by Scott Martindale
  President & CEO, Sabrient Systems LLC

The future direction of both stocks and bonds hinges on the trajectory of corporate earnings and interest rates, both of which are largely at the mercy of inflation, Fed monetary policy, and the state of the economy (e.g., recession). So far, 2023 is off to an impressive start, with both stocks and bonds surging higher on speculation that inflation will continue to subside, the Fed will soon pause rate hikes, the economy will endure at most a mild recession, China reopens, and corporate earnings will hold up…not to mention, stocks have risen in the year following a midterm election in every one of the past 20 cycles. The CBOE Volatility Index (VIX) is at a 52-week low.

Moreover, although inflation and interest rates surged much higher than I predicted at the beginning of 2022, my broad storyline around inflation and Fed policy remains intact:  i.e., a softening of its hawkish jawboning, followed by slower rate hikes and some balance sheet runoff (QT), a pause (or neutral pivot) to give the rapid rate hikes a chance to marinate (typically it takes 9-12 months for a rate hike to have its full effect), and then as inflation readings retreat and/or recession sets in, rate cuts commence leading to an extended relief rally and perhaps the start of a new (and lasting) bull market. Investors seem to be trying to get a jump on that rally. Witness the strength in small caps, which tend to outperform during recoveries from bear markets. However, I think it could be a “bull trap” …at least for now.

Although so far consumer spending, corporate earnings, and profitability have held up, I don’t believe we have the climate quite yet for a sustained bull run, which will require an actual Fed pause on rate hikes and more predictable policy (an immediate dovish pivot probably not necessary), better visibility on corporate earnings, and lower market volatility. Until we get greater clarity, I expect more turbulence in the stock market. In my view, the passive, broad-market, mega-cap-dominated indexes that have been so hard for active managers to beat in the past may see further weakness during H1 2023. The S&P 500 might simply gyrate in a trading range, perhaps 3600–4100.

But there is hope for greater clarity as we get closer to H2 2023. If indeed inflation continues to recede, China reopens, the war in Ukraine doesn’t draw in NATO (or turn nuclear), the dollar weakens, and bond yields fall further, then investor interest should broaden beyond value and defensive names to include well-valued growth stocks help to fuel a surge in investor confidence. I believe both stocks and bonds will do well this year, and the classic 60/40 stock/bond allocation model should regain its appeal.

Regardless, even if the major indexes falter, that doesn’t mean all stocks will fall. Indeed, certain sectors (most notably Energy) should continue to thrive, in my view, so long as the global economy doesn’t sink into a deep recession. Quality and value have regained their former luster (and the value factor has greatly outperformed the growth factor over the past year), which means active selection and smart beta strategies that can exploit the performance dispersion among individual stocks seem poised to continue to beat passive indexing in 2023—a climate in which Sabrient’s approach tends to thrive.

For example, our Q4 2021 Baker’s Dozen, which launched on 10/20/21 and terminates on Friday 1/20/23, is outperforming by a wide margin all relevant market benchmarks (including various mid- and small-cap indexes, both cap-weighted and equal-weight) with a gross total return of +9.3% versus -10.2% for the S&P 500 as of 1/13, which implies a +19.5% active return, led by a diverse group encompassing two oil & gas firms, an insurer, a retailer, and a semiconductor equipment company. Later in this post, I show performance for all of Sabrient’s live portfolios—including the Baker’s Dozen, Forward Looking Value, Small Cap Growth, and Dividend (which offers a 4.7% current yield). Each leverages our enhanced model that combines Value, Quality, and Growth factors to provide exposure to both longer-term secular growth trends and shorter-term cyclical growth and value-based opportunities. By the way, the new Q1 2023 Baker’s Dozen launches on 1/20.

Here is a link to a printable version of this post. In this periodic update to start the new year, I provide a comprehensive market commentary, discuss the performance of Sabrient’s live portfolios, offer my technical analysis of the S&P 500 chart, review Sabrient’s latest fundamentals based SectorCast quant rankings of the ten U.S. business sectors, and serve up some actionable ETF trading ideas. To summarize, our SectorCast rankings reflect a modestly bullish bias, the technical picture looks short-term overbought but mid-term neutral, and our sector rotation model remains in a neutral posture. Energy continues to sit atop our sector rankings, given its still ultra-low (single digit) forward P/E and expectations for strong earnings growth, given likely upside pricing pressure on oil due to the end of Strategic Petroleum Reserve releases (and flip to purchases), continued sanctions on Russia, and China’s reopening…and assuming we see only a mild recession and a second half recovery. Read on…

  by Scott Martindale
  President & CEO, Sabrient Systems LLC

Investors found optimism and “green shoots” in the latest CPI and PPI prints. As a result, both stocks and bonds have rallied hard and interest rates have fallen on the hope that inflation will continue to subside and the Fed will soon ease up on its monetary tightening. Still, there is a lot of cash on the sidelines, many investors have given up on stocks (and the longstanding 60/40 stock/bond allocation model), and many of those who are the buying the rally fear that they might be getting sucked into another deceptive bear market rally. I discuss in today’s post my view that inflation will continue to recede, stocks and bonds both will gain traction, and what might be causing the breakdown of the classic 60/40 allocation model—and whether stocks and bonds might revert back to more “normal” relative behavior.

