Pessimism Prevails…Again

By Crest Capital Advisors on May 20, 2022

Dow (2.90%) to 31,261.90
S&P 500: (3.05%) to 3,901.36
Nasdaq: (3.82%) to 11,842.25
Russell 2000: (1.08%) to 1,768.38
10 Year Yield: 2.78%
Outperformers: Consumer Staples 0.30%
Underperformers: REITs (3.96%), Financials (3.58%), Technology (3.50%)

US equities were lower again this week. The S&P logged its seventh straight weekly decline, its longest losing streak since 2001. The Dow capped an eight-week losing streak for the first time since 1923! And for those that care about semantics, The S&P 500 officially dipped into bear-market territory (defined as peak to trough decline of 20%+) during Friday trading, before recovering in the final hour to close unchanged on the day. (Any actual investor in the markets knows we’ve already been in a bear market despite the technical definition having not been met) Notably, bond yields have declined over the past few weeks, but lower rates have not been enough to shake the pessimism (more on this in the chart below).

While there was no defining catalyst for the week, multiple bearish themes remain the dominant force weighing on markets. The Fed continues its march on the path to tighter monetary policy as it seeks to tamp down inflation, with many investors now questioning its ability to engineer the hoped-for “soft” landing for the economy. Inflationary pressures remained front and center with this week’s earnings results from retailers suggesting consumers are shifting their spending away from higher-ticket items as food and fuel prices rise. China’s Covid lockdowns look to continue, along with their impacts on the supply chain and Chinese consumers, as Beijing continues to follow its zero-Covid strategy. The war in Ukraine, while not a top-tier concern, still represents a large cloud of uncertainty.

But amid the ramping recession calls and multiple analysts this week taking down GDP or S&P earnings estimates, there are still reasons to be optimistic. While personal consumption may be shifting away from goods and towards services, the overall volume remains robust. April CPI data was underwhelming, but we likely are past peak inflation, with lower readings to come. Equity outflows have been picking up and capitulation may be at hand as even perennially bullish commentators are turning cautious. Finally, in the 12 recessions since WWII, the S&P 500 has seen a median contraction of ~24%, suggesting much of the pain could already be priced in. There are also some contrarian buy signals in evidence, particularly a raft of indicators for depressed sentiment and positioning (BofA’s fund manager survey found portfolio cash levels at their highest since 9/11).

The chart below shows just how washed out the investor sentiment has become. We are at levels that are typically only visited at or near market lows.

Inflation Has Peaked

Last week we wrote, “It’s All About the Fed” (See link here) and noted that markets will find support once the Fed stops pushing longer-term rate expectations higher. This week we want to highlight why we believe the Fed may be closer than most market participants think to making the kind of “pivot” that at a minimum may stabilize markets.

The chart below shows the current and path of Core CPI (shaded are actuals) v. the likely path as we move forward through the balance of 2022 (darker shaded lines). The red line is Goldman’s estimate, the green line is UBS’s estimate. Either way, the likeliest path is indeed lower. We’ve been suggesting all year that CPI inflation at 8%+ is an anomaly, spurred on by Covid dislocations and exacerbated by the war in Ukraine. The seeds for lower inflation have been planted and the Fed has been causing financial conditions to tighten precipitously, mainly through their rhetoric and ‘forward guidance’ (Editor’s note: One might refer to guidance as manipulation if they were cynical.) Either way, the year-over-year comparisons are set to come in lower. Any weakness in the economy, whether brought on via Fed policy or elsewhere, will also contribute to lower inflationary readings. With lower inflation, will the path of Fed rate hikes be less than the market currently expects?

We’d suggest, yes, it will. This could lead to a re-rating of equities higher as recessionary fears are priced back out of this market.

Tech Sell-Off Overdone

For the better part of 6-months now, technology, biotech, and innovation stocks (those with high price-to-sales multiples and limited or no current profitability) have been utterly shunned by the market with the conventional excuse narrative being that higher rates make these businesses betting on future profitability and market share gains substantially less attractive. We’ve seen shocking price declines from all-time highs of 60%, 70%, 80%, and even 90% in certain names. The degree of selling begs the obvious comparisons to the dot-com era that ushered in similar magnitude losses once the “bubble” burst. Only, there are a couple of problems with these comparisons and investors would be wise to reconsider whether discarding these stocks will prove to have been the correct decision.

From a valuation standpoint alone, the median price to sales multiple on a group of Software stocks has declined to recessionary levels! The median multiple over the past 10 years is 7.9x. Today, we are trading at 5.8x. Yes, 2021’s multiple was way too high, but arguably, today’s 5.8x multiple is way too low. Software is not going away. Indeed, the market is only getting bigger.

