Financial Research

Tom Lee's Equity Strategy

Tom Lee's Equity Strategy

I asked for a sanity check last week since the S&P 500 index was selling at a 16 P/E and Treasuries at over a 100 P/E but the response was simple panic. Indeed, in the frenzied and sharply downward trading last week in reaction to the spread of coronavirus, or COVID-19, it seems the market sees the cure as worse than the disease. That is, it appears increasingly possible that the volatile lurching in financial markets could drive the US economy into a recession, a self-fulfilling prophecy. The market has digested a lot of negative news in the past week, leaving little room for a sanity check. Several companies drew down credit facilities, like Boeing (BA), Wynn Resorts (WYNN); the World Health Organization declared COVID-19 a pandemic; President Trump’s initiatives fell short of expectations. Tom Hanks and his wife Rita revealed they tested positive for COVID-19 and major league sports have suspended their play. So the disruption is becoming tangible in the US. and “price discovery” remains non-existent in equities. By that, I mean the market is so uncertain that stock prices are moving in unison on one or two simple macro factors, with high correlations to each other, instead of on their own corporate merits. Source: FS Insight, Bloomberg Markets have become deeply pessimistic because the “cure” for the pandemic seems worse than the disease. Social distancing, limiting movement, managing intercity and international movements look to be disruptive. Already, industries linked to travel and entertainment, among others, are suffering. The financial markets volatility is worsening an already weak liquidity environment. Italy has now taken drastic measures to curtail movement. What remains unknown is the ultimate path and level of spread in the US, which has a case count ~1,300 and growing. The paths seen by Iran and even Europe are very similar but Italy seems to be accelerating at a pace that makes this the worst case scenario. This is the reason many investors say the US is two weeks behind Italy. Despite the panic, rationality is required, and the best way to compare COVID-19 spread between countries, in my view, is to look at cases per 1 million population. Among the fastest spreads have been Italy, Iran and South Korea which saw 85-152 cases per 1 million within two weeks after passing the US milestone (1.4 cases, or 100 times increase in two weeks). This particular measure implies the U.S. could see 50,000 cases by the end of March. (See chart above.) However, this is only one potential path and if cases peak towards the end of the month (Italy seems the exception), this should result in a turning point for the equity markets. This was the case with China, Hong Kong, South Korea and even Japan, so that’s the “bright side” of an adverse case. I will also point out that the countries with the highest number of cases have the lowest level of toilet hygiene (measured as “percent of people washing hands after using toilet, as China and South Korea are among the worst). Perhaps this could be differentiating national experiences. The U.S. is in the middle on this metric. Source: FS Insight, Bloomberg Currently, the US has about 1.5 cases per 1 million pop, about the same as Canada. Both nations have reported their first case 40 days ago. This is curious, as it suggests both countries are tracking similarly in terms of disease outbreak. Yet, the US is only testing 5 people per 1 million Pops vs Canada at 222. In a sense, while we expect the cases in US to grow sharply in coming weeks (and no doubt there are many undiagnosed cases), perhaps the path does not have to follow Italy or Iran. The market bottom in the Asia equity markets (vs MSCI) all coincided with the peak in Corona COVID reported cases. (See chart above.) This is why the Street is so fixated on the “case count” in the US and Europe. In the meantime, stocks remain relentless oversold by many metrics. Some 75% of cumulative 10-day volume is down, an event that has happened only four times since 1990. Just 1.6% of industries are up month over month, something not seen since December 24, 2018 and before that, January 21, 2016. Those times turned out to both be good times to be long. Finally, another positive development last week was the yield curve fixed itself and is no longer “inverted” from 1 month forward. What could go wrong? COVID-19 could indeed morph into a more dangerous disease, changing the risk profile and the required response of markets. The good news is China’s cases seem to have peaked and are falling. Moreover, US policy makers and central bankers are ready to take necessary action. BOTTOM LINE: Price discovery remains non-existent as investors view fundamentals as uncertain. In our view, the panic by US households and markets, while disruptive, is likely to limit the spread of COVID-19. Case peak remains key bogey for markets at the moment. Figure: Comparative matrix of risk/reward drivers in 2020Per FS Insight Figure: FS Insight Portfolio Strategy Summary – Relative to S&P 500** Performance is calculated since strategy introduction, 1/10/2019 Source: FS Insight, Bloomberg

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In 2020 It's All About SPX's EPS Growth; We See a 10% Rise