Like me, you might be hearing highly compelling and reasoned arguments from both bulls and bears about why stocks are destined to either: 1) surge into a new bull market as inflation falls and the Fed pivots to neutral or dovish…or 2) resume the bearish downtrend as a deep recession sets in and corporate margins and earnings fall. Ultimately, whether this rally is short-lived or the start of a new bull market will depend upon the direction of inflation, interest rates, and corporate earnings growth.

The biggest driver of financial market volatility has been uncertainty about the terminal fed funds rate. DataTrek observed that the latest rally off the October lows closely matches the rally off the 12/24/2018 bottom, which was turbocharged when Fed Chair Jerome Powell backed down from his hawkish stance, which of course has not yet happened this time around. Instead, Powell continues to actively talk up interest rates (until they are “sufficiently restrictive”) while trying to scare businesses, consumers, and investors away from spending, with the goals of: 1) demand destruction to push the economy near or into recession and raise unemployment, and 2) perpetuate the bear market in risk assets (to diminish the “wealth effect” on our collective psyche and spending habits). Powell said following the November FOMC meeting that it is “very premature” to talk about a pause in rate hikes.

Indeed, the Fed has been more aggressive in raising interest rates than I anticipated. And although some FOMC members, like Lael Brainard, have started opining that the pace of rate hikes might need to slow, others—most notably Chair Powell—have stuck unflinchingly with the hawkish inflation-fighting jawboning. However, I think it is possible that Powell has tried to maintain consistency in his narrative for two reasons: 1) to reduce the terminal fed funds rate (so he won’t have to cut as much when the time comes for a pivot), and 2) to not unduly impact the midterm election with a policy change. But now that the election has passed and momentum is growing to slow the pace given the lag effect of monetary policy, his tune might start to change.

As the Fed induces demand destruction and a likely recession, earnings will be challenged. I believe interest rates will continue to pull back but will likely remain elevated (even if hikes are paused or ended) unless we enter a deep recession and/or inflation falls off a cliff. Although the money supply growth will remain low, shrinking the Fed balance sheet may prove challenging due to our massive federal budget deficit and a global economy that is dependent upon the liquidity and availability of US dollars (for forex transactions, reserves, and cross-border loans)—not to mention the reality that a rising dollar exacerbates inflationary pressures for our trading partners and anyone with dollar-denominated debt.

Thus, the most important catalyst for achieving both falling inflation and global economic growth is improving supply chains—which include manufacturing, transportation, logistics, energy, and labor. Indeed, 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 bring supply and demand into better balance and alleviate inflation, rather than relying primarily on Fed policy to depress the demand side (and perhaps induce a recession). The good news is that disrupted supply chains are rapidly mending, and China has announced plans to relax its zero-tolerance COVID restrictions, which will be helpful. Even better news would be an end to Russia’s war on Ukraine, which would have a significant impact on supply chains.

In any case, it appears likely that better opportunities can be found outside of the passive, cap-weighted market indexes like the S&P 500 and Nasdaq 100, and the time may be ripe for active strategies that can exploit the performance dispersion among individual stocks. Quality and value are back in vogue (and the value factor has greatly outperformed the growth factor this year), which means active selection is poised to beat passive indexing—a climate in which Sabrient's GARP (growth at a reasonable price) approach tends to thrive. Our latest portfolios—including Q4 2022 Baker’s Dozen, Forward Looking Value 10, Small Cap Growth 36, and Dividend 41 (which sports a 4.8% current yield as of 11/15)—leverages our enhanced model-driven selection approach (which combines Quality, Value, and Growth factors) to provide exposure to both: 1) the longer-term secular growth trends and 2) the shorter-term cyclical growth and value-based opportunities.

By the way, if you like to invest through a TAMP or ETF, you might be interested in learning about Sabrient’s new index strategies. I provide more detail below on some indexes that might be the timeliest for today’s market.

