PRO-EYES


Last Update: August 8, 2022

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

If a cyclical bear market is beginning given the difficult job that central banks have for the next few years, the longer-term bias has to be towards selling rallies and positioning portfolios as boring as they can be. Lower P/E stocks, more value and earnings quality makes sense for the next few years. We see sticky inflation building, which should be tough for most asset markets. Active rotation can payoff in an environment like this versus buy and hold where the uncertainty factor remains high. Expect volatility readings to remain elevated. There should be lots of two way opportunity to adjust portfolios. Long bond (10-year duration) is no longer compelling at 2.75% as it was close to 3.50%. This could be the trading range for several quarters ahead.

VALUATION

Risk Level: 68%

Overall valuation levels remain neutral, though up lower from last week on equity market strength. We are still seeing significant swings in risk premiums and the market debates the inflation, growth and earnings outlooks. We are starting to see macro multiple downgrades, while bottom up forecasts are just starting to move lower with about 86% of the S&P 500 reporting. Markets have responded well. Downgrades for 2023 are concentrated in tech, discretionary and communications sectors. We expect more of this if inflation remains sticky as we expect and central banks have to be tighter longer.

Enterprise Value to EBITDA

A reading about 60% historically means the average returns over the coming years will likely be modestly below average. Valuation metrics are not great timing indicators, but looks to frame longer-term expectations and magnitude of a correction when a catalyst develops. Enterprise value (EV) is the amount of debt plus equity capital a company uses less cash like holdings to generate free cash flow. Earning before interest taxes depreciation and amortization (EBITDA) has improved significantly over the past year while recent weakness in stocks and bonds has lowered EV. While not compelling given the recession risks still to play out, these are the best valuations since the COVID lows.

Price-to-Sales

A reading near 80% historically means the average returns over the coming years will likely be well below average. While the market is expensive historically, this metric suggests longer-term returns will be well 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. Nominal GDP looks to grow, so sales numbers are likely to grow over the next year and while margins may compress somewhat, EPS likely continues to grow. Expectations for a recession are still modest.

Forward P/E

A reading near 50% historically means we should expect about an average return over the coming years. Forward P/Es 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 18.22. Over the past month, 12-month forward EPS estimates have decreased by -1.01%. Over the past 3 months, forward EPS estimates have increased by 0.18%. The rate of EPS change is slowing but still good relative to nominal GDP expectations.

Equity Risk Premium

A reading around 80% historically means that ERP is very high, but is not extreme. The combination of stimulative interest rates and stock market multiples offer a cautionary message if either earnings or interest rates do not confirm expectations. Overall, the ERP declined 6.2bps last week. The yield of the 30-year bond increased 5.6bps. The earnings yield of the S&P 500 declined 0.6bps. We see the 10-year yield peaking just above 3% in the coming months, we were suprised by the speed of the rise. With tax receipts plentiful, Treasury should not have too much trouble funding the QT roll off in the next few quarters. Massive dollars are in the reverse repo market, which could fund the trillion need this year. If not, the ERP should expand in this backdrop pushing asset values lower.

BUSINESS CYCLE FACTOR

Risk Level: 77%

The cost of money and credit is no longer stimulative and risk factors are high, but not yet extreme. Parts of the economy are in contraction, but labour demand remains strong through July. Evidence is showing a slowing trend in labour demand. The late August Jackson Hole Fed conference is where Powell likely tries to get the 2023 rate cuts priced out of the market with more hawkish talk. This of course is misguided and will likely tip the boat. The parallels to the 1970s stagflation are popping up in many places. Asset markets could face a difficult number of years ahead.

Slope of Yield Curve

A reading near 90% suggests the yield curve (3-months vs. 10-years) is close to forecasting recession. A flat yield curve leads to credit contraction as lending profitability is curtailed. A curve this flat suggests financial conditions are tight. The recent trend has been flatter. Last week, the 3M-10Y curve was 22.4bps flatter. The significant inversion of 2s-10s again portends where the funding curve is heading. The forward curve is pricing rate cuts by mid 2023. The Jackson Hole conference at the end of August will likely set the risks between growth and inflation and will be key to a FOMC policy mistake. Being well behind the curve was a big one.

