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How to Make the Most of Today's Market

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Stocks have lost ground lately, with the S&P 500 index losing roughly 4% of its value from its recent record peak. Driving this shift in sentiment appears to be worries about the economy’s health in light of a delayed Fed easing cycle.

Inflation readings over the last few months have been moving in the right direction, but this followed unfavorable readings in the first three months of the year. While this uneven progress on the inflation front delayed the start of the easing process, market bulls remain sanguine about the Fed and inflation and see nothing egregious with valuations.

Market bears see this optimism in the market as without a solid basis and view the ongoing market weakness as the start of the long-awaited market sell off. This line of thinking sees inflation as ‘stickier’, leaving the Fed no room to loosen policy any time soon. 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 continues to be the market’s major driver. The bulls see the inflation issue as headed towards a resolution to the central bank’s satisfaction, with the recent run of decelerating monthly readings resuming last year’s favorable trend.

The bulls saw inflation as primarily resulting from pandemic related factors, with the combination of elevated Covid-driven demand in a number of product and service categories and snarled supply chains showing up in higher prices. These factors were on course to normalize in the post-Covid period anyway, but the Fed’s extraordinary tightening policy speeded up the process by moderating demand.

The Fed question on the market’s collective mind is about the timing of the first-rate cut and the number of subsequent cuts. In addition to direct Fed guidance, investors are looking at incoming economic data through the prism of what it tells them about inflation and growth.

The bulls acknowledge that economic growth is moderating in the aggregate and parts of the economy like housing, manufacturing and other rate sensitive areas are already suffering. They would like the central to forestall any further risks to the growth outlook by cutting rates.

The message coming out of the latest Fed meeting is that start easing policy at its next meeting, which is in September.

Continued . . .

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The Economy’s Strong Foundation: The U.S. economy remains is in solid shape as was reconfirmed by last week’s better-than-expected Q2 GDP report. But if we step back from the quarterly GDP reading and compare the economy’s growth pace in the first half of 2024 relative to the second half of 2023, it becomes clear that the growth trajectory has moderated in response to tighter Fed policy.

This is beneficial to the central bank’s inflation fight, particularly the demand-driven part of pricing pressures, as the downtrend in the GDP report’s price deflator reading confirmed.

Bears still remain worried about recession risks, but the U.S. economy’s resilient performance in the face of extraordinary Fed tightening has significantly increased the soft-landing odds. Underpinning this view is the rock-solid labor market characterized by strong hiring, an unemployment rate that is still low by historical standards, and steady wage gains. 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 on their recent earnings calls. But household balance sheets in the aggregate are in excellent shape, even though most of the Covid savings have largely been used up by now. This combination of labor market strength and steady wage gains 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 the second half of 2024.

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 still look reasonable given the expected interest rate trajectory.

The S&P 500 index is currently trading at 21.5X forward 12-month earnings estimates, up from 15.6X at the end of September 2022 but down -11.2% from the peak multiple of 24.2X some time back. It is hard to consider this valuation level as excessive or stretched, particularly given the coming Fed easing cycle.

The appropriateness or otherwise of valuation multiples has to be seen in the context of interest rate outlook. Valuation multiples typically expand when the Fed is easing policy, particularly when the catalyst for the loosened policy is confidence on the inflation front instead of growth fears.

Earnings outlook is a key part of the valuation discussion. Contrary to the earlier doom-and-gloom fears, the ongoing 2024 Q2 earnings season is reaffirming the resiliency and stability of the corporate profitability picture, with the growth pace expected to steadily improve in the coming quarters.

What we are seeing this earnings season is that while companies in a number of industries are unable to have adequate visibility in their business, there are many others that continue to drive sales and earnings growth even in this environment. We are seeing many of these leaders from a variety of sectors, including Technology, come out with strong quarterly results and describe trends in their businesses in favorable terms.

Current consensus expectations for this year and next reflect a resumption of strong growth after two years of below-trend profitability growth. In fact, the earnings outlook has started improving lately, with earnings estimates for this year and next starting to go up in recent weeks.

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 easing Fed policy.