Here is a link to a printable version of this post. In this periodic update, I provide a comprehensive market commentary (including constraints on hawkish Fed actions and causes of—and prognosis for—the breakdown of the classic 60/40 portfolio), discuss the performance of Sabrient’s live portfolios, offer my technical analysis of the S&P 500 chart, review Sabrient’s latest fundamentals based SectorCast quant rankings of the ten U.S. business sectors, and serve up some actionable ETF trading ideas. To summarize, our SectorCast rankings reflect a modestly bullish bias, the technical picture looks short-term overbought but mid-term bullish, and our sector rotation model has moved from a defensive to neutral posture. Read on...

  by Scott Martindale
  President & CEO, Sabrient Systems LLC

The rally to kick off Q4 was most welcome, but it quickly petered out. We must acknowledge that macro conditions are still dicey, and no industry is showing leadership—not even the Energy industry, with oil prices surging and green energy getting a tailwind from the new IRA spending bill. The traditional 60/40 stock/bond portfolio could be in for its worst year ever as interest rates surge while stocks flounder. Only the dollar is strong, as the US dollar index has hit its highest level in 20 years.

On the one hand, some commentators believe that things always look darkest before the dawn, so perhaps a bottom is near, and it is time to begin accumulating good companies. Others say there needs to be one more leg down, to perhaps 3400 on the S&P 500 (and preferably with the VIX touching 40), before the buying opportunity arrives. Either is a near-term bullish perspective, which aligns with my view.

On the other hand, there are those who say that markets don’t clear out such massive distortions quite so quickly. So, after such a long period in which “buy the dip” has always paid off (for many traders, it has been so their entire adult life), things are different now, including no “Fed put” or the shadowy “Plunge Protection Team” to backstop the market. Indeed, they say that given the persistent inflation, central banks can no longer embolden speculators by jumping in quickly to cushion market risk—and so, we should be preparing ourselves for global economic restructuring, broad liquidation, and a long, wealth-destroying bear market. This is not my expectation.

The most important number these days is the CPI, and the September number came in at 8.2%, which was only slightly below August’s 8.3%. Of course, inflation is a lagging indicator, and new Fed monetary policy actions can take several months to show their impact, but the Fed’s hawkish jawboning indicates it has less fear of a “doing too much than too little,” which I disagree with as I discuss in today’s post. Although the Fed’s preferred PCE gauge isn’t released until 10/28, market consensus following the CPI print is now for a 75-bp rate hike on 11/2 followed by another 75-bp hike on 12/14, and then a final 25-50 bps in February before it ultimately pauses with the fed funds rate around 5% or so.

However, because the September CPI print (again, a lagging indicator) shows a flatline with some slowing in inflation, it bolsters my ongoing view that inflation is on the decline, the economy is slowing down fast, and the Fed ultimately will raise less than expected (perhaps even calling for pause to watch and reflect after a 75-bp hike on 11/2) because of the vulnerabilities of a hyper-financialized global economy to rapidly rising rates and an ultra-strong dollar. Even bearish Mike Wilson of Morgan Stanley believes the Fed will need to tone down its hawkish monetary policy as global US dollar liquidity is now in the "danger zone where bad stuff happens.” In effect, a strong dollar creates QT (quantitative tightening) of global monetary policy.

It all hinges on the trajectory of corporate earnings and interest rates, both of which are largely at the mercy of the trajectory of inflation, Fed monetary policy decisions, and the state of the economy (e.g., recession). I believe inflation and bond yields are in volatile topping patterns (including the recent "blow-off top" in the 10-year Treasury yield to over 4.0%). Supply chains are gradually recovering (albeit hindered by Russia’s war) and the Fed is creating demand destruction, recession, and a global investor desire for the safety and income of elevated Treasury yields. Also constraining the Fed’s ability to shrink its balance sheet is a world hungry for dollars (for forex transactions, reserves, and cross-border loans), a massive federal debt load, and the reality that a rising dollar is painful to other currencies by exacerbating inflationary pressures for our trading partners and anyone with dollar-denominated debt service.

The biggest risks of course are catastrophic escalation in the war, or untamed inflation coupled with a rapid withdrawal of liquidity…or the possibility that central banks’ disinflationary tools of yore are no longer effective. But if inflation and nominal yields continue to fall, real yields (nominal minus inflation) should follow, leading to a neutral Fed pivot, improving corporate profitability, rising earnings, and perhaps some multiple expansion on stock valuations (e.g., higher P/Es). I discuss all of this in today’s post.

We continue to suggest staying long but hedged (e.g., with leveraged inverse ETFs and index puts). For long positions, a heightened emphasis on quality is appropriate, with a balance between value/cyclicals/dividend payers and high-quality secular growers. Sabrient’s terminating Q3 2021 Baker’ Dozen shows a +6% active gross total return versus the S&P 500 through 10/14 (even without any Energy exposure), while the latest Q3 2022 Baker’s Dozen that launched on 7/20 already shows a +8% active return of (with 23% Energy exposure). Also, our latest Dividend portfolio is sporting a 5.5% yield.

By the way, if you are a financial advisor who uses a TAMP (like SMArtX or Envestnet, for example) and might be interested in adding one of Sabrient’s new index strategies to your portfolio mix, please reach out to me directly for discussion! We have 17 strategies to consider. I provide more detail below on 3 strategies that might be the most timely today.

