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Investors are still cautious and have significant cash that needs to be put to work. Trickle-down of it into the US equity market may extend the rally. Overly bearish futures positioning is also a strong contrarian indicator. Disinflation is good for real earnings growth, and imminent earnings rebound may add support for equities.

Indian EPS growth is set for major disappointments vis-à-vis the lofty expectations. Weak domestic demand amid tight fiscal and monetary policy entails more downside in stock prices. Stay underweight.

The YTD market rally was driven by outperformance of high-quality growth stocks which offer protection in uncertain times. As growth continues to slow, high-quality growth stocks should continue to do well. Hence, we are moving to overweight Growth vs. Value.

We Introduce our new macro models for the Eurozone’s equity earnings, which include sectoral forecasts. Find out what they predict for the next six-to-nine months.

The equity market is back to the 2019 level on an inflation-adjusted basis. However, it is still not cheap as it is not pricing in the possibility of a prolonged and deep earnings recession or a higher interest rates regime. Many areas of the market that appear cheap, are cheap for a reason. The only industries that are cheap because they are growing into their valuations are Energy and Airlines. We are upgrading Airlines to equal weight.

The US equity market is in the midst of an earnings contraction driven by slowing sales growth – a manifestation of the weakening economic demand and loss of corporate pricing power that accompany disinflation. The telecommunications industry is a defensive industry that faces many challenges: Low growth, cut-throat competition, and incessant demands for capital investment.

Executive Summary If a loss of wealth persists for a year or more, it hurts the economy. The recent $40 trillion slump in global financial wealth is larger than that suffered in the pandemic of 2020, the global financial crisis of 2008, and the dot com bust of 2000-01. Partly countering this slump in global financial wealth is a $20 trillion uplift in global real estate wealth. However, Chinese home prices are already stagnating. And the recent disappearance of US and European homebuyers combined with a flood of home-sellers warns that US and European home prices will cool over the next 6 months. With the loss of wealth likely to persist, it will amplify a global growth slowdown already in train, aided and abetted by central banks that are willing to enter recession to slay inflation. The optimal asset allocation over the next 6-12 months is: overweight bonds, neutral stocks, and underweight commodities. A variation on this theme is: overweight conventional bonds and stocks versus inflation-protected bonds and commodities. Fractal trading watchlist: US telecoms versus utilities, and copper. We Have Just Suffered The Worst Loss Of Financial Wealth In A Generation The World Is $20 Trillion Poorer. Why That Matters The World Is $20 Trillion Poorer. Why That Matters Bottom Line: On a 6-12 month horizon, overweight bonds, neutral stocks, and underweight commodities. Feature Since the end of last year, the world has lost $40 trillion of financial wealth, evenly split between the crashes in stocks and bonds (Chart I-1). The slump in financial wealth, both in absolute and proportionate terms, is the worst suffered in a generation, larger than that in the pandemic of 2020, the global financial crisis of 2008, and the dot com bust of 2000-01.1 Chart I-1Global Stocks And Global Bonds Have Both Slumped By $20 Trillion Global Stocks And Global Bonds Have Both Slumped By $20 Trillion Global Stocks And Global Bonds Have Both Slumped By $20 Trillion Partly countering this $40 trillion slump in global financial wealth is a $20 trillion uplift in global real estate wealth. But in total, the world is still $20 trillion ‘asset poorer’ than at the end of last year. Given that global GDP is around $100 trillion, we can say that we are asset poorer, on average, by about one fifth of our annual income. Does this loss of wealth matter? A Loss Of Wealth Matters If It Persists For A Year Or More Some argue that we shouldn’t worry about the recent slump in our wealth, because we are still wealthier than we were, say, at the start of the pandemic (Chart I-2). Yet this is a facile argument. Whatever loss of wealth we suffer, there is always some point in the past against which we are richer! Chart I-2We Have Just Suffered The Worst Loss Of Financial Wealth In A Generation We Have Just Suffered The Worst Loss Of Financial Wealth In A Generation We Have Just Suffered The Worst Loss Of Financial Wealth In A Generation Another argument is that people do not care about a short-lived dip in their wealth. This argument has more truth to it. For example, in the extreme event of a flash crash, an asset price can drop to zero and then bounce back in the blink of an eyelid. In this case, most people would be oblivious, or unconcerned, by this momentary collapse in their wealth. But people do care if the