Scott Martindale  by Scott Martindale
  President & CEO, Sabrient Systems LLC

The New York Fed’s Global Supply Chain Pressure Index (GSCPI) for November was released today, and although it rose more than expected (likely due to disruptions from heightened global hostilities), it still suggests inflation will continue its gradual retreat, with a reading near the long-run average. But let me start by talking about October’s inflation indicators. Last week, the headline reading for Personal Consumption Expenditures (PCE) for October came in at 3.0% YoY, helped quite a bit by the fall in oil and gasoline prices (note: the US is producing an all-time high of 13.2 million barrels/day of crude oil). Core PCE, which is the Federal Reserve's preferred inflation metric, came in at 3.46% year-over-year. However, the month-over-month number for October versus September, which better reflects today's inflation trends and the lag effects of higher interest rates, came in at 0.16%, which annualizes to 1.98%. Keep in mind, the Fed's inflation target is 2.0%. But monthly data can be choppy, so looking at the rolling 3-month average, it annualizes to 2.37%.

Earlier reports had shown October PPI at 1.3% YoY and CPI at 3.2%, with core PPI (excluding food & energy) was 2.4% YoY, and core CPI was 4.0%. All of this was presaged by the GSCPI, which measures the number of standard deviations from the historical average value (aka Z-score) and generally foreshadows movements in inflation metrics. It plummeted from a December 2021 all-time high of +4.31 down to the October reading of -1.74—its lowest level ever. However, that ultra-low October reading has been revised to -0.39 due to “a change in exchange rate weighting methodology,” according to the New York Fed. Nevertheless, the writing was on the wall for last week’s favorable PCE report. The chart below illustrates the correlation between GSCPI, PPI, and CPI.


So, what to expect for November inflation? Well, as shown in the chart, GSCPI for November just came in today at 0.11. Although rising from its ultra-low levels, it still remains at the long-run average, and the chart illustrates that volatility is to be expected. All in all, I think it still bodes well for the next week’s CPI/PPI readings as supply chains continue to heal and diversify (albeit with occasional hiccups like we see today from heightened global hostilities), especially when you also consider that the consumer has become stretched with rising household debt and falling growth in job openings and wages, money supply growth is stagnant, and budget hawks are increasingly flexing their fiscal muscles in Congress. Thus, I believe the probability of a resurgence in either inflation or fiscal expansion is quite low.

Furthermore, although the second estimate for Q3 GDP was ultra-strong (the highest in 2 years), revised up to 5.2% annual rate (from previous 4.9%), the boost came from state and federal government spending, which was revised up to 5.5% from the prior estimate of 4.6% (i.e., more unsustainable deficit spending and issuance of Treasuries paying high coupons, mostly from an 8.2% increase in defense spending), while personal consumption was revised down to 3.6% from 4.0%. This tells me the “robust” GDP number was something of an illusion.

Indeed, looking ahead, the Atlanta Fed’s GDPNow forecasts only 1.3% GDP growth and 1.9% PCE growth for Q4 (as of 12/6). Moreover, the good folks at Real Investment Advice observed that Gross Domestic Income (GDI) for Q3 was reported at only +1.5%, displaying the widest gap below GDP in 50 years. (Note: GDP measures the value of goods and services produced, including consumption expenditures, investments and exports, while GDI measures incomes earned and costs incurred in production of GDP, including wages, profits, and taxes.) Also, last week’s Fed Beige Book showed that two-thirds of Fed districts reported slower economic activity over the prior six weeks, and the ISM Manufacturing Index came in at an anemic 46.7, showing continued contraction for the 15th straight month.

So, this all seems to be more “bad news is good news” when it comes to Fed policy moves, and investors will be eagerly watching Friday’s jobs report followed by next week’s CPI, PPI, and FOMC policy announcement. Stocks have been taking a healthy breather and consolidation in anticipation of it all, but so far, no major pullback. This year seems to be following the playbook of what economist Ed Yardeni has characterized as a series of “rolling recessions” (among sectors) and an “Immaculate Disinflation,” i.e., moderating inflation without a harsh recession or massive layoffs. As an aside, I have opined many times that it is ridiculous that we constantly find ourselves awaiting the edict of this unelected board of “wise elders” to decide our economic fate. Why can’t they take emergency measures only when absolutely necessary to avert economic cataclysm, and then once the crisis has passed, those emergency measures are quickly withdrawn so that the free market can get back to doing its productive, creative, wonderful thing? One can dream.

Regardless, in my view, the Fed is likely done with rate hikes and preparing for its eventual pivot to rate cuts—which I think will come sooner than most expect, likely before the end of H1 2024. Why? Because if inflation maintains its gradual downtrend while the Fed holds its overnight borrowing rate steady, the real (inflation-adjusted) rate keeps rising, i.e., de facto tightening. Indeed, Fed funds futures are projecting 98% chance for no rate change next week, and for 2024, 62% chance for at least one 25-bp rate cut by March, 97% for at least one 25-bp cut by June, and 89% chance of a full 1.0% in total rate cuts by December 2024, which would put the fed funds rate below 4.5%.

Accordingly, after kissing the 5% handle, the 10-year Treasury yield has fallen precipitously to below 4.2%—a level last seen at the end of August. So, I encourage and expect the FOMC to follow the message of the bond market and begin cutting the fed funds rate back towards the neutral rate, which I think is around 2.5-3.0% nominal (i.e., 2% target inflation plus 0.5-1.0% r-star), and hand back control of the economy to the free market. As of now, the Fed is on the verge of crushing the housing market…and by extension the broader economy. In addition, it must ensure money supply resumes a modest growth rate (albeit slowly), not continue to shrink or stagnate.

To be sure, the safe steadiness of bond yields was disrupted this year. After rising much faster than anyone anticipated, interest rates have fallen much faster than expected, especially considering that the Fed hasn’t made any dovish policy changes. Nevertheless, if rates are going to generally meander lower, investors might be expected to lock in sustainable yield with capital appreciation potential through longer-duration securities, including long-term bonds, “bond proxies” like dividend-paying equities (e.g., utilities, staples, and REITs), and growth stocks (like high-quality technology companies).

I also like oil, gold and uranium stocks, as well as gold, silver, and cryptocurrency as stores of value in an uncertain macro climate. Notably, gold is challenging its highs of the past few years as global investors and central banks are both hedging and/or speculating on a weaker dollar, falling real interest rates, rising geopolitical tensions, and potential financial crisis, and the World Gold Council reported robust demand among central banks, which purchased a record 800 tons during the first three quarters of the year. Similarly, Bitcoin is catching a bid on speculation of broader investor access (through spot-price ETFs) and dollar debasement (if debt and deficit spending continue to spiral).

Keep in mind that, when valuations get lofty within a given asset class, volatility and performance/valuation dispersion among stocks often increases while correlations decrease. For stocks, active selection strategies that can exploit the dispersion to identify under-the-radar and undervalued companies primed for explosive growth become more appealing versus passive index investing. Sabrient’s actively selected portfolios include the Q4 2023 Baker’s Dozen (launched on 10/20), Small Cap Growth 40 (launched on 11/3), and Sabrient Dividend 46 (just launched on 11/29, and today offers a 4.7% dividend yield).

In today’s post, I further discuss inflation, the US dollar, Fed monetary policy implications, and relative performance of asset classes. I also discuss Sabrient’s latest fundamentals based SectorCast quantitative rankings of the ten U.S. business sectors (which is topped by Technology and Industrials), current positioning of our sector rotation model (which turned bullish in early November and remains so), and some actionable ETF trading ideas.

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

Scott Martindale  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…

Scott Martindale  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…