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

The Market’s Fed Exuberance: At the start of the year, the consensus view reflected five to six rate cuts in 2024. But this view has shifted markedly after three back-to-back unfavorable inflation readings over the last three months. The expectation at present is for one or two rate cuts this year, with the first cut in September provided incoming economic data over the remaining two months remain supportive.

The risks to this outlook are twofold. The first is that the September rate-cut timeline may not pan out, as it will be next to impossible for the Fed to start cutting rates at its next meeting if next two inflation readings fail to show progress on the inflation front. This is exactly how inflation behaved in the first three months of the year, forcing a reset of the market’s Fed expectations.

Tied to the first risk is the prospect that economic health may be far more fragile than the quarterly GDP readings suggest. Low income households have been struggling for a while, but anecdotal evidence from Q2 earnings calls suggest that even better off consumers are getting more cautious in their spending plans.

In the worst case scenario, stalled progress on the inflation front may stop the Fed from easing policy even as the economy continues to weaken further. But even if that isn’t the case and the Fed starts easing in September or any of its subsequent meetings, the decelerating momentum in the economy may be hard to stop by then.

The Valuation Reality Check: Given the bears’ view that the prudent course for the Fed is to be in no hurry to start easing policy in the absence of any issues in the economy, they see no fundamental reason for valuation multiples to expand.

Higher-for-longer interest rates should have a direct impact on the prices of all asset classes, stocks included. Everything else is constant, investors will be using 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 Earnings Growth Question: Current consensus earnings estimates show +8.5% growth this year and +14.4% growth in 2025, which follows the modest earnings decline in 2023.

Market bears see these earnings growth expectations as inconsistent with the soft-landing outlook for the economy.

Notwithstanding the tough going in the manufacturing sector and the growth implications of the still inverted yield curve, earnings expectations for this year and will need to come down significantly to get them in-line with the economic ground reality.

Where Do I Stand?

While I acknowledge that the first rate cut can get pushed out from the September meeting, I am skeptical of the higher-for-longer Fed policy view and see this scenario as nothing more than a low-probability event.

The current Fed Funds rate level is almost twice what central bank officials and economists see as the ‘neutral’ policy rate. At the ‘neutral’ policy rate level, Fed policy is neither ‘stimulating’ nor ‘restricting’ economic activities.

Even if further progress on the inflation front is a lot slower than what the Fed and the market is projecting at present, the central bank has plenty of cushion in its policy arsenal to start easing policy without adversely affecting its inflation fight. This doesn’t mean that first rate cut is around the corner, but it does suggest that they don’t need to wait for an extended period to consolidate the inflation gains.

Given this year’s electoral calendar, I wouldn’t be surprised for the first rate cut to arrive in the post-election November meeting, particularly if labor market readings in the intervening months to continue to remain favorable. In other words, the ‘big disappointment’ will be nothing more than a few months delay in the start of the easing policy.

Regular readers of my earnings commentary know that the earnings picture continues to be resilient, with recent developments on the earnings front showing a favorable turn in the revisions trend. Importantly, positive estimate revisions are spreading beyond the trend’s earlier core in the Tech space.

The market’s recent weakness and tentativeness reflects a reassessment of the evolving economic outlook in light of a September or delayed onset to the Fed’s easing cycle. The recent run of some soft economic readings is a good-enough reason to go through this reassessment process. But we remain confident that investors will soon come around to our view of inflation, earnings and the much more positive times ahead after a short period of volatility.

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Stock #1:  Web3 Firm Making a Massive Turnaround
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Over the next year, this fast-expanding miner is poised to double production of one of today’s most in-demand commodities. With crazy low valuations (like its 9.0X P/E ratio) and a track record of crushing earnings, this stock is poised for a huge breakout.

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Businesses and consumers are increasingly using non-traditional financial tools to buy, sell and access their money – a trend that will only accelerate. The firm’s shocking 73% EPS growth projected for next year is a strong indicator of good things to come.

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Thanks and good trading,

Sheraz

Sheraz Mian serves as the Director of Research and manages the entire research department. He also manages the Zacks Focus List and Zacks Top 10 Stocks portfolios. He invites you to access Zacks Investor Collection.

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. Access grants you a comprehensive list of all open and closed trades.


 

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