Welcome to RBC’s Markets in Motion podcast, recorded October 24th, 2023. 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 take a deep dive into the outlook for the US equity market from the S&P 500 all the way down to Small Caps.
Three big things you need to know:
- First, we are sticking with our YE2023 S&P 500 price target of 4,250. Though upside risks remain, downside risks have grown, the outlook has become cloudier and we don’t think the pause in the S&P 500 rally that we called for in early August is done yet.
- Second, we continue to believe that Large Cap Growth is in need of a tactical correction, but we also acknowledge its longer-term fundamental appeal which is why we think the leadership transition has been so tough.
- Third, Small Caps remain intriguing from a valuation and earnings perspective, but have been dragged down by balance sheet concerns, rising bond yields, and lingering economic angst.
If you’d like to hear more, here’s another 6 minutes – a little longer than usual, but there’s a lot to say so please bear with us. Now, the details.
Takeaway #1 – Why we’re sticking with our YE 2023 S&P 500 price target of 4,250.
- Back in early August, we argued that the rally in the S&P 500 was due for a pause. Although our valuation work was constructive and highlighted upside risk to our call, our cross asset models highlighted a deteriorating case for US equities relative to bonds, our sentiment model was on the cusp of suggesting US equities were overbought,
- … concerns about the 2024 election were starting to emerge, the upward earnings revisions that had powered the market in the first half of the year seemed to be in the rear view mirror, ….
- and seasonality was worrisome as August and September have often been bad years for stocks.
- We were hoping that once we made it through August and September, US equities would be out of the woods. But that’s just not where we are, and today we find that the US equity market is “Still In A Spooky Place.”
- Our cross asset models continue to deteriorate,
- earnings revisions trends have turned modestly negative again for the S&P 500 after a brief move into positive territory,
- and our sentiment model – which did end up signaling an overbought market in mid August – has retreated abruptly but hasn’t quite made it back to levels suggesting that US equities have become oversold.
- Political cross currents have become even more complex with an extended government shutdown still a distinct possibility and a pick up in geopolitical tail risk given developments in the middle east.
- US equity funds flows, which had also been strong throughout the middle months of the year are also faltering as Growth inflows have faded.
- Obviously, the surge in bond yields has taken center stage. We think the broader market is unlikely to find its footing again until the recent surge in bond yields comes to an end.
- Our top chart in meetings right now shows how historically, the S&P 500 is usually able weather surges in 10-year Treasury yields when they amount to 275 basis points or less. But when they are more than that, as was the case in 2021-2022, stocks tend to fall. We’re entering an critical phase on this issue right now - the current pick up in bond yields really started post SVB in early April – if we get to 6% we’ll have hit that 275 basis point threshold.
- While we don’t consider ourselves to be deeply bearish, particularly on a 12 month view, we think the US equity market still has a number of critical issues to work through for now and that downside risks have grown.
Moving to takeaway #2: The Large Cap Growth trade has problems to work through but also has longer-term appeal.
- The basic problem for the Growth trade is that it’s crowded and expensive.
- The latest weekly data from CFTC on asset manager positioning in Nasdaq 100 futures highlights how positioning has started to roll over after exceeding the high end of the range that’s been in place the last 6-7 years.
- Within the Russell 1000, Growth has been near a peak multiple relative to Value.
- And this is coming at a time when 10 year yields are surging, something that’s normally a catalyst for Growth underperformance.
We think Growth hasn’t been able to truly cede leadership for three reasons:
- First, earnings momentum has favored Growth over Value, though this may be starting to change.
- Second, consensus economic forecasts continue to anticipate sluggish (below 2%) real GDP growth in 2024 and 2025. This is an environment which typically sees Growth stocks outperform as sluggish economic growth tends to increase the appeal of owning secular growers.
- Third, the US has ended up being the more appealing geographical story in 2023 with better flows than other major geographies. Typically, when US equities outperform non-US equities, within the US Growth tends to outperform Value as well.
Ultimately, we think how investors approach the style call will depend on their time horizon. Shorter-term investors may want to reduce exposure to Growth stocks. But longer-term investors will likely see that as an opportunity to add.
Wrapping up with Takeaway #3: Opportunity Exists in Small Caps For Longer-Term Investors, But Near-Term Catalysts Remain Elusive
- We continue to like Small Caps for the longer-term.
- Although few investors seem interested in hearing it, Small Cap balance sheets appear to be in better shape than they’ve been in past cycles. Like Large Caps, Small Caps have pivoted to long-term debt, and the effective interest rate for the median Small Cap company is still quite low relative to history.
- On average, the weighted average maturity for Small Caps is 4.5 years.
- Valuations also remain compelling for Small Caps relative to Large Caps, with the relative forward P/E breaking to new post Tech bubble lows.
- And Small Caps have also nearly closed the gap relative to Large Caps on earnings revisions trends, removing an important advantage for Large Caps.
- Positioning in Small Caps has also taken a sharply negative turn on the weekly CFTC data, and has gotten close to post SVB lows.
- All that being said, the near-term picture for Small Cap has admittedly deteriorated, and we think it may take longer than we’d previously anticipated for a positive inflection in Small Cap relative performance to emerge.
- After showing signs of improvement earlier this year, Small Cap flows have deteriorated in most of the categories we’ve been tracking.
- Fed cuts have also turned into a psychologically far off catalyst as investors have started to debate whether another hike is coming in late 2023 and have become fixated on the surge in 10-year yields that’s been underway.
- Small Caps are always a part of the market best left to those with strong stomachs, and that statement seems even more true today.
That’s all for now. Thanks for listening. And be sure to reach out to your RBC representative with any questions.