by Scott Martindale
  President & CEO, Sabrient Systems LLC

The first half of 2024 looked a lot like the first half of 2023. As you recall, H1 2023 saw a strong stock market despite only modest GDP growth as inflation metrics fell, and H2 2023 continued on the same upward path for stocks despite a slowdown in inflation’s retreat, buoyed by robust GDP growth. Similarly, for H1 2024, stocks have surged despite a marked slowdown in GDP growth (from 4.1% in the second half of 2023 to an estimated 1.5% in the first half of 2024) and continued “stickiness” in inflation—causing rate-cut expectations to fall from 7 quarter-point cuts at the start of the year to just 2 at most.

And yet stocks have continued to surge, with 33 record highs this year for the S&P 500 through last Friday, 7/5. Of course, it is no secret that the primary driver of persistent market strength, low volatility (VIX in the mid-12’s), and an extreme low in the CBOE put/call ratio (around 0.50) has been the narrow leadership of a handful of dominant, innovative, mega-cap Tech titans and the promise of (and massive capital expenditures on) artificial intelligence. But while the S&P 500 is up +17.4% YTD and Nasdaq 100 +21.5% (both at all-time highs), the small cap indexes are flat to negative, with the Russell 2000 languishing -14% below its June 2021 all-time high.

Furthermore, recessionary signals abound. GDP and jobs growth are slowing. Various ISM indexes have fallen into economic contraction territory (below 50). Q2 earnings season kicks off in mid-July amid more cuts to EPS estimates from the analyst community. Given a slowing economy and falling estimates, it’s entirely possible we will see some high-profile misses and reduced forward guidance. So, investors evidently believe that an increasingly dovish Fed will be able to revive growth without revving up inflation.

But is this all we have to show for the rampant deficit spending that has put us at a World War II-level ratio of 120% debt (nearly $35 trillion) to GDP (nearly $29 trillion)? And that doesn’t account for estimated total unfunded liabilities—comprising the federal debt and guaranteed programs like Social Security, Medicare, employee pensions, and veterans’ benefits—estimated to be around $212 trillion and growing fast, not to mention failing banks, municipal pension liabilities, and bankrupt state budgets that might eventually need federal bailouts.

Moreover, the federal government “buying” jobs and GDP in favored industries is not the same as private sector organic growth and job creation. Although the massive deficit spending might at least partly turn out to be a shrewd strategic investment in our national and economic security, it is not the same as incentivizing organic growth via tax policies, deregulation, and a lean government. Instead, we have a “big government” politburo picking and choosing winners and losers, not to mention funding multiple foreign wars, and putting it all on a credit card to be paid by future generations. I have more to say on this—including some encouraging words—in my Final Comments section below.

As for inflation, the Fed’s preferred gauge, Core Personal Consumption Expenditures (PCE, aka Consumer Spending), for May was released on 6/28 showing a continued downward trend (albeit slower than we all want to see). Core PCE came in at just +0.08% month-over-month (MoM) from April and +2.57% YoY. But Core PCE ex-shelter is already below 2.5%, so as the lengthy lag in shelter cost metrics passes, Core PCE should fall below 2.5% as well, perhaps as soon as the update for June on 7/26, which could give the Fed the data it needs to cut. By the way, the latest real-time, blockchain-based Truflation rate (which historically presages CPI) hit a 52-week low the other day at just 1.83% YoY.

In any case, as I stated in my June post, I am convinced the Fed would like to starting cutting soon—and it may happen sooner than most observers are currently predicting. Notably, ever since the final days of June—marked by the presidential debate, PCE release, various jobs reports, and the surprising results in Europe and UK elections, the dollar and the 10-year yield have both pulled back—perhaps on the view that rate cuts are indeed imminent. On the other hand, the FOMC might try to push it out as much as possible to avoid any appearance of trying to impact the November election. However, Fed chair Powell stated last week that the committee stands ready to cut rates more aggressively if the US labor market weakens significantly (and unemployment just rose above the magic 4-handle to 4.1%)—so it appears the investor-friendly “Fed put” is back in play, which has helped keep traders bullishly optimistic. The June readings for PPI and CPI come out later this week on 7/11-12, and July FOMC policy announcement comes out on 7/31.

