There was quite a bit of cheering from the investment community as market participants highlighted the accomplishment of a new year-to-date high in the S&P 500 last week. Journalist, Fintwitters, Wall St. institutions, and economists have quickly changed their cautionary tune as they believe the stock market is successfully climbing a wall of worry. And yes, at first glance, the 9.88% year-to-date return as of last Friday is quite impressive when factoring in that core sticky inflation (Atlanta Fed) has been running north of 5% on a 3-month annualized growth rate over the last five months, an impending debt ceiling default, and bank failures lurking in the corner. Add all of this up; it does seem the markets have done well in looking through the aforementioned issues without even factoring the slowing of economic growth. As always, the devil is in the details when analyzing these highly complex financial markets in a world where information is so readily available. And while I run the risk of what feels like me continuously pounding the "bearish" drum (DCA "bearish" call began Q1 2022), I must objectively take the cues from the market signals. Over this Coffee with Andrew, I will highlight that while the S&P 500 has achieved a year-to-date high, the market structure shows a stark difference to this sanguine attitude; sloppy market breadth and toppy valuations.
While market breadth, such as volume and price action, serve as a good technical analysis, the relative performance of classical defensive sectors and factors help solidify how unhealthy this market rally has been. Below is the sector performance that shows Counter-Cyclical Growth and Counter-Counter Cyclical Defensives outperforming the broader index since the announcement of SVBs bank failure..
Market breadth and sector leadership such as this are not indicative of a renewed bull market, as we would typically see leadership emerge in volume and early-cyclical sectors and factors. The analogs over the last four recessions showcase a similar market backdrop across bear market rallies that we are seeing today (1990, 2000, 2007, 2020); classical defensive leadership leading the next leg lower in asset prices.
Toppy Lofty
One of the unfortunate byproducts of the S&P 500’s recent ascent is that it was accompanied by expanding valuation, which is known as multiple expansion. Multiple expansion occurs during slowing economic growth cycles as investors bid up assets, such as growth stocks, in an environment where earnings are being revised lower. At face value, from data pulled on any financial news source, the Forward Price to Earnings ratio sits at 18.2x, which is well above the low in October last year of 15.3x. At present, Wall Street analysts expect earnings to come in around $227, (S&P 500 Price at $4,130 / Earning Per Share of $227 = 18.2x). But, as always, the devil is in the details.
Wall Street analysts are notoriously bullish by nature and always overestimate earnings during slowing economic environments. Therefore, an adjustment is necessary to reflect economic conditions. DCA models earnings estimates based on macro variables, core inflation, and credit yields, which puts our expected earnings per share at $205, which sits roughly 10% lower than market expectations. When adjusting the current valuation (S&P 500 Price at $4,130 / DCA Earnings Per Share of $205) we see the S&P 500 trading at 20x, which is much richer than most realize.
With the S&P 500 trading at 20x DCA 2023 expected earnings, we can also rephrase this by saying the S&P 500 has an implied yield of 5.0% which is roughly the same yield as a 3-month T-Bill.
Quick Debt Ceiling Thoughts
While a default risk is highly unlikely given the political suicide on both parties, the situation remains palpable and does contain a left tail risk event in the event of a costly and delayed resolution. Financial markets have had a tough time gaining clarity around the exact X-date as equity volatility has remained suppressed and yields relatively contained. As of now, predictions on the X-date range between June 1st and June 15th.
In the event of a short-term default, we do expect the Treasury to prioritize debt payments of notes and bonds over other government obligations. We do not foresee significant stress in the Treasury Bill market as those are discount investments rather than coupon paying. The risk we do foresee, and one of the central reasons we’ve steered away, is significant outflows in money markets back to bank deposits. This outflow will be hindered as the Money Market Reform Act allows these funds to impose redemption restrictions.
We are monitoring closely and will provide a full update as we get further clarity from Treasury Secretary Janet Yellen.
Sincerely,
Andrew H. Smith
Chief Investment Strategist
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