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Alpha City

Alpha City

A lot has happened since our last report. The Presidential election has still not been officially closed, there were two favorable COVID vaccine announcements, and the S&P 500 is back near all-time highs led by Value/Cyclicals. And during the entire move higher, there have been many doubters with bearish views ranging from the world is ending, valuations are too high and there will never be a medical solution to COVID among other. In times like these, having a disciplined process that does not get whipsawed by the story of the day is critical. And our work has remained steady throughout the conflicting headline news since the March 23rd bottom – stay bullish. We are still in the early innings of a profit recovery that is being accompanied by unprecedented monetary and fiscal stimulus. And I continue to recommend investors keep their focus on the bigger picture — 6, 12, and 18 months ahead. Since late March, I have been advising investors employ a barbell approach by having a mix of Growth/FAANG and Value/Cyclicals at the expense of cash and defensive areas (Staples, Utilities, Real Estate, legacy Telecom). And following our broad-based ERM review, I still recommend this approach, but recommend investors slowly shift away from Growth and towards Value/Cyclicals. Our work also highlighted a shift from Large Caps to Small and Midcaps is underway which will continue and once COVID starts moving to the rearview mirror, will accelerate. Over the last two months, I have been getting questions during our client calls about the elevated number of stocks that have N- (“less good”) readings in our stock selection model. In isolation, a slowing of our earnings revision metrics (ASM indicator) would normally spell trouble for the individual stocks that experienced rollovers as well as for the overall market. But, context is important. Communications for the Fed indicate that a more restrictive liquidity environment will not happen for quite some time and we are still early in a new earnings cycle. Thus, the rise in the number of “less good” ratings will likely be transitory within an ongoing multi-year recovery and healthy uptrend, which will provide a strong tailwind for the equity market. Bottom line: The broad-based earnings revisions data for the S&P 1500 is still quite robust and supportive of healthy equity markets. I continue to recommend a barbell mix of Growth/FAANG and Value/Cyclicals and recommend investors slowly shift away from Growth and towards Value/Cyclicals.

Early Innings of Powerful Profit Cycle; Sector Allocations

The U.S. equity markets have seen quite a bit of volatility since our last update in early October. The macro stories that investors have been focusing on were shifting quite a bit. And once the calendar flipped to November, the headlines intensified. At times like these, it is even more important to have a disciplined investment process. Despite the back and forth of markets, I have remained medium term constructive on equities and have repeatedly stated that based on our indicators and read on the macro environment, the most important underpinnings for even higher highs in the equity market are still very much in place: The Fed has clearly signaled that they will be on hold for an extended period and the favorable liquidity environment will not be interrupted any time soon. The interest rate backdrop remains near record lows and supportive of equities. The earnings revisions data for the broad equity market, which has a big impact in our investment process, is still robust. It shows that the rate of change in the depressed future profit expectations that were consensus in late-March and early-April, is still getting less bad for the broad universe of names within the S&P 500 and the S&P 1500, as shown by our proprietary earnings metric that we call Analyst Sentiment Measure (ASM). The headwinds that we discussed in our previous sector publication appear to be becoming less relevant for now. Expectations for some economic stimulus legislation have risen, regardless of the eventual outcome of the election cycle. COVID-19 remains stubborn, but as I had expected, we got a favorable vaccine announcement before year end with the news from Pfizer on Monday. Clearly, this news does not formally end the ongoing pandemic as there are still many things that need to occur to get the vaccine formally approved, distributed, and then administered to the public at large. But importantly, for equities, performance will react well in advance of all those real-world issues. Bottom line: Our research suggests that a powerful profit cycle is in the early innings and a favorable fiscal and monetary policy backdrop will combine to push equity prices higher. Any dips in the broad equity market that may occur in the coming days and weeks should be viewed as buying opportunities. Our updated sector allocations are listed below. Relative to previous recommendations Materials was raised while Technology and Staples were lowered. Most preferred sectors: Consumer Discretionary, Industrials, and Materials. With Comm Services and newly lowered Tech also being better than neutral. Neutral: Healthcare Least preferred sectors: Real Estate, Energy, and Staples with Financials and Utilities also below neutral.

