- Learn how anyone can do a decent top-down analysis of the S&P 500. No subscriptions needed, only persistence and critical thinking. And maybe a sense of humor.
- Parse through noisy geopolitical news and economic data, and emerge with unbiased (best effort basis) inferences.
- Sum up the inferences and glean actionable data!
This “quick and dirty” analysis is meant to provide a high level view of the macro condition underpinning the S&P 500, and is merely the first part of a complete investment thesis. However, for the purpose of gleaning a cogent conclusion (or as I like to call it, actionable data) out of the miasma of financial news and geopolitical drama, this piece should do the trick. It is important to note that pieces like this are easy to produce and thus can be done as a weekly recap by a single person within 3 hours.
Let’s dive in!
- P/E ratios of the S&P 500.
- Reversion to the mean
- Seasonal factors governing the S&P 500 price action fluctuations.
- Q4 2020 earnings estimates by sector
- Q1 2021 earnings estimates by sector
- Main Street vs Wall Street
- Economic data
- Risk-On vs Risk Off!
- Wk 51 catalysts recap
- Nascent catalysts
The P/E ratios of the S&P 500
The weighted P/E ratio, calculated by multiplying the P/E ratios of each equity in the S&P 500 with its weight being the fraction of its market cap against the total market cap of the S&P 500 index, is our first measure of market valuation. The data can be easily obtained from any brokerage’s trading platform, but I personally use Think Or Swim from TD Ameritrade. The weighted P/E ratio for the S&P 500 as at 20 Dec 2020 is 31.71, after eliminating outliers (any P/E ratios less than -1000).
Next, we obtain CAPE ratio (Shiller P/E) from Shiller PE Ratio --> 33.77, high above its mean of 16.77 and median of 15.81. The CAPE ratio is the acronym for cyclically adjusted P/E ratio, and is supposed to account for seasonal fluctuations in the P/E calculation. For reference, the S&P 500 during the Dot Com bubble has a CAPE ratio of 45; and 27 during the 2008 financial crisis.
We might not want to miss out on the Tobin’s Q ratio, also known as the Mises Stationarity Index – popularized by Mark Spitznagel in his book “The Dao Of Capital”. With a reading of 2.33 at the time of writing, it is far above its mean and median of 1.00.
Source: MS Index.
Reversion to the mean
Securities prices has a tendency to revert to the average price after a period of deviation from the mean, and the purpose of this section is to further examine the state of the S&P 500’s price deviation. As at Friday, 18 Dec 2020 EOD, 82% of S&P 500 stocks were above their 50-day EMA in Wk 51, even higher than the 76% barely a week ago in Wk 50; while 86% and 90% of them were above their 100-day and 200-day EMA by the end of Wk 51, compared to 81% and 91% in Wk 50. All three EMA oscillators are very close to their highest resistance levels according to data going back as far as 2016.
Screenshot from Think Or Swim platform provided by TD Ameritrade:
Seasonal factors governing the S&P 500 price action fluctuations.
Statistically speaking, in the past 5 years on average, December marked bearish returns for the S&P 500, while being marginally bullish for the 10-year and 15-year average, despite the probability of bullishness being between 60% to 70%. This means that the years with bearish Decembers experienced larger than average drawdowns.
Seasonally speaking, December is the month where institutions performed tax-loss harvesting, where investors realize losing positions to gain tax deductions, which can be used to offset capital gains taxes on their winning positions. Taken together, this means the likelihood of a large drawdown will be high indeed if the institutions deemed the market to be overvalued, or uncertainties lie ahead.
(Source: historical S&P 500 closing prices from Yahoo Finance, charts generated using MS Excel)
Q4 2020 earnings estimates by sector (sourced from FactSet)
During the month of October 2020, analysts increased earnings estimates for companies in the S&P 500 for the fourth quarter. The Q4 bottom-up EPS estimate (which is an aggregation of the median EPS estimates for Q4 for all the companies in the index) increased by 1.8% (to $36.72 from $36.08) during this period. However, it should be noted that analysts made substantial cuts to EPS estimates for Q4 during the second quarter (March 31 to June 30).
At the sector level, only three sectors recorded an increase in their bottom-up EPS estimate for Q4 during the first month of the quarter (September 2020):
- Financials (XLF: +14.0%)
- Communication Services (XLC: +7.6%)
- Materials (XLB: +6.3%).
