Broker Check

Be Patient and Unemotional

| April 22, 2024

Unfortunately, two weekends ago we saw geopolitical risks broaden in the Middle East just as markets began to dial back the number of expected Federal Reserve rate cuts in 2024. As a result, we’re now facing a moment of dual fragility for equities.

This situation arose just as the S&P 500* sat at somewhat important technical levels – the first being the index dipping below its 20-day moving average and the second being the index sitting at its 50-day moving average:

In our opinion, the eventual result of this market fragility depends on three important factors:

  1. How broad is the Iran/Israeli conflict?
  2. What will the Fed do?
  3. But most importantly…earnings season results.

Thus far, investors are understandably bracing for the worst and we’re beginning to see some level of de-risking. However, the effect on the market from a risk standpoint is far lower than the risk for markets when Russia invaded Ukraine in February 2022. The reason for that is margin debt (or leverage).

Margin debt is money loaned by investors to purchase assets. The purchased assets are collateral for the loan and are subject to margin calls, which occur when account values dip below required levels. Margin calls force investors to de-risk their portfolios via forced selling.

When Russia invaded Ukraine, margin debt was over $900 billion. De-risking forced the unwinding of leverage that eventually bottomed out in October 2022, around $600 billion. By contrast, margin levels today are at $736 billion – far lower than in 2022 as well as compared to February:

Lower margin levels mean fewer margin calls, which results in less forced selling of assets. In other words, there is less leverage to unwind than there was a couple years ago.

The question then becomes, what other macro risks require monitoring? In our view, there are three big ones:

  1. A spike in oil prices to more than $100 per barrel, which would increase the chance of a global recession.
  2. War escalation in the Middle East, which would likely slow hiring due to an abundance of caution.
  3. War fears causing significant instability in equity and bond markets.

These risks create market fragility tests. However, we need to keep in mind the dovish Fed and low leverage mean potentially better resilience than in early 2022. Still, it’s prudent to be patient and not blindly buy short-term dips until there’s a clearer picture regarding the overall geopolitical picture, Fed reaction, and fundamental data.

Also, earlier this year we prepared readers to be ready for a consolidation dip in the market sometime in the second quarter (see below for a reminder).

It’s clear that market participants have been keenly looking for a catalyst to create an excuse to de-risk portfolios. We’re seeing that play out now.

Upside Surprises Playing Out

Looking now to more fundamental-based data, it's clear these recent catalysts have spooked the market. The CBOE Volatility Index (VIX), which is referred to as the market’s “fear gauge,” increased to over 18, a level not seen since October 2023 (just prior to this bull run):

Obviously, recent bad news has been a driver of market volatility. But more importantly from a fundamental standpoint, earnings season is here again. Thinking long-term, earnings performance plays a bigger role in how markets will react and play out through the rest of the year than recent headline news.

FactSet shows that over the last decade, 74% of S&P 500 companies beat their earnings estimates and 64% beat revenue estimates. To us, that means either the analysts are bad estimators, or they want to underestimate. Regardless, let that trend continue.

Upcoming earnings reports for this year’s first quarter will likely follow the same pattern. Based on history, it’s fair to expect 79% of companies to beat earnings estimates and 67% to beat revenue estimates:

It’s still early for earnings announcements, but we’re seeing these upside surprises playing out, especially in the financial sector, which always kicks off earnings season:

If this historical context is true and early results indicate what’s to come, it means the economy is still working, even in the face of the risks mentioned above. Companies continue to generate sales, profits, and earnings. For investors, isn’t that what’s most important at the end of the day?

Additionally, in the face of inflation concerns and what the Fed will do with rate cuts, it’s important to note how the spread between interest rates and inflation is 1.93% (the current rate is 5.3% and inflation is at 3.4%).

Put another way, interest rates are 50% higher than inflation. In the past 64 years, the average spread between inflation and interest rates is just 1.03%. So, we’re nearly double that now. For more context, since 2000, the average spread is -0.75%.

Thankfully, this phenomenon of higher rates than inflation rarely lasts long:

We're including that context to balance out the fear of the recent consumer price index report that spooked markets. It’s caused significant downside pressure on MAPsignals’ trusty Big Money Index (BMI), which is a 25-day moving average of netted “big money” investor buys and sells. The BMI dipped below 55% for the first time since early November 2023:

This is a direct result of stock and exchange-traded fund selling picking up throughout last week. We’ll keep a close eye on how much that selling continues to accelerate, if at all.

While markets have been overtaken by fear, remember that should not have been unexpected. It’s crucial to be patient and unemotional, especially as we get into the heart of earnings season.

In some ways, we’re at a tipping point. Will fear-based selling take over? Or will strong earnings reports counteract the bad emotions?

We think data holds the answer. Fresh fundamental data and updated guidance from publicly traded companies (which will likely be cautious) will help dictate the market’s intermediate direction.

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* The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market.

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