or it could trigger a recession. As we noted last week, given that first quarter GDP was already negative, is it possible we are already halfway through a recession of two consecutive quarters of negative growth? Either way, earnings growth is at risk in 2022.
Because earnings are usually in danger in a major correction of a bear market, we use trailing operating earnings to help us define “value” and the potential downside risk for equities. In short, we are defining value, absent any earnings growth. Analysts typically measure value for the S&P 500 based upon a price-earnings multiple. But PE multiples can vary depending upon perspective. For example, when the SPX closed at 3991.24 on May 9, the 12-month trailing PE fell to 18.7. This was clearly below the 5, 10, and 30-year average PE multiples, but just barely below the 20-year average of 18.9 times. Yet 18.7 times is still above the 50-year or 74-year averages of 16.6 and 15.8 times, respectively. See page 3. In short, valuation is a matter of perspective. We have been using a PE of 17.5 with our $220 earnings estimate to define “value” in the market. This equates to a level at, or below, SPX 3850. This view is unchanged. The sum of the trailing PE and inflation is called the Rule of 23, and the current sum of 25.53 remains well above the normal range of 14.8 to 23.8. To return to the normal range, the SPX would need to fall to a 17.5 multiple while inflation declines to 5.5%. We believe this combination is possible in the coming months. Sadly, there is a more bearish case for equities, and it is best displayed by our valuation model. Even at the May 9 close of SPX 3991.24, the market remained 8.5% above our model’s predicted fair value range of SPX 2575-3676. This range rises to SPX 2734-3865 by year end which is closer to our target of SPX 3850. Nevertheless, most benchmarks point to value appearing 5% to 10% below the SPX 4000 level.
Gail Dudack
PLEASE NOTE: Unless otherwise stated, the firm and any affiliated person or entity 1) either does not own any, or owns less than 1%, of the outstanding shares of any public company mentioned, 2) does not receive, and has not within the past 12 months received, investment banking compensation or other compensation from any public company mentioned, and 3) does not expect within the next three months to receive investment banking compensation or other compensation from any public company mentioned. The firm does not currently make markets in any public securities.
