by Scott Martindale
  President & CEO, Sabrient Systems LLC

Falling inflation, weak manufacturing activity, cautious consumer sentiment, and sluggish GDP and jobs growth have conspired to elicit a dovish tone from the Federal Reserve and the likely start of a rate cut cycle to avert recession and more jobs losses. I continue to pound the table that the Fed is behind the curve and should have begun to cut at the July meeting.

Why? Well, here are my key reasons:

1. Although official inflation metrics still reflect lingering “stickiness” in consumer prices, my research suggests that real-time inflation is already well below the Fed’s 2% target, as I discuss in detail in today’s post.

2. Last week’s BLS jobs report shows 66,000 fewer employed workers in August 2024 versus 12 months ago after massive downward revisions to prior reports. And if you dig deeper into the August household survey it gets worse, indicating a whopping 1.2 million fewer full-time jobs (yikes!), partially offset by a big growth in part-time jobs.

3. The mirage of modest GDP and jobs growth has been temporarily propped up by unhealthy and inefficient government deficit spending (euphemistically called “investment”) rather than true and sustainable organic growth from a vibrant private sector that is adept at efficient capital allocation. Thus, despite government efforts to “buy” growth, recessionary signals are growing at home and abroad.

4. The burden caused by elevated real interest rates on surging debt across government, business, consumers at home and emerging markets abroad, and the impact of tight monetary policy and a relatively strong dollar on our trading partners must be confronted.

So, a 50-bps cut at the September FOMC meeting next week seems warranted—even if it spooks the markets. 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.”

A terminal fed funds neutral rate of 3.0-3.5% seems appropriate, in my view, which is roughly 200 bps below the current range of 5.25-5.50%). Fortunately, today’s lofty rate means the Fed has plenty of potential rate cuts in its holster to support the economy while remaining relatively restrictive in its inflation fight. And as long as the trend in global liquidity is upward (which it is once again), then it seems the risk of a major market crash is low.

Regarding the stock market, as the Magnificent Seven (MAG-7) mega-cap Tech stocks continue to flounder, markets have displayed some resilience since the cap-weighted S&P 500 and Nasdaq 100 both topped in mid-July, with investors finding opportunities in neglected market segments like financials, healthcare, industrials, and defensive/higher-dividend sectors utilities, real estate, telecom, and staples—as well as gold (as both a store of value and protection from disaster). However, economic weakness, “toppy” charts, and seasonality (especially in this highly consequential election year) all suggest more volatility and downside ahead into October.

Of course, August was tumultuous, starting with the worst one-day selloff since the March 2020 pandemic lockdown followed by a moon-shot recovery back to the highs for the S&P 500 (SPY) and S&P 400 MidCap (MDY), while the Dow Jones Industrials (DIA) surged to a new high. However, the Nasdaq 100 (QQQ) and Russell 2000 SmallCap (IWM) only partially retraced their losses. And as I said in my August post, despite the historic spike in the CBOE Volatility Index (VIX), it didn’t seem like the selloff was sufficient to shake out all the weak investors and form a solid foundation for a bullish rise into year end. I said that I expected more downside in stocks and testing of support before a tradeable bottom was formed, especially given uncertainty in what the FOMC will do on 9/18 and what the elections have in store.

In addition, September is historically the worst month for stocks, and October has had its fair share of selloffs (particularly in presidential election years). And although the extraordinary spike in fear and “blood in the streets” in early August was fleeting, the quick bounce was not convincing. The monthly charts remain quite extended (“overbought”) and are starting to roll over after August’s bearish “hanging man” candlestick—much like last summer. In fact, as I discussed in my post last month, the daily price pattern for the S&P 500 in 2024 seems to be following 2023 to a T, which suggests the weakness (like last year) could last into October before streaking higher into year end. Anxiety around a highly consequential election on 11/5 (with counting of mail-in ballots likely to last several days beyond that once again) will surely create volatility.

Many commentators believe the Fed is making a policy mistake, but it goes both ways. Some believe the Fed is turning dovish too quickly because inflation is sticky, the jobs market is fine, and GDP is holding up well, so it risks reigniting inflation. Others (like me) think the FOMC is reacting too slowly because the economy, jobs growth, and inflation are weaker than the mirage they seem, masked by inordinate government deficit spending, misleading headline metrics, and political narratives. As Fed Chair Jerome Powell said at the July meeting, “The downside risks to the employment mandate are now real,” and yet the FOMC still chose to hold off on a rate cut. Now it finds itself having to commence an easing cycle with the unwanted urgency of staving off recession rather than a more comfortable “normalization” objective within a sound economy.

Indeed, now that we are past Labor Day, it appears the “adults” are back in the trading room. As I discuss in detail in today’s post, economic metrics seem to be unraveling fast, stocks are selling off, and bonds are getting bought—with the 2-10 yield curve now “un-inverted” (10-year yield exceeds the 2-year). So, let’s get moving on rate normalization. After all, adjusting the interest rate doesn’t flip a switch on economic growth and jobs creation. It takes time for lower rates and rising liquidity to percolate and reverse downward trends, just as it took several months for higher rates and stagnant liquidity to noticeably suppress inflation. Fed funds futures today put the odds of a 50-bps cut at about 27%.

