Expectations: Reflecting on the Last 10 years for TEN & Next Year for Markets

Expectations: Reflecting on the Last 10 Years for TEN & Next Year for Markets

As we get ready to hold our 10th anniversary celebration as a firm tonight, we look back on the last 10 years, lessons learned, and apply them to what it means for investors today.

Five Things You Should Know

1. Equity Markets – were higher this week with U.S. stocks (S&P 500) up 4.65% while international stocks (EAFE) rose 3.53%.
2. Fixed Income Markets – were mixed with investment grade bonds (AGG) down -0.94% while high yield bonds (JNK) rose 1.17%.
3. Truss Out – after just 3 months, Liz Truss resigned this week as Prime Minister of the UK, setting the stage for a lightning quick contest to find her replacement. The U.K. economy continues to be broiled in market turmoil with the Bank of England announcing they will begin their bond sales program in November, resulting in a sell-off in short-term bonds and a rally for longer-term issues. With a replacement expected as early as Monday, expect parliamentary debate to pick up right where it left off.
4. Oil Reserves – the Biden administration is planning on releasing an additional 10 to 15 million barrels of oil from the nation’s emergency reserves in hopes of keeping gas prices in check. This marks the largest tranche of reserves released since the 180-million-barrel program began back in Spring.
5. Key Insight – [VIDEO] As we get ready to hold our 10^th anniversary celebration as a firm tonight, we look back on the last 10 years, lessons learned, and apply them to what it means for investors today. [ARTICLE] Expectations. Some say they are nothing more than pre-meditated resentments, but as investors, they often hold the key to what lies ahead. We discuss expectations around earnings, sentiment, and the Fed this week.

Insights for Investors

Intro

I love the quote, “expectations are premeditated resentments.” While that may have a lot of direct applicability to one’s personal life, how it relates to investing is a bit different – namely because of how often investor expectations are so dire.

Below we’ll update you on current expectations on a few fronts including a) earnings expectations, b) investor expectations and, c) Federal rate hike expectations, as well as discuss what it most likely means for the market in the year ahead.

Earnings Expectations

Expectations everywhere are about as bleak as they’ve been in a LONG time. A common misconception among investors is that markets need things to be “good” to move higher. However, that is not the case. They need things to be “better than expected.” So, while this is a challenging environment in many respects for both the economy and the market, the good news is the hurdle to exceed current expectations is low.

As the team at Bespoke recently highlighted, “…analysts have been consistently lowering forecasts for the companies they cover, and the trend has been broad-based. In fact, based on Bloomberg tracking of analyst estimates for individual companies, not a single sector in the S&P 1500 has seen a larger number of upward revisions than downward revisions for its constituents over the last four weeks… the pace of downward revisions has been the most pronounced in the Materials sector where a net of nearly 60% of companies in the sector have seen estimates cut. Going back to the start of 2009, the only earnings season with a more negative revisions spread for the sector was heading into the Q1 2020 period in early April of that year. In total, there have only been six prior quarters since the start of 2009 when the net revisions spread for Materials was negative 50% or lower.

In the table below, we summarize the performance of the Materials sector during each earnings season when its net EPS revisions spread was below negative 50%. In all six earnings seasons, the Materials sector was positive each time for an average gain of 4.88% (median: 5.48%).”

“Behind Materials, the sector with the next most extreme negative reading in earnings revisions is the Industrials sector (-36.2%). Since the start of 2009, there have been just 12 other periods where the sector had a revisions spread below negative 25 percentage points, and the current period ranks as the fifth most negative spread since 2009.

Like the table above with the Materials sector, the one below shows the performance of the Industrials sector during earnings seasons when its revisions spread was below negative 25 percentage points. Overall, the sector has averaged a gain of 5.98% during the ensuing earnings season (median: 6.03%) with gains 92% of the time. The only down earnings season for the sector of the ones shown was the Q1 2019 earnings season (-3.05%). While not always the case for all sectors, when analyst sentiment heading into earnings season has reached extreme negative levels for the Materials and Industrials sectors, it set the bar for investors very low.”

While this data applies to just two of the sectors within the broader market, the point holds in general across the equity space.

Investor Sentiment

The records pertaining to the dour attitude among investors just keeps accruing. As the chart below from Bespoke shows, bearish sentiment is still well above 50. This level has now held for five straight weeks, the second longest streak in the modern era, only trailing the seven-week mark set in 1990.

A recent report out of Bank of America “screams” investor capitulation according to a number of strategists. The report showed cash levels at their highest point since 2001, and that 49% of investors are underweight equities.

Alpine Macro summarized current sentiment stating the, “…degree of investor bearishness exceeds 2008; net short positions are still elevated. Pervasive bearishness is often a contrarian bullish signal.”

The Fed

According to a report from Bloomberg, “St. Louis Fed President James Bullard said he expects the central bank to end its, ‘’front-loading” of aggressive interest-rate hikes by early next year and shift to keeping policy sufficiently restrictive with small adjustments as inflation cools. “You do have to think about what the reasonable level is,” said Bullard, who has become Wall Street’s gauge for any Fed policy pivots.”

Jeffrey Gundlach, famed bond manager, along with various recent survey data, are increasingly coming around to the belief that the Fed hiking cycle is likely to end sooner than was feared after the most recent hot CPI report.

