Welcome to RBC’s Markets in Motion podcast, recorded June 21st, 2023. I’m Lori Calvasina, Head of US equity strategy for RBC Capital Markets. Please listen to the end of this podcast for important disclaimers.
This week the podcast is a little different. With the mid point of the year coming up, we’re revisiting the charts we discussed the most, and that resonated the most, in our meetings with investors in the first half of 2023. Although the S&P 500 has now pulled ahead of our recently revised year-end 2023 S&P 500 price target of 4,250, we’ve been north of the consensus tracked by Bloomberg on a median basis even before we raised it from 4,100 several weeks ago. For several months, the investors we’ve met with have generally assigned us to the bullish camp given what they’ve described as a more constructive view of the stock market on our part relative to other voices. We’ve joked that we’ve felt more neutral than bullish, but agree that we aren’t part of the bearish camp. Our top charts, which we discuss in today’s podcast, help illustrate why we’ve had this mindset. As for our market call today, most of our top charts are telling us the rally still has more room left in it, though one (which is sentiment based) requires close monitoring as it may soon signal that the rally has gone too far.
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Now, the details.
Top Chart #1 – The chart that caused many equity investors to get more open minded about the rally in our 2Q23 meetings
There’s no doubt in our minds that our top chart in the first half of 2023 is the one that shows how the S&P 500 essentially ignored the 1945 recession coming out of WW2, another period of post crisis normalization. We’ve written extensively about the similarities and differences between that period and today in several reports. The main thing to know is that back then the US economy experienced a technical recession (complete with a real GDP decline and job losses) when conditions started returning to normal and massive government support (in that instance, fiscal as opposed to monetary) was withdrawn in a hurry. Private investment and consumption remained strong, echoes of the resiliency of consumers and corporate profits that have helped prop up stock prices today. When investors (repeatedly) told us throughout 1H23 that the stock market couldn’t possibly have bottomed in October because the S&P 500 has literally never priced in a recession before it’s started, our response was perhaps that’s true, but there was one time when the stock market ignored a recession completely, and it actually has some similarities to the period we are in today. This chart has caused more than one bearishly inclined investor to pause, reflect, and reconsider their views. As one client told us recently, this comparison provided a realistic reason why things could be different this time than the typical recession path of market pricing.
Next up, Top Chart #2 – The chart that has framed our view of what kind of stock market environment we are in today
One of the reasons the 1945 chart spoke to us so deeply (other than our love of political science), is that we’ve never thought the label “bear market rally” was the right way to describe the move in the S&P 500 this year. Rather, dating back to last year, we’ve talked a lot in meetings about how the current environment has reminded us of two other periods that we’ve lived through in our two decade equity strategy career – 2002-2003 and 2010-2011. Both were multi-year periods that came after the initial, powerful recovery in the stock market that followed a major crisis and substantial decline (the bursting of the Tech bubble and the Great Financial Crisis). In both periods, the S&P 500 retested the same lows over and over and over again, and investors were constantly worrying about whether the US economy would tip back into recession again. Fall out from the major crises of those eras and geopolitical stresses (accounting fraud and the Iraq War in the case of 2002-2003, and the sovereign debt crises of 2010-2011) kept confidence extremely fragile. Interestingly, the S&P 500 has traded with a 71% correlation with 2002-2003 for the past year and a half. Using both the 2002-2003 and 2010-2011 periods as a guide, the stock market is at the point in the timeline where history suggests it should start to come out of its rut. As much as we’ve wanted the COVID narrative in the stock market behind us, we’ve been stuck in its epilogue. The good news is that recent trading suggests this post COVID phase may finally be ending.
Moving on to Top Chart #3 – The chart that debunked the myth that the October lows needed a retest b/c sell-side EPS forecasts were too high
Our long-time love of debate and appreciation for well thought out arguments is something that predates our time covering the stock market. One argument that has really bothered this lead author this year is the idea that the S&P 500 needed to retest the October lows because earnings estimates were too high. Experience has taught us that stocks are discounting mechanisms and often price big things in ahead of time. We spent some time early this year studying the timing and duration of EPS downgrade cycles and stock market bottoms and found that stock prices tend to bottom 3-6 months before EPS forecast on the sell-side start to be mostly positive again. The timeline was a little off in 2023, with the S&P 500 not returning to positive revision territory until late May. Despite being one month late, this rule of thumb came very close to the 2022-2023 reality (an October 2022 bottom, and the May 2023 return of positive revisions). Importantly, growth sectors like Tech that had been a major source of downward revisions in 2022 have helped lead the charge in the EPS revisions recovery for the broader market in early 2023.
Moving on to Top Chart #4 – The chart that has argued against the idea that the S&P 500 deserves to trade at a 15-16x P/E
This chart could easily be in our top five discussed over the past 12 months, as we began talking about it a lot last fall. It’s our S&P 500 P/E model, which forecasts a YE 2023 trailing P/E for the S&P 500 index based on data going back to the 1960’s. The current version of the model, which we’re constantly fine tuning, uses consensus forecasts for PCE, real GDP, 10 year-yields, and Fed funds to predict where the P/E should be at year-end. While many investors have been throwing out 15-16x times as the P/E they think the S&P 500 should trade at, our model has been suggesting that a P/E in the low 20’s is realistic at YE 2023 if inflation moderates to the mid 3% range as consensus forecast have been anticipating, even with weak GDP and Fed Funds above 5%. The expectation that 10-year yields will end up in the mid 3% range at YE 2023 has also been helping prop up the P/E forecast. One key thing we learned from this model is that in the 70’s and early 80’s, the last time the stock market grappled with intense inflation, inflation was a more significant driver of P/E’s than rates or the Fed. That tidbit of history suggests to us that the expectation for moderating inflation has been helping prop up P/E’s to levels greater than investors have anticipated in early 2023. Even on our below consensus EPS forecast of $213, this model has argued that the S&P 500 deserves to trade +4,600 if a 21.7x P/E manifests as the model projects. It’s been one of the more bullish components of our S&P 500 targeting process and suggests that the rally may have additional room to run from here.
Wrapping up with Top Chart #5 – The chart that has provided a gut check on deeply entrenched bearish views
Our last top chart is an old favorite used by many on the Street, and it’s one that we always return to because it helps us understand when sentiment has gotten too extreme in either direction. It’s our chart highlighting how deeply bearish individual investors were to start the year, with AAII net bullishness sitting near Financial Crisis lows. Typically, from those kinds of levels the S&P 500 posts mid teens gains over the next 12 months, something that suggests the S&P 500’s move to slightly above 4,400 has been rationale. Sentiment on this indicator had started to recover before the banking crisis, then quickly fell again. In recent weeks, another recovery appears to be taking hold and the bias is back in favor of the bulls. For now, the chart helps to explain how the move in the S&P 500 has been justified. Admittedly, we are now watching it closely as we expect it to help signal when the rally has gone too far. We’re getting closer to that point, but don’t think we’re there yet. On a 4-week average, +30% in favor of the bulls typically spells trouble for the stock market. The latest unadjusted weekly data point has bulls at +22% with the four-week average still at +5%. For now, this chart helps to keep us in the constructive camp. Admittedly, we’re not sure how long that will last.
That’s all for now. Thanks for listening, and be sure to reach out to your RBC representative with any questions.