Have Stocks Bottomed?

[Zacks | Our Research. Your Success.] Weekday Wisdom [Sheraz Mian - Editor] Have Stocks Bottomed? By: Sheraz Mian October 26, 2022 --------------------------------------------------------------- Stocks have enjoyed a few good sessions in recent days, after reaching a new low, below the prior bottom reached in June, two weeks back. This is raising hopes among some that the worst may be behind us. But there are others that cite various reasons to stay bearish, keeping alive questions about the market's next move. I am adding to that debate in this piece by pointing out two fundamental sources of support for the market that will help it not only stabilize, but actually rebound in the days ahead. Stocks need power to push higher, just as humans and machines do. For stocks, this 'power' comes from a variety of sources, but interest rates and corporate profits are the biggest. The market pullback this year has been driven by the uncertainty of market participants about how much more the Fed will need to raise rates in its inflation fight and the impact that this extraordinarily tight monetary policy will have on the economy’s health. This, in turn, has blurred earnings visibility, as corporate profitability is a function of economic health. I am increasingly of the view that we are on the cusp of getting better clarity and visibility with respect to interest rates as well as corporate earnings. This note explains the basis for that view. I don’t subscribe to the view that the current multi-decade high inflation readings are here to stay. This bearish view implies that the Fed will need to stay on the warpath for an extended period, which will push the economy into a deep recession. While recession risks have undoubtedly increased, it is hardly the only, or even the most likely, outcome for the U.S. economy. The Fed is not on some autopilot that constrains them to implement all the rate hikes they have communicated to us following recent meetings. Given the Fed’s data dependence, it is inconceivable that they will ignore recent trends that clearly show that their already-implemented tightening moves are starting to have an effect. My readings of the economic tea leaves make me conclude that peak inflation readings are in our rearview mirror now. This doesn’t imply that I expect to see the Fed’s target 2% reading next month, but rather that readings of inflation will be shifting into deceleration mode going forward. A non-trivial part of our inflation problem was always a result of the pandemic’s impact on global and local supply chains. The other part was due to the stronger-than-expected post-pandemic demand that likely got exacerbated by stimulative fiscal measures. The Fed fully understands that no amount of tightening on its part will have a bearing on stretched global supply chains. Its goal instead is to take the edge off excess demand by removing the extraordinary stimulus measures through unwinding the QE program and raising interest rates to a level where they no longer stimulate economic growth. We are close to the lower end of that range after the September rate hike. My sense is that they will implement another 75 basis-points rate hike in the next Fed meeting in early November, the fourth back-to-back rate increase of that magnitude. But, this will be the last hike of this magnitude, with the accompanying statement indicating the first of multiple ‘pivots’ where the central bank will indicate the need to gradually slow down the pace of rate hikes going forward. The market will see it as the beginning of the end for the Fed’s tightening cycle and will have anticipated it through pricing action ahead of time. The stock market optimism in recent days, that coincided with seemingly reassuring Q3 earnings results, is likely an early attempt to do just that. Continued . . . [Notification of Release: 5 Stocks Set to Double]( Zacks' experts have revealed their choice for which stocks have the best chance to gain +100%. Previous editions of this Special Report have racked up gains of +143.0%, +175.9%, +498.3%, and even +673.0%. Today, you are invited to download the just-released report that names new stocks and spotlights why their gain potential is so exceptional. [See Stocks Now »]( This brings us to the second fundamental force we mentioned earlier that powers stocks higher – corporate earnings. In contrast to widespread fears of an impending earnings drought, the ongoing Q3 earnings season is showing stability and resilience. Our unique vantage point, as one of only a handful of research teams in the country that keep a close watch over the evolving earnings trend, gives us plenty of confidence in extrapolating from what we have seen already this earnings season. The earnings picture isn’t great, but it isn’t even remotely as bad as market bears have been warning us of. Stepping back from the individual quarterly releases, we all know that the overall earnings growth trend has been decelerating as a result of cost pressures and moderating economic activities