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STRATEGY: A short week ahead but keep positive seasonals in mind
The US celebrates Thanksgiving this week and given the easing of COVID-19 restrictions in 2022, we expect many Americans to be especially thankful and celebrating. I know I will be having many guests over for Thanksgiving dinner.
- this also means a shortened trading week
- No trading Thursday
- Half session Friday
DECISIVE DATA POINTS: Next 3 weeks will be decisive
Just my opinion, but we think the next 3 weeks are decisive in the direction of the market narrative. For much of 2022, the central macro narrative is “inflation accelerating and Fed so far behind the curve.” But our central view has been that inflation pressures already peaked and it was a matter of time before the “hard” data (CPI, PCE, PPI) synced with the “soft” data (PMIs, major freight and other indices).
- October CPI was first real syncing of the data (downside surprise on CPI) and as we commented multiple times, the drivers behind this are repeatable.
- In the next 3 weeks, we get key incoming inflation reports, which we believe will decisively determine the market narrative on inflation
- 11/30 –> Oct JOLTS but labor has been strong-ish, so not expecting positive surprise
- 12/1 –> Oct PCE (personal consumption expenditures) and hopefully confirms Oct CPI readings
- 12/9 –> PPI November and Oct PPI was a positive surprise
- 12/13 –> CPI November and if this is 0.3% or less, key
- 12/14 –> FOMC but this is less key than Nov CPI
If Oct PCE + Nov PPI + Nov CPI show an inflation trend similar to October’s CPI, we believe this will be a decisive turn for markets. That is, if Nov CPI MoM comes in at 0.3% or so, we think this largely shatters the inflationista view that inflation in the US is accelerating:
- our clients generally think US inflation is running too “hot” at 7.7% plus (YoY figure)
- but if we get two consecutive months of core CPI at 0.3% or less, inflation is at a run-rate of 3.5% or less
- that is a massive gap vs what is perception (inflation running hot)
- moreover, if CPI does come in softish, we believe Fed’s hawkish rhetoric will diminish
- keep in mind that other central banks from ECB, Bank of Canada, BoE, BoJ, RBA have all made a dovish pivot
- most importantly, this would create a path for the Fed to become “predictable” rather than “bang out +75bp” each meeting
In short, if these incoming inflation reports confirm a softer inflation trajectory, the Fed and markets likely start to focus back towards the “soft” data and gain confidence that inflationary pressures might be waning faster than expected. There are no guarantees, of course, but this is our view.
Additionally:
- high-yield spreads continue to rally and the wides were made in July 5, 2022. This is a bullish divergence
- widely followed economists from Goldman Sachs and JPMorgan both published their 2023 economic outlooks and they are pushing back against the consensus view of a recession in 2023. They both see a “soft landing” which is positive for risk assets.
- FX strategists also note the USD is the most overvalued since 1985 and this points to a likely softening in 2023.
- USD surge of +18% likely subtracted 5% to 8% from S&P 500 EPS growth in 2022. A fall of 10% would be a 3% to 5% tailwind to consensus forecasts.
All in all, we believe the ingredients remain in place for equities to finish strongly into YE. And the probability favors a move greater than consensus expects. Thus, we believe the S&P 500 could move above the 200D average and rally towards 4,400 or so before YE.
HIGH-YIELD: Positive divergence as high-yield bottomed July 5th and tighter at equity low on Oct 13th
Foremost, pay attention to this divergence.
- High yield OaS (or options adjusted spread) move in tandem with equities historically, as both are a measure of risk appetite
- A bullish divergence is when equities make a low but HY OaS holds at a higher level
- this happened this past Oct 13th and we wrote about the divergence at the time
- but look at how this positive divergence seems confirmed
- high-yield has continued to rally and equities have moved higher from those Oct 13th lows
SANITY CHECK: If you want to own high-yield in 2023, then you will want to own equities
We have heard from many investors that they are beginning to overweight high-yield bonds given the high coupon of 9% or so.
- there is rationale actually
- in 2022, high-yield posted its second worst year ever, only 2008 was worse
- high-yield has never posted two consecutive negative return years
- but equities have always had a positive return in any year when HY has a positive year
Equities average +22% in the year after HY has a negative year
And take a look at the equity return following a negative HY year.
- stocks post an average gain of +22% in the year after a decline in HY
- food for thought
USD: Is USD most overvalued since 1985?
Another support for S&P 500 EPS and equity prices is the possibility of a dollar peak in coming months. As Goldman Sachs FX notes, the USD is the most stretched (in valuation) since 1985.
