Powell could tilt hawkish this coming week, but larger narrative is Fed "disinflation" is a massive course correction. Strong Jan equity returns borrowing from Feb, but dip buying still makes sense.

The January jobs report was strong = Fed wary, but also means US not in recession = good

The strong January jobs report (+517k vs 188k expected), along with strong JOLTS (aka job openings) and Fed Daly’s comments (hawkish), was overall too “hawkish”-ly tilted for equities, and thus, the sell-off on Friday.

• the strong jobs was a too much of a good thing as it risks an escalation of Fed
• this naturally raises the potential for Powell to tilt more hawkish this coming Tuesday when he speaks in Washington.
• but at the same time, this counters the economic gloom. The US economy is in very good shape currently
• this is arguably a data point for the notion of falling inflation taking place without needing a recession.
• furthermore, JPMorgan’s Michael Feroli, Chief US economist, Jan jobs might be a sign of “job hoarding” not strong job demand. Why? Because jobs are usually lost in Jan but it is the “seasonal adjustment” that makes it a positive month. We discuss below.

Is the Jan jobs report thesis-changing? In our view, no.

I don’t view this as ending the progress of markets in January. Here is a rundown of our take on 2023 so far.

• Inflation peaked in October and has been falling rapidly since aka “disinflation”
• Fed made an “unforced error” in December when Powell cited inflation trajectory higher vs Sept view and thus raised Fed funds terminal rates
• Feb FOMC (last week) was the course correction, and Powell went even further, noting that inflation continues to fall rapidly.
• Thus, Fed did not entirely dispel notion that Fed could be cutting rates in 2023.
• Collectively, this feels like a pivot from the lens of equity investors, significantly changing the calculus for equity markets for three reasons.
• First, volatility should decline as Fed becoming data-dependent aka predictable (vs “higher in a hurry”) and lower volatility means rising equity valuations via lower risk premia.
• Second, interest rates are collectively falling, which rates the terminal multiple of future cash flows (discount rate)
• Third, recession risks materially diminished with a “predictable” Fed, supporting upside to EPS forecasts and this is expressed via rising valuations.
• From an equity return perspective, with YTD gains >8%, January “borrowed” a touch from February returns. And we think February is likely a choppy month.
• This coming week, Fed chair Powell is set to speak on 2/7 at 12pm ET in Washington and given the stronger Jan jobs report plus JOLTS, it is natural to expect Powell’s tone to be relatively “hawkish” given the recent easing of financial conditions. So, this could be a reason for stocks to consolidate.
• Since 1950, using the “rule of 1st 5 days,” there are 7 instances where S&P 500 was both negative the prior year and 1st 5 day gains >1.4%. As we noted previously, this unusual combination is useful as this often signifies a turning point in markets, which we believe is the case for 2023. And full year gains average 26% with not a single year with negative returns (of 7).
• Notably, February in these 7 instances is a relatively flat month (4 of 7 positive) so we think this supports the idea that the strong Jan 2023 borrowed from Feb.

Still, as we noted last week, we think the “cancelled” buy the dip strategy is making a come back in 2023. And if there is chop and weakness this coming week, we would be buyers.

RULE OF 1ST 5 DAYS: February returns are muted in those 7 precedent years

The 7 precedent instances of both negative prior year plus 1st 5 days >1.4% are listed below:

• Feb is a muted month, with median gain of 0.2%, the worst of any calendar month and a win-ratio of only 57%. The only other month to be wary of is November.
• That said, in 1975, 1967 and 2019, Feb was strong
• So we would consider any pullbacks as buying opportunities.

And as we highlight below, the full year path of markets is promising. But there are expected periods of congestion ahead.

• Feb is one such period
• But the overall returns for 2023 should be far stronger than investors expect currently.

Before one suggests investors are already overweight stocks, this is not the case. There are many ways to show this, and JPMorgan Flows and Liquidity team had an interesting chart:

• this shows the implied leverage of risk-parity funds
• and current leverage is among the lowest levels during this pandemic era

JAN JOBS: Is January jobs report a sign of hoarding more than strong jobs

The strong January jobs understandably rattled markets. And while this is a message of solid labor market, it might be a sign of “job hoarding” not strong job demand. Why? Because jobs are usually lost in Jan but it is the “seasonal adjustment” that makes it a positive month.

• Jan 2023 lost -2.5 million jobs
• this was the best figure since 1998
• so it is less jobs lost, so it does mean labor is solid
• but it does raise questions of how this figure turns into a positive jobs report via seasonal adjustment

Looking at the breakdown of jobs in Jan, we can see the stark differences between seasonal adjustment and “not” seasonally adjusted (actual, aka NSA).

• top 3 jobs added were food servcies, state government education and educational services
• all 3 lost jobs NSA in Jan but this was less than in 2022
• so it become “positive” job added in Jan 2023 than in Jan 2022
• guess it makes it somewhat less conclusive to say labor market is “red hot” when it is simply losing less jobs in Jan

Michael Feroli, US economist, notes that the underlying message might be more of one of companies hoarding labor rather than a hiring blitz. It is a subtle difference, but something worth thinking about. As companies can be less concerned about hoarding in the future if labor conditions ease via rising layoffs, etc.

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

The best way to play easing financial conditions, in our view, is owning Technology and even small-caps. As the charts below highlight, both QQQ-2.08%  and IWM0.22%  are breaking out decisively

• IWM is more evident as the breakout was 1/11
• QQQ breaking out on a relative basis and just crossed above the 200D

And Technology remains a group where there are many down and out names.

• ~20% of Technology stocks in the broad market index Russell 3000 are >75% off their highs
• That means 1 in 5 technology stocks has been absolutely obliterated

And as shown below, there is a greater bludgeoning in Healthcare and Comm Services (which is essentially TMT).

Similarly, short interest has been rising in Technology. So this rally YTD has been met with investor skepticism and they are increasing their short selling of Technology. To me, this is fuel for further upside.

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:

• QQQ-2.08%  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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