slump in their wealth becomes more prolonged. How long is prolonged? The answer is, if the slump persists for a year or more. Why a year? Because that is the timeframe over which governments, firms, and households make their income and spending plans. Governments and firms do this formally in their annual budgets that set tax rates, wages, bonuses, and investment spending. Households do it informally, because their wages, bonuses, and taxes – and therefore disposable incomes – also adjust on an annual basis. Into this yearly spending plan will also come any change in wealth experienced over the previous year. For example, firms often do this formally by converting an asset write-down to a deduction from profits, which will then impact the firm’s future spending. This illustrates that what impacts your spending is not the level of your wealth, but the yearly change in your wealth. Spending Is Impacted By The Change In Wealth The intellectual battle here is between Economics and Psychology. The economics textbooks insist that it is the level of your wealth that impacts your spending, whereas the psychology and behavioural finance textbooks insist that it is the change in your wealth that impacts your spending. (Chart I-3and Chart I-4). In my view, the psychologists and behavioural finance guys have nailed this better than the economists, through a theory known as Mental Accounting Bias. Chart I-3The Change And Impulse Of Stock Market Wealth Are Both Negative The Change And Impulse Of Stock Market Wealth Are Both Negative The Change And Impulse Of Stock Market Wealth Are Both Negative Chart I-4The Change And Impulse Of Bond Market Wealth Are Both Negative The Change And Impulse Of Bond Market Wealth Are Both Negative The Change And Impulse Of Bond Market Wealth Are Both Negative Nobel Laureate psychologist Daniel Kahneman points out that we categorise our money into different accounts, which are sometimes physical, sometimes only mental – and that there is a clear hierarchy in our willingness to spend these ‘mental accounts’. Put simply, we are willing to spend our income mental account, but we are much less willing to spend our wealth mental account. Still, wealth can generate income through interest payments and dividends, which we are willing to spend. Clearly, the level of income generated will correlate with the amount of wealth – $10 million of wealth will likely generate much more income than $1 million of wealth. So, economists get the impression that it is the level of wealth that impacts spending, but the truth is that it is the income generated by the wealth that impacts spending.    We are willing to spend our income ‘mental account’, but we are much less willing to spend our wealth ‘mental account’. What about someone like Amazon founder Jeff Bezos who has immense wealth but seemingly negligible income – Mr. Bezos receives only a token salary, and his huge holding of Amazon shares pays no dividend – how then can we explain his largesse? The answer is that Mr. Bezos’ immense wealth generates tens of billions in trading income. So again, it is his income that is driving his spending. Wealth also generates an ‘income substitute’ via capital gains. For example, you should be indifferent between a $100 bond giving you $2 of income, or a $98 zero-coupon bond maturing in one year at $100, giving you $2 of capital gain. In this case the capital gain is simply an income substitute and fully transferred into the spending mental account. Nowhere is this truer than in China, where the straight-line appreciation in house prices through several decades has allowed homeowners to regard a reliable capital gain as an income substitute (Chart I-5). Which justifies rental yields on Chinese housing that are the lowest in the world and lower even than the yield on risk-free cash. In other words, which justifies a stratospheric valuation for Chinese real estate. Image Usually though, we tend to transfer only a proportion of our capital gains or losses into our spending mental account. As described previously, a firm will do this formally by transferring an asset write-down into the income statement. And households will do it informally by transferring some proportion of their yearly change in wealth into their spending mental account. The important conclusion is that spending is impacted by the yearly change in wealth. Meaning that spending growth is impacted by the yearly change in the yearly change in wealth, known as the wealth (1-year) impulse, where a negative impulse implies negative growth. Cracks Appearing In The Housing Market Given the recent slump in financial wealth, the global financial wealth impulse is in deeply negative territory. Yet by far the largest part of our wealth comprises housing, meaning the value of our homes2 (Chart I-6). In China, the recent stagnation of house prices means that the housing wealth impulse has turned negative. Elsewhere in the world though, the recent boom in house prices means that the housing wealth impulse is still positive, meaning a tailwind – albeit a rapidly fading tailwind – to spending (Chart I-7 and Chart I-8). Chart