The equity market has remained resilient off its October low. Investors, however, appear conflicted. While the consensus outlook for economic growth over the next 12-15 months almost universally involves recession, the appetite to start wading back into equities is palatable. We remain suspicious that the timing is right to do so. By our lights, bottoming is a process and bear markets associated with financial deleveraging and broad asset price corrections are conducive to strong countertrend moves.

Are we right? There would seem two important considerations when assessing the anatomy of a bear market: what type is it and has it run through all its phases? Modern markets appear to have produced three types of bears: 1) acute shocks that (can) reverse quickly, e.g., ’87 Crash or Covid collapse; 2) financial crises that reveal systemic failures or weakness, e.g. ’98 Asian Contagion, ’07/’08 GFC; and, 3) recession-linked asset bubbles which require unwinding, e.g. ‘00/’01 Tech wreck and today’s ZIRP normalization. Anticipating the onset of the first and second generally evades all but the keenest market observers and those investors at the epicenter (who are often powerless to avoid the fallout because of their very proximity). Asset bubbles are generally more recognizable, though their excesses are often excused, and can take far longer to work through than the consensus is prepared to accept. That’s where we believe we are; investors have not accepted their fate and all the valuation excess has yet to be wrung from the system. Volatility ensues in the form of (often powerful) counter-trend rallies. We saw this bear market first attack the speculative corners, e.g., SPACs (Special Purpose Acquisition Companies), crypto. More recently it has manifested as weakness in the long-duration names, e.g., Growth stocks, bonds. Before it’s over, the illiquid assets, i.e. private equity, will get marked down too. This has finally become what so many investors hoped for – a stock pickers’ market.

Against this backdrop we continue to favor an underweight allocation to Equities. More recently we have shifted our preference from U.S. shares to an overweight position in International equities, specifically in Developed Economies. We remain neutral against the benchmark to Emerging Market equities within our tactical allocation portfolios. The shift away from U.S. stocks is driven by four catalysts, each with different duration profiles. First, we find it inconsistent to be bearish on the Big Tech bellwethers while bullish on U.S. markets given their still dominant index weights. Second, while everyone was watching for the Fed to pivot, China’s reversal of their Zero Covid framework will likely result in a notable uptick in global demand, i.e., the “China re-opening trade.” Third, global central banks are intent on normalizing monetary policy leading to the fourth catalyst, De-Globalization – capital is being called home. Income players can increasingly find attractive local market yield alternatives devoid of currency pressure and operators remain influenced by the reorganization of global supply chains.

Source: Strategas, FactSet, Bloomberg

Domestically, we continue to rely on the same analytical framework for handicapping the market’s bottoming process that we’ve had since this time last year: 1) anchor inflation expectations; 2) level set valuations; and, 3) identify organic drivers of growth that will pull private capital into the real economy. While a reasonable case can be made that the Y/Y rates of change in the various inflation measures have peaked, wage pressures and the probability of a recession in the U.S. over the next 12-15 months both remain stubbornly high. Interest-rate sensitive sectors, like housing, are already showing the effects of tighter monetary policy. Moreover, as Strategas’ chief economist, Don Rissmiller reminds us, U.S. nominal activity is slowing: the U.S. PPI (Producer Price Index) was down -0.5% M/M in December of last year; nominal retail sales declined -1.1% M/M with the retail control group down -0.7%. U.S. industrial production also declined -0.7% M/M in December with downward revisions to prior months. The NY Fed manufacturing index plunged in January. Though this may overstate the weakness in the whole economy, other regional surveys are also showing some cracks. It seems, however, few investors have made the corresponding adjustment in their outlook for corporate profits or, by extension, their expected value forecast.

We expect tighter monetary conditions to exist for some time. This is likely to have a continued and negative impact on companies’ ability to expand operating margins. While the “money illusion” can result in higher levels of nominal earnings and make recession-related percentage declines appear less severe than they would in low inflation regimes, contracting operating leverage in combination with tighter financial conditions has historically led to lower earnings and earnings growth. Though estimates for aggregate S&P earnings for CY’23 have seen notable downward revision – to ~$225 from $250-$255 as recently as July – it is important to note that recession-related earnings declines have averaged -30% from their actual peak (i.e. ~$222 in 3Q’22) not their estimated peak. The Street’s estimates still imply profit growth for CY’23. [1] This is inconsistent with the near universally held view that the U.S. economy will contract in the next year. We reiterate our estimate of $200 for S&P 500 EPS (Earnings Per Share) in CY’23 and believe aggregate profits will continue to decline through 2Q’24 – falling toward ~$180 – before beginning to recover into year-end CY’24.