To Stage a Broad Rally, Stocks Need a Better Economic Outlook

The better-than-feared start to the earnings season has added some notes of cautious optimism to the previously somber headlines and gloomy guru talk. There are much fewer mentions of “economic crash”, or “hard landing” now than we saw in March, as the danger of a full-blown banking crisis dissipated while the economy still seems to be holding up against the interest-rate headwinds – and supplying additional support for forecasts of May’s interest rate hike expectations.

Meanwhile, retail investors didn’t get the recession memo at all, it seems, as data shows their stock purchases soared, providing an important source of support for U.S. equity markets so far in 2023. While bearish warnings are abundant, equity ETFs see larger investor inflows than in the previous months, apparently appeased by the absence of new lows in the stock market. Despite the souring risk appetite after aggressive Fed tightening and banking system turmoil, the S&P 500 is still nowhere near its worst levels of last October. Besides, it looks like the FOMO (Fear of Missing Out) trade is back on the table. As the S&P 500 (SPX) is up 14% from last fall’s lows and 7% year-to-date, $12.6 billion have flown into U.S. equity ETFs in the first three weeks of April alone.

Investor sentiment towards stocks is also lifted by the market’s belief that we are nearing the end of the interest-rate increase cycle. Stocks price in another hike, then pause, with many market participants talking about rate cuts as soon as this fall. At the same time, there seems to be a growing conviction that the economy can withstand the high interest rates with as much as a soft slowdown, without actually falling into a recession – that’s why we don’t see earnings downgrades of a recessionary scale.

How the belief that the economy will skip the recession combines with an outlook for rate cuts leaves many market watchers puzzled. But in many cases, there’s no logic to the short-term stock market moves, only hindsight explanations.

The Federal Reserve said in its last policy meeting that it expects “a mild recession” in H2 2023. But as we all know, monetary policy isn’t a precise laser cutter, so eventually, we may get anything from a minute slowdown to hard economic lending; it will depend on a large number of factors, many of which are not controlled by the policy makers, and many others easily get out of control. Case in point, the Fed’s aggressive push to squelch inflation was the factor leading to the regional banking crisis – which, in turn, continues to depress lending under the surface.

Meanwhile, the earnings are less terrible than they were expected to be – but are still falling year-on-year. Barring the currently unexpected surge in earnings in the reports yet to be released, it will mark the second straight quarter in which the S&P 500 has reported a decrease in earnings.

Two consecutive quarters of earnings declines by definition signify an earnings recession. However, if we look deeper than the headlines into the earnings data, we may notice that the S&P 500 has been in an earnings recession for a while and may now be nearing the trough. The index’s earnings excluding the energy sector (as represented by XLE) have been declining year-on-year since Q2 2022. Bloomberg’s forecast speaks of another decline in Q2 2023 – a small one – and a subsequent return to earnings growth in the second half of the year. If that’s how things play out, retail investors plowing money into stocks are correctly anticipating a “back to normal” rally.

So far this year we have been witnessing a two-tiered market, where almost all the increase in the S&P 500 can be attributed to a handful of Big Tech stocks. The difference in performance is underlined by comparing the large-cap technology index Nasdaq 100 (NDX), which is now in a bull market, with the blue-chip Dow Jones’ (DJIA) meager 1% increase year-to-date. The narrowness of the current rally indicates that it is probably not sustainable.

For the stock market to stage a broad-based “real” rally on the back of a rising earnings outlook, we must first see some all-clear signs from the economic front. And that’s where it gets complicated. The economic picture gets more and more uncertain with every fresh data point, as there are pockets of stubborn strength along with clearly weakening parts. The inflation is coming down, but not as fast as it should assuming the most aggressive Fed’s hiking campaign in decades; it remains way above the target. That’s why we don’t buy the all-out optimism on stocks, as the Fed’s pivot to monetary easing this year would mean that the economy is in serious trouble, and the companies’ profits will be severely impacted.

While we can’t be sure whether there will be a harsh recession or just a slowdown that is already underway, and whether the stocks will retest their October lows or stage another breath-taking rally, we know that we are in an uncertain patch, and investors need to be prepared for all scenarios, basing their decisions upon trustworthy data and analysis, which can help neutralize the markets’ “peer pressure” and avoid emotional decisions.