by Scott Martindale
  President & CEO, Sabrient Systems LLC

The year began with the market showing resilience in the face of the Fed’s rate hikes, balance sheet contraction, hawkish rhetoric, and willingness to inflict further economic pain, including a recession and rising unemployment (if that’s what it takes). Of course, we also had a treacherous geopolitical landscape of escalating aggression by Russia in Ukraine, by China (regarding both Ukraine and Taiwan), and North Korea (persistent rocket launches and saber-rattling). But really, the direction for stocks came down to the trend in inflation and the Fed’s response—and the latest readings on CPI and especially PPI are quite encouraging. But alas, it now appears it isn’t quite that simple, as we have a burgeoning banking crisis to throw another monkey wrench into the mix. As Roseanne Roseannadanna used to say in the early Saturday Night Live sketches, "It just goes to show you, it's always something—if it ain't one thing, it's another."

I warned in my January post that 1H 2023 would be volatile as investors searched for clarity amid a fog of macro uncertainties. And I often opine that the Fed can’t rapidly raise rates on a heavily leveraged economy—which was incentivized by ZIRP and massive money supply growth to speculate for higher returns—without fallout (aka “breaking something”). Besides impacts like exporting inflation and societal turmoil to our trading partners, the rapid pace of rate hikes has quickly lowered the value of bank reserves (as bond prices fell). Last week this in turn led to massive portfolio losses and a federal takeover for SVB Financial (SIVB) which caters to California’s start-up and technology community, as it was pushed into selling reserves to meet an onslaught of customer withdrawals. The normally stable 2-year T-Note spiked, crashing its yield by over 100 bps in just a few days. Other regional banks have required rescue or support as well, including stalwarts like Signature Bank (SBNY) and First Republic (FRC)…and then scandal-prone European behemoth Credit Suisse (CS) revealed “material weaknesses” in its accounting…and Moody’s cut its outlook on US banks from stable to negative. So, something indeed broke in the financial system.

Fortunately, inflation fears were somewhat assuaged this week, as all reports showed trends that the Fed (and investors) hoped to see. February CPI registered 6.0%, which is the lowest reading since September 2021. Despite the historical observation that a CPI above 5% has never come back down to a desirable level without the fed funds rate exceeding CPI, we already have seen CPI fall substantially from 9.1% last June without fed funds even cracking the 5% handle, much less 6%—and CPI is a lagging indicator. So, given the 12 encouraging signs I describe in my full post below, I believe the writing is on the wall, so to speak, for a continued inflation downtrend.

So, the question is, will the Fed feel it must follow-through on its hawkish inflation-busting jawboning at the FOMC meeting next week to force the economy into recession? Or will recovering supply chains (including manufacturing, transportation, logistics, energy, labor) and disinflationary secular trends continue to provide the restraint on wage and price inflation that the Fed seeks without having to double-down on its intervention/manipulation?

My expectation is the latter—and it’s not just due to the sudden banking crisis magnifying fragility in our economy. Nothing goes in a straight line for long, and inflation is no different, i.e., the path is volatile, but disinflationary trends remain intact. I talk more about this in my full post below. Regardless, given the anemic GDP growth forecast (well below inflation) and the historical 90% correlation between economic growth and aggregate corporate profits, the passive broad-market mega-cap-dominated indexes that have been so hard for active managers to beat in the past may well continue to see volatility.

Nevertheless, many individual companies—particularly within the stronger sectors—could still do well. Thus, investors may be better served by pursuing equal-weight and strategic-beta ETFs as well as active strategies that can exploit the performance dispersion among individual stocks—which should be favorable for Sabrient’s portfolios, including the newest Q1 2023 Baker’s Dozen, Small Cap Growth 37, and Dividend 43 (offering both capital appreciation potential and a current yield of 5.2%), all of which combine value, quality, and growth factors while providing exposure to both longer-term secular growth trends and shorter-term cyclical growth opportunities.

Quick plug for Sabrient’s newest product, a stock and ETF screening and scoring tool called SmartSheets, which comprise two simple downloadable spreadsheets that provide access to 9 of our proprietary quant scores. Prior to the sudden fall of SIVB, on a scale of 0-100 with 100 the “best,” our rankings showed SIVB carried a low score in our proprietary Earnings Quality Rank of 35, a GARP (growth at a reasonable price) score of 37, and a BEAR score (relative performance in weak market conditions) of 13. Also worth mentioning, Lantheus Holdings (LNTH) was consistently ranked our #1 GARP stock for the first several months of the year before it knocked its earnings report out of the park on 2/23 and shot up over +20% in one day. (Note: you can find our full Baker’s Dozen performance details here.) Feel free to download the latest weekly sheets using the link above—free of charge for now—and please send us your feedback!

