5 reasons equities rallying. Expanding breadth affirms 2022 “bottom” is in. P/E can expand with Fed hikes, as long as “shocks” are avoided. 2H rally.

We are starting to see strengthening internals for equity markets, including key leadership improvements from Technology (QQQ-0.59% ) and small-caps (IWM-0.10% ) and measures such as advance/decline lines. Thus, from the perspective of our Head of Technical Strategy, Mark Newton, this is the healthiest expansion of participation all year, and a key reason he believes the “bottom” for 2022 is in.

• skepticism of this rally is rampant, not surprisingly
• the plurality of our clients call this a “bear market” rally and doomed to fail
• investors are waiting for 3 things:
• retail to capitulate
• EPS to get downgraded 20% or more
• Fed to capitulate
• In the absence of the 3 above, investors remain skeptical

5 reasons equities rally despite skepticism

The S&P 500 has closed at the highest level since June and is nearing 4,000. This is an important psychological level, as it puts the market closer to its all-time high than the 3,000 downside that many investors are “waiting for.”

But why are equities rallying? We can cite a few factors:

• inflation risks are abating as gasoline tanks, food prices ease (see below)
• 2Q2022 EPS results are better than feared with 70% beating on EPS
• many companies are reporting easing of “supply chains” meaning supply-chain inflationary pressures abating sharply, including semiconductor chip availability

• Strategists capitulated last week with many seeing S&P 500 closing 3,800 or lower by YE
• Institutional investors are arguably near maximum pessimism given BofA gross exposure at 2008 levels

The above, in our view, explains the dramatic improvement in market behavior post the awful and horrific June CPI report.

Supply chains are easing, evidenced by a material improvement in supply chain indices

The NY Fed has a supply chain index (Bloomberg: GSCPI) and as this chart below shows:

• the index is at the best level since March 2021
• this index was at its worst in December 2021
• steady improvements since

In fact, FH, an institutional client of ours, passed along some of his notes from EPS calls. A few really caught my eye regarding the supply chain:

• Volvo says semi chip access improving and production is at best levels all year
• Volvo sees themselves past peak pain
• CSX0.69%  said “clear signs from auto manufacturers that semiconductor challenges easing”
• this corroborates the vast improvement in the NY Fed supply chain index.

And this tweet from Island Life (@galaxy_orion) is a great example of how easing supply chains are leading to lower retail food prices. We discussed in the past few months, how easing supply chains were going to eventually lead to better inventory levels, which in turn, lower food prices.

• King Crab is down 18% at Costco (COST-0.55% )
• this is a substantial decline

Fed is not only “waiting” for CPI to roll over, but looking for a comprehensive set of data to affirm inflation falling…

One thing that seems to have come up in multiple conversations is the view by clients that the Fed will not ease up on hikes until CPI prints are well on their way to 2%.

• this is mostly correct
• but CPI (PCE) is so lagged, we believe the Fed will be watching many other measures
• thus, the leading indicators and “soft data” will be key to watch

• SUMMARY: Roundtable with group heads, contrasting and harmonizing the views across sector heads
• We hosted a roundtable of the group heads of FSinsight on Monday 7/18. As our members know, our group heads often have divergent views or timeframes, and this huddle was a chance for members to query and harmonize/contrast our views. With a total audience of >1,000 of our members, there was considerable interest and we received an enormous number of questions (of which we could only answer a handful).
• Thomas Lee, Head of Research
• Mark Newton, Head of Technical Strategy
• Brian Rauscher, Head of Global Portfolio Strategy
• Adam Gould, Head of Quantitative Strategy
• Sean Farrell, Head of Digital Assets
• Tom Block, Head of Washington Policy
• MACRO: When could equities bottom?
• Equities have been in a painful downtrend since the start of 2022, so this is the paramount question for investors. Within our teams, there are a range of views on when markets will bottom, and the rationale. At the core, it is really an assessment as to when the “P/E” bottoms, not “E” as we explain later:
• Rauscher: Sees equities bottom when EPS revisions bottom. This is not days, nor quarters, but probably sometime within 3-5 months. Possible first bottom S&P 500 3,600-3,500, but with downside risk.
• Gould: Markets are reaching fair value, but rarely bottom at “fair value” so a new low likely is needed. Fair value right now is in the range of 3,650-3,725
• Newton: Sees risk assets bottoming and moving higher in 2H 2022 which will become more clear post July FOMC. Newton sees a last push for 10-yr to 3.5% and USD push to new highs, but unclear whether SPX needs to make a new low. Cycles and sentiment are key reasons for optimism while recent trend breakouts make a long bias viable, looking to buy dips. Any pullback into late July should not undercut 3500 and lows for the year already might be in place.
• Lee: Fed playbook has changed to “measured” and this means fewer market shocks. And along with falling inflation expectations, no more pressure on P/E. Bottom is in.
• MACRO: S&P 500 earnings in 2022 and 2023

