Market Update
PORTFOLIO STRATEGY
Weekly Market Guide
March 2, 2023
The month of February was a reality check for investors following January’s surge higher on “soft landing” optimism, as sticky inflationary readings over the past several weeks resulted in higher rate expectations, rising bond yields, and lower equities. It is a reminder that the path ahead will be a lumpy process and that the market is not ready to sprint back to new highs. We expect choppy trading over the coming weeks and months, as investors digest the economic dataflow- and sentiment swings may occur due to elevated uncertainty on inflation, Fed policy, and ultimately economic growth. That said, we do remain positive on equities over the next 12 months and view the recent pullback as opportunity to accumulate favored areas within a longer-term perspective.
Fed rate hike expectations have moved substantially higher as a result of the recent “sticky” inflation readings. For example, the market-implied peak Fed funds rate is now 5.46% by September vs. an expected peak just one month ago of 4.88% by June. This shift in expectations is pushing bond yields higher- the 2-year yield is up to 4.95% (cycle highs) and the 10-year yield is up to 4.06% (approaching October highs of 4.23%)- which is a headwind to equity valuations.
But just as the “goldilocks” market view was unjustified, this current adjustment in the other direction may be misguided as well. The highest odds are that the normalization process (from pandemic/record stimulus) will create confusing data along the way with upside runs and pullbacks to follow for equities. Until we get some clarity regarding inflation and then the economy, a market run to new all-time highs is a low probability. But the amount of technical positives over recent months also suggest that the lows of this bear market may be in. Hence, the pullback can be accumulated with a percentage of cash set aside and earmarked for equities.
- Don’t overthink Growth vs. Value- stay with diversity. If the economy does not rollover, Value may continue to lead. If the economy softens to the point to drive rates down, Growth may lead (on a relative basis).
- Mid-caps have some of the best price momentum. Small-caps are holding up and likely justify at least an equal weight. Risk of economic weakness (they suffer more) holds us back from being too bullish or overweight.
- Global- although it is tough to square with potential economic weakness ahead, the technical price momentum is difficult to ignore (despite it being driven by dollar weakness). The result is an equal weighting in-line with long-term targets- potential economic weakness keeps us from being overweight. Emerging Markets are interesting with China reopening (and pulling back).
- Bonds- 10-year yield nearing top of near-term range?
Also Highlighted in This Week’s Report:
- The Fed, Bond Yields, and Equities
- Earnings and Valuation
- Technical: S&P 500
- Global Markets and US Dollar
- Consumer Discretionary
- Communication Services
PORTFOLIO STRATEGY
Weekly Market Guide
February 16, 2023
Equity markets have experienced a strong start to the year- the average S&P 500 stock is up ~8% YTD with outperformance coming from the higher-beta, harder-hit areas in last year’s decline. This is significant, as technical improvements often come well ahead of the fundamentals out of bear markets.
On one hand, the technical positives are becoming difficult to ignore. For example, the S&P 500 held its 200-week moving average at the October lows (a good level of long-term support). Investor sentiment and net positioning reached depressed levels, and selling conviction decreased at the October lows vs. June lows. Additionally, the S&P 500 staged impressive breadth thrusts in the advance and broke above its 12-month downtrend with a risk-on tone. These are characteristics often consistent with a market attempting to turn out of bear market lows. We do view equities as overbought in the short-term and due some consolidation.
On the other hand, we also believe that a glide path higher (V-bottom) is unlikely at this point. 2023 will be heavily influenced by the degree of inflation moderation, central bank policy, and ultimately the level of economic weakness inflicted (in order to bring inflation down). This week’s stickier-than-expected CPI and PPI reports support our view that the path to inflation normalizing is unlikely to be smooth. Core CPI and core PPI rose 0.4% and 0.5% respectively- both likely to keep the Fed uneasy and more restrictive. To be sure, we do believe the Fed will be successful in bringing inflation down, but this process will also take some time.