Here is a link to a printable version of this post. In this periodic update, I provide a comprehensive market commentary, offer my technical analysis of the S&P 500 chart, review Sabrient’s latest fundamentals based SectorCast quant rankings of the ten U.S. business sectors, and serve up some actionable ETF trading ideas. To summarize, our SectorCast rankings reflect a slightly bullish-to-neutral bias, the technical picture looks short-term oversold, and our sector rotation model has taken a defensive posture. Technology has taken over the top position in our sector rankings. Read on…

  by Scott Martindale
  President & CEO, Sabrient Systems LLC

The future direction of both stocks and bonds hinges on the trajectory of corporate earnings and interest rates, both of which are largely at the mercy of inflation, Fed monetary policy, and the state of the economy (e.g., recession). So far, 2023 is off to an impressive start, with both stocks and bonds surging higher on speculation that inflation will continue to subside, the Fed will soon pause rate hikes, the economy will endure at most a mild recession, China reopens, and corporate earnings will hold up…not to mention, stocks have risen in the year following a midterm election in every one of the past 20 cycles. The CBOE Volatility Index (VIX) is at a 52-week low.

Moreover, although inflation and interest rates surged much higher than I predicted at the beginning of 2022, my broad storyline around inflation and Fed policy remains intact:  i.e., a softening of its hawkish jawboning, followed by slower rate hikes and some balance sheet runoff (QT), a pause (or neutral pivot) to give the rapid rate hikes a chance to marinate (typically it takes 9-12 months for a rate hike to have its full effect), and then as inflation readings retreat and/or recession sets in, rate cuts commence leading to an extended relief rally and perhaps the start of a new (and lasting) bull market. Investors seem to be trying to get a jump on that rally. Witness the strength in small caps, which tend to outperform during recoveries from bear markets. However, I think it could be a “bull trap” …at least for now.

Although so far consumer spending, corporate earnings, and profitability have held up, I don’t believe we have the climate quite yet for a sustained bull run, which will require an actual Fed pause on rate hikes and more predictable policy (an immediate dovish pivot probably not necessary), better visibility on corporate earnings, and lower market volatility. Until we get greater clarity, I expect more turbulence in the stock market. In my view, the passive, broad-market, mega-cap-dominated indexes that have been so hard for active managers to beat in the past may see further weakness during H1 2023. The S&P 500 might simply gyrate in a trading range, perhaps 3600–4100.

But there is hope for greater clarity as we get closer to H2 2023. If indeed inflation continues to recede, China reopens, the war in Ukraine doesn’t draw in NATO (or turn nuclear), the dollar weakens, and bond yields fall further, then investor interest should broaden beyond value and defensive names to include well-valued growth stocks help to fuel a surge in investor confidence. I believe both stocks and bonds will do well this year, and the classic 60/40 stock/bond allocation model should regain its appeal.

Regardless, even if the major indexes falter, that doesn’t mean all stocks will fall. Indeed, certain sectors (most notably Energy) should continue to thrive, in my view, so long as the global economy doesn’t sink into a deep recession. Quality and value have regained their former luster (and the value factor has greatly outperformed the growth factor over the past year), which means active selection and smart beta strategies that can exploit the performance dispersion among individual stocks seem poised to continue to beat passive indexing in 2023—a climate in which Sabrient’s approach tends to thrive.

For example, our Q4 2021 Baker’s Dozen, which launched on 10/20/21 and terminates on Friday 1/20/23, is outperforming by a wide margin all relevant market benchmarks (including various mid- and small-cap indexes, both cap-weighted and equal-weight) with a gross total return of +9.3% versus -10.2% for the S&P 500 as of 1/13, which implies a +19.5% active return, led by a diverse group encompassing two oil & gas firms, an insurer, a retailer, and a semiconductor equipment company. Later in this post, I show performance for all of Sabrient’s live portfolios—including the Baker’s Dozen, Forward Looking Value, Small Cap Growth, and Dividend (which offers a 4.7% current yield). Each leverages our enhanced model that combines Value, Quality, and Growth factors to provide exposure to both longer-term secular growth trends and shorter-term cyclical growth and value-based opportunities. By the way, the new Q1 2023 Baker’s Dozen launches on 1/20.