October Earnings Revision Review; Medium Term Bullish

Last month, we commented that our earnings revisions work for the broad equity market had finally cooled somewhat. We also indicated that it was likely that it would not be long lasting or problematic. Well, the October review showed stabilization and minor improvement and suggests will continue through year end supporting our ongoing medium-term bullish view. While many of the bearish forecasters view the ongoing rally is as unjustified and disconnected from reality, they are still only focused on the price moves of certain sectors and stocks. They continue to underappreciate the powerful combination of positive earnings revisions as measured by our proprietary Analyst Sentiment Measure (ASM) indicator, historically low interest rates, record monetary and fiscal stimulus, and the potential end of crippling lockdowns in the coming 3-6 months. When looking at the broad-based S&P 1500 Index on cap size basis, Large Caps (S&P 500) revisions are still the best followed by Midcaps (S&P 400) and the weakest relative revisions are within the S&P 600 Small cap index. I continue to believe that this will stay in place until COVID-19 starts moving to the rearview mirror. When that does happen, I expect a major shift that will contribute to change in relative performance trends as well. Broadly, there still remains two main areas of favorable readings. One is dominated by Secular Growth/FAANG and the other is the Value/Cyclicals. And there has been a subtle shift away from Growth towards Value. Going forward, I expect the environment to shift from a beta market to a more typical alpha market where idiosyncratic factors become important again, and it will be even more critical to be in the right stocks as differentiation returns. our proprietary methodology will continue to be extremely valuable for the remainder of the year highlighting the best stocks to own. Last week I introduced my FSI Sector Allocation ETF driven strategy. This strategy seeks to increase alpha and lower risk by investing in those sectors of the S&P 500 that should Outperform, while cutting exposure to the sectors that should Underperform. This balancing should help deliver more profits in a bull market and reduce losses in a bear market. I encourage you to take a look at the comprehensive methodology which can be found on here. Bottom line: The important drivers for higher equity prices are still in place. Our work suggests that investors should be tactically cautious and allocate additional equity exposure within the sectors supported by our proprietary research tools.

Tactically Cautious, Remaining Medium Term Bullish

September has not been friendly towards equity investors. The Standard and Poor’s 500 Index has posted its first decline of greater than 10% for the first time since the 3/23 trough near 2,200. That level was not only the nadir for 2020 but also the lowest point for equities going back to 4Q16. Although this is the first double-digit drawdown over the last six months, it is the fourth decline greater than 5%. And all other 5% declines represented dips and buy opportunities within the context of an ongoing recovery rally. The most important underpinnings of our expectation for even higher highs for the equity markets are still very much in place. The Fed has clearly signaled it is on hold for an extended period and the favorable liquidity environment will not be interrupted. Interest rates remain near record lows which is supportive for equities. The earnings revisions data, as shown by our proprietary Analyst Sentiment Measure (ASM), is still robust. It shows that the rate of change in the depressed future profit expectations, which were consensus in late-March and early-April, is still getting less bad for the universe of names within the both the S&P 500, as well as the S&P 1500. Granted, some other factors have helped create some tactical headwinds for the equity markets over the past few weeks. Congress has been unable to pass another stimulus package which has muted recovery expectations. COVID-19 remains stubborn and cases have not fallen low enough to quicken the pace of normalization, despite the fact that hospitalizations and deaths are significantly below wave one peak levels. Our preferred tactical indicator flashed its most recent caution/sell signal during the middle parts of Q3 and is yet to experience a positive inflection. Accordingly, our work suggests that investors should be tactically cautious and allocate within sectors supported by our work. This week we updated our most preferred and lest preferred sector lists. The results are as follows: Most preferred: Consumer Discretionary, Technology, Industrials. Communication Services, and Materials rated better than neutral Neutral: Health Care Least preferred: Energy, Real Estate. Utilities, Consumer Staples and Financials were rated below neutral. Relative to previous recommendations, Industrials and Materials were upgraded from Neutral to better than neutral and Financials and Energy lowered to below neutral. Bottom line: The important drivers for higher equity prices are still in place. Our work suggests that investors should be tactically cautious and allocate additional equity exposure within the sectors supported by our proprietary research tools.

