Excell with Options: Are we going to break or breakout?
Executive summary
With earnings season underway, Rich shares an E-mini S&P 500 options strategy that considers the potential for a market breakout.
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.
Image 1: S&P earnings, P/E and price vs. the 10-year Treasury yield
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.
Image 2: Year over year expected change in Sector earnings per share
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.
Image 3: S&P 500 Index sector earnings surprise analysis
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.