by Scott Martindale
  President & CEO, Sabrient Systems LLC

July saw new highs for the broad market indexes followed by a big fall from grace among the Magnificent Seven (MAG-7) stocks. But it looked more like a healthy rotation than a flight to safety, with a broadening into neglected market segments, as inflation and unemployment metrics engendered optimism about a dovish policy pivot from the Federal Reserve. The rotation of capital within the stock market—as opposed to capital flight out of stocks—kept overall market volatility modest. But then along came the notorious month of August. Is this an ominous sign that the AI hype will come crashing down as the economy goes into a recession? Or is this simply a 2023 redux—another “summer sales event” on stock prices—with rate cuts, accelerating earnings, and new highs ahead? Let’s explore the volatility spike, the reset on valuations, inflation trends, Fed policy, and whether this is a buying opportunity.

Summary

Up until this month, a pleasant and complacent trading climate had been in place essentially since the Federal Reserve announced in Q4 2023 its intended policy pivot, with a forecast of at least three rate cuts. But August is notorious for its volatility, largely from instability on the trading floor due to Wall Street vacations and exacerbated by algorithmic (computer-based) trading systems. In my early-July post, I wrote that I expected perhaps a 10% correction this summer and added, “the technicals have become extremely overbought [with] a lot of potential downside if momentum gets a head of steam and the algo traders turn bearish.” In other words, the more extreme the divergence and euphoria, the harsher the correction.

Indeed, last Monday 8/5 saw the worst one-day selloff since the March 2020 pandemic lockdown. From its all-time high on 7/16 to the intraday low on Monday 8/5 the S&P 500 (SPY) fell -9.7%, and the Technology Select Sector SPDR (XLK) was down as much as -20% from its 7/11 high. The CBOE Volatility Index (VIX) hit a colossal 67.73 at its intraday peak (although tradable VIX futures never came close to such extremes). It was officially the VIX’s third highest reading ever, after the financial crisis in 2008 and pandemic lockdown in 2020. But were the circumstances this time around truly as dire as those two previous instances? Regardless, it illustrates the inherent risk created by such narrow leadership, extreme industry divergences, and high leverage bred from persistent complacency (including leveraged short volatility and the new zero-day expiry options).

The selloff likely was ignited by the convergence of several issues, including weakening economic data and new fears of recession, a concern that the AI hype isn’t living up to its promise quite fast enough, and a cautious Fed that many now believe is “behind the curve” and making a policy mistake by not cutting rates. (Note: I have been sounding the alarm on this for months.) But it might have been Japan at the epicenter of this financial earthquake when the Bank of Japan (BoJ) suddenly hiked its key policy rate and sounded a hawkish tone, igniting a “reverse carry trade” and rapid deleveraging. I explain this further in today’s post.

Regardless, by week’s end, it looked like a non-event as the S&P 500 and Nasdaq 100 clawed back all their losses from the Monday morning collapse. So, was that it for the summer correction? Are we all good now? I would say no. A lot of traders were burned, and it seems there is more work for bulls to do to prove a bottom was established. Although the extraordinary spike in fear and “blood in the streets” was fleeting, the quick bounce was not convincing, and the monthly charts look toppy—much like last summer. In fact, as I discuss in today’s post, the market looks a lot like last year, which suggests the weakness could potentially last into October. As DataTrek opined, “Investor confidence in the macro backdrop was way too high and it may take weeks to fully correct this imbalance.”

Stock prices are always forward-looking and speculative with respect to expectations of economic growth, corporate earnings, and interest rates. The FOMC held off on a rate cut at its July meeting even though inflation is receding and recessionary signals are growing, including weakening economic indicators (at home and abroad) and rising unemployment (now at 4.3%, after rising for the fourth straight month). Moreover, the Fed must consider the cost of surging debt and the impact of tight monetary policy and a strong dollar on our trading partners. On the bright side, the Fed no longer sees the labor market as a source of higher inflation. As Fed Chair Jerome Powell said, “The downside risks to the employment mandate are now real.” 

