It’s a new year and so all the talk in the markets is on what to do at a macro level with the various asset classes. Towards the end of last year, the perception among the financial punditry on both the mainstream media as well as social media was that a recession was imminent. However, as the new year enters, there seems to be a loud and growing chorus in support of the soft landing the Federal Reserve has been espousing. As we looked last week, the bond market is dovish and we see the Fed going on pause and then cutting in the back half of this year and into next year. However, the sum of these cuts would still leave rates above the perceived neutral rate at 2.5% to 2.75%, which may indicate the bond market in aggregate is looking for a soft landing.

If this is the case, what is an equity investor to do? As you can see in the first chart, 2022 was a year where equity markets were driven by the changing multiple of the market (orange) which in turn was driven by the changing view of rates (purple). The price of the SPX Index (blue) was tightly correlated to these moves and quite unrelated to the changing perceptions of earnings (white). With historic tightening by the FOMC, it is not surprising that the actual earnings being reported took a back seat. Earnings are a lagging indicator anyway and you can see earnings were still rising even as the market sold-off in Q2/Q3.

However, 2023 is a new year and perhaps a new focus for investors. With the FOMC potentially going on a pause in the upcoming two meetings, interest rates and multiples may play much less of an influence on stock prices in the coming quarters. We may be at a point where the rubber hits the road and investors want to see what the actual earnings are in a stock, sector, and market before pulling the trigger on investments.

Along these lines, we can see from S&P Cap IQ what is expected this quarter from earnings. We are now in the throes of the earnings season, but coming in, the only places we expected to see growth at the sector level were in energy, industrials, and utilities. All other sectors were expected to have some amount of challenge as growing nominal sales were offset by shrinking margins, and therefore, lower earnings. We can see Real Estate and Communication Services have the lowest expectations. Given the dividend cuts at some big REITs and the layoffs at the big media and tech names, this may not be a surprise.

As I said, we are now in the throes of earnings season with about 10% of the index having reported by the time while I write this and another 15% more in the coming week. So far, the surprise on the sales side is basically nil with a surprise of about 4% on the earnings side. We all know there is a bit of a game that is played between management and analysts, meaning that such earnings almost always come in better than expected. This is why I like to also look at two other components. On the lower left is the surprise level vs. previous quarters. Again, you can see that it has always been positive, but this amount of positive surprise has been shrinking, particularly when it comes to sales.

The other important place to look is on the reaction to the news in the lower right. We have generally seen a positive reaction to news with positive surprises leading to positive moves and vice versa. The big outlier here is in the single report within communications, which came from Netflix, where subscriber growth mattered much more than earnings. So far, I think it is fair to say that investors are responding to good news by buying and to bad news by selling. It is still very early though.

I said the surprise game is always a bit tricky but what have the actual earnings been? The first chart on the expectations at S&P Cap IQ was looking at the actual growth. When we take this view, we can see the picture isn’t so promising, as earnings growth is coming at a negative 4% clip with a majority of sectors showing this negative growth. Again, looking at the lower right for the performance, we can see the picture is a bit more mixed as the gains on actual earnings in Industrials and energy do not see the same price increases and the misses in materials saw positive price moves. It can be a bit tricky to trade the earnings season because of this expectations component. However, stepping back, we do see that earnings are coming lower.

Bulls will be quick to point out that the market is ahead of the curve on this. A chart of the SPX price move vs. the expected forward earnings over the last few years shows this. In white is the move in the index and in blue is the move in expected year forward earnings. We can see coming out of Covid-19, prices moved higher well before earnings reacted. Also, prices have moved lower throughout 2022 in expectations of this earnings decline in blue, which has yet to commence.

This struggle between the bears, that are focused on possible recession and negative earnings, and the bulls, who are focused on this earnings story being priced in as well as in a soft-landing possibility. This may be why the futures have landed at a critical possible inflection point. Many of you have seen variations of this chart, which shows that futures have risen to and bounced off this declining trend line several times in the past year. We are right back to the trend line as we are entering the heart of earnings season. Is this the catalyst for us to finally break through this trend line?

Adding to the possibility is a look at positioning. For this I always refer to the Commitment of Traders report, which I can access through the QuikStrike tool. If I focus in on the positioning among leveraged funds, we can see that there has been a large short of E-mini S&P 500 futures position persistently for the last six months. This is not being driven by spreading in the futures. We can see that this short was reduced into the end of the year, but as the calendar shifted, the short has been growing. Perhaps leveraged funds are adding to either outright shorts or to hedges as we hit this trend line in anticipation of the negative news from earnings.

How can we take advantage of this potential inflection point? The first thing I want to do is look at the term structure of volatility to see if there is any information to be gleaned or any opportunities that stand out. We can see declining volatility through the end of January, which makes some sense because earnings are seen as a micro or idiosyncratic event and not something to be played via the index. However, we see volatility perk back up through early February because of the FOMC meeting on February 2. Volatility then reverts towards the 18 level for the rest of February.

I also want to compare the implied volatility to the historic or realized volatility to know how much of an insurance premium is being built into the price. We can see that the realized volatility the past month is about 17 vs. the 18 implied. This spread of 1 is somewhat close to the mean over the past six months as we can see on the right side of the chart. This suggests to me that implied volatility is somewhat fairly priced at the current levels.

I also want to look at the entire volatility surface to compare the price of both puts vs. calls, but also look at which puts have the highest implied and which calls may look relatively less expensive. This can help us navigate how we choose the strikes for the ideas that we put on. We can get all this information within the QuikStrike tool.

As I pull the information together, I can see the following:

1. Earnings are expected to be poor and are coming in largely in line with expectations
2. Traders are already short the market and we are seeing some positive reaction even to negative news
3. There is a peak in implied around the FOMC, but if we go a little further past, implied volatility is fairly priced both across the term structure and relative to realized or historic volatility
4. Puts have a premium to calls and calls themselves look relatively inexpensive especially given the potential for a big upside move if we breakout above the trend line

My gut tells me to sell puts and buy calls given this set up. However, very few traders are allowed or can afford to have open downside exposure on the short options side, so I would sell a put spread and use this premium to buy upside calls. Yes, there is a risk of negative earnings news, but we are not seeing that as a big catalyst at the moment. In fact, the surprise, if anything, is on better-than-expected news. Given we are very close to the trend line, positive news that cause the breakout could see a quick move higher, thus, I like having open-ended exposure to the topside. In this example, I use the weekly options that go out past the FOMC meeting to sell the 3920-3870 put spread, defining my potential risk. I take that premium and buy a 4150 call. This may seem a bit far away from the current 4007 futures price, but as I indicated, a measured move could take us to 4400.

Both puts are about a 20 implied volatility while the calls are a 17 implied volatility. I am picking up some higher implied, which helps me pull the call strike closer and increase the odds of a payoff. The trade is long delta but has little exposure on the other Greeks.

2023 is set to be a year with a strong consensus that may shift over the course of the year. We see this consensus in not only the commentary but also the positioning. As traders, we like to take advantage when investors may be leaning on the same side of the boat. However, given the very real risks of a recession and downside to earnings, we need a defined risk way of being contrarian. Selling the put spread to buy a call using weekly options may be just the way to do that.

Good luck trading.

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