The S&P 500 is up more than 8% since mid-June, leading to speculation about whether or not a bottom is in following the market turmoil that consumed the first half of 2022.
But according to Jason Hsu, the pain is a long way from over.
Hsu, the founder and CIO of Rayliant, which manages $22 billion in assets, said in a recent commentary that downward revisions to corporate earnings are ahead as the US economy moves into a recession, meaning stocks have another leg down.
Up until now, the sell-off in stocks has been drive by price multiple compression due to rapidly rising interest rates, not earnings destruction.
"The second shoe has yet to fall," Hsu said. "In a recession, especially one that follows a speculative bubble economy with mass over-investment, the decline in earnings can be precipitous. This means prices must fall more before P/E contracts back toward normality."
He continued: "I predict that once we start to see earnings decline, it will signal the most difficult part of the recession – but it will also be the period during which the best tactical buying opportunities will emerge."
Hsu said on Thursday that the downside would be another 20% following the completion of the current rally. From Thursday's levels, a 20% drawdown would put the S&P 500 around 3,150. From January's peak, that's a 34% drop.
But the rest of the decline won't be quick, he said.Markets Insider
Stocks are likely to finally bottom in the first half of 2023, Hsu believes.
Hsu's argument is based on his view that inflation will soar above 10% in the coming months. The premier measure of inflation, the Consumer Price Index, currently sits at 9.1% year-over-year.
The pressure this will put on the Federal Reserve to tighten policy even harder, he said, will send the economy into recession.
"There's nothing special about 10% other than it's a scary round number," Hsu said. "The Fed's going to try really hard, but I think we're going to cross that, and once we cross it, I think all hell breaks loose. The Fed will be under such pressure to put in an even more aggressive course of rate hikes, and the narrative is going to turn toward 'the Fed has lost control of inflation.'"
The bottom will come when the focus shifts from inflation to the labor market, he said. Eventually, the Fed will begin quantitative easing again, leading to another rally.
Stocks are entering a critical period as firms begin to report their second-quarter earnings . Like Hsu, many strategists see a rough road ahead for the market due to impending downward earnings revisions and negative forward guidance from companies.
Morgan Stanley, Goldman Sachs, and other Wall Street institutions have all warned of earnings being hurt by inflation and a strengthening dollar , which hurts revenue from exports.
Glenmede, a private wealth management firm, pointed out in a note earlier this month that the current bear market is the only one of the four since 2000 that hasn't seen negative earnings, but that this may change.Glenmede
"So far, the ongoing bear market is the first of the millennium to feature rising earnings estimates. In each of the other three, the peak-to-trough decline in the S&P 500 could be attributed to a mix of falling earnings estimates and falling valuation multiples (e.g., price-to-earnings ratios) that are applied to those estimates," Jason Pride, Glenmede's CIO, said in the note.
Walmart, one of the largest retailers in the country and a bellwether for the health of the economy, revised downward their profit guidance on Monday . The firm now expects earnings to decline by between -11% and -13% in 2022 compared to the -1% drop they had been expecting.
The development could signal trouble for other retailers. Shares of Walmart fell nearly 10% on the news in after-hours trading.
In addition to earnings, investors will be paying close attention to the Federal Open Market Committee meeting this week, when the central bank makes decisions on rate hikes and gives guidance on how they will approach monetary policymaking going forward.
The Fed is expected to hike 75 basis points for the second meeting in a row — and just the second time since 1994 — as they attempt to cool inflation. More hawkish or dovish messaging than is expected could send the market on a more sustainably bearish or bullish path in the months ahead.
Key economic data also lies ahead. The Q2 GDP report will be released on Thursday , and if the economy posts negative growth for the second quarter in a row, the economy would be officially considered in a recession by the traditional definition. Expectations are for a 1.6% decline, according to the Atlanta Fed.
The severity of the negative growth, if that is the case, along with the results of July's CPI report in August, will inform how the Fed behaves in future meetings.