Stock Market Headed Toward Severe Sell-off
Over the past six months, stocks have performed extremely well. The S&P 500, which is usually considered a measure of the overall stock market, has increased by about 12% over the past six months. Those are impressive returns, but past performance really doesn’t mean much. Investors have to focus on what’s ahead. Sadly, the stock market’s outlook seems gloomy at best.
This is not the time to be complacent. The fundamentals of the stock market are getting more dire with each passing day. The odds of a broad market sell-off are increasing. The volatility that’s ahead could make what we saw in 2022 seem like a cakewalk.
If you want to know the direction of the stock market, you need to know three factors: earnings expectations, the economy, and investor sentiment.
The stock market moves heavily based on corporate earnings. If earnings are expected to be good, there will be a stock market rally. If earnings are expected to fall hard, a stock market crash will eventually follow.
The current economic conditions give us an indication of how high business earnings will be in the near future.
Investor sentiment is also key. You can have robust corporate earnings and a great economy, but if investor sentiment is dire, the stock market won’t go up much (if at all). If earnings are dismal, the economy is in bad shape, and investor sentiment is extremely pessimistic, there will likely be a stock market crash.
Earnings Expectations Suggest Stock Market Is in Trouble
As it stands, business earnings expectations are horrible, to say the least.
Companies have just started reporting their first-quarter 2023 financial results. Going into this earnings season, analysts were expecting companies on the S&P 500 to report a decline of close to seven percent in their earnings per share (EPS).
The number of S&P 500 companies that issued negative guidance for their first-quarter EPS is concerning, too. As of April 6, 78 S&P 500 companies issued negative guidance for the first quarter, while 28 issued positive EPS guidance. That means, for each positive first-quarter EPS guidance, there were 2.8 negative ones. The number of companies that issued negative EPS guidance was above the five-year average of 57 and the 10-year average of 65. (Source: “Earnings Insight,” FactSet Research Systems Inc., April 6, 2023.)
Earnings expectations for the second quarter have been getting worse, too. At the beginning of 2023, analysts were expecting a second-quarter EPS decline of 0.5% for S&P 500 companies. (Source: “Earnings Insight” FactSet Research Systems Inc., January 6, 2023.)
Now, analysts expect the second-quarter EPS of S&P 500 companies to drop by 4.6%! (Source: FactSet Research Systems Inc., April 6, 2023, op. cit.)
Keep in mind, the second quarter just began at the beginning of April.
Economic Conditions Getting Worse
Moreover, the U.S. economy is in very bad shape these days.
Inflation has taken a toll on average consumers, the savings rate has plunged, and consumer spending figures have started to show cracks. Don’t forget, consumers are one of the biggest forces in the U.S. economy—consumption amounts to about 70% of the total U.S. gross domestic product (GDP).
The U.S. housing market has started to take a downward turn, too: home sales numbers have been plunging, and home prices have been dropping a bit.
Furthermore, business activity has been slowing down. Job cuts and layoffs have been growing, and companies haven’t been hiring workers fast enough.
Investors Aren’t Too Excited About Stocks
As for investor sentiment, it’s pessimistic right now.
Take a look at the chart below. It plots the National Association of Active Investment Managers (NAAIM) Exposure Index.
This index shows what portion of active investment managers’ portfolios consist of stocks. When the NAAIM Exposure Index is at 100, it means active money managers are fully invested in stocks. When the index is over 100, it means active money managers are leveraged long on the stock market.
Since 2021, active money managers haven’t been very excited about stocks. Since late 2021, their portfolios haven’t been fully invested in stocks. This says pessimism.
Chart courtesy of StockCharts.com
But don’t stop there; look at another chart below. This chart plots the percentage of bullish responses to the American Association of Individual Investors (AAII) Sentiment Survey. On a weekly basis, this survey asks individual investors where they see the stock market going in the next six months.
Since early 2022, fewer than 30% of the respondents to the AAII Sentiment Survey have been bullish. In April 2022, the bullish responses dropped to as low as 17.5%! In the most recent AAII Sentiment Survey, just 26.1% of the respondents were bullish on the stock market. The historical average is about 37.5%.
Chart courtesy of StockCharts.com
Stock Market Outlook: Bare-Minimum Drop of 16%?
Dear reader, at the moment, irrationality prevails in the stock market. One of the only factors that has kept the market resilient over the past few months is investors’ hope that the Federal Reserve will pivot when it comes to its monetary policy and lower interest rates. No one is really talking about the fundamentals that matter.
The irrationality can go on for a while, but not forever. The fundamentals matter in the long term. So, investors need to be careful. Being complacent could result in big losses.
How low could the stock market go? If investors come to their senses, I think we could easily see the S&P 500 fall to its October 2022 lows (roughly 16% below where the S&P 500 currently sits). If those lows break, there could be a lot more downside.
However, not everything about the stock market is bad right now. I truly believe there are opportunities present all the time, no matter how things appear from a bird’s eye view. Companies with consistent financial performances, great products, growing markets, and capable management teams tend to go unhurt no matter what.