And as inflation recedes, real interest rates rise. As it stands today, I think the real yield is too high—great for savers but bad for borrowers, which would suggest the Fed is behind the curve. The current fed funds rate is roughly 3% above the CPI inflation forecast, which means we have the tightest Fed interest rate policy since before the 2008 Global Financial Crisis (aka Great Recession). This tells me that the Fed has plenty of room to cut rates and still maintain restrictive monetary policy.

As I have said many times, I believe a terminal fed funds rate of 3.0-3.5% would be the appropriate level so that borrowers can handle the debt burden while fixed income investors can receive a reasonable real yield.

Nevertheless, even with rates still elevated today, I believe any significant pullback in stocks (which I still think is coming before the November election, particularly in light of the extraordinarily poor market breadth) would be a buying opportunity. It’s all about investor expectations. As I’ve heard several commentators opine, the US, warts and all, is the “best house in a lousy [global] neighborhood.” I see US stocks and bonds (including TIPS) as good bets, particularly as the Fed and other central banks inject liquidity. But rather than chasing the high-flyers, I suggest sticking with high-quality, fundamentally strong stocks, displaying accelerating sales and earnings and positive revisions to Wall Street analysts’ consensus estimates.

By “high quality,” I mean fundamentally strong companies with a history of, and continued expectations for, consistent and reliable sales and earnings growth, upward EPS revisions from the analyst community, rising profit margins and free cash flow, solid earnings quality, and low debt burden. These are the factors Sabrient employs in selecting our growth-oriented Baker’s Dozen (primary market for the Q2 portfolio ends on 7/18), value-oriented Forward Looking Value portfolio, growth & income-oriented Dividend portfolio, and our Small Cap Growth portfolio (an alpha-seeking alternative to a passive position in the Russell 2000), as well as in our SectorCast ETF ranking model. Notably, our Earnings Quality Rank (EQR) is a key factor in each of these models, and it is also licensed to the actively managed, absolute-return-oriented First Trust Long-Short ETF (FTLS) as an initial screen.

Each of these alpha factors and how they are used within Sabrient’s Growth, Value, Dividend income, and Small Cap investing strategies is discussed in detail in David Brown’s new book, How to Build High Performance Stock Portfolios, which will be out shortly (I will send out a notification soon!).

In today’s post, I provide a detailed commentary on the economy, inflation, valuations, Fed policy expectations, and Sabrient’s latest fundamentals based SectorCast quantitative rankings of the ten U.S. business sectors, current positioning of our sector rotation model heading into earnings season, and several top-ranked ETF ideas.

Click here to continue reading my full commentary. Or if you prefer, here is a link to this post in printable PDF format. I invite you to share it with your friends, colleagues, and clients (to the extent compliance allows). You also can sign up for email delivery of this periodic newsletter at Sabrient.com.

  by Scott Martindale
  President & CEO, Sabrient Systems LLC

Stocks and bonds both sold off in August before finishing the month with a flourish, as signs that the jobs market is weakening suggest an end to Fed rate hikes is nigh. The summer correction in equities was entirely expected after the market’s extraordinary display of strength for the first seven months of the year in the face of a relentlessly hawkish Federal Reserve, even as CPI and PPI have fallen precipitously. State Street’s Institutional Investor Risk Appetite Indicator moved dramatically from bearish in May to highly bullish at the end of July, and technical conditions were overbought. And although the depth of the correction took the bulls by surprise, it was quite orderly with the CBOE Volatility Index (VIX) staying tame (i.e., never even approaching the 20 handle). In fact, a 5% pullback in the S&P 500 is not unusual given the robust 20% YTD return it had attained in those seven months. Weakness in bonds, gold, and commodity prices also reversed.