I-6Housing Comprises By Far The Largest Part Of Our Wealth Housing Comprises By Far The Largest Part Of Our Wealth Housing Comprises By Far The Largest Part Of Our Wealth Chart I-7Chinese House Prices Have Stagnated, US House Prices Have Surged The World Is $20 Trillion Poorer. Why That Matters The World Is $20 Trillion Poorer. Why That Matters Chart I-8The Chinese Housing Wealth Impulse Is Negative, The US Housing Wealth Impulse Is Fading The Chinese Housing Wealth Impulse Is Negative, The US Housing Wealth Impulse Is Fading The Chinese Housing Wealth Impulse Is Negative, The US Housing Wealth Impulse Is Fading In China, the recent stagnation of house prices means that the housing wealth impulse has turned negative. Still, as we explained in The Global Housing Boom Is Over, As Buying Becomes More Expensive Than Renting, the disappearance of homebuyers combined with a flood of home-sellers is a tried and tested indicator that US and European home prices will cool over the next 6 months. US new home prices have already suffered a significant decline in June (Chart I-9). Some of this is because US homebuilders are building smaller and less expensive homes. Nevertheless, it seems highly likely that the non-China housing wealth impulse will also turn negative later this year. Chart I-9US New Home Prices Fell Sharply In June US New Home Prices Fell Sharply In June US New Home Prices Fell Sharply In June To be clear, the wealth impulse is just one driver of spending growth. Nevertheless, it does have the potential to amplify the growth cycle in either direction. With global growth clearly slowing, and central banks willing to enter recession to slay inflation, the rapidly fading global wealth impulse will amplify the slowdown. Therefore, the optimal asset allocation over the next 6-12 months is: Overweight bonds. Neutral stocks. Underweight commodities. A variation on this theme is: Overweight conventional bonds and stocks versus inflation-protected bonds and commodities. Fractal Trading Watchlist After a 35 percent decline since March, copper has hit a resistance point on its short-term fractal structure, from which it could experience a countertrend move. Hence, we are adding copper to our watchlist. Of note also, the underperformance of US telecoms versus utilities has reached the point of fragility on its 260-day fractal structure that has signalled previous major turning points in 2012, 2014, and 2017 (Chart I-10). Hence, the recommended trade is long US telecoms versus utilities, setting a profit target and symmetrical stop-loss at 8 percent. Chart I-10US Telecoms Versus Utilities Are At A Potential Turnaround US Telecoms Versus Utilities Are At A Potential Turnaround US Telecoms Versus Utilities Are At A Potential Turnaround Fractal Trading Watchlist: New Additions Copper’s Selloff Has Hit Short-Term Resistance Copper's Selloff Has Hit Short-Term Resistance Copper's Selloff Has Hit Short-Term Resistance Dhaval Joshi Chief Strategist dhaval@bcaresearch.com   Footnotes 1     The value of global equities has dropped by $20tn to $80tn, the value of global bonds by $20tn to around $100tn, while the value of global real estate has increased by $20tn to an estimated $370tn. 2     Strictly speaking, housing wealth should be measured net of the mortgage debt that is owed on our homes. But as the wealth impulse is a change of a change, and mortgage debt changes very slowly, it does not matter whether we calculate the impulse from gross or net housing wealth. Chart 1CNY/USD At A Potential Turning Point CNY/USD At A Potential Turning Point CNY/USD At A Potential Turning Point Chart 2Copper's Selloff Has Hit Short-Term Resistance Copper's Selloff Has Hit Short-Term Resistance Copper's Selloff Has Hit Short-Term Resistance Chart 3US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities Chart 4CAD/SEK Is Reversing CAD/SEK Is Reversing CAD/SEK Is Reversing Chart 5Financials Versus Industrials Has Reversed Financials Versus Industrials Has Reversed Financials Versus Industrials Has Reversed Chart 6The Outperformance Of Resources Versus Biotech Has Ended The Outperformance Of Resources Versus Biotech Has Ended The Outperformance Of Resources Versus Biotech Has Ended Chart 7The Outperformance Of Resources Versus Healthcare Has Ended The Outperformance Of Resources Versus Healthcare Has Ended The Outperformance Of Resources Versus Healthcare Has Ended Chart 8FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal Chart 9Netherlands' Underperformance Vs. Switzerland Has Ended Netherlands' Underperformance Vs. Switzerland Has Ended Netherlands' Underperformance Vs. Switzerland Has Ended Chart 10The Sell-Off In The 30-Year T-Bond At Fractal Fragility The Sell-Off In The 30-Year T-Bond At Fractal Fragility The Sell-Off In The 30-Year T-Bond At Fractal Fragility Chart 11The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 12Food And Beverage Outperformance Is Exhausted Food And Beverage Outperformance Is Exhausted Food And Beverage Outperformance Is Exhausted Chart 13German Telecom Outperformance Has Started To Reverse German Telecom Outperformance Has Started To Reverse German