Nevertheless, stock prices are always forward-looking and speculative with respect to expectations of economic growth, corporate earnings, and interest rates, so prices will begin to recover before the data shows a broad economic recovery is underway. I continue to foresee higher prices by year end and into 2025. Moreover, I see current market weakness setting up a buying opportunity, perhaps in October. But rather than rushing back into the MAG-7 stocks exclusively, I think other stocks offer greater upside. 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 the growth-oriented Baker’s Dozen (our “Top 13” stocks), the value-oriented Forward Looking Value, the growth & income-oriented Dividend portfolio, and Small Cap Growth, which is 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, 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 shortly.

In today’s post, I discuss in greater detail the current trend in inflation, Fed monetary policy, and what might lie ahead for the stock market as we close out a tumultuous Q3. I also discuss 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. And be sure to check out my Final Thoughts section with some political comments—here’s a teaser: Democrats have held the presidency for 12 of the past 16 years since we emerged from the Financial Crisis, so all these problems with the economy, inflation, immigration, and global conflict they promise to “fix” are theirs to own.

Click here to continue reading my full commentary online or to sign up for email delivery of this monthly market letter. And here is a link to it in printable PDF format. I invite you to share it as appropriate (to the extent your compliance allows).

  by Scott Martindale
  President & CEO, Sabrient Systems LLC

Last week, the much-anticipated inflation readings for May—and the associated reaction from the Fed on planned rate cuts—was pretty much a non-event. The good news is core inflation continues to gradually fall. The bad news is it isn’t falling fast enough for the Fed. Headline CPI and PPI are pretty much stagnant over the past 12 months. This led the Fed to be mealy-mouthed about rate cuts. One might ask, why does it matter so much what the Fed does when the economy is doing fine, we have avoided recession, wages are growing, jobs are plentiful, unemployment is low, and asset prices are rising?

But the reality is there is a slow underlying deterioration happening from the lag effects of monetary tightening that is becoming increasingly apparent, including a lack of organic jobs and GDP growth (which is instead largely driven by government deficit spending) and a housing market (important for creating a “wealth effect” in our society) that is weakening (with growing inventory and slowing sales) given high mortgage rates that make for reluctant sellers and stretched buyers (notably, the 10-year yield and mortgage rates have pulled back of late just from rate cut talk). Moreover, real-time shelter inflation (e.g., rent) has been flat despite what the long-lagged CPI metrics indicate, and the real-time, blockchain-based Truflation reading has been hovering around 2.2% YoY, which happens to match the April and May PPI readings—all of which are very close to the Fed’s 2.0% inflation target.

Of course, stock market valuations are reliant upon expectations about economic growth, corporate earnings, and interest rates; and interest rates in turn are dependent on inflation readings. Although some observers saw promising trends in some components of May CPI and PPI, Fed chair Jay Powell played it down with the term “modest further progress,” and the “dot plot” on future rate cuts suggests only one or perhaps two rate cuts later this year.

Nevertheless, I continue to believe the Fed actually wants to cut rates sooner than later, and likely will do so during Q3—especially now that central banks in the EU, Canada, Sweden, Switzerland, Brazil, Chile, and Mexico have all cut rates. Moreover, Japan is struggling to support the yen with a positive interest rate—but it needs to keep rates low to prevent hurting its highly leveraged economy, so it needs the US to cut rates instead. The popular yen “carry trade” (short the yen, buy the dollar and US Treasuries) has been particularly difficult for the BoJ. All told, without commensurate cuts here in the US, it makes the dollar even stronger and thus harder on our trading partners to support their currencies and on emerging markets that tend to carry dollar-denominated debt. I talk more about this and other difficulties outside of the (often misleading) headline economic numbers in today’s post—including the “tapped out” consumer and the impact of unfettered (wartime-esque) federal spending on GDP, jobs, and inflation.

As for stocks, so far, the market’s “Roaring 20’s” next-century redux has proven quite resilient despite harsh obstacles like global pandemic, multiple wars, a surge in inflation, extreme political polarization and societal discord, unpredictable Fed policy, rising crime and mass immigration, not to mention doors flying off commercial aircraft (and now counterfeit titanium from China!). But investors have sought safety in a different way from the past, particularly given that stubborn inflation has hurt real returns. Rather than traditional defensive plays like non-cyclicals, international diversification, and fixed income, investors instead have turned to cash-flush, secular-growth, Big Tech. Supporting the bullishness is the CBOE Volatility Index (VIX), which is back down around the 12 handle and is approaching levels not seen since 2017 during the “Trump Bump.” And given their steady performance coupled with the low market volatility, it has also encouraged risk-taking in speculative companies that may ride coattails of the Big Tech titans.

But most of all, of course, driving the rally (other than massive government deficit spending) has been the promise, rapid development, and implementation of Gen AI—as well as the new trends of “on-premises AI” for the workplace that avoids disruptions due to connectivity, latency, and cybersecurity, and AI personal computers that can perform the complex tasks of an analyst or assistant. The Technology sector has gone nearly vertical with AI giddiness, and it continues to stand alone atop Sabrient’s SectorCast rankings. And AI poster child NVIDIA (NVDA), despite being up 166% YTD, continues to score well in our Growth at Reasonable Price (GARP) model (95/100), and reasonably well in our Value model (79/100).

