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October 12, 2022- As we enter earnings season, attention will shift from interest rate fears to corporate performance. Pepsi kicked it off this morning with good results, hopefully an encouraging sign. As always, the story for the season will revolve around expectations versus reality. In July, reality beat expectations sparking the best rally of the year. The key will be the relative performance of the large tech names, notable laggards coming into earning season.

//  by Tower Bridge Advisors

Stocks ended mixed yesterday in a very volatile session where the Dow Industrial Average moved back and forth by more than 1000 points. News was rather sparse. A brief afternoon plunge occurred after the Bank of England signaled it would halt its planned intervention to support the pound Friday as originally planned. Stock, bond, and currency markets all had brief spasms but settled down. The important 10-year Treasury bond fell in price for the day, but yields remained below the important 4.0% level.

Today producer price numbers for September will be announced. Unless they are far off consensus, they should be much less market moving than tomorrow’s CPI report. Tomorrow’s inflation report could be followed by volatile stock movement, in either direction. It is unlikely, by itself, to change the likelihood of a 75-basis point move by the Federal Reserve next month. The Fed needs to see some persistence to move lower and it won’t get it from one month’s data no matter how favorable it might be. But you can’t start a trend without a good month, so, it’s important.

Once the CPI report is out, the focus will turn to earnings. In both the first and second quarters, earnings beat expectations. In July particularly, the beat came against sour investment sentiment and fed a sizeable rally. It lasted less than a month, overtaken by the persistence of inflation, borne out in the August CPI report, and higher interest rates.

In some ways, this time is different, and in some ways it’s the same. What’s similar is the awful sentiment. September was an awful month for equities but most of the negativity related to persistent inflation and the need for further forceful Fed action. Parts of the economy showed increased downward momentum including housing, semiconductor manufacturing, and auto sales. In all three cases either higher costs or increased inventories arrived just as demand waned, a nasty combination. But for most of the rest of the economy, demand remains strong. In fact, demand has remained strong enough to encourage further price increases in many cases. That signals we remain in the early innings of the fight against inflation, a reality that has been bad for stocks all summer amid more aggressive increases in interest rates.

But back to earnings, we once again expect most companies to meet or exceed forecasts with one major caveat, the impact of a stronger dollar on earnings. The dollar strength will be a weight on results as earnings generated overseas get translated back into fewer dollars. Investors and analysts tend to pay less attention to currency translation losses than they do to general operating results, but the impact on reported numbers is the same.

Pepsi# kicked off earnings season this morning with a strong quarter, one that beat forecasts. Its shares, premarket, are up 1-2%. Not a bad way to start. On Friday a trio of large banks will report. Results should be mixed but close to expectations. International banks, like JP Morgan Chase# will face more headwinds, but investors know that. Last quarter, it was the ability of the large tech names that dominate the top of the S&P 500 to beat estimates that sparked the market’s July rally. Since then, only Amazon has held even some of its gains. Slower demand for chips, PCs, and less growth in digital advertising threatens to weigh on most of the big names. If they disappoint, it will be hard for the overall market to push higher, but if they surprise by beating muted forecasts, a bear market relief rally is possible.

October is often the time for market bottoms. It is possible again this time. In early October, markets face headwinds of mutual fund window dressing and the fact that most companies cannot buy their own stock in the interim between quarter’s end and the time they report results. If tomorrow’s CPI report sparks some optimism and the tone of future expectations from managements are encouraging, there could be a bottom or a significant bear market rally to come.

The other focus will be on the 10-year Treasury yield. Logically, slower growth going forward, and lower inflation combined should begin to move the rate lower. On the other hand, rising yields overseas could put upward pressure on rates, and if the Fed continues its effort to reduce assets on its balance sheet (mostly via roll off of maturing bonds), then Federal deficits will start to rise again as the growth of Treasury receipts slows and spending rises. If long-term yields can stabilize, markets could as well, assuming future earnings and expectations match.

But therein lies the rub. It is very rare for stock markets to bottom before an economic downturn begins. The latest forecast from the Atlanta Fed is that third quarter GDP grew 2.9%, the best performance of the year. Last night President Biden suggested we face a very mild or no recession, but since when does a President predict gloom on his watch? Most economists now believe the odds of a recession in 2023 are over 50% and it hasn’t begun yet.