Telecom Outperformance Has Started To Reverse Chart 14Japanese Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal Chart 15ETH Is Approaching A Possible Capitulation ETH Is Approaching A Possible Capitulation ETH Is Approaching A Possible Capitulation Chart 16The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended Chart 17The Strong Downtrend In The 3 Year T-Bond Has Ended The Strong Downtrend In The 3 Year T-Bond Has Ended The Strong Downtrend In The 3 Year T-Bond Has Ended Chart 18A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis Chart 19Biotech Is A Major Buy Biotech Is A Major Buy Biotech Is A Major Buy Chart 20Norway's Outperformance Has Ended Norway's Outperformance Has Ended Norway's Outperformance Has Ended Chart 21Cotton Versus Platinum Has Reversed Cotton Versus Platinum Has Reversed Cotton Versus Platinum Has Reversed Chart 22Switzerland's Outperformance Vs. Germany Is Exhausted Switzerland's Outperformance Vs. Germany Is Exhausted Switzerland's Outperformance Vs. Germany Is Exhausted Chart 23USD/EUR Is Vulnerable To Reversal USD/EUR Is Vulnerable To Reversal USD/EUR Is Vulnerable To Reversal Chart 24The Outperformance Of MSCI Hong Kong Versus China Has Ended The Outperformance Of MSCI Hong Kong Versus China Has Ended The Outperformance Of MSCI Hong Kong Versus China Has Ended Chart 25A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare Chart 26GBP/USD At A Potential Turning Point GBP/USD At A Potential Turning Point GBP/USD At A Potential Turning Point Chart 27US Utilities Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal Chart 28The Outperformance Of Oil Versus Banks Is Exhausted The Outperformance Of Oil Versus Banks Is Exhausted The Outperformance Of Oil Versus Banks Is Exhausted   Fractal Trading System Fractal Trades The World Is $20 Trillion Poorer. Why That Matters The World Is $20 Trillion Poorer. Why That Matters The World Is $20 Trillion Poorer. Why That Matters The World Is $20 Trillion Poorer. Why That Matters 6-12 Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area     Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed     Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations     Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations    

Executive Summary Analysts Have Little Confidence In Their Forecasts Analysts Have Little Confidence In Their Forecasts Analysts Have Little Confidence In Their Forecasts In the front section of the sector chart pack, we conduct cross-sectional comparisons. Profitability: Earnings expectations for the cyclical sectors are too high and will come down since analysts have little confidence in their forecasts. But despite their bullishness, analysts also expect margins of the most cyclical sectors to contract over the next 12 months. Balance sheet quality: Post-pandemic demand has resulted in a free cash flow windfall for companies in multiple sectors, which they used to repair their balance sheets. Tech, Materials, and Financials have improved the most. Valuations and technicals: Cyclical sectors appear inexpensive (both in absolute terms and relative to history) because multiples have contracted. Technicals signal that the market is oversold.  Much of the bad news is priced in, but “new” bad news is likely on the way: We are still in the early stages of the monetary tightening cycle, there is talk about earnings and economic recessions, rates have not stabilized yet, and inflation has not peaked. Bottom Line: We continue to recommend that investors remain patient and pad the more defensive and quality allocations in their portfolios at the expense of cyclical sectors that are geared to a slowdown. Companies with strong and resilient earnings and quality balance sheets will be able to better weather the storm, if it arrives.     This week we are sending you a Sector Chart Pack, which offers macro, fundamentals, valuations, technicals, and uses of cash charts for each sector. In the front section of this publication, we will focus on cross-sectional comparisons.  As investors are starting to shift their attention away from worries about intransigent inflation toward concerns about slowing growth, they will seek out companies and sectors that offer the strongest and most resilient earnings growth, pristine balance sheets, and strong cash yield. In other words, companies that have the highest chance of surviving the downturn unscathed and of outperforming the market. Performance vs. Our Portfolio Positioning Chart 1Looking Under The Hood... Taking Stock Of Sectors And Industry Groups Taking Stock Of Sectors And Industry Groups The S&P 500 is down roughly 20% off its January 2022 peak. However, 11 industry groups have performed even worse, with Automobiles and Components down as much as 39% off peak. The rest of this inglorious list is dominated by Consumer Cyclicals, Technology, and Financials (Chart 1). We were foreseeing headwinds, and have preempted some of the damage by shifting our portfolio positioning away from the most cyclical areas of the market: We underweighted Semiconductors back in January, observing that Semis are both highly economically sensitive and “growthy” and will be hit by a double whammy of slowing growth and rising rates.  