As we move into the second half of 2023, I would like to share some of my views as to where the market will be at the end of the year and how do I see the recent rally in the big tech names. Is it a buy on weakness or a sell on strength? Next week we will see the second quarter earnings swing in full force.
In the first quarter of the year, US companies faced several headwinds including lackluster economic growth and inflationary pressure. Stress in the banking system was also experienced in March with banks failing. Many analysts were pessimistic coming into 2023 expecting a recession to happen. Also, companies’ executives have been conservative with their forecasts.
2nd Quarter 2023 Consensus
As of 7th of July 2023, 113 S&P 500 companies have issued EPS guidance for the second quarter. This number is above the 5-year average of 96 and above the 10-year average of 98 according to FactSet. In fact, the second quarter saw the highest number of S&P companies issuing positive EPS guidance for a quarter since Q3 2021. Looking ahead, analysts still expect earnings growth for the second half of 2023. For Q3 2023 and Q4 2023, analysts are projecting earnings growth of 0.3% and 7.8%, respectively. For the entire fiscal year 2023, analysts predict earnings growth of 0.8%.
As we look forward to the second quarter, the guidance numbers have started out much more positively than they did in the first quarter. There have been 31 negative announcements for Q2 compared to 27 positive announcements, resulting in a negative/positive ratio of 1.3. For context, Q1 only saw 26 positive announcements in total.
Interestingly, the dramatic improvement in Q1 earnings growth has not translated throughout the rest of the year, as Q2, Q3, and Q4 growth expectations have all declined marginally since April. Perhaps analysts are adopting a ‘wait-and-see’ approach before revising estimates further.
Weakening US$ a tailwind
The US Dollar index has been coming off its recent high at the end of 2022 (Refer to the chart below). This has boosted exports and reduced US trade deficit as a result (Refer to he second chart below).
Statistically, roughly 40% of S&P 500 revenues are generated outside of the U.S., and about 58% of Information Technology company sales come from abroad. As such, a weakening US Dollar grows revenue of these companies (since their reporting is in US$). We are currently at the tail-end of the current interest rate hike cycle. If the FED eventually reduces rates in 2024, this will cause downward pressure on the US$. This in turn will result in the revenue growth of these US companies who derive a large chunk of their income overseas. As we can see from the above chart, the Bureau of Economic Analysis expects US Trade Deficit to reduce from the current -70 USD Billion to c. -40 USD Billion by the end of the year. We may also see downward pressure on the greenback if the FED lowers interest rates in 2024.
Employment Cost Index
On the employment front, the YOY percentage change in private industry compensation has slowed since June 2022. Many companies have started retrenching staff in the second half of 2022 and I see that feeding positively into their financial results in the second half of 2023. This should help companies defend their margins in a diminishing topline situation.
As long as the companies are able to grow their revenues going forward (by 2024), this cost-savings exercise (retrenchment) will increase their margins and improve their bottom line.
Inflation – a profit margin booster
During the recent inflation situation, we saw many big companies increasing their prices to keep up with higher cost of raw materials and cost of operation. This did not affect their market share too much which reflects the pricing power of these big companies. Recently, Pepsi Co. CEO was asked if Pepsi might consider rolling back price increases if demand weakens. The answer was that they were trying to create brands that stand for higher value for consumers and they are more willing to pay for their brands. In a nutshell, it’s basically a “no”.
A series of “overlapping emergencies” in recent years gave companies the peg they need to collectively raise prices. Publicly reported supply chain bottlenecks and cost shocks can also create legitimacy for price hikes and consumers’ acceptance of higher prices. This renders demand less elastic. Because these disruptions and shocks affect entire industries, firms can hike prices without fear of losing market share, even for two notorious competitors like Pepsi and Coca-Cola.
With supply-chain bottlenecks easing and commodity prices falling, production costs should fall. In addition, if companies do not reduce their prices to reflect lower costs of operations, this will also have a positive impact on their profit margin.
Tighter credit conditions not impacting much
S&P 500 companies, still with fortified balance sheets, don’t rely on banks for credit. So while tight credit will continue to put pressure on smaller companies, the big companies that drive S&P 500 profits are perhaps more insulated than markets had assumed. Also note, the big S&P 500 banks have been beneficiaries of banking stress, gaining deposits from smaller banks.
Consensus estimates have stabilised during the first quarter earnings season
Presidential Election Cycle Theory: Bullish 2023?
Since 1928, the third year of the presidential cycle has produced positive S&P 500 returns 78% of the time, generating 13.5% average returns vs. an all-year average of 7.7%.
From the above chart, we can see that the market has the best performance in the third year (2023), one year before the election year (2024). So far, the market has performed as expected in a pre-election year. Generally, the market will continue to rally higher during the fourth quarter, making year-highs only in December. Historically, if the S&P 500 is up more than 10% through June, it will continue to rise during the second half of the year.
Analysts have been too pessimistic coming into 2023
As most analysts have been too pessimistic with their earnings forecasts for 2023, I would assume that most clients have not positioned themselves during the current rally. If earnings continue to surprise on the upside, analysts (Brokers, Investment banks, etc) will need to reverse their calls and advise their clients to position, possibly fueling the next rally.
Short interest has also increased since April 2023 and if the index is to rally further in the second half of the year as a result of improved economic conditions or better corporate earnings, short covering may fuel the next market rally as well.
Technical – 1st half 2023 rally
As market has rallied hard since the start of 2023, both on the S&P and Nasdaq, many investors may be wondering whether they are late in the game. Is the current situation a buy on weakness or a sell on strength?
The market started the year 2023 on the back of a very poor performance in 2022, with the S&P down nearly 20% and the NASDAQ down a whopping 33% (refer to the table below).
From the above charts, we can see that the market is trying to recover from its dismal performance in 2022. However, both indices have not recovered to their last highs in early 2022.
Interestingly, the NASDAQ pulled back 33% in 2022 and it doesn’t mean that the market will reach the same level if it rallies 33% from its low (Refer to the table above). To get back to where it has fallen, the index will need to move 50.51% higher.
If you have invested and gotten a return of 10% in the first year and in the second year, it drops 10%. Is your portfolio breaking even? No! In fact you have made a lost.
1st Year: 10% (gain) X $1,000 (capital) = $1,100 (Total Portfolio value)
2nd Year: 10% (Loss) X $1,100 (Capital at the start of the second year) = $990 (Total Portfolio Value)
Valuation
Based on the above possible tailwinds, I will pegged the year end target for S&P500 at 20x FPE, with a EPS of $225 (Consensus as of writing is $219.14), thus arriving at 4,500.
Watching the 2Q and 3Q earnings seasons closely to possibly revise the target higher if earnings beats.
Action
Buy on weakness and NOT sell on strength. As usual, go with the fundamentally strong companies. The recent market rally was concentrated within the big-tech space. For this rally to continue, it has to broaden out to include more than just the biggest tech stocks. Other segments (value and smaller caps) may play catch up with improved economic condition. Consumers have stayed relatively strong and the Consumer Discretionary Select Sector SPDR Fund has gained c. 32% year-to-date. Continue to avoid commodities/ material related companies as I am expecting margin compression with falling demand and higher cost of production to continue into the second half of the year.
Risks to the above assumption:
- Market-negative events as a result of monetary tightening (high interest rates) currently unknown.
- Worse than expected economic recession (above forecast is based on no-recession in the US).
- Inflation worsening, negatively impacting companies’ bottom-line.
- US-China tension worsening.