June 27, 2022: Risks remain, but opportunities abound

It felt good to end last week solidly in the green after the worst weekly decline since the start of the pandemic. But was this reversal just a bear market rally or is the market truly starting to find a bottom?

“It’s too early to tell,” said Matt Orton, CFA, Chief Market Strategist at Carillon Tower Advisers. “It wasn’t surprising to have a bounce given incredibly oversold conditions. But I still think we have to assume the base case is fairly negative, where this is just a bear market rally. There’s still just too much uncertainty in my opinion to get the market to make a change and I don’t think we can have confidence in any rally until we start to see what happens with respect to earnings.”

The market was historically oversold heading into last week and sentiment remains apocalyptic, both of which could continue to be a catalyst higher. But Orton said there remains tremendous uncertainty with respect to the potential for recession and the impact that could have on earnings expectations, both for the remainder of 2022 and into 2023. While he said he doesn’t believe we will or need to see massive earnings revisions, especially in growth where expectations have already come down, there are still risks that downgrades are met severely by investors. As he advocated in the March and May rallies, Orton said investors should not chase the market higher. Rather, he said a more prudent approach would be to use instances of highly oversold conditions opportunistically.

I don’t think we can have confidence in any rally until we start to see what happens with respect to earnings.

What does that really mean? Orton said investors need to have market exposure to take advantage of a recovery when it happens. Therefore, he said, maintaining a core defensive bias remains important to navigating these markets. That means leaning into high-quality companies — those with high profitability, earnings stability, and high free cash flow — that pay and are growing dividends. But investors should also use downside and extreme conditions to add some beta exposure on the margin. When we see reflex rallies like last week and earlier this year, you need beta to keep up, he said. Small caps and high-quality information technology remain Orton’s favored ways to increase portfolio beta. The Russell 2000^® Index is having its worst first half in history. Valuations are cheap, Orton said, especially for higher-quality companies. Earnings also are generally more insulated from the U.S. dollar, which he expects to be a common problem in large-cap earnings coming up. Growth at a reasonable price (GARP) also has been quietly outperforming year to date. And if the market narrative continues to focus on economic growth concerns, reasonably valued growth companies should outperform. Orton said his preference remains enterprise software.

When can we have confidence in a bottoming process?

Last week Orton laid out a framework to help assess when the market is nearing an absolute bottom. He said he wouldn’t be surprised to see some further follow-through of last week’s rally as quarterly rebalancing provides support for equities and negative sentiment provides additional tailwinds. But he said there is still too much uncertainty around three key indicators heading into the end of the second quarter:

1. Financial conditions need to stop accelerating higher and credit spreads need to find resistance. We made some tenuous progress, he said, but it’s too early to draw any conclusions. Financial conditions held steady last week, a marked improvement, but remain at the tightest levels since the COVID shutdown. It’s also too early to tell if credit spreads have in fact hit some resistance.
2. Valuations need to be compelling and earnings expectations need to come down. Equities still look cheap, Orton said, especially in growthier areas of the market where multiples have contracted the most in decades. However, until we have more clarity around earnings he said this uncertainty will be hard to overcome. Growth equities have already started to see lower earnings expectations, but we haven’t seen this play out in value, which is a risk heading into earnings season. In fact, Orton said it’s really the increase in earnings expectations in energy, materials, and industrials companies that are masking the normalization occurring across the other sectors. Small- and mid-caps have seen earnings come down and look cheap following massive valuation compression, he said.
3. Sentiment and positioning need to signal capitulation. Sentiment is still apocalyptic and can’t get much worse. We need to see sentiment hold up as earnings are released and investors reward good news.

Financial conditions held steady last week but need to ease
in order for the rally to sustain

Source: Bloomberg, as of 6/24/2022.

Credit spreads eased slightly, but it’s too soon
to tell whether this will continue

Source: Bloomberg, as of 6/24/2022.

Does the VIX need to cross 40 to signal capitulation?

