Politics and inflation are the features of this week; however, third-quarter earnings results continue to provide plenty of drama in the background.
Politics and Equities
In terms of this week’s elections, a number of strategists are noting that since WWII, the S&P 500 has had a perfect record of gains following the midterm elections. In addition, the S&P 500 has posted an increase in each of the 12-month periods after the midterm vote and these gains have averaged an impressive 15%. As we show on page 3, the fourth quarter of the midterm election year tends to be the best fourth quarter of any of the four years in the election year cycle. And more importantly, the first quarter of the pre-election year tends to be the best quarter in the entire election cycle for most of the popular indices. In short, the last quarter of 2022 and the first quarter of 2023 are periods that have a solid history of being strong periods for stock prices.
To date, 2022 has been very volatile and has underperformed historical averages. This severe underperformance is best displayed by the chart on page 4. However, it is this underperformance that may have led to the strong rebound seen in October. Yet even apart from politics, November marks the start of the best 3-month and 6-month periods for equity prices. In short, the stock market should have the wind at its back in the coming months.
And we do not see anything in terms of election results that could hamper stock prices. History shows that equity investors tend to like a split Congress. According to Reuters, when a Democrat is president, the market performs best when Republicans hold either the House, Senate, or both. The average annual S&P 500 returns have been 14% with a split Congress, 13% with a Republican-held Congress, and a 10% gain when Democrats control both the White House and Congress. All in all, the midterm elections should have a positive effect on investor sentiment.
While we do expect the election to be a positive for equities, we are less optimistic about the next six to twelve months due to the deterioration we see in corporate earnings. The steady decline in S&P 500 earnings for this year and next year has continued as the third-quarter earnings season passes its midpoint. This week the S&P Dow Jones consensus earnings estimates for 2022 and 2023 fell $0.57 and $2.76, respectively. Refinitiv IBES consensus earnings forecasts fell $0.36 and $3.28, respectively. What is notable about the last two weeks’ revisions is not just that they continue to fall but that estimates for 2023 are beginning to plummet. As a result, the 2022/2023 forecasts from S&P Dow Jones and IBES Refinitiv are now $204.17 and $230.11 for 2022 and $220.91 and $232.64 for 2023. Earnings growth rates for 2022 are (1.9%) according to S&P and 6.1% according to IBES.
We have been stating that our S&P 500 earnings estimates would be reviewed after third quarter results, however, results have been so poor that we believe our earnings estimates need addressing this week. Our 2022 and 2023 estimates are slashed this week from $209 to $202 and from $229 to $204, respectively. The decline in this year’s estimate reflects the weakness seen in 2022 earnings results to date. More importantly, and more dramatically, our revision for 2023 earnings is due to the negative impact we expect to see from current and future Fed rate hikes on economic activity. Although some economists are now placing odds on the ability of the Fed to maneuver a soft landing in 2023, we believe many parts of the economy are already in or will inevitably face a recession. As a result, this will continue to put pressure on consumers and therefore on top-line revenue growth. Plus, inflation will continue to pressure corporate profit margins. For these reasons, we continue to favor the more recession-resistant areas of the stock market such as energy, utilities, staples, and defense stocks. Healthcare is a DRG-neutral weighting (see page 13) but many health-related stocks are necessities and are therefore recession resistant. Note that this means one should emphasize value versus growth and growth at a reasonable price.
In terms of the economy, the ISM nonmanufacturing survey’s composite index fell from 56.7 to 54.4 in October and the details of the report were unfavorable. New orders and business activity declined, and employment slipped below the neutral 50 mark. Note that the service sector, which has been the relative outperforming sector of the US economy, now appears to be joining the manufacturing sector which has been in decline since early 2021. See page 5.
The jump in short-term interest rates from nearly zero to 4.2% is currently having and will continue to have a dramatic impact on equity valuation. The current earnings yield of 5.4% and dividend yield of 1.8% still hold a slight edge over bonds, but this will continue to evaporate as interest rates rise and earnings forecasts fall. When we put our revised earnings forecasts of $202 and $204 into our valuation model, coupled with our estimates for headline CPI of 7.1% this year and 4.0% next year, and short-term interest rates of 4.75% this year and 5.0% for next year, equity valuations fall. The midpoints of our valuation model drop to SPX 2666 for 2022 and to SPX 3020 for 2023. In sum, equity risk due to inflation, rising interest rates, and falling earnings continues. See page 7.
Technical Indicators Remain Interesting
The charts of the popular indices are as revealing as many of our technical indicators this week, and each tells a slightly different story about the equity market. On page 8 we have ordered the charts of the indices in terms of technical strength. The DJIA is the strongest index and has just exceeded its long-term 200-day moving average this week. It is less than 3% above the moving average that confirms a breakout, nevertheless, it is trading above all its moving averages. The Russell 2000 is approaching its 200-day moving average but remains below it. The S&P 500 continues to find resistance in the narrow range between its 50-and-100-day moving averages. And lastly, the Nasdaq Composite is the weakest of all the indices and is trading well below all its moving averages. This divergence in the indices is a demonstration of shifting leadership from growth to value.
The 25-day up/down volume oscillator is currently neutral with a reading of 1.11. Last week we noted that the indicator was rising toward an overbought reading of 3.0 or greater, which could signal a turning point for the market. The significance of an overbought reading is that bear markets rarely reach overbought territory and if they do the reading is brief. However, in recent days this indicator retreated before reaching overbought territory – a sign of decelerating buying pressure on the rally. Nevertheless, this indicator will be important to monitor in the coming weeks since it could be a bellwether of the strength of future advances in prices. See page 9. With many indices at, or near resistance levels, it will be important to see if this week’s inflation data has a significant impact on investor sentiment.
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