We have been underweight Hardware and Equipment since last summer, moving to this trade a bit too early.  We downgraded Consumer Durables And Retailing in February, observing that demand for goods, pulled forward by the pandemic, is waning and consumption is shifting away from goods to services. More recently, we downgraded Media and Entertainment. The sector has fallen significantly, but we reasoned that if an economic downturn is indeed on the way, advertisement expense is one of the first that companies curtail when they are tightening their belts. Last week, we downgraded Travel to underweight: Even well-heeled consumers are starting to feel the pinch of surging prices. And while most will take that long-awaited post-COVID vacation, the outlook beyond summer is bleak with surging costs of fuel and labor. As for Autos, we were complacent in our thinking that car shortages will eventually translate into strong earnings growth. Despite the disappointing performance, the EV Revolution remains a long-term investment theme for us. Also having opened the position in June 2021, we are still in the green at +7% in relative terms. We have also upgraded our position in Staples to overweight on a premise that many Americans are reeling from surging prices of food, fuel, and shelter. Consumer Staples is the only likely beneficiary, and its pricing power is on the rise. Bottom Line: We have been able to contain some of the damage incurred by market rotation away from cyclicals. Profitability Earnings Growth Expectations As we have written extensively in the past (e.g., “Is Earnings Recession In The Cards”,) the analysts' earnings growth forecast for the S&P 500 of 10% is too high, especially considering the number of adverse events that have taken place since the beginning of the year, and the overall trajectory of monetary policy and economic growth. The analysts are yet again missing the turning point, just as they did back in 2008, and even in 2020. Chart 2Earnings Forecasts For Cyclicals Are Still Way Too High Taking Stock Of Sectors And Industry Groups Taking Stock Of Sectors And Industry Groups We have noticed that the cyclical industries with the highest EPS growth forecasts, such as Consumer Services, Transportation, and Auto, are most prone to earnings disappointment. To be fair, EPS growth expectations for Consumer Services and Transportation are down from December when they stood at 550% and 143% respectively (Chart 2).  Earnings Uncertainty So how certain are analysts about their projections? A short answer is – not particularly.  We gauge earnings uncertainty by looking at the dispersion of analyst EPS expectations scaled by the magnitude of EPS. In a way, this is a measure of analyst consensus, with estimates clustered around a certain number indicating extreme certainty of forecasts. We notice that the advent of COVID-19 rendered panic among analysts with the rate of uncertainty surging. More recently, uncertainty has decreased but remains elevated by historical standards (Chart 3). Looking at earnings projections by industry group (Chart 4), we notice that earnings uncertainty is the highest in the cyclical pockets of the market where the highest EPS growth is still expected: Consumer Services, Transportation, and Retailing. Chart 3Analysts Have Little Confidence In Their Forecasts... Analysts Have Little Confidence In Their Forecasts Analysts Have Little Confidence In Their Forecasts Chart 4... Especially For Cyclical Industry Groups Taking Stock Of Sectors And Industry Groups Taking Stock Of Sectors And Industry Groups   Implications? Analysts as a group have little confidence in cyclical sector growth, and downward revisions are imminent. Margins In the “Marginally Worse” and subsequent “Sector Margin Scorecard” reports in October, we called for margins to roll over as early as 2022.  Curiously, despite their bullishness, analysts expect the margins of most cyclical sectors to contract over the next 12 months (Chart 5). Chart 5Despite Their Bullishness, Analysts Expect Margins To Contract Taking Stock Of Sectors And Industry Groups Taking Stock Of Sectors And Industry Groups Chart 6Pricing Power Is Declining But There Are Exceptions Taking Stock Of Sectors And Industry Groups Taking Stock Of Sectors And Industry Groups Pricing Power As we observed early on, one of the key reasons for margin contraction is a decline in companies’ pricing power, i.e., their ability to pass costs on to their customers (Chart 6).  The Materials sector experienced the most significant decline in pricing power, likely a positive as this may be an early sign that inflation is abating.  