Welcome to RBC’s Markets in Motion podcast recorded June 7th, 2022. This week in the podcast, we’re updating our outlook on the broader US equity market. Three big things you need to know: First, we are trimming our S&P 500 year-end 2022 price target to 4700 from 4860. This is a housekeeping move. We are continuing to bake in a slower economic growth backdrop in 2022-2023 as opposed to a recession. Second, we continue to be more intrigued with Growth over Value going forward as most of our indicators look better for Growth or are fading for Value. Third, we recommend removing underweights on Small Cap and moving back to neutral vs. Large Cap, as Small Cap looks intriguing or better on our positioning/sentiment, valuation, and earnings work. The better risk/reward for Small Cap is something that reinforces our view that equity markets generally can move higher through year end.
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Takeaway #1: We are trimming our S&P 500 year-end 2022 price target to 4,700 from 4,860, a reduction of 3.3%.
- We’ve refreshed our models that go into our targeting process and reworked a few of them. 4,700 is roughly the average and median of 11 different scenarios that we examined.
- Our GDP based models, which bake in a slowdown in economic growth but not a recession, point to an annual gain of 4-6% on the S&P 500 this year and are the most constructive of our models pointing to a year-end close in the 4950-5100 in the S&P 500.
- Our GDP assumptions in our models are inspired by the views of our in house economics team and trends in sell-side consensus economic forecasts. Our economists see recession as up for debate, but their call is for real US GDP to come in at 2% for the year. For 2023 they are pointing us to a mid 1% type number.
- Sell-side GDP forecasts have shifted lower and are looking for 2.6% this year and 2% for next year. This is all telling us to prepare for a return to below average GDP in 2023, but we think it’s premature to bake in a recession.
- Our sentiment models, which bake in typical recoveries off bottoms in the AAII survey and off growth scare lows, call for the S&P 500 to end the year in the 4,500-4,900 range. When net bearishness on the weekly AAII retail investor survey bottoms, stocks are usually up more than 9% 7 months later and more than 15% 12 months later.
- Off growth scare lows like 2010, 2011, 2015-2016, and late 2018, recoveries in the S&P 500 tend to be fast and furious with 25% gains 7 months down the road and a return to pre-crisis highs within 4-5 months.
- Our three cross asset models, which compare stocks to bonds and focus on earnings yields vs. 10 year yields, the dividend appeal of stocks vs. Treasuries, and real yields, all suggest the S&P 500 should end the year in the 4,300-4,400 range - a reminder that bond yields are taking a bite out of forward equity returns.
- Meanwhile, our new valuation test bakes in a 17% contraction in the S&P 500’s forward P/E multiple similar to what was seen in 1994, 2001, and 2020, and more extreme than what was seen in 2018. It suggests the S&P 500 should end the year in the 4,200-4,300 area based on current EPS growth forecasts on the sell-side.
- We continue to see recession and a broadening out of the Russia/Ukraine war as the big risks to our market call and as we’ve discussed before if the 3850 level in the S&P 500 – which would price in a full growth scare similar to 2011 and late 2018 – doesn’t hold – the S&P 500 could fall to 3,200 for a 32% drop which would bake in the average recession. But we don’t think recession is a foregone conclusion right now and that it’s premature to bake one in.
- If a recession can be avoided, stocks have probably seen their lows. There were some initial signs of healing in last week’s AAII retail investor sentiment update. And we’re also seeing signs of a rebound from institutional investor capitulation in the weekly CFTC data.
- Moving on to takeaway #2: We continue to be more intrigued with Growth over Value going forward as most of our indicators look better for Growth or are fading for Value.
- Growth got hit hard in May but is attempting yet another comeback over the past few weeks.
- Our work suggests that the reasons to like Growth far outnumber the reasons to stick with Value – Growth has better quality, Growth valuations look reasonable or slightly attractive vs. Value again, long-term EPS growth expectations for Growth have stabilized vs. Value – which tends to track the relative P/E b/tw the two, our rates strategy team thinks 10 year yields may have peaked which removes an impediment for Growth leadership since the direction of yields has been driving this trade, we usually see a leadership away from Value back to Growth after Fed rates hikes begin, and Growth tends to outperform Value when economic growth is tracking below average as consensus economic forecasts expect to be the case in late 2022 and 2023.
- The earnings backdrop has favored Value, but this could soon change. Value has only a slight advantage vs. Growth on the rate of upward earnings revisions, an important gauge of earnings sentiment, and Tech, an important Growth constituent, is starting to ramp up again.
- Additionally, Value margins tend to display better trends than Growth margins when the economy is running above average, but Growth margins tend to trend better when GDP Growth is below average.
- It’s also worth noting that the three primary Growth sectors – Comm Svcs, CD, and Tech – are at historic lows relative to Defensive sectors (Staples, Uts, and HC) on relative P/E – something else that supports the idea of rotation into Growth as well as the idea that the stock market has bottomed.
- We recognize that this call may not work in the short-term if US equities take another leg lower and start to price in a full recession. Hedge fund derisking, which swept markets in March and April, is usually worse for Growth than Value, Nasdaq futures positioning among asset managers doesn’t look washed out on the CFTC data right now, and while the performance and valuations of popular hedge fund stocks is back to 2017-2019 ranges, neither has quite make it back to the past lows of that era.
- Wrapping up with takeaway #3: We recommend removing underweights on Small Cap and moving back to neutral vs. Large Cap.
- Small Cap has been holding steady relative to Large Cap for most of 2022.
- We think this is deserved - as Small Cap has started to look intriguing or better on our positioning/sentiment, valuation, and earnings work.
- Importantly, Small Cap futures positioning among asset managers actually fell below Financial Crisis lows in May pointing to true capitulation.
- On valuation, the Russell 2000’s weighted median forward P/E is well below it’s long-term average and below pandemic lows, while the Small/Large relative P/E indicator is the cheapest we’ve seen since the Tech bubble. The Small Cap valuation case is broad-based, as every quintile of market cap, and almost every small cap sector except Consumer Staples and Utilities looks reasonably valued or undervalued.
- And on earnings, Small Caps are starting to look a little better than Large Cap on the rate of upward EPS estimate revisions. Large Cap also seems to be losing its margin advantage vs. Small Caps.
- Though the risk/reward for Small Cap has improved, we’re not ready to shift back to overweight yet due to ongoing fundamental headwinds. Small Cap typically underperforms Large Cap when ISM manufacturing is falling, when GDP is below average, after the Fed starts tightening, and when high yield spreads are widening.
- Given that Small Cap peaked relative to Large Cap in early 2021, it’s fair to say a lot of this is baked in. But it’s also fair to say that positive catalysts for a Small Cap breakout are hard to identify. The most likely one we see is a pause in Fed hikes this Fall or more clarity on the end of the hiking cycle.
- In a way, recession could be another. Historically small caps underperform early on in a recession, but outperform in the market rebound on the way out of recession, and usually end up outperforming over the course of recessions from start to finish.
That’s all for now. Thanks for listening. And be sure to check out our sister podcast, RBC’s Industries in Motion, for additional thoughts on specific sectors from RBC’s team of industry analysts.