Still Bullish Over Medium-Term; Growth/FAANG Not Done

Our latest review shows that the impressive recovery in our earnings revisions work has finally cooled, somewhat. After a nearly uninterrupted period of improvement from 3/20 through early September, it’s not surprising that a pause occurred. Especially since the domestic economic re-openings stalled during August. With that said, our medium-term bullish outlook remains unchanged. By itself, a slowing of earnings revision metrics would spell trouble for the individual stocks that experienced rollovers in our proprietary Analyst Sentiment Measure (“ASM”) as well as for the overall market. However, context is important. If these small roll downs were occurring late in a cycle when the Fed was moving towards a tighter monetary policy backdrop, we would most certainly be shifting to an early bearish stance. That is not the case. This is the beginning of a NEW earnings cycle, and the Fed has made comments that it is likely on hold for quite some time. Thus, the recent minor deterioration in the earnings revision backdrop is likely just a dip in an ongoing multi-year uptrend. Going forward, I expect the environment to shift from a beta market to a more typical alpha market where idiosyncratic factors become important again, and it will critical to be in the right stocks as differentiation returns. I expect my ERM model will be a valuable tool in highlighting the best stocks to own through year end. I still see two main areas with favorable readings: Secular Growth/FAANG and Value/Cyclicals. While any stock, sector, or the overall market can have corrections and pullbacks, my work focuses on the most important component of the performance equation: underlying earnings revisions. If earnings revisions are rising, the tactical overbought situation has been resolved and the price uptrend has a high probability of resuming. On the other hand, if earnings revisions are falling, the price decline is likely to be prolonged and very well may be the beginning of a new down trend. So, what do the revisions for Growth/FAANG and Tech stocks look like now? They are broadly positive and nothing like the Tech Wreck top of February/August 2000 or the GFC Crisis highs that occurred during 4Q 2007. Not surprisingly, some of the front-line value/cyclical impacted names (as my colleague Tom Lee refers to as “Epicenter” stocks) are still struggling a bit. Yet, I still have high conviction that this is neither worrisome nor a concern, just part of the longer-term healing process that takes time. Bottom Line: I expect the environment to shift from a beta market to an alpha market where idiosyncratic factors become important. My ERM model will be a valuable tool through year end to highlight the best stocks to own.

Summer Bull Continues to Run; Stay the Course

The 2Q20 earning season is now about 95% finished and not surprisingly, companies beat very low expectations by a wide margin.  In fact, 83% that have reported have been upside surprises, and companies that have reported are beating on average by over 23 percentage points. 2Q20 consensus EPS on the S&P 500 now stands at $28.20 while consensus for FY20 now stands at $133. With less than 10% of names left to report that don’t cover much aggregate income, I don’t see these numbers going much further up.  So, getting through $29 is not really expected. Quite frankly, relative to low expectations, the season has been a real homerun, which was my view going into the season.  There is no nice way to put this, but the profit bears completely got this wrong. Except for the banks raising their reserves, there were few, if any, large restructuring charges taken. Now what?  Stimulus is likely coming within the next couple weeks and the Fed has very definitively waived the all clear sign.  Thus, the push higher should continue.  My indicators remain VERY BULLISH, and this rally is still hated/disbelieved.  Thus, it sure looks like the risk is more UPSIDE rather than a painful down move at this point.  Bottom Line: Stay the course and buy intra-day or week dips on macro headlines and keep the barbell for now.

