S&P 500: Yes, Be Careful But Don’t Be Too Pessimistic At These Levels (NYSEARCA:VOO)

Bear Market

DNY59

Thesis

The Vanguard S&P 500 ETF (NYSEARCA:VOO) has come under further pressure after we urged investors to add more aggressively in our previous update, given the market pessimism.

Notwithstanding, the market digested the buyers’ attempt to bottom out based on its June lows after the release of a hot CPI print in September. As such, it led to continued volatility in the S&P 500 as the bulls and bears battle it out, even as the VOO attempts to consolidate at its critical support zones.

In a recent commentary on the SPX (SP500), we suggested that investors can no longer ignore the risks of a severe recession with the global macroeconomic headwinds amid the aggressive synchronized policy tightening moves globally.

Despite that, we remain optimistic that we could be closer to the end of the Fed’s tightening cycle. As such, we think the VOO’s reward-to-risk profile still points to the upside at these levels. Notwithstanding, investors are urged to consider the outside risks of a policy error that could result in further downside volatility. However, investors should not view such an outcome negatively but positively, as it could further improve their potential outperformance moving forward.

Hence, we reiterate our Buy rating on the VOO, but encourage investors to layer in their exposure, taking advantage of potential downside volatility.

Higher Risks Of Recession, And Rates Could Remain High

The recent release of the Fed Beige Book suggests that the Fed has acknowledged the increasing risks of a recession, given its aggressive rate hikes to nix record inflation rates. The Fed highlighted:

Outlooks grew more pessimistic amidst growing concerns about weakening demand. Several Districts reported a cooling in labor demand, with some noting that businesses were hesitant to add to payrolls amid increased concerns of an economic downturn. – Bloomberg

Bloomberg Economics highlighted in a recent update that it sees a 100% chance of a recession in the next twelve months, above the consensus estimates of a 60% chance. Therefore, the Fed’s updated commentary is now in sync with the consensus base case of a recession. With that in mind, investors are demanding to know when the Fed will be ready to pause its unprecedented rate hikes at least and assess the fallout, transiting into a “data-dependency” mode.

Economists expect the Fed to start cutting rates in late 2023 or early 2024. St. Louis Fed President James Bullard (who sits on the 2022 FOMC) also suggested that “2023 should be a data-dependent sort of year.” Bullard is well-known to be one of the FOMC’s most hawkish members, and therefore his commentary suggests that the Fed could pause its rate hikes in 2023 after December’s hike.

However, the determination of the Fed’s terminal rate is still up for grabs, with Edward Yardeni highlighting 4.5% to 4.75% as a distinct possibility in his October 18 briefing. However, Bloomberg Economics US chief economist Anna Wong (former Fed principal economist) was more cautious, suggesting that the Fed Fund rate (FFR) could reach 5%. That means Bloomberg Economics prognosticates that another 50 bps hike is necessary in early 2023 before the Fed could pause and move into “data-dependency” mode.

Wong’s caution emanated from the Fed’s staff notes indicating that the US economy was well above its potential output in 2021, which resulted in record inflation rates in 2022. She articulated:

The policy implication is significant. Lower potential growth means the economy has been more overheated last year and this year than realized, and it will take more rate hikes or a longer period of below-trend growth to close the output gap. [We] estimate the [Fed] will deliver a fourth consecutive 75 basis-point rate increase next month and keep going until they get rates in the 5% range next year. – Bloomberg Economics

So, What Now?

As usual, economists and market strategists cannot decide how high the FFR could get. If the rate hikes need to persist higher and longer, it’s more likely than not that the recession could be worse-than-expected.

Our analysis suggests that the market has likely priced in a mild-to-moderate recession but not a severe one, as explained in our recent SPX article.

Hence, if the market were to anticipate that a worse fallout is increasingly likely, then investors need to be prepared that the market could reprice the VOO markedly downward to reflect worse recessionary risks ahead of time (as the market is forward-looking).

So, the question is, how far down?

VOO price chart (monthly)

VOO price chart (monthly) (TradingView)

Note that the VOO has not given up its long-term uptrend bias, despite the significant bear market in 2022. Its 50-month moving average (blue line) has continued to stanch further selling downside from June to October, despite the recent downside volatility.

Therefore, from a bigger-picture perspective, the current levels are attractive. Long-term buyers have consistently appeared over the past ten years to deny a decisive break of VOO’s 50-month moving average. Even the downside break in March 2020 turned out to be an astute bear trap before a robust bullish reversal followed.

VOO price chart (weekly)

VOO price chart (weekly) (TradingView)

A closer look at VOO’s medium-term chart evinces the robustness of its June lows. The market is still attempting to form a bullish reversal (not validated yet) despite last week’s selloff. Hence, the market’s positioning suggests that it expects the current thesis of a mild-to-moderate recession to hold, which has likely been priced in.

However, if the market anticipates a worse recession moving ahead, then investors need to expect more downside volatility after adding at the current levels. As such, investors should then wait patiently for the VOO’s intermediate support to be re-tested successfully before adding more exposure.

Therefore, it’s critical for investors to layer in overtime and improve their chances of capitalizing on downside volatility.

Is VOO ETF A Buy, Sell, Or Hold?

The S&P 500 last traded at an NTM P/E of 15.3x. Therefore, it’s far from the levels seen in 2008 (closer to 9x) but is quite close to the levels in 2020 (13x).

S&P 500 Net earnings revisions %

S&P 500 Net earnings revisions % (Yardeni Research, Refinitiv)

Notwithstanding, Street analysts remain optimistic about the resilience of US companies through the recession, as the earnings estimates revisions remain relatively low compared to past recessionary scenarios.

The recent Q3 earnings release from the banks in the S&P 500 also indicate that they do not expect a significant recession in 2023. FactSet highlighted that the industry’s provisions for losses are much lower than the 2020 bear market, even though they are markedly higher than 2019’s metrics. Therefore, we postulate that banks remain cautiously optimistic through the cycle.

As such, we believe the price action and underlying metrics suggest that the current levels remain attractive for long-term buyers to add exposure to the VOO, despite the pessimism.

We reiterate our Buy rating on the VOO.

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