With the S&P 500 falling around 20% in 2022 it was not surprising that sentiment and position heading into the year were quite negative. That dynamic coupled with hopes that the Fed would be able to pull off a soft landing, and yet another better-than-feared start to the Q4 earnings season helped equity markets rally to start the year. In the month of January, the S&P 500 was up 6.2%. That rally was most pronounced in the areas of the market that had underperformed in the prior year and where investors had turned the most negative, namely growth/tech. This made for a nearly perfect concoction of the “Dogs of the Dow Theory” with a side of the “Pain Trade”. The mega-cap tech names led the charge with the NYSE FANG+ index ending higher by nearly 19%, which would normally make for a good year.
As we moved into February, which tends to be a tough month for markets from a seasonal perspective, the hopes for a soft landing gave way to discussions of no-landing, following much stronger than expected January economic data. Unfortunately, this was also accompanied by inflation data that remained stubbornly high. There was a steady stream of hawkish Fed commentary as officials continued banging the higher for longer drum. However, markets seemed to be ignoring that message as they continued to price in rate cuts in the back half of the year. This pushed yields, especially at the front end of the curve, sharply higher with the 2yr yield trading to a new cycle high as it approached 5%.
Earnings season continued to play out and while it was not gang busters by any stretch of the imagination, the widespread guidance cuts that some had been calling for, also did not come to fruition. The S&P 500 gave back a little over a third of the January rally with last year’s darling, energy, leading to the downside followed by yield-oriented sectors. Despite the move higher in yields info tech was the only sector in the S&P 500 that ended higher. The NYSE FANG+ index modestly extended the January gains. Cost cutting and capital discipline measures being instituted by some of these companies helped on the earnings front with the height of the ChatGPT/AI craze putting a cherry on top.
The beginning of March brought with it the biggest surprise of the year as multiple abrupt bank failures shook confidence and accelerated the downside momentum in broader indices. At the same time, we saw a very sharp reversal in yields with the 2yr yield falling ~100bps over a three-day period, just as market expectations for Fed tightening had reached its peak. This episode caused volatility gauges to surge with the VIX jumping from ~20 to ~30, while the ICE BofA MOVE index hit levels not seen since the financial crisis.
What may have been the most impressive thing during the height of fear was the resilience seen in broader US indices as investors seemed to compartmentalize the weakness, primarily to financials. The initial headlines which brought the SVB situation to the forefront came on a Wednesday night and the S&P 500 bottomed the following Monday, the day after the coordinated response by the Treasury/FDIC/Fed to protect depositors and to create a credit facility to help banks weather the storm. The concerns quickly shifted overseas the following week which led to a shotgun wedding between Credit Suisse and UBS with the help of the Swiss National Bank. However, there weren’t any new negative developments over the following weeks which helped major indices rally for three consecutive weeks. The S&P 500 ended the month of March up 3.5%, closing out Q1 with a 7% gain.
The drawdown and subsequent rebound in the S&P 500 does not tell the whole story though. The large cap financials within the index fell ~10% in the month of March and are only modestly off the low. Regional banks are down well over 25% and have yet to muster a sustainable bounce. Other cyclical sectors were under pressure through much of the month but had recouped a good portion of those losses as there haven’t been additional signs of contagion. Once again, the “all-weather” mega-cap tech names provided the buffer as investors flocked to their fortress balance sheets and cash flow/earnings streams which have seemed reasonably impervious to the economic cycle. The NYSE FANG+ index was up 13% in the month of March bringing YTD gains to nearly 40%.
Data compliments of FactSet Earnings Insight as of April 6
Number and percentage of companies issuing negative guidance above historical averages (78 of 106)
Analyst earnings estimates had been cut significantly heading into both the Q3 and Q4 reporting season. On both occasions sentiment was very negative as there were concerns that forward guidance would be slashed, signaling an acceleration of the weakness. However, those concerns were overblown, and this did not come to pass as corporate earnings continued to show resilience. That being said, the numbers were not great. In Q4 YoY EPS for the S&P 500 fell for the first time since Q3 2020.
This quarter, the story is similar heading into the reporting season. For the third consecutive quarter estimates have been cut by >6% which is setting up for the second quarter of YoY earnings declines, which by definition qualifies as an earnings recession, as there is no organization like the NBER with other qualifiers to declare this in hindsight. While there have been more negative pre-announcements this time around, the companies that have reported very early in the cycle are not sounding alarm bells.
Some of the broad themes this quarter will be similar but with some new twists. Previous headwinds related to supply chains have been alleviating and many companies seem to have worked through prior inventory issues. Margins remain a focal point and have been moving lower over the last few quarters. The prior two factors along with cost cutting measures and the easing of commodity/logistics costs could have a positive impact going forward. However, there have been signs that price increases, which have helped companies preserve margins, are starting to impact demand.
The demand side of the equation has remained quite resilient over the last year. However, there are some signs that the lagged effects of monetary policy are starting to be felt. In addition, the most recent banking crisis is expected to tighten credit conditions. Raising the question, how much longer can this resilience last? One other offsetting factor to the declining domestic demand concerns could come from overseas as the USD has fallen sharply from last year’s highs, the European economy has avoided some of the most dour scenarios and the economy in China seems to be picking up some steam.
Investors continue to believe earnings estimates remain overly optimistic though there seems to be some fatigue in the calls for impending doom. As always seems to be the case, the key for the quarter will be on guidance and management commentary. Financials always take pole position during earnings season. That will be especially interesting given the recent banking strains and the commentary on these calls could be especially insightful from a macro perspective.
Companies may once again be able to clear the lowered bar after the recent estimate cuts but given the recent market strength, valuation is once again becoming a headwind. 2023 EPS estimates have been cut by ~12.5% from last year’s high but still call for about 1% YoY earnings growth which puts the index at ~19X this year’s numbers. This starts to look a bit more reasonable if investors start to look out to 2024 estimates which are factoring in a short-lived economic slowdown and rebound, currently ~$245 and just under 17X, but clearly there is a lot that needs to go right between now and then.
As we have seen over the last few years management teams have been fast to adapt to the difficult and fast changing operating environments, which has helped corporate earnings to remain more resilient than most had expected. Given the cumulative and lagged effects of monetary policy and some of the recent economic data it appears the long-awaited economic slowdown is coming into view. The big questions are: How deep and prolonged will that pullback be? And are managements teams once again up to the challenge?