The Navigator | November 2022
| After a brutal September, equity markets rebounded in October on technical signals, a slew of “better-than-feared” Q3 earnings from some corporations, and speculation on the Fed’s slowing pace of interest hikes. Unlike the summer rally that was driven by growth stocks, the September rebound was primarily driven by value stocks, with the Dow rallying 14.1%. The S&P 500 ended the month up about 8.1%, while the tech-heavy Nasdaq gained 3.9%. Stock markets have off and on, speculated on an earlier Fed pivot after some recent Fedspeak (including Kansas City Fed President Ester George) expressed concerns that “a series of very super-sized rate increases might cause you to oversteer and not be able to see those turning points.” However, in our view, the markets’ speculation is premature as resilient labor market data and stubbornly high inflation are likely to keep policy risks high. The labor market remained robust as nonfarm payrolls held firm in September. The unemployment rate is currently at 3.5%, matching the post-pandemic low from July. In the meantime, the September inflation data is anything but encouraging. On a year-ago basis, the headline and core CPI rose 8.2% and 6.7%, respectively, stronger than consensus expectations. One of the risks is the uncertainty around time lags between wholesale and retail prices; that is, the lower wholesale prices still need to be passed down to consumers in a more meaningful way. More importantly, a tight labor market has pushed up wages in a wide range of occupations. According to our wage index, wage inflation moderated slightly in September but remained at 6.1% YOY compared to 6.2% in August. The bottom line: we maintain our view that, barring an event of dramatic financial turmoil, the “Fed put” is unlikely to come soon as the Fed is determined to carry out its inflation-fighting mission. The stock market also found a reason to rally due to “better-than-feared” Q3 earnings reports from some companies. In our view, however, this is partially because analysts have been revising down their Q3 earnings estimates going into the earnings season and market positioning was quite bearish going into October. In fact, the Q3 earnings season so far has been weaker than usual. According to FactSet data published as of 10/28/2022, of roughly 52% of the companies in the S&P 500 index that have reported third-quarter figures to date, 71% have reported a positive EPS surprise – below the five-year average of 77%. The blended earnings growth rate for the S&P 500 is 2.2%. If 2.2% is the actual growth rate for the quarter, it will mark the lowest earnings growth rate reported by the index since Q3 2020 (-5.7%). Also, we believe that 2023 earnings estimates have not fully priced in the damage due to high rates, growth slowdown, and the increasing risk of a recession. We see more downside risks to earnings as consumers reduce goods spending, and sticky costs and wage inflation hurt margins. Also, falling inflation at the initial stage could have a negative effect on the net profit margin, with sales growth slower than cost growth. It occurs when companies’ pricing power fades with falling inflation and waning demand, while at the same time, the cost of goods remains constant as companies deal with wage pressure and work through inventories that have been acquired at higher prices. Overall, we believe that such a rally will be short-lived as macro headwinds and earnings uncertainties continue to dominate the markets. We remain conservative with U.S. equity exposure (43%), and only a slight increase to our international equity exposure from 28% to 32% to reflect better valuations. |
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↓ Valuation | The S&P 500 rebounded 8.1% this month, and valuation metrics for equity remained negative. P/E increased from 17.6 at the end of September to 18.9 at the end of October. Forward P/E increased to 17.4 at the end of October from 16.1 at the end of September. Inflation-adjusted valuation metrics continued to be negative.
↓ Sentiment | The ISM manufacturing index dropped more than anticipated, from 52.8 to 50.9 in September. Although the index remains above its recessionary threshold (closer to 48), the details are concerning, with new orders falling below the neutral level of 50. University of Michigan consumer confidence continued to move slowly higher from its historic low and rose modestly from 58.6 to 59.9 in October. The index remains strikingly low, with high gasoline prices and a volatile equity market still weighing on sentiment. The NAHB index fell further below the neutral level in October to 38 (from 46 in September), the lowest level since 2012, with elevated mortgage rates and worsening affordability.
↔ Technical | Technical indicators were neutral to slightly negative, with the decrease in fear indexes and short-term reversal signals offset by momentum signals. The S&P 500 was 6% below its 200-day moving average, 1% below the 100- day average, and 1% above the 50-day average. The VIX index decreased this month and settled at 25.9 at the end of October (compared with 31.6 at the end of August). Bearish positionings going into the month, stronger-than-feared Q3 earnings reports, and speculation of a potential Fed pivot all contributed to the market’s rebound.
↑ Macroeconomic | The U.S. labor market showed signs of cooling in October but remained strong. The nonfarm employment increased by 263,000 in September, modestly higher than the consensus forecast. The four-week moving average of initial jobless claims rose slightly to 219,000 for the week ending October 22 but still indicated a robust job market. The headline CPI rose 0.4% in September (stronger than consensus) compared with a 0.1% gain in August. On a year-ago basis, the headline and core CPIs were up 8.2% and 6.7%, respectively. Retail sales remained little changed in September after rising 0.3% in August, and core sales excluding gasoline stations and auto dealers rose 0.3%. The robust labor market and wage growth overcame lingering low confidence and a shift from goods to service spending. U.S. industrial production climbed 0.4% in September; a bit more robust than the consensus forecast.
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As of 10/31/2022
1 Source: Bloomberg, NorthCoast Asset Management.
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