Tug of War Into Year End - Transcript

Welcome to RBC’s Markets in Motion podcast, recorded September 13th, 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 update our thoughts on the broader US equity market outlook as well as bigger picture positioning trades. Three big things you need to know: First, there’s no change to our year-end 2022 S&P 500 target of 4,200 or our 2023 S&P 500 EPS forecast of $212, though we have tweaked our 2022 S&P 500 EPS forecast up to $218 from $214. Second, we continue to anticipate choppy conditions through year end, in which stocks are caught in a tug of war between deeply bearish sentiment and ongoing concerns about further Fed tightening and its longer-term economic ramifications and downward earnings revisions. The mid-term elections remain a major headache, but may ultimately still be a positive catalyst. Third, we continue to prefer US equities over non-US equities and Small Cap over Large Cap. We wouldn’t be surprised to see the pause in Growth leadership persist in the near term, but still like Growth over Value longer term given that we expect a sluggish economic backdrop to be the price markets will have to pay for a short/shallow economic downturn.

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Flip to slide 2 (target table)

Takeaway #1: There’s no change to our YE 2022 S&P 500 price target of 4,200,of our 2023 EPS forecast of $212, though we are tweaking our 2022 EPS forecast up to $218 from $214.

  • Our 4,200 forecast is roughly the average of 9 different scenarios and back tests that we examined. We come up with a wide range of outcomes which underscores the complexity of the backdrop this year.

Flip to slide 3 (sentiment test)

  • Our most optimistic test –which assumes the S&P 500 bottomed in mid June and sees its typical 6 month post recession bottom rally – puts the index just below 5,000 at year end.

Flip to slide 4 (valuation table)

  • Meanwhile, our most conservative test – which assumes the forward P/E for the S&P 500 will contract by 17% for the full year in 2022 or the average move in recent growth scare/crisis/recession years – anticipates the index will close the year around 3,850.

Flip to slide 5 (div yield test)

  • Our cross asset indicators, which look at stocks vs. bonds, suggest the index deserves to end the year around 4,100.

Flip to slide 6 (EPS model page)

  • In our earnings forecast, the macro backdrop we are baking in to our model is one in which real GDP growth gets to the brink of contraction in 4Q22 and 1Q23 and sees inflation ramping down to the 2-3% range by the end of 2023. The increase in our full year-year 2022 number from $214 to $218 is mostly due to better than expected 2Q22 results for 2Q22. During 2Q, interest expense relative to sales came in significantly lower than we’d expected, while revenue growth and margins both came in a little light compared to what we’d been modeling.

Flip to slide 7 (betting markets)

Takeaway #2: We continue to anticipate choppy conditions in US equities through year-end, essentially a tug of war between the bearish and bullish narratives in play.

  • Major problems include further downward revisions to earnings, the mid-term elections (where Democrats are gaining on Republicans in polling and betting markets)…
    • Flip to slide 8 (valuation page)… valuations (which are looking a bit elevated again), Fed tightening (which tends to pressure P/E’S and hit economic growth), declines in C suite confidence, and likely deterioration in the economic/labor backdrop.

Flip to slide 9 (revisions vs. S&P 500)

  • But we are also mindful that the S&P 500 tends to bottom in major crises while earnings forecasts are still falling, think it’s still more likely than not that the Republicans will take at least one chamber of Congress in November, Flip to slide 10 (valuation with Fed shading) note that valuations are still well below past peaks and that substantial contraction already took place at the mid June lows, see evidence that corporate balance sheet strength is providing a cushion to EPS, Flip to slide 11 (S&P 500 vs. claims)… and have done some work suggesting that the stock market is already baking in a material deterioration in the labor market. Flip to slide 12 (supply chains)
  • Supply chains also improving, inflation expectations have peaked, and Flip to slide 13 (high freq) high frequency economic indicators are stable or improving, and flip to slide 14 (claims and layoffs) employment indicators have calmed down, keeping the deeply bearish narratives in check.
  • Overall, we feel more neutral than bullish or bearish. Whenever we are tempted to get more cautious, images of our main sentiment indicators pop into our head. Flip to slide 15 (AAII)…Retail investors have felt as bad as they did at the depths of the Financial Crisis, Flip to slide 16 (CFTC)…and Institutional investor positioning in US equity futures has actually been a little worse than during the Financial Crisis, on par with 2015-2016 lows.

Flip to slide 17 (US/non-US valuations)…

Takeaway #3: In terms of positioning, we continue to prefer US equities over non-US equities, think the pause in growth leadership may persist a little while longer but still like growth longer-term, and continue to see Small Caps over Large Caps are our highest conviction call.

  • On the US/non-US call, even though we think US equities are likely to keep benefiting from safe haven treatment for a while longer, though we have grown concerned about valuations as US equity valuations are starting to get back to peak relative to non US equities again. This trade bears watching closely.

Flip to slide 18 (Nasdaq CFTC)…

  • On growth/value, we’ve been talking about how the Growth trade was starting to look crowded again at the end of the summer, based on CFTC data on Nasdaq futures positioning for asset managers. The unwind has started but hasn’t fully played out and this could keep some pressure on Growth short term.

Flip to slide 19 (Growth/Value GDP)…

  • But longer term, we continue to prefer Growth due to its higher quality and the tendency of Growth to outperform Value when real GDP growth is tracking below 2%, the likely price to pay for a short/shallow recession.

Flip to slide 20 (small/large recessions)…

  • Small Cap over Large Cap remains our highest conviction call.
    • Small Caps typically start to outperform Large Cap midway through recessions and when the unemployment rate starts to move up.

Flip to slide 21 (small cap CFTC)…

  • We also believe that a recession was baked into Small Cap performance well in advance, as is typically the case.
    • Positioning in Small Caps by asset managers in the futures market has been well below financial crisis lows.

Flip to slide 22 (small cap claims and u rate)…

  • R2000 performance over the past year has been consistent with a spike in jobless claims beyond what has already materialized.

Flip to slide 23 (small large ISM)…

  • And Russell 2000 performance relative to the S&P 500 over the past year resembles what one would expect to see if we’d already seen ISM manufacturing drop to typical troughs.

Flip to slide 24 (small cap PE)…

  • The forward P/E of the R2000 also ended August at 11x, the low end of its historical range.

Flip to slide 25 (small large revisions)…

  • We have gotten some questions about why Small Caps ended the summer on a weaker note. We think this is because EPS revisions trends stopped favoring Small Cap over Large Cap as they did in the spring.

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 industry analysts.