by Scott Martindale
  President & CEO, Sabrient Systems LLC

So far this year, the Federal Reserve has been removing liquidity from the markets via rate hikes and quantitative tightening, hence the 1H22 crash. But stocks have rallied strongly since the mid-June lows on the growing belief that the Fed will make one more rate hike in September and then pause ahead of the midterm elections – and perhaps even start cutting rates in the New Year. However, many others remain adamant that the Fed is committed to keep raising rates until it is clear that inflation is under control.

I remain of the belief that the hyper-financialization of the US and global economies means that rising rates could cripple debt-addicted businesses and governments (including our own federal government!), and the housing market (which is critical for a healthy consumer) depends upon mortgage rates stabilizing soon. And as the dollar further strengthens (it just went above parity with the Euro!) given the relatively higher interest rates paid by the US, some emerging market economies with dollar-denominated debt may be forced to default. In other words, today’s financial system simply can’t handle much higher rates – which suggests the Fed may already be at or near the elusive “neutral rate” and will ultimately choose to live with elevated inflation.

Earnings season has turned out better than expected, even though profit margins have been challenged by inflationary pressures. Still, at an estimate of about 12.4% (down from a record 12.8% in Q1), profit margins remain well above the 5-year average of 10.8%, according to FactSet. After a long period of low and falling inflation, massive monetary and fiscal stimulus combined with extreme supply chain disruptions (including lockdowns in manufacturing centers, labor shortages, logistics bottlenecks, and elevated energy and labor costs) sent inflation soaring. This cut into profit margins (albeit less than many predicted), as did falling US labor force productivity, which has seen its worst drop so far this year since 1948, according to DataTrek.

But now, inflation is showing signs of retreating due to both demand destruction and mending supply chains (including lower energy, commodity, and shipping costs), as well as a strong dollar. U.S. business inventories are up such that the important inventory/sales ratio is back to near pre-pandemic levels, which is disinflationary. Moreover, productivity-enhancing technologies continue to proliferate along with other disinflationary structural trends, which I believe will reverse the troublesome recent trend in labor productivity and help to contain costs and boost profitability – leading to rising corporate earnings and real wages, which together reflect a healthy and sustainable economy and stock market. All of this is of critical importance because the direction of interest rates and stock prices largely depend upon the direction of inflation and the Fed’s reaction to it.

In addition, positive catalysts like an end to Russia’s war on Ukraine or China’s COVID lockdowns, and/or a Republican sweep in November that brings greater support for domestic oil & gas production, all would be expected to hasten improvement in supply chains and have an immediate impact on inflation. In other words, compared to prior inflationary periods in history, it seems to me that there is a lot more potential on the supply side of the equation to alleviate inflation rather relying primarily on Fed policy to depress the demand side.

So, what comes next? I suggested in my late-June post that there were numerous signs of a market capitulation, and indeed the market has roared back. The big questions are whether we have seen the lows for the year and whether we will see new highs; whether this has been simply a strong bear-market rally or the start of a new bull market. I believe the current pullback is simply a normal reaction to the extremely overbought technical conditions after such a strong (nearly monotonic) rally. It simply ran into a brick wall at the convergence of the May highs and the 200-day moving average, mostly due to buyer exhaustion. In fact, some traders have observed that the S&P 500 historically has never fallen to new lows after retracing more than 50% of its bear-market losses, as it has done. I talk more about this in my full post.

In this periodic update, I provide a comprehensive market commentary, offer my technical analysis of the S&P 500 chart, review Sabrient’s latest fundamentals based SectorCast quant rankings of the ten US business sectors, and serve up some actionable ETF trading ideas. To summarize, our SectorCast rankings reflect a bullish bias, with 5 of the top 6 scorers being cyclical sectors. In addition, the technical picture looks short-term bearish but longer term bullish, and our sector rotation model has taken on a neutral posture (at least until the S&P 500 retakes its 200-day moving average). I also offer up a political comment that you might want to ponder. Read on…

  by Scott Martindale
  President & CEO, Sabrient Systems LLC

The S&P 500 officially entered a bear market by falling more than -20% from its all-time high in January, with a max peak-to-trough drawdown of nearly -25% (as of 6/17). The Nasdaq Composite was down as much as -35% from its November all-time high. During the selloff, there was no place to hide as all asset classes floundered – even formerly uncorrelated cryptocurrencies went into a death spiral (primarily due to forced unwinding of excessive leverage). But then stocks staged an impressive bounce last week, although it was mostly driven by short covering.