Nevertheless, I continue to believe there is more of a market correction in store this summer—even if for no other reason than mean reversion and the adage that nothing goes up in a straight line. Certainly, the technicals have become extremely overbought, especially on the monthly charts—which show a lot of potential downside if momentum gets a head of steam and the algo traders turn bearish. On the other hand, the giddy anticipation of rate cuts along with the massive stores of cash in money market funds as potential fuel may well keep a solid bid under stocks. Either way, longer term I expect higher prices by year end and into 2025 as high valuations are largely justified by incredible corporate earnings growth, a high ratio of corporate profits to GDP, and the promise of continued profit growth due to tremendous improvements in productivity, efficiency, and the pace of product development across the entire economy from Gen AI. In addition, central banks around the world are starting to cut rates and inject liquidity, which some expect to add as much as $2 trillion into the global economy—and into stocks and bonds.

On another note, it is striking that roughly half the world’s population goes to the polls to vote on their political leadership this year, and increasingly, people around the world have been seeking a different direction, expressing dissatisfaction with the status quo of their countries including issues like crime, mass immigration (often with a lack of assimilation), sticky inflation, stagnant economic growth, and a growing wealth gap—all of which have worsened in the aftermath of the pandemic lockdowns and acquiescence to social justice demands of the Far Left. Ever since the Brexit and Trump victories in 2016, there has been a growing undercurrent of populism, nationalism, capitalism, and frustration with perceived corruption, dishonesty, and focus on global over local priorities. Not so long ago, we saw a complete change in direction in El Salvador (Bukele) and Argentina (Milei) with impressive results (e.g., reducing rampant crime and runaway inflation), at least so far. Most recently, there were surprises in elections in India, Mexico, and across Europe. Although we are seeing plenty of turmoil of our own in the US, global upheaval and uncertainty always diverts capital to the relative safety of the US, including US stocks, bonds, and the dollar.

I expect US large caps to remain an attractive destination for global investment capital. But while Tech gets all the (well deserved) attention for its disruptive innovation and exponential earnings growth, there are many companies that can capitalize on the productivity-enhancing innovation to drive their own growth, or those that are just well positioned as “boring” but high-quality, cash-generating machines that enjoy strong institutional buying, strong technicals, and strong fundamentals in stable, growing business segments—like insurers and reinsurers for example.

So, I believe both US stocks and bonds will do well this year (and next) but should be hedged with gold, crypto, and TIPS against a loss in purchasing power (for all currencies, not just the dollar). Furthermore, I believe all investors should maintain exposure to the Big Tech titans with their huge cash stores and wide moats, as well as perhaps a few of the speculative names (as “lottery tickets”) having the potential to profit wildly as suppliers or “coat-tailers” to the titans, much of their equity exposure should be in fundamentally solid names with a history of and continued expectations for consistent and reliable sales and earnings growth, rising profit margins and cash flow, sound earnings quality, and low debt.

Indeed, Sabrient has long employed such factors in our GARP model for selecting our growth-oriented Baker’s Dozen portfolio, along with other factors for other portfolios like our Forward Looking Value portfolio, which relies upon our Strategic Valuation Rank (SVR), our Dividend portfolio, which is a growth & income strategy that relies on our proprietary Dividend Rank (DIV), and our Small Cap Growth portfolio, an alpha-seeking alternative to the Russell 2000. Notably, our Earnings Quality Rank (EQR) is not only a key factor we use internally for each of these portfolios, but it is also licensed to the actively managed 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 published imminently. (I will send out a notification soon!)

In today’s post, I talk more about inflation, the Fed, and the extreme divergences in relative performance and valuations. I also discuss Sabrient’s latest fundamentals based SectorCast quantitative rankings of the ten U.S. business sectors (which, no surprise, continue to be led by Technology), current positioning of our sector rotation model, and several top-ranked ETF ideas. And don’t skip my Final Comments section, in which I have something to say about BRICS’ desire to create a parallel financial system outside of US dollar dominance, and the destructiveness of our politically polarized society and out-of-control deficit spending.

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 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!

  by Scott Martindale
  President & CEO, Sabrient Systems LLC

The US stock market has gone essentially straight up since late October. While the small-cap Russell 2000 (IWM) surged into year-end 2023, pulled back, and is just now retesting its December high, the mega-cap dominated S&P 500 (SPY) and Nasdaq 100 (QQQ) have both surged almost uninterruptedly to new high after new high. They have both briefly paused a few times to test support at the 20-day moving average but have not come close to testing the 50-day, while the CBOE Volatility Index (VIX) has closed below 16 the entire time. History says this can’t go on much longer.

I think this market rally is getting out over its skis and needs at least a breather if not a significant pullback to cleanse itself of the momentum “algo” traders and FOMO investors and wring out some of this AI-led bullish exuberance. That’s not say we are imminently due for a harsh correction back down to prior support for SPY around 465 (-9%) or to fill the gap on the daily chart from November 13 at 440 (-14%). But it will eventually retest its 200-day moving average, which sits around 450 today but is steadily rising, so perhaps the aforementioned 465 level is good target for a pullback and convergence with the 200-day MA.

