Home Trading ETFs SPDR SPY: We’re In The Eye Of The Storm (NYSEARCA:SPY)

SPDR SPY: We’re In The Eye Of The Storm (NYSEARCA:SPY)

by Vidya
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For those who aren’t aware, the SPDR S&P 500 Trust ETF (NYSEARCA:SPY) tracks the S&P 500 index and is often utilized as a reference for the broader index. Today’s article provides an outlook for the SPY with inferences drawn from the S&P 500’s key metrics.

After much debate, we’ve realized that the market is a long way from its bottom, and we believe SPY could be set for a further downturn; here’s why.

Chart
Data by YCharts

Overview & Proximities

The SPY and S&P 500 are closely correlated as the SPY’s tracking errors are infinitesimal. I’d say that much of the tracking error is because SPY holds some cash in its portfolio while the S&P 500 is a stock-only composite. Moreover, the turnover of the SPY ETF is high, meaning that it’s a liquid asset without thin trading disrupting its price efficiency.

Tracking Error vs S&P 500

Seeking Alpha

Valuation

The S&P 500 is often valued by utilizing the Fed model, which measures the relationship between long-dated government bond yields and the earnings yield of the composite. The intuition here is to forecast whether realized interest rates and the earnings yield will converge, diverge or remain parallel. Based on the index’s latest data, the 10-year treasury yield is shooting up sharply (4.7), while the index’s earnings yield is assuming moderate growth at 2.9. Thus, based on ex-post data, it makes logical sense for stocks to retreat in the current cross-asset environment.

FED MODEL

Yardeni Research

Although the Fed model provides a lucrative way to describe the index’s ex-post returns, a forward-looking approach must be used in conjunction. Yardeni’s theory suggests that forward earnings be considered rather than the current earnings yield.

Instead of using a discrete metric to opine on future earnings, I’d rather provide a rundown of what I anticipate for the index’s forward earnings.

SPY Constituents.

Seeking Alpha

Considering the SPY’s sector composition in relation to the yield curve is necessary. I highlight this because of the effect of cyclicality on differing sectors.

Nearly 25% of the SPY comprises of technology stocks, 11% of consumer cyclical stocks, more than 8% of the index comprises industrials, and more than 5% of the index is filled with real estate and basic materials. In essence, nearly 50% of the index could head for a cyclical downturn if interest rates follow along the yield curve as these sectors are sensitive to contractionary economic policies.

To touch more on the yield curve. At a minimum, the economy could be under contractionary monetary policies for the next 2 years (as displayed by the yield curve). Whether economic activity wanes or not is another debate. However, the stock market is forward-looking, and as long as the curve holds, it’s likely going to price a decline in forward earnings, especially as the curve starts to level in the medium term. I’d thus say that a large portion of the index’s forward earnings yield could be in trouble, while it’s also clear that the 10-year yield will remain firm.

Yield Curve

Gurufocus

A few more factors worth mentioning here are the financial sector, which makes up roughly 13% of the index, and non-cyclical stocks, which make up approximately 37% of the index.

Financial stocks are in the balance at the moment. One would usually say they’d rise over the coming years as the banking industry’s earnings strongly correlate with rising interest rates. However, the opposite could happen if we head into a period where rising rates cause stagflation or, even worse, a recession.

According to Goldman Sachs (NYSE:GS) it’s 15% to 30% likely that we will enter a recession. At the other end of the spectrum is Citigroup- (NYSE:C), which thinks we’re near 50% likely to enter a near-term recession.

Recessions are part of the economic cycle, and I won’t be surprised if we enter one in the near term, which could send financial sector companies’ earnings into a downward spiral. However, defensive stocks such as healthcare, consumer discretionary, communications, and utilities could hang on to preserve the future earnings yield to some extent.

To conclude this section. I expect forward earnings to decline due to a cyclical retreat. Additionally, the long-term bond yields will probably remain elevated, compressing the overall valuation of the S&P 500 and SPY.

Technical Level

If we look at modern bear markets, it’s safe to say that they’ve all lasted a long time apart from the 2020 bear market. My opinion is that the 2020 bear market recovered quickly as it wasn’t caused by an asset bubble but rather an external non-market-related event. Moreover, governments and central banks were well equipped to apply expansionary economic policies, which soon dissolved the pressure.

S&P 500 Price Level

Wong, J. (2022), Bloomberg Terminal.

More extensive history indicates that there have been an array of long and short-dated bear markets. However, it’s necessary to consider the nature of the current bear market that we’re in. Today’s market is comparable to the 1970s’ bear market, which lasted 1.2 years. It’s a market characterized by high inflation, no capacity to operate at low-interest rates any longer, and industrialization is in full flow.

In our opinion, this bear market has only just begun as there’s a long way to go before we reach economic balance. Furthermore, there’s an array of new asset classes such as cryptocurrencies, SPACs, and NFTs. It remains to be seen whether there could be secondary effects on these asset classes, which could further dilute the near-term prospects of the broader financial marketplace.

Bear Markets

BMG Group

From a pure price level vantage point, the SPY is trading below its 10-, 50-, 100-, and 200-day moving averages, meaning that the SPY is on a downward spiral and will likely require a catalyst to change its fate.

A Few Positives

Although most matters are grim, there remain a few potentials that could lead to a recovery for SPY. First of all, the industrialization process during the past years has brought about several secular growth companies benefiting from a highly leveraged economy. Thus, a recovery could be possible if the 2022 bear market was a technical correction more than anything else.

Furthermore, many North American energy companies look set to enjoy multiple years of success as U.S. oil and gas production has increased by 60% in the past year amid energy shortages. So, in the event of the SPY rebalancing with various energy stocks, we could see support being provided to its broader valuation.

Concluding Thoughts

The SPY looks overvalued if one considers the S&P 500 earnings yield, forward earnings potential, and the shape of the yield curve on long-duration bonds. Furthermore, SPY remains top-heavy with cyclical stocks such as the technology sector, which could wane as the risk of a recession emerges. Lastly, technical levels imply that this could be a prolonged bear market amid the nature of economic circumstances that are proximate to those in the 1970s.



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