Welcome to RBC’s Markets in Motion podcast, recorded April 22nd, 2024. I’m Lori Calvasina, Head of US Equity Strategy at RBC Capital Markets. Please listen to the end of this podcast for important disclaimers.
Four big things you need to know: First, investor sentiment has taken a bit of a hit, but it’s too early to say the pullback is over. Second, while we continue to expect the pullback to bottom out in the 5-10% range vs. recent highs, we’ve taken a look at S&P 500 performance around recent wars to gauge potential downside risks if we are wrong in that assumption. Third, it’s been a rough start to 1Q reporting season as companies beating consensus EPS forecasts have been underperforming significantly in terms of immediate price performance. Fourth, we’ve been surprised to see Large Cap Growth underperforming given the recent move up in 10-year yields, and run through the reasons (besides crowding and overvaluation) that we think this is happening.
If you’d like to hear more, here’s another 7 minutes. Let’s jump into the details.
#1: Starting with Takeaway #1: Sentiment Takes A Hit, But Not Quite Enough
With the S&P closing on Friday more than 5% below its recent peak, it’s reasonable to ask whether the pullback has run its course. Our answer is possibly, but we’re not convinced. The key thing we are watching are net bulls in the AAII survey which have, for the past few months, kept us on guard for some disruption in equity markets. In December, net bulls returned to levels roughly one standard deviation above their long-term average, similar to where they were last August when another pullback sparked by hot inflation prints, Fed fears, and rising 10-year yields took the S&P 500 down 10% by Halloween. In last week’s update, net bullishness fell to 4.3%, taking the four-week average down to 19.1 %. That’s a better range for stocks, to be sure, on a go-forward basis than where we were a few weeks ago, but is still well above the level seen last year in late October when this indicator fell to one standard deviation below the long-term average.
US equity futures positioning on the buyside, per the latest data from CFTC, also suggests that the frothy sentiment that’s been in place for the broader US equity market and mega cap growth trade in particular is a problem that’s far from fixed. Positioning on the buyside for the broader US equity market
S&P 500 futures
and Nasdaq futures hasn’t fallen much and is still sitting at extreme highs.
Meanwhile, widely watched indicators of stress in financial markets – the VIX…
… equity put/call…
…and the TDEX, a gauge of tail risk – have moved up a bit, providing some additional tangible evidence that market stress has picked up. These are close to levels seen last fall, but still remain quite low when looking back over longer periods of history.
And while it’s not exactly a sentiment gauge, it’s also worth noting that the period of outflows from U.S. equity funds that’s been seen on the EPFR data recently has been relatively short in terms of its duration.
Global equity funds have also started to see outflows in EPFRs’ recent updates. Both point to derisking.
Our approach is fundamental, but when sentiment-driven moves in the equity market take hold, we think it’s important to consult the technicians. RBC Dominion Securities’ technical strategist believes an important technical threshold was broken last week and that the next major level to watch on the S&P 500 is 4,931 then 4,845. That’s interesting to us because our valuation model has pointed to 4,900 as fair value for the S&P 500 if the Fed doesn’t cut again this year, inflation is stickier than anticipated with PCE around 2.8% at year-end, and 10-year yields end the year at 4.75%, far more elevated than most forecasters anticipated to start the year but still below last year’s 5% peak.
#2: Moving on to Takeaway #2: S&P 500 Declines Around Recent Wars Have Been Similar To Recessionary Drops
We pointed out last week that our base case is that the current pullback will bottom out in the 5-10% range vs. recent highs, ending up no worse than the pullback that hit the S&P 500 last fall. Pullbacks more than 10% usually occur when a growth scare occurs, as investors start to bake in a recession that doesn’t end up happening. The improvement we’ve been seeing in US GDP forecasts makes us doubt that we’ll see a pullback beyond 10%. If we are wrong, we think it will be because the economic narrative will shift, or because current geopolitical conflicts take a much bigger turn for the worse.