There’s an obsession in the current market narrative that the Chicago Board Options Exchange (CBOE) Volatility Index, or VIX, must hit 40 in order to signal that the bottom is in. But Orton said there’s a reason why this is absent from his criteria for looking for a market bottom:

It’s arbitrary and assumes the regime in which we find ourselves is similar to past events. First, the VIX is simply an index that is calculated using a formula to derive expected volatility by averaging the weighted prices of out-of-the-money puts and calls. Unlike past episodes where the VIX spiked, we’ve been in a rising volatility regime since the end of last year and this has already been reflected in the implied volatility used to calculate option prices. Additionally, investor positioning is pretty light right now: Cash levels in the last Bank of America Merrill Lynch Fund Manager Survey showed very elevated levels of cash on the part of institutional investors. Given lighter positioning, there isn’t as much of a need for protection. In fact, he said, volatility skew has come down to post-pandemic lows because most option positioning is being used to rent upside rather than to put cash to work and buying protection.

What to watch

A rough second quarter will come to an end this week, but not before some big earnings reports from companies in shoe and sportswear retailing; financial services; software; military drone manufacturing; human resources and payroll services; consumer food production; home goods retailing; beer sales; and pharmacies. Orton said we also will get some important data releases, including updates on durable goods orders, consumer sentiment, home prices, and gross domestic product.

This week's data releases

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Oversold is a term used to describe a security believed to be trading at a level below its intrinsic or fair value.

Growth investing is a stock-buying strategy that focuses on companies expected to grow at an above-average rate compared to their industry or the market.

Value investing is an investment strategy that involves picking stocks that appear to be trading for less than their intrinsic or book value.

Defensive stocks provide consistent dividends and stable earnings regardless whether the overall stock market is rising or falling. Companies with shares considered to be defensive tend to have a constant demand for their products or services and thus their operations are more stable during different phases of the business cycle.

Beta is a measure of the volatility or systemic risk of a security or portfolio compared with the market as a whole.

Growth at a reasonable price (GARP) is a stock investment strategy that seeks to combine tenets of both growth and value investing in the evaluation and selection of individual stocks. GARP investors look for companies with consistent earnings growth above broad market levels but try to avoid companies with very high valuations. By trying to avoid the extremes of either growth or value investing, GARP investors often end up focusing on growth-oriented stocks with relatively low price-to-earnings multiples in normal market conditions.

A credit spread is the difference in yield between a U.S. Treasury bond and another debt security with the same maturity but different credit quality. Also referred to as “bond spreads” or “default spreads,” credit spreads are measured in basis points, with a 1% difference in yield equaling a spread of 100 basis points. Credit spreads reflect the risk of the debt security being compared with the Treasury bond, which is considered to be risk-free. Higher quality securities have a lower chance of the issuer defaulting. Lower quality securities have a higher chance of the issuer defaulting.

A multiple, sometimes referred as the price multiple or earnings multiple, is a measure of a company’s value based on the ratio of its current share price to its earnings per share. This ratio is known as the price-to-earnings ratio, or P/E.

Valuation compression, also referred to as multiple compression, is an effect that takes place when a company’s earnings rise, but its stock price does not move in response. This decreases the company’s financial multiple, and this often reflects a change in investor expectations. In the case of a company that posts flat earnings, a multiple compression could see the stock price fall or, in the event that the company reports falling earnings, the stock price could fall faster than the earnings.

The Goldman Sachs U.S. Financial Conditions Index is designed to track the weighted average of riskless interest rates, the exchange rate, equity valuations, and credit spreads, with weights that correspond to the direct impact of each variable on gross domestic product.

The Markit CDX North America High Yield 5-Year Index is composed of 100 liquid North American entities with high-yield credit ratings that trade in the credit default swap market. The credit default swap index (CDX) also is a tradable financial product that investors can use to gain broad exposure to the market for credit default swaps.

A credit default swap is a financial derivative or contract that allows an investor to “swap” or offset a credit risk with one owned by another investor. Credit default swaps act like insurance policies in the financial world, offering a buyer protection in case a borrower defaults on credits such as corporate bonds, mortgage-backed securities, municipal bonds, or emerging market bonds.

The daily moving average (DMA) is a calculation that takes the arithmetic mean of a given set of prices over the specific number of days in the past; for example, over the previous 15, 30, 100, or 200 days.

Basis points (bps) are measurements used in discussions of interest rates and other percentages in finance. One basis point is equal to 1/100th of 1%, or 0.01%.

