Signs of Stress Emerging, Not Sufficient To Call An End - Transcript

Welcome to RBC’s Markets in Motion podcast, recorded August 22nd, 2022. This is Lori Calvasina, Head of US Equity at RBC Capital Markets. Please listen to the end of this podcast for important disclaimers.

Today in the podcast, we reflect on some of the most interesting things we saw last week in terms of insightful charts and questions plus the high frequency sentiment, economic, and political indicators we track. Three big things you need to know: First, our chart of the week highlights how the S&P 500 has been able to establish major bottoms in past periods of extreme stress before EPS forecasts were fully cut. Second, our question of the week addresses investor concerns that valuations no longer look appealing for the stock market following the big summer rally. Our work indicates that top S&P 500 valuations are above average but below recent major peaks, while Small Caps still look attractively valued, telling us valuation pressures are not sufficient to call an end to the summer rebound just yet. Third, what jumps out most in our sentiment work is that Nasdaq futures are starting to look overbought in the weekly CFTC data for asset managers, a negative data point for the market, but that positioning in S&P 500, R2000, and Dow contracts are still in the early days of their recoveries, a positive signal.

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Takeaway #1: It Is Possible For Stocks To Put In A Major Bottom Before EPS Forecasts Have Finished Falling

  • In our meetings with investors over the past week, one issue that clearly weighed on the minds of most of those we spoke with was whether the stock market can bottom while EPS forecasts are still getting cut.
  • Our chart of the week highlights clearly – to us at least – that this is not only possible, it’s something that’s tended to be the case in past periods of extreme stress.
  • To investigate this issue we reviewed trends in earnings sentiment -- the percent of sell-side EPS estimate revisions to the upside for the S&P 500 on a combination of FY1 and FY2 EPS since the late 1990s in relation to S&P 500 index performance. We found that the stock market experienced major bottoms in September 2001, October 2002, March 2009, February 2016, December 2018, and March 2020, but that the rate of upward EPS estimate revisions did not move above 50% - meaning mostly upward revisions were in place again at the single stock level – until February 2002, May 2003, June 2009, May 2016, May 2019, and July 2020.
  • While we remain concerned that the need to pull down 2022 and 2023 EPS forecasts will contribute to volatility in the stock market in coming months, this exercise leaves us more concerned about another swing lower in the S&P 500 that merely gives back some of the recent gains or retests the June low, and reduces our concerns about establishing a new low.

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Moving on to Takeaway #2: Valuations Are Elevated, But Not Extreme, For The S&P 500 Again But Small Caps Still Look Cheap

  • The bigger issue on investors’ minds that we heard more about in our meetings last week was valuations, and how the summer rally in the S&P 500 has left stocks looking expensive again. It’s true that S&P 500 P/E’s have moved slightly above average on bottom-up consensus EPS forecasts, and look even more elevated on our own EPS forecasts of $214 for 2022 and $212 for 2023. But even when we substitute in our own EPS views to the P/E calculation, it’s worth noting that multiples are still decently below the last few major peaks. In our minds, while this is worrisome, it’s not sufficient to call an imminent end to the summer rebound.

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  • We find it more reassuring for near-term market direction, frankly, that the Russell 2000’s forward P/E remains a bit below its own long-term average. In December 2018 and March 2020, major bottoms in the stock market were achieved when this particular indicator briefly dipped below its long-term average, and its foray to the low end of its historical range helped the broader market establish the mid June 2022 low. At the very least, investors who have become uncomfortable with S&P 500 valuations can still find bargains in the Small Cap space.

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Wrapping up with Takeaway #3: Nasdaq Futures Are Starting To Look Overbought Among Asset Managers, But Other US Equity Contracts Have Room To Run

  • Deeply depressed levels of investor sentiment for both retail investors and institutional investors, which continue to show signs of healing, have kept us out of the bearish camp.

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  • But we did see one red flag emerge in last week’s updates, as Nasdaq is starting to look overbought in the futures market. Since Growth and TIMT stocks have powered the rebound, that’s a concerning data point to be sure.
  • A positive signal for the market, however, is that the recovery in S&P 500, Russell 2000, and Dow futures positioning among asset managers still has plenty of room to run before even getting close to past highs. In particular, we are struck by how deeply negative positioning on Russell 2000 and Dow futures has been, with both still in deep net short territory and well below Financial Crisis lows recently.

One final thought before we conclude - overall, our sense is that stocks are setting up for some choppiness in the back half of the year, but it seems premature to call an end to the rebound just yet.

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 equity analysts.