Regardless, I believe that short of a Black Swan event (like a terrorist strike on US soil or another credit crisis) that puts us into recession, stocks would recover from any correction to achieve new highs by year-end. As famed economist Ed Yardeni says, “Over the years, we’ve learned that credit crunches, energy crises, and pandemic lockdowns cause recessions. We are looking out for such calamities. But for now, the outlook is for a continuation of the expansion.”

As for bonds, they have been weak so far this year (which pushes up interest rates), primarily because of the “bond vigilantes” who are not happy with the massive issuances of Treasuries and rapidly rising government debt and debt financing costs. So, stocks have been rising even as interest rates rise (and bonds fall), but bonds may soon catch a bid on any kind of talk about fiscal responsibility from our leaders (like Fed chair Powell has intimated).

So, I suspect both stocks and bonds will see more upside this year. In fact, the scene might follow a similar script to last year in which the market was strong overall but endured two significant pullbacks along the way—one in H1 and a lengthier one in H2, perhaps during the summer months or the runup to the election.

Moreover, I don’t believe stocks are in or near a “bubble.” You might be hearing in the media the adage, “If it’s a double, it’s a bubble.” Over the past 16 months since its October 2022 low, the market-leading Nasdaq 100 (QQQ) has returned 72% and the SPY is up 47%. Furthermore, DataTrek showed that, looking back from 1970, whenever the S&P has doubled in any 3-year rolling period (or less), or when the Nasdaq Composite has doubled in any 1-year rolling period, stock prices decline soon after. Well, the rolling 3-year return for the S&P 500 today is at about 30%. And the high-flying Nasdaq 100 is up about 50% over the past year. So, there appears to be no bubble by any of these metrics, and the odds of a harsh correction remain low, particularly in a presidential election year, with the added stimulus of at least a few rate cuts expected during the year.

Meanwhile, while bitcoin and Ethereum prices have surged over the past few weeks to much fanfare, oil has been quietly creeping higher, and gold and silver have suddenly caught a strong bid. As you might recall, I said in my December and January blog posts, “I like the prospects for longer-duration bonds, commodities, oil, gold, and uranium miner stocks this year, as well as physical gold, silver, and cryptocurrency as stores of value.”  I still believe all of these are good holds for 2024. The approval of 11 “spot” ETFs for bitcoin—rather than futures-based or ETNs—was a big win for all cryptocurrencies, and in fact, I hear that major institutions like Bank of America, Wells Fargo, and Charles Schwab (not to mention all the discount brokers) now offer the Bitcoin ETFs—like Grayscale Bitcoin Trust (GBTC) and iShares Bitcoin Trust (IBIT), for example—to their wealth management clients. And they have just begun the process of allocating to those portfolios (perhaps up to the range of 2-5%).

As for inflation, I opined last month that inflation already might be below the 2% target such that the Fed can begin normalizing fed funds rate toward a “neutral rate” of around 3.0% nominal (i.e., 2% target inflation plus 1.0% r-star) versus 5.25–5.50% today. But then the January inflation data showed an uptick. Nonetheless, I think it will prove temporary, and the disinflationary trends will continue to manifest. I discuss this in greater length in today’s post. Also, 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, I think the real yield is too high—i.e., great for savers but bad for borrowers.

Finally, 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 a passive index like the Russell 2000), and Dividend (a growth plus income strategy paying a 3.8% current yield). The new Q1 2024 Baker’s Dozen just launched on 1/19/24.

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 continues 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. 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 geared mostly to individual investors, although financial advisors may find it valuable as well. I will provide more information as we get closer to launch. In the meantime, as a loyal subscriber, please let me know if you’d like to be an early book reviewer!

  by Scott Martindale
  President & CEO, Sabrient Systems LLC

To be sure, 2023 was another eventful year (they just keep coming at us, don’t they?), ranging from escalating hot wars to a regional banking crisis, rising interest rates, falling inflation, a dire migration crisis, and an AI-driven frenzy in the so-called “Magnificent Seven” (MAG7) corporate titans— Meta Platforms (META, ne: FB), Apple (AAPL), Nvidia (NVDA), Alphabet (GOOGL), Microsoft (MSFT), Amazon (AMZN), and Tesla (TSLA), aka “FANGMAT,” as I used to call them—which as a group contributed roughly 60% to the S&P 500’s +26.2% gain in 2023. Their hyper-growth means that they now make up roughly 30% of the index. Nvidia (NVDA), whose semiconductors have become essential for AI applications, was the best performer for the full year at +239%.

Small caps finally found some life late in the year, with the Russell 2000 small cap index essentially keeping up with the S&P 500 starting in May and significantly outperforming in December. Bonds also made a big comeback late in the year on Fed-pivot optimism, which allowed the traditional 60/40 stock/bond allocation portfolio to enjoy a healthy return, which I’m sure made a lot of investors and their advisors happy given that 60/40 had been almost left for dead. The CBOE Volatility Index (VIX) has been below 20 for virtually the entirety of 2023 and as low as 11.81 in December, closing the year at 12.45. Also, as a breadth indicator, the percentage of stocks that finished the year above their 200-day moving average hit 75%, which is bullish.

