PRO-EYES


Last Update: September 29, 2023

Jump to section: Valuation | Business Cycle Factor | Tactical Factor

While it appears now that we are much closer to the terminal rate, we do not see an easing until the market and Main Street feels more pain. The FOMC does not expect inflation to return to target until 2025, which suggests that higher for longer is here well into 2024. Main street has felt no pain yet given the employment situation is still relatively strong. Historically, we do not see the bottom is in until Main Street feels the recession. It does not have to be deep, but no cycle in history has ever bottomed at full employment. Inflation is unlikely to get back towards the Feds target without some labour market pain that the FOMC is willing to endure to make sure inflation expectations are grounded. A soft landing is an extremely low probability that is fully priced in.

VALUATION

Risk Level: 75%

Forward based EPS are still likely too high unless you believe the fastest rate hike cycle in history does not end in recession. So while valuations have moved back to somewhat more median levels as price has declined and forward EPS is rising, risk premiums are still too low on trend. At major cycle lows, valuations should be at a discount to fair value and longer-term averages. There is still more work to do ahead. Valuation risk factors are showing a high degree of caution.

Enterprise Value to EBITDA

A reading about 80% historically means the average returns over the coming years will likely be below average. While the market is relatively expensive historically, this should not be used as a timing indicator, but adds to the cautionary environment. Enterprise value (EV) is the amount of debt plus equity capital a company uses less cash like holdings to generate free cash flow. EBITDA and EPS expectations are likely far too high given the tighter financial conditions that are likely to continue for a while longer. The challenge with valuation ratios is that the divisor is a forecast and will change over time.

Price-to-Sales

A reading near 70% historically means the average returns over the coming years will likely be below average. While the market is modestly expensive historically, this metric suggests longer-term returns will be below average and should not be used as a timing indicator, but adds to the cautionary environment. The revenue a company generates is less subject to manipulation (financialization) like earnings per share can be and can be a better valuation metric than comparisons to earnings. Many industries have higher margins, so price-to-sales is not a perfect guide. With several recessionary indicators now fully flashing high risk, decay in the employment picture would cement an earnings recession. With nominal growth still strong, revenue growth is still likely, but margin pressures are building and volumes are already in decline. This should negatively impact EPS going forward.

Forward P/E

A reading near 60% historically means the average returns over the coming years may be a little below average. While the forward P/E is slight above average, historically, this metric suggests returns will likely be close to average. Forward PEs should not be used as a timing indicator, but rather a guide to current longer term expectations. Earnings expectations are a key factor for longer-term market growth. Forward P/Es historically are 2 multiple points below trailing average. The historic average P/E for US large caps is about 16.5x earnings versus the current forward P/E of 19.61. Over the past 3-months forward EPS estimates have increased by 1.65%. Over the past month, forward EPS estimates have decreased by -0.05%. The rate of EPS change is declining at a faster pace.

Equity Risk Premium

A reading of 100% historically means the average returns over the coming years will likely be well below average. While the market is expensive historically, this metric suggests returns will be well below average and should not be used as a timing indicator, but adds to the cautionary environment. The equity risk premium is the discount factor investors are paying for stocks above the risk free rate. The inverse of the P/E called the earnings yield plus the long-term government yield is a reasonable estimate. Overall, the ERP declined 9.4bps last week. The yield of the 30-year bond increased 17.5bps. The earnings yield of the S&P 500 increased 8.1bps. The tightening of financial conditions is likely to continue in the short run. But we are very close to fully pricing in the terminal rate of Fed funds and weakening of the economy and earnings should start to balance out. Markets remain on the expensive side, but it’s mostly because of higher rates.

BUSINESS CYCLE FACTOR

Risk Level: 75%

A reading of 100% historically means the average returns over the coming years will likely be well below average. While the market is expensive historically, this metric suggests returns will be well below average and should not be used as a timing indicator, but adds to the cautionary environment. The equity risk premium is the discount factor investors are paying for stocks above the risk free rate. The inverse of the P/E called the earnings yield plus the long-term government yield is a reasonable estimate. Overall, the ERP declined 9.4bps last week. The yield of the 30-year bond increased 17.5bps. The earnings yield of the S&P 500 increased 8.1bps. The tightening of financial conditions is likely to continue in the short run. But we are very close to fully pricing in the terminal rate of Fed funds and weakening of the economy and earnings should start to balance out. Markets remain on the expensive side, but it’s mostly because of higher rates.