Valuation & Sentiment

The common theme this week is valuation and sentiment are getting excessively overdone on the downside. Looking at the S&P 500 chart of price/earnings multiples (PE) below, you can see at a glance that we’ve more than worked off any over-valued condition that may have existed in 2021. Notably, we’ve declined below the 18x level, at 17.2x today and well within the average multiple over the past decade or so. It’s also true that we haven’t reached washed-out low levels yet, but we are close.

If you’ve had the “feeling” that this current market environment has been excessively negative and devoid of the usual helping of positive trading sessions to offset some of the pain, you’d be absolutely correct. With just 43 positive days in the last 100, there hasn’t been a lower frequency of positive days since October 2008…at the depths of the Financial Crisis! The chart below puts this current period of excessive pessimism in perspective over the past 20 years.

It’s only mid-May, but nearly 90% of days year-to-date have seen the S&P 500 daily trading range exceed a 1% threshold. It’s a trait historically consistent with difficult equity environments (e.g. 2000, 2008), and helpful in explaining where the bulk of investor allocations are being directed. Over the last 3-months, flows to Treasury products (all durations) have surged to +$36 billion, exceeding the spikes during the 2020 Covid crash (+$25 billion), the hiking cycle induced 2018 equity bear market (+$34 billion), and also holding the top spot in all categories. The curious mannerism of this data though is that Treasuries are currently mired in their largest intra-year drawdown over nearly 50 years of data!

Crazy Stat(s) of the Week

Here are this week’s crazy stats:
• Earlier this week, we got the earnings report of major big-box retailers, and the results at several high-profile names, Walmart and Target to be specific, were not well received by Wall Street. What’s ‘crazy’ about these market reactions is they resulted (in back-to-back trading sessions Tuesday and Wednesday) in the worst single-day stock performance for each company respectively since the crash day of October 1987! Talk about a market that is crazy pessimistic!
• Here’s the daily chart of Walmart. The -11.38% decline this past Tuesday was almost as bad as the single-day performance during the crash of 1987.

• If you thought Walmart’s -11%+ pounding was bad, Target took the prize. Target, while they reported significantly weaker than expected earnings, it came on better-than-expected revenues (Sales still robust), but with ‘unexpectedly high costs’ (inflation!) that it faced throughout the quarter responsible for the earnings miss. The news had Target shares trading down more than -24% on the day. That’s right — roughly a quarter of Target’s market cap went “poof” on one bad inventory/profit margin report.

• The Dow Jones Industrial Average closed the week negative, for the 8th consecutive week. This has only happened one other time in history and that was nearly 100 years ago in 1923!

Quote of the Week

“The underlying driving force behind market timing decisions seems to be emotional – fear, greed, chasing performance – buying something after it has gone up, disappointment, and sales after something has declined.”

-David Swensen

Calendar of Events to Watch for the Week of May 23rd

The vast majority of earnings reports for Q1 are largely behind us, however, we still have a handful of notable reporters next week in technology, retail, and consumer discretionary. The latter two categories will get outsized focus coming on the heels of the poorly received Walmart and Target reports this week.

On the US Economic calendar, we get data readings on Manufacturing/Services PMI early in the week, but perhaps the most important item on the calendar will be the Friday release of the Personal Spending/Income data, the Fed’s preferred measure of inflation. Investors will want to see this data-set receding year-over-year in order to moderate the Fed’s rhetoric around hawkish interest rate policy.

Monday 5/23 – The Chicago Fed National Activity Index for April is expected to come in relatively flat. Both the Empire and Philly Fed indices have been showing unexpected declines in activity lately. Something that bears watching as the Fed’s rhetoric is starting to bite.

Tuesday 5/24 – The Markit PMI Manufacturing and Services reports for May activity will be out with economists expecting a slight downtick in both reports to 57.8 and 57.0 respectively. We’ll also get New Home Sales data which is expected to decline to 750k v. 763k in the prior month.

Wednesday 5/25 – US Durable Goods data for April is expected to decline by about ½ to a 0.6% month-over-month rate, down from 1.2% in March. We’ll also get the release of the meeting minutes from the most recent FOMC meeting, so market participants (e.g trading algorithms) will be scouring these reports for more clues as to the Fed’s current commitment to higher rates.

Thursday 5/26 – We’ll get the second preliminary reading on US Q1 GDP where economists aren’t expecting any changes from the surprise -1.4% contraction due to export/import distortions. Pending home sales for April will be reported and we’ll also be watching the weekly jobless claims data to see if there are any notable upticks worth watching. We are starting to see modest job cut announcements at various corporates as businesses seek to right-size their workforce.

Friday 5/27 – The Fed’s favored measure of inflation, the Personal Consumption Expenditure (PCE) report for April is expected to post a 0.5% month-over-month increase (0.2% for the core PCE) and a 4.8% core PCE reading, down from 5.2% last month. The market really needs to see ongoing proof that inflation is moderating before we can get real stabilization. This report may be the highlight of the week.

Source: FactSet