Weekly Preview / January 23
Notable Events on our Weekly Watchlist:
Monday: N/A
Earnings: LOGI, ZION
Tuesday: N/A
Earnings: MSFT, DHI, GE, HAL, JNJ, LMT, RTX, TXN, VZ
Wednesday: N/A
Earnings: TSLA, ABT, ASML, T, ADP, BA, CSX, GD, HESS, LCRX, NEE, NEP, STX, NOW, STLD
Thursday: GDP Growth, Durable Goods Orders, Jobless Claims
Earnings: V, MA, ALK, AAL, ADM, BX, DOW, INTC, KLAC, NUE, SAP, LUV, X, VLO
Friday: PCE Price Index, Personal Income / Spending
Earnings: AXP, CVX, CL
ETFs to watch: SPY, XLK, XLB
The showdown continues
Last week saw volatility make a return to the equity markets, with the S&P500 testing both the 20 and the 50-day Moving Averages successfully. Commentators are likely to point out that it was Loretta Mester’s (voting member of the FOMC) comment that sparked the downturn. Mester said that she expects the Fed’s policy rate to go “a bit higher” than 5% and stay there for some time to slow inflation further.
Q4 Earnings have so far had a limited impact on the price action, but we suspect this is subject to change, going further. The week’s calendar is packed with blockbuster earnings featuring MSFT, TSLA, V, MA, and other important names. We will be watching the impact on profit margins, since these are the most vulnerable to weakness as inflation is still present.
We believe the mid-week downturn in SPY was caused by some technical profit taking. It has not reversed any of the short-term bullish bias that is still present. If anything, the successful test of moving-average support should give bulls the impetus to press further.
SPY Analysis
The market is closer to a neutral state, being neither oversold, nor extremely overbought. The MACD Signal is clearly positive. We believe that truly overbought conditions will exist once SPY manages a break through the $402 area, and causes the last remaining shorts to capitulate. As FOMO would accelerate on this break, the plan is for us to remain sellers. Contrarian positioning has worked very well for the past year, and we anticipate it will work well in 2023.
Market breath is higher than the median level, but not extreme (Market Internals, Overbought/Oversold). We see this as bullish with the expectation that a break higher for SPY will coincide with our indicator reaching 2-standard deviations overbought (confirming speculator’s FOMO).
The good news is that Dollar Transaction Volume is confirming the current bullish price trend. As long as prevailing prices connect buyers and sellers to a healthy extent, we can expect tailwinds to equity prices. Should the volume suddenly drop, that would be our signal to start reducing exposure once more. The current trend in transaction volumes is unchanged and still down, as the Fed is removing liquidity from financial markets.
Q4 Earnings
As Q4 Earnings season revs up to full throttle, the following 2 weeks will be crucial in determining the health of corporate profits.
Our instrument (Market Fundamentals, P/E Ratio) measures internal metrics for S&P500 companies and makes it easy for us to judge where we currently stand in the business cycle. The main focus of our analysis will be Net and Gross Profit Margins, both highly mean reverting series.
Gross Profit Margins have already been under pressure since Q3 2022. The decline has been quite pronounced, albeit from record levels. As we currently stand, corporate profit margins are back at pre-pandemic levels, but still about 200bps above the cycle mean. As inflation erodes companies Net Profits, a shrinking gross margin is usually a leading indicator to a recession. Economist Albert Edwards notes:
“To the extent that I believe it is the response of the corporate sector to downward pressure on profits that ‘causes’ recessions, this fall in margins is a key leading indicator. Optimists may say margins still remain high and companies can absorb this pain, but history indicates that any substantial decline in profit margins precedes a recession”
Net Margins are only starting to deteriorate, and have managed to resist a more pronounced downturn so far. The increase in profit margins to record levels was the result of a combination of unique circumstances:
The economic shutdown led to a reduction in payroll expenses, which is a major cost for companies.
Simultaneously, the government provided financial assistance to households, boosting consumer demand.
Limited production capabilities caused prices to soar, resulting in inflation.
With lower payroll expenses, and rising prices, companies saw significant profit margins.
Currently, the scenario has reversed. Salaries have increased significantly, borrowing costs are also on the rise, an abundance of inventory is causing prices to decrease, consumer demand is slowing, and no additional stimulus is expected in the near future. Layoffs are expected to boost Net Margins, but it is precisley the dynamic of laying off employees that triggers a recession.
Atlanta Fed GDPNow estimate for Q4 +3.5%
Curiously, despite many economic indicators slowing down significantly, Atlanta Fed predicts a strong Q4. We shall find out if the economy has indeed accelerated on Thursday, when the official measurement is announced.
We are still worried that the Federal Reserve is enacting tighter financial conditions, even though the average inflation rate for the past three months has already reached the Fed's target rate. This implies that the Fed is taking a significant risk of over-tightening and causing a more severe economic decline than is currently reflected in asset prices. However, this outlook only dictates the longer term trend for bonds and equities, not the immediate dynamics.
If we are right, 2023 will mean lower prices for stocks and higher prices for long term bonds. The Fed controls short-term interest rates, but the overall economy and inflation determine long-term yields. If a recession takes hold, long-term interest rates will decrease (and bonds will appreciate in value). Yield curves will invert until something “breaks”. Only then will the Federal Reserve start to lower rates.
Takeaway
Last week, we used Horizon’s signal to gain exposure to equities. We made the following adjustments to the Sigma Portfolio:
BOUGHT 7% position in MTUM (Momentum ETF)
BOUGHT 7% position in XLV (Healthcare ETF)
Since our baseline assumption for 2023 is an earnings recession (which is not priced in at current levels), this positioning currently remains “just a trade”. We hope to benefit from the short-term bullish tailwinds to equities in the following weeks and sell some FOMO to the crowd who will ultimately chase the markets into overbought territory.
The plan is to eventually buy back the hedge positions (PSQ, RWM) at better prices, and avoid a short-squeeze in the meantime. We can continue to build long term core positions in long term treasuries (TLT) and defensive / quality companies.
Andrei Sota