Nevertheless, the Russell 2000 (+16.8%) and the equal-weight version of the S&P 500 (+13.7%) were up much less for the full year than the cap-weighted S&P 500 (+26.2%) and Nasdaq 100 (+54.9%). In fact, 72% of the stocks in the S&P 500 underperformed the overall index for the full year, illustrating that despite the improvement in breadth during the second half of the year, it could not overcome the huge outperformance of a small cohort of dominant companies. This suggests that either the market is set up for a fall in 2024 (as those dominant companies sell off) …or we’ll get a continued broadening into other high-quality companies, including mid- and small caps. I think it will be the latter—but not without some volatility and a significant pullback. Indeed, despite signaling investor confidence and complacency by remaining low for a long stretch, the VIX appears to be ripe for a spike in volatility. I think we could see a significant market correction during H1 (perhaps to as low as 4,500 on the S&P 500) even if, as I expect, real GDP growth slows but remains positive and disinflationary trends continue, supporting real wage growth and real yields—before seeing an H2 rally into (and hopefully following) the November election. And don’t forget there’s a potential tsunami of cash from the $6 trillion held in money market funds, as interest rates fall, much of it may well find its way into stocks.

Not surprisingly, last year ended with some tax-loss harvesting (selling of big losers), and then the new year began last week with some tax-gain harvesting—i.e., selling of big winners to defer tax liability on capital gains into 2024. There also has been some notable rotation of capital last week into 2023’s worst performers that still display strong earnings growth potential and solid prospects for a rebound this year, such as those in the Healthcare, Utilities, and Consumer Staples sectors. Homebuilders remain near all-time highs and should continue to find a tailwind as a more dovish Fed means lower mortgage rates and a possible housing boom. Energy might be interesting as well, particularly LPG shipping (a big winner last year) due to its growing demand in Europe and Asia.

As I discussed in my December commentary, I also like the prospects for longer-duration bonds, commodities, oil, gold, and uranium miner stocks this year, as well as physical gold, silver, and cryptocurrency as stores of value in an uncertain macro climate. Also, while Chinese stocks are near 4-year lows, many other international markets are near multi-year highs (including Europe and Japan), particularly as central banks take a more accommodative stance. Indeed, Sabrient’s SectorCast ETF rankings show high scores for some international-focused ETFs (as discussed later in this post).

While stocks rallied in 2023 (and bonds made a late-year comeback) mainly due to speculation on a Fed pivot toward lower interest rates (which supports valuations), for 2024 investors will want to see more in the way of actual earnings growth and other positive developments for the economy. I expect something of a “normalization” away from extreme valuation differentials and continued improvement in market breadth, whether it’s outperformance by last year’s laggards or a stagnation/pullback among last year’s biggest winners (especially if there are fewer rate cuts than anticipated)—or perhaps a bit of both. Notably, the S&P 500 historically has risen 20 of the last 24 election years (83%); however, a recent Investopedia poll shows that the November election is the biggest worry among investors right now, so it’s possible all the chaos, wailing and gnashing of teeth about Trump’s candidacy will make this election year unique with respect to stocks.

Regardless, I continue to believe that investors will be better served this year by active strategies that can identify and exploit performance dispersion among stocks across the capitalization spectrum—particularly smaller caps and the underappreciated, high-quality/low-valuation growers. Small caps tend to carry debt and be more sensitive to interest rates, so they have the potential to outperform when interest rates fall, but you should focus on stocks with an all-weather product line, a robust growth forecast, a solid balance sheet, and customer loyalty, which makes them more likely to withstand market volatility—which may well include those must-have, AI-oriented Tech stocks. Much like the impact of the Internet in the 1990s, AI/ML, blockchain/distributed ledger technologies (DLTs), and quantum computing appear to be the “it” technologies of the 2020’s that make productivity and efficiency soar. However, as I discuss in today’s post, the power requirements will be immense and rise exponentially. So, perhaps this will add urgency to what might become the technology of the 2030’s—i.e., nuclear fusion.

On that note, 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 a passive index like the Russell 2000), and Dividend (a growth plus income strategy paying a 4.5% current yield).

By the way, several revealing economic reports were released last week, which I discuss in today’s post. One was the December reading on the underappreciated New York Federal Reserve Global Supply Chain Pressure Index (GSCPI), which has fallen precipitously from it pandemic-era high and now is fluctuating around the zero line. This historically suggests falling inflation readings ahead. As for the persistently inverted yield curve, I continue to believe it has more to do with the unprecedented supply chain shocks coupled with massive fiscal and monetary stimulus to maintain demand and the resulting surge in inflation, which as observed by Alpine Macro, “makes the inversion more reflective of different inflation expectations than a signal for an impending recession.”

Also, although M2 money supply fell -4.6% from its all-time high in July 2022 until its low in April 2023, it has essentially flatlined since then and in fact has been largely offset to a great extent by an increase in the velocity of money supply. Also, we have a robust jobs market that has slowed but is far from faltering. And then there is the yield curve inversion that has been gradually flattening from a low of about -108 bps last July to -35 bps today.

I discuss all of this in greater detail in today’s post, including several illustrative tables and charts. I also discuss Sabrient’s latest fundamentals based SectorCast quantitative rankings of the ten U.S. business sectors (which is topped by Technology), current positioning of our sector rotation model (which turned bullish in early November and remains so), and some actionable ETF trading ideas.

