Welcome to RBC’s Markets in Motion podcast, recorded July 22nd, 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.
This week in the podcast, we update our outlook for the S&P 500 and several key positioning trades. The big things you need to know: First, we’ve made another cut to our YE 2022 S&P 500 price target to 4,200 from 4,700 and have lowered our S&P 500 EPS forecasts to $214 for 2022 and $212 for 2023. Second, looking into the back half of the year, the midterm election could be a positive catalyst for stocks and help stocks find a bottom, if one hasn’t been established already. (3) In terms of positioning, we continue to prefer US equities over non-US equities and Growth over Value. Meanwhile, our conviction level on Small Caps has strengthened and we are now going overweight Small Cap.
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Now, let’s jump into the details.
Takeaway #1: We have lowered our S&P 500 price target and EPS forecasts for 2022 and 2023.
- Our price target – which we think of as a number the index will trade at on December 31st -- has gone to 4,200 from 4,700, and our 2022 EPS forecast has gone from $223 to $214 – below the bottom up consensus of $230. Our 2023 EPS forecast has gone from $243 to $212 – below the bottom up consensus of $248.
- Our new 4,200 price target is the average of 10 different backtests based on performance in past crisis years, valuations, earnings revisions, sentiment, and cross asset analysis on stocks vs. bonds.
- Our 2022 and 2023 EPS forecasts of $214 and $212 compare to 2011’s actual of $211. These forecasts assume that earnings go no where for a few years, similar to 2015-2016. Our model uses consensus macro estimates for things like GDP and CPI along with forward commodity prices. It’s baking in real GDP that comes close to contraction in 4Q22 and stays sluggish throughout 2023. It has margins getting hit decently hard.
- We’ve also prepared a 2nd version of our earnings model that bakes in a clear recession, with outright contraction in real GDP growth in several quarters in late 2022 and early 2023 on a yr/yr basis. This version of our model argues that S&P 500 EPS should come in at $200 for 2022 and $195 for 2023 and calls for even more significant deterioration in margins than our base case.
- Looking beyond the numbers at the path we anticipate for stocks… if a short/shallow recession that’s concentrated in late 2022/early 2023 materializes, we think it’s possible that the S&P 500 has already bottomed, or will find a bottom during the 3rd quarter. As far as we’re concerned for the stock market, the sooner the better.
- There are a lot of reasons why we think stocks may have bottomed or are close to one – stocks tend to bottom 4-5 months before a recession ends, and the 24% decline in the S&P 500 as of mid June was very close to the median recession drawdown of 27%.
- We’re also seeing peak valuations in defensive sectors which characteristic of market bottoms, and outperformance by popular HF stocks since late May. The latter is important b/c we saw popular hedge fund names start to outperform about a month before the market bottomed in late 2018.
- Additionally, the trailing P/E for the S&P 500 has already fallen as much as it did during the Tech bubble, the downward earnings revisions has finally started,
- As we’ve discussed on the podcast before, we’ve also seen deeply bearish sentiment and positioning among retail investors where net bulls on the AAII survey are back to historical lows.
- We’re seeing the same thing on the institutional side with CFTC data on asset manager positioning in US equities finally back to all time/2015-2016 lows.
- We do worry that it’s a little too early for earnings expectations to completely reset for 2023. I actually don’t like that reporting season has gotten off to a good start – this may delay the ripping off of the band-aid investors have wanted to see until the 3Q reporting season when more evidence of slowing demand is seen by corporates and visibility into 2023 economy is greater. Recently, 37% of sell-side EPS estimate revisions have been to the upside, but bottoms on this indicator tend to happen in the 10-30% range.
Moving on to Takeaway #2: Looking into the back half of the year, the midterm election could be a positive catalyst for stocks and helps stocks find a bottom, if one hasn’t been established already.
- Typically, mid-term election years are weak for stocks, but the S&P 500 tends to bottom in early October about one month before the event, before rallying back around 7% through year end.
- While a good outcome for Republicans seems unlikely to surprise investors, it could help stabilize consumer sentiment as Republicans have been feeling much worse than Democrats in the University of Michigan survey.
- A good showing for Republicans in the midterms could also generate excitement about the political backdrop for stocks longer-term especially. Year 3 of the Presidential Cycle tends to be the best for stocks,…
- as does the combination of a Democratic President and split or Republican led Congress.
- And the polling data is starting to suggest that the Democrats look weak and divided with some polls suggesting Democrats want a different nominee in 2024.
Wrapping up with takeaway #3: In terms of positioning, we prefer US equities over non-US equities, Growth over Value, and Small Cap over Large Cap.
- We’ll dig more into our US/non-US and Growth/Value calls another time – for now, suffice it to say Growth has been outperforming Value since late May and this tends to be accompanied by US leadership relative to ROW.
- Looking more closely at Small Cap, we’ve been telling investors for a while to get back to neutral on Small vs. Large and pull off Small Cap underweights. Small Cap has been trading sideways relative to Large Cap. But our conviction level on Small Cap has continued to grow and so we are going overweight.
- The key thing to remember is that historically, recessions are buying opportunities for Small Cap – they lag on the way down and outperform after the market finds its mid recession bottom.
- Small Cap valuations have also been near historical lows in both absolute terms
- and relative to Large Cap.
- Positioning has also been hit hard on the CFTC data - asset manager positioning in Russell 2000 futures contracts is deep in new short territory and well below GFC lows.
- We’ve also seen a clear shift in earnings revisions trends back in Small Cap favor. They experienced downward revisions earlier than Large Cap and are holding up better now.
- And most importantly, Small Caps are already baking in the deterioration that’s starting to show up in economic data. Small Cap performance over the past year has been consistent with ISM manufacturing levels already at typical troughs,
- and a sharp spike in jobless claims. It’s also worth remembering that historically Small Caps have tended to start outperforming Large Caps when the unemployment rate starts to move up – they price in the bad news on the labor market ahead of time.
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 additional sectors from RBC’s team of industry analysts.