Welcome to RBC’s Markets in Motion podcast recorded August 29th, 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.
Today in the podcast, we reflect on some of the most interesting things we saw last week in terms of charts, questions, quotes and high frequency data. Three big things you need to know: First, our chart of the week (inspired by our top investor question) highlights how the Russell 2000 has been able to establish major bottoms in past periods of extreme stress about 3-6 months before EPS forecasts started to turn positive again. This time has been different, however, as Small Cap EPS revisions actually turned slightly positive a few months ahead of the June low in the R2000. Second, political polling data, mid-term betting markets, and recent political news flow continue to highlight a shift in momentum back in Democrats’ favor, a growing headache for the stock market in the near-term. Third, stock market valuations improved after Friday’s Jackson Hole sell-off but don’t look cheap.
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Starting with takeaway #1: as we get deeper into the back half of the year, investors need to keep a close eye on Small Cap earnings revisions trends, not just Large Cap earnings revisions trends.
- In last week’s Pulse, we highlighted how the S&P 500 tends to put in major bottoms during periods of extreme economic stress several months before sell-side EPS estimate revisions turn positive again.
- Our Chart of the Week addresses a question we received about whether patterns have been similar for the R2000. The takeaways are the same – at least historically. Looking back over the past few decades, the R2000 put in major bottoms in September 2001, October 2002, March 2009, September 2011, February 2016, December 2018, and March 2020. But R2000 sell-side EPS estimate revisions did not return to positive territory (or the 50% mark) until February 2002, May 2003, June 2009, April 2012, May 2016, May 2019, and July 2020 – basically a 3-6 month lead.
- What’s most interesting, however, is that 2022 does look a little different. The percent of R2000 sell-side EPS estimate revisions returned to positive territory in April 2022, before the June 2022 YTD low in the R2000 index. Small Caps are usually an important barometer for the broader market in challenging times, and that remains true today.
Moving on to takeaway #2: the midterms are a growing headache for the stock market.
- US equity investors were anticipating a strong showing for Republicans in the midterms as the summer got underway which contributed to the summer rally in the stock market. But the risk to the consensus narrative around the midterms has continued to mount.
- Biden’s approval rating has continued to rise as gas prices have continued to come down.
- The generic Congressional ballot continues to slightly favor Democrats, which is a recent shift.
- And the betting markets for the mid term races, which recently flipped back in favor of the Democrats for the Senate by a slight margin, are now also showing a pick up in expectations for the Democrats in the House.
- Political news flow has continued to trend favorably for the Democrats over the past week with Biden’s plan to cancel some student debt, which may invigorate Democratic voters, and the results of the NY 19 special election for Congress. The latter is a district that some election watchers view as a national bellwether given that it was won by Obama, Trump, and Biden in the last three presidential contests. Last week the Democratic candidate not only won but (according to Politico) outperformed Biden. Politico also reports that major nonpartisan election forecasters are starting to adjust their forecasts for the Fall and talking about how the ‘red wave looks more like a red ripple.’
- Our base case remains that Republicans will take at least one chamber of Congress this fall, a positive development for the stock market since Democratic Presidencies and split or Republican led Congresses tend to be accompanied by some of the strongest stock market returns.
- But the shift in momentum seems strong enough to unsettle markets in the short term, or at least postpone any further, meaningful recovery in the stock market until later in the year in line with the more typical trading of stocks in mid term election years.
Wrapping up with takeaway #3: S&P 500 valuations improved after Friday’s Jackson Hole sell-off, but don’t look cheap.
- We got an earful about how the S&P 500 lost its valuation appeal this summer in our early/mid August investor meetings.
- After Friday’s big sell-off, the S&P 500 was a little below its long-term average on trailing P/E (19.2x) as well as on forward P/E using consensus forecasts for 2022 and 2023 EPS (17.8x and 16.7x).
- Using RBC forecasts for 2022 and 2023, at 19.0-19.1x the forward P/E’s were above average but still well below the peaks of the past few years.
- With uncertainty about the earnings outlook still swirling, this partially chips away at investors’ valuation concerns but doesn’t erase them.
- Something that we take more comfort in is that the R2000’s forward P/E remains well below average.
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.