Slope of Yield Curve

A reading near 100% suggests the yield curve (3-months vs. 10-years) is forecasting recession within the next 12 months. An inverted yield curve leads to credit contraction as lending profitability is curtailed. A curve this flat suggests financial conditions are extremely tight. The recent trend has been steeper. Last week, the 3M-10Y curve was 18.1bps steeper. The forward curve is pricing in only modest rate cuts by mid 2023. Powell launched the higher for longer narrative and we expect the curve to remain in recession mode until inflation clearly breaks. This restrictive curve could last into 2024, though the recent banking insolvencies can complicate the FOMCs job fighting inflation.

High Yield vs. Investment Grade Credit Spreads

At a reading near 40%, credit spreads are slightly below the mid point of their long-term extremes and show moderate risks. We should expect the direction of the recent shorter-term trends to continue until reading become more extreme. The yield-to-worst (maturity) for junk bonds is 8.65%, which is -1.7 standard deviations below average. The FOMC and other central banks are reducing liquidity and e expect them to maintain tighter financial conditions than equity markets are pricing for an extended period. Looking out, we should expect tighter financial conditions and wider credit spreads until the economy troughs. Over the past month, HY-IG spreads are 13bps wider. Over the past 3 months, HY-IG spreads are -17bps narrower. Momentum is increasing.

NY Fed Weekly Leading Indicators

Over the past week, the NY Fed weekly leading economic index slowed. The trend over the past month is rising at a slower pace. The recent trend suggests evidence of weaker growth. Growth challenges are significant without deficit driven stimulus. For more details see: https://www.newyorkfed.org/research/policy/weekly-economic-index#/interactive We are now past the stimulative phase of the cycle and looking ahead, quantitative tightening (QT) will likely provide a major hedwind for risk premiums. The labour market remains the stickiest part of the core inflation push with real assets showing signs of deflation.

Real Yields & Inflation Expectations

Over the past week, real 10-Year Treasury yields increased 14.2bps. Nominal yields increased 13.7bps, while long-term inflation expectations fell -0.5bps to 2.69%. Real monetary policy is restrictive relative to long-term expectations. Short-term inflation numbers remain extremely elevated, while longer-term market based inflation expectations are elevated relative to the range of the past decade. Based on recent curve moves, the market has likely priced in more tightening than the FOMC actually will need to do given increasing odds of a recession.

TACTICAL FACTOR

Risk Level: 28%

Tactical factors are showing more opportunity than risks in terms of buying dips. The challenge remains the macro headwinds of higher for longer should limit rally potential until the FOMC actually cuts rates. We expect a hard landing is needed to move the FOMC to ease unless inflation falls to targets without it. It seems like a very low probability outcome. So while there is likely to be strong support around the 4200 area on the S&P 500, we doubt it’s the next major bottom. If it fails to hold, we will likely see all the 2023 gains erased in due course.

5-Day Put/Call Ratio
Risk Level: 11%
The Put/Call ratio measures a degree of speculation and hedging in the options markets. A reading around 10% suggests an extreme degree of bearish protection is being traded relative to bullish speculation. Last week, the average put volume incresed 4,710 contracts per day while the average call volume incresed 1,397 contracts per day.