Through 2020 and into 2021, it’s all about earnings per share growth for the Standard & Poor’s 500 index and potential U.S. equity returns. As noted last week, I see 10% plus EPS growth and that should translate into another double-digit equity return next year as investors begin to discount EPS of 2021 some12 months from now. Of course, it’s a Wall Street axiom that every year profits matter and 2020 is no different. Over the long term it’s true. However, in the short term sometimes EPS can matter less than price/earnings ratios (P/E)—and vice versa—for example. Let’s look at the big picture over the past few years. Remember, that the SPX EPS shot up over 20% in 2018 to $162 from $131, thanks mainly to a one-time Federal tax cut. Yet the result was a market that was down 6% in price. In 2019, earnings are essentially flat at $163 estimated, with a few days left, from in 2018, yet the market has soared about 30%. Clearly there were other things hampering investor sentiment in 2018, and those things generally, as I have outlined from time to time, were the Federal Reserve, which was tightening when it shouldn’t have; a global economic growth slowdown, and trade war between the U.S. and China, among other countries. All this appears to be behind us for the most part and because there was a bear market in the fall of 2018—on an intraday basis—the market has now reset, let’s say, to move on earnings from here, as it normally does. Hence, I believe that EPS will matter more in 2020, the opposite of 2018-2019. Indeed, the SPX EPS and price have roughly tracked each other since 2009, but as shown below, there are times where P/E led, and times where EPS led. Again, the last 2 years have been about P/E (de-rated in 2018, re-rated in 2019), but in 2020 and beyond, I view EPS being the key. I realize this is mere a “crude comparison” but in my view, 2018 was a proper bear market and a reset of economic and fundamental expectations. And while many date this bull market from March, 2009, I suggest that 2020 is in many ways Year 2 of a newish bull market, analogous to 2010. I stated at the start of this year that “2009 was the best analog for 2019” for U.S. equity markets, and I believe this remains correct. Thus, I see 2020 equity moves mirroring 2010’s (year 2 of that bull market), with some headwinds in the first half of the year. Where do I get my confidence that the entire year will be better? I think the Purchase Managers Indexes have bottomed and the 2020 global economy will be better than 2019’s drowsy growth. The leading indicators, such as the Economic Cycle Research Institute leading index and those global PMI indexes are all pointing to the same general picture: that the persistent economic weakness from mid-2018 through 2019 is ending and setting the stage for an improved growth outlook in 2020. The October ISM Exports posted a 50.4 print, a sharp rebound from September’s 41.0, lowest since the Great Recession. As shown on nearby table, each 1-point increase in ISM Exports adds 0.6% to S&P 500 EPS growth. The recent ISM reading of 50.4 is 9.4 points higher than September. History suggests the SPX EPS growth should rise by 545 basis points. I believe this recovery reflects abating of oil shock, weakening greenback and generally improving conditions. In a nutshell, I see in the next year reviving “Animal Spirits” as PMI indexes bottom, plus an accommodative Fed and potential fiscal support will equal EPS upside— and by extension an SPX rise. Bottom line: Given that, my forecast is for the SPX to reach about 3,450 (from about 3235 currently) in our base case, or a bit less than 18 times price/earnings ratio on that $178 EPS. My best case scenario is for $184 EPS, to which we apply an 18 multiple for a level of nearly 3600 on the SPX. Figure: Comparative matrix of risk/reward drivers in 2020Per FS Insight Figure: FS Insight Portfolio Strategy Summary – Relative to S&P 500** Performance is calculated since strategy introduction, 1/10/2019

Stocks Take Break; Raising S&P 500 target to 3,800 for Year End

Given the fierce move by equities in the past few weeks, it is not entirely surprising to see stocks consolidate over the last few days.  And not surprisingly, there are more than a few who believe markets have become overly exuberant.  To an extent, I understand this. There has been both a sizable move in markets coupled with a sizable rotation into epicenter stocks. However, I still see upside into year end. More on this below. On the COVID-19 front, daily cases came in at 181,547 on Thursday, and Wave 3 remains on the rise. And although the daily change vs 7D ago, which is the key leading indicator we track, dipped below 20,000 on Wednesday, it jumped again on Thursday to 32,824. And daily deaths from COVID-19 in wave 3 are now meaningfully higher than the death toll seen in wave 2 and are only 27% below the peaks in Wave 1. Given daily cases are almost four times the magnitude of wave 1 and are a leading indicator of mortalities, we should expect daily deaths from COVID to surge in the coming weeks. But it is worth mentioning that in just the past few weeks, we have witnessed advances in the treatment and prevention of COVID-19. While we are not yet seeing this in reduced cases or mortality, these collectively should slow the scourge of COVID-19 and eventually stop it in its tracks (vaccine). New treatments like Olumiant, etc also reduce the risk of mortality, so we can be less pessimistic than previously. STRATEGY: Raising S&P 500 target to 3,800 by year-end (vs 3.525 prior) This week, I highlighted ten main tailwinds that I see driving P/E expansion which are causing me to raise my 2021 P/E estimate to 19.7X from 18.3X. This translates to an S&P 500 target of 3,800 (based on EPS of $193). Thus, we are revising our YE target up from 3,525 (which we raised on 8/13) which represents about 6.5% upside. For context, this is about the magnitude of a typical Santa Claus rally, so the expectation is that markets see their typical seasonal gains. And form a valuation standpoint, this target P/E of 19.7x is about the same as the high yield implied P/E (inverse yield to worst) of 20.6x. We have written multiple commentaries about the tailwinds for epicenter stocks, and in particular, how they are the most leveraged to both vaccine/therapeutics (i.e demand recovery) and economic recovery (i.e. operating leverage via cost cutting). And interestingly, while the broad-based S&P 500 index was “treading water” for the greater part of this week, Epicenter stocks took the lead in response to the improved healthcare outlook. During this same period and using the SPHB ETF as a proxy for epicenter stocks, they have risen strongly in that same 9-day period with SPHB rising approximately 15% in that timeframe versus a nearly flat S&P 500. I continue to see the best risk/reward in the epicenter. However, unlike earlier in 2020, there is much greater visibility and tangibility to a vaccine and cure for COVID-19. Thus, the ability for markets to look beyond contemporaneous cases should be much higher. And interestingly, even though epicenter stocks have outperformed the past two weeks or so, this outperformance has been a fraction of the approximately 7,000bp YTD outperformance of growth stocks and is still weaker than the post wave 1 epicenter rally. Thus, I see substantial upside for epicenter stocks. Bottom Line: I see upside for equity P/E ratios rising which increases my S&P 500 target to 3,800. I continue to see epicenter stocks as the most attractive risk/reward. Figure Comparative matrix of risk/reward drivers in 2020Per FSInsight Figure: FSInsight Portfolio Strategy Summary - Relative to S&P 500** Performance is calculated since strategy introduction, 1/10/2019