Expectations for the Year Ahead

Volatility and market drawdowns are challenging to say the least, and quite literally trigger our brains in ways only rivaled by mortal dangers.

The reality is, dealing with drawdowns as an investor is an inevitable part of the journey, however, experiencing the corresponding rebound is not for those that don’t a) plan in advance and b) control their emotions during the storm.

The next chart from Goldman Sachs shows the historic averages for the S&P 500 after 25%+ drawdowns. They highlighted that, “While US equities may experience further downside, history suggests that those who stay the course have been rewarded. Historical drawdowns of 25% or more have delivered a forward one-year return of 27%, on average, with longer investment periods proving even more compelling. Timing the market bottom is difficult, but investors early to this recovery may see favorable returns over time.”

For those fearing the worst, Tom Essaye, in highlighting the difference between the current environment and the drawdowns in 2008 (Bank malfeasance), 1998 (emerging market debt fueled currency crisis, or 2010/11 (Southern Europe debt crisis) noted that, “…these were existential crises that confront- ed investors with a stark lack of information—a veritable black hole into which investors peered and wondered how far contagion would go. This current environment is not that. This is much more “run of the mill … For markets to stabilize, we must get proof inflation is receding. There’s anecdotal proof of it from companies and economic data, but it’s not conclusive yet—and the Fed will continue to hike rates until that decline in conclusive. Once that drop in inflation is conclusive, markets will likely stabilize.”

He continued with, “I am not advocating exiting the market and going to cash. Pinpointing when that Fed pivot occurs will remain extremely difficult, but while it’s not imminent, it may not be that far away, either. Remember, inflation expectations over the next several years remain not far from the Fed’s target (just under 3% for University of Michigan and 2.26% for the 5-year TIPS/Treasuries break evens). That tells us that the markets and investors expect inflation to return to normal relatively quickly—and that point can’t be lost amidst the still-elevated current price data. My point is that disinflation will come, and it could easily come more quickly than the current market consensus. If that’s the case, the Fed pivot will be “on” and the outlook for markets will improve substantially.”

Also making the argument that all is not lost, was Scott Grannis former fund manager and one of my favorite market commentators. In pointing out the economy is actually holding up quite well he discussed how the following chart, “…shows the level of 2-yr swap spreads, my favorite indicator and predictor of the health of the U.S. economy and financial markets. Swap spreads are still within a "normal" range, which implies that liquidity is still abundant and the corporate profits and the economy are likely to remain reasonably healthy. As the chart suggests, swap spreads would have to rise appreciably before one might expect to see a recession on the horizon. Note also that swap spreads have tended to decline in advance of recoveries.”

And while of course anything can happen, and I would hate to set expectations resulting in your future resentment, it is important to counterbalance the doomsayers out there with the historically probabilities based on similar scenarios. As you can see from the chart below, during periods of steep selloffs and bearish sentiment what lies ahead more often than not, is not more pain but rather sharp reversals. Furthermore, even including the Great Depression year of 1932 and Great Recession year of 2008, the average bear market has resulting in a decline of 30.5%.

The question for investors to ask how they want to balance the “average” decline from similar levels as compared to the “average” rebound.

The best approach to that dilemma is of course to spend your time fine-tuning your plan and not attempting to make any great prognostications that induce you to try to time the markets.

Have a wonderful weekend,

Tim and the team at TEN Capital

Data, Just the Data

Data points this week included:

• U.S. Jobless Claims – decreased by 12K to a claimant count of 214K for the week ending October 15^th, which was far below expectations of an increase to 230K. The four-week moving average rose by only 1,250 people to a reading of 212.2K.
• U.S. Industrial Production – rose 0.4% MoM for September and moved up from 3.9% to 5.3% YoY. Overall manufacturing output has risen to 4.7% thanks to an increase in durable output of 6%. Nondurable manufacturing jumped by 3.6% and mining and utilities output expanded 11.1% and 0.5%, respectively.
• U.S. Housing Starts & Permits – declined (8.9%) to a YoY rate of 1.439M for the month of September. The housing market has been hit hard by high prices of materials and a rapid rise in mortgage rates, now eclipsing 7%. Single family housing starts dipped (4.7%) to an annualized rate of 892K, marking the lowest level since May 2020. Building permits contracted (1.4%) MoM.
• U.S. Existing Home Sales – tumbled (1.5%) to a YoY rate of 4.71M for September, marking the lowest reading since May 2020 and in line with forecasts. This is now the eighth consecutive MoM decline, again thanks to rising interest rates. The median existing home sales price has bumped up 8.4% from a year ago to $384.8K and the existing home inventory has declined to 3.2 months’ supply.
• U.S. Manufacturing Index – the Philadelphia Fed manufacturing index moved up one point from the month previous but still edged down (8.7) points for October. This is far below the forecasts of a (5) point decline. General activity and new orders sustained negative territory, and the price index continued to climb. Future expectations are negative for the next six months for general activity.
• U.K CPI – the inflation rate in the United Kingdom rose from 9.9% to 10.1% YoY in September, matching July’s reading for the highest in 40 years. Food jumped up 14.8%, with housing and utilities rising 20.2%. Motor fuel slowed from a 12% rise to 10.6% and the annual core inflation rate (excluding energy and food) climbed to a record high of 6.5%.