Market Has Strong Rally Despite Tech Earnings, Apple Holds The Line

Our Views

Tom Lee, CFA
AC
Head of Research
FY22 Target: 5100
YE P/E: 20.5x
EPS: 250

Inflation narrative now two-sided and central banks noticing, even as markets push back

Equities have staged a pretty impressive rise in the past 2 weeks, gaining 10% and up 10 of the last 12 sessions. This even as corporate earnings have been OK (some big misses) and September CPI (released 10/13) was a massive disappointment. In conversation after conversation, many of our clients tell us “nothing has changed” and this is just another short bear market rally that will fail.

But we believe there are supportive drivers and substance for this change in market tone:

  • inflation narrative has become more two-sided (vs “black hole of pain”)
  • we highlight below 3 drivers why CPI services are set to materially ease soon
  • global central banks are making modest dovish pivots: first, Fed hawks, now Bank of Canada and now ECB
  • interest rates are finally easing and USD backing off
  • investors remain stalwart in their bearishness evidenced by put premiums, sentiment, positioning and general feedback in our meetings
  • the most watched report will likely be the 3Q22 ECI (employment cost index) as this is a definite measure of wage pressures. A reading below 1% (4% annualized) will be seen as positive
  • even if Fed keeps terminal rate at 4.5%-5%, our report earlier this week shows this is consistent with a 19X P/E versus 15X-16X today. Upside to valuations if risk premium stabilizes
  • Technicals are improving and Mark Newton, Head of Technical Strategy, sees risks of modest pullbacks but buyable into YE

SUMMARY: Could this rally turn into the most hated rally? Yes. As we discuss at the end of this report, there are multiple factors supporting why stocks should see a stronger rally than the 23 trading day/+16% rally seen in June.

  • given the above, couldn’t a rally of 50 days/ +25% ensue?
  • this would likely create FOMO
  • but also push S&P 500 above the 200D moving average of 4,100-4,150
  • thus, YE rally view remains intact

NOT PRICED FOR PERFECTION: Since 1930, when Fed tightening, P/E 18.5X when US 10-yr between 3.5% to 4.5%

We believe investors are overly pessimistic on P/E ratios when 10-yr interest rates stay at 4% to 5%.

  • rates can stay “higher for longer” so P/E could be pinned there
  • many investors believe P/E could fall to 15X or less
  • history does not support this
  • take a look below
  • since 1930, when UST 10-yr is 3.5% to 5.5%, P/E historically the highest
  • even during Fed tightening cycles (see solid blue line)
S&P 500 ~30% loss in real terms staggering, leaving room for rally. Not priced for perfection. Since 1930, median P/E when 10Y 3.5% to 4.5% is 19X, and 18.5X when Fed tightening.

 

LOOK PRIOR TO DOT-COM: High P/Es when interest rates at these levels

In case one thinks we are only looking at dot-com valuations. That is not correct. Our data science team, led by tireless Ken, has plotted all tightening cycles below:

  • During tightening cycles, US 10-yr was between 3.5% to 5.5%
  • Nov 1954 to Oct 1957
  • July 1958 to Nov 1959
  • Dec 1965 to Nov 1966
  • June 1999 to July 2000 (dotcom)
  • You get the picture
  • This is not “selective history”
S&P 500 ~30% loss in real terms staggering, leaving room for rally. Not priced for perfection. Since 1930, median P/E when 10Y 3.5% to 4.5% is 19X, and 18.5X when Fed tightening.

 

NARROW RANGE: But look at how narrow the P/E range is during UST at 3.5% to 4.5%

Cleaning up the charts, we only wanted to look at the distribution range of P/E by:

  • excluding top 20% and bottom 20%, thus, only looking at middle 60%
  • look at how narrow the P/E range is for interest rates around here (shaded)
  • P/E median is 18.5X with a small range
  • None of the plots are 15X P/E
  • This is what is important to keep in mind
S&P 500 ~30% loss in real terms staggering, leaving room for rally. Not priced for perfection. Since 1930, median P/E when 10Y 3.5% to 4.5% is 19X, and 18.5X when Fed tightening.

 

REAL RETURNS: S&P 500 is down nearly 30% in “real terms” (CPI adjusted) in 2022… Fed won

The Fed wanted to tighten financial conditions in 2022. And this is transmitted by causing asset prices to fall. Take a look at YTD returns of various household assets in 2022.

  • the Fed won
  • everything is down
  • focus on the YTD returns in “real terms” as inflation is a factor

 

And with the snowballing declines in home prices (Case Shiller only shows August), this is a sign that the earlier tightening is already having a strong effect.

Since August:

  • Fed raised another +75bp
  • Housing indicators show far worse slowing
S&P 500 ~30% loss in real terms staggering, leaving room for rally. Not priced for perfection. Since 1930, median P/E when 10Y 3.5% to 4.5% is 19X, and 18.5X when Fed tightening.