Here is a link to a printable version of this post. In this periodic update to start the new year, I provide a comprehensive market commentary, discuss the performance of Sabrient’s live portfolios, offer my technical analysis of the S&P 500 chart, review Sabrient’s latest fundamentals based SectorCast quant rankings of the ten U.S. business sectors, and serve up some actionable ETF trading ideas. To summarize, our SectorCast rankings reflect a modestly bullish bias, the technical picture looks short-term overbought but mid-term neutral, and our sector rotation model remains in a neutral posture. Energy continues to sit atop our sector rankings, given its still ultra-low (single digit) forward P/E and expectations for strong earnings growth, given likely upside pricing pressure on oil due to the end of Strategic Petroleum Reserve releases (and flip to purchases), continued sanctions on Russia, and China’s reopening…and assuming we see only a mild recession and a second half recovery. Read on…

  by Scott Martindale
  President & CEO, Sabrient Systems LLC

Investors found optimism and “green shoots” in the latest CPI and PPI prints. As a result, both stocks and bonds have rallied hard and interest rates have fallen on the hope that inflation will continue to subside and the Fed will soon ease up on its monetary tightening. Still, there is a lot of cash on the sidelines, many investors have given up on stocks (and the longstanding 60/40 stock/bond allocation model), and many of those who are the buying the rally fear that they might be getting sucked into another deceptive bear market rally. I discuss in today’s post my view that inflation will continue to recede, stocks and bonds both will gain traction, and what might be causing the breakdown of the classic 60/40 allocation model—and whether stocks and bonds might revert back to more “normal” relative behavior.

Like me, you might be hearing highly compelling and reasoned arguments from both bulls and bears about why stocks are destined to either: 1) surge into a new bull market as inflation falls and the Fed pivots to neutral or dovish…or 2) resume the bearish downtrend as a deep recession sets in and corporate margins and earnings fall. Ultimately, whether this rally is short-lived or the start of a new bull market will depend upon the direction of inflation, interest rates, and corporate earnings growth.

The biggest driver of financial market volatility has been uncertainty about the terminal fed funds rate. DataTrek observed that the latest rally off the October lows closely matches the rally off the 12/24/2018 bottom, which was turbocharged when Fed Chair Jerome Powell backed down from his hawkish stance, which of course has not yet happened this time around. Instead, Powell continues to actively talk up interest rates (until they are “sufficiently restrictive”) while trying to scare businesses, consumers, and investors away from spending, with the goals of: 1) demand destruction to push the economy near or into recession and raise unemployment, and 2) perpetuate the bear market in risk assets (to diminish the “wealth effect” on our collective psyche and spending habits). Powell said following the November FOMC meeting that it is “very premature” to talk about a pause in rate hikes.

Indeed, the Fed has been more aggressive in raising interest rates than I anticipated. And although some FOMC members, like Lael Brainard, have started opining that the pace of rate hikes might need to slow, others—most notably Chair Powell—have stuck unflinchingly with the hawkish inflation-fighting jawboning. However, I think it is possible that Powell has tried to maintain consistency in his narrative for two reasons: 1) to reduce the terminal fed funds rate (so he won’t have to cut as much when the time comes for a pivot), and 2) to not unduly impact the midterm election with a policy change. But now that the election has passed and momentum is growing to slow the pace given the lag effect of monetary policy, his tune might start to change.

As the Fed induces demand destruction and a likely recession, earnings will be challenged. I believe interest rates will continue to pull back but will likely remain elevated (even if hikes are paused or ended) unless we enter a deep recession and/or inflation falls off a cliff. Although the money supply growth will remain low, shrinking the Fed balance sheet may prove challenging due to our massive federal budget deficit and a global economy that is dependent upon the liquidity and availability of US dollars (for forex transactions, reserves, and cross-border loans)—not to mention the reality that a rising dollar exacerbates inflationary pressures for our trading partners and anyone with dollar-denominated debt.

Thus, the most important catalyst for achieving both falling inflation and global economic growth is improving supply chains—which include manufacturing, transportation, logistics, energy, and labor. Indeed, compared to prior inflationary periods in history, it seems to me that there is a lot more potential on the supply side of the equation to bring supply and demand into better balance and alleviate inflation, rather than relying primarily on Fed policy to depress the demand side (and perhaps induce a recession). The good news is that disrupted supply chains are rapidly mending, and China has announced plans to relax its zero-tolerance COVID restrictions, which will be helpful. Even better news would be an end to Russia’s war on Ukraine, which would have a significant impact on supply chains.