High Yield vs. Investment Grade Credit Spreads

Credit spreads are thought to be a leading indicator. At a reading around 40% is slightly wider than long-term averages, suggesting the risks are tilted a bit better than neutral, but it’s the trend that matters. Credit spreads are finally reacting to tighter financial conditions. The problem with the market is not credit related, as liquidity remains ample, but is being withdrawn at the fastest pace in decades. Credit widening portends economic weakness, which we are closely monitoring. The hot inflation pressure is not as much a business cycle effect as it is a supply side issue. If credit spreads start to lead wider, we have bigger trouble. They should stabilize for now and are attractive in the IG space. Over the past month, HY-IG spreads are -79bps narrower. Over the past 3 months, HY-IG spreads are 26bps wider. Momentum is fading.

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 modest contraction. Growth challenges are significant without deficit driven stimulus. For more details see: https://www.newyorkfed.org/research/policy/weekly-economic-index#/interactive
There are severe distortions in leading indicators due largely to the start stop nature of the COVID influence and massive start top stimulus. We are not paying much attention to leading indicators. Recent trends are pointing to contraction at the same time job growth is strong.

Real Yields & Inflation Expectations

Over the past week, real 10-Year Treasury yields increased 22.7bps. Nominal yields increased 17.8bps, while long-term inflation expectations fell -4.9bps to 2.58%. Real monetary policy is tight 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: 47%

Seasonality, volatility and short-term breadth indicators are negative factors while sentiment readings are slight positives. Overall the indicator is very neutral leaving the it close to a coin flip. Macro indicators continue to point to a policy mistake on the eve of recession is a biggest issue for the next few quarters.

5-Day Put/Call Ratio
Risk Level: 56%
The Put/Call ratio measures a degree of speculation and hedging in the options markets. A reading around 60% suggests modest speculation. Last week, the average put volume declined 4,735 contracts per day while the average call volume declined 13 contracts per day. The market bounce from extreme PCR oversold readings is not surprising. We do not see scope for bullish speculation yet.
Speculative Position S&P 500 Futures
Risk Level: 2%
Positions of speculators in the S&P 500 futures contracts offers a potential future source of supply or demand. Current readings are very bullish and extreme enough that it is a contrary indication. As of July 19, S&P 500 E-mini speculators reduced their net short position last week by 369.0 million dollars. The shift in positioning suggests some degree of capitulation and extreme bearishness. Earnings will need to be exceptional to overcome the Fed’s policy path, but this aspect suggest good short covering potential.
Percentage Deviation from 200-Day Moving Average
Risk Level: 1%
The market only spends less than 30% of the time below the 200-day average. While this can denote a bearish trend, it most often coincides with a buying opportunity. It’s rare that the market falls this much below the 200-day average without a tradable bounce coming. The 50-day average recently crossed below the 200-day average and marked the recent low perfectly. It suggests rallies should be sold until the current anxiety has passed. The bias has shifted far more towards selling rallies for now despite the market behaviour as the trend lines crossed. The failure to hold above the 200-day on the recent rally is a significant negative signal. Rallies can happen, but likely fail to make higher highs.
AAII Bull vs. Bear Sentiment Spread
Risk Level: 16%
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 increased 2.7% while the percentage of bears decreased 4.3%. 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: 80%
The 1-Month forward based return is poor. Historically the average return is close to zero. 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: 56%
The 1-Month forward based return is slightly below average based on the current year of the presidential cycle model. The second year of the presidential cycle typically is the worst of all. That tilts the bias a bit in favour of being more cautious when seasonal factors are weakest. That expectation is historically seen between March and September.
Current vs. Average Volatility (VIX)
Risk Level: 74%
Last week, volatility was -5.0% below the previous week. It was -13.0% compared to it’s 50-day average. The 50-day average is 34.8% above it’s long term trend. in the past few weeks we moved from extreme pessimism to complacency levels. It speaks to the high uncertainty factor and why volatility levels overall are elevated compared to longer-term averages in past cycles. We expect more volatility during the tightening cycle. Policy mistake is a huge probability.
Current vs. Future Volatility (VIX)
Risk Level: 43%
Last week, current volatility was 1.2% above the previous week. Future volatility was -1.5% below the previous week. The ratio of current volatility to future volatility is lower than median, but not yet 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: 43%
The percentage of stocks in the S&P 500 above their own 50-Day averages is 56.9%, which is 28.4% above the previous week. It is 24.4% above the average of the past month. Tactically, not weak enough for a 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: 1%
The percentage of stocks in the S&P 500 above their own 200-Day averages is 22.8%, which is 3.2% above the previous week. It is 0.2% 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: 13%
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: 8%
The 13-week RSI is very weak 44. 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.