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

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.