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

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

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).