In any case, it appears likely that better opportunities can be found outside of the passive, cap-weighted market indexes like the S&P 500 and Nasdaq 100, and the time may be ripe for active strategies that can exploit the performance dispersion among individual stocks. Quality and value are back in vogue (and the value factor has greatly outperformed the growth factor this year), which means active selection is poised to beat passive indexing—a climate in which Sabrient's GARP (growth at a reasonable price) approach tends to thrive. Our latest portfolios—including Q4 2022 Baker’s Dozen, Forward Looking Value 10, Small Cap Growth 36, and Dividend 41 (which sports a 4.8% current yield as of 11/15)—leverages our enhanced model-driven selection approach (which combines Quality, Value, and Growth factors) to provide exposure to both: 1) the longer-term secular growth trends and 2) the shorter-term cyclical growth and value-based opportunities.

By the way, if you like to invest through a TAMP or ETF, you might be interested in learning about Sabrient’s new index strategies. I provide more detail below on some indexes that might be the timeliest for today’s market.

Here is a link to a printable version of this post. In this periodic update, I provide a comprehensive market commentary (including constraints on hawkish Fed actions and causes of—and prognosis for—the breakdown of the classic 60/40 portfolio), discuss the performance of Sabrient’s live portfolios, offer my technical analysis of the S&P 500 chart, review Sabrient’s latest fundamentals based SectorCast quant rankings of the ten U.S. business sectors, and serve up some actionable ETF trading ideas. To summarize, our SectorCast rankings reflect a modestly bullish bias, the technical picture looks short-term overbought but mid-term bullish, and our sector rotation model has moved from a defensive to neutral posture. Read on...

  by Scott Martindale
  President & CEO, Sabrient Systems LLC

The rally to kick off Q4 was most welcome, but it quickly petered out. We must acknowledge that macro conditions are still dicey, and no industry is showing leadership—not even the Energy industry, with oil prices surging and green energy getting a tailwind from the new IRA spending bill. The traditional 60/40 stock/bond portfolio could be in for its worst year ever as interest rates surge while stocks flounder. Only the dollar is strong, as the US dollar index has hit its highest level in 20 years.

On the one hand, some commentators believe that things always look darkest before the dawn, so perhaps a bottom is near, and it is time to begin accumulating good companies. Others say there needs to be one more leg down, to perhaps 3400 on the S&P 500 (and preferably with the VIX touching 40), before the buying opportunity arrives. Either is a near-term bullish perspective, which aligns with my view.

On the other hand, there are those who say that markets don’t clear out such massive distortions quite so quickly. So, after such a long period in which “buy the dip” has always paid off (for many traders, it has been so their entire adult life), things are different now, including no “Fed put” or the shadowy “Plunge Protection Team” to backstop the market. Indeed, they say that given the persistent inflation, central banks can no longer embolden speculators by jumping in quickly to cushion market risk—and so, we should be preparing ourselves for global economic restructuring, broad liquidation, and a long, wealth-destroying bear market. This is not my expectation.

The most important number these days is the CPI, and the September number came in at 8.2%, which was only slightly below August’s 8.3%. Of course, inflation is a lagging indicator, and new Fed monetary policy actions can take several months to show their impact, but the Fed’s hawkish jawboning indicates it has less fear of a “doing too much than too little,” which I disagree with as I discuss in today’s post. Although the Fed’s preferred PCE gauge isn’t released until 10/28, market consensus following the CPI print is now for a 75-bp rate hike on 11/2 followed by another 75-bp hike on 12/14, and then a final 25-50 bps in February before it ultimately pauses with the fed funds rate around 5% or so.

However, because the September CPI print (again, a lagging indicator) shows a flatline with some slowing in inflation, it bolsters my ongoing view that inflation is on the decline, the economy is slowing down fast, and the Fed ultimately will raise less than expected (perhaps even calling for pause to watch and reflect after a 75-bp hike on 11/2) because of the vulnerabilities of a hyper-financialized global economy to rapidly rising rates and an ultra-strong dollar. Even bearish Mike Wilson of Morgan Stanley believes the Fed will need to tone down its hawkish monetary policy as global US dollar liquidity is now in the "danger zone where bad stuff happens.” In effect, a strong dollar creates QT (quantitative tightening) of global monetary policy.

It all hinges on the trajectory of corporate earnings and interest rates, both of which are largely at the mercy of the trajectory of inflation, Fed monetary policy decisions, and the state of the economy (e.g., recession). I believe inflation and bond yields are in volatile topping patterns (including the recent "blow-off top" in the 10-year Treasury yield to over 4.0%). Supply chains are gradually recovering (albeit hindered by Russia’s war) and the Fed is creating demand destruction, recession, and a global investor desire for the safety and income of elevated Treasury yields. Also constraining the Fed’s ability to shrink its balance sheet is a world hungry for dollars (for forex transactions, reserves, and cross-border loans), a massive federal debt load, and the reality that a rising dollar is painful to other currencies by exacerbating inflationary pressures for our trading partners and anyone with dollar-denominated debt service.