Earlier this year when stocks began their initial descent, laggards and more speculative names sold-off first, but later, as the selling accelerated, the proverbial baby was thrown out with the bathwater as investors either were forced to deleverage (i.e., margin calls) or elected to protect profits (and their principal). Even the high-flying Energy sector sold off on this latest down leg, falling over -25% intraday in just 10 days, as the algorithmic momentum trading programs reversed from leveraged buying of Energy to leveraged selling/shorting.

These are common signs of capitulation. So is historically low consumer and investor sentiment, which I discuss in detail later in this post. But despite the negative headlines and ugly numbers, it mostly has been an orderly selloff, with few signs of panic. The VIX has not reached 40, and in fact it hasn’t eclipsed that level since April 2020 during the pandemic selloff. Moreover, equity valuations have shrunk considerably, with the S&P 500 and S&P 600 small caps falling to forward P/Es of 15.6x and 10.8x, respectively, at the depths of the selloff (6/17). This at least partially reflects an expectation that slowing growth (and the ultra-strong dollar) will lead to lower corporate earnings than the analyst community is currently forecasting. Although street estimates have been gradually falling, consensus still predicts S&P 500 earnings will grow +10.4% in aggregate for CY2022, according to FactSet. Meanwhile, Energy stocks are back on the upswing, and the impressive outperformance this year of the Energy sector has made its proportion of the S&P 500 rise from approximately 2% to 5%...and yet the P/Es of the major Energy ETFs are still in the single digits.

A mild recession is becoming more likely, and in fact it has become desirable to many as a way to hasten a reduction in inflationary pressures. Although volatility will likely persist for the foreseeable future, I think inflation and the 10-year Treasury yield are already in topping patterns. In addition, supply chains and labor markets continue their gradual recovery, the US dollar remains strong, and the Fed is reducing monetary accommodation, leading to demand destruction and slower growth, which would reduce the excess demand that is causing inflation.

Bullish catalysts for equity investors would be a ceasefire or settlement of the Russian/Ukraine conflict and/or China abandoning its zero-tolerance COVID lockdowns, which would be expected to help supply chains and further spur a meaningful decline in inflation – potentially leading to a Fed pivot to dovish (or at least neutral)…and perhaps a melt-up in stocks. Until then, a market surge like we saw last week, rather than the start of a V-shaped recovery, is more likely just a bear market short-covering rally – and an opportunity to raise cash to buy the next drawdown.

Nevertheless, we suggest staying net long but hedged, with a heightened emphasis on quality and a balance between value/cyclicals and high-quality secular growers and dividend payers. Moreover, rather than investing in the major cap-weighted index ETFs, stocks outside of the mega-caps may offer better opportunities due to lower valuations and higher growth rates. Regardless, Sabrient’s Baker’s Dozen, Dividend, and Small Cap Growth portfolios leverage our enhanced model-driven selection approach (which combines Quality, Value, and Growth factors) to provide exposure to both the longer-term secular growth trends and the shorter-term cyclical growth and value-based opportunities. In particular, our Dividend Portfolio – which seeks quality companies selling at a reasonable price with a solid growth forecast, a history of raising dividends, a good coverage ratio, and an aggregate dividend yield approaching 4% or more to target both capital appreciation and steady income – has been holding up well this year. So has our Armageddon Portfolio, which is available as a passive index for ETF licensing.

In this periodic update, I provide a comprehensive market commentary, offer my technical analysis of the S&P 500 chart, review Sabrient’s latest fundamentals based SectorCast quant rankings of the ten US business sectors, and serve up some actionable ETF trading ideas. To summarize, our SectorCast rankings reflect a bullish bias, with 5 of the top 6 scorers being cyclical sectors. In addition, the near-term technical picture looks neutral-to-bearish after last week’s impressive bounce, and our sector rotation model remains in a defensive posture.  Read on...