Welcome to RBC’s Markets in Motion podcast recorded June 21, 2022. I’m Lori Calvasina, Head of US Equity Strategy at RBC Capital Markets. This week in the podcast, highlights from our conversations with institutional equity investors last week, plus updates on the valuation and sentiment indicators we’re watching.
Five big things you need to know: First, we’ve outlined two possible recession paths for S&P 500 EPS which suggest a valuation case for the S&P 500 can be made today on next year P/E if the recession is short-lived or at 3,200 on current year EPS. Second, as investors seek out clues on what’s been de-risked, we’ve been highlighting why the risk/reward for Small Caps has improved and note that Russell 2000 valuations returned to levels that often mark the low last week. Third, on sectors, we’ve also been highlighting how defensive sectors have been close to peak valuation vs. Secular Growth and Cyclicals, how Energy’s strong move up in early 2022 is out of sync with the typical recession drawdown, and how declines in Consumer Discretionary and Communication Services are already baking in recession to a significant degree. Fourth, the midterm elections are starting to emerge as a potential positive catalyst for US equities later this year in the eyes of some investors. Fifth, institutional investor sentiment appeared to get closer to a bottom last week.
If you’d like to hear more, here’s another 6 minutes. While you’re waiting, a quick reminder that if you’ve found this podcast helpful, we’d appreciate your vote in this year’s Institutional Investor All America Research Survey in the Portfolio Strategy category. Now, the details.
Takeaway #1: We’ve outlined two possible recession paths for S&P 500 EPS in a recession which suggest a valuation case for the S&P 500 can be made today on forward or next year P/E if the recession is short-lived, or at 3,200 on current year EPS.
Valuations have been in focus in our recent conversations, and our sense is that equity investors aren’t look for heroic multiples, but rather reasonable P/E’s in the 15-16x range to get interested in buying again. The big problem is that they have no confidence in the current earnings outlook where bottom-up estimates still haven’t been cut.
To continue our conversation about P/E’s with investors, we modeled out two recession paths for EPS – a longer recession based on median trends in EPS growth looking back over the past 3 recessions – 2001, the financial crisis, and the pandemic – and a quick recession modeled on the 2020 path. In both we assumed the recession starts in 3Q22.
I’ll spare you the math, but suffice it to say that the longer recession scenario anticipates S&P 500 EPS of $190 for 2022 and $164 for 2023. The quick recession scenario anticipates S&P 500 EPS of $187 for 2022 and $235 for 2023.
When we used these EPS numbers to gauge P/E’s at current pricing on the S&P 500, 3,500 and 3,200, two things stood out: First, on our quick recession scenario the next year P/E based on 2023 EPS is below the long-term average using all three price points including today. Second, at 3,200 – which would take the index down 32% for an average recession drawdown -- the P/E will look attractive on current year EPS on both of our recession scenarios. At 3,500 – which would take the index down 27% for a median recession drawdown - we’ll be close to average – which may end up being good enough - but not quite cheap.
Second, as investors seek out clues on what’s been de-risked, we’ve been highlighting why the risk/reward for Small Caps has improved and note that Russell 2000 valuations returned to levels that often mark the low last week.
One thing that jumps out from last week is that the Russell 2000 weighted median forward P/E is back down to 12.2x – an important development since this multiple tends to bottom in the 11-13x range.
We’ve been talking a lot about how CFTC positioning has been below GFC lows for Small Cap ….
…and Small Cap underperformance is already discounting a plunge in ISM mfg to trough levels/negative territory.
We’ve also been highlighting how the R2/S&P 500 relative ratio has been flat – small caps have actually stabilized relative to Large Caps in terms of performance – and that has continued in recent trading.
Third, on sectors and where the risks lie, we’ve also been highlighting how defensive sectors have been close to peak valuation vs. Secular Growth and Cyclicals, how Energy’s strong move up in early 2022 is unusual given recession concerns, and how declines in Consumer Discretionary and Communication Services are already baking in recession to a significant degree.
The chart in our meeting that has been particularly eye catching is the one showing how Energy stocks tend to fall in recession drawdowns, while Consumer Discretionary and Comm Svcs declines are basically already back to their typical recession declines.
Over the past month, it’s worth noting that Energy is now the worst performing sector relative to the S&P 600, while Consumer Staples and CD are the two best performers. Defensives and inflation sensitive sectors generally lagging, while Tech and Industrials, where valuations have improved significantly since the start of the year are also outperforming a bit lately.
Fourth, the midterm elections are starting to emerge as a potential positive catalyst for US equities later this year in the eyes of some investors.
We’ve been surprised at the number of questions we got about the midterms last week.
Investors are latching on to the tendency of stocks to sell off ahead of the midterms, and start to rally back about a month before they take place.
We’ve pointed out that Republican victory could be good for consumer confidence, not just the stock market, since Michigan survey is showing that consumer sentiment has been hit much harder for Republicans than Democrats.
Fifth, institutional investor sentiment appeared to get closer to a bottom last week.
CFTC positioning data for asset managers in US equity futures finally got back to 2015-2016 lows, the one low that had been eluding it.
We are also seeing some stabilization in the performance and valuations of the most popular stocks in hedge funds – it appears to us that both relative performance and valuations bottomed in May at the moment. This is important b/c stabilization in the performance of popular hedge fund names helped anticipate a bottom in stocks back in late 2018.
There are other indicators that continue to suggest the bottoming process needs more time to play out. The VIX and put/call still haven’t spiked enough as both are still below their post GFC highs.
We’d also like to see stabilization in crypto as bottoms in bitcoin and the S&P 500 tend to be coincident.
Retail investor sentiment remains deep in net bear territory on AAII but does appear to have stabilized.
That’s all for now. Thanks for listening. And be sure to check out our sister podcast, RBC’s Industries in Motion, for thoughts on specific sectors from RBC’s team of industry analysts.