The Market Mosaic 4.23.23
The bear market will come down to earnings.
Welcome back to The Market Mosaic, where I gauge the stock market’s next move by looking at macro, technicals, and market internals. I’ll also highlight trade ideas using this analysis.
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And be sure to check out Mosaic Chart Alerts. It’s a midweek update covering my best chart setups among long and short ideas in the stock market, along with levels that could trigger a trade.
Now for this week’s issue…
With about 18% of the S&P 500 reporting earnings through last week, 76% are beating earnings estimates for the first quarter period. That might sound impressive, but that’s how earnings season typically goes…with companies usually exceeding their own massaged estimates.
But a closer look reveals a more disturbing trend. The year-over-year growth rate in earnings stands at -6.2% (see the sector breakdown below), which would rank as the biggest decline since the start of the pandemic according to FactSet. Profit margins have also slid for seven straight quarters as inflation and higher rates translates to higher costs.
There’s still a lot of earnings season left, with over 40% of the S&P’s market capitalization set to report next week alone. But the trend of falling earnings should be closely monitored.
That’s because earnings are what ultimately drives the index. You can see that in the chart below from macrotrends, which shows corporate profits (orange line) overlaid with the S&P 500 Index (blue line).
There’s several ways to guess where forward earnings could be heading. It’s certainly worthwhile to listen to quarterly conference calls that accompany earnings reports, where corporate management will discuss results and the outlook.
But you also shouldn’t forget to check on leading indicators for clues about the state of the future economy. And this is one area that featured a batch of bad news that doesn’t bode well for the outlook.
The Bear Market is Earnings Dependent
During 2022, stock prices felt the weight of the Federal Reserve’s rate hikes through the impact to valuations. Higher interest rates do two things:
Future corporate profits are worth less in today’s dollars.
It presents competition for investor capital as cash can earn a more attractive return.
Falling valuations like the price-to-earnings ratio accounted for much of the stock market’s downside in 2022. That was the first phase of the bear market.
The next phase really comes down to one thing, and that’s if a recession hits the economy. That’s because of the impact on corporate earnings which has driven some of the really nasty bear markets, like the 2008 financial crisis and dot-com bust starting in 2000.
On the other hand, no recession means that the stock market lows were likely seen in October of last year.
So while I will be paying close attention to comments from corporate executive teams and the path of forward estimates, I’m also not forgetting to check in on leading economic indicators.
And last week featured less than ideal news on this front. First, an updated report on leading economic indicators from the Conference Board showed a worsening year-over-year decline (chart below). In an accompanying statement, the Conference Board expects a recession to start in the middle of the year based on their data.
Also, a key yield curve is pushing inversion toward historic levels. You can see the 10-year/3-month yield curve in the chart below, which is now more inverted than at any point in the last 40 years.
Here’s why that level of curve inversion matters. According to a model maintained by the Federal Reserve, a steeper yield curve inversion historically translates to a greater chance of recession in the next 12 months. That model currently pegs the odds of recession at 57%, which is the highest level since the early 1980s.
Here’s another reason why that matters. Earnings for the S&P 500 might be 11% off the highs from the start of 2022. But as you can see in the chart below, this level of yield curve inversion has historically led to much more severe earnings drawdowns (h/t Lance Roberts).
As I showed you above, the path of earnings will ultimately drive the direction of the stock market. And the message from key macro variables is that the drawdown in earnings is not over.
Now What…
The state of future earnings is a big picture concern for the stock market, but it’s one that’s hard to time. When the yield curve first inverted in 2006 ahead of the financial crisis, it took a couple more years to fully experience the earnings drawdown that helped drive 2008’s bear market.
That’s why I turn to measures of trend, breadth, and sentiment to gauge the shorter-term path in the markets. And the intersection of those variables is suggesting caution over the near-term as well.
First, the rally since mid-March is leading to a sharp increase in bullish sentiment, signaling too much greed among investors. There’s also a big negative breadth divergence across multiple time frames in the stock market’s rally since mid-March.
Just take a look at the percent of stocks trading above their 50-day moving average (MA). When the S&P was trading at a similar level back in early February, nearly 81% of stocks were in solid uptrends as shown with the arrows. But look at where things stand now with the circles. While the S&P 500 finds itself right back to similar levels, only 41% of stocks are in uptrends.
That might be weighing on the inability for the S&P’s trend to escape the ascending triangle pattern in play since February’s high. If anything, a breakdown through support is starting to develop in last week’s price action.
Those bearish breadth divergences can always be resolved positively on a strong breakout from the pattern above. But I’m playing it cautiously on new positions by sizing more conservatively and proactively taking gains when available.
If the bearish scenario does play out, I’m watching stocks that are already testing key support levels. I’ve highlighted several in Mosaic Chart Alerts, and am following the action closely in MOS as well.
You can see in the chart below the stock is turning back down toward support at around the $42 level. Each bounce off that level since last July has seen a smaller rally, showing the bears might succeed on a breakdown with this next test.
There’s still plenty of long setups as well if the average stock can get more traction in this market. That includes HIMS, which is on the verge of taking out the $12 resistance level while the MACD and relative strength line are in good position to support a breakout.
That’s all for this week. Expect plenty of single-stock volatility in the week ahead. And with over 40% of the S&P 500 market-cap reporting, those names can throw the index around as well. I’ll be closely watching how forward earnings estimates evolve, and how the market resolves deteriorating participation under the hood.
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Disclaimer: these are not recommendations and just my thoughts and opinions…do your own due diligence! I may hold a position in the securities mentioned in this report.