S&P 500 no longer fearful above 200D as our "unpopular opinion" of inflation undershoot now looking to be central case. Technology/FAANG arguably best upside 1H2023 story.

The S&P 500 is no longer “fearful” above the 200D

Friday (1/27/2023) is an important comeuppance day with two key pieces of incoming economic data:

• Core PCE inflation (Dec) and
• U Mich 1-yr inflation (Dec final).

Why is this day so pivotal? The incoming data will arguably determine which narrative best explains inflation and the course of the Fed for 2023 and beyond:

• Consensus: inflation “sticky” so Fed needs to keep rates “higher for longer” to make sure inflation is “deader for surer” ala 1970s. Stocks remain in “whack-a-mole” mode with Fed.
• Fundstrat: inflation hit a wall in October, proving inflation was largely transitory and Fed needs to “course correct” allowing financial conditions to ease. Thus, S&P 500 up >20% in 2023.
• The incoming data for the past few weeks is supportive of our view and hence, equites are showing far more resilience that the consensus narrative.
• The “unpopular” view is equities bottomed on 10/12 (below) when inflation “hit a wall” and the Fed is now behind the curve. This is akin to August 1982, and if this view (ours) is correct, equities will gain >20%

Take a look below and we can see the S&P 500 is now 5 days above the 200D moving average. This is the longest stretch since the start of this “inflation induced bear market” and really argues the “unpopular view” is in fact the new central case.

Friday is a day of reckoning for “inflation-istas”

Friday is certainly a day of reckoning of sorts. The inflation reports since October 2022 have been materially undershooting consensus and now we get Dec Core PCE inflation.

This has particular importance for several reasons. But the biggest is that Dec Core PCE will impact how equity markets align with Fed:

• we have written consistently of our view Fed likely made an “unforced error” in Dec by raising their 2022 inflation outlook and terminal rate forecasts
• our data science team, led by tireless Ken sees Dec Core PCE inflation at 0.2% to 0.3% which implies YoY Dec 2022 Core PCE inflation at 4.3%-4.4%
• by contrast, in Dec 2022, Fed FOMC raises 2022 inflation base case to 4.8% (from 4.5%) citing hotter inflation
• thus, if Dec Core PCE comes in at any figure below 0.70% MoM (consensus +0.3%), Fed will have significantly overshot

PCE FORECAST: Analysis by data science team shows only 10% of PCE not known by release date— no huge surprises lurking

Our data science team, led by “tireless Ken” analyzed and mapped core PCE line items to source data and found only 10% of PCE is not known before the release date:

• 73% of PCE comes from actual CPI figure
• 18% is from PPI figure
• 10% is “unknown” by simply looking at existing releases
• largest items are “final consumption of non-profits” and “financial services” and lesser are food products and social assistance
• collectively, these are the swing factors

But the takeaway to us is there aren’t necessarily huge surprises lurking.

CORE PCE FORECAST: Tireless Ken forecasts +0.3% Dec

Tireless Ken’s forecast is +0.3%, which is inline with consensus. The swing will ultimately come from the above factors but the message remains the same.

• inflation has slowed considerably
• look at the monthly core PCE prints below
• there is a notable downshift since Oct
• going forward in 2023, housing will further weaken, driving downside into core PCE well into 2023

Overarching takeaway is inflation is now running at sub-3% since October

The overarching takeaway is inflation hit a wall in October and is running well below 3% and arguably on its way to sub-3% by mid-2023.

• below is 3M annualized inflation both core CPI and core PCE
• this is a huge drop in the pace of inflation and far undershooting Fed view
• recall, Fed view is: 4.8% in 2022 and 3.6% in 2024 for core PCE inflation
• Fed arguably has to course correct in Feb, either a “pause” or change in terminal rates
• but in any case, we see this leading to a significant easing of financial conditions

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

Technology is our top sector pick for 2023, as we outlined in our 2023 Outlook (published Dec 2022) and we believe the case for Technology strengthened so far.

Technology largest beneficiary of easing FCIs and less correlated to PPI

The two big macro changes to impact 2023, in our view, are:

• easing of financial conditions, of FCIs
• easing of PPI, or easing of cost pressures for producers
• some sectors are negatively impacted by falling PPIs as this spells margin pressure

As shown below, Technology is arguably the greatest beneficiary of each:

• Technology at 88% has the highest correlation to easing FCIs
• and has less exposure to PPIs falling as margin correlation is only 28%

Moreover, Technology technicals seem to be improving:

• QQQ1.75%  relative performance of SPY broke above a key trendline
• and QQQ is now closed above the 200D for the first time since April 2022
• So the technical picture has flipped positive

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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