Are US PMIs bottoming? If so, Industrials gain >90% of the time with 12M returns 20-30%. 5 stocks + 3 ETFs. While seasonals and "hotter" economic data drive risk-off, Fed becoming "data dependent" historically leads to rising stocks despite higher rates.

Following several somewhat “hotter” data prints, markets are now moving back into the “higher for longer” camp, and in turn, markets are shifting into risk-off. We think this will prove to be temporary as much of the “hot” inflationary data points stem, in part, from seasonals (Jan issues) and warmer weather (in Jan). So some payback is coming.

Still, this is just further reflect that equity markets have become “data reactive” while the Fed has become “data dependent.” That is, for the past 5 months (since October 2022 lows), investor sentiment and “narratives” shift rapidly each data point, even as the larger story arc shows inflation slowing.

• Some of the weakness in equities is purely “seasonals” as the composite of “rule of 1st 5 days” (see below) shows stocks historically consolidated between 2/16 to 3/7 on the heels of strong January gains.
• Markets reflexively treat “Fed still set to hike” as a risk-off signal. However, since 1970, of the 14 Fed hiking cycles, only 3 saw equities fall as Fed was raising rates. Yes. This is shown below. The 3 cycles of “higher Fed funds = falling stocks” were (i) Fed Burns 1973-1974, (ii) Burns 1976-1978 and (iii) Powell 2022-now.
• Stocks rose during the 11 other Fed hike periods. That means 78% of the time, when Fed is hiking, stocks are rising.
• What is the difference? Burns was trying to stamp out inflation in a hurry, similar to Powell’s “higher in a hurry” of 2022. What about Volcker? His inflation war of 1979 to 1982 was one of fighting inflation on multiple fronts including keeping interest rates pinned at levels Fed Chair Miller implemented (>10%).
• What might surprise most investors is that equities compounded at 15.6% under Fed Chair Volcker, the best stock performance of any Fed Chair. Even Fed Chair Miller (between Burns and Volcker) managed 13% gains despite “higher for longer” rates.
• The point is that a tough Fed doesn’t mean stocks need to fall at every hint of an inflation data point. Moreover, the Fed is increasingly “data dependent” which we see as a Fed raising rates predictably. This means a higher terminal rate is not the death knell for stocks.
• Under Fed Chair Greenspan, he embarked on 5 hiking cycles lasting 12-24 months. And 5 of 5 times, equity prices managed to gain. See our point? A Fed that is predictable is not “shocking” equity markets. We think this pattern will emerge as dominant later in 2023.
• In the meantime, we are wondering if US Manufacturing PMIs might finally be bottoming. The S&P Global Feb US PMIs came out at 47.8, the second consecutive month of improvement. The ISM Manu PMIs are still falling and Feb is due out on 3/1.
• Since 1948, Industrial stocks see the best risk/reward once the PMIs slip below 50. When PMIs <48 (like today), 12M median return is +18.6% with a 79% win-ratio.
• If the PMIs are bottoming (hence rising), median return jumps to +32% with a 12M win-ratio of 98%. Yes, Industrials should dramatically outperform if the PMIs are bottoming.

SEASONALS HURT: But 2023 thesis intact

Stocks took a gut punch Tuesday, but as the chart below highlights, the uptrend remains intact.

And as we wrote about last week, there is some seasonal weakness to be expected. After all, the strong Jan historically borrows from Feb. And in the composite below, using the 7 precedent instances of S&P 500 gaining >1.4% on the first 5 days (“rule of 1st 5 days”), there is a period of congestion that can be expected from 2/16 to 3/7.

PMI BOTTOMING? If so Industrials should lead

The manufacturing PMIs have been falling since early 2021, taking a more dramatic downturn after Fed began its ‘higher in a hurry’ approach in early 2022.

• The S&P US PMIs could be bottoming, rising for 2 consecutive months. This could be a head fake as this also happened in early 2022, but the difference is the Fed soon thereafter began shocking markets.
• The ISM Manufacturing PMIs are still falling, showing no evidence of bottoming, but this could come with the Feb ISMs to be released on March 1.

As the chart below shows, Industrials equity performance closely tracks the changes in PMIs. This has been the case since 1948.

• so both level and rate of change seem to matter

Industrials equity performance inverse to PMIs

Industrials equity returns are inverse to the level of PMIs. That is, on an absolute basis:

• since 1948
• best time to buy Industrials is when the PMIs are below 48
• they are below 48 today
• the win ratio >88% when PMIs are in the lowest decile

And this is even more true if the PMIs have bottomed. As shown, when PMIs bottomed:

• since 1948
• Industrials 12M returns surge to >32% when PMIs <44
• Even below 50, the 12M return is +21.5%

STRATEGY: 5 stocks and 3 ETFs to leverage exposure to Industrials

We have listed 5 stocks and 3 ETFs linked to Industrials:

• Granny Shots: GD 0.18%  JCI 1.94%
• Seasonality stocks: BA -1.80%  HWM 2.31%  TDG 1.05%
• ETFs: XLI 0.66%  VIS IYJ 0.74%

VOLCKER: Stocks did well under the most “hawkish” Fed

There is a misconception that stocks did poorly under Volcker. The opposite is true. In fact, during his 8 year tenure, stocks were only down in 1981. Yup, 1 year.

