by Scott Martindale
  President & CEO, Sabrient Systems LLC

The first half of 2024 looked a lot like the first half of 2023. As you recall, H1 2023 saw a strong stock market despite only modest GDP growth as inflation metrics fell, and H2 2023 continued on the same upward path for stocks despite a slowdown in inflation’s retreat, buoyed by robust GDP growth. Similarly, for H1 2024, stocks have surged despite a marked slowdown in GDP growth (from 4.1% in the second half of 2023 to an estimated 1.5% in the first half of 2024) and continued “stickiness” in inflation—causing rate-cut expectations to fall from 7 quarter-point cuts at the start of the year to just 2 at most.

And yet stocks have continued to surge, with 33 record highs this year for the S&P 500 through last Friday, 7/5. Of course, it is no secret that the primary driver of persistent market strength, low volatility (VIX in the mid-12’s), and an extreme low in the CBOE put/call ratio (around 0.50) has been the narrow leadership of a handful of dominant, innovative, mega-cap Tech titans and the promise of (and massive capital expenditures on) artificial intelligence. But while the S&P 500 is up +17.4% YTD and Nasdaq 100 +21.5% (both at all-time highs), the small cap indexes are flat to negative, with the Russell 2000 languishing -14% below its June 2021 all-time high.

Furthermore, recessionary signals abound. GDP and jobs growth are slowing. Various ISM indexes have fallen into economic contraction territory (below 50). Q2 earnings season kicks off in mid-July amid more cuts to EPS estimates from the analyst community. Given a slowing economy and falling estimates, it’s entirely possible we will see some high-profile misses and reduced forward guidance. So, investors evidently believe that an increasingly dovish Fed will be able to revive growth without revving up inflation.

But is this all we have to show for the rampant deficit spending that has put us at a World War II-level ratio of 120% debt (nearly $35 trillion) to GDP (nearly $29 trillion)? And that doesn’t account for estimated total unfunded liabilities—comprising the federal debt and guaranteed programs like Social Security, Medicare, employee pensions, and veterans’ benefits—estimated to be around $212 trillion and growing fast, not to mention failing banks, municipal pension liabilities, and bankrupt state budgets that might eventually need federal bailouts.

Moreover, the federal government “buying” jobs and GDP in favored industries is not the same as private sector organic growth and job creation. Although the massive deficit spending might at least partly turn out to be a shrewd strategic investment in our national and economic security, it is not the same as incentivizing organic growth via tax policies, deregulation, and a lean government. Instead, we have a “big government” politburo picking and choosing winners and losers, not to mention funding multiple foreign wars, and putting it all on a credit card to be paid by future generations. I have more to say on this—including some encouraging words—in my Final Comments section below.

As for inflation, the Fed’s preferred gauge, Core Personal Consumption Expenditures (PCE, aka Consumer Spending), for May was released on 6/28 showing a continued downward trend (albeit slower than we all want to see). Core PCE came in at just +0.08% month-over-month (MoM) from April and +2.57% YoY. But Core PCE ex-shelter is already below 2.5%, so as the lengthy lag in shelter cost metrics passes, Core PCE should fall below 2.5% as well, perhaps as soon as the update for June on 7/26, which could give the Fed the data it needs to cut. By the way, the latest real-time, blockchain-based Truflation rate (which historically presages CPI) hit a 52-week low the other day at just 1.83% YoY.

In any case, as I stated in my June post, I am convinced the Fed would like to starting cutting soon—and it may happen sooner than most observers are currently predicting. Notably, ever since the final days of June—marked by the presidential debate, PCE release, various jobs reports, and the surprising results in Europe and UK elections, the dollar and the 10-year yield have both pulled back—perhaps on the view that rate cuts are indeed imminent. On the other hand, the FOMC might try to push it out as much as possible to avoid any appearance of trying to impact the November election. However, Fed chair Powell stated last week that the committee stands ready to cut rates more aggressively if the US labor market weakens significantly (and unemployment just rose above the magic 4-handle to 4.1%)—so it appears the investor-friendly “Fed put” is back in play, which has helped keep traders bullishly optimistic. The June readings for PPI and CPI come out later this week on 7/11-12, and July FOMC policy announcement comes out on 7/31.

And as inflation recedes, real interest rates rise. As it stands today, I think the real yield is too high—great for savers but bad for borrowers, which would suggest the Fed is behind the curve. The current fed funds rate is roughly 3% above the CPI inflation forecast, which means we have the tightest Fed interest rate policy since before the 2008 Global Financial Crisis (aka Great Recession). This tells me that the Fed has plenty of room to cut rates and still maintain restrictive monetary policy.