The Chicago Board Options Exchange (CBOE) Volatility Index, or VIX, is a real-time market index that represents the market’s expectation of 30-day forward-looking volatility. Derived from the price inputs of the S&P 500 index options, it provides a measure of market risk and investors’ sentiments.

An option is a financial instrument based on the value of underlying securities such as stocks. An options contract offers its buyers the opportunity to buy or sell — depending on the type of contract they hold — the underlying asset.

Put options are financial contracts that give the buyer of the option the right, but not the obligation, to sell a specified amount of a stock, bond, commodity, or other instrument at a pre-determined price (the “strike price’) within a specified time frame. Put options increase in value as the price of the underlying asset falls, as the volatility in the price of the underlying asset increases, or as interest rates decline.

Call options are financial contracts that give the buyer of the option the right, but not the obligation, to buy a stock, bond, commodity, or other instrument — known as the underlying asset — at a specified price (the “strike price”) within a specific time period (the expiration or time to maturity). The buyer profits when the underlying asset increases in price.

“Out of the money” (OTM) describes a put or call contract that only contains extrinsic value. Such options have a delta — that is, the ratio that compares the change in the price of the underlying asset to the corresponding change in the price of its derivative — of less than 0.50. An OTM call option has a strike price higher than the market price of the underlying asset. An OTM put option has a strike price lower than the market price of the underlying asset.

“At the money” refers to what happens when an option’s strike price is identical to the current market price of the underlying security.

“In the money” refers to an option that possesses intrinsic value and presents a profit opportunity due to the relationship between the strike price and the prevailing market price of the underlying asset. An in-the-money call options means the option holder can buy the security below its current market price. An in-the-money put option means the option holder can sell the security above its current market price.

The Bank of America Merrill Lynch Fund Manager Survey is a monthly canvass of the views of about 200 mutual and hedge fund managers around the world.

Implied volatility is a measure of volatility levels based on the market’s assessment of likely future volatility. It is thus different from realized volatility, also known as historical volatility, which measures levels of volatility that took place in the past.

Skew, also known as volatility skew, is the difference in implied volatility between out of the money-options, at-the-money options, and in-the money options. Skew is affected by sentiment and the supply and demand relationship of particular options in the market, and provides information on whether fund managers prefer calls or puts.

The Richmond Manufacturing Index is a monthly composite index published by the Federal Reserve Bank of Richmond that represents a weighted average of the business conditions of manufacturing companies in Maryland, North and South Carolina, Virginia, most of West Virginia, and the District of Columbia. The index focuses on shipments, new orders, order backlogs, capacity utilization, supplier lead times, number of employees, average work week, wages, inventories, and capital expenditures. A rise in the index signifies improvement and growth, while a decrease in the index signifies a contraction.

The Purchasing Managers’ Index (PMI) measures the prevailing direction of economic trends in the manufacturing sector. It is created by the Institute for Supply Management (ISM), and consists of an index summarizing whether market conditions as reported in a monthly survey of supply chain managers are expanding, staying the same, or contracting.

The Eurozone Harmonised Index of Consumer Prices is a composite measure of inflation in the Eurozone based on changes in prices paid by consumers in the European Union for items in a basket of common goods. The index tracks the prices of goods such as coffee, tobacco, meat, fruit, household appliances, cars, pharmaceuticals, electricity, clothing, and many other widely used products.

The China Caixin Services Purchasing Managers Index is compiled from responses to questionnaires sent to purchasing executives in over 400 private service sector companies.

The Japan Consumer Price Index, released monthly by the Statistics Bureau of Japan, tracks core inflation by monitoring price changes in a wide variety of goods and services, excluding fresh foods but including energy, purchased by households nationwide.

The daily moving average (DMA) is a calculation that takes the arithmetic mean of a given set of prices over the specific number of days in the past; for example, over the previous 15, 30, 100, or 200 days.

The S&P 500 Index measures change in stock market conditions based on the average performance of 500 widely held common stocks. It is a market-weighted index calculated on a total return basis with dividend reinvested. The S&P 500 represents approximately 75% of the investable U.S. equity market.

The Russell 2000^® Index measures the performance of the 2,000 smallest companies in the Russell 3000® Index, which represents approximately 10% of the total market capitalization of the Russell 3000^® Index.

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CTA22-0413 Exp. 10/27/2022