• Powell is working with the best employment market perhaps in history
• this is a reason we don’t think he needs to crush equities
• in fact, stocks did worst under Burns, which was characterized by a “data reactive” Fed.
• the Fed has communicated that it is becoming “data dependent”
• we pointed out 11 of 14 hiking cycles were akin to “data dependent” and stocks perform well.

So while we don’t think Powell needs to go full “Volckan,” equities did well under Volcker.

Take a look at the periods below and you can see what we are highlighting. Stocks did well under most hiking cycles.

• yes, this is contrary to most views
• FYI, the most “data dependent” period was arguably during the Greenspan years
• 5 of 5 times, equities rose during those hiking cycles.

MARKET STRUCTURE: Vast improvement in market structure – 5 SIGNALS now

Lastly, the S&P 500 has seen vast improvements in market structure. This is something that Mark Newton, our Head of Technical Strategy at Fundstrat, has been commenting upon. Take a look:

• on 1/9/2023, the “rule of 1st 5 days >1.4%” triggered
• on 1/12/2023, the trifecta of market breadth triggered, first time EVER since 1950 (see past reports)
• on 1/23/2023, the 3rd day S&P 500 close >200D, first time since Jan 2022
• on 2/2/2023, S&P 500 “golden cross” where 50D > 200D, first time since March 2022
• on 2/7/2023, S&P 500 closed above 50% retracement of entire decline for 2nd day

The list is growing to validate that internal market structure of S&P 500 is vastly improving.

STRATEGY: Technology is primary beneficiary of Fed “course correction”

The best way to play easing financial conditions, in our view, is owning Technology and even small-caps. As the charts below highlight, both QQQ 1.54%  and IWM 1.03%  are breaking out decisively

• IWM is more evident as the breakout was 1/11
• QQQ breaking out on a relative basis and just crossed above the 200D

STRATEGY: VIX matters far more for 2023 returns than EPS growth

Our data science team compiled the impact on 2023 equity returns from variables:

• S&P 500 post-negative year (2022)
• the varying impacts of
• VIX or volatility
• USD change
• Interest rates
• EPS growth
• All of the 4 above, positive or negative YoY
• Data is based on rolling quarters and summarized below

The surprising math and conclusions are as follows:

• most impactful is VIX
• Post-negative year (rolling LTM)
• if VIX falls, equity gain is 22% (win ratio 83%, n=23)
• if VIX rises, equity lose -23% (win ratio 14%, n=7)
• I mean, this shows this all comes down to the VIX
• EPS growth has little impact
• If EPS growth is negative YoY (likely), median gain +14.8% (win-ratio 70% n=33)
• If EPS growth is positive YoY, median gain is 15.5% (win-ratio is 78%)
• Hardly a sizable bifurcation

As the scatter below highlights, we can see the sizable influence of the VIX. Even in all years, the VIX is a key factor:

• in our view, if inflation falls sharply
• and wage growth slows
• Fed doesn’t have to cut, but this is a dovish development
• we see VIX falling to sub-20
• hence, >20% upside for stocks

And as shown below, EPS growth has a somewhat important correlation, but hardly as strong as VIX changes.

• the difference in median gain is a mere 70bp (positive vs negative) post-negative year
• the importance of EPS growth is stronger in other years

STRATEGY: Financial conditions should ease in 2023, driving higher equity prices. Technology, Discretionary and Industrials levered to easing FCI

The “base” case for 2023 should be below. That stocks gained >1.4% in the first 5 trading days, and this portends strong gains for the full year:

• Post-neg year + up >1.4% on first 5 days
• Day 5 to first half median gain is 9.5%
• Full year median gain is 26%, implies >4,800 S&P 500
• 7 of 7 years saw gains.

Those 7 precedent years are shown below.

• the range of full year gains is +13% to +38%
• so, this is a VERY STRONG signal
• the two most recent are 2012 and 2019
• we think 2023 will track >20%

The path to higher equity prices is discussed above:

• core inflation falling faster than Fed and consensus expects
• wage inflation is already approaching 3.5% target of Fed (aggregate payrolls)
• Fed could “dovishly” leg down its inflation view
• allowing financial conditions to ease
• bond market has already seen this and is well below Fed on terminal rate

BASE CASE: The “maths” for what to expect in 2023, post a “negative return” year (2022)

Question: how common is a “flat” year? Our team calculated the data and it is shown below:

• since 1950, there are 19 instances of a negative S&P 500 return year. In the following year,
• stocks are “flat” (+/- 5%) only 11% of the time (n=2)
• stocks are up >20% 53% of the time (n=10)
• yup, stocks are 5X more likely to rise 20% than be flat
• and more than half of the instances are >20% gains

So, does a “flat year” still make sense?

As shown below, these probabilities are far higher compared to typical years:

• since 1950, based upon all 73 years
• stocks are “flat” 16% of the time vs 11% post-negative years — BIG DIFFERENCE
• stocks are up >20% 27% of the time vs 53% post-negative years — BIG DIFFERENCE
• see the point? The odds of a >20% gain are double because of the decline in 2022

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37 Granny Shot Ideas: We performed our quarterly rebalance on 1/30. Full stock list here –> Click here

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