Market-implied Fed expectations have shifted toward a hike-and-hold Fed strategy over the past two weeks, rather than optimism for a dovish pivot in the back half of this year- and this is resulting in higher bond yields. The US 2-year yield is back up to 4.67% (near cycle highs from early November), and the US 10-year yield has risen to 3.85% (from 3.40% two weeks ago). This is a headwind to equities in our view, as P/E multiples have held a strong inverse correlation to bond yields over the past two years. Moreover, earnings estimates continue to get revised lower- and we expect this trend to continue as Fed tightening (which remains ongoing) works with a lag on economic growth.
The net result is a bottoming process and recovery that are likely elongated- with normal back-and-forth trading along the way. We believe that stocks will be higher over the next 12 months as investors gain clarity on inflation, Fed policy, and their impacts on economic growth. Multiple expansion will drive upside despite weak earnings growth (as stocks discount the future). However, that clarity needed for sustained appreciation is also likely to take some time. And with equities short-term overbought in our view, we recommend exercising some patience at current levels- using weakness as opportunity to accumulate favored stocks for the longer-term.
Also Highlighted in This Week’s Report:
- Core Inflation Based on Potential Monthly Paths
- Interest Rates and Valuation
- Earnings Declining, What’s the Right Multiple?
- Emerging Markets
- Communication Services
PORTFOLIO STRATEGY
Weekly Market Guide
January 12, 2023
Equities are bouncing to begin the new year, buoyed by the past week’s December jobs and CPI reports. Nonfarm payrolls rose by a still strong 223k, but investor focus was on the 0.3% wage growth reading that came in below expectations- a welcomed sign as moderating wage growth should ease inflationary pressures. Additionally, December core CPI rose by 0.3% m/m, which brings the 3-month annualized rate down to just 3.1% (from 7.9% last June). The net takeaways for monetary policy are that the Fed still has more work to do but likely can scale back its pace of rate hikes (as inflation is still elevated). Depending on the data ahead, the Fed may be able to stop hiking rates near 5% (from 4.5% today). But the Committee will also be reluctant to cut rates until inflation is clearly on a sustainable path to its target of ~2%, avoiding a potential repeat of the stop-and-go policy that spurred stagflation in the ’70s. The Fed wants to end high inflation while they can with a hike-and-hold policy this time in our view.
A major catalyst for individual stocks will be Q4 earnings season, which kicks off tomorrow morning with the banks. We expect lackluster results for S&P 500 earnings (with economic leading indicators contracting), but the focus will be on forward guidance, what is baked into that guidance (economic expectations), and the market’s reaction to results. Whereas market weakness into Q3 results may have set up stocks for positive reactions last quarter, the average S&P 500 stock is now 16% off its lows and weak earnings may be more of a headwind this reporting season.
Lower valuations were the major influence on equity market returns in 2022, as stocks discounted earnings weakness to come. Now that earnings estimates are declining (which we expect to continue), the question becomes how much negativity is priced in? We have yet to see that capitulation (“throw in the towel”) moment that can sometimes occur at the end of bear markets- where valuations briefly reach depressed levels. However, multiples have contracted 41% from their peak already and may have already seen their lows. With this in mind, the overall market trend may become more sideways, and our long-term positive outlook lends itself to using weak periods as opportunity.
Technically, we believe the pattern of lower highs and lower lows in 2022 will be broken, as the downtrend becomes more range-bound (potentially ~3700-4300) over the coming months. The chance of breakouts is increasing (many stocks are shaping up technically), hence the potential to move up to 4300 at some point. On the flip side, even if 3700 is broken on the downside, we do not currently feel that a new low will be established. Our rationale comes from inflation readings that are likely to improve (which can lead to rally periods), but also remain volatile. Upside inflation throughout 2022 likely becomes moderating inflation in 2023. Market trends will improve on this, but it will also take some time before we know if high wage growth and inflation are moving down to the Fed’s target (jobs are a lagging result of tightening). Therefore, double digit declines are still a high probability as investor sentiment can shift rapidly.
Also Highlighted in This Week’s Report:
- Q4 Earnings Season
- Bond Yields and Valuation
- Technical Backdrop- Many Charts Are Shaping Up
- 2022’s Laggards Are Leading To Start 2023