Moreover, IG, BBB, and HY bond spreads have barely moved during this market pullback despite rising real rates, which signals that the correction in stocks is more about valuations in the face of the sudden spike in interest rates (and fears of “higher for longer”) rather than the health of the economy, earnings, or fundamentals. Certainly, the US economy looks much stronger than any of our trading partners (which Fed chair Powell seems none too happy about), with the Atlanta Fed’s GDPNow model estimating a robust 5.6% growth for Q3 (as of 8/31) and the dollar surging in a flight to safety [in fact, the US Dollar Index Fund (UUP) recently hit a 2023 high].

However, keep in mind that the US is not an island unto itself but part of a complex global economy and thus not immune to contagion, so the GDP growth rate will likely come down. Moreover, Powell said in his Jackson Hole speech that the Fed’s job is “complicated by uncertainty about the duration of the lags with which monetary tightening affects economic activity and especially inflation.”

Investors have generally retained their enthusiasm about stocks despite elevated valuations, rising real interest rates (creating a long-lost viable alternative to stocks—and a poor climate for gold), a miniscule equity risk premium, and a Fed seemingly hell-bent on inducing recession in order to crush sticky core inflation. Perhaps stock investors have been emboldened by the unstoppable secular force of artificial intelligence (AI) and its immediate benefits to productivity and profitability (not just “hope”)—as evidenced by Nvidia’s (NVDA) incredible earnings release last week.

I have discussed in recent posts about how the Bull case seems to outweigh the (highly credible) Bear case. However, the key tenets of the Bull case—and avoidance of recession—include a stable China. Since 2015, I have been talking about a key risk to the global economy being the so-called “China Miracle” gradually being exposed as a House of Cards, and perhaps never before has it seemed so close to implosion, as it tests the limits of debt-fueled growth—and a creeping desperation coupled with an inability (or unwillingness) to pivot sharply from its longstanding policies makes it even more dangerous. I talk more about this in today’s post.

Yet despite all the significant challenges and uncertainties, I still believe stocks are in a normal/predictable summer consolidation—particularly after this year’s surprisingly strong market performance through July—with more upside to come. My only caveat has been that the 2-year Treasury yield needs to remain below 5%—a critical “line in the sand,” so to speak. Although I (and many others) often cite the 10-year yield because of its link to mortgage rates, I think the 2-year is important because it reflects a broad expectation of inflation and the duration of the Fed’s “higher for longer” policy. Notably, during this latest spike in rates, the 2-year again eclipsed that critical 5-handle for the third time this year and challenged the 7/5 intraday high of 5.12%, before pulling back sharply to close the month below 4.9%.

If the 2-year reverses again and surges to new highs, I think it threatens a greater impact on our economy (as well as our trading partners’) as businesses, consumers, and governments manage their maturing lower-rate debt—and ultimately impacts the housing market and risk assets, like stocks. But instead, I see it as just another short-term rate spike like we saw in March and July, as investors sort out the issues described in my full post below. Indeed, August finished with a big fall in rates in concert with a big jump in stocks, gold, crypto, and other risk assets across the board, as cracks in the jobs and housing markets are showing up, leading to a growing belief that the Fed is finished with its rate hikes—as I think they should be, particularly given the resumption of disinflationary secular trends and a deflationary impulse from China.

Some economists believe that extreme stock valuations and the ultra-low equity risk premium are pricing in both rising earnings and falling rates—an unlikely duo, in their view, on the belief that a strong economy is inherently inflationary while a weakening economy suggests lower earnings—and thus, recession is inevitable. But I disagree. For one, respected economist Ed Yardeni has observed that we have already been in the midst of a “rolling recession” across segments of the economy that is now turning into a “rolling expansion.” And regarding elevated valuations in the major indexes, my observation is that they are primarily driven by a handful of mega-cap Tech names. Minus those, valuations across the broader market are much more reasonable, as I discuss in today’s post.

