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Stocks rallied sharply on Tuesday, a pretty impressive showing given that the long holiday weekend gave investors plenty of time to wring hands and place sell orders. The move was broad-based with all eleven major sectors notching gains. Upside volume to upside volume plus downside volume was solid at 80.2%, but not spectacular. As of this morning, the S&P 500 SPY is about 4% above its intraday low last Friday.

That may have you wondering if “the bottom” is in. However, it’s paid to be a skeptic this year. We’ve had a significant rally in the S&P 500 this year in every month except April, including an 11.3% rally from the low in March and a 9.7% rally beginning in May. Unfortunately, each has proven to be “a” rally instead of “the” rally. Frankly, it’s been – and is likely to remain – prudent to treat the market like it’s from the ‘show-me’ state of Missouri.

Why? Because the Federal Reserve’s inflation-fighting machine has yet to show progress in taming inflation. In May, the consumer price index increased 8.6% year over year, accelerating from 8.3% in April and above the prior 8.5% high in March. The fact the Fed’s behind the curve in its plans to – bluntly – destroy enough demand to wrangle inflation lower prompted a 0.75% rate increase last month, rather than the 0.50% increase that was anticipated. It’s also significantly increased the odds that the Fed will increase by another 0.75% in July. According to the CME’s FedWatch tool, there’s a 91% chance that we’ll get another three-quarter point move up in the Fed Funds rate. If so, the odds the U.S. suffers a more substantial recession, rather than a mild one will climb.

Are earnings in trouble?

Stocks follow earnings over time, and because the market is forward-looking, performance can be significantly impacted by the direction of forward earnings expectations. If earnings are expected to grow in a straight line, with upward revisions stemming from positive earnings surprises, then the market will cooperate with gains. However, if expectations falter because of poor performance or worrisome guidance, the more likely path for stocks is lower.

In “We're Taking a Larger Look at Earnings Expectations for the S&P 500,” Action Alerts PLUS Co-Portfolio Managers Chris Versace and Bob Lang broach an important, and somewhat overlooked, question: What’s happening with earnings estimates?

You might think Wall Street’s number crunchers have become more sanguine about profits given that GDP was negative in the first quarter and increasingly, looks to be flat to down in the second quarter. If so, you’re going to be surprised by what Versace and Lang discovered:

“Back at the end of February, as we were moving past omicron, before China's lockdowns, relatively early days in the Russia-Ukraine war, and before inflationary pressures reared their multi-faceted heads, the consensus EPS expectation for the S&P 500 for the second half of 2022 was $119.43. For some context, that was up 10.8% compared to the first half of 2022 and more than 9% vs. the second half of 2021. [emphasis mine]

Flash forward to last Friday, June 17, and while many might think expectations for the second half of 2022 would have fallen given the confluence of headwinds that have emerged during the June quarter, the data shows the consensus view for the S&P 500's EPS expectations in the second half of 2022 ticked higher to $120.63 [emphasis mine].”

So, Wall Street’s minions are actually ramping up their outlook despite slowing economic growth and a Fed bent on demand destruction? Yup.

According to FactSet's data, analysts believe that full-year earnings will grow 10.4% year over year this year. In March, they were projecting 9.6% full-year growth. For Q2, analysts have revised earnings growth lower to 4.3% from 5.9% only two months ago, yet they still expect third-quarter year-over-year earnings growth of 10.7%. Call me crazy, but that seems like a pretty tough ask given the current backdrop.

Looking more closely at FactSet’s data shows a lot of earnings strength is coming out of the energy sector. That makes sense. Ongoing demand, stubborn spigots, and crimped global supply because of the War in Ukraine have sent crude and nat gas skyrocketing, taking oil & gas profits along for the ride. Energy isn’t the only basket where the outlook has remained stable or improved though. Since March, the year-over-year projection is flat to better in industrials, materials, real estate, and utilities.


The outlook for consumer discretionary stocks has fallen most, dropping to 2.4% from 17.2%, but analysts are still looking for an 11.6% year-over-year improvement in information technology, the most heavily-weighted sector in the S&P 500, which is down only slightly from 11.7% in March. 

