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How to Make the Most of Today's Market

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Stocks have enjoyed a few positive sessions in recent days. Driving this shift, in sentiment, appears to be optimism about Fed policy and a corporate earnings picture that is far better than many in the market were fearing.

Many in the market justifiably see the Fed moving towards concluding its extraordinary cycle in the next few months. Improved visibility on this front has prompted many in the market to buy quality stocks at discounts. This narrative is sanguine about the Fed, sees inflation as having already peaked and sees nothing egregious with valuations, given improved visibility for interest rates and a stable earnings outlook that has smoothly adjusted lower.

Market bears see this emerging optimism in the market as without a solid basis and view the positive stock market gains of recent days as nothing more than a bear-market rally in a long-term downtrend. This line of thinking sees inflation as far ‘stickier’, which requires the Fed to continue tightening for a while. Valuation worries also figure prominently in the bearish view of the market.

The interplay of these competing views will determine how the market performs in the coming months and quarters. To that end, let’s examine the landscape of bullish and bearish arguments to help you make up your own mind.

Let's talk about the Bull case first.

Inflation & the Fed: The outlook for inflation and what that means for Fed policy is the biggest point of difference between market bulls and bears at this point in time. The bulls see peak inflation readings to be in the rearview mirror at this stage, with the steadily decelerating trend of the last 6 months firmly remaining in place. Declines in commodity prices and signs of cooling demand as a result of moderating economic activities provide confirmation of this favorable inflation view. We saw proof of this in the soft internals of the seemingly strong Q4 GDP report and consensus expectations for the coming periods.

It is hard to argue with the bulls’ view that the heightened post-lockdown demand in a number of product and service categories was bound to eventually normalize, with its attendant beneficial effect on prices. Related to the above argument are favorable developments on the supply side of the equation as the worst of the supply-chain snarls have started easing. The recent reversal of China’s zero-Covid policies further strengthen this trend, with continued disruptions caused by the war on Ukraine partly offsetting the gains.

With interest rates already close to the neutral level, investors are looking at incoming economic data through the prism of what it tells them about inflation and growth. The market correctly sees the Fed implementing a 25 basis-point (bp) rate hike next week, which would follow the 50 bp hike in December and the extraordinary four back-to-back 75 bp hikes preceding that.

We are at the ‘pivot’ stage already, without the Fed explicitly telling us in so many words. After the February 1st hike, they will be 50 bps away from their indicated peak rate, meaning at most the following two meetings.

The market sees these coming rate hikes as the beginning of the end for the Fed’s tightening cycle and is anticipating it through pricing action ahead of time. The stock market optimism in recent days, that coincided with seemingly reassuring Q4 earnings results, is likely an early attempt to do just that.

Continued . . .


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The Economy’s Strong Foundation: The strong Q4 GDP report notwithstanding, the U.S. economy’s growth trajectory has shifted gears in response to the combined effects of aggressive Fed tightening, persistent logistical bottlenecks and the runoff in the government’s Covid spending. This is beneficial to the central bank’s inflation fight, particularly the demand-driven part of pricing pressures, as we saw in the decelerating trend in the Q4 GDP report’s price deflator reading.

Many in the market are legitimately concerned about rising recession risks as a result of the unprecedented Fed tightening. While such risks have undoubtedly increased, a recession is by no means the only or even most likely outcome for the U.S. economy. Underpinning this view is the rock-solid labor market characterized by strong hiring and a record low unemployment rate. It is hard to envision a recession without joblessness.

The purchasing power of lower-income households has likely been eroded by inflationary pressures, as confirmed by a number of companies during their earnings calls. But household balance sheets in the aggregate are in excellent shape, with plenty of savings still left from the Covid days. This combination of labor market strength and plenty of savings cushion should help keep consumer spending in positive territory in the coming quarters.

While estimates for the coming periods have been coming down, the Zacks economic team is projecting below-trend but nevertheless positive GDP growth in 2023.

All in all, the strong pillars of the U.S. economic foundation run contrary to what are typically signs of trouble ahead on the horizon.

Valuation & Earnings: Tied to the economic and interest rate outlook is the question of stock market valuations that have become very alluring after last year’s pullback.

The S&P 500 index is currently trading at 18X forward 12-month earnings estimates, up from 15.4X at the end of September 2022, but down -24.7% from the peak multiple of 23.9X some time back. It is hard to consider this valuation level as excessive or stretched, particularly given emerging signs of optimism on the Fed front.

Granted there are parts of the market that need to get rerated as the full effects of the Fed’s tightening cycle take hold, resulting in cooling consumer and business demand and moderating economic growth. But not all sectors are exposed to the ongoing Fed-driven negativity in outlook to the same degree, as sensitivity to interest rates and the macroeconomy are much bigger drivers for some sectors than others.