Overall, I expect inflation will resume its decline, even with positive GDP growth, particularly given stagnant money supply growth, mending and diversifying supply chains (encompassing manufacturing, transportation, logistics, energy, and labor), falling or stabilizing home sale prices and new leases, slowing wage inflation, slower consumer spending on both goods and services, and a strong deflationary impulse from China due to its economic malaise and “dumping” of consumer goods to shore up its manufacturing (US imports from China were down 25% in 2023 vs. 2022). This eventually will give the Fed (and indeed, other central banks) license to begin cutting rates—likely by mid-year, both to head off renewed crises in banking and housing and to mitigate growing strains on highly leveraged businesses, consumers, government, and trading partners. Current CBOE fed funds futures suggest a 98% chance of at least 100 bps in rate cuts by year end (target rate of 4.25-4.50%), and 54% chance of at least 150 bps.

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). And 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 Scott Martindale
  President & CEO, Sabrient Systems LLC

As expected, last week the FOMC left the fed funds rate as is at 5.25-5.50%. Fed funds futures suggest the odds of a hike at the December meeting have fallen to less than 10%, and the odds of at least three 25-bp rate cuts by the end of 2024 have risen to nearly 80%, with a 25% chance the first cut comes as soon as March. As a result, after moving rapidly to cash for the past few months, stock and bond investors came rushing back with a vengeance. But what really goosed the market were underwhelming economic reports leading to Fed Chair Jerome Powell’s comments suggesting the lag effects on surging interest rates and the strong US dollar are finally manifesting. Investors apparently believed the Fed’s promise of “higher for longer” (making the Fed’s job easier), which spiked Treasury yields (and by extension, mortgage rates) much faster and more severely than the Fed intended.

The S&P 500 had fallen well below all major moving averages, accelerating downward into correction territory, and was down 10% from its 7/31 high. Moreover, the S&P 500 Bullish Percent Index (BPSPX), which rarely drops below 25, had fallen to a highly oversold 23 (anything below 30 is considered oversold), and the CBOE Volatility Index (VIX) had surged above the 20 “panic threshold” to hit 23. Both were contrarian bullish signals. Then stocks began to recover ahead of the FOMC meeting, and after the less-than-hawkish policy announcement, it triggered short covering and an options-driven “gamma squeeze,” with the S&P 500 surging above its 200-day, 50-day, and 20-day moving averages (leaving only the 100-day still above as potential resistance), the BPSPX bullish percent closed the week at 43 (which is still well below the overbought level of 80 last hit on 7/31), and the VIX closed the week below 15.

The recovery rally was broad, and in five short days put the major indexes back to where they were two weeks ago. The best performers were those that sold off the most, essentially erasing the late-October swoon in any instant. As for Treasury yields, the week ended with the 2-year at 4.84% (after hitting 5.24% in mid-October) and the 10-year at 4.57% (after touching 5.0% in mid-October), putting the 2-10 inversion at -27 bps. The 30-year mortgage rate has fallen back below 7.50%. Recall that my “line in the sand” for stocks has been the 2-year staying below 5.0%, and indeed falling below that level last week correlated with the surge in equities.

Looking ahead, investors will be wondering whether last week’s huge relief rally is sustainable, i.e., the start of the much-anticipated Q4 rally. After all, it is well known that some of the most startling bull surges happen during bear markets. Regardless, stock prices are ultimately based on earnings and interest rates, and earnings look quite healthy while interest rates may have topped out, as sentiment indicators are flashing contrarian buy signals (from ultra-low levels). But much still hinges on the Fed, which is taking its cues from inflation and jobs reports. Last week’s FOMC statement suggests a lessening of its hawkishness, but what if the Fed has viewed our post-pandemic, return-to-normalcy, sticky-inflation economic situation—and the need for harsh monetary intervention—all wrong?

Much of the empirical data shows that inflation was already set to moderate without Fed intervention, given: 1) post-lockdown recovery in supply chains, rising labor force participation, and falling excess savings (e.g., the end to relief payments and student debt forbearance); and 2) stabilization/contraction in money supply growth. These dynamics alone inevitably lead to consumer belt-tightening and slower economic growth, not to mention the resumption in the disinflationary secular trends and the growing deflationary impulse from a struggling China.

Notably, the New York Fed’s Global Supply Chain Pressure Index (GSCPI), which measures the number of standard deviations from the historical average value (aka Z-score) and generally presages movements in PPI (and by extension, CPI), was released earlier today for October, and it plummeted to -1.74, which is its lowest level ever. This bodes well for CPI/PPI readings next week and PCE at month end, with a likely resumption in their downtrends. So, although the Fed insists the economy and jobs are strong and resilient so it can focus on taming the scourge of inflation through “higher for longer” interest rates, I remain less concerned about inflation than whether the Fed will pivot quickly enough to avoid inducing an unnecessary recession.

