2023 US Equity Market Outlook - The Tug of War Continues Transcript

Welcome to RBC’s Markets in Motion podcast, recorded November 30th, 2022. I’m Lori Calvasina, Head of US Equity Strategy at RBC Capital Markets. Please listen to the end of this podcast for important disclaimers.

Today in the podcast, our thoughts on the 2023 outlook for the US equity market.

Three big things you need to know: First, our year-end 2023 S&P 500 target of 4,100 is unchanged, though we have lowered our 2023 S&P 500 EPS forecast by roughly 4% to $199. Second, we continue to anticipate choppy conditions in US equities over the next few quarters. Third, in terms of higher-level positioning, we prefer US equities over non-US equities, Value over Growth, and Small Cap over Large Cap.

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Now, the details.

Takeaway #1, there’s no change to our year-end 2023 S&P 500 target of 4,100, though we have lowered our 2023 S&P 500 EPS forecast by roughly 4% to $199.

  • Our 4,100 target represents a gain of 3% from Monday’s close. It’s the median of five different models encompassing analysis on the economy, valuations, sentiment, politics, and stocks vs. bonds. Our most optimistic test puts the index at 4,600, our “bull case” if our “base case” of 4,100 is too conservative.
  • For our $199 EPS forecast, we are leveraging consensus economic forecasts as tracked by Bloomberg, baking in sub 1% real GDP throughout 2023 and CPI that falls to 3.1% at the end of next year. We also bake in a few Fed cuts baked in the 2nd half and the 10-year yield returning to 3.5%.
    • The two big things contributing to the downshift in our 2023 EPS forecast are: (1) weaker GDP assumptions than our last update, and, (2) our new interest expense model, which increased our expectations for the bite that this will take out of earnings.
    • The $199 puts us even farther below consensus which is still tracking at $231.

Takeaway #2: We continue to anticipate choppy conditions in US equities over the next few quarters.

  • We continue to see stocks as caught in a tug of war between the bulls and the bears.
  • On the bullish side, our sentiment work is constructive (net bullishness was still below -10% in the latest AAII survey, normally accompanied by a 15% 12 month forward return in the stock market), … and our valuation model also implies that moderating inflation and slightly lower interest rates can support some modest P/E expansion into the low 20’s on a trailing basis. Both of those help push up price target up.
  • On the flip side, the Fed is still a problem. The S&P 500 is typically down one month before final hikes, which our economics team expects to happen in March.
  • And as we’ve discussed on the podcast before, the S&P 500 is also trading on the 2002-2003 path. Back then, stocks peaked in November and retested the October lows in March. The US invasion of Iraq helped to put in the final market bottom, but we have a hard time seeing geopolitics getting better anytime soon.
  • Other challenges include a limping economy (stocks are typically flat when full year real GDP is in the 0-2% range), the diminished appeal of stocks relative to bonds (which was also a problem as 2011 and 2018 began, as seen in our dividend yield test and earnings yield gap analysis), and the need for sell-side earnings estimates to come down.
  • On earnings, there are a couple interesting data points to keep in mind as we ponder what further estimate cuts mean for stocks.
    • First, stocks already trading like a major hit to EPS growth is coming.
    • Second, in percentage terms, most cuts in bad earnings years are typically done by April, and for all the talk about how 2023 numbers need to come down, it’s not unreasonable to assume that will be the case this time around as well as this is the sharpest earnings downgrade cycle since 2009.
    • And third, we’d keep a close eye on the rate of upward EPS estimate revisions for individual companies in the S&P 500. Typically, the stock market bottoms 3 to 6 months before the rate of upward revisions turns positive again.

Takeaway #3: In terms of higher-level positioning, we prefer US equities over non-US equities, Value over Growth, and Small Cap over Large Cap.

  • On US/non-US, fundamentals favor the US …recession odds are lower, and the US outperforms when recessions occur… …but valuations are stretched as we suspect once a bottom is firmly in place non-US equities will assume leadership again.
  • On Growth/Value, balance sheets look better for Value the stronger Dollar is worse for Growth, and recessions usually usher in big sticky leadership shifts but Growth is higher quality and tends to outperform when GDP is weak.
    • We’d keep an eye on 10 year yields as declines tend to favor Growth stocks.
    • Valuations are also worth watching, as they are starting to turn attractive for Growth again but just barely.
  • Our highest higher level conviction call is Small Cap over Large Cap.
    • We upgraded Small Cap to overweight back in July. Small Caps have actually been outperforming Large Caps since mid-May. We were early on this call and see more room to run.
    • There are four things we really like about Small Caps right now –
      • First, valuations still look attractive, in both absolute and relative terms vs. Large Caps,
      • Second, Small Caps are more domestic, meaning the stronger US dollar is less of a headwind,
      • Third, Small Caps have a better earnings profile than Large Caps right now with better trends on earnings revisions and margins seen at the moment, and
      • Fourth, Small Caps already appear to be baking in a recession – Small Cap performance is already baking in a spike in jobless claims and a plunge in ISM to typical troughs.

That’s all for now, thanks for listening, and be sure to reach out to your RBC representative with any questions.