Forget the US downgrade. Here's what really matters to the market.
Investors reacted Monday morning to the U.S.'s credit rating before stocks rebounded later. A better bet is to focus on what really drives stock returns: corporate earnings.
The S&P 500 was down early Monday, as investors reacted to the recent decision by Moody's to strip U.S. sovereign debt of its triple-A credit rating. They may be overreacting, While psychologically jarring, history suggests the move will have little impact on stock returns in the longer term.
'The history of U.S. sovereign debt rating agency downgrades spans +10 years and uniformly shows that these actions do not portend higher rates, recession, or lower stock prices," wrote DataTrek analyst Nicholas Colas in a note Monday. 'Over the last 20 years, 10-year Treasury yields were highest when America was AAA rated by all three agencies,"
Indeed, Colas noted Standard & Poor's cut its rating on U.S. debt all the way back in 2011, and Fitch did so in 2023. Neither move ultimately scared investors away from Treasury bonds, which remained capital markets ultimate safe haven. Meanwhile the S&P 500 has enjoyed one of its best stretches in recent memory.
A better way to gauge where stocks are headed may simply be to focus on corporate profits. There has been cause for worry there too, noted Morgan Stanley analyst Michael J. Wilson in a Monday note, but the picture is improving. One of Wilson's preferred gauges is 'earnings revision breadth," a sentiment measure which compares the number of downward earnings revisions issued by Wall Street stock analysts to upward ones.
While the earnings revision breadth measure is still bearish, it's improved dramatically in the past few weeks. Wilson notes that breadth for the S&P 500 is now at -15%, up from a low of -25% in mid-April. If that trend continues, the S&P 500 could approach its mid-February highs.
'The combination of upside momentum in revisions breadth and last week's deal with China has placed the S&P 500 firmly back in our pre-Liberation Day range of 5500-6100," Wilson wrote. 'We think continued upward progress in EPS revisions breadth back toward 0% will be needed to break through 6100 on the upside."
The S&P 500 hit its all-time high of 6144 on Feb. 19
Among the sectors that have enjoyed the biggest rebounds are media and entertainment, materials, capital goods and tech hardware. By contrast, laggards with worsening outlooks include consumer durables, autos and consumer services.
Citi analysts, for their part, are also bearish on consumer stocks, worrying about recent signs that spending by American consumers is slowing. On Friday, the University of Michigan reported its consumer sentiment index slipped to 50.8, its second-lowest reading in more than 40 years.
'We have been [underweight] consumer discretionary and staples stocks this year as the U.S. consumer has been in the crosshairs of tariff policy risk," analysts wrote Friday. 'A worst-case policy impact has seemingly been alleviated, yet recent signs of consumer slowing are concerning."
Citi analysis recommended investors who do want to own consumer stocks pick and choose, with an emphasis on defensive names. To that end, they ran a screen hunting for individual stocks, with low cyclicality, high debt-to-capital ratios and high capital expenditures relative to deprecation.
Among the names that came up: Walmart, Dollar Tree, Amazon and Procter & Gamble.
Write to Ian Salisbury at ian.salisbury@barrons.com
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