Large-cap estimate revisions holding up much better than small-caps

Our indicators of analyst earnings estimates revisions in the US highlight a key theme: revisions for large-cap (and mid-cap) stocks have held up much better recently than those of small-cap stocks.

While the proportion of analysts raising their earnings estimates relative to those cutting estimates has been declining ever since its extremely high peak in the middle of last year, the difference between large-cap and small-cap revisions has favored large-caps, and has shifted further in favor of large-caps most recently.

Why are you not more bearish?

Client Question: There is a possible world war going on along with a seemingly never-ending pandemic, inflation is at multi-decade highs, the Fed and other central banks are tightening monetary policy, and the world may lose access to Russian oil and gas entirely soon – why aren’t you massively bearish on stocks, which everyone knows is the high-risk asset class?

Answer: While naturally reserving the right to get more cautious on stocks (we downgraded equities to neutral on Feb. 14th), there are a few reasons we are not more bearish on stocks or the broader economic outlook at the moment.

Commodity prices post record surge, near-term inflation to follow

Commodity markets have become the center of global economic and financial market attention recently, showing unprecedented volatility. Russia’s invasion of Ukraine, coming on top of the volatility caused by COVID and the subsequent policy responses, has highlighted the supply constraints now facing a wide variety of commodities.

The S&P GSCI commodity price index is a widely-watched benchmark for global commodity prices, with history back to 1970. As shown in the chart below, the rolling 3-month percent change in the GSCI index has just hit its highest reading in its 52-year history. This exceeds the moves following the OPEC oil embargo of 1973-74, the 1979 oil shock, the invasion of Kuwait in 1990, the rebound in prices in 2009 after the 2008 collapse, and the rebound in 2020 from the initial COVID-driven collapse.

Market impacts of Russia’s invasion of Ukraine

While we hesitate to comment too much on the situation in Russia/Ukraine given how fast conditions are changing, many investors are naturally interested in the market impacts of the recent invasion and the resulting sanctions.

The first order impact is clearly volatility, in many different markets. Stocks, bonds, currencies, and commodities are all seeing increased volatility recently amid extreme uncertainty surrounding the unprecedented global response to Russia’s invasion of Ukraine. And of course, Russian assets of all kinds have seen their prices plunge, if they are still being traded at all — the Russian stock market has remained closed since February 25th.

Macro events overshadow a positive earnings season

With macro events dominating the headlines (Ukraine, Fed, oil), along with a high-profile “blow up” or two (i.e., Meta, PayPal), it is perhaps not surprising that there has been less attention lately on the overall Q4 earnings season results. And while almost any earnings season might seem disappointing after the string of blockbuster quarters from late 2020 through 2021, the reports for Q4 2021 have in fact been reasonably good overall.  Thus far, the company guidance has been sufficiently supportive that analysts are still raising estimates for this year and next, a contrast to the usual pattern of trimming calendar year estimates over the course of a year.

Shifting to neutral on equities

Our intermediate-term (3-6 month) indicators have deteriorated enough recently to argue for shifting from overweight equities in our asset allocation framework to neutral. While stocks are still favored over bonds on a longer-term relative valuation basis, the prospect for further consolidation and volatility means that easing back equity exposure and holding somewhat more cash makes sense in our view.

Sector estimate revisions led by Technology, Energy, and Real Estate

Earnings estimates in the US continue to rise overall, helped by the continued solid economic backdrop, but the pace has eased from last year’s extraordinarily positive levels and divergences among sectors are more visible now.

Part of our sector analysis includes monitoring the aggregate earnings estimate revisions trends for the 11 GICS sectors as well as the more granular industries (we track 62 in the US currently). One of the key metrics is what we call “revisions breadth”, which is the net proportion of analysts covering a stock who have most recently raised their earnings forecasts versus those who have lowered estimates. Thus breadth readings can theoretically range from +100% (if all analysts are raising estimates) to -100% (if all analysts are reducing estimates). Thus higher is better on revisions breadth as it indicates the fundamental news is broadly improving within a sector.

Stay with large-caps as volatility picks up

In our view, equity markets have been shifting toward a backdrop of higher volatility and thus more modest gains relative to the last 18 months. After an all-time high in early January, the S&P 500 recently endured its first 10% decline since September 2020 before rebounding sharply in recent days. This pickup in volatility is consistent with the pullback in fiscal and monetary stimulus, and the natural development of the economic cycle. Bonds are still unattractive on a relative valuation basis compared to stocks, but market and macro conditions are no longer as lopsidedly in favor of stocks as they have been.

Volatility returns as investors adjust to policy outlook

Equities, and asset prices in general, have seen a return of volatility during January, following over a year of very subdued volatility and strong returns. Why, especially in a historically favorable seasonal period? In our view, markets are adjusting to the indications of moderately tighter monetary and fiscal policy following a period of extraordinary support from both US macro policy drivers. Investors are debating whether policy makers will be able to reduce stimulus and inflation pressures without provoking excessive economic weakness, and this debate is showing up as volatility in markets.

Macro uncertainty is provoking volatility

Rate policy diverging among global central banks

Central bank policy remains a key focus for investors as rates are set to rise in the US this year, with debate about the pace of the rate hikes and balance sheet adjustment ongoing. However, this is not true everywhere, as there have been growing divergences in expected rate policies among the major developed market central banks.

As shown in the chart below of two-year sovereign bond yields for the US, UK, Japan, and Germany (Eurozone), investors are pricing in multiple rate hikes over the next year or two from the US Fed and the Bank of England (BoE): US and UK two-year yields are at or near 1% now, up from around zero for most of the time since early 2020.