Indeed, rather than passive positions in the broad market indexes, investors may be better served by strategies that seek to exploit improving market breadth and the performance dispersion among individual stocks. Sabrient’s portfolios include Baker’s Dozen, Forward Looking Value, Small Cap Growth, and Dividend, each of which provides exposure to market segments and individual companies that our models suggest may outperform. Let me know how I can better serve your needs, including speaking at your events (whether by video or in person).

As stocks and other risk assets finish what was once destined to be a dismal month with a show of renewed bullish conviction, allow me to step through in greater detail some of the key variables that will impact the market through year-end and beyond, including the economy, valuations, inflation, Fed policy, the dollar, and China…and why I remain bullish. I also review Sabrient’s latest fundamentals based SectorCast quant rankings of the ten U.S. business sectors (topped by Technology and Energy) and serve up some actionable ETF trading ideas.

Click here to continue reading my full commentary … or if you prefer, here is a link to my full post in printable PDF format (as some of my readers have requested).

by Scott Martindale
President, Sabrient Systems LLC

The month of May turned out to be pretty decent for stocks overall, with the S&P 500 large caps up about +2%, with growth greatly outperforming value, and June has got off to a good start, as well. But the smaller caps were the bigger stars, as I have been predicting for several months, with the S&P 600 small caps up +6% for the month. Even after a volatile April, and even though the headlines on trade wars, oil prices, Iran, North Korea, Venezuela, Italy, et al were confusing if not frightful, and even though technical signals suggested overbought conditions and a likely pullback, investors have been reluctant to sell their equities and the late-month pullback was fleeting.

Nevertheless, many commentators are offering up lots of reasons why further upside is limited and stocks likely will turn tail into a downtrend, including political contagion in the EU, the US dollar strengthening too much such that overseas corporate profits take a hit, and yields rising too quickly such that they 1) burden a heavily-leveraged economy and 2) suppress stock prices by spiking the risk-free rate used in a discounted cash flow analysis. But I think the main thing weighing on investors’ minds right now is fear that things are “as good as it gets” when it comes to synchronized global growth, monetary and fiscal stimulus, and year-over-year growth in corporate earnings. In other words, now that the hope and optimism for strong growth actually has materialized into reality, there is nothing more to look forward to, so to speak. The year-over-year EPS comparisons won’t be so eye-popping. Earnings growth inevitably will slow, higher interest rates will suppress valuations, and P/E compression will set in.

However, recall that the so-called “taper tantrum” a few years ago led to similar investor behavior, but then eventually cooler heads prevailed as investors realized that the fundamental picture was strong and in fact extraordinary monetary accommodation was no longer necessary (or even desirable). Similarly, I think there is still plenty of fuel in the tank from tax reform, deregulation, and new corporate and government spending plans, offering up the potential to drive strong growth for at least the next few years (e.g., through revived capex, onshoring of overseas capital and operations, and M&A).

In this periodic update, I provide a market commentary, offer my technical analysis of the S&P 500, review Sabrient’s latest fundamentals-based SectorCast rankings of the ten US business sectors, and serve up some actionable ETF trading ideas. In summary, our sector rankings still look bullish, while the sector rotation model takes a bullish posture as stocks try to break out.

By the way, in response to popular demand, Sabrient is launching this week our first International Opportunity portfolio comprising 30-35 stocks from non-US developed markets (e.g., Canada, Western Europe, Australasia, Far East) based on the same “quantamental” growth-at-reasonable-price (GARP) portfolio construction process used for our Baker’s Dozen portfolios, including the in-depth earnings quality review and final vetting by our wholly-owned forensic accounting subsidiary Gradient Analytics. In addition, we are nearing two years since the inception of our Sabrient Select actively-managed strategy, a 30-stock all-cap GARP portfolio that is available for investment as a separately managed account (SMA) through a dual-contract arrangement. (Please contact me directly if you would like to learn more about this.) Read on....

Last week, stocks cycled bullish yet again. In fact, the S&P 500, NYSE Composite, and NASDAQ each closed at record highs as investors positioned for the heart of earnings season in the wake of strong reports from some of the Tech giants. Notably, Utilities stocks got some renewed traction as yield-starved investors returned to the sector.