On the other hand, it is rare for stock markets to fall 25% before a recession begins. The famed economist Paul Samuelson famously noted that markets had predicted 9 of the last 5 recessions. Markets aren’t always right. That’s the hope here. Can inflation be licked with such a tight labor market as we have today? Probably not.

To me, the more natural scenario would be for managements to tone down future expectations as they report third quarter results. While companies beat second quarter expectations as noted above, when the results were reported, analysts took down Q3 forecasts by almost 7%. I would expect similar adjustments this quarter with several high-profile adjustments of a much larger amount. It may take one more quarter to complete the task, to align expectations to future reality. January would be a logical time for that to happen. This is the time everyone uniformly focuses on 2023. The Fed should be near the end of its interest rate raising cycle. The impact of rate increases since last March should begin to impact demand and growth rates. Managements will want to set up 2023 in a way that allows them to match expectations in a weak economy, recession or not.

The average bear market, post WWII shows a decline of 25-30%. If interest rates stabilize and the recession is no worse than average, perhaps we can stay within that range. The bottom could be close at hand. The last 4 bear markets have all shown declines of over 30%. They include the valuation adjustment in 1987 and the bursting of the Internet bubble in 2000. The most pain was in the high multiple stocks. We are seeing replication today. I am not sure the speculation purge is yet complete even as many of the most popular stocks of 2020-2021 are now down well over 50%. It still seems much easier to construct a portfolio of solid growing companies selling for less than 15x earnings than to rebuild using a basket of stocks selling for 20-30 times earnings or more. The temptation to race back and buy yesterday’s superstars simply because they have fallen so far ignores the fact that many of those names that have fallen were overhyped companies that may never live up to expectations. In the 1973-74 bear market, one that massacred the so-called “Nifty Fifty”, some came back quickly once the bear market ended, but some never came back. Think Polaroid, Kodak, Avon, and Xerox. In 1987, the market punctuated its decline with a one-day drop of 22%. It bounced from there, but Digital Equipment and other mini-computer names never recovered. They are all gone today. After 2000, names like Yahoo never came back. Cisco# and Intel still sell well below their 2000 highs. Some do come back. Amazon# and Microsoft# are notable examples. But they are the exceptions, not the rule.

Bottom line, the ingredients exist for a good rally if long-term rates stabilize near here, the CPI number tomorrow is in line or better than expectations, and earnings once again beat forecasts. It’s hard to think this is the real bottom before an economic slowdown even begins. A true sign of a bottom is when companies report worse than expected news and markets shrug off the disappointment. We aren’t there yet. A more logical time for a bottom is early in 2023 as the Fed completes its cycle of rising rates. Jamie Dimon, CEO of JP Morgan Chase, said in an interview this week, that another 20% decline wouldn’t surprise him. That wasn’t a prediction. One can get to 2800 on the S&P using a 14 P/E and $200 for earnings. But a 16x multiple, where the market is now, and a more modest decline in profits, perhaps to $215, suggest a possible bottom of 3440, a further decline of less that 4%. There is a lot of space in between. A conclusion might be that there remains a bit more risk than reward at the moment and this isn’t the time to try and be a hero. Guessing a bottom before it happens is hazardous, especially when bonds are now offering positive returns adjusted for inflation. Indeed, the attractiveness of bonds will temper the pace of future equity recovery.

Today Hugh Jackman is 54.

James M. Meyer, CFA 610-260-2220

Additional information is available upon request.

Tower Bridge Advisors manages over $1.7 Billion for individuals, families and select institutions with $1 Million or more of investable assets. We build portfolios of individual securities customized for each client's specific goals and objectives. Contact Nick Filippo (610-260-2222, nfilippo@towerbridgeadvisors.com) to learn more or to set up a complimentary portfolio review.

# – This security is owned by the author of this report or accounts under his management at Tower Bridge Advisors.

Additional information on companies in this report is available on request. This report is not a complete analysis of every material fact representing company, industry or security mentioned herein. This firm or its officers, stockholders, employees and clients, in the normal course of business, may have or acquire a position including options, if any, in the securities mentioned. This communication shall not be deemed to constitute an offer, or solicitation on our part with respect to the sale or purchase of any securities. The information above has been obtained from sources believed reliable, but is not necessarily complete and is not guaranteed. This report is prepared for general information only. It does not have regard to the specific investment objectives, financial situation or the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities or investment strategies discussed in this report and should understand that statements regarding future prospects may not be realized. Opinions are subject to change without notice.