ERM Shows Healing Process Continuing; Keep the Barbell

The negative sentiment and disbelief about the current stock market rally remain pervasive. With this as a backdrop, we ran our monthly update of our single stock quantitative selection model (ERM) this past week, and the bullish conclusions coming from our deep dive were quite interesting. Our latest review shows that the healing process, which began in late-March, continues strongly and impressively. The number of stocks in our ERM model that have shifted to favorable has increased nearly every week and is still rising. I cannot overstate how supportive this is for equities. In other major earnings revisions bottoming periods, post-Tech Wreck in March ’03 and post the Great Financial Crisis in March ‘09, my work looked very similar to the current period. In these periods, when earnings revision hit their lows, powerful rallies followed. When looking at the broad-based S&P 1500 Index on cap size basis, Large Caps (S&P 500) revisions are still the best followed by Midcaps (S&P 400) and finally Small caps (S&P 600). I believe that structure will stay in place until COVID-19 starts moving into the rearview mirror. But once this does happen, I expect a major shift in relative performance on many levels. There are currently two main areas of favorable readings: Secular Growth/FAANG and Value/Cyclicals. COVID-19 cases around the U.S. rose over the past four weeks, and economic growth has slightly downshifted. Not surprisingly with this rise in cases, some of the front-line Value/Cyclical impacted names (as my colleague Tom Lee refers to as “Epicenter” stocks) are still struggling. Importantly, however, I have high conviction that this is just part of the longer-term healing process that just takes time. Relative to low expectations, the 2Q20 earnings season has been a homerun in my view. I had been very bullish on the outcome and the results were even better than expected. We are still recommending a barbell approach that includes a mix of FAANG/secular growth stocks and cyclicals/value as Overweights and defense and cash as Underweights. I expected that earnings revisions would lag on an absolute basis, but would be “less bad”, which is exactly what has happened. Going forward, profit expectations should start flipping from slowing cuts to outright raises during the next 1-6 months. This will be critical, and, if I am right, the backdrop for equities will stay constructive for the remainder of 2020 and beyond.

Don’t Exit Barbell Positioning (Growth/Cyclicals) Just Yet

This edition of Alpha City is a recap of my recent webinar. A replay is available here: Here are some questions I’ve been getting from clients and my answers: Is the U.S. equity market disconnected with reality? NO. The ongoing market rise makes sense. The oversold condition on 3/20 was extreme and there have been positive inflections in all our preferred tactical indicators. Earnings revisions have clearly turned less bad — and that’s BULLISH. Investors are valuing the S&P 500 and its constituents on some type of forward normalized earnings, NOT trough profits. We’ve seen unprecedented monetary and fiscal policy and more is likely to come. Continued skepticism by investors, which is a contrarian positive, is helping equites climb the proverbial Wall of Worry. Earnings revisions are driving equities higher Is the S&P 500 extremely overvalued? NO. Investors should use normalized S&P 500 index SPX EPS not depressed 2020 profits—at least 2021 EPS, and better would be 2022, which I estimate preliminarily $180-200. Fair value forward P/E calculation should include interest rates, inflation, and the policy backdrop. With all these factors near maximum bullish, I could make a strong case that the forward P/E SPX multiple should reach 20x-22x, at minimum. I see a range of 3600 (20 x $180) to 4400 (22 x $200) as achievable over time. Should investors finally be moving away from our recommended barbell (Growth/FAANG & Value/Cyclicals) positioning? NOT YET, but the time is coming. I advise lower cash levels and raising risk exposure as we look for higher markets 6-12 months into the future. Also, lower weightings in traditional defensive areas of the equity market — Staples, Utilities, Real Estate, and legacy Telecom within Comm Services sector — when they outperform. Importantly, our work recommends a barbell approach of having some of both Secular Growth/FAANG and Value/Cyclicals while Covid-19 still on the front page. Once we are close to passing pandemic fears (peaking cases and/or definitive vaccine announcement), shift quickly towards Value/Cyclicals and take some profit in Secular Growth/FAANG. Will the equity markets start evolving from macro/technicals to fundamentals/earnings revisions? YES. Initial bounces tend to do little with operating fundamentals or with single stock idiosyncratic factors, but more to do with behavioral/psychological, fear, greed, technicals, and news releases. However, as the healing process continues there is a transition as the environment reverts to more fundamental or operating indicators and correlations fall. Thus, be ready to shift from macro, technicals, and headline watching (Beta) back to earnings revisions and our ERM model (Alpha) to help generate returns.

