The point of maximum pessimism?

Oversold markets primed for rally, but caution still warranted

Equity markets may continue to rally from oversold conditions in the near term despite weakening economic and corporate earnings data that could limit future gains and lead to more volatility ahead.

In fact, according to AGFiQ’s latest analysis, several facets of the market remain deeply depressed and could garner further support from investors who believe them to be underperforming at an unreasonable extreme.

For instance, U.S. equities deemed expensive (from a value perspective) or low quality are among the most oversold, as are those characterized as high-beta names and those that attract the most short-selling interest from investors (see “Short Interest” graph below). In each of these cases, losses have been far more than the broad U.S. equity market, which has been down as much as 25% and fallen into bear market territory on two separate occasions year-to-date. 

Similarly, some sectors of the U.S. equity market are equally oversold (or almost as much), including, most notably, communications services, consumer discretionary, information technology, and real estate. Unsurprisingly, many stocks within these sectors are characterized by higher valuation (i.e., they’re expensive) and higher beta profiles, as well as heightened sensitivity to higher interest rates.

Of course, how much these oversold factors and sectors can rally from here largely depends on the evolving macro backdrop for stocks. Our research shows that the future performance of high-beta stocks may be hindered by the deterioration in U.S. Purchasing Manager Indexes (PMIs), which have fallen from the four-decade high in March 2021 to just above 50 in recent months.

(Note: PMIs measure the prevailing direction of economic trends in manufacturing. A PMI above 50 represents an expansion when compared with the previous month while a PMI reading under 50 represents a contraction.)

While this level is still deemed a signal of an expanding economy, the direction PMIs have taken of late clearly marks a significant deceleration in the pace of economic expansion. Moreover, they may have further to fall before bottoming despite easing pressures on inputs (i.e., supply chains and prices) as well as strong employment and production offsetting somewhat softer demand. After all, based on our research over the past 40 years, PMIs typically bottom lower (signifying a slightly deeper economic contraction than average) following an aggressive tightening by the U.S. Federal Reserve – like what is happening now.

Beyond that, earnings revisions may be another headwind that keeps a lid on the potential for markets to rally much more from here.

Again, our research shows a rapid decline in the breadth of estimate revisions this year and only about 30% of stocks have had their earnings revised upwards (through October), while 70% have been revised down. And not only that, the magnitude of upward revisions has also fallen significantly, while the magnitude of downward revisions is getting larger.

Given this dynamic, it’s not surprising that most of the worst-performing sectors mentioned above – communication services, information technology, consumer discretionary – are the ones with some of the worst downward earnings revisions to date.

Perhaps that suggests the worst is over for these sectors, but further estimate revisions to the downside should be expected as the current cycle progresses – at least if history is any guide.

All in then, the combination of extreme oversold conditions, incrementally improving price pressures, and the potential overshoot in earnings pessimism could help push equity markets higher in the near term. However, investors should remain cautious as the economic and earnings backdrop continues to evolve. In this environment, a balanced approach to both high- and low-beta stocks and a continued focus on higher quality names may help investors take advantage of potential upside in markets while also navigating the risk of greater volatility to come. 

Abhishek Ashok, M.A., MFE, CFA, is Analyst at AGF Investments Inc. He is a regular contributor to AGF Perspectives. Click to learn more about AGF’s quantitative capabilities.

Notes and Disclaimer

© 2022 by AGF Ltd. This article first appeared in AGF Perspectives. Reprinted with permission.

The commentaries contained herein are provided as a general source of information based on information available as of November 18, 2022 and are not intended to be comprehensive investment advice applicable to the circumstances of the individual. Every effort has been made to ensure accuracy in these commentaries at the time of publication, however, accuracy cannot be guaranteed. Market conditions may change and AGF Investments accepts no responsibility for individual investment decisions arising from the use or reliance on the information contained here.

References to specific securities are presented to illustrate the application of our investment philosophy only and do not represent all of the securities purchased, sold or recommended for the portfolio. It should not be assumed that investments in the securities identified were or will be profitable and should not be considered recommendations by AGF Investments.

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