Have Stocks Bottomed?

[Zacks | Our Research. Your Success.] Weekday Wisdom [Sheraz Mian - Editor] Have Stocks Bottomed? By: Sheraz Mian July 27, 2022 --------------------------------------------------------------- Stocks have enjoyed a nice rebound in recent days, raising hopes among some that the worst may be behind us. But there are others that cite various reasons to stay bearish, keeping alive questions about the market's next move. I am adding to that debate in this piece by pointing out two sources of support for the market that will help it not only stabilize, but actually rebound in the days ahead. Stocks need power to push higher, just as humans and machines do. For stocks, this 'power' comes from a variety of sources, but interest rates and corporate profits are the biggest sources. The market pullback this year has been driven by market participants' uncertainty about the speed and magnitude with which the Fed will change interest rate policy in the days ahead and what impact those higher rates will have on the economy's health. This in turn has blurred earnings visibility, as corporate profitability is a function of economic health. I am increasingly of the view that we are on the cusp of getting better clarity and visibility with respect to interest rates as well as corporate earnings. This note explains the basis for that view. I don't subscribe to the view that the current multi-decade high inflation readings are here to stay. This bearish view implies that the Fed will need to implement the full extent of tightening that they have penciled in, which will push the economy into a deep recession. While recession risks have undoubtedly increased, it is hardly the only, or even the most likely, outcome for the U.S. economy. The Fed is not on some autopilot that constrains them to implement all the rate hikes they have communicated to us following recent meetings. Given the Fed's data dependence, it is inconceivable that they will ignore recent trends that clearly show that their already-implemented tightening moves are starting to have an effect. My readings of the economic tea leaves make me conclude that peak inflation readings are in our rearview mirror now. This doesn't imply that I expect to see the Fed's target 2% reading next month, but rather that the growth trend shifts into deceleration mode going forward. A non-trivial part of our inflation problem was always a result of the pandemic's impact on global and local supply chains. The other part was due to the stronger-than-expected post-pandemic demand that likely got exacerbated by stimulative fiscal measures. The Fed fully understands that no amount of tightening on its part will have a bearing on stretched global supply chains. Its goal instead is to take the edge off excess demand by removing the extraordinary stimulus measures like unwinding the QE program and raising interest rates to a level where they are neither stimulating nor restricting economic growth. We are close to that level after this week's rate hike. My sense is that by the next Fed meeting in September, they will have sufficient data to allow them to pivot from or pause the ongoing tightening cycle. This could be in the shape of language change accompanied by a modest rate hike or a pause to rate hikes altogether. Either way, the market will see it as a formal end to the tightening cycle and will have anticipated it through pricing action ahead of time. The stock market optimism in recent days that coincided with seemingly reassuring Q2 earnings results is likely an early attempt to do just that. This brings us to the second force we mentioned earlier that powers stocks higher - corporate earnings. Corporate earnings enjoyed an impressive rebound last year, with each of the last few quarters generating all-time record aggregate earnings tallies. This was despite continued pandemic-related issues in the broader leisure, hospitality and travel spaces. We knew that last year's impressive growth pace would decelerate this year and we are seeing that in the ongoing 2022 Q2 earnings season. That said, earnings are still growing, with Q2 earnings on track to increase +3.6%, with the growth increasing to +9.8% once Finance sector's results are excluded from the mix. Finance results at their core are good as well, but they are held down by non-cash reserves and tough comparisons to last year when the trading and investment banking businesses were literally on fire. Importantly, contrary to fears ahead of the start of this earnings season, most companies are providing favorable and reassuring outlook for their businesses, despite the well-known headwinds of logistical bottlenecks and inflationary pressures that are weighing on margins. This is not only helping stabilize earnings outlook, but also easing worries about the economy. We strongly believe that investors will find it difficult to justify continued market weakness in the face of strong earnings releases in