Seven sectors recorded a decline in their bottom-up estimate for Q4 during the first month of the quarter, led by the Energy (-84.4%) sector. However, the other six sectors witnessed declines of 4% or less. One sector saw no change during this time. These EPS estimates are fluid and will change from time-to-time as we go through the current Q4 earnings season for 2020.
Q1 2021 earnings estimates by sector (sourced from FactSet)
According to this chart and data from Factset (S&P 500 CY 2021 Earnings Preview: Largest YoY Earnings Growth Since 2010), the Energy sector is expected to record a $24.0 billion in CY 2021 compared to an expected loss of $3.7 billion in CY 2020, which means the expected earnings growth rate cannot be calculated as the base earnings number is negative. However, the energy sector is ecpected to report the highest YoY revenue growth of all 11 sectors due to rising oil prices. The sectors expected to have highest earnings growth next quarter are the Industrials and Consumer Discretionary sectors, led by Aerospace & Defense, Industrial Conglomerates, Automobiles, and Auto Components industries.
The rest of the sectors had been faring better during the pandemic, and thus is expected to experience a lower earnings growth margin. However, these figures are likely to be revised upward if the economic recovery does not experience serious setbacks, as several industries within the Industrial sector like Airlines, as well as the Hotels, Restaurants, & Leisure industry in the Consumer Discretionary sector cannot provide growth estimates as of the time of writing due to projected losses in CY 2020.
Before we jump the gun and focus on any individual stocks to buy or short based on these earnings forecasts, it is far better to take a deep breath and look for convergence with the most powerful and active catalysts driving stock market prices right now - the economic reopening that is being supported by the potential fiscal stimulus (however lean) and the vaccine rollout - otherwise known as the value rotation trade. We notice here that Energy, Industrials, and Materials the 3 big covid-loser sectors, are expected to recover based on FactSet's higher estimated earnings growth for them. Consumer Discretionary having high estimated earnings growth is definitely a plus in any economic situation because it is as close to a risk-off indicator as a sector can go.
Main Street vs Wall Street:
The Nasdaq 100 index is STILL the clear leader in the equities coronavirus recovery rally despite suffering the biggest pullback among the 5 observed indices. It was followed by the smaller-cap Russell 2000 (which analysts use as a proxy for Main Street firms), with an impressive 7 straight weeks of gains. The mid-cap Russell 3000 and the S&P 500 was next, with the large cap Dow Jones bringing up the rear of the pack.
Just by looking at this section of the analysis and disregarding other data, we might be inclined to think that the bull run should continue, with the real economy seemingly performing well. Until we realized that the Russell 2000 is still an equity index, run by market sentiment. To know the economy, we should look at the economic data, which is detailed in the next section.
Economic data: sourced from - United States - Economic Indicators (tradingeconomics.com)
|PRICES||Inflation Rate YoY||Expectations:+1.10%||1.20%|
|Core Inflation Rate YoY||
|PCE Index YoY||Expectations: NA|
|Core PCE Index YoY||Expectations: NA|
|Inflation Expectations YoY||Expectations: NA||2.96%|
|PPI YoY (Producer Price Changes)||Expectations: 0.80%||0.80%|
|Core PPI YoY||Expectations: 1.50%||1.40%|
|LABOR||Nonfarm Payrolls||Expectations: 469,000||245,000|
|ADP Employment Change||Expectations: 410,000||307,000|
|Unemployment Rate||Expectations: 6.80%||6.70%|
|Labor Force Participation Rate||Expectations: NA||61.50%|
|CONSUMER||Consumer Confidence Index (UoM)||Expectations: 76.50||81.40||76.90|
|Retail Sales YoY||Expectations: 5.90%||4.10%|
|Retail Sales Ex-Autos MoM||Expectations: +0.10%||-0.90%|
|HOUSING||Building Permits||Expectations: 1550 K||1639 k|
|Housing Starts||Expectations: 1530 K||1547 k|
|New Home Sales||Expectations: 970 K|
|Existing Home Sales||Expectations: 6450 K|
|BUSINESS (MANUFACTURING & PRODUCTION)||ISM Manufacturing PMI (Bus. Conf.)||Expectations: 58||57.5|
|IHS Markit US Manufacturing PMI||Expectations: 56.7||56.7|
|ISM Non-Manufacturing PMI||Expectations: 56||55.9|
|IHS Markit US Services PMI||Expectations: 57.7||58.4|
|IHS Markit US Composite PMI||Expectations: 57.9||58.6|
|Industrial Production YoY||Expectations: NA||-5.50%|
|Manufacturing Production YoY||Expectations: NA||-3.70%|
|Capacity Utilization||Expectations: 72.90%||73.31%|
Looking at labor, consumer, and business productivity data, we discern the overall sentiment on productivity:
For the month of November 2020, labor data was weaker than expected, with the reduction in unemployment rate more than offset by the greater absolute reduction in the labor force participation rate. Consumer data missed expectations and were overall negative, convergent with the negative picture painted by business productivity numbers. The ISM data shows weaker than expected productivity while IHS Markit is slightly more optimistic. Building permits and housing starts were higher than expectations in Nov 2020, pointing to better times ahead because the house building sector involves many professions across the economy and is one of the main sources of economic productivity.