• There was considerable discussion on EPS. S&P 500 companies are far more efficient today given the massive cost and optimization efforts taken during pandemic. So there is a less of an “operating leverage” mistake. Moreover, hiring environment is tight, so employee payrolls aren’t necessarily bloated. But there is the “bullwhip” effect from the supply chain that will roil results:
• Rauscher — 2023 EPS is $242 to as high as $285: There will be a downwards EPS revisions cycle, which is why he is still negative on equities. His “back of envelope” is 2022 falls from $238-ish today to $215-220 for 2022, and 2023 growth rate is dependent on Fed easing and crude (peace deal or not) – no Fed easing — +2-6%, with Fed easing — +8-15%, peace deal & Fed – +12-20%.
• Lee — “Unkillability” 2023 EPS $245-$255: Inflation means nominal sales still growing. US companies have operating leverage, meaning good flow through to EPS. Headwinds fade if inflation is falling.
• Taking a step back, Street bears saying 2023 $200-$215 EPS seems too skeptical.
• MACRO: When will P/E…
• The above expectations S&P 500 bottoms are less about EPS, but more about P/E. This is where the team has considerable uncertainty. After all, P/E is based upon market confidence about the macro:
• Newton: Oil could go to high $80s, and this would cool inflation risks in 2H2022. P/E support
• Block: Russia doesn’t just end wars. So risk of war overhangs. P/E compression risk
• Rauscher: Negative earnings revisions only starting. Thus, markets will overreact to EPS revisions. P/E compression risk, especially for cyclicals.
• Lee: It is all about inflation expectations. If gasoline is falling, consumer expectations for inflation fall. P/E expands.
• MACRO: How quickly can stocks recover?

• We did not speak specifically about when markets will reattain new highs. That would simply be conjecture. But there were discussions about economic risks and the associated implied recoveries.
• Rauscher: doesn’t see this as a long EPS downward cycle like 2000-2003. Nor does he see a collapse like 2008 nor 2020. Rather, he thinks cyclicals need to face reality. This will be especially true for areas that are more cyclical, including commodity cyclicals, industrial cyclicals, consumer cyclicals (including discretionary retailers), and even tech cyclicals.
• Gould: key is watching market reaction to EPS misses.
• Lee: Doesn’t require Fed “put” but rather, inflation hysteria needs to fade. 1982 is best analog.
• On the point of 1982, take a look below.
• once inflation “broke” (measured based as consumer expectations)
• S&P 500 recovered entire bear market within 4 months
• a 36-month bear market, erased in 4 months
• applied to today, if inflation breaks down,
• S&P 500 could easily see new highs in late 2022 or early 2023
• SECTOR: Energy be more selective in 2H
• Energy equities led markets in 1H2022 given the triple tailwinds of higher oil, stocks cheap vs oil and energy equities were underowned. But the calculus is different in 2H22:
• Rauscher: Be selective, still above neutral, but focus on better names rather than broad overweighting
• Newton: Oil could be short-term weak, but still in a secular bull
• Lee: Energy stocks can’t rise if oil is falling. So no point in being a hero, but the upside is still there.

• SECTOR: Falling oil = OW Technology and Growth Stocks
• If oil is not the kingpin sector, what should investors own?
• Rauscher: Growth stocks, both defensive and offensive, are looking more attractive, as secular growth insulates from cyclical EPS risk. Sees valuation compression towards later innings, especially if rates show signs of topping and moderating.
• Newton: Technology and Growth are showing good relative strength and are buyable.
• Gould: Growth stocks valuations have improved considerably. Another potential area to consider is health care (specifically biotech).
• Lee: FAANG should lead in 2H2022. Best EPS visibility. Valuations have come in sharply. Street is less constructive.
• Overall, a lot of bad news is priced in. Look at the Russell 2000 Index (IWM-0.10% ) below.
• Russell 2000 has basically roundtripped to 2019 levels,
• erasing entire post-pandemic rally
• EPS is +72% higher, revs +27%
• lots of bad news baked in

• WASHINGTON: Midterms. Dems keep Senate. Republicans take House.
• Tom Block believes Republicans will take the House.
• Democrats may keep Senate with a one seat gain with more Republican seats up for election this year.
• As for Fed, listen to Fed officials as July FOMC meeting approaches, as under Chair Powell they have been telegraphing policy so as to not surprise markets.
• CRYPTO: Beware of bottom 1.0, wait for 2.0
• Sean Farrell sees risk/reward very attractive in crypto. For multiple reasons:
• massive deleveraging events are done
• unlike prior cycles, there are real things being done
• crypto remains beta to overall market
• if Fed playbook is changing, tailwind for crypto
• if Tech/growth are leading 2H, crypto is highest beta
• crypto valuations have become reason on multiple metrics
• signs of panic selling/capitulation by retail

• signs of capitulation by miners
• regulatory headwinds diminished
• dollar weakening bullish for crypto
• best ideas are BTC, ETH and SOL

Figure: FSInsight Portfolio Strategy Summary

** Performance is calculated since strategy introduction, 1/10/2019