Confusion Abound

After last week’s surge up in the cap-weighted S&P 500 into the quad witching that saw the index rally 3.5% to 4448, it is not surprising to see the equities take a breather this week. The news during this shortened week certainly was not supportive for additional gains, in my view, as we had hawkish central bank actions across Europe combined with weak economic data, Chair Powell’s testimonies in front of both house of Congress reiterated the commentary provided during the recent FOMC meeting that were skewed toward more hiking, and U.S. economic activity also showed incremental signs of deterioration. When combined with several measures of investors sentiment ranging from increasingly optimistic to extremely favorable, it certainly looks like the potential path higher for equities will be challenging.

During my client interactions, I continue to hear similar comments and frustrations.

• I still do not get the sense that there is any overriding view. Clearly, I am hearing less uber bearish comments, but to be balanced I also do not hear much super bullish thoughts either. Thus, said another way there is little fear of significant downside risk and a decent amount of skepticism that a new broad-based bull market has begun, which has been my ongoing view since I took my uber bear case off the table in February.
• Most are happy that they are participating in the Magnificent 7 that have surged higher during 2023 and raised the cap-weighted indexes along with them, but many did not aggressively buy them at their lows and also are not overweight them. They are generally unimpressed by the level of the cap-weighted S&P 500 because for most they have to own a diversified portfolio of stocks and can’t only be significantly overweighted the Magnificent 7, and with the broader-based indexes (S&P 500 equally weighted or Russell 2000) only up marginally for the year they are not seeing a new bull market.
• I hear from nearly all that valuations of the broader market does not appear too rich, but they also do not look super cheap either. When looking at expectations for forward earnings, there is not a lot of concerns about collapse, but I do not hear a lot of optimism either.
• The sector that I have been getting the most questions about is Energy, and if it is finally buyable. The next area is the Magnificent 7, and what is my work showing. Rounding out the top three in client interest has been offensive Health Care. There has been close to zero interest in defensive Staples and Health Care, Utilities, Real Estate, or Retailers. Lastly, there has been an increasing interest in single stock names regardless of sector.
• From a macro perspective, there still continues to be a bimodal view on inflation and what the Fed will do with monetary policy. One group is focusing more on headline inflation, and they hold a strong view that Chair Powell and Gang are within reach of declaring victory and that the last hike has occurred. However, I do not hear any expecting any imminent easings. In the other group, the focus has been on the lack of improvement in the core inflation readings, as well as the ongoing resilience of the labor market. These folks continue to think that the next move for the Fed will most definitely be a hike, and that higher for longer is the likely outcome. They also do not see the Fed flipping back to accommodation any time soon. My research has had me firmly in the latter group for well over a year, and nothing in my work suggests that I need to change my view.

As we move toward the end of 2Q23, the company-specific news will likely be light and as we head into early July the beginning of the earnings preannouncement season will begin in earnest. Based on my work, I am quite confident that some high profile economically sensitive companies will provide negative comments, but the question is will there be enough of them to raise investor concerns. The probability that there will a surge in profit warnings is possible, but the odds appear low and that my expected increase in profit fears will be pushed out to 4Q23.

So, the equity markets will have to live mainly on macro news, expectations for the July Fed meeting, and month-end/new quarter repositioning, which in aggregate is unlikely to be majorly bullish or bearish. Thus, it would not be surprising to see the equity markets have limited upside until the 2Q23 earnings season begins during the back half of July.

Getting a bit more granular, the following are the areas/stocks that came up the most over the week or so:

• Energy still does not look ready. Continues to slowly get closer to an upgrade, but not yet. Based on where the sector’s key indicators are, I am still expecting to upgrade before the end of the year.
• The Magnificent 7 still looks magnificent on my earnings revision’s indicator. Yes, a case can be made for each name being overbought, but their respective ASM’s suggests that any tactical price pullbacks are likely dips in ongoing rallies
• There are an abundant number of Health Care Equipment and Hospitals that look favorable in my work. The Life Sciences sub-industry, which has been weak, appears to need one more round of cuts, but is getting close to becoming contrarian buys.
• The Regional Banks do not look ready yet, and I would advise resisting the urge to become too aggressive. There are some Large Cap Value long-only managers that have done some nibbling, and I don’t object to this, but my work says it’s too early to ring the bell for these names. My work prefers the exchanges, SPGI, MCO, and BRK/b.
• Within Staples, my work likes the growthier names — MNST, COST, as well as CHD.
• A few single stock names that came up a lot were: GNRC, EXAS, ALB, BA, EQIX, CELH, MDB, AMZN, and TDG.

Below are my updated macro/market thoughts:

• Broad labor market is clearly not flashing, which keeps the Fed’s inflation fight challenging.
• Core inflation readings are not falling at the same pace as before and have caused some uncertainty about their path in the coming quarters, which lowers the probability of the market’s dovish Fed expectations.
• I remain in the Fed is higher for longer camp and my forecast for the terminal rate is still 5.25-6.25%.
• NO EASING — Despite the recent problems in the banking industry, my view remains that once the Fed does pause it will likely keep policy unchanged for an extended period. I expect Chair Powell to reiterate this at the upcoming May FOMC meeting.
• The weakest quarters for the U.S. economy are still in front of us. It looks headed toward a shallow recession, and then an extended period of sluggish growth.
• Corporate profit expectations remain too high and need to be lowered as there are strong headwinds.
• Importantly, the immediate upside potential for the S&P 500 equally weighted still appears limited, at best, while considerable downside risk remains for equity investors. Despite being tactically overbought, my work suggests that any pullback in the AI/Tech leadership will likely be a dip in an ongoing uptrend that should likely last till their ASM indicators rollover.
• From a positioning standpoint, economically sensitive areas/names are looking the riskiest based on my key indicators while secular growth ideas look relatively favorable.
• Single stock opportunities are sparse, but they are slowly increasing. The general theme is higher vs lower quality and larger vs smaller cap.