Good Evening:
Markets had a strong week after the 4th of July holiday although light volume during peak summer vacation time likely kept a lid on big moves. The market has quietly drifted up 5% in the last three weeks which has been among the longest uninterrupted rallies of 2022 so far. There is some reason for hesitance as to whether THE bottom is in yet. However, given the persistence of selling and the scale of multiple compression there seems to be an improving risk/reward for stocks given historical precedents.
This morning the Jobs report cast some dispersion on those fearing a vicious slowdown. On the jobs front, at least, there is still a lot of strength. Payrolls grew by 372,000 which was expecting only 250,000. The headline unemployment rate remained at 3.6%. Some decelerating in key economic indicators had some pundits suggesting that we could be currently in a recession. This seems less likely given the persistent strength in the labor market. Average hourly earnings also increased and are up 5.1% from a year ago, so for the time being, wage pressures remain on the strong side. We do see some leading indicators suggesting that labor markets should begin cooling.
Looking under the hood you can already see signs that labor markets, which are very consequential for inflation, are cooling. The industries shedding jobs are the “right” industries, or the industries the Fed would want to see come down. Retailing employment, residential construction and some banking and mortgage jobs have come down a lot. One of the Fed’s primary concerns is when consumer expectations for inflation become “unanchored.” The May CPI report gave some cause for concern here but since then inflation expectations have come down a lot. Our Research Team had a lively discussion on Thursday morning about the current state of markets. We’ve captured the essence of this exchange and core views on the state of markets below.
Tom Lee – Head of Research
Tom has been doing some in-depth work on inflation. He has observed some pretty prolific falls in inflation expectations in the past three weeks that he will elaborate on below. However, he mentioned that consumer expectations are firmly tied to food and gasoline. Oil has now come down to within a few dollars of the levels it was at prior to the outbreak of war in Europe. Tom believes gasoline should likely follow.
The commodities slowdown and building inventories should be disinflationary. Many physical goods are seeing the “bull-whip” effect. Tom believes the data shows that inflation will come down faster and allow the Fed to reverse course sooner than consensus currently suggests. Tom also believes strength in Chinese Tech and FAANG are positive developments. His work suggests that inflation coming down faster than expected will trump coming weakness in earnings. Tom believes that persistent “stagflation” is an unlikely outcome. Tom believes that US markets are looking relatively attractive compared to global markets and this dynamic is unlikely to change in the near future.
Brian Rauscher – Head of Global Portfolio Strategy
Brian did his monthly deep dive into his earnings revision model and has emerged from the process more bearish than he was even in the last few months saying, “The cutting hasn’t even started in earnest.” His research suggests we are still very early in the coming downward cuts for cyclical earnings expectations whereas we should be in the 8th or 9th inning for a lot of the most oversold Growth names. He is still unsure whether the negative revisions will “bleed down” or have a definitive and quick capitulation event that brings equity markets down quickly. He has recently shifted his sector allocations to be much more defensive and sees a case for holding both offensive and defensive growth. Brian sees some relative attractiveness in the following areas after doing his deep dive.
Aerospace & Defense, Environmental & Facilities, Casinos, Pizza, Dollar Stores, Brewers, Distillers & Vintners, Beverages, Tobacco, HMOs, Large Cap Biotech, Pharma, signs of life in Software.
Rauscher agrees with Tom Lee that inflation will eventually come down to the Fed’s liking. While the Ukraine War may have let the “inflation genie out of the bottle,” his key indicators are signaling that the bigger future worry may go back to deflation much sooner the inflationista camp would suggest. As Brian looks out 18 months to three years, his key tools lead him to conclude that there is a high probability of a return to the low growth, low interest rate environment that was pervasive between the Global Financial Crisis up until the end of 2021. Brian concurs with Tom that “stagflation” is an unlikely outcome. However, due to the earnings weakness his research has flagged, Brian mentioned he might issue an even lower downside target tan the 3,600-3,500 level he has been writing about in the last few months. Brian’s recent publications are below:
BRauscher (FSInsight Portfolio Strategy): Wall Street Whispers — 7/1/22
BRauscher (FSInsight Portfolio Strategy): Wall Street Whispers — 6/24/22
BRauscher (FSInsight Portfolio Strategy): Wall Street Whispers — 6/17/22
Mark Newton- Head of Technical Strategy
Mark believes this recent bounce should be sold. He doesn’t believe we’ve seen the last of the downside action, but he does believe we are in the last stages of this sell-off. He sees markets bottoming around the third week of July. One of the headwinds he expects in the coming weeks for markets is that his work suggests rates will go back to recent highs, which should be a headwind for the Tech Generals that are so important for the overall levels of the indexes. He continues to see strength in the Healthcare Sector but advocates shifting from Pharma to Biotech. One reason why Newton doesn’t trust the staying power of this rally is that the breadth and participation in this rally have both been lacking.