The biggest risks of course are catastrophic escalation in the war, or untamed inflation coupled with a rapid withdrawal of liquidity…or the possibility that central banks’ disinflationary tools of yore are no longer effective. But if inflation and nominal yields continue to fall, real yields (nominal minus inflation) should follow, leading to a neutral Fed pivot, improving corporate profitability, rising earnings, and perhaps some multiple expansion on stock valuations (e.g., higher P/Es). I discuss all of this in today’s post.

We continue to suggest staying long but hedged (e.g., with leveraged inverse ETFs and index puts). For long positions, a heightened emphasis on quality is appropriate, with a balance between value/cyclicals/dividend payers and high-quality secular growers. Sabrient’s terminating Q3 2021 Baker’ Dozen shows a +6% active gross total return versus the S&P 500 through 10/14 (even without any Energy exposure), while the latest Q3 2022 Baker’s Dozen that launched on 7/20 already shows a +8% active return of (with 23% Energy exposure). Also, our latest Dividend portfolio is sporting a 5.5% yield.

By the way, if you are a financial advisor who uses a TAMP (like SMArtX or Envestnet, for example) and might be interested in adding one of Sabrient’s new index strategies to your portfolio mix, please reach out to me directly for discussion! We have 17 strategies to consider. I provide more detail below on 3 strategies that might be the most timely today.

Here is a link to a printable version of this post. In this periodic update, I provide a comprehensive market commentary, offer my technical analysis of the S&P 500 chart, review Sabrient’s latest fundamentals based SectorCast quant rankings of the ten US business sectors, and serve up some actionable ETF trading ideas. To summarize, our SectorCast rankings reflect a bullish bias, with the top 5 scorers being economically sensitive sectors. In addition, the technical picture shows the S&P 500 may have successfully tested critical support at its reliable 200-week moving average, although our sector rotation model remains in a defensive posture. Read on…

  by Scott Martindale
  President & CEO, Sabrient Systems LLC

The S&P 500 officially entered a bear market by falling more than -20% from its all-time high in January, with a max peak-to-trough drawdown of nearly -25% (as of 6/17). The Nasdaq Composite was down as much as -35% from its November all-time high. During the selloff, there was no place to hide as all asset classes floundered – even formerly uncorrelated cryptocurrencies went into a death spiral (primarily due to forced unwinding of excessive leverage). But then stocks staged an impressive bounce last week, although it was mostly driven by short covering.

Earlier this year when stocks began their initial descent, laggards and more speculative names sold-off first, but later, as the selling accelerated, the proverbial baby was thrown out with the bathwater as investors either were forced to deleverage (i.e., margin calls) or elected to protect profits (and their principal). Even the high-flying Energy sector sold off on this latest down leg, falling over -25% intraday in just 10 days, as the algorithmic momentum trading programs reversed from leveraged buying of Energy to leveraged selling/shorting.

These are common signs of capitulation. So is historically low consumer and investor sentiment, which I discuss in detail later in this post. But despite the negative headlines and ugly numbers, it mostly has been an orderly selloff, with few signs of panic. The VIX has not reached 40, and in fact it hasn’t eclipsed that level since April 2020 during the pandemic selloff. Moreover, equity valuations have shrunk considerably, with the S&P 500 and S&P 600 small caps falling to forward P/Es of 15.6x and 10.8x, respectively, at the depths of the selloff (6/17). This at least partially reflects an expectation that slowing growth (and the ultra-strong dollar) will lead to lower corporate earnings than the analyst community is currently forecasting. Although street estimates have been gradually falling, consensus still predicts S&P 500 earnings will grow +10.4% in aggregate for CY2022, according to FactSet. Meanwhile, Energy stocks are back on the upswing, and the impressive outperformance this year of the Energy sector has made its proportion of the S&P 500 rise from approximately 2% to 5%...and yet the P/Es of the major Energy ETFs are still in the single digits.

A mild recession is becoming more likely, and in fact it has become desirable to many as a way to hasten a reduction in inflationary pressures. Although volatility will likely persist for the foreseeable future, I think inflation and the 10-year Treasury yield are already in topping patterns. In addition, supply chains and labor markets continue their gradual recovery, the US dollar remains strong, and the Fed is reducing monetary accommodation, leading to demand destruction and slower growth, which would reduce the excess demand that is causing inflation.

Bullish catalysts for equity investors would be a ceasefire or settlement of the Russian/Ukraine conflict and/or China abandoning its zero-tolerance COVID lockdowns, which would be expected to help supply chains and further spur a meaningful decline in inflation – potentially leading to a Fed pivot to dovish (or at least neutral)…and perhaps a melt-up in stocks. Until then, a market surge like we saw last week, rather than the start of a V-shaped recovery, is more likely just a bear market short-covering rally – and an opportunity to raise cash to buy the next drawdown.

