S&P 500 - What To Do Now?

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by: RadaEcoWatch

Summary

The S&P 500 upward trend started in March 2016 ended with a decline below 2754.

We do not expect the S&P 500 to enter into a bear market as economic activity remains solid.

A downward revision of analysts’ earnings growth expectations in 2019 is the main risk for the U.S. equity market.

We would re-enter the S&P 500 only after a return above 2754.

The decline of the S&P 500 below 2754 marked the end of the upward trend started in March 2016. As we highlighted in our article “Why We Are Still Bullish On The S&P 500 - And What Could Make Us Change Our Mind,” the decline below that level would have made us change our bullish stance on the main U.S. equity index. For this reason, we would not be invested in the US equity markets now.

A correction or the start of a long bear market?

We think that only a recession of the U.S. economy could push the S&P 500 into a bear market. However, economic data recently published signaled that U.S. economic activity remains solid. For example, Q3 GDP – published on Friday 26 – expanded by 3.5%, ahead of consensus estimates at 3.3%. Consumer spending, up 4%, was the main driver of economic activity.

Moreover, the most utilized leading indicators of a recession are not anticipating that it could come anytime soon. For example, the recession probabilities model of the NY Fed sees only a 14% chance of a recession over the next 12 months.

Recession probabilities at 14% Initial jobless claims, which started rising some months ahead of the start of the last four recessions, remain at a historical low level (215k in the week to October 2).Initial jobless claims close to historical low Finally, the Conference Board Leading economic index remains in an upward trend while a year-over-year contraction anticipated all the latest recessions.

In this scenario, the possibilities to see a long and prolonged bear markets look contained. A reversal of the previous leading indicators would make us change our mind.

What to expect the next week

During the next week, the release of the Conference Board consumer confidence index (Tuesday, October 31), of the ISM manufacturing index (Wednesday, November 1) and of the labor market (Friday, November 3) for October will give more indication on the outlook for the U.S. economy.

The Conference Board consumer confidence index is expected to decline from 138.4 – close to the highest in 18 years – to 134. The main reason for the decline of the index should be the recent correction of the equity markets. However, consumer confidence is likely to remain at a level in line with a positive trend of consumer spending at year-end.

The ISM manufacturing is likely to continue the correction started in September, when the index fell from 61.3 to 59.8. In October, the index is likely to edge down to 59, a level that would be in line with a GDP growth slightly below 5%.

ISM manufacturing index and GDP growth Finally, the labor market report is likely to confirm that the positive trend is continuing. Non-farm payrolls should rise by 200k and the unemployment rate should remain unchanged at 3.7%. We expect average hourly earnings to rise by 0.3% m/m and by 2.8% y/y, in line with September data and with a moderate growth rate of consumer spending at year-end.

Earnings season still on the spotlight

The focus is likely to remain on the earnings season. Over the next week, 62 companies in the S&P 500 report their quarterly results. Results published so far have been reporting results better than expected, with a 19.5% average yearly increase of EPS. However, the main concern is that earnings growth rate in 2019 could decelerate more than currently projected by analysts: 10.3%. The weakening of main international economies – China GDP growth slowed more than expected in Q3 from 6.7% y/y to 6.5% y/y and eurozone leading indicators continue to deteriorate – and the strengthening of the U.S. Dollar will weigh on earnings growth in 2019.

The flattening of the yield curve is a negative indication for earnings growth over the next 3 years. The 10-2 year government bond yield spread was at 28bp on Friday.

As indicated by the following chart, it anticipates a weak compounded average growth rate of earnings over the next 3 years.

earnings growth and yield curve

In this scenario, we see a downward revision of 2019 earnings growth as the main risk for the S&P 500.

Conclusion

The fall of the S&P 500 below 2754 marked the end of the latest upward trend started in March 2016. While the decline started at the beginning of October could be a correction and we do not expect the beginning of a prolonged bear market as economic activity remains solid, we would re-enter the S&P 500 only after a return above 2754. A strong downward revision of 2019 earnings growth projections is the main risk facing the markets.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.