Get our view why the end of the bear market may not be in sight, but the US -led stock market sell off could slow down.
Does technical analysis even matter anymore? For the last 20 plus years, we could, with a bit of luck and central bank support, predict where markets would fall to on any given sell off. Take the financial crisis, or the global pandemic, when these major events pulled the rug out underneath global stock market bulls, the market tended to sell off quickly before being calmed down by an influx of multilateral central bank support led by the Federal Reserve. But the last two months have been epoch-shifting. Firstly, stocks and bonds have fallen side by side, the first time that they have done this in decades and US and global markets are in the midst of their longest sell off in years. The S&P 500 is down 19%, just above bear market territory, while big tech has fared worse, the Nasdaq is down more than 25% so far in 2022. Bonds have also taken a battering, the benchmark 10-year Treasury yield has fallen slightly, however, it remains at 2.78%, to put that move in perspective, 6-weeks ago this yield, which is usually stable, was trading at 1.75%.
Bonds lose safe haven title
This is a major problem for the investment community. Usually during a stock market sell off the harbour in the storm has been bonds. However, during this sell off, all sectors of the S&P 500 are lower apart from the energy sector. Typically, one would not assume that energy would be the safest place to park your money. In the FX space, the yen has collapsed as a haven, the dollar is king and is now threatening parity with the euro. Rampant inflation, growth fears, a Fed intent on hiking interest rates and taming inflation regardless of the damage done to the global economy means that the dollar liquidity that we have become accustomed to is no longer there. The question now is, when will this sell off come to an end?
Why US stocks have ignored positive earnings surprises
We have mentioned above that technical analysis seems to be dead in the water right now, and instead it is important to look at fundamental analysis. We believe that financial markets will only calm down once there is a buffer to inflation. Either inflation must fall, or the market must be comfortable that sectors of the stock market can cope with high levels of inflation. Even positive earnings data hasn’t helped markets. To date, 95% of companies on the S&P 500 have reported Q1 earnings. Of those 95%, 75% of companies have reported earnings above their EPS estimate. However, companies that have reported earnings above their EPS estimate have seen a negative price reaction on average. If this persists, then it will mark the largest average negative price reaction to positive EPS surprises since Q2 2011, according to FactSet. For those 25% of companies that have posted negative EPS surprises, their share prices have seen a much larger negative reaction than average. FactSet uses the example of gym-wear firm Under Armour. It reported Q1 EPS at -$0.01 on May 6th. From May 4th – May 10th Under Armour’s stock price dropped more than 33%!
The reason for this reaction to the Q1 earnings season is twofold. Firstly, companies are beating their EPS estimates by a smaller margin than they have in recent quarters. Q1 2022 saw companies beat EPS estimates by 4.7% on average, below the 5-year average of 8.9%, according to FactSet. Added to this, companies and analysts have been more pessimistic in their outlooks for the rest of the year. 70% of the 88 S&P 500 companies that have issued forward guidance have issued negative guidance. Analysts have also cut EPS estimates for Q2 2022 by an average of 1%. This is only the second time in 8 quarters that analysts have cut EPS estimates on aggregate. Thus, the market sell off could be driven by future earnings expectations rather than what happened in Q1.
Why the path of least resistance means further downside
This gloomy backdrop suggests more selling is possible, however, the selloff could be stymied if Q2 earnings beat estimates and prove the analysts wrong. We will have to wait until the start of July to get that information. For now, we are waiting for some key fundamental reports to try and get some direction about the future path for markets. Sadly, for the bulls among us, the path of least resistance remains to the downside, and we do not think that this week’s economic data will shift the dial for the market mood. This means that we could see stocks continue to sell off, albeit at a slower pace than we have seen in the last 3-4 weeks. The key this week will be if bond yields respond to the wave of negative economic data that we expect to see in the coming days. If the US 10-year bond yield continues its decline on the back of economic fears, then can stocks find their bottom? This question is why we will be looking closely at bond markets this week.
Three key economic releases this week
1. Federal Reserve minutes:
The Federal Reserve hiked interest rates at their meeting earlier in May and according to the CME’s FedWatch tool the market is pricing in more than 90% probability of two 50-basis point rate hikes at the June and July meetings, which would see the Fed Funds rate rise to 1.75%-2% by mid-summer. While we believe that these minutes will put to bed the prospect of a 75bp rate hike at a single meeting, we do not think that they will shift expectations for rate increases in the next two months. Instead, the market will be looking for reasons why the Fed is taking a softer path when it comes to reducing the size of its balance sheet. The Fed will reduce it by $47.5bn from June, rising to a $95bn cut from September? Why not reduce by a larger amount from June? Could the Fed be taking things slowly because it is worried about the prospects for economic growth? If yes, then we expect this could calm markets as it would suggest that the Fed may use balance sheet reduction to calm markets in the months ahead.
2. US Q1 GDP
This is the second reading of Q1 GDP, and it not something that we would normally look at so closely, but this report is worth watching. The initial reading saw a 1.4% decline in GDP, the market expects this to revised down a touch to -1.3%. The GDP price index is expected to remain steady at 8%. The reason why we are watching this reading is that the market is still expecting US growth to remain in positive territory this year, largely driven by a resilient consumer. Thus, if we see any downward surprises in net trade or inventories, then it could be harder for US growth to pick up later this year and make up for Q1 weakness. Any sign that the US economy is even weaker than the initial GDP reading could weigh on stocks and push the dollar higher.
3. Flash PMIs for May
Preliminary May S&P Global PMI estimates for Europe, the UK and the US will be released on Tuesday. Although all regions are expected to see moderations in their manufacturing and service sector PMIs, they are all expected to remain solidly above the 50 mark. This doesn’t make sense: growth is rapidly weakening across the world and Q1 corporate results point to a weaker Q2. Thus, PMI data is becoming obsolete when it comes to predicting what will happen to global growth. Will surging inflation finally weigh on these indices this month? If yes, then we could see market jitters as it would another piece of the bear market puzzle that would paint a bleak picture for the economic outlook.
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