The takeaway from the July update to the Market Expectations Table is clear: The S&P 500 is overvalued by 5%-10%.
2023 earnings expectations have declined sharply thanks to a growing number of companies cutting guidance. At the start of this year 2023 S&P 500 EPS was $250. This number looked too optimistic given the deterioration of fundamentals, so I used $240. Well, now conditions have changed to some where between $220-$230 with downside risks.
The two biggest influences on the markets right now, inflation and Fed rate hikes, got worse in June via the 8.6% CPI report and the 75-basis-point rate hike.
Economic growth is clearly rolling over, and that means we had to drop the multiple range for the market because even if we avoid a recession, economic growth will stall, it’s just a question of how soon and how bad it gets.
COVID-19 cases declined in China and the economy has reopened, but “Zero COVID” remains the policy so investors are constantly operating under the threat of a lockdown.
So, while the spike lows of June at 3,636 were likely a bit too negative, this recent bounce in stocks isn’t being driven by anything fundamental—and that’s why I am skeptical. Instead, this bounce, like the one in March and May, is being driven by the idea that rates may have peaked, inflation may have peaked, and Fed hawkishness may have peaked. For the current levels of the S&P 500 to be fundamentally supported, we’ll need some proof that’s actually happening, and if we don’t get that proof don’t be surprised if we see another 5%-10% drop in the S&P 500.
Things Get Better If:
CPI declines from the 8.6% June reading
The Fed hikes 50 bps and opens the door to a pause late in 2022
China distances itself from “Zero COVID”
Russia/Ukraine have a ceasefire and economic growth slowly moderates but doesn’t collapse
This situation would pave the way for a potential end to this market decline/bear market, but even if we were to get this series of events, the fundamental upside in stocks will be limited for one main reason: The economy is declining. Put simply, a series of positive turns in the macroeconomic fundamentals would importantly put in a bottom, but until we know how intense the economic slowdown will be, and when the Fed might start to cut rates, then any material rallies will be unlikely.
Things Get Worse If:
July CPI rises above the June reading
The Fed hikes 75 bps in July and threatens there’s more to come
China locks down again
Economic growth collapses increasing the chances of a material contraction.
This would essentially be a repeat of what happened last month, and in this instance, we’d expect the June lows to be taken out and, worst case, for another 10%-20% declines in stocks because the Fed won’t be close to peak hawkishness, inflation would still not have peaked, global growth will still be under intense pressure, geopolitics would remain unsettled, and chances of a recession would be rising.
Bottom line, the July Market Expectations Table reflects the reality that fundaments got worse for this market in June, it’s not based on the actual fundamental situation—it’s based on the idea that we could be close to peak hawkishness and peak inflation. Those hopes were broken in June, and if we get more of the same via next week’s CPI and the July Fed meeting, a drop through the June lows in the S&P 500 should not surprise any-one. Conversely, if we do get real progress towards peak hawkish-ness and peak inflation, that will help put in a bottom—but don’t expect a material, sustainable rally because earnings are still declining while economic growth is rolling over.
The S&P 500’s low close was 3,666 in mid-June, less than 15 points below the support level I pointed out last month, which reiterates the importance of these price levels that have both a fundamental “market math” component, as well as historical technical significance.
Zooming out and looking at the longer-term trends and technical patterns currently in play for the S&P 500, the market is still trending lower, confirmed by multiple sets of lower lows and lower highs across the major U.S. equity indices so far in 2022 (recall Dow Theory turned
negative in early May). The measured move target out of the well-defined, bearish head-and-shoulders pattern dating back to H2’21 was elected in April and that target of 3,545 has still yet to be reached. That target also lies just below the lower bound of the current situation range of 3,600, which increases its importance as the area has both fundamental and technical significance.
Feel free to reach out to me and use me as a sounding board.
Kurt S. Altrichter, CRPS®
Fiduciary Advisor | President