The Next Shoe To Drop?

earnings

Market momentum is Red. Today, the S&P 500 continued its effort to break resistance above the 3,920 level. It has pulled back after multiple efforts to move higher. The next catalyst that will drive momentum “Green” or push the markets lower again (thus proving another dead cat bounce) will be the PCE inflation data on Thursday. This is a quiet week with low volumes. Don’t trade just to trade. 

This is historically a quiet week for the markets. Despite Nike’s (NKE) earnings report this afternoon, most traders and investors are looking forward to the earnings calendar in mid-July. 

This week’s only significant data point is the PCE Inflation reading that is central to the Fed’s policy plans. If the reading exceeds expectations on Thursday, we are facing yet another leg down for the markets. If it’s lower than estimates, we might see a push for the S&P 500 above its next support level at 4,026. 

I stand among the rest of the traders looking out a few weeks to the starting point of the earnings season. Over the weekend, I saw an essential chart that warrants your attention. It speaks to how critical the upcoming earnings season will be for your money well into 2023. 

Have a Look into Earnings

I spend every weekend writing about the markets and digging into research from investment firms. This weekend, I stumbled upon a great report by Edward Jones about the state of this market. I’ve mentioned “Valuation Compression” in the pages of the Haven Investment Letter a few times. I’m talking about the phenomenon where stock prices decline because investors are not willing to pay higher price-to-earnings levels or price-to-revenue levels than the previous owner. 

When a stock trades at 20 times earnings, the investor must justify the ability to wait 20 years to recoup all their money through profit payments back to shareholders. If profits aren’t increasing, the only way the stock can go higher is if someone is willing to pay a higher premium, perhaps 21x earnings, 22x earnings, or even higher. But at some point, investors and traders recognize that these valuations may be irrational. Someone is no longer willing to pay 20x earnings… 

Other investors think… Why should I pay 19x times earnings? The stock drops to fall in line with more muted expectations. This is valuation compression. The chart below shows that earnings expectations have increased, but the stocks are falling because of declining valuations. Edward Jones suggests that nearly all of the losers in 2022 are tied to this phenomenon.

And that makes sense. Since the Federal Reserve announced plans to raise interest rates in October 2022, the markets have reacted with a steady pattern of compression on price-to-earnings multiples. Yet – forward earnings are moving higher. 

So, What’s The Real Issue Now? 

For the last few months, the Federal Reserve and its monetary policy have been the driving factor behind the performance of the market. I regularly argue that in terms of driving markets up or down, the largest factors go in this order:

1. The Federal Reserve

89 MILES OF DIRT

2. Earnings Report

3. Insider Buying/Selling and Activist Investors

Well, the second factor is about to come into play… 

With the heavy focus today on the state of the U.S. economy, most investors are fretting about the possibility of a recession. But, how much of a recessionary threat is priced into the market? Not all of it – companies will need to set their forward guidance for investors during this upcoming earnings season.

In addition to the focus on top-line and bottom-line performance during the second quarter – when the economy was slowing, and consumer and business spending remained unpredictable – a stock repricing may come if companies start to slash their guidance. As a result, the earnings season could be far more volatile than in April. 

Remember, it’s very dangerous and challenging to speculate with options around earnings season. Instead, you’re better off looking for companies that have improved their balance sheet, boosted dividends, and deployed capital in a responsible manner. 

We are still returning to a market driven by fundamentals, not HYPE. My focus this week – in preparation – is to trade around the upcoming inflation report and look for specific targets for stocks that I want to own in the months ahead. We’ll talk about the sectors that look positive heading into earnings season this week.

Garrett Baldwin
Garrett Baldwin
Garrett Baldwin joined Godesburg Financial Publishing as Chief U.S. Markets Analyst in early 2021. A Johns Hopkins-trained Economist, he’s worked with hedge funds, venture capital firms, angel investors, and economic advisors to the U.S. government. Baldwin specializes in market anomalies and alternative investments. He’s written extensively on momentum, value, insider buying, and other unique strategies that provide investors that elusive edge.
Garrett Baldwin
Garrett Baldwin
Garrett Baldwin joined Godesburg Financial Publishing as Chief U.S. Markets Analyst in early 2021. A Johns Hopkins-trained Economist, he’s worked with hedge funds, venture capital firms, angel investors, and economic advisors to the U.S. government. Baldwin specializes in market anomalies and alternative investments. He’s written extensively on momentum, value, insider buying, and other unique strategies that provide investors that elusive edge.

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