The real-time, blockchain-based Truflation metric (which historically presages CPI) keeps falling and recently hit yet another 52-week low at just 1.38%; Core PCE ex-shelter is already below 2.5%; and the Fed’s preferred Core PCE metric will likely show it is below 2.5% as well. So, with inflation less a worry than warranted and with corporate earnings at risk from the economic slowdown, the Fed now finds itself having to start an easing cycle with the urgency of staving off recession rather than a more comfortable “normalization” objective within a sound economy. As Chicago Fed president Austan Goolsbee said, “You only want to stay this restrictive for as long as you have to, and this doesn’t look like an overheating economy to me.”

The Fed will be the last major central bank in the West to launch an easing cycle. I have been on record for months that the Fed is behind the curve, as collapsing market yields have signaled (with the 10-year Treasury note yield falling over 80 bp from its 5/29 high before bouncing). It had all the justification it needed for a 25-bp rate cut at the July FOMC meeting, and I think passing on it was a missed opportunity to calm global markets, weaken the dollar, avert a global currency crisis, and relieve some of the burden on highly indebted federal government, consumers, businesses, and the global economy. Indeed, I believe Fed inaction forced the BoJ rate hike and the sudden surge in US recession fears, leading to last week’s extreme stock market weakness (and global contagion).

In my view, a terminal fed funds “neutral” rate of 3.0-3.5% (roughly 200 bps below the current “effective” rate of 5.33%) seems appropriate. Fortunately, today’s lofty rate means the Fed has plenty of potential rate cuts in its holster to support the economy while still remaining relatively restrictive in its inflation fight. And as long as the trend in global liquidity is upward, then the risk of a major market crash this year is low, in my view. Even though the Fed has kept rates “higher for longer” throughout this waiting game on inflation, it has also maintained liquidity in the financial system, which of course is the lifeblood of economic growth and risk assets. Witness that, although corporate credit spreads surged during the selloff and market turmoil (especially high yield spreads), they stayed well below historical levels and fell back quickly by the end of the week.

So, I believe this selloff, even if further downside is likely, should be considered a welcome buying opportunity for long-term investors, especially for those who thought they had missed the boat on stocks this year. This assumes that the proverbial “Fed Put” is indeed back in play, i.e., a willingness to intervene to support markets (like a protective put option) through asset purchases to reduce interest rates and inject liquidity (aka quantitative easing). The Fed Put also serves to reduce the term premium on bonds as investors are more willing to hold longer-duration securities.

Longer term, however, is a different story, as our massive federal debt and rampant deficit spending is not only unsustainable but potentially catastrophic for the global economy. The process of digging out of this enormous hole will require sustained, solid, organic economic growth (supported by lower tax rates), modest inflation (to devalue the debt without crippling consumers), and smaller government (restraint on government spending and “red tape”), in my view, as I discuss in today’s post.

In buying the dip, the popular Big Tech stocks got creamed. However, this served to bring down their valuations somewhat, their capital expenditures and earnings growth remains robust, and hedge funds are generally underweight Tech, so this “revaluation” could bode well for a broader group of Tech stocks for the balance of the year. Rather than rushing back into the MAG-7, I would suggest targeting high-quality, fundamentally strong stocks across all market caps that display consistent, reliable, and accelerating sales and earnings growth, positive revisions to Wall Street analysts’ consensus estimates, 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, value-oriented Forward Looking Value (which just launched on 7/31), growth & income-oriented Dividend portfolio, and the Small Cap Growth (an alpha-seeking alternative to a passive position in the Russell 2000).

We also use many of those factors in our SectorCast ETF ranking model. And 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 our alpha factors and their usage within Sabrient’s Growth, Value, Dividend income, and Small Cap investing strategies is discussed in detail in Sabrient founder David Brown’s new book, How to Build High Performance Stock Portfolios, which will be published this month (I will send out a notification).