Mr. Newton also doesn’t think the Elliott Wave structure of this bounce is very promising. He sees the downtrend as still intact. While Growth has outperformed in the recent weeks, Newton believes this should reverse as treasury yields rise. He is short-term bearish on equities and treasuries and thinks commodities are NOT done weaking yet—they should continue coming down into late July. He also believes the US dollar rally is on its final legs. He thinks you should avoid Discretionary, Industrials, Financials and Energy. Energy should be looked at again at the end of July though. He believes Managed Care within Healthcare looks attractive. He likes Utes and Staples as well.
Adam Gould- Head of Quantitative Strategy
Adam Gould is still bearish on markets for the short-term as well. His valuation indicators suggest that markets are currently overvalued, and this may be exacerbated by earnings projections coming down. The dispersion between cheap and expensive stocks (valuation dispersion) was coming down for the first 4 months of the year, but it has since started coming up. There appears to be a significant amount of uncertainty about key risks driving behavior in markets according to Gould’s research. As far as his factor weighting strategy, Value has been a big loser recently. Mr. Gould has also shown that companies who miss have been getting punished a lot in recent quarters, this dynamic will likely be repeated in this coming earnings season.
Source: FSInsight, (Shows the 3-day relative return for stocks beating (green bars), in line with (gray bars) and missing (dark blue bars) earnings estimates. An earnings “beat” (“miss”) is defined as the stock reporting earnings at least 2% greater than (less than) consensus estimates. Period of analysis is from December 16, 2019 through May 23, 2022. Transaction costs are not considered.)
Gould’s Factor Weights are heavily tilted toward Momentum and Low Volatility. The portfolio is currently underweight Growth, Value and Quality. The market has struggled significantly in 2022 but for much of the year it was a good environment for stock pickers as dispersion was high. Dispersion measures stocks correlation to each other and tends to go up during disorderly selloffs. Recently, dispersion has retreated compared to levels seen earlier in the year.
Update on Key Catalysts and Major Items from This Week
- The War in Ukraine saw Russian forces conduct an operational pause after they made territorial gains in the Donbass. Don’t be too encouraged by the temporary lull in intensity, it appears that Putin’s government is making efforts to increase mobilization and government control of industries critical to the military in preparation for a long and grinding conflict.
- Former Japanese Prime Minister Shinzo Abe was gunned down at a political event Friday. He was Japan’s longest serving Prime Minister and father of the “Abe-nomics” which describes the super accommodative monetary policy coming out of Japan over the past decades. Political violence and gun violence are very rare in Japan. This event is very significant and has shaken the Japanese population in a way reminiscent of President Kennedy’s assassination.
- Fed Minutes were released on Wednesday. The minutes showed a clearly hawkish bent and that the Fed is willing to risk a recession to subdue inflation. The minutes suggested members think getting rates to a restrictive level is likely appropriate. Raphael Bostic, usually dovish, also indicated later in the week that he thought another 75-bps hike at the coming meeting was likely. If there is another 75-bps hike, the Fed will be pretty close to the neutral rate which many economists think is likely around 2.5%.
- Earnings will begin next week. JPM, Delta, Pepsi and United Health Group will all be among those reporting. Our entire team agrees that weakness in cyclical names is likely to be pronounced this season as economic activity has slowed and estimates will need to be revised. From a CEO’s perspective, there likely isn’t a lot of upsides to giving positive guidance given the persistent risks and uncertainty about the resilience of consumer spending power. Financials should provide some clues as to the consumer’s health.
Looking Ahead to Next Week
Next Monday July 11th we will get the 3-year inflation expectations. As Tom Lee has noted, these expectations have had a prolific collapse in the last three weeks so keep an eye on this number to see whether the downward momentum continues.
Wednesday is data-heavy and will include the CPI release at 8:30 am. The Federal Reserve will also release the informative Beige Book which includes key insights from economic surveys across the 12 Fed districts.
Thursday will see the monthly Producer Price Index and Initial Jobless claims. Friday will see a big data dump. Retail sales, Import Price Index, The Industrial Production Index, Capacity Utilization and the University of Michigan Consumer Sentiment Index will all report on Friday. Business inventories will also be reported. It will be interesting to see whether inventories are continuing to rise to high levels which might result in discounting. This is important because if consumers anticipate discounts, they may put off purchases until prices are lowers which, all else being equal, should result in disinflation.