Looking at price index and housing data, we discern the overall picture on the state of purchasing power:
The Nov data shows that besides the core PPI data, inflation is relatively healthy when compared to estimates. In fact, inflation measures hadn't changed much since Jul 2020. The new home sales and existing home sales data, which are not yet available at the time of writing (20 Dec 2020), will shed some light on the housing price inflation.
Risk-On vs Risk-Off:
Treasury yield curve shape normalized, no inversion, with the yields across maturities getting steeper as we head into the end of CY 2020. (Source: data from tradingview.com, chart generated with MS Excel).
Gold (TOS: /GC) futures made a decisive move upward in Wk 51 as much as +2.35% on slightly higher volumes that the week before. However, gold futures trading volume had been on a precipitous decline over the past 5 weeks, with the exception of Wk 51. Silver (TOS: /SIL) futures outperformed its counterpart by moving up by almost +8% with significantly higher volume week-on-week. Both metals showed healthy EMA distribution, with price levels bouncing off the EMA 20.
Copper (TOS: /HG), the most commonly utilized industrial metal saw a seventh straight week of price hikes starting from beginning of Nov 2020 until Wk 51. Light Sweet Crude Oil (TOS: /CL) futures showed similar price action in the same time period. However, zinc had been consolidating since hitting its 52-week high of $222.95. Both metals are trading at prices far above their EMA 20. The metals' rally coincided with the equities' recent November rally.
The Dow Jones FXCM Dollar Index (TOS: $USDOLLAR) is on a downtrend since end March and beginning Apr 2020, which coincided with the equities rebound after the coronavirus trough. The DJ FXCM USD Index plunged below its 200-week EMA in Wk 30 for the first time since January 2018 - which means that investors prefer foreign currency denominated assets RELATIVE to the US Dollar denominated ones. It had gone on to make new lows at 11,710.45 by Wk 51.
- EURUSD --> increased in Wk 51 by 1.18%.
- JPYUSD ----> decreased in Wk 51 by -0.01%.
- AUDUSD --> increased in Wk 51 by 1.19%.
- GBPUSD --> increased in Wk 51 by 2.30%.
INFERENCE: The DJ FXCM USD Index's -0.93% week-on-week drop in Wk 51 is due to the strength in EUR, AUD, and GBP.
The VIX is still above the 20 level, with the moving averages still showing an elevated volatility in the options market.
Wk 51 catalysts recap (source: CNBC and MarketWatch)
Monday: Bearish with no significant market moving news, with the possible exception of Biden being confirmed as POTUS by Electoral College. There was also a bipartisan effort by Senate and House lawmakers to push for a compromised $908 billion, two-part fiscal stimulus package, but the market did not seem to respond.
Tuesday: Bullish, with convergent market internals. According to David Wagner, portfolio manager at Aptus Capital Advisors, this is a "slow bleed up" caused by market expectations of the possibility of the slimmed down fiscal aid package proposed on Monday. The item got more attention today because Nancy Pelosi invited congressional leaders to hash it out alongside a separate $1.4 trillion government funding bill in order to avoid a government shutdown by the weekend. The Fed also started their two-day FOMC starting today.
Wednesday: Despite Powell promising once again to use the Fed’s full range of tools until the labor market and the economy recover from the pandemic, the market seems to have priced in the majority of the upside into Tuesday, causing much weaker bullish sentiment on Wednesday. Weak retail sales and business productivity metrics may have also played a part in dampening the bullish sentiment.
Thursday: Gap up and then flat but slightly bullish price action, with convergent bullish internals. News that lawmakers are nearing an agreement regarding the fiscal aid package - valued at $900 billion - overwhelmed higher than expected unemployment data due to the resurgence of the COVID-19 pandemic. This is a high likelihood that the weak jobs data is seen by investors as ammunition to pass the fiscal aid stimulus.