Investors Carry ‘08 Hammers’ Looking for ‘2008 Nails’

It is nearly a universally held—albeit logical—view that equity markets are currently carving out a top, that the ‘end’ is nigh. I find myself involved in recurring conversations with investors and businesspeople I encounter: the Standard & Poor’s 500 index is topping, they assert. Why? Well, the market is facing too many risks from China/US trade war, Brexit, low rates, etc. It’s just a matter of time. They see little reason to think markets can rise since they have been going up for 11 years already. The logic there, admittedly, is faulty. This is consensus thinking, which is sometimes right but is often enough wrong. When that happens investors could make hay by going against it. Source: FS Insight, Bloomberg This consensus view strengthens my contrarian conviction that an upside market breakout is coming for S&P 500 index. It’s possible that this rise could be potentially significant, if history is any guide. As I have pointed out previously, since 1945 there have been six major tops, which were followed by a 30% or greater decline in equity prices. However, the major tops, highlighted in red, show an accelerating rise in the 20 months leading to the highs. Instead, flat markets that are “going nowhere” were resolved with substantial upside moves. What we see in 2019, a flat market while hovering near all-time highs, is actually uncommon. Since 1945, this has happened only three times, which highlights the rarity. History suggests plateaus are a base before a strong up move. Meanwhile, investors seem to carry 2008 hammers looking for 2008 nails, using the previous crash as a template for the next one. The current situation does not resemble 2008. However, burned by the financial crisis, investors remain largely too pessimistic, something chronic since 2009. What is notable is the conviction many have that 2019 is 2008 all over again, citing repo market weakness, inverted yield curves and high levels of debt. The maturity of the 2002-2008 expansion was evident by late-2005 (when the 3 measures above largely peaked). Similarly, post-internet bubble (2003), investors kept looking for the tech bubble to burst again. Skepticism about the health of the business cycle is rising. Of course, there are understandable factors: China/US trade war, resulting visible weakening of global purchasing managers indexes; inversions of yield curve; underperformance of cycle leaders (FANG), and the poor performance of recent IPOs. This combination could naturally feel late-cycle, but, again, a surprising number of our clients see parallels to the events in 2008. That said, the US still looks more mid-cycle than late. Economic expansions end when incremental returns on invested capital turn negative, due to one of multiple factors: (i) exhaustion of labor pool; (ii) overinvestment (capacity utilization or investment as a percentage of GDP) and (iii) excessive debt service crowds out spending. Yet, in the US currently, the employed as a percentage of the population is 61% vs 63%- 65% in prior peaks, implying a 6 million to 10 million jobs growth before peak. Meanwhile, private investment/GDP is 24% vs 28% peaks, which suggests $800 billion further, and finally debt service for government, corporates and households is well below typical peaks. See chart. Basically, it comes down to these observations: (i) there remains plenty of labor slack. Our work still argues the U.S. “unemployment rate” overstates the strength in the labor market. (ii) investment spend is too low. Two measures of private investment spending maturity, capacity utilization and private investment to GDP ratio shown in charts, are still well below what is typically seen at expansion peaks. (iii) US debt service, much more important because this is what ultimately crowds out private spending, is the lowest compared to prior cycles due to our low interest rate environment. Despite a surge in federal debt as percentage of GDP, debt service requirements remain at record low levels. In other words, by a comprehensive set of measures, the US still has plenty of room to grow. My 2H19 thesis remains “flat markets going nowhere” resolve to the upside, which will surprise most investors. Equities have gone nowhere for 20 months, yet hover near alltime highs. This has been seen three times since 1945 and all three were resolved by a significant upside breakout—average gain 51%. I see a rebound in the next few months, coinciding with a bottoming of Purchase Managers Indexes. An end to the GM strike also strengthens this case. What could go wrong? Investor confidence is weak due to impeachment, trade uncertainty, market volatility. And this could result in a self-fulfilling contraction. Bottom line: I still look for a year-end rally and overweight cyclicals, on the premise of a bottoming of PMIs. Interesting tickers are KSS, LEN, PHM, EXPE, LMT, CAT, EMR, ROK, CSCO, QCOM, XLNX, MSFT, EMN, CF, NUE, TTWO, VIAB, DISCK, ATVI, GOOGL and FB. Figure: Comparative matrix of risk/reward drivers in 2019Per FS Insight Figure: FS Insight Portfolio Strategy Summary – Relative to S&P 500** Performance is calculated since strategy introduction, 1/10/2019