the days ahead. The market set up for this earnings season couldn't have been better. Continued . . . [Notification of Release: 5 Stocks Set to Double]( Five Zacks' experts have each revealed their single favorite stock with the best chance to gain +100% and more in the months ahead. Previous editions of this Special Report have racked up gains of +143.0%, +175.9%, +498.3%, and even +673.0%. Today, you are invited to download the just-released report that names new stocks and spotlights why their gain potential is so exceptional. [See Stocks Now »]( With respect to the market, we should keep in mind that we don't need continuation of the outsized earnings growth from 2021 to push stocks higher. What we do need, however, is an environment of improving earnings outlook, with estimates stable or steadily going up. And that's exactly what we have at present. We make the following two points in support of this view: First: Market bears argue that stocks are unlikely to stabilize unless current consensus estimates are sharply cut to reflect a recessionary outcome for the economy. That's a fair argument if we assume the inevitability of a major recession on the horizon. As stated earlier, we acknowledge that such risks have increased, but we find it a stretch to assume that to be the only outcome. In fact, a direct extrapolation of our aforementioned inflation and Fed outlook is the economy experiencing a modest slowdown. The ongoing Q2 earnings season has provided us plenty of evidence about the financial health and spending trends of households and businesses that point to an orderly moderation in activity levels instead of falling off the cliff. Trends in earnings estimate revisions confirm this view, which we describe in the second point. Second, earnings estimates have barely come down. In fact, aggregate S&P 500 earnings estimates for this year have actually increased since the start of the year, though they have modestly ticked down over the past month. This seemingly inexplicable revisions trend makes sense once we take into account developments in the Energy sector. The Energy sector has been riding an unprecedented wave of positive earnings estimate revisions and the trend is still very much in place. As a result, aggregate earnings estimates for the sector have increased more than +80% since the start of the year, causing the sector's 'earnings weight' in the index to increase from 5.6% in January to 9.8% today. Earnings estimates outside of the Energy sector have come down, with the biggest declines in the consumer discretionary and retail spaces. In the aggregate, excluding the Energy sector, earnings estimates for the index have declined roughly -2% since the start of the year. The revisions trend to estimates for Q3 is relatively more pronounced to the downside. In other words, the outlook for earnings is in-sync with the outlook for a moderating economy, admittedly with the usual lag. Putting It All Together The ongoing Q2 earnings season is far from confirming the doom-and-gloom fears of market bears. Granted earnings aren't great, but no one expected that at this stage of the cycle in the face of aggressive Fed tightening. Importantly, they are as good as could be expected in this environment. What we are seeing instead is continued resilience in household and business spending, with tell-tale signs of the expected moderation. This implies an orderly slowdown instead of falling off the cliff. The implication of all of this discussion of interest rates and earnings for investors is that while we still have to contend with some uncertainties, the clouds have started to lift. We typically know of market bottoms only in retrospect and this time will likely be no different. But we are reasonably confident that the worst is now behind us. How to Take Advantage Today is an ideal time to get aboard this market. That's why I'm inviting you to download our just-released Special Report [5 Stocks Set to Double](. 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Last year alone, they closed 68 double and triple-digit wins. There have already been 24 more in 2022. Gains have reached as high as +150.9%, +348.7%, and even +995.2%.¹ The opportunity to download this just-released Special Report, 5 Stocks Set to Double, ends midnight Sunday, July 31. [Get started now with Zacks Investor Collection and 5 Stocks Set to Double »]( All the Best, [Sheraz Mian - signature] Sheraz Mian Sheraz Mian serves as the Director of Research and manages the entire research department. He also manages the Zacks Focus List and Zacks Top 10 Stocks portfolios. He invites you to [access Zacks Investor Collection](. ¹ The results listed above are not (or may not be) representative of the performance of all selections made by Zacks Investment Research's newsletter editors and may represent the partial close of a position. This free resource is being sent by [Zacks.com](). 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