Q2 Earnings Season Kicks Off

Administrative Note: July is vacation month for myself at Signal Sigma; there will be 2 periods with no market updates (unless warranted by exceptional circumstances):

• 11-16 July

• 25-31 July

Meanwhile, the development team is working full time toward the production of the radical new version of the platform (see updates at the end of this article).

-Andrei

Last week, equity markets have achieved fresh all time highs on less than average volume, in a holiday shortened period. Light trading means that current pricing is not entirely validated. However, with several support levels in the immediate vicinity of the last close, the market maintains its bullish composure into the looming Q2 Earnings Season, which starts in earnest on Friday.

SPY has advanced in a gradual and unspectacular (almost “boring”) way in the last month. While new highs are in and of themselves a bullish catalyst, the records have been rather marginal. In the short term, the benchmark ETF is overbought, but has just triggered a MACD BUY signal nevertheless. This suggests that the market may attempt to climb higher in the next couple of weeks, despite limited upside.

The 20-DMA is offering support at $544 (-1.8%), while upside is not constrained by any technical levels. $582 is our fundamental target for now, which implies an extra +5.05% potential gains. We will review this target once most companies report Q2 Earnings, in late August.

Part of the reasoning behind the market’s advance has been an understanding that the Fed will definitely cut rates in September. Judging strictly by historical data, this thesis is well supported, leaving aside any bets made by interest rate traders.

Let’s instead look at December 2019 as a comparison point and ignore the exceptional post pandemic years for a correct perspective. At the end of 2019, these were the key economic indicators:

• Unemployment Rate: 3.6%

• Core PCE: 1.6%

• Fed Funds Rate: 1.5%

Today, the Unemployment Rate is 4% (+0.4% higher), Core PCE sits at 2.6% (+1.0% higher), yet the Fed Funds Rate is 5.5% (+4.0% higher). In hindsight, and without extrapolating inflation measures, it looks like the Fed Funds Rate is exceptionally high and a 1% - 2% cut can be entirely justified.

As shown below, using the Fed’s own Summary of Economic Projections, the longer run Unemployment and PCE inflation targets of 4.2% and 2% respectively should result in a Fed Funds rate of 2.8%. Arguably, both Unemployment and Inflation are currently running much closer to the Fed’s target than the benchmark interest rate level.

In our opinion, lower inflation going forward is a given (and that’s why we love the capital gains appreciation potential of treasuries). This week, we’ll get new inflation readings on Thursday, in what is probably the key economic release day of the week. Core Inflation is expected at 3.4% YoY, while headline Inflation should come in at 3.1% YoY.

The Fed’s main concern at this point should be to not overtighten financial conditions and keep the economy from slipping into a serious recession. As shown below, incoming data continues to disappoint, as an unexpected deterioration in activity shows up in the latest Atlanta Fed GDPNow projection for Q2’24.

Most notably, in an economy comprised roughly 80% of services, the sharp deterioration in the ISM Services PMI is very problematic. The reading in June featured the largest contraction since April 2020 (-9.3%) and is now in negative territory (48.8), usually associated with recessionary conditions.

While a one-month drop is not that meaningful by itself, the trend over the last 2 years has clearly been lower. Should PMI measures remain in contraction territory in the next couple of months, we may be looking at more than one rate cut.

The real problem for equity investors are valuations, which are running way ahead of fundamental data. The problem with rallying on “rate cuts” is that everyone is making the assumption that economic activity will pick up, given lower interest rates. This is a valuation expansion game, and it is nearing its historical limits on both a trailing and forward P/E Ratio basis.

The reality is that bullishness will quickly evaporate once it becomes clear that declining economic activity is showing up in company’s bottom lines (EPS results & guidance). At the end of the day, there’s only so much that higher multiples can do for stock prices in the absence of real EPS growth.

At a time when various economic indices are pointing to contraction, Wall Street analysts have been busy ratcheting up expectations for the future (not the very near future, mind you - projections for Q2 2024 have been lowered, in order to facilitate a high beat rate).

For the rest of the year and into 2025, S&P 500 EPS is expected to grow 17% to around $260 / share. This still requires investors to pay 21.4 times forward EPS, much higher than the 5-year average (19.3) and above the 10-year average (17.9). Meanwhile, actual realized EPS has been flat, at around $225 for the past 2 years.

A return to the 5-year trend in valuations (19.3), on low — but still positive — 6% EPS growth ($238.5), would take the S&P 500 index to around 4.600, representing a -17% drawdown from current levels. The mainstream financial media would most likely spin this as a “doom and gloom” / “markets in turmoil” type scenario, but it wouldn’t even trigger our stop loss. We would still be in a bull market and a drop of this magnitude would represent a great “buy the dip” opportunity.

The point that we are trying to make here is not one of extreme bearishness. Rather we are trying to calibrate expectations to the most likely economic outcome. One of the reasons why mega caps have been outperforming lately is their relative resilience to the economic cycle, especially when they can simply deploy cash to buy back shares and “paper over” any poor EPS growth issues.

The recent performance of AAPL is telling. As a reminder, AAPL has recorded 5/8 negative YoY revenue growth quarters in the past 2 years, yet the demand for shares outstrips supply.

Signal Sigma V2 Updates

Signal Sigma is undergoing a complete interface overhaul, in order to become much faster and bring you more advanced functionality.

In the new platform you’ll be able to directly import your portfolio and view exposure across factors and sectors…

…rebalance your holdings according to the risks and performance targets you set for yourself…

…and keep track of your trades through an intuitive journaling experience meant to build your investing confidence and create a sense of accountability when trading.

Our Trading Strategy

For now, bulls are in complete control of the narrative. Such was the case exactly one year ago, when equity investors were chasing the same “A.I.” and “rate cut” catalysts. The market topped in late July 2023, and several months of consolidation / correction followed.

Typically, such a pattern would fit well with an election year. It would not be at all surprising to see markets correct at least 5-10% ahead of November, on a mix of fundamental, technical and headline driven reasons.

That is why we are “pausing” our equity buying for the time being. It’s not that we are bearish longer term, just that current prices don’t inspire a lot of confidence in a slowing economy. In other words - there’s no reason to exceed target allocations, as there’s a decent chance we’ll get a much better opportunity to do so in the next couple of months.

Signal Sigma PRO members will be notified by Trade Alert of any live portfolio changes (if subscribed). If you’re not on this plan yet, you can get a free trial when you join our Society Forum. If you need any help with your trading strategy (or would like to implement one on your account), feel free to reach out!