Bearish Models Versus Bullish Seasonals

Bearish Models Versus Bullish Seasonals

November 01, 2023

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For the last couple of months, as the equity and bond markets have been taking it on the chin, I have consistently mentioned the seasonal expectations while at the same time trying to scream my message over the relentless drum beat of negativity and negative market action. This is what I intend to cover in this week's note. At the end of the first half of the year (July 19th to be exact) the US equity market, as measured by the S&P 500 and NASDAQ 100, absolutely ripped to the upside. Many negative market prognosticators said that this may have been true, but it was not sustainable given that the "Magnificent Seven '' companies of the market pulled the market up and therefore the advance was unsustainable due to a lack of a broadening of leadership. This was further compounded by furious moves in interest rates, inflation, continued supply chain issues, Russia/Ukraine, consumer demand, profit destruction from AI and most recently the Gaza/Israel conflict. No doubt, this is quite a large and diverse group of bad things!

So, what is an investor to do? Is this bearish tone to the markets going to continue, or will bullish seasonals prevail and company earnings and forward earnings projections prevail with the help of inflation growth quieting? I clearly can't promise anything, but I can give several reasons to explain why I believe that even though this pullback has clearly been painful, particularly when the recollection of the 2022 bear market is still fresh in everyone's mind, it should be more of a pause to refresh than a continuation of the 2022 decline. To begin with, let's take a look at yields on 10-year Government bonds across the world. As can be seen in the chart below, the US 10-year Treasury is the highest yielding interest rate instrument in the chart. I have to scratch my head on this one. If the US Dollar is the reserve currency of the world, and US consumption is what China is dependent upon for their manufacturing, and continental Europe is dependent on US consumer travel leisure related activities, why would our interest rates infer the least amount of safety? I believe that our rates have moved up too much, too quickly, and US consumption should abate as is being recognized in the tailspin that China and now Germany are in. It should also be noted that the Euro zone decided last week not to continue raising rates after 10 consecutive rate hikes. They certainly wouldn't halt interest rate hikes unless their current concern is a future economic slowdown/recession.

The next chart I want to share is that of Eurozone: Potential vs. Actual Real GDP Growth. Please focus on the area in the yellow circle. Clearly a noticeable decline into the Pandemic low when supply chains shut down and consumption exploded based on fears of a lack of everything. Then the supply chains opened back up, consumption rocketed, fueled by unprecedented government money distribution, only to then be spanked down by global government overt warnings of large interest rate hikes to stifle the negative demon, inflation, due to overzealous consumption from every walk of life. It should be no wonder that after the large bounce in the equity markets following the October 2022 low that came in late July of this year, some level of digestion could be due.

As of last Friday, listening to the "experts" on the financial stations, it becomes apparent there is absolutely no clue among them as to the situation. The majority look at the current data of this specific period and from there draw a conclusion that things are too good even though the world is so bad. What we have is a clear bifurcation that I have been touching on for months: some parts of the country / world are good and others not. More than that, it is a class issue as well; upper class is good, and not upper class is right back where they were before the pandemic. The gulf between them is huge and has grown larger as the middle class is sure to continue to bear the brunt of inflationary pressures and lack of mid-level wage growth. This is a point I will be writing an entire note on, yet it should be recognized that the lower and lower middle class was showered with an immeasurable amount of money without any judgement. This created copious consumption. It was clear that this was the case as discretionary spending skyrocketed, prices skyrocketed and lower-level jobs could not be filled (ala restaurants, hotels, basically discretionary service sectors). If they have money, and continue to get it for no work, why work? The Wall Street Journal published an article yesterday (page 2) titled “Workers See Growth in Paid Time Off.” This is not a good solution to a never-before-seen problem. 

Ned Davis Research said it best in their report of last week titled, "I'm okay but you're not." Again, refer to the chart above. It has been a unique economic cycle. From shuttering the economy to massive fiscal and monetary support, we have seen rapid changes in the economic outlook. Unemployment soared to nearly 15% during the pandemic before falling to as low as 3.45 this year. Real GDP has been remarkable, clocking at 4.9% in the most recent Q3, despite an aggressive Fed Tightening cycle. And after battling for many years to get inflation up to 2%, CPI inflation surged to over 9% last year, before dropping back to 3% this year. Now there is a sense of dread about the broader economic outlook. And along with that, negative market sentiment and negative consumer confidence surveys. 

SO, WHAT SHOULD HAPPEN NOW?

The S&P 500 rallied post COVID, dropped due to economic issues and inflation / interest rate issues last year, recovered in the first seven months of this year, and then a digestion since late July. So where are we? I want to start to answer this by looking at the chart below. This is a picture of the world markets above the global sentiment composite. Note that where I have circled extreme pessimism it was a quite opportune time to invest in the equity markets. The circle to the lower right is now. The pessimism isn't just extreme, but THE MOST extreme as seen in this time period. Could it mean that this extreme, coupled with seasonal forces and third quarter earnings surprises could set the stage for a respectable year-end rally? 

The next set of facts, that began with third quarter earnings releases and seem to be continuing to get stronger, is the percentage of companies beating earnings expectations. As of Monday, 49% of S&P 500 companies had declared earnings. 79% of these companies beat their expectations and did so by over 6%. This is really quite significant. Please take a moment to look at the charts below:

In listening to all the earnings call summaries, the use of terms like "uncertainty” or "lack of visibility" has fallen off greatly. The primary reasons, if they are existent, are still supply chain, consumer demand, inflation, and AI. But they are all declining greatly. So, I ask you, if the markets are so bad, overvalued, and ready for even greater decline, why aren't senior management of major US companies stating this in their conference calls?

The consensus for earnings for the S&P 500 for 2024 seems very doable and possibly could be on the light side of things. Accordingly, if the S&P 500 can trade at 20x earnings, it implies a 4800-price objective for the index (240X20=4,800). If that is correct, it means the S&P has 16%+ upside from here. 

The one last point I want to make is the action of the market in this recent corrective move. It is very common that markets correct in three waves lower. It sells off initially, tries to come back, can't, and then declines once again. Then it is thought to maybe be done declining, only to be met with further selling at which time it flushes out. This decline has had three quite uniformed legs to the downside, which is typically how such declining chart patterns end:

  1. S&P 500 goes from 4607 (July 27th) to 4335 on (August 18th) a decline of 272 points.
  2. S&P 500 goes from 4512 (September 14th) to 4216 a decline of roughly 296 points.
  3. S&P 500 peaks at 4393 (October 17th) and falls to 4103 last Friday (October 27th) for a decline of 290 points.

Jeffrey Saut, famed leader of Saut Research said, “I find it interesting that all of the three step declines measured about 288 points on average. According to my method of chart interpretation, the classic way declines end unless you are in a ‘selling freefall.’”

This week has clearly started off with a violent bounce on Monday, on absolutely no news other than oil dropping quite significantly- even in the face of heightening Gaza conflict. The last point on these index price levels that I want to bring up is that the low reached on Friday was 4103, almost exactly a 50% retracement of the move from the lows of October 2022 to the high in July (50% would be exactly 4060). Coincidence, maybe, but maybe not. I could give you a number of other statistical points that support this market being ready for a bounce, but I think you understand my point. Why markets hit highs and lows are usually not known till after all information is in, but it must be remembered that stock prices are a discounting mechanism for "expected" future earnings and economic data. What is becoming abundantly clear is that in the absence of a major economic or global calamity a recession in the immediate future doesn't really appear to be in the cards. 



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