We are starting to see this bifurcation in earnings outlook in the ongoing Q4 earnings season already, with operators in the at-risk sectors unable to have adequate visibility in their business. But there are many other companies that continue to drive sales and earnings growth in this environment.

We have seen many of these leaders from a variety of sectors and industries, including Technology, come out with strong quarterly results in recent days.

Contrary to fears ahead of the start of the Q4 earnings results, the actual results are turning out to be fairly stable and resilient. Estimates for the coming periods have been steadily coming down already, with 2023 earnings outside of the Energy sector now down more than -12% since peaking in April 2022. While it is reasonable to expect some further downward adjustment to estimates for macroeconomic reasons, the overall earnings outlook is now largely in-line with the economic ground reality. In the absence of a nasty economic downturn, the earnings picture can actually serve as a tailwind for the stock market in an environment of diminishing Fed uncertainty.

Let's see what the Bears have to say in response.

Endemic Inflation & Fed Tightening: Thursday’s Q4 GDP report showed that the U.S. economy was still far too strong to ease the Fed’s inflation worries. A big part of the strong ‘headline’ GDP growth number was due to contribution from inventories that tends to be volatile, the report nevertheless showed plenty of strength in household and business spending.

The decline in inflation readings in recent months has resulted from pullback in commodity prices, the easing of logistical bottlenecks and moderation in demand for the ‘goods’ part of the economy. The much tougher part of the inflation fight is on the services side of the economy. Given ongoing trends in wages and rents, to name just two areas, inflation is likely a lot stickier than most people assume.

Many in the market believe that the Fed’s tough policy stance last year was meant to counteract the damage to its inflation-fighting credentials as a result of its earlier ‘transitory’ narrative. Given this, the central bank simply can’t afford to declare a premature victory and risk the inflation scourge to reemerge.

The Valuation Reality Check: A big driver of the stock market’s earlier bull run was the Fed’s ability to flood the market with liquidity. The central bank achieved that by keeping interest rates at zero and buying a boat-load of U.S. treasury and mortgage-backed bonds that expanded its balance sheet to almost double the pre-Covid size.

Fed tightening and the associated higher interest rates have a direct impact on the prices of all asset classes, stocks included. Everything else constant, investors will be required to use a higher discount rate, a function of interest rates, to value the future cash flows from the companies they want to invest in.

This means lower values for stocks in a higher interest rate environment.

The Growth Question: Since Fed rate hikes work with a lag, the central bank’s aggressive tightening moves since March 2022 likely haven’t fully seeped into the economy.

Current projections of GDP growth for this year assume that the Fed is successful in executing a ‘soft landing’ for the U.S. economy as it moves towards concluding the current policy stance in the coming months. That said, most projections show the U.S. economy barely in positive territory as it exits 2023.

There is no basis for us to doubt this confidence in the central bank’s abilities, but we shouldn’t lose sight of history that tells us that economic growth typically falls victim to the Fed’s inflation-fighting efforts.

A handy metric to keep an eye on for growth outlook is the spread between the 2-year and 10-year treasury bond yields. Inversion in this metric, as is the case at present, will suggest the need for reigning in growth expectations.

Where Do I Stand?

I am very skeptical of the bearish Fed tightening outlook and see this scenario as nothing more than a worst-case or low-probability event.

My base case all along, saw the Fed moving from the then ‘stimulative’ policy stance to one that was only modestly ‘restrictive’. Following the already implemented rate hikes, the level of interest rates is at the ‘neutral’ policy level, when Fed policy is neither ‘stimulating’ nor ‘restricting’ economic activities.

Estimating an accurate level for ‘neutral’ policy is very difficult in real time, but most analysts believe that we will be in ‘restrictive’ territory after this week’s expected 25 bps hike.

The Fed will most likely shift to a ‘wait and see’ mode after two more rate hikes of that magnitude. This appears to be the most plausible scenario given the risks to growth as a result of premature tightening, a threat to the Fed’s second ‘full employment’ mandate.

The recent pullback in benchmark treasury yield and positive momentum in the stock market reflects this interpretation. The resulting stability in financial conditions and interest rates should keep the economy’s growth trajectory in place, admittedly at a moderate pace.

Regular readers of my earnings commentary know that the earnings picture continues to be resilient, with the steady downward revisions to estimates since the April 2022 peak having brought them in-line with the economic ground reality. In the coming months, the market will start looking past this year’s moderating earnings growth picture to the eventual recovery on that front.

The market’s recent positivity reflects a growing convergence to our favorable views on the Fed and the growth questions. We don’t envision these questions to be put to rest next week, but we do see investors eventually coming around to our view of inflation, earnings and the much more positive times ahead after a short period of volatility.

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¹ The results listed above are not (or may not be) representative of the performance of all selections made by Zacks Investment Research's newsletter editors and may represent the partial close of a position.


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