Click here to continue reading my full commentary, in which I go into greater detail on the economy, inflation, monetary policy, valuations, and Sabrient’s latest fundamental-based SectorCast quantitative rankings of the ten U.S. business sectors, current positioning of our sector rotation model, and several top-ranked ETF ideas. Also, here is a link to this post in printable PDF format. I invite you to share it as appropriate (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

StocksThe S&P 500 fell more than 5% over the first three weeks of April (it’s largest pullback since last October). Bonds also took it on the chin (as they have all year), with the 2-year Treasury yield briefly eclipsing 5%, which is my “line in the sand” for a healthy stock market. But the weakness proved short-lived, and both stocks and bonds have regained some footing to start May. During the drawdown, the CBOE Volatility Index (VIX), aka fear index, awakened from its slumber but never closed above the 20 “panic threshold.”

In a return to the “bad news is good news” market action of yore, stocks saw fit to gap up last Friday as the US dollar weakened and stocks, bonds, and crypto all caught a nice bid (with the 10-year yield falling 30 bps)—on the expectation of sooner rate cuts following the FOMC’s softer tone on monetary policy and a surprisingly weak jobs report. So, the cumulative “lag effects” of quantitative tightening (QT), falling money supply, and elevated interest rates finally may be coming to roost. In fact, Fed chairman Jay Powell suggested that any sign of weakening in inflation or employment could lead to the highly anticipated rate cuts—leaving the impression that the Fed truly wants to start cutting rates.

But I can’t help but wonder whether that 5% pullback was it for the Q2 market correction I have been predicting. It sure doesn’t seem like we got enough cleansing of the momentum algo traders and other profit-protecting “weak holders.” But no one wants to miss out on the rate-cut rally. Despite the sudden surge in optimism about rates, inflation continues to be the proverbial “fly in the ointment” for rate cuts, I believe we are likely to see more volatility before the Fed officially pivots dovish, although we may simply remain in a trading range with downside limited to 5,000 on the S&P 500. Next week’s CPI/PPI readings will be crucial given that recent inflation metrics have ticked up. But I don’t expect any unwelcome inflationary surprises, as I discuss in today’s post.

The Fed faces conflicting signals from inflation, unemployment, jobs growth, GDP, and the international impact of the strong dollar on the global economy. Its preferred metric of Core PCE released on 4/26 stayed elevated in March at 2.82% YoY and a disheartening 3-month (MoM) rolling average of 4.43%. But has been driven mostly by shelter costs and services. But fear not, as I see a light at the end of the tunnel and a resumption of the previous disinflationary trend. Following one-time, early-year repricing, services prices should stabilize as wage growth recedes while labor demand slows, labor supply rises, productivity improves, and real disposable household income falls below even the lowest pre-pandemic levels. (Yesterday, the San Francisco Fed reported that American households have officially exhausted all $2.1 trillion of their pandemic-era excess savings.) Also, rental home inflation is receding in real time (even though the 6-month-lagged CPI metrics don’t yet reflect it), and inflation expectations of consumers and businesses are falling. Moreover, Q1 saw a surge in oil prices that has since receded, the Global Supply Chain Pressure Index (GSCPI) fell again in April. So, I think we will see Core PCE below 2.5% this summer. The Fed itself noted in its minutes that supply and demand are in better balance, which should allow for more disinflation. Indeed, when asked about the threat of a 1970’s-style “stagflation, the Fed chairman said, "I don't see the stag or the 'flation."

The Treasury's quarterly refunding announcement shows it plans to borrow $243 billion in Q2, which is $41 billion more than previously projected, to continue financing our huge and growing budget deficit. Jay Powell has said that the fiscal side of the equation needs to be addressed as it counters much of the monetary policy tightening. It seems evident to me that government deficit spending has been a key driver of GDP growth and employment—as well as inflation.