Here is a link to a printable version of this 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 the top 5 scorers being economically sensitive sectors. In addition, the technical picture shows the S&P 500 may have successfully tested critical support at its reliable 200-week moving average, although our sector rotation model remains in a defensive posture. Read on…

  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

Stocks continued their bullish charge from the pandemic selloff low on 3/23/20 into early-June, finally stumbling over the past several days due to a combination of overbought technicals, a jump in COVID cases as the economy tries to reopen, and the Fed giving grim commentary on the pace of recovery. But then of course Fed chair Jerome Powell (aka Superman) swooped in this week to save the day, this time to shore up credit markets with additional liquidity by expanding bond purchases into individual corporate bonds rather than just through bond ETFs. But despite unprecedented monetary and fiscal policies, there are many prominent commentators who consider this record-setting recovery rally to be an unwarranted and unsustainable “blow-off top” to a liquidity-driven speculative bubble that is destined for another harsh selloff. They think stocks are pricing in a better economy in the near-term than we enjoyed before the pandemic hit, when instead normalization is likely years away.

Certainly, the daily news and current fundamentals suggest that investors should stay defensive. But stocks always price a future vision 6-12 months in advance, and investors are betting on better times ahead. Momentum, technicals, fear of missing out (FOMO), and timely actions from our Federal Reserve have engendered a broad-based bullish foundation to this market that appears much healthier than anything displayed over the past five years, which was marked by cautious sentiment due to populist upheaval, political polarization, Brexit, trade wars, an attempt to “normalize” interest rates following several years of zero interest-rate policy (ZIRP), and the narrow leadership of the five famed mega-cap “FAAAM” Tech stocks – namely Microsoft (MSFT), Apple (AAPL), Amazon (AMZN), Alphabet (GOOG), and Facebook (FB).

Equal-weight indexes solidly outperformed the cap-weighted versions during the recovery rally from the selloff low on 3/23/20 through the peak on 6/8/20. For example, while the S&P 500 cap-weighted index returned an impressive +45%, the equal weight version returned +58%. Likewise, expanded market breadth is good for Sabrient, as our Baker’s Dozen portfolios ranged from +62% to +83% (and an average of +74%) during that same timeframe, led by the neglected small-mid caps and cyclical sectors. Our Forward Looking Value, Small Cap Growth, and Dividend portfolios also substantially outperformed – and all of them employ versions of our growth at a reasonable price (GARP) selection approach.

Although the past week since 6/8/20 has seen a pullback and technical consolidation, there remains a strong bid under this market, which some attribute to a surge in speculative fervor among retail investors. There is also persistently elevated volatility, as the CBOE Volatility Index (VIX) has remained solidly above the 20 fear threshold since 2/24/20, and in fact has spent most of its time in the 30s and 40s (or higher) even during the exuberant recovery rally. And until earnings normalize, the market is likely to remain both speculative and volatile.

Regardless, so long as there is strong market breadth and not sole dependence on the FAAAM stocks (as we witnessed for much of the past five years), the rally can continue. There are just too many forces supporting capital flow into equities for the bears to overcome. I have been predicting that the elevated forward P/E on the S&P 500 might be in store for further expansion (to perhaps 23-25x) before earnings begin to catch up, as investors position for a post-lockdown recovery. Indeed, the forward P/E hit 22.5x on 6/8/20. But I’d like to offer an addendum to this to say that the forward P/E may stay above 20x even when earnings normalize, so long as the economy stays in growth mode – as I expect it will for the next few years or longer as we embark upon a new post-recession expansionary phase. In fact, I believe that rising valuation multiples today, and the notion that the market actually has become undervalued, are a direct result of: 1) massive global liquidity, 2) ultra-low interest rates, and 3) the ever-growing dominance of secular-growth Technology on both our work processes and the broad-market indexes – all conspiring to create a TINA (“There is No Alternative”) climate for US equities.

In this periodic update, I provide a market commentary, offer my technical analysis of the S&P 500, and review Sabrient’s latest fundamentals-based SectorCast rankings of the ten US business sectors, and serve up some actionable ETF trading ideas. In summary, while our sector rankings look neutral (as you might expect given the poor visibility for earnings), the technical picture is bullish, and our sector rotation model moved to a bullish posture in late May.

As a reminder, Sabrient has enhanced its forward-looking and valuation-oriented stock selection strategy to improve all-weather performance and reduce relative volatility versus the benchmark S&P 500, as well as to put secular-growth companies (which often display higher valuations) on more equal footing with cyclical-growth firms (which tend to display lower valuations). You can find my latest Baker’s Dozen slide deck and commentary on terminating portfolios at http://bakersdozen.sabrient.com/bakers-dozen-marketing-materials.  Read on....