ERM Conclusions, Staying Bullish, Keep the Barbell

While the U.S. equity market continues to trade sideways and has been unable to make a new high since peaking on June 8th, our tools and key indicators remain bullish. I initially turned bullish on the U.S., equity markets in late March subsequent to our key tactical indicators flipping back to favorable. Since then, I have been quite consistent and vocal about our constructive outlook and our main conclusions remain as follows: Despite the possibility of short-term consolidation/pullbacks, I am constructive on US equities for 6-12months and are viewing any tactical weakness as a buying opportunity. Based on our research, the low for the S&P500 is in and there is a rising probability that the benchmark index will make new HIGHS before the year is over. The market is NOT extremely overvalued as some are fearing. In fact, our work is suggesting an S&P 500 target range of 3600-4400.I am still recommending a barbell approach that includes a mix of FAANG/secular growth stocks and cyclicals/value as Overweights and defense and cash as Underweights. Not surprisingly, some of the front-line Cyclical/Value impacted names (as my colleague Tom Lee refers to as “Epicenter” stocks) are showing small pauses. I view this as just part of the longer-term healing process and do not find it worrisome or a major concern. Clearly, there are fewer favorable readings in traditional defensive areas of Staples, Utilities, legacy Telecom, and Real Estate, and that makes it harder to find interesting opportunities within these sectors (though not impossible as there are some). On the Earnings Revision front, I am expecting to see revisions start reaching their max downside level and begin showing signs of improving as the July/August 2Q20 earnings season unfolds. This should continue to underpin our constructive outlook for U.S. equities. What will I be looking for from our work to confirm our continued medium-term constructive outlook? I want to be very clear that we are STILL expecting absolute earnings revisions to be lowered for at least another 2-3 months. However, our key proprietary revision indicators should continue looking LESS BAD and eventually start moving towards outright GOOD. This will be critical, and, if I am right, the backdrop for equities will stay constructive for the remainder of 2020 and beyond.

Rally Has Big Skeptics Grousing but Data Backs the Bulls

In the past week alone three big market “skeptics” tried to take center stage and herald their bearish forecasts. We’ll take a look at their arguments below. I’ve been on the record for months now that based on our analysis, equity markets should be higher in the future. Skeptic #1: A high-profile hedge fund manager with an impressive long-term track record suggested that equity investors are likely headed toward a “lost decade” after suggesting “cash is trash” just five short months ago, weeks before the February 2020 high in the S&P. This conclusion is apparently based on a forecast that U.S. corporate profit margins are about to experience a sharp and sustained decline. Yes, profit margins for 2Q20, and maybe 3Q20, will take an initial hit from their historically high levels as profits fall as a direct result of the self-imposed nationwide and global lockdowns. However, our research suggests that they will rebound sharply and will RISE in the coming year. According to our historical analysis, equity markets will likely reflect where things are going and not where they are now during this blip. Skeptic #2: A notable value investor known for his historical bearish calls—not all correct—said: the U.S. stock market is in an unprecedented bubble that will end badly: the rally is without precedent and takes place against a background of undeniable economic problems. Additionally, it is difficult to imagine when the broad economy will completely recover from the effects of the pandemic; and the current P/E on the U.S. market is in extreme. After reviewing his comments, I needed a break to sit back and absorb everything. I’ve addressed this before. Yes, the market rally will end at some point, but our research says that it will be from higher levels and not in the foreseeable future. And yes, the equity market is going up while the economy is still struggling. However, our historical analysis shows that is nearly always the case when coming out of a trough. It will take time for economies to completely recover. what stocks need to provide positive returns for investors is first moving from less bad, second derivative improvement, then shifting to levels of good, and finally to some acceleration. My work shows this has already started. As for the “high PE” our research on long-term multiples shows that once all factors that contribute to valuation are included the current readings are NOT extreme. In fact, they may move even higher before the rally has finally run its course. Skeptic #3: There have been several recent reports that measure broad-based investor sentiment released this week. Two bearish points stand out (which are contrarian favorable in my view): Over 50% still think it’s a bear market rally, and a record net 78% of investors say stock market most overvalued since 1998. Massive Overvaluation is not the problem. Suggesting that there is a bubble in equities and that valuation is massively extreme are a couple of the favorite negative arguments for the bears, and again our research does not support these views.