S&P 500 Sets New All-Time High; Falling VIX = Risk-On

If you had any reservations about whether last week’s rally was sustainable, this week’s performance was decisive. On top of a 7% rally last week, the S&P 500 rose another 2.2% this week to 3,585; a new all-time high for the index. And I see several reasons that push the market and epicenter stocks in particular, higher into year end. More on this below. COVID-19 is spreading across the US at an accelerating rate and as we commented earlier this week, the US could see >200,000 cases within a few weeks. The tally for Thursday was >148,000 (+34,000 vs 7D ago), so by Thanksgiving, daily cases should surpass 200,000. And given flu season lasts until Feb 2021, a peak in cases is still sometime away. But the states we are watching most closely are those with fastest case growth in Wave 3, WI, IL, ID, ND, SD, UT, or WIINSU. With the exceptions of ND and SD, daily cases are still surging there. And while we are seeing soft lockdowns in New York and even Illinois, we have yet to see real panic by policymakers in these wave 3 states. Interestingly, the hospitalization coefficient (or % of new cases requiring hospitalization) varies widely by state. Take North Dakota and Utah for example. These wave three states have a coefficient around 0.4%, which translates to about 1 in 250 confirmed COVID-19 cases resulting Compare this with Connecticut and New Jersey. The coefficient In these wave 1 states is 2.7% and 3.1%, or 1 in 37 and 1 in 32, respectively. That is a massive differential. A COVID-19 confirmed case in CT/NJ, aka NY tristate, is basically 10X more likely required to be hospitalized. Wow. Is this due to demographics (age), co-morbidities (obesity, smoker?), or just plain bad luck? We have no idea. But within the major wave 3 states, which I refer to as WIINSU states, they are dealing with less severe forms of COVID-19. And looking at mortality rates (daily deaths), the severity of COVID-19 in wave 3 states is running below Waves 1 and 2. Wave 1 saw a massive level of carnage in the NY tristate area with 20 deaths per 1mm. Wave 2 saw the states of FL, CA, AZ, TX, or F-CAT see daily deaths of 7 per 1mm. Wave 3, so far, is running below that level of 7 deaths per 1mm residents seen in wave 2 for F-CAT states. So, despite record cases in Wave 3, the daily deaths have trailed what we saw in Wave 1 and Wave 2. In other words, the level of mortality is far lower. STRATEGY: Is 200,000 daily cases enough to stop the epicenter rally? For the better part of the last few weeks, we have seen a fierce rally in epicenter stocks, and gasoline was added this week with the Pfizer vaccine news. But over the past few days, the epicenter rally has run into a brick wall. Did the surge in cases finally break the market's tolerance? Was stimulus talk failure on Thursday throwing water on Washington getting something done? Is this just profit taking? I don't know. But I think the risk/reward is favorable for epicenter stocks into year-end, even as COVID-19 cases are rising. I see major developments that favor these stocks: (i) Development towards a vaccine are now outweighing the headwinds of rising COVID-19 cases, (ii) Europe COVID-19 cases are indeed rolling over (iii) Retail investors are finally moving cash off sidelines -- they are going to become dip buyers, and (iv) the VIX, a measure of market's anticipated volatility, looks ready to fall below 20. The VIX, has not been below 20 since the start of the pandemic and in our view, a move below 20 would be a major risk-on signal, as it would suggest that investors see lower volatility in the coming months. This would be quite a change for much of 2020. And if so, investors would not only be more risk-on but we could see a risk on investment leverage as well. In other words, this would be more firepower to buy equities. This week we also updated our Trifecta Epicenter stock list. These are the stocks which were hit the hardest by the pandemic and have the greatest operating leverage to a re-opening. And we like the earnings upside in these stocks, because of the massive cost reset. The stocks are based on positive views coming from the trifecta of: (i) Quant (tireless Ken), (ii) Global Portfolio Strategy (Brian Rauscher, aka Rocky) and (iii) Technicals (Rob Sluymer). Bottom Line: I think the risk/reward is very favorable for epicenter stocks into year-end, even as COVID-19 cases are rising. A break below 20 in the VIX would be a major risk-on signal and would equate to more firepower to buy equities. Figure Comparative matrix of risk/reward drivers in 2020Per FSInsight Figure: FSInsight Portfolio Strategy Summary - Relative to S&P 500** Performance is calculated since strategy introduction, 1/10/2019

