Monthly Outlook: Watch Out for Potential Downward Adjustments to US Stock Earnings

MonthlyOutlook202211 EquityResearch·StrategyResearch·MonthlyOutlook WatchOutforPotentialDownwardAdjustmentstoUSStockEarnings ReportThesis: TherecentrallywehaveobservedintheUSstockmarketislargelybasedonsignsofinflationpeakingoutandapotentialshiftininvestors’sentiment.Ontheonehand,withthelower-than-expectedinflationdatainOctober2022,investorsaregenerallylookingattheFedtosignalthatpolicyrateswillpeakinMay2023,andhencehelprepairstockvaluationsthathavebeenbatteredsincetheendof2020.Moreover,marketsentimentisexpectedtobottomout.Historically,stockmarketsentimentbottomingoutin1990,2003,2009and2020weresignsofcapitulationandassociatedwithhighstockreturnsinthesubsequent6months. ReportAbstract: OutlookforearningsandvaluationofUSstocks.Fortheearningsside,wehavejuststartedtoseethecompressionofmarginsasthesuppressionofconsumptionbythehighinflationbeginstokickin.WithconsumerdemandgraduallydigestedaftertheendofCOVIDlockdown,theincreaseofinventories,thedeclineofhouseholdincomesuggestthatcorporatemarginsstillhaveplentyofroomtodeteriorate.ThemarketisnowpricingintheFed’sdovishpivotbutignoringthefactthatthedovishstanceisaccompaniedbyrecession.Therefore,fallingcorporateearningsresultedfromahardlandingsituationhasyettobepricedin.AccordingtoFactSetearningsestimates,analystsexpectS&P500netprofitmarginstobehigherthanQ32022fortherestof2022andthefirsthalfof2023,butthisestimationisdifficulttoachievegiventhecurrenteconomicoutlook.Therefore,webelievetheriskofdownwardpressureonthesharepricefromearningsrevisionsneedstobepaidcloseattentionto. Intermsofvaluation,weconsiderexistingevidenceinsupportoftheassumptionthattheFedwillenditsratehikesinthefirsthalfof2023toberelativelyweak.IftheFeddoesnottakeadovishturnanytimesoon,thecurrentstockpriceincreasecausedbyexpectationofadovishpolicystancewillhavetoberepaireddownwards.WhilevaluationsforUSstockshavefallen,theystillcannotbecalledcheap.Inaddition,althoughinflationappearstobemoderatedtemporarily,coreservicesinflationremainsatitshistoricalhighonayoybasis,mainlybecauserentalcostshavenotfallen,andthusoverallinflationarypressurehasnotdissipated. Finally,wethinkanothersignificantriskisthatmarketexpectationsarelargelybasedontheassumptionthattheFedwillbeabletodeliveraccurateandtimelypolicyresponses.However,theFedhasprovedtobemistakenformultipletimesoverthepastyearinunderestimatingthedegreeofinflationpersistenceandinitsslowresponsetosteminflationarymomentum.Anyimperfectpolicymeasurescouldcomewithsideeffectsandleadtomarketvolatility.Atthesametime,aswearguedinourOctober2022report,duetotheshrinkingFedbalancesheetandthedecreasingshort-termTreasuryissuance,USmarketliquidityrisksremainaconcernforinvestors. Risks:DownwardadjustmentstoUSstockearningscouldhurtstockprices;Inflationdatacouldrebound,disappointingmarketexpectationsformonetaryeasing;PolicymiscalculationbytheFedcouldworseneconomicrecessionandhitbothvaluationandearnings. 28November2022 ResearchAnalystShiruiOuyang(852)38923120 ouyangshirui@dwzq.com.hk Relatedreports 1.EmbracingRisksandOpportunities 2022-04-11 2.TheUSStockMarketHasNotFullyPricedinInflationDataandInterestRateHikes 2022-06-29 3.FadingInflationandGrowth:WhatAretheSignalsDeliveredbyUSEconomicIndicators? 2022-07-20 4.NegativeInterestRateEraisOver,andWhereisEurope Headed? 2022-08-09 5.BePreparedforFurtherAggressiveFedRateHikes 2022-09-16 6.ReduceriskexposuretoEuropeanmarketsandbewareofliquidityshortageintheUS 2022-10-17 Wewouldliketoacknowledgethecontributionandsupportprovided byHanruoFeng(冯涵若). TableofContents 1.ExpectationfordovishpivotandashiftinsentimentsupportedUSstocksontheupside5 2.RisksforearningsandvaluationofUSstocks6 3.RisksHighlight11 TableofFigures Figure1:TherecentrallywehaveobservedintheUSstockmarket4 Figure2:The10-year&3-monthUSTreasuryspreadhasrecentlyinverted5 Figure3:InvestorsaregenerallyexpectingthatpolicyrateswillpeakinMay20235 Figure4:Ratecutexpectationispositivenewstostockvaluationswhichhavefallensharply6 Figure5:Deeplowsinsentimentwereaccompaniedbystrongsubsequentstockmarketperformance6Figure6:Therewasadouble-bounceininflationintheearly1980swhenrateswerebroughtdowntoosoon7 Figure7:Thespreadbetweenstocksearningsyieldandtherisk-freeTreasuryyieldisnarrowing7 Figure8:MoneyisstillflowingintoUSstocksonanetbasis7 Figure9:Wehavejuststartedtoseethecompressionofmargins8 Figure10:USBusinessinventoriesareincreasingduetofallingdemand8 Figure11:AnalystsexpectS&P500netprofitmarginstobehigherthanQ32022fortherestof2022andthefirsthalfof2023(asof2022/10/24)8 Figure12:EstimationofS&P500sector-Levelnetprofitmargins:2022Q3vs2022Q2(asof2022/10/24) ..................................................................................................................................................................8 Figure13:EstimationofS&P500sector-Levelnetprofitmargins:2022Q3vs2021Q3(asof2022/10/24) ..................................................................................................................................................................9 Figure14:WhilevaluationsforUSstoc