Nevertheless, we suggest staying net long but hedged, with a heightened emphasis on quality and a balance between value/cyclicals and high-quality secular growers and dividend payers. Moreover, rather than investing in the major cap-weighted index ETFs, stocks outside of the mega-caps may offer better opportunities due to lower valuations and higher growth rates. Regardless, Sabrient’s Baker’s Dozen, Dividend, and Small Cap Growth portfolios leverage our enhanced model-driven selection approach (which combines Quality, Value, and Growth factors) to provide exposure to both the longer-term secular growth trends and the shorter-term cyclical growth and value-based opportunities. In particular, our Dividend Portfolio – which seeks quality companies selling at a reasonable price with a solid growth forecast, a history of raising dividends, a good coverage ratio, and an aggregate dividend yield approaching 4% or more to target both capital appreciation and steady income – has been holding up well this year. So has our Armageddon Portfolio, which is available as a passive index for ETF licensing.

In this periodic update, I provide a comprehensive market commentary, offer my technical analysis of the S&P 500 chart, review Sabrient’s latest fundamentals based SectorCast quant rankings of the ten US business sectors, and serve up some actionable ETF trading ideas. To summarize, our SectorCast rankings reflect a bullish bias, with 5 of the top 6 scorers being cyclical sectors. In addition, the near-term technical picture looks neutral-to-bearish after last week’s impressive bounce, and our sector rotation model remains in a defensive posture.  Read on...

  by Scott Martindale
  President & CEO, Sabrient Systems LLC

Needless to say, investors have been piling out of stocks and bonds and into cash. So much for the 60/40 portfolio approach that expects bonds to hold up when stocks sell off. In fact, few assets have escaped unscathed, leaving the US dollar as the undisputed safe haven in uncertain times like these, along with hard assets like real estate, oil, and commodities. Gold was looking great in early-March but has returned to the flatline YTD. Even cryptocurrencies have tumbled, showing that they are still too early in adoption to serve as an effective “store of value”; instead, they are still leveraged, speculative risk assets that have become highly correlated with aggressive growth stocks.

From its record high in early January to Thursday’s intraday low, the S&P 500 (SPY) was down -19.9% (representing more than $7.5 trillion in value). At its lows on Thursday, the Nasdaq 100 (QQQ) was down as much as -29.2% from its November high. Both SPY and QQQ are now struggling to regain critical “round-number” support at 400 and 300, respectively. The CBOE Volatility Index (VIX) further illustrates the bearishness. After hitting 36.6 on May 2, which is two standard deviations above the low-run average of 20 (i.e., Z-score of 2.0), VIX stayed in the 30’s all last week, which reflects a level of panic. This broad retreat from all asset classes has been driven by fear of loss, capital preservation, deleveraging/margin calls among institutional traders, and the appeal of a strong dollar (which hit a 20-year high last week). The move to cash caused bond yields to soar and P/E ratios to crater. Also, there has been a striking preference for dividend-paying stocks over bonds.

It appears I underestimated the potential for market carnage, having expected that the March lows would hold as support and the “taper tantrum” surge in bond yields would soon top out once the 10-year yield rose much above 2%, due to a combination of US dollar strength as the global safe haven, lower comparable rates in most developed markets, moderating inflation, leverage and “financialization” of the global economy, and regulatory or investor mandates for holding “cash or cash equivalents.” There are some signs that surging yields and the stock/bond correlation may be petering out, as last week was characterized by stock/bond divergence. After spiking as high as 3.16% last Monday, the 10-year yield fell back to close Thursday at 2.82% (i.e., bonds attracted capital) while stocks continued to sell off, and then Friday was the opposite, as capital rolled out of bonds into stocks.

Although nominal yields may be finally ready to recede a bit, real yields (net of inflation) are still solidly negative. Although inflation may be peaking, the moderation I have expected has not commenced – at least not yet – as supply chains have been slow to mend given new challenges from escalation in Russian’s war on Ukraine, China’s growth slowdown and prolonged zero-tolerance COVID lockdowns in important manufacturing cities, and various other hindrances. Indeed, the risks to my expectations that I outlined in earlier blog posts and in my Baker’s Dozen slide deck have largely come to pass, as I discuss in this post.

