US Strategy Weekly: Watch Earnings Not the Fed

The S&P 500 index jumped nearly 6% in the first two days of October, as investors once again focused on the possibility that a Fed “pivot” is near. The incessant focus on a Fed pivot lacks an understanding of how difficult the Fed’s job is in terms of conquering an inflationary trend that has persisted for two years and reached double-digit levels. In our view, the Fed pivot mania is an attempt to simplify a global financial environment that is getting more complicated by the day. More importantly, it could be a misguided and potentially dangerous strategy for a number of reasons.

Forget the Pivot

First, it underestimates the Federal Reserve’s commitment to fight inflation. Most Fed governors have indicated that they are serious about lowering inflation and that they will remain vigilant and steadfast until it gets back to the Fed’s 2% goal. That will take a long time. Second, even if prices remain unchanged for the next several months, headline CPI will still be above the 6% level. This is far from nearing the Fed’s goal. The one piece of good news for inflation is that oil prices appear to be stabilizing at lower levels. But this will not be enough to get to lower levels of inflation. Even with WTI futures (CLc1 – $86.35) below $90 a barrel and down 25% from its May closing high, WTI is up 3.3% on a year-over-year basis. And in the background, OPEC+ is discussing cutting output. In short, the CPI is unlikely to come down substantially until 2023. Third, what could get the Fed to “pivot” on interest rates would be a financial crisis, or more specifically, a liquidity crisis in the banking system. However, such an event would be a disaster and rather than sparking an equity rally it would likely trigger a sizeable selloff. Unfortunately, this risk cannot be ruled out, particularly in an environment of rising rates and a strengthening dollar. There is instability in the global system as seen by the fact that the Bank of England had to employ emergency gilt purchases when British pension funds were swamped by margin calls. There are rumors of liquidity issues at Credit Suisse Group AG (CSGN.S – $4.29) and the government of Finland had to extend credit packages totaling 3.55 trillion euros to stabilize the power industry and the energy debt derivative sector, due to a deteriorating debt market. These events may seem unrelated, but we have seen lesser matters ripple through the global banking system and create chaos. It brings back memories of the financial crisis of 2008.

In other words, the focus on a Fed pivot is not a practical exercise in our opinion. Even if the Fed were to pause rate increases, it would not necessarily reflect a change in monetary policy and bring back the easy money policies that had encouraged speculators to the markets. All in all, it is a very short-term view. But it did spark an impressive two-day rally, to date.

A Focus on Earnings

We think a more appropriate focus for investors would be on corporate earnings. Although the financial press places its emphasis on whether or not a company has beaten its quarterly consensus earnings forecast, we think it would be more insightful to focus on whether quarterly earnings growth is positive or negative on a year-over-year basis. Companies have been beating consensus earnings, but that is a bit of a charade since corporations have lowered guidance and analysts have reduced estimates as earnings season approaches. Therefore, the charts from Refinitiv on page 10 are important. They show that the earnings estimate revision trend has been negative for most weeks at least since the middle of July. For the week ending September 30, the earnings revisions for S&P 500 companies were 67% negative and 33% positive. For all US companies, revisions for the week were 62% negative and 38% positive. And it is important to note that since April, according to S&P Dow Jones consensus estimates, the 2022 forecast has declined 8.2% and the 2023 forecast has decreased 4.4%. At present, the S&P Dow Jones earnings growth rates for this year and next are 0.3% and 14.3%. Both of these numbers include earnings for the energy sector which is providing most of the growth.

However, if the Fed continues its tightening policy the risk of recession increases and earnings forecasts for 2023 are apt to fall from positive to negative. In our opinion, this is where the financial press, analysts, and investors should concentrate. And this is what keeps us cautious.

Technical Breakdown

The two-day October rally has been impressive and included a 91% and 95% up day in volume. The advance was triggered from a deeply oversold condition and gained momentum on softer economic news and a smaller than expected increase of 25 basis points by the Reserve Bank of Australia. This combination refueled predictions of a Fed pivot. However, despite the strength of the two-day rally, breadth statistics remain negative. Sadly, the 25-day up/down volume oscillator hit an oversold reading of negative 5.6 on September 30 and was in oversold territory for a string of 10 consecutive trading sessions. The current reading is neutral at negative 2.66. Nevertheless, the 10-day oversold reading was more extreme than the oversold reading at the June low. This means September’s test of the June lows was unsuccessful and the bear market continues. See page 12.

This was not the only indicator that broke down at the end of September. The 10-day average of daily new lows reached 1,038, exceeding the previous peak of 604 made in May. The NYSE cumulative advance/decline line fell below its July 2022 low and is now 47,465 net advancing issues away from its all-time high. See page 13. The charts of the indices show prices are well below their 200-day moving averages and could rally back to test their 100-day moving averages. However, the long-term trend would still remain bearish.

The one positive is sentiment. Last week’s AAII bull/bear readings showed a 2.3% increase in bullishness to 20.0% and a 0.1% decrease in bearishness to 60.8%. Last week’s 17.7% bullish reading was among the 20 lowest readings since the survey began in 1987. Sentiment indicators are not good timing indicators, but they do suggest that this is not the time to become too bearish. Equity prices tend to be higher in the next six and/or twelve months following such extreme readings.

Economic Review

Many housing statistics were released in the last week, and they paint a picture of a housing sector experiencing an accelerating slowdown. Pending home sales have been declining since October 2021. Affordability is at its lowest level since 2006. Median home prices reached a record level relative to income in June 2022, and when coupled with rising mortgage rates, make this a difficult time to buy a home. The NAHB confidence index has been falling all year and in the September survey, dropped to levels last seen in 2014. Census Bureau data indicated that building permits fell in August to its lowest level in two years. But in a surprise, housing starts picked up from 1.404 million to 1.575 million in August. The ISM manufacturing index fell from 52.8 in August to 50.9 in September. New orders dropped from 51.3 in August to 47.1 in September and have been below 50 (neutral) for three of the past four months. Employment fell from 54.2 to 48.7 and has been below 50 for four of the last five months. These weak statistics may increase the hope of a Fed pivot, but they will not be good for earnings growth in coming quarters. Stay cautious.

Gail Dudack

Click to Download