Stocks up 7.3% in Big Week; Potential for 10% Rally into YE

After notching four consecutive days of gains, the S&P 500 took a well-deserved break and finished flat on Friday, leaving a massive 7.3% weekly rally intact. I consider this a huge win, especially in the face of a still undecided election outcome. Since the start of this rally at the end of October, we are now nearing the September 2020 highs around 3,580. And I see further upside into year end. More on this below. As for COVID-19, the spread continues at an accelerating pace. This week, daily cases came in above 100,000 for the first time and they seem set to rise further.  The fastest spread remains in the wave three states, in particular, WI, IL, ID, ND, SD, UT, or WIINSU. Within WIINSU, the most rapid spreads are in North Dakota and South Dakota. In these states, daily cases per one million residents are roughly four times the amplitude seen in wave one and wave two states. Wow. These states also have very low levels of testing (the positivity rate is >50%) and daily deaths per one million residents, while still below the peaks seen in New York City/Tristate region, have surpassed Italy in its darkest days. Peeling back the onion another layer, I think county level data bears watching; especially in these states that are seeing massive outbreaks. Looking at the percentage of the state where daily cases are exceeding certain thresholds (e.g. 1,500 daily cases per one million residents – which is where Miami peaked), the situation in South Dakota could provide some insight into what signs of “herd immunity” look like. Cases are rising in SD and I have not found a single statewide policy action taken. And interestingly, the percentage of counties with daily cases exceeding 1,500 cases in South Dakota is declining, which could prove to be a data fluke or could be first signs of “herd immunity”. I think this bears watching. STRATEGY: Was this rally justified, even with a contested election? In our view, if one believes more than one of the following factors below, then the answer is yes. (i) Stocks already discounted a contested election and fell 10% in the past month, (ii) Investors were cautiously positioned into election day (cash on sidelines >$4.5T), (iii) Tech rallied due to Republicans holding the Senate (tax cuts off table), (iv) Mutual fund/ year-end tax loss selling is over and seasonal weakness is ending, (v) Santa Claus rally still in play, (vi) Republicans holding the Senate makes fiscal stimulus prior to year-end more likely (vs lame duck), (vii) Republicans holding Senate maintains a balance of power which is good, (viii) many of our clients were bracing for a limit down Tuesday overnight futures session, so markets priced in a scary night, and (ix) the VIX collapse suggested the market saw more certainty in the election outcome compared to the official electoral college. So, as you can see, there are multiple reasons that stocks were relieved. In fact, this goes back to a simpler observation: less uncertainty, is incremental certainty and this supports a risk on sentiment. So, I think the rally in stocks makes sense and still see the potential for a 10% rally into year end, taking the S&P 500 to 3,600 while noting that a protracted legal battle that morphs into a street level chaos and violence could be a headwind. We have written exhaustively about why the epicenter stocks (aka cyclical tilt) post-election day was the most logical (both under a Biden and a Trump win, and even contested). But consider the timeline shown to the right. Into year end, a rollover in Europe COVID-19 cases and fiscal stimulus create a favorable environment for epicenter stocks to lead. And looking forward to 2021, positive developments on the vaccine/therapeutics front and US COVID-19 wave 3 ending create a favorable environment for epicenter stocks. Bottom Line: Based on several factors, the S&P 500’s strong rally this week seems justified, even with a contested election outcome. I see the potential for a 10% rally for stocks and still think epicenter stocks make the most sense. Figure Comparative matrix of risk/reward drivers in 2020Per FSInsight Figure: FSInsight Portfolio Strategy Summary - Relative to S&P 500** Performance is calculated since strategy introduction, 1/10/2019

The Fed Cut and Trump Tariff are fueling the "asset light" trade

It seems these days the markets are a broken record. The latest, confusing Fed cut (was it dovish? hawkish? we think somewhere in between), coupled with Trump’s latest tariff announcement and a 2.4% drop in the S&P 500 over two days is a scenario that should no longer surprise markets. But yet again we have seen a resulting surge in bearish sentiment and confidence levels appropriate for an economy in late-cycle (which it’s not). There are three macro factors that belie this reborn market bearishness and support further upside for equities. i. Falling 10-year yield ii. Weakening USD iii. Odds of a rate cut in September have risen to 100% Remember folks, since 2009, with rare exceptions, pullbacks NEED TO BE BOUGHT. What to buy? Here are the four trades that this Fed cut supports: i) Overweight US vs. rest of world; ii) asset-light stocks over asset-heavy stocks; iii) large caps; iv) cyclicals over defensives. The Fed cut is especially adding gasoline to asset-light stocks because it is further cementing the market belief that interest rates can only fall lower, which makes asset heavy businesses less attractive to investors. And by the way, we define asset-light stocks as those with low assets to EBIT (earnings before interest and tax expenses). Need proof? Since 2015 our asset-light index, composed of 5% of stocks from the S&P 500 with the lowest assets to EBIT ratio outperformed our asset-heavy index (5% of stocks from S&P 500 with highest assets to EBIT ratio) by 11,070 basis points! See chart below. The question to consider though is how much longer this trade can continue. We believe the asset-light trade will jump the shark when the market is convinced interest rates will stay low forever. But here’s the secret. “Forever” is a dangerous word in markets and we believe reflationary conditions will resurface in 2020 for two reasons. First, we’ve witnessed the recent steepening of the long-term yield curve (30Y-10Y) and this has led the ISM Manufacturing Index by 16 months. So, expect ISM to bottom sometime in late 2019 at 48 (was 51.2 in July). Second, we expect labor markets to tighten in 2020. Hence, asset-heavy stocks should start working again in 2020. What could go wrong? Markets do not like trade wars and China could escalate tensions. Bottom line: We remind investors that 2019 is the strongest YTD gains for markets since BEFORE 2009. And we see falling 10-yr and weakening USD and higher odds of a September cut as VERY BULLISH—hence, we strongly urge investors to take advantage of this weakness. For now, we believe Fed is adding gasoline to support the trades that are working in 2019 (now new regime) and especially asset light stocks. We have identified 15 “asset light” stocks which are top decile of asset light + DQM ranked 1 and 11 underweights which are “asset heavy” and DQM ranked 5. The OW tickers are ROK, VRSN, LRCX, MXIM, QCOM, XLNX, MSFT, CL, MNST, MO, PM, AMGN, BIIB, GILD, BMY, while the UW tickers are WAB, CRM, WDC, JPM, ICE, CB, L, STI, HCP, WELL, NI. Figure: Comparative matrix of risk/reward drivers in 2019, Per FS insight Figure: FS Insight Portfolio Strategy Summary – Relative to S&P 500** Performance is calculated since strategy introduction, 1/10/2019Source: FS Insight, Bloomberg

