Equity market outlook - January 2023

2023年1月1日

Purpose
This analysis is meant to provide a long-term outlook for equity markets.
I also use this to support my data-driven, long-term investment decisions. Sharing this with the public helps me avoid one of the most common mistakes investors make in the market - missing the forest for the trees.

Table of contents

• Central banks policy
  
• Economic growth outlook
  
• Earnings growth outlook
  
• Liquidity in the financial system
  
• Summary
  

Central banks policy

Central banks around the world are still tightening monetary policy which is a headwind for economic growth - see the section below.


Tight monetary policy means there will be potentially more pressure on 10Y real yields - if inflation will be persistent.
There has been a strong correlation between 10Y RE and S&P 500 Forward P/E since 2018. Tight monetary policy + persistent inflation = lower Forward P/E = higher pressure on S&P 500.
What has already been embedded into the price? Eurodollar futures term structure can help answer this question. The market expects rate cuts in September 2023. This would support a higher P/E, but it would also mean that something has been broken on the market. The shape of the curve suggests that the market expects rather hard landing than soft landing.


No one knows for sure what FED will do in the future, but if they follow the path outlined by the eurodollar futures market then we are near the bottom of forward P/E. In that context, the cheapest stocks are in the S&P 600 index = small cap index. Forward P/E is 12.5. Their lowest value was during the GFC - just below 10. The most expensive is S&P 500, with a forward P/E of 16.7.


Economic growth

Central banks' policy leads economic growth / contraction that can be measured by CLI Diffusion Index:

The index suggests we should not expect positive stock indices YoY growth yet. What's more important, it says a high volatility period might be around the corner.


However, the National Financial Condition Index has already been elevated, so lots of depression fears have already been discounted.



Earnings growth outlook

I use the Nominal Broad U.S. Dollar Index, BBB US Corporate Yield, WTI price, and ISM New Orders less ISM Customer Inventories to measure the impact of current conditions on future corporate earnings.
As a result, I get an indicator that tends to lead stock indices YoY changes, especially Russell 2000 - because it is the index that is the most sensitive to real economy changes.
We should not expect earnings to grow in that kind of environment.




Liquidity in the financial system

I use three indicators to measure liquidity. I normalized the readings to z-scores - just to look at them from the same perspective.
1. FED Balance sheet less Reverse Repo (Overnight Reverse Repurchase Agreements) less TGA (U.S. Treasury General Account): there is still plenty of money flowing in the financial markets despite ongoing QT


2. Top of the ES futures order book (the number of contracts in buy orders and sell orders): despite the end of the year period, the liquidity (on average) is just fine. No need to worry about air pockets right now.


3. Finra margin debt - the deleveraging is ongoing. 292B has been removed from investors' margin accounts so far, but there is still plenty of money borrowed from brokers - we're at levels last seen in 2018.



Summary
Forward P/E trough might be just around the corner, but central banks policy still does not support growth. It can be seen on the CLI Diffusion Index.
On the other hand, tight financial conditions should soon impact corporate earnings.
In that kind of environment - where EPS should not be rising and P/E not falling - selling the rip and buying the dip strategy might benefit more than just buy&hold.
I'll wait with my long-term investments.