Welcome to RBC’s Markets in Motion podcast, recorded May 16th, 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, our latest thoughts on economic expectations, sentiment, and valuations.
The big things you need to know: First, the S&P 500 is still trading as though it’s experiencing a growth scare, a framework that has been pointing to downside in the S&P 500 to ~3,850. Current trends in economic forecasts continue to support the idea that this is the right way to think about how far stocks should fall. Second, institutional investor sentiment has made significant progress catching down to retail investor sentiment, with overall US equity futures positioning among asset managers now below 2020 & Great Financial Crisis lows, and getting close to 2011 and 2015/2016 lows – something that makes the case for a bottoming in stocks relatively soon if recession fears can be kept at bay. Third, while valuations aren’t yet a reason to buy US equities on their own, they are no longer a problem for the market as a whole.
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Now, the details.
Takeaway #1: The S&P 500 is still trading like we’re experiencing a growth scare.
Despite how much worse the tape has felt, the S&P 500 closed on Thursday just 18.1% below its early January high. With that move, the S&P 500’s decline has been a little worse than the average post GFC (Great Financial Crisis) growth scare (the declines of 2010, 2011, 2015-2016, and late 2018), but not quite as bad as the more extreme ones of 2011 (-19.4%) and 2018 (-19.8%). The duration of the early 2022 drawdown (129 days) is also getting close to the average duration of the other major post GFC growth scares (147 days).
As we’ve highlighted before, if the S&P 500’s decline this time around matches the late 2018 drawdown, the index would fall to around 3,850, a level that the S&P 500 came close to hitting but failed to breach intraday on May 12th. In this context, we think the S&P 500 is currently at an important crossroads.
If 3,850 doesn’t hold, we think the equity market will be telling us that it’s starting to price in a recession. If that happens the key number to keep in mind is 3,200 which would represent a 32% drop from the January high – right in line with the average drawdown seen in past recessions.
Though we remain mindful that the risks to the economy have grown, it makes sense to us that the S&P 500 is attempting to stabilize just as it is approaching the outer band of growth scare territory. While recession expectations among economic forecasters have inched up recently per Bloomberg, they are still only on par with another post GFC growth scare (2011).
GDP forecasts on the Street have been pulled down, but are still slightly above trend for 2022 and are still north of 2% for 2023.
US economic surprises remain in positive territory.
High frequency economic indicators like dining, flying, back to work and same store sales remain stable.
Freight rates have come down sharply from their highs.
And inflation expectations are retreating. We don’t blame the stock market for wanting to see evidence of an unraveling before pricing it in, given how frequently the economy and US consumer have been more resilient than expected in recent years.
As for the Fed and the fear that they will tighten too aggressively, our economics team wrote last week that “It’s fair to wonder if the Fed will even get to neutral. We think Powell is growing worried about the degree to which the economy is going to slow.” More specifically, they think Powell’s dovish side is likely to re-emerge once the Fed starts to hear more about job losses.
Takeaway #2: Institutional investor sentiment has made significant progress in catching down to retail investor sentiment.
In our last Spotlight, we noted that while retail investor bearishness on equities has been extreme, such that it has been sending a contrarian buy signal for the S&P 500, that simply hasn’t been the case for institutional investors. And it may have simply been that in order for the US equity market to find a bottom, institutional investors have needed to catch down to retail. Today, there’s been no meaningful change in the sentiment for retail investors, where net bearishness remains at the deepest levels we’ve seen since the Financial Crisis.
Important progress has been made on the institutional side, however. The main way that we monitor institutional investor sentiment is by tracking the weekly CFTC data on asset manager positioning in US equity futures. Importantly, when we aggregate the data for all of the major contracts, we find that notional positioning is now below 2020 and GFC lows. Though it’s still technically above 2011 and 2015/2016’s lows, it’s gotten much closer to them.
Note that when we look at specific contracts among asset managers, we’ve seen significant progress towards past extremes in S&P 500 futures positioning in particular, which had been the main one that needed to catch down according to our previous updates. On a notional basis, S&P 500 futures positioning is now approaching GFC, 2011, 2018, and 2020 lows, though it remains a bit above its 2015-2016 lows.
Importantly, Russell 2000 futures positioning has already returned to GFC lows on a notional basis.
Meanwhile Dow futures positioning has fallen a bit below its GFC lows on a notional basis.
Elsewhere on the sentiment front, we are continuing to keep a close eye on the VIX and the equity put/call ratio, as well as crypto. On the VIX and equity put/call ratios, we continue to note that while they have been elevated they haven’t quite reached many of their post GFC peaks – perhaps arguing that institutional sentiment hasn’t fully unwound yet.
On crypto, which we view as another barometer of sentiment that matters to stocks, we point out that bitcoin and the S&P 500 have been positively correlated in recent years for the most part. We also note that bitcoin tends to peak well ahead of the S&P 500, in effect serving as a leading indicator.
Unfortunately, bitcoin doesn’t provide the same kind of long lead for stocks at the troughs. In addition to the trends in crypto, we’ll be keeping an eye on how the recent problems in crypto may have impacted consumer perceptions of wealth and possible reverberations in spending, as well as any impact on the labor market, either from job cuts or adding supply back to the labor force due to impacts on perceived wealth.
One data point that we find comforting regarding crypto and the potential for broader financial market contagion – public company references to crypto and blockchain in earnings and conference transcripts over the last few months have paled in comparison to the references made to the China trade war and tariffs back in 2018 and 2019 – suggesting to us that crypto poses less fundamental risk than even that development to the US equity backdrop.
Wrapping up with Takeaway #3: Valuations are no longer a problem for the stock market.
One thing that emerged for the S&P 500 last week was that all three top-down versions of the S&P 500 P/E multiple that we track – the P/E against last year’s EPS, this year’s EPS, and next year’s EPS – moved to levels slightly below their long-term averages. Though the stock market doesn’t look deeply undervalued on a P/E basis yet, we think this is an important milestone nevertheless since it sends the message that stocks are no longer expensive and valuations are no longer a problem.
On this topic, it’s also worth noting that the relative P/E multiples of the baskets of the most popular stocks in hedge funds that we track (as measured against the median S&P 500 stock) have returned to 2018-2019 levels, though not pandemic lows. While valuations aren’t a reason to own US equities yet, they are no longer a reason to avoid them.
Overall, while downside risks haven’t evaporated, the preponderance of the evidence we’re looking at makes us comfortable doing some bargain hunting.
That’s all for now. Thanks for listening. And be sure to check out our sister podcast, RBC’s Industries in Motion, for sector specific thoughts from RBC’s team of equity analysts.