And they note that as inflation weakens, USD tends to peak. This is also true of growth trajectory (core retail sales or industrial production). Both are softening and point to USD weakness.
SOFT LANDING: Consensus expects a recession and the minority see a soft landing
One of the strongest views held by those that are bearish is that the US economy is heading towards, or is in, a recession. There are multiple arguments advanced for why US is in a recession:
- Fed is raising rates so fast, something will break –> yes, but it looks like it is outside USA
- Fed has backed off their “soft landing” view –> yes, but Fed is trying to contain inflation and we think inflation tracking better than “hard” data shows
- Housing is tanking and will take economy with it –> yes, but avg homeowner FICO score today is >750 vs 650-ish in 2008
- Yield curve 10Y less 2Y is inverted which is guarantee –> yes, but this is due to the backwardation of inflation (higher now vs future)
There are others, but you get the idea. But a growing minority of economists believe a soft landing is the central case. Below is the 2023 outlook from Goldman Sachs and they see US “approaching a soft landing”
- their rationale is as follows
- Fed tightening keeps US growth soft at 1% or so
- Second, US labor markets soften with a drop in job openings not by a rise in unemployment
- Third, this slows wage growth to 4% which is close to 3.5% needed to sustain 2% inflation
- Fourth, inflation falls towards 3% and preventing Fed from having to accelerate pace of hikes
JOBS: Curiously strong, but Harvard Business Review article argues JOLT overstates strength
A pretty interesting article was shared with us (thanks PB in CA) published in the Harvard Business Review. It was co-authored with some folks from LinkedIn. Basically:
- LinkedIn has a real lens into job seekers and jobs postings.
- Their measure shows the ratio of job openings vs job seekers is 1:1
- This is far less than the 1.8 seen by the official JOLTS report
- The trend in 2022 has also diverged sharply
- LinkedIn shows job market softening consistently past 5 months
- While JOLTS shows strength
Many have questioned the quality of JOLTS data since the data is only available since 2000 and could be affected by employers listing the same job in multiple cities. JOLTS claims this error is not there as they seek to look at unique openings.
- But who knows
- Why would LinkedIn have a far different picture?
- 1.0 vs 1.8 is a massive difference
STRATEGY: Keep in mind the seasonals
Keep in mind the positive seasonals in YE. We highlight market returns (since 1987) based upon sentiment.
- when sentiment is the most negative (see red line, ex-2008)
- stocks perform strongly into YE
- this is roughly 7-10% upside from here
Please don’t ignore the 6 key signals from last week
Most of 2022 has been a cascade of ever more troubling developments, from surging inflation, Russia-Ukraine war, Fed going full Volcker, China issues and multiple seismic crypto events (terra luna, 3 Arrows, Voyager Digital, and now FTX). And this has pushed interest rates higher, panicked policymakers and punished equities. Still, equities found some sort of footing on 10/13 (day of Sept CPI) and since risen 15%.
Last week was a “game changer” in our view, principally due to the far softer and repeatable Oct CPI but there were 6 signals generated last week. Each of these 6 are why we see a far different path forward for markets:
- Foremost is the positive Oct soft CPI (and repeatable) which showed a favorable break in 3 key inflationary areas: shelter/OER, medical care and goods (apparel and used cars). We expect this to be sufficient for Fed to slow pace of hikes, and possibly December 2022 may be the last hike.
- Second, bond volatility is collapsing (VXTLT or MOVE -1.86% ) and this is a point made repeatedly by one of macro clients (HA in NYC, who works at a major pod of macro HF). Similarly, Tony Pasquariello of Goldman Sachs notes bond volatility “is one asset that every other asset is priced off.” For perspective, TLT Vol (VXTLT) lows has marked every equity market high in 2022. The 8/12 low of 17 marked S&P 500 highs of 4,300.
- VXTLT has plunged from 33 to 21 in less than 15 sessions and we expect to fall to 15 or so. This collapse in volatility, in our view, would support S&P 500 surging to 4,400-4,500 before YE.
- Third, US yields saw a massive decline ranking in the bottom 1% largest downside moves in the past 50-years. Analysis by our data scientist, Matt Cerminaro, shows yield declines of this magnitude portend further declines in rates 6M and 12M forward. In other words, chances are rising the highs for the 2Y and 10Y yield are in further supportive of P/E multiple expansion.