In this context, we’ve updated some work that we first put together back in 2022. It looks at the depth and duration of S&P 500 declines around the Gulf War that began in 1990, the US invasion of Afghanistan after the 9/11 terrorist attacks, the Iraq War of 2003, and the Russia/Ukraine War. Though none of these is a perfect point of comparison to the current situation in the Middle East, we think it’s telling that these market declines ranged from 20% to 34%, in line with the kind of drops that the S&P 500 experiences during a recession.
#3: Next, Takeaway #3: It’s Been A Rough Start to 1Q24 Reporting Season
EPS beats have been plentiful for both Large Cap…
… and Small Cap. But revenue beats have been lacking.
Interestingly, the companies in the Russell 1000 that have beaten consensus EPS forecasts have actually been underperforming in terms of their immediate stock price reaction post results.
This has also been the case within the Russell 2000.
As our regular readers are well aware, our team reads through as many earnings transcripts as we can to get a feel for key themes. Core themes are still emerging. Some of the things that are jumping out to us so far:
- For the most part, descriptions of the US economy and consumer continued to be favorable and emphasize its strength and resiliency.
- Some companies are planning for a wide range of economic interest rate scenarios or highlighting the uncertainty of the interest rate path, while others are still baking in a general easing scenario which will be a stimulus for better trends going forward.
- Some companies are still talking about back-end loaded forecasts, which has made some investors we’ve spoken with recently nervous.
- Several companies emphasized how they or their customers/consumers are managing through challenges and headwinds well.
- The big banks mostly emphasized the restarting of the IPO and M&A markets and full pipelines, alongside healthy corporate confidence levels. We can’t help but wonder if those confidence levels will stay high if the geopolitical situation continues to deteriorate.
- Companies continued to highlight elevated geopolitical risks, though few specific thoughts were shared about the current situation in the Middle East. The uncertainty associated with the current heightened level of geopolitical risk was in focus in these discussions.
- Color on geography was light, which was not surprising given the heavy presence of Financials in results so far. Commentary here was mixed and company specific.
- AI was in focus, with several companies highlighting their view that Generative AI is still in its early days and will take some time to mature and evolve. One company pointedly said this is a 2026 and beyond story. Companies, particularly Financials, also highlighted their efforts to build out these capabilities and their use as a productivity/cost savings tool.
#4: Wrapping up with Takeaway #4: The Growth Trade Has Come Under Pressure
We confess that we’ve been surprised to see Large Cap Growth underperform so badly last week given the recent move up in 10-year yields. For most of the past year, leadership in the top 10 names in the S&P 500 (vs. the rest of the index)
and the Large Cap Growth trade generally (relative to Large Cap Value) has been moving pretty closely with trends in 10- year yields.
We’ve been vocal about the overvaluation
and crowding that we see in the mega cap Growth trade for quite some time. Beyond those issues, which have been in place for quite some time, there are a few other recent developments that we think are encouraging the leadership rotation in the market.
- Earnings sentiment no longer looks better in Growth than Value. Within the Russell 1000, the rate of upward EPS estimate revisions on the sell-side is a little bit strong for Value than Growth right now. This reverses trends seen throughout 2023 when the rate of upward revisions was far stronger in Growth than Value.
- GDP forecasts have moved up another notch. As of Friday, the consensus 2024 projection for real US GDP moved up again to 2.4%, taking it close to this stat’s long-term average. An economy that’s running above trend has tended to be a better environment for Value than Growth in recent years. Secular growth themes are in less demand when cyclical growth is more abundant.
- The deterioration in funds flows that’s been underway recently has been sharper in Growth funds than Value funds.
- We are also continuing to see negative or deteriorating flows from growth-oriented sectors like Consumer Discretionary and Technology …
- … alongside improving flows to cyclical and commodity sectors like Energy, Financials, Industrials and Materials. We think this is further evidence that the US equity market is really taking its cues from the rapidly improving perceptions of the US economy.
That’s all for now, thanks for listening. And be sure to reach out to your RBC representative with any questions.