in response to the aforementioned Fed tightening. The way we see it, there are two aspects to the prevailing market discourse about corporate profitability that reflect a misreading of the fundamental ground reality. There is this notion that earnings estimates, say for next year, are very high and remain out-of-sync with the economic outlook. This view claims that a fair earnings level for next year would be one that is below this year’s level. After all, with economic growth turning negative as a result of the coming recession, earnings growth should also turn negative instead of the mid-single digit positive growth currently expected. These views are widely held in the marketplace and even many well-meaning investment professionals can be seen repeating them in the financial media. I strongly disagree with these views and next, I’ll explain why. Before I address the view that earnings estimates haven’t come down enough, I would like to highlight that tracking earnings estimate revisions is a core part of our research process. It is not some tangential activity that we start paying attention to in times of macroeconomic uncertainty, but rather a fundamental driver of our equity rating system. We are always monitoring estimate revisions because that’s how we rate stocks, industries and sectors. To get a nuanced understanding of trends in earnings estimate revisions, we have to appreciate that big cuts to estimates over the last few months for major sectors like Technology, Consumer Discretionary, Construction and Retail get camouflaged at the aggregate index level as a result of the unprecedented counter-cyclical behavior of the Energy sector. Regular readers know that we have consistently been pointing out that earnings estimates for the S&P 500 index outside of the Energy sector peaked in mid-April and have been coming down ever since. In fact, 2023 earnings estimates for the index are down -5.3% since mid-April as a whole, and -8% once we exclude the Energy sector from the index. The -8% cut to 2023 earnings estimates since mid-April is a material reset in expectations. We aren’t dismissing some further downside risks to estimates, but continue to hold the strong view that a big part of the declines is now mostly behind us. Driving this view is our expectation that the coming economic downturn will be a mild and short one, unlike what we experienced in 2008. This brings us to the second point that sees the current +5.1% earnings growth expected for the S&P 500 index in 2023, as unrealistic if the U.S. economy was expected to experience two or more quarters of negative GDP growth. This seemingly reasonable assertion is comparing apples and oranges by requiring ‘nominal’ earnings to turn negative in the face of a modest ‘real’ or inflation-adjusted decline in GDP. The fact is that U.S. GDP growth will most likely remain positive in nominal terms in our outlook of a mild and short-lived recession. We strongly believe that investors will find it difficult to justify continued market weakness in the face of stable and resilient earnings releases in the days ahead, particularly as they gain more confidence in their Fed outlook. The market set up for this earnings season couldn’t have been better. Putting It All Together The ongoing Q3 earnings season is far from confirming the doom-and-gloom fears of market bears. Granted earnings aren’t great, but no one expected that at this stage of the cycle in the face of aggressive Fed tightening. Importantly, they are as good as could be expected in this environment. What we are seeing instead is continued resilience in household and business spending, with tell-tale signs of the expected moderation. This implies an orderly slowdown instead of falling off the cliff. The implication of all of this discussion of interest rates and earnings for investors is that while we still have to contend with some uncertainties, the clouds have started to lift. We typically know of market bottoms only in retrospect and this time will likely be no different. But we are reasonably confident that the worst is now behind us. How to Take Advantage Today is an ideal time to get aboard this market. 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It gives you access to the picks and commentary from all our long-term portfolios in real time for the next 30 days. Plus, it includes Zacks Premium research so you can find winning stocks, ETFs and mutual funds on your own. Last year alone, they closed 68 double and triple-digit wins. There have already been 33 more in 2022. Gains have reached as high as +188.3%, +348.7%, and even +995.2%.¹ The opportunity to download this just-released Special Report, 5 Stocks Set to Double, ends Sunday, October 30. [Get started now with Zacks Investor Collection and 5 Stocks Set to Double »]( All the Best, Sheraz Mian Sheraz Mian serves as the Director of Research and manages the entire research department. He also manages the Zacks Focus List and Zacks Top 10 Stocks portfolios. 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