- Fourth, USD (DXY) posted one its largest ever declines (6D) falling -5.8%, ranking it the 8th largest ever decline since 1970. As our data science team shows, USD historically lower 6M and 12M later. Increasingly looks like the top is in for USD as well. Several FX strategists are making similar comments including Deutsche Bank’s George Saravelos.
- Fifth, there is economic signal in the fact that Republicans fared poorly in 2022 midterm elections. While preliminary, it looks like Democrats will hold a majority in the Senate and Republicans have only a slim margin in the House. While many politicos call this an indictment of Trump, we think the bigger message is the economy is simply not bad enough for voters to kick out the Democrats. Inflation arguably is not bad enough that voters are blaming incumbents. Think about that. If inflation is “as bad as 1980s” I would have thought midterms would have been an incumbent massacre.
- Sixth, crypto had one of the tsunami of financial collapses ever (largest in dollar terms), with liquidations (to zero) of >300,000 accounts with leverage and the stranding of $10b or more in assets in FTX along with further contagion effects. Only Mt Gox hack was worse. Yet, the S&P 500 managed to post strong gains in the final two days of last week. This shows that investors are becoming more discerning, rather than “hit the sell button” on any bad news.
BOTTOM LINE: Case for a sustainable rally in equities is the strongest it has been in 2022
In our view, the case for owning equities is the strongest now than it has been in all of 2022. The reasons are cited above. But consider this additional perspective:
- Skeptics will say “growth is the problem now” and point to downside in EPS. But as we have written (see below), S&P 500 has historically bottomed 11-12 months before EPS troughs. So EPS is lagging.
- In 2020 and 2009, S&P 500 bottomed 12M and 10M before EPS bottomed. Since 1900, 13 of 16 major equity lows saw S&P 500 bottom before EPS. See table below.
- From 1982 to 1990, S&P 500 EPS only grew a cumulative 19% (or 2% per annum) but S&P 500 3X. Collapse in bond volatility (risk of higher rates) matters far more in our view
- If inflation is indeed slowing to a 3.5% annualized pace (0.2% to 0.3% per month, as we expect), this shows inflation is far less sticky than inflationistas have argued.
- While we have maintained that view “inflation not as sticky” (given the constellation of leading indicators), it is only now that we are seeing this in the “hard” data (CPI)
- Lastly, recency bias is keeping investors bearish. We have many clients telling us October CPI did “not change a thing. Inflation still too high and Fed will keep raising until something breaks”
- We still see a rally into YE
Rally should exceed the “June false dawn pivot”
As far as market implications, we think the case for a strong rally into YE has been strengthened:
- Foremost, Fed no longer has its “back to the wall” on inflation as October CPI beat looks repeatable and therefore the case for a pause after December is stronger. This counters the hawkish rhetoric of Powell post-FOMC but he did not have October CPI in hand.
- For most of 2022, Fed has not been able to point to measurable progress on containing inflation but a significant constellation of leading indicators showed deflation/soft inflation was in the pipeline. October CPI is the first month the “hard” data syncs with the “soft” data.
- Softening inflationary pressures strengthen the case for a “soft landing,” counter to the consensus narrative that Fed is spiraling economy to a hard landing. Core inflation running at 3.5% annualized (above) will not require Fed to bang out +75bp and arguably 4.5% Fed funds would be very tight.
- A Fed shifting from “higher in a hurry” to “predictable but possibly longer” is far better for risk assets. Fed has acknowledged serious and unknown lags in monetary policy and with inflation improving, Fed can gain some measure of patience.
- While some bears say the Fed doesn’t want equities to go up, this is an oversimplification. Fed just was in a hurry to slow things down in 2022. Stocks are far more complex than bonds which are arguably two variable assets (inflation and future Fed funds).
- Stocks are acting like “beach balls under water” because P/E averages 19X when 10Y between 3.5% to 5.5% — true since 1871. Thus, those arguing P/E should be 15X or less are just plain ignoring history.
- The “false dawn June pivot” rally lasted 23 trading days and saw S&P 500 rise +16%
- We believe this “Fed pause” rally should last closer to 50 days and push S&P 500 +25% higher. Thus, we think S&P 500 should surpass the 200D average of 4,100 and given possibility of another weak Dec CPI could see a move well beyond that. Why wouldn’t 4,400-4,500-plus be a possibility?
- Recall, in 1982, following the final low in August 1982, the S&P 500 reached a new all-time high within 4 months, erasing entire 27-month bear market. That was a vertical rally. Vertical.
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37 Granny Shot Ideas: We performed our quarterly rebalance on 10/19. Full stock list here –> Click here
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