Despite Pullback, Earnings Revisions Support Rally

Given last week’s pullback, I remind investors to keep your eyes on the bigger target, the horizon six, 12, and 18 months away. Our work tells us that equity markets will be higher in the future. Additionally, from a positioning standpoint our proprietary sector single stock quantitative stock models still strongly suggest that offensive, like tech and cyclicals, areas will lead at the expense of cash and traditional defense sectors. I continue to recommend a barbell approach of Growth/FAANG and Value/Cyclicals. The bears claim the rally since March 23 is non-sensical, a bubble, disconnected from the economy, and only rising because of Fed policy. The impressive equity market bounce that began after our preferred tactical indicators flashed a buy signal on 3/20 has not only made sense, but also has the underpinnings for more gains. Our research is supported by the following: Extreme oversold condition that occurred on 3/20 and positive inflections in all our preferred tactical indicators; earnings revisions that have clearly turned less bad; investors valuing the S&P 500 and its constituents on some type of forward normalized earnings, NOT trough profits; and valuation expansion that is based on historical factor analysis of what drives multiples. Additionally, unprecedented monetary and fiscal policy has rained on the economy, with more likely. Finally, continued skepticism by investors, which is a contrarian positive, and helps equites climb the proverbial Wall of Worry. Earnings revisions are clearly getting less bad. This is VERY important. This alone strongly backs the rally and makes a case against the market being illogical or only being fueled by Fed Policy. The historical precedent for this is powerful with no exceptions for major market bottoms since 1990. Markets don’t wait for profit growth to return to absolute positive before beginning to rally. The key driver has always been positive inflections and signs of less bad. The number of companies with absolute revisions positive and improving has risen once again. I generally expect all these figures to continue to trend higher for the next 4-8 weeks. I will be on the lookout in coming months for more names are shifting from “earnings revisions still absolute negative but less bad” to “absolute revisions positive and improving,” or double plus. Our research suggests that valuing the equity market or specific stocks on the current depressed profits levels from the self-inflicted corona virus lockdowns is misleading and not reflecting the true earnings power of Corporate America. Normalized earnings stream provides a better gauge. Investors should use at least 2021 and or 2022 EPS estimates, preliminarily a range of $180-200. I take exception to comparing forward P/Es absolutely with historic readings. Without considering other factors, including interest rates, inflation one is really comparing apples and oranges. At the 2000 S&P 500 price and valuation peak, the fed funds rate was above 5.5% while today’s level is near zero. In our view, this alone clearly argues for a higher level of valuation for equities. I could make a case based on historical valuation analysis that P/Es should not only be at the north end of their long-term ranges but should also trade at all-time peak levels. If the current low level of interest rates stays in place and inflation remains quiescent, the forward P/E could reach 20-22x the normalized OEPS level for 2022, which may prove to be conservative. Thus, we see a range of 3600 (20 x $180) to 4400 (22 x $200) as achievable over time.

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