A couple of weeks ago, we published a Coffee with Andrew on the commencement of the S&P 500’s official bear market, where we briefly discussed our thesis for 2022, which called for a materially slowing economic backdrop. During our discussion last week, we briefly went through how Q4 of 2021 began to exhibit ample warning signs that the prevailing economic conditions were set to deteriorate based on one of the most historic tightening regimes we’ve seen in several financial proxies in recent history. Now, with the S&P 500 and Nasdaq firmly off their local lows over the last ten days, we are fielding questions on whether the worst is behind us. This is undoubtedly a valid question, especially since sentiment has never been this dire. While the answer is always a hard one, as it is hard to time the markets, we believe that we have more wood to chop as the financial markets (and economy) transition attention from peak inflation momentum to growth cuts. Over our coffee today, I am going to provide more detail on why we believe the pain trade has a bit more room to run, probabilistically. I will also provide color on why we have maintained a heavier than normal cash weight than we typically would in this stage of the market cycle. As always, grab your cup of coffee and enjoy! It’s not hard to get the notion that fear is abundant within the market. Many investor sentiment indicators have been anchored down by overwhelming fear as market participants have gone from “Buy the Dip” to “Dear-in-the-headlight” mentality. We can’t blame those investors as they have recency bias stemming from the last 12-13 years of ultra-accommodative monetary policy, which led to a scenario where all boats (good and bad) rose with the (liquidity) tide. In fact, it is interesting to see how the bull market over the last decade has shaped the mentality of many practitioners, as most that I have met with over the last six months have marched on with a buy-the-dip approach using the ole’ dollar-cost averaging method. This mentality has even been seen in the data we follow; although sentiment is at bearish lows, investors have yet to put their money where their mouth is based on the average equity allocation. See the chart below. The divergence between sentiment and allocation is enough to warrant caution. This data is further confirmed by the YTD cumulative equity flows up 4.11% accordingly to Bloomberg. Doesn’t really seem like capitulation, does it?
Now, let me be clear, there is a point on when you buy-the-dip and average into the financial markets but we argue you only do so when you have a clear catalyst such as a trough in economic data AND/OR a durable pivot in monetary policy. Simply buying the dip on the premise that assets have sold off or that sentiment is it an all-time low is not sufficient for a durable bull market. The chart below shows how the trough in S&P 500 drawdowns coincides (3-month window) with a trough in PMIs, a leading economic indicator proxy.
This begs the ultimate question of where we anticipate a trough in leading economic data to occur so we may determine if a durable low is set to begin. As readers of our work know, our DCA Investment Strategy is rooted in the thesis that financial assets are acutely sensitive to the rates of change in the cost of money and cost of goods within the global economy. Using this analytic approach, we can deduce that as of January, the lagged effects of rising market rates and the cost of goods have begun to impact financial conditions negatively. Using one of our costs of money models, we can probabilistically ascertain that leading economic indicators are on a path to a mid-40s output level which implies negative economic growth. See the chart below. We are seeing similar readings from our cost of goods models as inflation has been more robust than most have anticipated.
Where the challenging part comes is that most investors, namely Wall Street analysts, still believe that we have endured the worst of this drawdown. While that may be the case, we must remember that many bear markets are met with numerous countertrend rallies. So far this year, we have seen five bear market bounces that have fueled the “buy-the-dip” mentality. Truth be told, bear markets can cause a lot of frustration for both bears and bulls as these rips occur very quickly. At DCA, we remain committed to our process and further our analysis to determine if the pain trade is in the latter innings. Just as we’ve been skeptical of the sentiment narrative given equity fund flows and investor allocations, we believe investors have yet to recognize that S&P 500 earnings are still too lofty based on the anticipated path of leading economic data. As of this letter, S&P 500 earnings are still projected to finish the year at $239 which represents an 11% year-over-year growth rate. We find that to be highly improbable given the two standard deviations move higher in corporate borrowing costs, intense margin pressure from inflation, and a dramatic increase in the household cost of borrowing given mortgage credit card rates. Furthermore, we’ve already begun to see cracks within company fundamentals as there have been 88 announcements YTD of hiring freezes and/or layoffs, and inventory overhang from lack of demand.
So, while the first phase of this contraction has stemmed from a valuation reset due to the Federal Reserve being materially behind the curve on monetary policy, we firmly believe the next drawdown to financial assets will derive from the lofty expectations that Wall Street has assigned to the S&P 500 constituents. See the chart below on analyst expectations.
While the pain trade still exists, we can estimate that the next phase of this classic business cycle slowdown will come in the form of earnings contraction. Once profit estimates contract and trough, we typically see a bottom in leading economic data thus allowing for a durable market low to form. Given how fast economic data is slowing, we believe we will begin to see downside earning surprises as early as next quarter. So, while we may be in the latter innings on the magnitude of this drawdown, we may be in the middle inning of the timing of the drawdown. Where to from here? As our clients know, we have been holding higher than normal cash allocations given our thesis listed above. And while we believe the cash allocation still represents a phenomenal opportunity to deploy cash during the impending earnings correction, we have begun to see negative beta investments (hedges that work well during a business cycle slowdown) such as long-duration bonds begin to show signs of life. The DCA Investment Committee believes we have reached peak inflation momentum thus ushering in relative and potentially absolute outperformance from classical defensive segments such as utilities, staples, health care, and real estate. As always, bear markets are fluid environments. We are watching the data closely and anticipate the inflection from inflation worries to growth scares in the coming months. This transition will bring about outperformance in the aforementioned negative beta assets. Our anticipation of a quickly contracting earnings estimate will provide the final catalyst the begin to deploy capital into risk assets. Sincerely, Andrew H. Smith Chief Investment Strategist
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