Earnings Season Begins amidst Geopolitical Risk

The conflict in Israel grabbed the attention of investors and almost all of the business headlines last week. Talk of World War III being on our doorstep, the fall of U.S. influence around the world, and the demise of the U.S. Dollar have predictably contributed to a risk-off mindset. The market is trading in “Fear” mode again. And “Fear” is also sold part and parcel through social and traditional media channels.

When investing, we need to be as level-headed and rational as humanly possible. It’s not always an easy task, especially when focus and emotional energy is spent toward other goals. Through this newsletter, we aim to distill the market action for you, and help you realize the risks and potential rewards of the current set-up in an objective manner.

Last week, the market digested important CPI and PPI data. SPY managed to close the week with gains and triggered a short term BUY signal, despite the ominous headlines. This coincides with the “seasonally strong” period of the year, but for the moment the advance ran into resistance at the Upper Trend-Line. We expect further consolidation in the week ahead, before another attempt at resistance is made.

SPY Analysis

From a technical perspective, SPY closed just above R1 support, at $431. A cluster of resistance sits just above, with the 50-DMA and the Upper Trendline capping gains at $440. Further up, the R2 level sits at $449.

To the downside, extra support is offered at the 200-DMA, at $421.

The near term direction of the market will undoubtedly depend on earnings reports, especially as Netflix and Tesla hold conference calls on Wednesday. The bar has been significantly lowered from last year, so we can expect a high “beat rate”, which would embolden risk appetite. Of course, analysts have lowered EPS expectations by around 20% since last year for S&P 500 companies (from $236 to $187), so that the 75% + beat rate is maintained.

So far, FactSet data indicates that 84% of S&P 500 companies have reported a positive EPS surprise and 66% of S&P 500 companies have reported a positive revenue surprise. 6% of total companies have reported results, and the “beat rate” is trending in the positive direction. Analysts maintain a $240 EPS estimate for next year.

Since Earnings Season starts with markets near the “Fear” side of the sentiment spectrum, we can surmise that there should be significant upside available in the near and medium term. Commitment of Traders data (second screenshot below) shows hedge funds still being net-short in their equity allocations. Short covering activity will also act as fuel to the upside.

…the war in Ukraine compounded by last week’s attacks on Israel, may have far-reaching impacts on energy and food markets, global trade, and geopolitical relationships. This may be the most dangerous time the world has seen in decades. - Jamie Dimon, on JPM’s Earnings Call

On the geopolitics side, we need to recognize that conflict is problematic for the stock market only in the short term. Initially, capital flows to the perceived safe havens of the market - treasuries, gold, and in this particular care - oil.

Longer term, however, developments tend to be positive. Armed conflicts are a boon for companies’ bottom lines, especially for sectors that contribute to the war effort - materials producers, defence contractors, services for troops at home and abroad. Conflicts mean capital is moved around, people get employed, activity is increased and the economy grows.

Case in point: since Russia invaded Ukraine, in February 2022, SPY has returned around 7.9%. In the interim, the drawdown reached -14%.

Seasonality and the Bond Market

Seasonality also looks encouraging for stock market investors. So far, 2023 has tracked historical return patterns particularly well, as shown below. Stock buybacks also start at the end of October, offering yet another support to the equities asset class.

Bonds have been the beneficiary of recent “safe haven” flows. TLT has regained the all-important M-Trend level, at $86.42, and becomes technically viable again. The benchmark long term bonds ETF is no longer oversold, which is a technical positive factor. There have been a couple of “myths” perpetuated around social media regarding bonds that we’d like to adress.

Myth # 1: There are fewer foreign buyers of US debt.

Fact: yes, but only if you take Q4 of 2021 as a comparison level. Otherwise, the long-term trend is still strongly positive and intact. And while foreigners are indeed important buyers of treasuries, their holdings don’t hold a candle to the Fed’s own balance sheet.

“Japan and China hold about $1.1 trillion and $800 billion of U.S. Treasuries. While that may seem significant, they pale compared to the largest holder of Treasuries, the Federal Reserve. The Fed owns about $8 trillion. Even if China or Japan were to sell aggressively, the Fed could easily step in and absorb their selling pressure.” - Michael Leibowitz

Myth #2: Yields are higher because the treasury is issuing debt at an unsustainable pace, creating a debt spiral.

Fact: while the US Debt / GDP ratio of 120% is problematic by itself, recent issuance is not the cause of higher yields. In fact, yields were lower when Debt / GDP was higher, in 2020 and 2021.

Myth # 3: Treasury debt issuance is much larger now than it used to be in the past.

Fact: false. Treasury auction data does not show any significant abnormalities when compared to the recent 5 year history. Auction sizes for longer-term bonds are above pre-pandemic levels but below their 2021 peaks.

Our Trading Strategy

Our portfolio is nearly at target. We are monitoring for risks at the moment, and making small tweaks to positions as risk-reward changes for each. Strong seasonality and positive headlines should help the market going forward.

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