Non-Consensus View: Cyclical Stocks Should Come Alive

The market consensus is sometimes correct but sometimes wrong. I like to push against the consensus. Not only is it intellectually stimulating, but when the consensus is wrong investors can do well by using a contrarian approach. Currently, for example, the central thesis of market skeptics is that numerous political risks—such as the ongoing U.S.-China trade spat, a looming hard Brexit later this year, and President Donald Trump’s regular shoot from the hip tweets—will undermine corporate and financial market’s confidence sufficiently enough to lead to a selfsustaining economic contraction. That’s otherwise more commonly known as a recession. This is a consensus view and as such, investors are defensively positioned. Yet there’s some cognitive dissonance here: Why then are cyclical stocks—such as consumer discretionary and industrials—doing well this year and also leading in the rally from the June 3? (See nearby chart.) Secondly, why is the real estate sector second best? I believe that cyclical stocks are responding to, among other factors, the steepening long term yield curve and to rising inflation expectations. Cyclicals are leading year to date, and do so despite the 7% correction in May. The interesting sector anomaly is real estate, which reflects a rising inflation risk. Historically, the only time the market generally sees strong cyclical relative performance is when the long-term yield curve is steepening. This is the case currently, and I think owning cyclical stocks is the appropriate investment stance as well. This is analogous to the 2009 2010 period, which is fitting because I believe a new bull market started in December 2018, when stocks fell 20%–a bear market—from the September’s all-time high, on an intraday basis. The inflation risk is perceived to be rising because the Fed’s forward 5-year breakeven inflation rate less the consumer price index—a measure of that risk—has risen this year. (The breakeven rate is derived from the nominal 5-year Treasury yield minus the 5-year TIPS yield.) The gap between expected and actual inflation has widened, suggesting financial markets are pricing in a rise in inflation risk. Investors shouldn’t misread the drop this year in the US Treasury 10-year yield, which as I have argued several times earlier, is more due to zero interest rates in much of the rest of the world’s major bond markets than to a potential economic slowdown. Meanwhile, even as bears fret about the inversion of the 3 months-10-year Treasury yield spread and as the front end of curve is pricing in a Federal Reserve easing of the Fed funds rate quite soon, the more important long-term yield curve has moved counter to that and is steepening. Indeed, the best indicator of business cycle health is the long term yield curve, notably the 30 year-10 year spread. And its steepening suggests long-term growth outlook is accelerating and there is stronger growth ahead. The spread, now about 40 basis points, was just 12 bps one year ago. That’s bullish for cyclical outperformance, and similar to 2009-2010. The inversion in the front end reflects the need for the Fed to cut rates to correct for having tightened financial conditions in 2018, which aren’t hurting the long-term growth outlook. Additionally, as all the world knows by now, the Fed has made a very quick about face in the last month and is now expected to cut interest rates in 2019 instead of hike. Fed futures are pricing a rate cut potentially as early as next month. A rate reduction often leads an expansion in the market’s price/earnings (P/E) ratio. When the economy is not in a recession, as now, such Fed cuts lead to an average P/E expansion of 1.7 times over the next six months. This implies the forward P/E (2020) should rise to about 17 times, which would put the S&P 500 index comfortably at 3,100 or higher by year. My yearend target of 3125 is based on 17 times my S&P 500 Index EPS estimate of $184 in 2020. What could go wrong? With purchasing managers index surveys weakening, the current stall in economic momentum could lead to an economic downturn. However, this isn’t my base case and the US economy remains fairly resilient. Bottom line: I’m constructive on equities and see tailwinds for cyclicals. The following are the ticker symbols for 21 highly-ranked cyclical stocks: TRP, GM, BKNG, LMT, MMM, NSC, CSCO, ADP, MSFT, LYB, APD, NUE, CVX, XOM, PSX, BLK, NTRS, COF, FB, GOOGL and DIS.