And as if that all isn’t enough, some commentators think the world is teetering on the brink of a currency crisis, starting with the collapse of the Japanese yen. Indeed, Japan is in quite the pickle with the yen and interest rates, which is a major concern for global financial stability given its importance in the global economy. Escalating geopolitical tensions and ongoing wars are also worrisome as they create death, destruction, instability, misuse of resources, and inflationary pressures on energy, food, and transportation prices.

All of this supports the case for why the Fed would want to start cutting rates (likely by mid-year), which I have touched on many times in the past. Reasons include averting a renewed banking crisis, fallout from the commercial real estate depression, distortion in the critical housing market, the mirage of strong jobs growth (which has been propped up by government spending and hiring), and of course the growing federal debt, debt service, and debt/GDP ratio (with 1/3 of the annual budget now earmarked to pay interest on the massive and rapidly growing $34 trillion of federal debt), which threatens to choke off economic growth. In addition, easing financial conditions would help highly indebted businesses, consumers, and our trading partners (particularly emerging markets). Indeed, yet another reason the Fed is prepared to cut is that other central banks are cutting, which would strengthen the dollar even further if the Fed stood pat. And then we have Japan, which needs to raise rates to support the yen but doesn’t really want to, given its huge debt load; it would be better for it if our Federal Reserve cuts instead.

So, the Fed is at a crossroads. I still believe a terminal fed funds rate of 3.0% would be appropriate so that borrowers can handle the debt burden while fixed income investors can receive a reasonable real yield (i.e., above the inflation rate) so they don’t have to take on undue risk to achieve meaningful income. As it stands today, assuming inflation has already (in real time, not lagged) resumed its downtrend, I think the real yield is too high—i.e., great for savers but bad for borrowers.

Nevertheless, I still believe any significant pullback in stocks would be a buying opportunity. As several commentators have opined, the US is the “best house in a lousy (global) neighborhood.” In an investment landscape fraught with danger nearly everywhere you turn, I see US stocks and bonds as the place to be invested, particularly as the Fed and other central banks restore rising liquidity (Infrastructure Capital Advisors predicts a $2 trillion global injection to make rates across the yield curve go down). But I also believe they should be hedged with gold and crypto. According to Michael Howell of CrossBorder Capital, a strong dollar will still devalue relative to gold and bitcoin when liquidity rises, and gold price tends to rise faster than the rise in liquidity—and bitcoin has an even higher beta to liquidity. Ever since Russia invaded Ukraine on 2/24/2022 and was sanctioned with confiscation of $300 billion in reserves, central banks around the world have been stocking up, surging gold by roughly +21% and bitcoin +60%, compared to the S&P 500 +18% (price return). During Q1, institutions bought a record 290 tons, according to the World Gold Council (WGC).

With several trillions of dollars still sitting defensively in money market funds, we are nowhere near “irrational exuberance” despite somewhat elevated valuations and the ongoing buzz around Gen AI. At the core of an equity portfolio should be US large cap exposure (despite its significantly higher P/E versus small-mid-cap). But despite strong earnings momentum of the mega-cap Tech darlings (which are largely driven by robust share buyback programs), I believe there are better investment opportunities in many under-the-radar names (across large, mid, and small caps), including among cyclicals like homebuilders, energy, financials, and REITs.

So, if you are looking outside of the cap-weighted passive indexes (and their elevated valuation multiples) for investment opportunities, let me remind you that Sabrient’s actively selected portfolios include the latest Q2 2024 Baker’s Dozen (a concentrated 13-stock portfolio offering the potential for significant outperformance) which launched on 4/19, Small Cap Growth 42 (an alpha-seeking alternative to the Russell 2000 index) which just launched last week on 5/1, and Dividend 47 (a growth plus income strategy) paying a 3.8% current yield. Notably, Dividend 47’s top performer so far is Southern Copper (SCCO), which is riding the copper price surge and, by the way, is headquartered in Phoenix—just 10 miles from my home in Scottsdale.

