Broker Check

The Market Isn’t Acting Overbought Anymore

| May 13, 2024

Last week we showed how April's decline went a long way to favorably reset the risk/reward metrics in the market. A few weeks prior we mentioned any consolidation of an overheated market would need earnings to provide downside put support.

As of this writing, we’re seeing those scenarios play out as the S&P 500* is up 3.50% so far in May.

To refresh readers, the case for positive monthly equity gains could reverse the perhaps outdated adage of “Sell in May” to “Buy in May.”

We think there are six reasons:

  1. The economic narrative is no longer “red hot” after the softer April jobs data and March Job Openings and Labor Turnover Survey (JOLTS) report.
  2. Thus the Federal Reserve can maintain its dovish stance and push back against the idea of interest rate hikes.
  3. The current earnings season is so far producing the strongest beats since 2021 (more on that later).
  4. The S&P 500’s 4% decline in April alleviated overbought conditions.
  5. Investors completed deleveraging in April.
  6. Bears became overconfident, which is an ever-present contrarian indicator.

Of these factors, we think the most relevant is the early signs of economic cooling, which undermines those who view inflation as reaccelerating.

Markets have been pricing in significant inflation acceleration, but with the recent employment news, that is significantly less the case. This has allowed the Fed to be less “on its heels” while arguing for a dovish interpretation of incoming data.

Thus, the macro picture is converging towards our base case. We continue to see softening inflation ahead, especially as shelter and auto insurance costs keep falling.

Key Earnings Takeaways

With light macro data releases recently, earnings have become the market’s focus. Last week alone, 59 companies in the S&P 500 reported.

Overall, earnings season has been quite strong:

Here are some highlights, per FactSet, with 80% of the S&P 500 reporting:

  1. 81% of firms beat consensus estimates.
  2. The overall beat margin is 7.5%, which is the highest rate since 2021.
  3. 46% of companies reported greater than 10% earnings per share growth – the best figure since early 2022.

Furthermore, S&P 500 earnings grew 7.1% on a quarterly basis thus far, and 10.2% when excluding energy companies:

Per the above table, only two other sectors show negative EPS growth (health care and materials). However, of the three negative sectors (energy, health care, and materials), health care and energy will flip to positive year-over-year earnings growth starting in the second quarter.

This helps establish a further expected acceleration of earnings growth in the second quarter of 11% overall. Stronger earnings momentum would provide an even more significant tailwind for stocks.

We’ve seen some key earnings takeaways so far.

First, earnings beats have been strong enough to raise expectations for the second quarter and the entire year:

This is the first time since 2021 quarterly earnings estimates have revised higher in the quarter’s first month. The last time was in 2021.

Next, earnings momentum and sector reversals are driving acceleration of year-over-year earnings growth through the rest of 2024:

As noted above, three sectors are reversing to positive (or nearly positive) momentum on a quarterly basis (energy, health care, and materials).

Third, this EPS growth improvement is historically consistent with early cycle earnings growth, which follows an upturn in purchasing managers index (PMI) readings (measures of manufacturing activity):

PMI readings typically lead earnings growth momentum by four months.

Another takeaway is that despite strong EPS beats, stock reactions have been muted relative to the last three quarters. One-day gains after beats are averaging 0.5% versus 1% for the prior three quarters. Inline results are flat, which is consistent with history. Meanwhile, EPS misses are producing average one-day losses of 3.5% versus 2% in prior quarters.

The market isn’t acting overbought anymore.

Next, some may suggest underwhelming stock reactions are a result of good news being bad. We don’t think that’s true, especially with the most important sectors, because the worst reactions to EPS have been in technology and consumer staples:

It’s even true in the leading mega-cap stocks:

To us, this selectivity represents macro data uncertainty. However, it should be alleviated as progress on inflation continues and there’s less skepticism of the doveish Fed.

Lastly, with the economy no longer seeming “red hot” due to cooler employment reports, the market is assigning more credibility to the Fed’s dovish view. This is evidenced by the continued decline in interest rates, crude oil prices, and market volatility:

Overall, we don’t think the immediate market reaction to positive earnings is a sign of a late cycle or risks being off the table. Rather, we view this as a sign of macro caution by investors awaiting further confirmation on inflation.

Turning to one more inflation point, the Manheim Used Vehicle Value Index for April showed a monthly decline of 2.5% (-30% annualized). This proves further downside acceleration of used car prices, which points to further declines in the ever-troublesome consumer price index autos subset and more support for potential disinflation being in the pipeline further supported by a subsequent cooling the lagging auto insurance inflation.

Markets Focus on Data

As our readers might recall, the trusty Big Money Index (BMI) from our friends at MAPsignals had a precipitous 40% drop throughout April. The BMI is a 25-day moving average of netted buys and sells by “big money” professional investors.

As a refresher, MAPsignals provided research showing the historical, forward-looking context of what we might expect when these rare 40% drops occur so quickly:

After experiencing key consolidation and the BMI drop, while perhaps slightly premature, early indications are that selling has slowed significantly while buying is beginning to resume. This corresponds with the strong earnings season.

Notice the quick drying up of selling in stocks (far right in chart):

Even more so with exchange-traded funds:

For the moment, the BMI stabilized and perhaps found a floor:

Notice there’s even been a slight uptick in the index recently. It may signal the worst of near-term volatility is behind us. That said, more data is due in the coming weeks, and like us, markets focus on data rather than narrative-driven drivel.

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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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