6 reasons why we are taking some profits

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The S&P 500 had been trading in a narrow range for the past 6 months with some rotation. We were bullish on the index last October because the valuation was attractive. It was at a time when the rate was expected to top in the near term, and dollar strength was peaking.

In 2023, the valuation was challenging due to our expectation of a corporate earnings recession. But, today, we are seeing renewed strength in the index, keen to break up by another 1% higher as we had discussed last week and this week.

Yesterday’s trading reaffirmed this notion as investors await the outcome of the debt ceiling negotiation.

We are taking some chips off the table as the situation is materially different. Our previous bullish outlook was marked by leadership in key sectors: Energy, Materials, Financials and Industrials. At the same time, we see laggards in technology. Small caps were strong, and the market breadth was robust. That is now all in the past.

Fast forward to today, the breadth of the market rebound is very weak. Technology, consumers and discretionary sectors are the only vital sectors participating in the rally. Specifically, AI is the key driver of the bullish sentiment, and it is unlikely to prevent the deep recession that could be impending.

So based on our reading and listening to various literature, here’s the compressed version of 6 key reasons.

#1 Stock market valuations are now demanding

Median estimates multiple to stock valuation stood around 18 times, near the peak of historical reference.

#2 Earnings estimates are too rosy

Earnings estimates continued to appear too optimistic, which could pave the way for downside risk should sectorial miss occur. The risk and reward now appeared to be dimmer. Defensive counters may have the pricing power to help alleviate risk to profit margin. Still, the degree to how much it can be amplified could be challenged as consumers spending power weakens.

#3 The wishlist of Fed cuts is less likely

The market is trying to price in 2-3 Fed cuts before year-end, which is unlikely to happen, at least for now, given a sticker headline core inflation. Instead, it is more likely for the Fed to reduce the rate if the US is sure to reach a hard landing or the credit market deteriorates swiftly.

#4 Tightener monetary policy is set to deepen credit risk

There is an expectation that the banking turmoil is over and it will not worsen and lead to systematic risk. The commercial property sector appeared to be a red light spot for the financial industry and could ignite a new wave of uncertainty.

While we do not foresee the 2008 and 2009 widespread meltdown, the acceleration of the credit crunch could be actual by year-end as loan growth is slowing.

#5 Consumers are more cautious about spending

5) Discretionary spending had slowed despite consumers showing some resilience in the face of geopolitical risk, banking crisis, inflation headwinds and unbalanced supply chain nodes globally.

Recent surveys do show some weakness in spending, even for high-net-worth individuals.

#6 Debt ceiling outcome is the no-man winner

Even as the debt ceiling agreement is reached, we see it as a lose-lose situation. The market will likely display heightened volatility towards the downside if no consensus is achieved. On the other hand, should a bipartisan plan be brought forward, it could have spending cuts, further reducing the economy’s growth potential and pushing it further into recession.

Moreover, increasing the debt ceiling can dampen market liquidity given the expectation of a $1.2 trillion in Treasury bill issuance expected to roll out in the next 6 months.

While significant indices are sparkling and dancing with champagne, the underlying current appears milky and bouncy. As a result, risks are more elevated, and a contraction in liquidity with the debt ceiling passes.

Hence, we are taking profits off our compass as the market tends to top on good news.

It is 23 May, Tuesday, at 9.10 am in Singapore and 9.10 pm in New York. We wish everyone a cool Tuesday morning and a delightful dance to work and school.