Assuming the Fed follows through on its softer tone and real yields continue to fall (and we manage to avoid World War III), I think this latest rally has given investors renewed legs—likely after a profit-taking pullback from last week’s 5-day moonshot. With over 80% of the S&P 500 having reported, Q3 earnings are handily exceeding EPS expectations (3.7% YoY growth, according to FactSet, driven mostly by a robust profit margin of 12.1%), and optimistic forecasts for 2024-2025 earnings growth are holding up. Meanwhile, a renewed appetite for bonds promises to drive down interest rates.

I like the prospects for high-quality/low-debt technology companies, bonds and bond-proxies (e.g., utilities and consumer staples), oil and uranium stocks, gold miners, and bitcoin in this macro climate. Furthermore, we continue to believe that, rather than the broad-market, passive indexes that display high valuations, investors may be better served by active stock selection Sabrient’s portfolios include the new Q4 2023 Baker’s Dozen (launched on 10/20), Small Cap Growth 40 (just launched on 11/3), and Sabrient Dividend 45 (launched on 9/1, and today offers a 5.5% dividend yield).

In today’s post, I discuss the trend in supply chains and inflation, equity valuations, and Fed monetary policy implications. 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 is switching from neutral to a bullish bias, assuming support at the 50-day moving average holds for the S&P 500), 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).

  by Scott Martindale
  President & CEO, Sabrient Systems LLC

Federal shutdown averted, at least for another 6 weeks, which may give investors some optimism that cooler heads will prevail in the nasty tug-of-war between the budget hawks and the spendthrifts on the right and left flanks. Nevertheless, I think stocks still may endure some turmoil over the next few weeks before the historically bullish Q4 seasonality kicks in—because, yes, there are still plenty of tailwinds.

From a technical standpoint, at the depths of the September selloff, 85% of stocks were trading below their 50-day moving averages, which is quite rare, and extreme September weakness typically leads to a strong Q4 rally. And from a fundamental standpoint, corporate earnings expectations are looking good for the upcoming Q3 reporting season and beyond, as analysts are calling for earnings growth of 12.2% in 2024 versus 2023, according to FactSet. But that still leaves us with the interest rate problem—for the economy and federal debt, as well as valuation multiples (e.g., P/E) and the equity risk premium—given that my “line in the sand” for the 2-year Treasury yield at the 5% handle has been solidly breached.

But the good news is, we learned last week that the Fed’s preferred inflation metric, core PCE (ex-food & energy), showed its headline year-over-year (YoY) reading fall to 3.9% in August (from 4.3% in July). And more importantly in my view, it showed a month-over-month (MoM) reading of only 0.14%, which is a better indicator of the current trend in consumer prices (rather than comparing to prices 12 months ago), which annualizes to 1.75%—which of course is well below the Fed’s 2% inflation target. Even if we smooth the last 3 MoM reports for core PCE of 0.17% in June, 0.22% in July, and 0.14% in August, the rolling 3-month average annualizes to 2.16%. Either way, it stands in stark contrast to the upward reversal in CPI that previously sent the FOMC and stock and bond investors into a tizzy.

Notably, US home sales have retreated shelter costs have slowed, wage inflation is dropping, and China is unleashing a deflationary impulse by dumping consumer goods and parts on the global market in a fit of desperation to maintain some semblance of GDP growth while its critical real estate market teeters on the verge of implosion.

So, core inflation is in a downtrend while nominal interest rates are rising, which is rapidly driving up real rates, excessively strengthening the dollar, threatening our economy, and contributing to distress among our trading partners and emerging markets—including capital flight, destabilization, and economic migration. Also, First Trust is projecting interest on federal debt to hit 2.5% of GDP by year-end, up sharply from 1.85% last year (which was the highest since 2001 during a steep decline from its 1991 peak of 3.16%).

Therefore, I believe the Fed is going to have to lighten up soon on hawkish rate policy and stagnant/falling money supply. When the Fed decides it’s time to cut rates—both to head off escalating crises in banking and housing and to mitigate growing strains on highly leveraged businesses, consumers, and foreign countries (from an ultra-strong dollar and high interest rates when rolling maturing debt)—it would be expected to ignite a sustained rally in both stocks and bonds.

But even if the AI-leading, Big Tech titans can justify their elevated valuations with extraordinary growth—and according to The Market Ear, they trade at the largest discount to the median stock in the S&P 500 stock in over 6 years on a growth-adjusted basis—investors still may be better served by active strategies that exploit improving market breadth by seeking “under the radar” opportunities poised for explosive growth, rather than the broad passive indexes. So, we believe this is a good time to be invested in Sabrient’s portfolios—including the new Q3 2023 Baker’s Dozen (launched on 7/20), Forward Looking Value 11 (launched on 7/24), Small Cap Growth 39 (launched on 8/7), and Sabrient Dividend 45 (launched on 9/1 and today offers a 5.5% dividend yield).

In today’s post, I discuss inflation, stock-bond relative performance, equity valuations, and Fed monetary policy implications. I also discuss Sabrient’s latest fundamentals based SectorCast quantitative rankings of the ten U.S. business sectors (which continues to be topped by Technology and Energy), current positioning of our sector rotation model (neutral bias), and some actionable ETF trading ideas. Your feedback is always welcome!

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).