As I have said many times, I believe a terminal fed funds rate of 3.0-3.5% would be the appropriate level so that borrowers can handle the debt burden while fixed income investors can receive a reasonable real yield.

Nevertheless, even with rates still elevated today, I believe any significant pullback in stocks (which I still think is coming before the November election, particularly in light of the extraordinarily poor market breadth) would be a buying opportunity. It’s all about investor expectations. As I’ve heard several commentators opine, the US, warts and all, is the “best house in a lousy [global] neighborhood.” I see US stocks and bonds (including TIPS) as good bets, particularly as the Fed and other central banks inject liquidity. But rather than chasing the high-flyers, I suggest sticking with high-quality, fundamentally strong stocks, displaying accelerating sales and earnings and positive revisions to Wall Street analysts’ consensus estimates.

By “high quality,” I mean fundamentally strong companies with a history of, and continued expectations for, consistent and reliable sales and earnings growth, upward EPS revisions from the analyst community, 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 (primary market for the Q2 portfolio ends on 7/18), value-oriented Forward Looking Value portfolio, growth & income-oriented Dividend portfolio, and our Small Cap Growth portfolio (an alpha-seeking alternative to a passive position in the Russell 2000), as well as in our SectorCast ETF ranking model. 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 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 out shortly (I will send out a notification soon!).

In today’s post, I provide a detailed commentary on the economy, inflation, valuations, Fed policy expectations, and Sabrient’s latest fundamentals based SectorCast quantitative rankings of the ten U.S. business sectors, current positioning of our sector rotation model heading into earnings season, and several top-ranked ETF ideas.

Click here to continue reading my full commentary. Or if you prefer, here is a link to this post in printable PDF format. I invite you to share it with your friends, colleagues, and clients (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

Stocks are once again challenging all-time highs as the forward earnings estimates are being raised at an historically high rate in the wake of another impressive earnings season that blew away all consensus expectations. YTD through May, index total returns were strong across the board, including +12.7% for S&P 500, +6.6% for Nasdaq 100 (as mega-cap growth endured the brunt of the Value rotation), and +15.2% for Russell 2000 small caps. The strong earnings reports have given rise to further upgrades to forward sales and earnings from a highly cautious analyst community, many of whom are still concerned about COVID variants, supply chains, inflation, and Fed tapering, among many other worries.

Nevertheless, share prices have not gone up as fast as earnings, so valuations have receded a bit, with the S&P 500 falling from a forward P/E of 21.8x at the start of the year to 21.2x at the end of May (i.e., -2.8% versus a total return of +12.7%). Cyclicals in particular have seen this same trend, since they were largely bid up on speculation. For example, Energy (XLE) is up +39.2% YTD, but its forward P/E has fallen from 29.2x to 17.2x (-28.4%). With plenty of cash on the sidelines, many investors likely are holding back and hoping for a solid pullback rather than deploy cash at what may still appear to be elevated valuations and stretched technicals, as they move past a speculative investing mindset and into a more fundamentals and quality-oriented stage. While more speculative asset classes like SPACs and cryptocurrencies already have endured a pretty severe correction (driven by negative press or tweets from influential personalities), stocks really haven’t yet seen a healthy cleansing.

When the April YOY CPI reading came out on 5/12 at a surprisingly high +4.2%, stocks were expected to selloff hard, led by mega-cap growth stocks. But instead, they quickly gathered conviction and resumed their march higher. Small-cap value (which is dominated by cyclical sectors like Financial, Industrial, Materials, and Consumer Discretionary) in particular remains quite strong this year as the Value rotation continues in the face of an expansionary/recovery economic phase, unabated government support and largesse, and a continued productivity boom. And with GDP growth accelerating, particularly as the economy fully reopens and hobbled global supply chains are mended or rerouted, it is likely that the Street’s forward earnings estimates (even after the recent upgrades) are still too low, which means stocks should have more room to run without relying upon multiple expansion, in my view.

So, two questions seem to linger on everyone’s mind: 1) how might inflationary pressures impact economic growth and the stock market, and 2) are stock valuations overdone and at risk of a major correction? I tackle these questions in today’s post. In short, I believe earnings momentum should win out over overblown inflation worries and multiple contraction as we embark upon a multi-year boom (a “Roaring ‘20s” redux?) – but not without bouts of volatility.