Filed Under: Market Commentary

Previous Post: « October 5, 2022 – Two huge up days in a row put bulls back in charge. Is this the market bottom? Only time will tell. It will largely depend on the severity of the pending economic downturn. But retreating interest rates, and weaking labor market statistics suggest the end to the Fed’s cycle of higher interest rates is nearing an end. That is at least one key ingredient to the end of a market downturn.
Next Post: October 26, 2022- Stocks have now risen sharply for three straight sessions as both the value of the dollar and the yield on 10-year Treasuries retreated. But disappointing earnings last night from a trio of tech names may spoil the party this morning. Or at least give it some reason to pause. The poor numbers from tech land remind us to look forward, not back. The great opportunities that technology created over the last quarter century are now maturing. The good news is that new opportunities will appear. They always do in a capitalistic entrepreneurial society. »

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  • September 22, 2023 – Stocks fell sharply, continuing a negative reaction to the outcome of Wednesday’s FOMC meeting. While rates remained unchanged, the committee expressed a bias toward increasing rates again at the next meeting that ends November 1. In addition, the dot-plot of projections from Committee participants suggested only one (net) rate cut between now and the end of 2024. While short-term rates barely budged, yields on 10-year Treasuries rose by about 15 basis points, suggesting tougher economic conditions ahead, higher rates for longer and, by extension, lower P/E ratios. Lower P/Es mean lower stock prices.
  • September 20, 2023 – Today concludes the 2-day FOMC meeting. No change in rates is expected but investors will parse every detail of the post-meeting releases as well as comments from Fed Chair Jerome Powell. Recent data suggests both inflation and the economy are slowing. The ideal soft landing is still within reach, but it is also quite possible that the economy might slip into recession over the next few months.
  • September 18, 2023 – Markets are directionless, torn between better economic activity and an increase in storm clouds from labor unrest to China. What is crucial is the future trend for interest rates. Investors will parse this week’s FOMC meeting for clues, but probably won’t get a much clearer picture for their efforts.
  • September 15, 2023 – Auto workers are out on strike. So far, markets don’t care. They probably won’t care overall, unless the strike becomes extended. Elsewhere the public offering of ARM Holdings signals a healthier IPO market. Instacart is likely next. Traders are waking up from the late summer doldrums, but valuations, high bond yields and rising oil prices probably suggest more sideways churning ahead.
  • September 13, 2023 – Today’s focus will be on the August CPI report. The headline number will be disturbing thanks to higher oil prices, but core inflation is likely to stay muted. Bond yields have been creeping higher and are back at the top end of recent trading ranges. Any breakout to higher yields would be disturbing to equity markets.
  • September 11, 2023 – Spectrum and Disney are locked in a battle over how TV content is delivered to the home. Both want a bigger economic piece of the pie. The battle reminds us of the strike by actors and screenwriters. All are fighting for a bigger piece of a smaller pie. These battles are part of a process, one where the consumer will be the winner in the end. But before the wars end, there will be lots of carnage as economic reality sorts out those parts of the puzzle that cannot survive.
  • September 8, 2023 – The reported impending ban on the use of iPhones in Chinese government offices sent Apple’s shares reeling and infected the entire tech sector, sending stocks lower this week. While China’s government hasn’t officially commented, this news is yet another sign of the deterioration of economic cooperation between the U.S. and China. Economically, that can’t be a good sign.
  • September 6, 2023 – Stock prices remain slaves to interest rates. A spike in rates the past two days has put downward pressure on stock prices once again. Higher oil prices add further pressure. With little economic or corporate news coming that should change sentiment, the key data in the weeks ahead will focus on the pace of decline in inflation readings.
  • September 1, 2023 – We all hear about the lag effects of higher rates. That lag varies from sector to sector. When rates first started to rise, it affected home buyers immediately. But for those who financed or refinanced debt in 2020 or 2021, the impact was delayed. For some, that cheap debt is starting to come due. Over the next couple of years, debt service is going to become a bigger and bigger cost of doing business.
  • August 30, 2023 – At a time on the calendar when there is a dearth of economic and corporate data, traders look to the bond market for direction. Yesterday, yields on the10-year Treasury fell by almost 2% and stocks staged a solid rally. Trying to guess day-to-day moves in the bond market is pure folly, and thus trying to guess the stock market’s next move is equally foolhardy. Friday’s employment report could be market moving.

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