I talk more about inflation, federal debt, the yen, and oil markets in today’s post. I also discuss Sabrient’s latest fundamentals based SectorCast quantitative rankings of the ten U.S. business sectors (which continue to be led by Technology), current positioning of our sector rotation model, and several top-ranked ETF ideas. And in my Final Comments section, I have a few things to say about the latest lunacy on our college campuses (Can this current crop of graduates ever be allowed a proper ceremony?).

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). Please feel free to share my full post with your friends, colleagues, and clients. You also can sign up for email delivery of this periodic newsletter at Sabrient.com.

By the way, Sabrient founder David Brown has a new book coming out soon through Amazon.com in which he describes his approach to quantitative modeling and stock selection for four distinct investing strategies (Growth, Value, Dividend, and Small Cap). It is concise, informative, and a quick read. David has written a number of books through the years, and in this new one he provides valuable insights for investors by unveiling his secrets to identifying high-potential stocks. I will send out an email once it becomes available on Amazon.

  by Scott Martindale
  President & CEO, Sabrient Systems LLC

Stocks are pulling back a bit to start Q2 but have shown remarkable resilience throughout their nearly 6-month (and nearly straight-up) bull run, with the S&P 500 (SPY) finding consistent support at its 20-day simple moving average on several occasions, while the slightly more volatile Nasdaq 100 (QQQ, beta=1.18) has found solid support at the 40-day moving average. Moreover, the Relative Strength Index (RSI) on SPY has reliably bounced off the neutral line (50) on every test. And it all happened again early last week—at least until Thursday afternoon when Minnesota Fed president Neel Kashkari ventured off Fed chairman Jerome Powell’s carefully crafted script to say they may not cut interest rates at all this year if inflation’s decline continues to stall.

Before that moment, Powell had been keeping his governors in line and saying all the right things about imminent rate cuts in the pipeline (albeit making sure not to provide a firm timetable). And the pervasive Goldilocks outlook has lifted stocks to uncomfortably elevated valuations (current forward P/E for SPY of 21.3x and for QQQ of 26.6x) that suggest a need for and expectation of both solid earnings growth in 2024-25 and falling interest rates (as the discount rate on future earnings streams).

Up until Kashkari’s unexpected remarks, it appeared that once again—and in fact every time since last November, when the indexes look extremely overbought and in need of a significant pullback (as typically happens periodically in any given year) a strong bid arrived like the Lone Ranger to save the day and push stocks higher. It has burned bears and kept swing traders who like to “fade” spikes hesitant. Not surprisingly, the CBOE Volatility Index (VIX) has seen only a couple of brief excursions above the 15 line and has been nowhere near the 20 “fear threshold.”

But after his remarks, the market finished Thursday with a huge, high-volume, “bearish engulfing candle,” and the CBOE Volatility Index (VIX) surged 20% intraday (closing at 16.35), and all those previously reliable support levels gave way—until the very next day. On Friday, they quickly recovered those support levels following the apparently strong March jobs report, finishing with a “bullish harami” pattern (that typically leads to some further upside). As you recall from my March post, I have felt a correction is overdue—and the longer it holds off, the more severe the fall. The question now is whether SPY and QQQ are destined for an upside breakout to new highs and a continuation of the bull run…or for a downside breakdown to test lower levels of support. I believe we may get a bit of a bounce here, but more downside is likely before an eventual resumption in the bull run to new highs.

Regardless, the persistent strength in stocks has been impressive, particularly in the face of the Fed's quantitative tightening actions (balance sheet reduction and “higher for longer” rates)—along with the so-called “bond vigilantes” who protest excessive spending by not buying Treasuries and thus further driving up rates—that have created the highest risk-free real (net of inflation) interest rates since the Financial Crisis and reduced its balance sheet by $1.5 trillion from its April 2022 peak to its lowest level since February 2021.