Stocks Fall Again; Odds Heavily Favor a Post-Election Rally

This has been an ugly week for the stock market with the Standard and Poor’s 500 index declining 5.6% and all sectors deeply in the red. And also of note, the VIX spike above 40 for the first time in months this Wednesday. Nevertheless, I think risk/reward remains attractive and the odds heavily favor a post-election rally. More on this below. On the COVID-19 front, in a nutshell, it is spreading and much worse in Europe but mortality is falling. The skeptics would say mortality is low because the virus is making its way to the vulnerable cohorts (lag). Others would point to the deadwood issue and many of the vulnerable have already been killed. Therapeutics are far better. And mitigation is better. But the key issue is avoiding the level of policymaker panic that would lead to broad economic shutdowns. The takeaway is to that wave 3 is really a wildfire through areas of the US that were largely untouched. In fact, if we look at some of the cities at the heart of Wave 1 and Wave 2, we can see that there is hardly a new wave of cases burning across these cities. Daily cases in Florida have hardly increased from their low and remain way off their peaks. And New York City has barely seen a perceptible rise in cases since October 1. And interestingly, this is very different from Europe’s second wave in which the same cities are seeing a resurgence. The daily change in cases vs 7D ago in the US which, in our view is the key leading metric, is rising but the rate of increase is been constant and the rise does not seem to be accelerating (becoming exponential), which is key. And while hospitalizations are also up, we can see daily deaths are flat to down while daily cases are soaring. This is a reminder that the future is very uncertain. So, while this is a relatively benign picture now, it could also easily worsen. This week we identified 6 states (Wisconsin, Illinois, Idaho, North Dakota, South Dakota and Utah or simplified to “WIINSU”) that are out-sized contributors to the 3rd wave of cases in the US. These states have remarkably high case prevalence based on daily cases per 1mm. And within each of these 6 states, our data science team identified the 3 key counties, based upon either case prevalence or case velocity (daily cases per 1mm) which bear watching over the coming weeks as wave 3 unfolds as they could provide insight into when wave 3 should peak. And after all, once policymakers and residents panic, we could start to see a mitigation of case growth rates. STRATEGY: Market weakness creating a positive risk/reward for stocks It has been a rough run for epicenter stocks for the past few weeks. The surge in COVID-19 cases coupled with the delay in fiscal stimulus has weighed heavily. But I still remain constructive on these stocks, even as the past few weeks have been awful. Mainly, I see US economic momentum strengthening in 2021, even with COVID-19 still surging in the US (less deadly and lockdowns are not needed here). And I see additional reasons Cyclicals, aka epicenter, could see surprisingly strong EPS in 2021: (i) restricted topline environment forces these companies to slash operating costs ala 2008, (ii) demand recovery from either stimulus or vaccine results in operating leverage, and (iii) Price to Earnings ratios can expand because these companies have proven to be unkillable by surviving the biggest contraction in modern history. Investors are reluctant to add risk because they do not know who will prevail on the Election day. And also, they are concerned about a contested election. Would a contested election change the 2020 economic outlook materially? There is one scenario. The US economy badly needs action on fiscal stimulus. So, if the contested election raises the risk of delaying a stimulus bill until after the new President is sworn in, we could see a delay in the badly needed financial bridge. But if this happened, we believe the Fed would intervene. In other scenarios, we see fiscal stimulus moving forward with the same Fed backstop. So, the odds heavily favor a rally post-election. In short, while people are sitting on the sidelines into election day, we see a rally taking root thereafter. Bottom Line: This has been an ugly week with the S&P 500 declining 5.6%. I see this weakness as a positive risk/reward and continue to see opportunity in “epicenter” stocks as economic momentum strengthens. Figure Comparative matrix of risk/reward drivers in 2020Per FSInsight Figure: FSInsight Portfolio Strategy Summary - Relative to S&P 500** Performance is calculated since strategy introduction, 1/10/2019

Stocks Down 0.5% on Week; Stimulus Should be “when not if”

One of the top market rules for me, maybe even rule #1, is never to try to impose my views on the markets.  And perhaps, it is more useful to try to decipher the message from market behavior.  If I had to describe equities over the past week, they seemed to have been treating fiscal stimulus as a binary event. Regardless of the fact that this seems more of a “when not if” question to me. More on this below. On the COVID-19 front, the trend in daily cases continued rising this week. This has been the case for the past few weeks and I see two major takeaways: (i) US cases could reach 70,000 within 2 weeks, matching the July highs, (ii) Because the spread is primarily in 11 states, we might be nearing peak velocity in those states. We are still in wave 3 of COVID-19 in the US. And this wave, so far, is primarily a spread of cases in states that were largely unscathed in wave 1 (NY tristate +MA +RI) and wave 2 (FL, CA, AZ, TX, or F-CAT along with 19 tag along states). And this means COVID-19 is finding its way into areas of the US which are caught off guard. So, part of the key over the next few weeks is for policymakers and citizens in these 20-ish states to panic enough to reduce the spread. There must be some of this taking place already, as daily cases are increasing but not soaring exponentially. And even states like South Dakota and North Dakota might already have reached peak velocity. I think hospitalizations are increasingly a better measure for tracking COVID-19 spread and severity.  I see several reasons for this: (i) expanded testing is leading to more detected cases, but not necessarily meaning rising infection, (ii) wide scale testing at schools, offices, certain businesses, means we will see greater detection (iii) there are many people who are testing PCR positive but are recovered. In fact, the testing positivity rate in the US is 6.2% right now, well below 9% of wave 2. (see chart nearby).  And in wave 1 and wave 2 states, positivity rates are very low. So, on balance, I am feeling a bit better about COVID-19 this week, despite the fact that cases and we could reach 70,000 within a few weeks. STRATEGY: Markets implying fiscal deal a binary event but it is when not if For the millions of Americans with stimulus benefits expiring, the next coronavirus relief package is truly critical.  Those who need this next installment of payments are those who are relying on the US for the safety net. However, I see less at stake for equities.  In other words, it does entirely make sense to me that stocks were stuck in neutral and seem to pivot on fiscal stimulus updates.  But I revert to the rule #1, I can't tell markets what to do. And despite the fact that a stimulus deal did not happen this week, it will happen before year end. This week JPMorgan's Fixed Income team made a very interesting comment. Their strategists suggest that US High-yield defaults have peaked for this cycle. This is a significant statement. High-yield is a close cousin of equities.  And this economic depression has led to a surge in defaults in High-yield.  But now, it looks like this cycle has peaked and if this is indeed the case, this is a major risk-on signal. Especially with 3Q20 earnings signaling that the EPS nadir is passed. Bottom Line: Given the fairly robust incoming economic data, high levels of cash on the sidelines, and high anxiety into elections, this surely seems to be a set-up for a pretty big post-election rally.  The more we churn here, the more impressive the post-election surge. Figure Comparative matrix of risk/reward drivers in 2020Per FSInsight Figure: FSInsight Portfolio Strategy Summary - Relative to S&P 500** Performance is calculated since strategy introduction, 1/10/2019

