Administrative Notice: New Pricing options are now available! Click Here to explore.

This week, the “Portfolio Rebalance” Article will resume, and will be published on Wednesday, July 12.

We will publish the next Quarterly Market Outlook at the end of August, after most companies report Q2 Earnings Season - in today’s edition, we’ll tell you what we expect from this season’s calls.

As Q2 Earnings Season Begins, Inflation and A.I. will take center stage

Before we review the busy period that lies ahead of us, let’s quickly recap where we left off last week. We wrote that optimism and “FOMO” were driving forces behind investors newfound risk appetite. The potential for a 5% - 10% correction in the equity market remained elevated, with the main indices hovering at abnormally overbought levels.

It does seem like the week’s economic data damped risk-taking quite a bit - and outright confused certain investors. The latest ISM Services number, which exceeded expectations, indicates that there is currently no indication of an impending recession. As noted in the chart below, there has never been a recession since the 2000’s when services (which comprise 80% of the economy) are not in contraction.

However, Friday’s employment report showed some signs of deterioration, with only 209K jobs added, versus 225K consensus. Just one day earlier, ADP’s employment report said private employers added 497K jobs in June, versus expectations of 245K - a very hot print. Are statisticians and economists doing a lousy job, is there noise in the data or are we dealing with seasonal quirks?

Either way, bonds sold off, and yields are now close to the record levels reached in March (on the 2-year). SPY has not managed to reverse the MACD Sell Signal and has remained under pressure.

SPY Analysis

In terms of Market Internals, our chief concern remains Dollar Transaction Volume. This has softened to well below average values. In the past, strong rallies accompanied by lower than average volume have tended to “stall”, as the fuel to push spot prices higher in a continuation move is missing. This leads to a situation where the next volume spike happens on a down-move, as traders “buy-the-dip”.

Unfortunately, the bulk of the advance since late March has materialized in only in a handful of stocks. Our Z-Score Divergence chart illustrates the performance differential that exists between SPY and the average stock in the market. This remains elevated at over 1 standard deviation, relative to the past 2 years. While momentum has propelled SPY to 52-week highs, the reality is that most stocks have not benefited from the same buying interest.

As mentioned previously, we would rather increase exposure using a better entry point. The next important catalysts loom: Wednesday’s Inflation report, where a 3.1% headline print is expected, and Q2 Earnings Season that gets underway on Thursday with Delta’s results.

Q2 Earnings - Will results support the Bullish case?

If you are an astute observer of the markets, you will have, by now, remarked a stunning fact - no matter what happens in the markets, or in the economy, there is always a high number of companies beating “earnings estimates”. Are analysts simply too pessimistic when predicting corporate results, or is there something else going on? To what extent can we rely on estimates and “expectations-beating results” in our investing? As FactSet notes, analysts always lower their estimates as the reporting season approaches:

In terms of estimate revisions, analysts lowered earnings estimates for Q2 2023 by a smaller margin than average during the quarter. On a per-share basis, estimated earnings for the second quarter decreased by 3.0% from March 31 to June 30. This decrease is smaller than the 5-year average of -3.4% and smaller than the 10-year average of -3.4%.

Downward revisions to Q2 earnings estimates for S&P 500 companies by analysts have been less pessimistic than average, while negative earnings guidance issued by companies for the second quarter has been consistent with recent averages. Overall, estimated earnings for the S&P 500 for the second quarter are lower today compared to expectations at the start of the quarter. The index is now expected to report its largest year-over-year decline in earnings since Q2 2020. - FactSet

For companies to win the “beat the estimate game,” they need the bar lowered far enough to ensure they can clear it. Many companies would miss, rather than beat, if not for these downward revisions in analysts’ estimates.

Unsurprisingly, it’s management that benefits from these lowered bars, as the bulk of C-suite compensation is directly tied to share price performance. Over the years, companies have resorted to 4 primary tools in order to boost profitability:

• Wage Growth Suppression

• Productivity Increases via usage of Technology

• Labor Reduction via offshoring

• Share Buybacks

These tools only create the mirage of profitability. As shown in the chart below, from our Market Fundamentals instrument, SPY’s CAGR over the last decade is nearly double the median revenue growth registered by constituent companies. Normally, there should not be such a discrepancy, as the pace of revenue increase should match economic activity and corporate profitability. Outside of the labor force and wage controls, corporations have heavily engaged in share buybacks to increase EPS (and consequently, share prices).

It is not surprising to see a large “wealth gap” between workers and executives. Given this backdrop, and the advent of A.I., we expect the future to look more like the past, and see this “wealth gap” exacerbating. Note the recent decline of revenue growth to the decade median.

Albert Edwards from Societe Generale notes:

“The over-anticipation of an imminent recession last year helps account for the snap back in equities this year. Our excellent cross-asset derivatives strategist, Jitesh Kumar, pointed out the great chart below from JP Morgan (H/T @dailychartbook on Twitter) showing that, within the equity market, belief in a cyclical upswing is really taking a firm grip. That chart certainly suggests that investors believe the threat of recession has passed.

But if you take a closer look at Gerard Minack’s chart, one thing is clear – economists having apparently got their recession call wrong, always give up on it just at the point when it arrives. Indeed, I can remember even I, an uber bear, finding myself doubting my own recession forecast as we went through 2007.“

Despite the usual downward revisions ahead of the reporting period, analysts have raised future estimates in order to support Price Targets. As noted by FactSet:

Industry analysts in aggregate predict the S&P 500 will see a price increase of 9.3% over the next 12 months. […] At the sector level, the Energy (+23.0%) and Health Care (+15.6%) sectors are expected to see the largest price increases, as these two sectors had the largest upside differences between the bottom-up target price and the closing price on July 6. On the other hand, the Consumer Discretionary (+3.8%) and Information Technology (+4.6%) sectors are expected to see the smallest price increases, as these two sectors had the smallest upside differences between the bottom-up target price and the closing price. - FactSet

However, EPS for S&P500 companies is already running at very elevated levels (+1 Z-Score), and has yet to revert to the decade trend. In the face of decelerating revenue growth, maintaining profit margins via the implementation of technology in order to reduce costs will become dominant themes.

Historically bloated inventories do not bode well for margins going forward. As the chart below suggest, consumer discretionary (as well as staples) companies will have a hard time shifting merchandise. Our commentary regarding Nike’s earnings report illustrates the point:

EPS was in line with expectations, despite higher revenues;  gross margins fell 140 basis points to 43.6% from an average of 45.04% in the last 2 years, with the company blaming“higher product input costs and elevated freight and logistics costs, higher markdowns and continued unfavorable changes in net foreign currency exchange rates.” Basically, Nike’s report shows an increased difficulty in passing on higher input costs to the final customer; - NKE earnings commentary

Our Trading Strategy

We might be in for quite a bit of turbulence in the summer months, as equity prices seem to be on a “collision course” with economic reality and the Fed (which is still expected to raise rates twice in the remainder of 2023).

For now, however, investors seem to ignore the fundamental red flags and technicals have improved dramatically as a consequence. Such positioning can last much longer than logic would dictate. While we remain underweight equity exposure for now, our goal is to increase risk exposure once a better entry point is reached (somewhere around $420 on SPY, or below “Neutral” values on our sentiment indicator).