The latest asset movements
The market achieved a solid market rally, as we predicted in our macro report last week but also in our bullish analysis for the S&P 500. This was a rally from exhaustion, but macro fundamentals still look bad and are more inclined to the bearish side. That happened exactly at the end of the week due to a strong job report. However, in some assets, a great valuation can be spotted. Stocks removed almost all the gains from the week, while bond yields continued to surge. The years 2022 and 2023 will be about precise stock picking.
Asset movements, Source: Investro analytics team
Mixed signals in macro – many reactions in the market
Last week brought significant volatility to the market on both sides. Upwards and downwards. Firstly, followed by Monday and Tuesday’s rallies, there was a clear impact of the weakening of crucial economic leading indicators – US ISM Manufacturing and New Orders.
Both dropped more than the consensus-estimated and reached levels not seen since 2008, except for COVID-19 time (2020). This was a pure market sign, just when market participants believed that the Fed would pivot earlier than anticipated. However, as we said previously, the market had been very oversold and needed just a “bullish trigger” for a short-lived reversion.
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If you read our special report, which analyzes a substantial breakdown from the latest FOMC meeting and the market’s expectations, you will understand how the Fed tried to scare the market with its hawkishness.
The economy shows the slowdown will continue on the manufacturing side as well as on the service side. However, the service side surprised positively versus market expectations, with some improvements in September but still weaker figures than a month ago. A great chip leader also confirms the negative trend – AMD released very weak preliminary results due to weak macro. Other companies will follow. This was also one of the last triggers in the previous week, which let the stocks fall.
US ISM manufacturing PMI and New Order Indexes, Source: YCHARTS via Seeking Alpha
Almost the whole upward move was removed by the trigger from still strong labor market, in our Market Movers section:
“EU and US stocks extended losses after the release of NFP data. The US economy added 263K jobs last month, above forecasts of 250K, and the unemployment rate fell from 3.7% to 3.5%. The data suggests that Fed will continue to raise interest rates quickly to combat inflation, despite expected pain in the medium term.”
The outcome was really surprising on a positive note, which ended the bullish song for the day. While this data is crucial for the Fed, it will give them comfort to be sure about the following hikes ahead, as long as the job market remains strong.
Data from labor market, Source: FXSTREET
Yes, we just said that the employment rate and strong results in nonfarm payrolls are strong enough, but really? In the next great chart from Nordea, we can see that the labor market (NFP) remains one of the most lagged indicators in the economy.
The chart considers NFIB hiring plans (momentum) as a leading indicator, which leads by 5 months above NFM on an M/M basis. According to momentum, NFP should continue to decrease on a monthly basis.
USA NFP m/m and NFIB Hiring plans momentum, Source: Nordea via Macrobond
Additional rate hikes are priced in
The problem in the current macro cycle for stocks can be perceived and is impacted by two sources. Firstly, the recent market decline is mainly driven by an increase in Fed Funds Futures (Rate) and just about market expectations about rate hikes. The actual yields rose too (not just nominal), and that was the main driver of the market’s downfall.
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The theory about rate cuts till Dec 2023 vs. Dec 2022 is absolutely “out of mind” for the market participants. Yes, they expect some cuts from the peak in 2023, but compared to the Dec levels in 2022, the market awaits more significant tightening as FFFR for Dec 2023 increased to 4.43%, while for Dec 2022, it was at 4.15%. It could also be measured in real yields, which is currently the primary driver of P/E normalization.
Fed Funds Rate measured by Futures (market), Source: Investro analytics via Tradingview
This is also confirmed on the next chart, which describes the odds of the market participants at the following FOMC meeting. The odds dramatically changed at the end of the week, impacted by the strong labor market. The odds of a 75 bps hike increased to 81%, while the odds of a 50 bps hike decreased to 19%.
Target Rate Probability, Source: Investing.com
Negative surprises in EPS and trading idea
Negative surprises in EPS will be considered negative as well. Estimates for 2022 and 2023 EPS remain pretty high, with a positive year-on-year change. However, with rising rates, increased debt service, and lower demand, the odds of lowered EPS in 2023 are significantly increasing. And when the market reprices further EPS “lowering,” it can cause further declines in the market.
We saw this in the AMD case last week, or in Apple’s, or by many other companies, which lowered their guidance for 2022/2023 due to bad macro improvements. Although the valuation for the S&P 500 is high, the Russel 2000 can be currently found at the very great valuation – in case of P/E. Small cap (Russel 2000) P/E trades at a historical discount last seen in the nineties.
Small cap forward P/E below the long-term average, Source: BofA GLOBAL RESEARCH
Despite a further possible contraction in the market, our team reveals a solid pair trade opportunity with hedged risk. The idea: Long IWM and Short SPY. We consider IWM valuation as very cheap in the long term, while SPY valuation is still above the long-term average.
However, IWM usually has greater volatility than SPY, and we believe it can grow faster, as it can be spotted with better valuations. The IWM/SPY ratio is also trading near multi-year lows. Volatility can be reduced with the hedged idea, and risk management can provide some protection in the event of further market decline.
IWM/SPY ratio, Source: Investro analytics team via Tradingview
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