Rules are there to be broken. This may be a standard mantra for anarchists. But for traders, such thinking can prove dangerously repellent.
Investors should therefore consider the latest note from Bank of America’s Savita Subramanian, in which the star analyst describes that “a rule with a perfect track record says the market hasn’t bottomed yet.”
Subramanian, head of U.S. equity and quantitative strategy, says that after this recent rebound that sent the S&P 500 SPX up -0.72%, up 16.6% from its mid-June low, only 30% of the conditions required for a market floor are met . As a rule, at least 80% of the states must be registered before the all-clear can be given.
One of these guideposts is particularly important – the rule of 20. That is, if the sum of annual consumer price inflation and the market’s trailing price-to-earnings ratio is less than 20 when the market bottoms.
Currently, the market’s P/E ratio is 20 and the CPI is 8.5%, Surbramanian notes. That’s 28.5.
“Barring inflation falling to 0% or the S&P 500 falling to 2500, it would take a 50% earnings surprise to meet the Rule of 20, while the consensus is already pushing an aggressive and, in our view, unattainable growth rate of 8% forecast in 2023,” she says.
Source: Bank of America
Meanwhile, BofA also thinks its shares aren’t cheap enough because the market is underestimating the odds of a contracting economy.
“A 20% chance of recession is now priced in versus 36% in June. In March, stocks were pricing in a 75% chance of a recession. Even at enterprise value to sales, where revenue should rise on tailwinds of 9% CPI, the market multiple is excessively high (+40%) compared to the past – possibly because real non-energy revenue growth is essentially flat.”
Other signposts that need to be triggered to confirm a bottom but are not currently are: the Fed’s rate cuts; a decline of 50 basis points or more in 2-year Treasury yield TMUBMUSD02Y, 3.253%; a rising unemployment rate from a 12-month low; a sell-side buy signal.
Signals bulls are currently giving the green light include: improving PMIs; and more bears than bulls.
Given all of this, Subramanian favors the energy and industrials sectors and suggests selling consumer-facing stocks.
“The industry could be lifted by already strong capital spending (they grew +19% yoy in the second quarter) and by companies forecasting their capital spending to be even higher during the second quarter earnings season. In a tight labor market that justifies automation and deglobalization, capital spending may be more of a necessity and should hold up better than in previous recessions,” she writes.
The S&P 500 is down 10% this year. The Dow Jones Industrial Average DJIA, -0.50%, is down 6%, while the Nasdaq Composite COMP, -1.25%, is down 17%.