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A Look Through Equity Markets
Welcome to The Observatory. The Observatory is how we at Prometheus monitor the evolution of the economy and financial markets in real-time. The insights provided here are slivers of our research process that are integrated algorithmically into our systems to create rules-based portfolios.
Today, we take a look at equity markets’ performance. Our assessment is that the gains we have seen over the last month have largely come from increases in valuations in technology, communications, and consumer discretionary stocks, while increases in earnings expectations have almost entirely come from the technology sector. This composition of equity market strength shows fairly lopsided improvements and does not look indicative of broad economic strength. Sectors more exposed to the real economy (industrials, materials, & energy) continue to show weak performance. Overall, current equity market strength looks unlikely to be sustained.
When we examine equity markets, we can decompose their total returns into those coming from changes in earnings expectations and valuations. Over May, the S&P 500 rose 0.87%, primarily driven by valuations. Earnings expectations and valuations contributed 0.13% & 0.74% to the 0.87% rise in markets. Below, we show the sequential evolution of market prices, along with our decomposition of returns:
Over the last year, the S&P 500 has been dominantly driven by valuations, with total returns rising by 1.03%. We show cumulative returns on the S&P 500 over the last year, decomposed into earnings expectations and valuations:
We further decompose these yearly returns into their sector contributions. We begin by showing the primary drivers of the S&P 500. We show the top three drivers in blue (Technology, Financials, Industrials) and the bottom three in red (Consumer Discretionary, Healthcare, Energy):
We drill down into these total returns by isolating the changes in earnings expectations. We show the top three drivers in blue (Consumer Staples, Utilities, Energy) and the bottom three in red (Financials, Consumer Discretionary, Technology):
Finally, we examine the contributions of sectors to valuations changes. We show the top three drivers in blue (Financials, Technology, Industrials) and the bottom three in red (Energy, Healthcare, Utilities):
Zooming back into the most recent month, we show the composition of the most recent strength in equity markets. We show the sector-wise composition of the most recent months’ returns, changes in earnings expectations, and changes in valuations below:
Overall, current equity market gains remain lopsided. When assessing the future of equity markets, we think it is important to recognize that sustained gains at the current pace would require either increased valuations or improved growth expectations from sectors more connected to the real economy to sustain the current pace of gains coming from technology, communications, and consumer discretionary stocks.
This context is crucial in evaluating equity market trend strength and sustainability. S&P 500 trend measures remain elevated; however, playing current dynamics forward, there is a considerable chance that trend strength will weaken. We show our S&P 500 trend signal below:
We think there is potential for this to continue the equity trend at the current pace; either technology and related stocks need to continue to see expanding valuations & earnings expectations, or economically sensitive sectors need to see a significant improvement in earnings expectations. Given the headwinds to growth, we think it is unlikely to see either of these outcomes— though further news related to AI may power this rally further. It is crucial to realize that, barring these equity names, equity markets are not pricing strong economic outcomes. At this stage in the economic cycle, it pays to stay cautious. Looking through our trend signals, there remains considerable dispersion within equity sectors, creating long-short opportunities beyond just beta timing. We think being cautious on equity beta or being beta neutral probably makes the most sense here. We show our daily trend signals below:
Until next time.