Nevertheless, I still expect a sequence of events over the coming months as follows: more hawkish Fed rhetoric and some tightening actions, modest demand destruction, a temporary economic slowdown, and more stock market volatility … followed by mending supply chains, some catch-up of supply to slowing demand, moderating inflationary pressures, bonds continuing to find buyers (and yields falling), and a dovish turn from the Fed – plus (if necessary) a return of the “Fed put” to support markets. Time will tell. Too bad the Fed can’t turn its printing press into a 3D printer and start printing supply chain parts, semiconductors, oil, commodities, fertilizers, and all the other goods in short supply – that would be far more helpful than the limited tools they have at hand.

Although both consumer and investor sentiment are quite weak (as I discuss below), and there has been no sustained dip-buying since March, history tells us bear markets do not start when everyone is already bearish, so perhaps Friday’s strong rally is the start of something better. Perhaps the near -20% decline in the S&P 500 is all it took to wring out the excesses, with Thursday closing at a forward P/E of 16.8x ahead of Friday’s rally, which is the lowest since April 2020. So, the S&P 500 is trading at a steep 22% discount compared to 21.7x at the start of the year, a 5-year average of 18.6x, and a 20-year post-Internet-bubble average of 15.5x (according to FactSet), Moreover, the Invesco S&P 500 Equal Weight (RSP) is at 15.0x compared to 17.7x at the beginning of the year, and the S&P 600 small cap forward P/E fell to just 11.6x (versus 15.2x at start of the year).

But from an equity risk premium standpoint, which measures the spread between equity earnings yields and long-term bond yields, stock valuations have actually worsened relative to bonds. So, although this may well be a great buying opportunity, especially given the solid earnings growth outlook, the big wildcards for stocks are whether current estimates are too optimistic and whether bond yields continue to recede (or at least hold steady).

Recall Christmas Eve of 2018, when the market capitulated to peak-to-trough selloff of -19.7% – again, just shy of the 20% bear market threshold – before recovering in dazzling fashion. The drivers today are not the same, so it’s not necessarily and indicator of what comes next. Regardless, you should be prepared for continued volatility ahead.

In this periodic update, I provide a comprehensive market commentary, offer my technical analysis of the S&P 500 chart, review Sabrient’s latest fundamentals based SectorCast quant rankings of the ten US business sectors, and serve up some actionable ETF trading ideas. To summarize, our SectorCast rankings reflect a bullish bias, with 5 of the top 6 scorers being cyclical sectors, Energy, Basic Materials, Financials, Industrials, and Technology. In addition, the near-term technical picture looks bullish for at least a solid bounce, if not more (although the mid-to-long-term is still murky, subject to news developments), but our sector rotation model switched to a defensive posture last month when technical conditions weakened.

Regardless, Sabrient’s Baker’s Dozen, Dividend, and Small Cap Growth portfolios leverage our enhanced Growth at a Reasonable Price (GARP) selection approach (which combines Quality, Value, and Growth factors) to provide exposure to both the longer-term secular growth trends and the shorter-term cyclical growth and value-based opportunities – without sacrificing strong performance potential. Sabrient’s latest Q2 2022 Baker’s Dozen launched on 4/20/2022 and is off to a good start versus the benchmark, led by three Energy firms, with a diverse mix across market caps and industries. In addition, the live Dividend and Small Cap Growth portfolios have performed quite well relative to their benchmarks. Read on....

  by Scott Martindale
  President & CEO, Sabrient Systems LLC

I have been warning that the longer the market goes up without a significant pullback, the worse the ultimate correction is likely to be. So, with that in mind, we might not have seen the lows for the year quite yet, as I discuss in the chart analysis later in this post. January saw a maximum intraday peak-to-trough drawdown on the S&P 500 of -12.3% and the worst monthly performance (-5.3%) for the S&P 500 since March 2020 (-12.4%). It was the worst performance for the month of January since 2009 (during the final capitulation phase of the financial crisis) and one of the five worst performances for any January since 1980. The CBOE Volatility Index (VIX), aka “fear gauge,” briefly spiked to nearly 39 before settling back down to the low-20s.

It primarily was driven by persistently high inflation readings – and a suddenly hawkish-sounding Federal Reserve – as the CPI for the 12 months ending in December came in at 7.0% YoY, which was the largest increase for any calendar year since 1981. Then on Feb 10, the BLS released a 7.5% CPI for January, the highest YoY monthly reading since 1982. Of course, stocks fell hard, and the 10-year T-note briefly spiked above 2% for the first time since August 2019.