In Choppy Week for Markets Stocks Finish up 0.2%

Equity markets were choppy over the past week. And while impacted by the stalemate in Washington over the fiscal stimulus and the surging COVID-19 cases in Europe and the US, the Standard and Poor’s Index finished the week essentially flat; up 0.2%. Unfortunately, COVID-19 is spreading at a faster rate in the US. While cases are spreading in nearly every state, this surge since early September is being driven by a new set of about 20 states. Wave 1 was NY tristate, wave 2 was FL, CA, AZ, TX, or F-CAT, and as the chart below shows, these other 20 or so states are driving wave 3. Daily cases are spreading at such a high-speed in these states to hopefully cause their residents to take appropriate action. Similar to wave 1 and wave 2, I think it’s possible that we see this third wave peak within the next 2 weeks. And if these states avoid a shutdown, this would be good news. Source: COVID-19 Tracking Project Nevertheless, it was not all bad news on the COVID-19 front this week. The severity of this wave of cases seems less lethal than prior waves with the US seeing 1% incremental hospitalizations vs 4% in July. And over the next 20 days, equity markets are primarily focused on Washington (election and fiscal stimulus) and the path of COVID-19. Importantly, the daily change in COVID-19 cases vs 7D ago has not shown an exponential rise, which I see as a positive. Source: COVID-19 Tracking Project This week, we looked at the “peak speed” of COVID-19 spread on a state by state basis. Similar to waves 1 and 2, this recent spread also seems to have what I call a built-in speed governor, in the sense that once cases reach a certain level of spread, there is a policy response as well as behavioral changes that mitigate further spread. A simple example of this is the many anecdotes we received from those in Texas. Once COVID-19 reached a certain level of spread, many Texans donned masks and practiced other mitigation measures. On a state by state basis, we are seeing different levels of “peak daily cases per 1mm” and will be watching this closely. I expect these “peak” levels on a state by state basis to provide insight into the overall trajectory of this third wave Strategy: 3Q2020 EPS season affirming we are moving past the bottom on EPS. A simple guide to seeing this is to look at the relationship between ISM exports and EPS growth. As can be seen in the chart below, when ISM exports recover back above 50, this coincides with a turning point for EPS. Hence, the run-rate for EPS is now positive quarter over quarter. And overall, this EPS recovery is far stronger than we expected, and US corporates are more unkillable than we expected. Previously, we expected 3Q2020 EPS to be similarly bad to 2Q2020, so this is better than our expectations. Source: FSInsight, Bloomberg, ISM Accordingly, we are raising our 2020 EPS estimate from $50 to $100. Decomposing this growth into sectors, more than 50% of this increase is driven by EPS growth from the epicenter sectors (Discretionary, Financials, Industrials, Energy, Materials). A little less than 50% of the increase will be driven by Secular Growth (Technology, Communication Services, Healthcare) with little growth being driven by defensive sectors. We are keeping our 2021 EPS estimate at $193. Source: FSInsight, Bloomberg, ISM This week we re-balanced our “Granny Shots” portfolio adding five new stocks and removing six stocks. On a year to date basis, the granny shots portfolio is outperforming the S&P 500 by 25.4%. We continue to view Granny Shots as a way to construct a core portfolio as these stocks fall within our three thematic portfolios and three tactical portfolios and encourage you to refer to the updated list on page 1. Bottom Line: The choppiness in equity markets over the last week is understandable given the focus on election outcomes, fiscal stimulus and rising COVID-19 cases. Nevertheless, I think stocks have made their pre-election lows and am encouraged by 3Q2020 earnings results. Figure Comparative matrix of risk/reward drivers in 2020Per FSInsight Figure: FSInsight Portfolio Strategy Summary - Relative to S&P 500** Performance is calculated since strategy introduction, 1/10/2019

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