But (surprise!) gold has been performing even better than either SPY or QQQ (as have cryptocurrencies, aka “digital gold”). Gold’s appeal to investors is likely in anticipation of continued buying by central banks around the world as a hedge against things like growing geopolitical turmoil, our government’s increasingly aggressive “weaponization” of the dollar to punish rogue nations, and rising global debt leading to a credit or currency crisis.

To be sure, solid GDP and employment data, a stall in inflation’s decline, rosy earnings growth forecasts for 2024-2025, tight investment-grade and high-yield credit spreads, low volatility in interest rates, a low VIX, and a sudden recovery in manufacturing activity, with the ISM Manufacturing Index having finally eclipsed the 50 threshold (indicating expansion) after 16 straight months below 50 (contraction), all beg the question of why the Fed would see a need to cut rates. As Powell himself said the other day, we have seen an unusual and unforeseen occurrence in which “productive capacity is going up even more than actual output. The economy actually isn't becoming tighter; it's actually becoming a little looser…” Indeed, the “higher for longer” mantra might seem more appropriate, at least on the surface.

Yet despite the rosy outlook and investor confidence/complacency (and Kashkari’s latest comments), the Fed continues to suggest there will be multiple rate cuts this year, as if it knows of something lurking in the shadows. And that something might be a credit crisis stemming from our hyper-financialized/ultra-leveraged economy—and the growing debt burden across government, small business, and consumers being refinanced at today’s high interest rates. We are all aware of the outright depression in commercial real estate today; perhaps there is a contagion lurking. Or perhaps it’s the scary projection for the federal debt/GDP ratio (rising from 97% of GDP last year to 166% by 2054). Or perhaps it is a brewing currency crisis with the Japanese yen, given its historic weakness that may lead the BOJ to hike rates to stem capital outflows. Or perhaps it’s because they follow the real-time “Truflation” estimate, which indicates a year-over-year inflation rate of 1.82% in contrast to the latest headline CPI print of 3.2% and headline PCE of 2.5%.

I discuss all these topics in today’s post, as well as the relative performance of various equity and asset-class ETFs that suggests a nascent market rotation and broadening may be underway, which is a great climate for active managers. Likewise, Michael Wilson of Morgan Stanley asserts that the stock rally since last fall has been driven more by loose financial conditions, extreme liquidity (leverage), and multiple expansion (rather than earnings growth), but now it's time to be a stock picker rather than a passive index investor.

So, if you are looking outside of the cap-weighted passive indexes (and their elevated valuation multiples) for investment opportunities, let me remind you that Sabrient’s actively selected portfolios include the Baker’s Dozen (a concentrated 13-stock portfolio offering the potential for significant outperformance), Small Cap Growth (an alpha-seeking alternative to the Russell 2000 index), and Dividend (a growth plus income strategy paying a 3.74% current yield). The latest Q1 2024 Baker’s Dozen launched on 1/19/24 and remains in primary market until 4/18/24 (and is already well ahead of SPY).

Click here to continue reading my full commentary in which I also discuss Sabrient’s latest fundamentals based SectorCast quantitative rankings of the ten U.S. business sectors (which continue to be led by Technology), current positioning of our sector rotation model (which turned bullish in early November and remains so today), and several top-ranked ETF ideas. Or if you prefer, here is a link to this post in printable PDF format (as some of my readers have requested). Please feel free to share my full post with your friends, colleagues, and clients! You also can sign up for email delivery of this periodic newsletter at Sabrient.com.

By the way, Sabrient founder David Brown has a new book coming out soon through Amazon.com in which he describes his approach to quantitative modeling and stock selection for four distinct investing strategies (Growth, Value, Dividend, and Small Cap). It is concise, informative, and a quick read. David has written a number of books through the years, and in this new one he provides valuable insights for investors by unveiling his secrets to identifying high-potential stocks. Please let me know if you’d like to be an early book reviewer!