Looking under the hood is even worse. Twelve months ago, new 52-week highs were vastly outpacing new 52-week lows. But this year, even though new highs on the broad indexes were achieved during January, we see that 2/3 of the 3,650 stocks in the Nasdaq Composite have fallen at least 20% at some point over the past 12 months – and over half the stocks in the index continue to trade at prices 40% or more below their peaks, including prominent names like DocuSign (DOCU), Peloton Interactive (PTON), and of course, Meta Platforms, nee Facebook (FB). Likewise, speculative funds have fallen, including the popular ARK Innovation ETF (ARKK), which has been down as much as -60% from its high exactly one year ago (and which continues to score near the bottom of Sabrient’s fundamentals based SectorCast ETF rankings).

Pundits are saying that the “Buy the Dip” mentality has suddenly turned into “Sell the Rip” (i.e., rallies) in the belief that the fuel for rising asset prices (i.e., unlimited money supply and zero interest rates) soon will be taken away. To be sure, the inflation numbers are scary and unfamiliar. In fact, only a minority of the population likely can even remember what those days of high inflation were like; most of the population only has experienced decades of falling CPI. But comparing the latest CPI prints to those from 40 years ago has little relevance, in my view, as I discuss in the commentary below. I continue to believe inflation has been driven by the snapback in demand coupled with slow recovery in hobbled supply chains – largely due to “Nanny State” restrictions – and that inflationary pressures are peaking and likely to fall as the year progresses.

In response, the Federal Reserve has been talking down animal spirits and talking up interest rates without actually doing much of anything yet other than tapering its bond buying and releasing some thoughts and guidance. The Fed’s challenge will be to raise rates enough to dampen inflation without overshooting and causing a recession, i.e., the classic policy mistake. My prediction is there will be three rate hikes over the course of the year, plus some modest unwinding of its $9 trillion balance sheet by letting some maturing bonds roll off. Note that Monday’s emergency FOMC meeting did not result in a rate hike due to broad global uncertainties.

Longer term, I do not believe the Fed will be able to “normalize” interest rates over the next decade, much less the next couple of years, without causing severe pain in the economy and in the stock and bond markets. Our economy is simply too levered and “financialized” to absorb a “normalized” level of interest rates. But if governments around the world (starting with the US and Canada!) can stand aside and let the economy work without heavy-handed societal restrictions and fearmongering, we might see the high supply-driven excess-demand gap close much more quickly.

In this periodic update, I provide a comprehensive market commentary, offer my technical analysis of the S&P 500 chart, review Sabrient’s latest fundamentals based SectorCast quant rankings of the ten US business sectors, and serve up some actionable ETF trading ideas. To summarize, our SectorCast rankings reflect a bullish bias, with the top three scorers being deep-cyclical sectors, Energy, Basic Materials, and Financials. In addition, the near-term technical picture remains weak, and our sector rotation model moved from a neutral to a defensive posture this week as the market has pulled back.

Overall, I expect a continuation of the nascent rotation from aggressive growth and many “malinvestments” that were popular during the speculative recovery phase into the value and quality factors as the Fed tries to rein in the speculation-inducing liquidity bubble. And although I don’t foresee a major selloff in the high-valuation-multiple mega-cap Tech names, I think investors can find better opportunities this year among high-quality stocks outside of the Big Tech favorites – particularly among small and mid-caps – due to lower valuations and/or higher growth rates, plus some of the high-quality secular growth names that were essentially the proverbial “baby thrown out with the bathwater.” But that’s not say we aren’t in for further downside in this market over the near term. In fact, I think we will see continued volatility and technical weakness over the next few months – until the Fed’s policy moves become clearer – before the market turns sustainably higher later in the year.

Regardless, Sabrient’s Baker’s Dozen, Dividend, and Small Cap Growth portfolios leverage our enhanced Growth at a Reasonable Price (GARP) selection approach (which combines quality, value, and growth factors) to provide exposure to both the longer-term secular growth trends and the shorter-term cyclical growth and value-based opportunities – without sacrificing strong performance potential. Sabrient’s new Q1 2022 Baker’s Dozen launched on 1/20/2022 and is already off to a good start versus the benchmark. In addition, our Dividend and Small Cap Growth portfolios have been performing well versus their benchmarks. In fact, all 7 of the Small Cap Growth portfolios launched since the March 2020 COVID selloff have outperformed the S&P 600 SmallCap Growth ETF (SLYG), and 7 of the 8 Dividend portfolios have outperformed the S&P 500 (SPY). In particular, the Energy sector still seems like a good bet, as indicated by its low valuation and high score in our SectorCast ETF rankings.

Furthermore, we have created the Sabrient Quality Index Series comprising 5 broad-market and 5 sector-specific, rules-based, strategic beta and thematic indexes for ETF licensing, which we are pitching to various ETF issuers. Please ask your favorite ETF wholesaler to mention it to their product team!
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