Friday: Bearish day with market internals showing bearish convergence. Being a quadruple witching day, the options activity very likely contributed to the heightened volatility as shown by the VIX. The down day was also timely, according to talking heads, signifying profit taking on the heels of three straight bullish days.
Nascent catalysts (source: CNBC and MarketWatch)
According to seasonal analysis, tax loss harvesting season begins this month - institutions are motivated to sell their losers to realize tax deductions, which can be used to offset some of their capital gains taxes on some the winning positions that they may liquidate. The selling will be particularly severe if institutions have a reason to believe that massive uncertainty lies ahead. With items like the fiscal stimulus indecision and the potential for a Blue Wave in US politics, downside risk is significant for the remainder of December until January 2021.
On 05 January 2021, the Georgia Senate seats will be key to determine if there will be a blue wave or not, which will then impact tax policy. Effects are expected to be short term. With Joe Biden as the projected winner of the presidential race, Democrats needed a net gain of three seats to win control of the Senate. As at 13 Dec 2020, Democrats have netted one seat gain, with the Republicans netting 1 loss. Georgia will hold two runoffs on 5 January 2021 that will decide if Democrats gain two more seats for a 50-50 split and control of the Senate.
$900 billion fiscal stimulus bill on the verge of being passed. On Sunday, the fiscal aid is set to pass as Dems and Reps reconciled their differences. The stimulus is split into 2 packages:
- The first part provides for state and local aid+liability protection worth $160 billion
- The second part provides direct payment to individuals and businesses worth $748 billion:
- Weekly $300 additional state unemployment benefit for 4 months
- $300 billion aid to small businesses
- $35 billion aid to health care providers
Covid-19 vaccine developments - Emergency Use Authorization (EUA). As both the Pfizer-BioNtech and Moderna vaccines get the FDA authorization to be distributed in the US for emergency use, we should expect logistics hiccups like supply shortages and the like. There is a very low (but not negligible) chance of a major and permanent logistical SNAFU like the FDA revoking the EUA for either vaccine supplier.
Belligerent Chinese response to the US Commerce Department's Entity List expansion. It remains to be seen what the Biden administration - to be led by Katherine Tai as the incoming USTR - will do in its trade policy with China and traditional US allies. So far, they hadn't outlined their trade policies, but they seem to be following the previous administration's policy trajectory. The recent blacklisting of SMIC and SZ DJI Technology Co. by the outgoing Trump administration might raise the sceptre of a renewed trade war with an emboldened China. Though the Biden administration seemed to be maintaining Trump's policies and tariffs. The change in US government might prompt the Chinese to delay any in-kind response to the Wk 51 Entity List expansion.
Conclusion - Summing up observations:
With the safe haven / speculative metals - Gold and Silver - consolidating, and the industrial commodities - Copper, Zinc, and Light Sweet Crude Oil - getting a 5th straight week of price hike, I am inclined to think that global markets are in a risk-on mode, provided the stimulus from central banks the world over keep on flowing. And I am betting that they will.
The Dow Jones FXCM US Dollar Index consolidated and languished below its 200 week EMA since end of July 2020, and had made new lows since, most recently threatening to break below the 11,800 level owing to the relative strength of the JPY, AUD, and GBP. It could be that the world markets are optimistic again, and funds are seeking higher returns outside the "safe haven" of the US markets.
On the numbers side, we have the P/E ratios, seasonal dynamics (tax loss harvesting), the VIX, and economic data (especially productivity data) indicating bearishness, or at the very least, volatility; on the other hand, data from safe haven and industrial commodities, currencies, and the Treasury yield curve point to a risk-on sentiment.
The Russell 2000 is finally going at full steam despite worsening consumer and business productivity data, but one can argue that the negative can be offset by the better than expected housing data, which implies that the vaccine-catalyzed rotation-to-value trade has legs in the long term, though it may flounder in the near term. However, we also see 82% of all S&P 500 companies going above their 50 day EMAS. More than 90% are above their 200-day EMAs. These are worrying numbers - the same level right before the covid-catalyzed crash. We also bear in mind the implications of our seasonal data - the probability of a drawdown in Decembers are only around 40% to 30%, but when they do happen, they tend to be large.
Thus for the remainder of Dec 2020, I am looking for bearish windows to build up bullish positions in stocks that lie within the Consumer Discretionary, Industrials, and/or the Energy sector, specifically renewable energy and EV holdings - something the Biden administration has a roadmap of generous stimulus for - while reducing Big Tech holdings.
Analyst's Disclosure: I am/we are long FB, AAPL, NVDA.
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