It is also important to note that three sectors – Consumer Staples, Utilities, and Tech–are still growing their pricing power. Consumer Staples and Utilities are necessities, demand for which is fairly inelastic, while Tech is offering services that are still in high demand, as they help improve productivity and substitute labor, which is in short supply, for capital, which is still abundant. Degree of Operating Leverage Chart 7Low Operating Leverage Helps In Case Of Downturn Taking Stock Of Sectors And Industry Groups Taking Stock Of Sectors And Industry Groups If pricing power is waning, what else can come to the rescue? After all, with inflation in the high single digits, nominal sales growth is to remain robust. The crucial piece of the puzzle is the ability of companies to convert sales into profits, i.e., operating leverage (Chart 7). Companies with high fixed costs enjoy higher operating leverage, and a small increase in sales translates into significant earnings growth (and vice versa). However, in case of an outright sales contraction, we are better off holding industries and sectors with low operating leverage, such as Staples and Healthcare. Earnings Stability Chart 8Defensives Have The Most Resilient Earnings Taking Stock Of Sectors And Industry Groups Taking Stock Of Sectors And Industry Groups What sectors have the most resilient earnings, that won’t let investors down in a downturn? To answer this question empirically, we looked at a historical variation in EPS-realized growth rates by sector1 (Chart 8).  We found that Staples, Healthcare, and Technology have had the most stable earnings growth rates. However, the last 12 years or so, characterized by low yields and nearly non-existent inflation, were a boon for long-duration technology stocks – so our experiment may not be pure. Bottom Line: Earnings expectations for the cyclical sectors are too high and will come down as analysts have little confidence in their forecasts.  Balance Sheet Quality Free Cash Flow Chart 9Post-pandemic Surge In Demand Resulted In Free Cash Flow Windfall... Taking Stock Of Sectors And Industry Groups Taking Stock Of Sectors And Industry Groups Post-pandemic demand has resulted in a free cash flow windfall for companies in multiple sectors. Technology benefited from the transition to remote working. Energy and Materials have not been able to meet the “reopening” demand after years of underinvestment, which resulted in constrained supply, and soaring prices (Chart 9). Chart 10...Which Companies Used To Repair Their Balance Sheets Taking Stock Of Sectors And Industry Groups Taking Stock Of Sectors And Industry Groups Interest Coverage The companies used this profits windfall to repair their balance sheets and reduce their levels of debt. As a result, the interest coverage ratio has picked up across the board (Chart 10). Bottom Line: Corporate balance sheets across most sectors look strong. Tech, Materials, and Financials have improved the most. Cash Yield Companies that pay dividends and buy back their stocks not only enhance the returns of their shareholders but also signal their confidence in future earnings and the strength of their balance sheets (Chart 11). That is one of the reasons income funds were strong performers over the past few months as investors were seeking out quality investments (Chart 12). Chart 11Cash Yield Has Not Been This Attractive In Years... Taking Stock Of Sectors And Industry Groups Taking Stock Of Sectors And Industry Groups Chart 12High Dividend Yield Signals Corporate Confidence Taking Stock Of Sectors And Industry Groups Taking Stock Of Sectors And Industry Groups Valuations A corollary to our conclusion that earnings estimates are hardly trustworthy, is that forward multiples are not a great valuation metric on the verge of an earnings contraction. Trailing multiples are a better measure of value at this point in the cycle. We sorted PE multiples by their Z-score to 10 years of history (Chart 13) and notice the most cyclical sectors are rather inexpensive, both in absolute terms and relative to history as markets are forward looking.  Chart 13High Dividend Yield Signals Corporate Confidence Taking Stock Of Sectors And Industry Groups Taking Stock Of Sectors And Industry Groups Technicals Chart 14US Equities Appear Oversold Taking Stock Of Sectors And Industry Groups Taking Stock Of Sectors And Industry Groups   And last, but not least: The US equity market is oversold, and most industry groups are several standard deviations below the neutral reading (Chart 14).  Bottom Line: Technicals signal that the market is oversold. Yet, a sustainable rebound may still be months away. Investment Conclusion Is it finally time for bottom fishing? We believe that oversold conditions and sectors trading at 30-40 percent of their peak are “necessary but insufficient conditions.” For the equity market to rebound, all the bad news needs to be fully priced in – however, we are still in the early stages of the monetary tightening cycle, and there is talk about earnings and economic recessions, the severity of which is impossible to gauge at this point. Rates have not stabilized yet, and inflation has not peaked. Much of the bad news is priced in, but “new” bad news is likely on the way.   Bottom Line We recommend that investors remain patient and pad the more defensive and quality allocations in their portfolios at the expense of cyclical sectors that are geared to a slowdown. Companies with strong and resilient earnings and quality balance sheets will be able to better weather the storm, if it arrives.