Speculative Position S&P 500 Futures
Risk Level: 70%
Positions of long only speculators in the S&P 500 futures contracts offers a potential future source of supply or demand. Current readings are elevated, it’s not until the position gets to an extreme that it becomes a good contrary indication. As of September 26, S&P 500 E-mini long only speculators reduced their net long position last week by 5,209.2 million dollars. This group of long-only asset managers are as long as they have been since November 2021.
Percentage Deviation from 200-Day Moving Average
Risk Level: 36%
When the market is close to the 200-day average, it could go either way. If recently trends are bearish it can act as resistance. If recent trends are bullish, it can act as support. In volatile markets, it has somewhat less meaning. Timing can be difficult and we need other confirming indicators to identify the opportunity. The 50-day average is now above the 200-day average (Golden Cross), but the trend over the past month is weaker. The 200-day average held a key test last week. It must continue to hold or the bull-trend signal will turn bearish again.
AAII Bull vs. Bear Sentiment Spread
Risk Level: 17%
When the percentage of Bulls is well below the percentage of Bears, there is plenty of pent up demand and cash to buy. Last week the percentage of bulls decreased -3.5% while the percentage of bears increased 6.3%. Over the past month we have seen extremely bearish sentiment, which happens frequently in bear markets, but also sets up a high probability of a counter trend rally.
Seasonal Pattern (All Years) Since 1928
Risk Level: 58%
The 1-Month forward based return is slightly below average based on the 4-year presidential cycle model. The second year of the presidential cycle offers the most volatility and lowest returns on average of all years combined. With both a fiscal and monetary reversal in play, there is a strong catalyst for poor returns this year. We are over weighting seasonal factors this year.
Presidential Cycle (Current Year) Since 1928
Risk Level: 70%
Positions of long only speculators in the S&P 500 futures contracts offers a potential future source of supply or demand. Current readings are elevated, it’s not until the position gets to an extreme that it becomes a good contrary indication. As of September 26, S&P 500 E-mini long only speculators reduced their net long position last week by 5,209.2 million dollars. This group of long-only asset managers are as long as they have been since November 2021.
Current vs. Average Volatility (VIX)
Risk Level: 36%
When the market is close to the 200-day average, it could go either way. If recently trends are bearish it can act as resistance. If recent trends are bullish, it can act as support. In volatile markets, it has somewhat less meaning. Timing can be difficult and we need other confirming indicators to identify the opportunity. The 50-day average is now above the 200-day average (Golden Cross), but the trend over the past month is weaker. The 200-day average held a key test last week. It must continue to hold or the bull-trend signal will turn bearish again.
Current vs. Future Volatility (VIX)
Risk Level: 35%
Last week, current volatility was 1.6% above the previous week. Future volatility was 1.8% above the previous week. The ratio of current volatility to future volatility is now close to inverted. Volatility levels remain elevated. We expect this to continue as investors debate central banks taking the punchbowl away while waying the risks of WWIII.
Percentage of S&P 500 Holdings Above 50-Day Average
Risk Level: 2%
The percentage of stocks in the S&P 500 above their own 50-Day averages is 15.5%, which is 3.4% below the previous week. It is 14.6% below the average of the past month. Tactically, extremely close to a strong oversold buy signal. It’s now been a few months since the market made its all-time high and so the opportunity for more stocks to break trend has developed. The 50-day average will cross below the 200-day average this week. Look for an oversold rally soon, but a move to new highs is unlikely until the reasons for the market corrections have been fully priced in. That could take a while given the rate hike cycle just started.
Percentage of S&P 500 Holdings Above 200-Day Average
Risk Level: 11%
The percentage of stocks in the S&P 500 above their own 200-Day averages is 40.8%, which is 3.3% below the previous week. It is 9.1% below the average of the past month. Statistically, breadth readings are extremely oversold and odds of a rally are high once a catalyst develops. At this point we need a friendly FOMC and a ceasefire in the Russia-Ukraine war.
Breadth-McClellan Summation Index
Risk Level: 9%
The breadth of the market is extreme near record lows. Few stocks are participating in the advance. Overhead divergences suggests that a rally to new highs is unlikely. But there should be enough support buying dips as long as earnings fundamentals hold up.
Overbought-Oversold 13-Week Relative Strength Index
Risk Level: 28%
The 13-week RSI is a neutral 47. Overall, RSI has much higher signal efficacy at extremes and better at bottoms than tops. The extreme seen last week coupled with the bullish weekly chart pattern suggest decent bounce potential. This is likely “a” bottom, but probably not the bottom.