Only one sector, financials, is expected to see earnings contract year-over-year. Again, that seems a little optimistic in the face of cash-strapped consumers eyeballing yet another 0.75% increase in rates next month.

Back to Versace and Lang:

“Given all that has unfolded in the current quarter and what's expected to continue into the second half of the year, we have reservations about the consensus EPS forecast for S&P 500. Granted the market multiple has come down, but the other shoe to drop, that is earnings expectations, have yet to do so. As that happens, it means the market isn't likely to be as cheap as some may think.”

Stocks may be pricier than they appear

There’s been a lot of finger-pointing (OK, Tweeting) that the fact the S&P 500’s price-to-earnings ratio has fallen to levels more in line with historical trends is bullish. That argument could come under pressure if the denominator starts shrinking, though. 

So far, P/E compression has come solely from the 22% drop in the S&P 500’s value. That price decline alongside stable-to-improving earnings estimates means that the index’s forward 12-month P/E has fallen to 15.8, according to FactSet, which is beneath the 10-year average of 16.9.

But what happens if earnings estimates start falling? Well, in that case, the market may not appear all that cheap anymore.

Back to Versace and Lang:

“We're also likely to see some EPS revisions in the coming months for 2023 EPS expectations as well. Currently, the consensus view published by FactSet sits at $251.76, up 9.2% over this year. In the past when we've seen expectations for the second half of a year be revised lower, those revisions tend to carry over for the following year as well, especially when concerns are growing over the speed of the economy and consumer spending.

Using the past as a guide, when the June quarter earnings season gets underway there will be some that are taken aback by the downward revisions to be had in EPS expectations. As competitors, suppliers, and customers report, the 360-degree picture will firm up what we're likely to hear by the time the June quarter earnings season is over. We already have some insight following Target's  (TGT)  margin cut, Intel's  (INTC)  warnings on foreign exchange, more recently fabless semiconductor Himax Technologies  (HIMX)  cutting its June quarter guidance, and Tesla  (TSLA)  targeting a 10% reduction in salaried workers. What FedEx  (FDX) , Darden  (DRI)  and others say later this week when they report will add some color to that picture.”

In short, if the second-quarter earnings season shows cracks in the earnings armor are becoming chasms, the resulting downward earnings revisions to the back-half of the year will be extrapolated into 2023, further pressuring the index’s forward P/E ratio.

The Smart Play

It’s true that stocks usually bottom before a recession ends, but “the bottom” will only be apparent in retrospect. Until then, investors should recognize that bear markets can be painful, and that they last longer when they’re accompanied by a recession.

While it’s tempting to think that the “V”-shaped bottoms witnessed in 2018 and again, in 2020 mean we’ll see a similar outcome this year, it usually takes months of pops and drops to work through sellers trapped at higher prices. For this reason, a skeptical view that focuses on the ‘return of capital’, rather than “return on capital” remains wise.

If you’re a long-term investor using indexes, the advice remains the same: Increase your dollar-cost averaging contributions over the next 12 to 18 months. There’s never been a market where lowering your average costs during a recession hasn’t been profit-friendly long term.

However, if you’re not in the accumulation phase of your life, and you invest in individual stocks, then wealth protection remains key. That means focusing on low-beta value stocks, defensive sectors that do best in a recession, such as healthcare, and risk control, such as stop losses. Diversification to limit single-stock risk, the avoidance of leverage, including margin, and upgrading the quality of your holdings are important too.

It’s tempting to think the most beaten-down stocks will yield the greatest return off the lows, but that’s not necessarily true. Wall Street dustbins are full of former high-flyers that never returned to their prior peaks, went out of business, or were sold for pennies on the Dollar. If your portfolio includes suspect names where your thesis is broken or your confidence is low, then selling into strength in order to buy a market leader with staying power is smart. 

Stocks rallied sharply on Tuesday, a pretty impressive showing given that the long holiday weekend gave investors plenty of time to wring hands and place sell orders. The move was broad-based with all eleven major sectors notching gains. Upside volume to upside volume plus downside volume was solid at 80.2%, but not spectacular. As of this morning, the S&P 500 SPY is about 4% above its intraday low last Friday.

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