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com S&P 500 Chart II-1Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-2Profitability Profitability Profitability Chart II-3Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-4Uses Of Cash Uses Of Cash Uses Of Cash   Communication Services Chart II-5Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-6Profitability Profitability Profitability Chart II-7Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-8Uses Of Cash Uses Of Cash Uses Of Cash Consumer Discretionary Chart II-9Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-10Profitability Profitability Profitability Chart II-11Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-12Uses Of Cash Uses Of Cash Uses Of Cash Consumer Staples Chart II-13Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-14Profitability Profitability Profitability Chart II-15Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-16Uses Of Cash Uses Of Cash Uses Of Cash Energy Chart II-17Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-18Profitability Profitability Profitability Chart II-19Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-20Uses Of Cash Uses Of Cash Uses Of Cash Financials Chart II-21Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-22Profitability Profitability Profitability Chart II-23Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-24Uses Of Cash Uses Of Cash Uses Of Cash Health Care Chart II-25Sector vs Industry Groups Sector vs Industry Groups Sector vs Industry Groups Chart II-26Profitability Profitability Profitability Chart II-27Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-28Uses Of Cash Uses Of Cash Uses Of Cash Industrials Chart II-29Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-30Profitability Profitability Profitability Chart II-31Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-32Uses Of Cash Uses Of Cash Uses Of Cash Information Technology Chart II-33Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-34Profitability Profitability Profitability Chart II-35Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-36Uses Of Cash Uses Of Cash Uses Of Cash Materials Chart II-37Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-38Profitability Profitability Profitability Chart II-39Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-40Uses Of Cash Uses Of Cash Uses Of Cash Real Estate Chart II-41Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-42Profitability Profitability Profitability Chart II-43Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-44Uses Of Cash Uses Of Cash Uses Of Cash Utilities Chart II-45Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-46Profitability Profitability Profitability Chart II-47Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-48Uses Of Cash Uses Of Cash Uses Of Cash   Table II-1Performance Taking Stock Of Sectors And Industry Groups Taking Stock Of Sectors And Industry Groups Table II-2Valuations And Forward Earnings Growth Taking Stock Of Sectors And Industry Groups Taking Stock Of Sectors And Industry Groups Footnotes 1           Scaled and inverted Recommended Allocation

Chart 1 From Hero To Zero From Hero To Zero The S&P Media & Entertainment (M&E) index remains under fire due to its exposure to high beta names like GOOG(L), NFLX, FB, and DIS. These four companies dominate the industry group, comprising nearly 80% of the market cap. Initially, the group pulled back as a victim of stretched valuations, unreasonable growth expectations, and a broad ruckus within Big Tech on the back of the swift tightening of financial conditions (see chart). Notably, the M&E index’s forward P/E multiple contracted by nearly 50% moving from 30x to 16.7x in absolute terms, and now trading on par with the S&P 500. It may appear that these stocks have sold off, technicals are attractive, and valuations are no longer a concern. However, we are concerned that the M&E stocks are actually more expensive than they appear: Earnings are likely to come under more pressure. Netflix and Disney are consumer stocks, with entertainments falling under the discretionary column of a family budget.  With American families struggling with rising prices and negative real wage growth, discretionary spending may be curtailed. As for the other media companies, like FB, Alphabet, and their less famous brethren, SNAP earnings have just flashed a warning sign: Advertising spending is highly economically sensitive and is often one of the first expenses companies cut back on when tightening the belt. Therefore, it appears, that the M&E industry group is not out of the woods yet and is likely to face even more challenges over the next several months.  As such, we recommend using the next bear market rally to lighten the allocation. Sell the rip! Bottom Line: The sector's high exposure to discretionary spending and high economic sensitivity of advertising expenditures point to continued earnings disappointment. Today, we downgrade the S&P Media & Entertainment industry group from overweight to neutral, with an eye on eventually taking the allocation to underweight.