Despite Increased Volatility, Key Model Says Stay Bullish
One of my most important analytical tools is my quantitative stock selection model, which I call ERM and will be the basis for the upcoming release of FSI’s new single stock Dunks product.
My team and I update my model every week and are always looking for new opportunities for clients. Importantly, we do a deep dive into the names in the S&P 1500 Super Composite and I wanted to share my main conclusions in this week’s comment.
Broad Summary Comments:
The first key takeaway is the same one that we have been discussing for the last 6-9+ months — the earnings revisions backdrop for the S&P 1500 names remains robust and supportive of additional gains in the U.S. equity markets, which has been in place since the end of March 2020.
Hence, I am retaining my longstanding constructive medium-term view for equities, which was first communicated on 3/20/20. There remains a plethora of bears that that are still focused on overvaluation, the size of the move off the March low, the ongoing COVID cases, and now fears of rising inflation and interest rates. These are all fair points to consider. Yet, my focus continues to be on the powerful bullish combination of broad-based positive earnings revisions as measured by my proprietary ASM indicator, still historically low interest rates, record monetary and fiscal stimulus that should continue to overpower the negative headwinds.
New Observations from the broad-based S&P 1500 ERM review
When looking at the overall Index on cap size basis, the slow shift of favorable revisions down the cap scale that we first saw in our work back in 3Q20 is still occurring. Thus, we have been more favorable on SMid cap names relative to Large Caps for the first time in many years.
There are three main areas of favorable earnings revision readings — 1) Secular Growth/FAANG; 2) Value/Cyclicals that are higher quality and generally more growthy (e.g., Capital Goods, Machinery, Semi related); and 3) Value/Cyclicals/Financials that includes the front line recovery/Epicenter universe and deep commodity/industrial/consumer/interest rate cyclicals.
Sector level observations that I found interesting:
Energy — even though my work is still not broadly favorable, there continues to be slow marginal improvement, which we first highlighted back in November. Please note that we have upgraded the sector twice over the last four months.
Materials — there are still a healthy number of interesting names in Chemicals, Industrial Metals (Copper/Steel/Aluminum), and Packaging.
Industrials — Defense-related names continue to look weak and the more interesting areas are in Machinery, Cap Goods, Rails, and Airlines, which has been the case for several months.
Consumer Discretionary — the work continues to flag compelling names in Auto/Related, the entire travel/vacation space (Casinos/Hotels/Travel companies), Restaurants, and many Retailers.
Technology — my indicators are still highlighting the Semi-cap equip and Chips names despite their explosive price moves my work portends that this profit cycle is still in the early innings, which would strongly imply additional stock price outperformance. Furthermore, most cyclical names within the sector look quite interesting with Hardware, Electronic Equip & Instruments, Electronic Components, Electronic Manufacturing Svcs, and Tech Distributors.
Financials —the SMID regional banks started looking better back in late October/early November and this trend has broadened up the cap scale as time has passed, which has led us to upgrade the sector twice in the last four months.
Defensive areas — my work has been flagging since April 2020 that the least number of favorable names in Staples, Utilities, legacy Telecom, and Real Estate. If one is looking for exposure within these sectors, there are some single stock ideas that do look like interesting opportunities, but it does take some digging.
Most preferred sectors: Consumer Discretionary, Industrials, and Materials with Information Technology and Financials better than neutral
Neutral sectors: Energy, Communication Services
Least preferred sectors: HC, Utilities, Consumer Staples and Real Estate
Bottom Line: Despite the recent volatility as a result of weakness in the fixed income markets, our key indicators remain supportive of additional gains in the U.S. equity market. Despite the possibility of pullbacks, our research strongly suggests that investors view them opportunistically and raise exposures in our preferred sectors and stocks if they occur.