  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 & CEO, Sabrient Systems LLC

April CPI and PPI both reflect continued moderation—albeit as much as the precipitous fall in the Global Supply Chain Pressure Index would suggest (given that supply chains comprise nearly 40% of inflation, according to the New York Fed). The fed funds rate is now officially above both CPI and PCE. Nevertheless, despite hinting in their May FOMC statement that a pause in rate hikes may be imminent, the Fed insists there are no rate cuts in the foreseeable future because inflation remains stubbornly high. But this singular focus on inflation is ignoring all the fallout their hawkishness is causing—which is why investors are not buying it, and instead are pricing in a 99% chance of at least one 25-bp rate cut by year-end and a 17% chance of four cuts (according to CME Group fed funds futures, as of 5/12) while scooping up Treasuries. Regardless, I expect inflation readings to fall substantially over the coming months.

On the good-news front, both investment grade and high yield bond spreads remain tame and in fact are roughly the same level as they were one year ago. Typically, a rise in credit spreads corresponds to a drop in the S&P 500, and indeed the SPY is roughly unchanged over the past year as well. So, apparently there is little fear of a “hard landing” or mass defaults on corporate debt. And given the historical 90% correlation between economic growth and corporate profits, the better-than-expected Q1 earnings season is promising. Certainly juggernaut/bellwether Apple (AAPL) and most of its mega-cap Tech (or near-Tech) cohorts (aka FAANGM) have done their part.

So, this all supports the bull case, right? If inflation remains in a downward trend while earnings are holding up, and investors are so confident in imminent rate cuts, then why are most stocks (other than the aforementioned mega caps) struggling for traction?

Well, it seems there’s always something else to worry about. There is the regional banking crisis (and associated credit crunch) that refuses to go away quietly, thanks to nervous depositors who don’t want to be the last ones left holding the bag. And then there is that pesky debt ceiling standoff, which is easily fixable but also highly politically charged. Amazingly, US credit default swaps are currently priced higher than in emerging markets (including debt graveyards like Mexico, Greece, and Brazil), with potential payouts upwards of 2,500% if the crap hits the fan, according to Bloomberg! Why then are Treasuries simultaneously getting bought up? I think it’s because there’s no doubt about “if” interest will be paid but rather “when,” so they serve as both a value play and a safe haven.

In my view, overly dovish fiscal and monetary policies during the pandemic lockdowns (helicopter money and surging money supply) followed by hawkish policies (rapid increase in interest rates and shrinking of money supply) have been overly disruptive to the both the US and global economies, including a severely inverted yield curve (consistently 50-60 bps on the 10-2 year Treasuries), a banking crisis, and a strong dollar (as a safe haven, despite the recent pullback), which has exported inflation to emerging markets, exacerbating geopolitical turmoil and mass migration (including our border crisis)—not to mention paralysis in the US housing market as homeowners are reluctant to sell and give up their low interest rate mortgages. So, I continue to believe the FOMC has gone too far, too fast in raising rates in its single-minded focus on inflation—which was already destined to fall as supply chains (including manufacturing, transportation, logistics, labor, and energy) gradually recovered.

Moreover, the apparent strength and resilience of the mega-cap-dominated S&P 500 and Nasdaq 100 is a bit of an illusion. While the FAANGM stocks provided strong earnings reports and have performed quite well this year, beneath the surface the story is less inspiring, as illustrated by the relative performance of the equal-weight and small-cap indexes, as I discuss below. From a positive standpoint, fearful investor sentiment is often a contrarian signal, and elevated valuations of the broad market indexes—24.6x forward P/E for the Nasdaq 100 (QQQ) and 18.1x for the S&P 500 (SPY)—suggest that investors expect lower interest rates ahead. However, the high valuations and relatively low equity risk premium (ERP) on those mega-cap-dominated indexes may lead institutional investors to target small and mid-cap stocks as inflation falls and rate cuts arrive, such that market breadth improves.

I believe this enhances the opportunity for skilled active selection and strategic beta indexes that can exploit elevated dispersion among individual stocks. It was money supply (and the resultant asset inflation) that pushed up stock prices. So, if money supply continues to recede, while it will help suppress inflationary pressures, it will be difficult for the mega-cap-driven market indexes to advance—although well-chosen, high-quality individual stocks can still do well.

On that note, the Q2 2023 Baker’s Dozen launched on 4/20. The portfolio has a diverse mix across market caps, equally split between value and growth and between cyclical and secular growers. Some of the constituents are familiar names, like large-cap Delta Airlines (DAL), but many are relatively “under the radar” stocks, like mid-cap cloud security firm Zscaler (ZS), small-cap oil & gas services firm NextTier Oilfield Solutions (NEX), and small-cap mortgage servicer Mr. Cooper Group (COOP). By the way, Sabrient’s newest investor tool is called SmartSheets, providing fast and easy scoring, screening, and monitoring of over 4,200 stocks and 1,200 equity ETFs, and they are available for free download for a limited time. SmartSheets comprise two simple downloadable spreadsheets with 9 of our proprietary quant scores for stocks and 3 scores for ETFs. Please check them out and send me your feedback!

Here is a link to my full post in printable format. In this periodic update, I provide a comprehensive market commentary, review Sabrient’s latest fundamentals based SectorCast quant rankings of the ten U.S. business sectors, and serve up some actionable ETF trading ideas. Read on…