With no clear path for runaway inflation and given the recent rotation out of the Growth factor, investors now seem to be adding exposure to both secular and cyclical growth – which is what my regular readers know I have been suggesting and what Sabrient’s GARP portfolios reflect (including our flagship Baker’s Dozen). As a reminder, you can go to http://bakersdozen.sabrient.com/bakers-dozen-marketing-materials to find my latest presentation slide deck and market commentary (which includes an update on the Q2 2020 Baker’s Dozen portfolio and an overview of the latest Q2 2021 Baker’s Dozen).

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 sector rankings reflect a solidly bullish bias, the technical picture is still long-term bullish (although in need of further near-term consolidation), and our sector rotation model retains its bullish posture. Read on….

by Scott Martindale
President, Sabrient Systems LLC

In my prior commentary in early May, I wrote that investors were aggressively bidding up stocks and appeared to have “stopped looking over their shoulders with fear and anxiety and are instead focused on the opportunities ahead.” The S&P 500 was retrenching after a breakout to new highs in preparation for a major upside move driven by a risk-on rotation – which I expected would bode quite well for Sabrient’s Baker’s Dozen portfolios that have been predominantly composed of stocks from growth-oriented cyclical sectors and small-mid caps. After all, recession fears had subsided, US and Chinese economic data were improving, Q1 corporate profits were coming in better than expected, the Fed had professed that it had our backs, and of course, a resolution to the US/China trade impasse was imminent. Or so it seemed. Instead, the month of May gave stocks a wild ride.

It was exactly one year ago that President Trump escalated the trade war with China from simple threats of tariffs to actual numbers and dates, which ignited a risk-off rotation and a starkly bifurcated market, as the S&P 500 large-cap index continued to rise on the backs of defensive sectors and mega-caps while risk-on cyclical sectors and small-mid caps sold off. The big oversold risk-on recovery following Christmas Eve began to peter out in late-April as the S&P 500 challenged its all-time high, but then the breakdown in negotiations in last month created another risk-off market reaction reminiscent of last summer. In other words, stocks and investor sentiment have been jerked around by Trump’s tweetstorms.

I talk a lot more about China and the trade war in today’s commentary, but the upshot is that this problem has been festering for a long time, and to his credit, President Trump decided he wasn’t going to continue the practice of kicking the can down the road to a future administration. China clearly (and dangerously) is intent on challenging the US for global dominance – economically, technologically, and militarily – with its powerful brand of state-sponsored capitalism. I support the cause against China’s unfair practices, given the enormous importance for our nation’s future – even though the resulting lengthy period of risk-off sentiment (essentially 9 of the past 12 months) has been challenging for Sabrient’s growth-and-valuation-driven portfolios (which are dominated by the neglected cyclical sectors and smaller caps), as the negative news stream creates a disconnect between analyst consensus earnings estimates and investor preferences. Fund flows instead suggest strong demand for low-volatility and momentum strategies as well as fixed income (tilted to shorter maturities and higher credit quality), and the 10-year TIPS breakeven inflation rate has fallen to 1.73% (as worries of deflation have set in).

In response to the recession fears and rampant defensive sentiment, the FOMC felt compelled last week to issue a highly accommodative statement that essentially said, we got your back, which turned around the fading stock market. Fed chairman Jay Powell asserted that the trade war is on the list of the committee’s concerns and that the central bank would “act as appropriate to sustain the expansion,” i.e., cut interest rates if necessary. This explicitly reestablished the proverbial “Fed put” as a market backstop, and investors liked it. We already are seeing a somewhat weaker dollar, which could be a further boost to US equities (especially those that sell internationally).

My view is that the May pullback was another buy-the-dip opportunity, particularly in risk-on market segments, as the pervasive worries about imminent global recession and a bear market caused by escalating trade wars have little basis in reality. The latest defensive rotation, including shunning of cyclical sectors, relative weakness in small caps, and global capital flight into Treasuries causing plunging yields (and a 3-mo/10-yr yield curve inversion), has been driven by uncertainty rather than hard data. Every piece of worsening economic data can be offset with encouraging data, in my view. Yes, the economic expansion (consecutive positive GDP prints) has been going on for a longer-than-average period of time, but there is no time limit on expansions, i.e., they don’t die of old age but rather from excesses and inflation that must be reined in (but there is nary of whiff of inflation anywhere in the developed world). I still expect that a resolution to the trade war will send stocks in general, and risk-on market segments in particular, into orbit … but until then, it is hard to predict when investor sentiment will again align with the still-solid fundamentals.

In this periodic update, I provide a market commentary, offer my technical analysis of the S&P 500, review Sabrient’s latest fundamentals based SectorCast rankings of the ten US business sectors, and serve up some actionable ETF trading ideas. In summary, our sector rankings have turned neutral, while the sector rotation model retains its bullish posture. Read on…