 

Multiple economists, including Paul McCulley, formerly of PIMCO, noted similarly. That in real terms, a rally in equities does not unwind the Fed’s efforts. Financial conditions have already tightened dramatically.

Read the Latest First Word
  • Healthcare looks quite attractive for further relative strength and outperformance in Q4.
  • Small-caps look quite attractive following a five-year relative breakout vs QQQ.
  • AAPL remains attractive compared to other large-Cap Tech names. It broke its two-month downtrend earlier this month.
  • Equities seem to be responding more to Treasury yields than earnings of late.
Read the Latest Daily Technical Strategy
  • Despite chatter and hopes, the Fed’s battle with inflation has a lot more work to do. My concerns still center around the Fed having to do more NOT less. The potential for a disappointment next week is growing.
  • Tech earnings show the economy is decelerating. The consumer is growing increasingly stretched, and other cyclical areas are facing problems going into what should be a relatively sluggish holiday consumption season. Seasonal tailwinds can be strong, but my work is still very negative on US equities.
  • The equity market bottom is NOT in, and considerable downside risk remains for the U.S. equity markets so my view remains that strategic investors should not be chasing rallies but using strength to sell into as they drift higher.
  • A simple look at forward profits and p/e valuations suggest big upside is hard to justify.
Read the Latest Wall Street Whispers
  • My work on market valuation continues to show the market is overvalued and suggests prices will likely be headed lower in the medium term, potentially in early 2023.
  • The Reddit Alert retail sentiment tool has flipped toward negative. This suggests the current rally could have some more room to run and makes me more constructive on equities in the short-term.
  • Companies that are missing earnings have been severely penalized by investors. Companies beating are getting rewarded more than at anytime in the last few years.
  • The environment is still favorable to stock picking. Investment grade corporate bonds are still relatively attractive compared to equities.
Read the Latest Quant Commentary
  • Crypto dramatically outperformed tech stocks despite a historically strong correlation. This was largely attributed to a relief in rates over the past week.
  • Recent events suggest Ethereum’s revised inflation rate will have a profound impact on the network in the future, especially when paired with periods of increased network activity.
  • Twitter’s acquisition by Elon Musk presents an intriguing opportunity to open small, long positions in  DOGE and  SHIB.
  • Strategy – We remain constructive on select assets (core:  BTC,  ETH,  SOL, merge-adjacent:  LDO,  RPL,  OP,  MATIC) through the balance of the year.
Read the Latest Crypto Strategy
  • After weeks of guessing what the Fed’s Federal Open Markets Committee (FOMC) may do on interest rates, Wednesday is decision day, and the all-important post-meeting press conference by Chair Powell happens around 2:30 pm ET on Wednesday. The press conference is fraught with risk for Powell coming on the heels of midterm elections.
  • As Election Day approaches there doesn’t appear to be any event that would stop what appears to be the inevitable gain by Republicans of enough seats to capture control of the House. The historical pattern is clear—in all but four off-year elections since the Civil War, the party that controls the White House has lost seats in the House.
  • The Senate remains too close to call but polling appears to show growing Republican support in seats currently held by Democrats in New Hampshire and Arizona.
Read the Latest US Policy

Wall Street Debrief — Weekly Roundup

Key Takeaways

  • Markets had a volatile week but ended up rallying strongly. The S&P 500 closed at 3,901.06. The VIX closed at $25.75.
  • Tech earnings disappointed, particularly for digital advertising as demand slows. There was also unexpected weakness in the cloud.
  • Apple held the line on Friday and had its strongest day in years.
  • PCE came in a little elevated, but the Employment Cost Index showed some progress to indicate loosening labor markets.

Markets had their fourth consecutive weekly gain and showed stunning resilience in the face of headwinds. Markets rallied very strongly and closed at the highs of the day and the VIX went to the 25 handle. The Dow is on track for its strongest monthly performance since Gerald Ford’s presidency. The great debate on the Street is whether this is yet another bear market rally or the beginning of a change in the pervasive volatility and chop that have defined 2022 so far. Our Head of Research, Tom Lee, has pointed out that the stock market can rally quite a bit from here and still not run afoul of the wealth effect the Fed is trying to achieve. Stock picking is still working, and earnings are paying, or hurting, this season more than they have in recent quarters. Our Head of Quantitative Strategy, Adam Gould, has a retail sentiment indicator based on Reddit that has flipped negative, suggesting this rally could have some room to run.

Source: Fundstrat Reddit Alert Indicator

There was major weakness in the Tech Generals, yet the market not only took it in stride, but it also rallied strongly. We are entering a period of traditionally favorable seasonals. This rally seemed to come out of nowhere and under the hood, the market strength is even more impressive as there’s been major outperformance in Energy, Industrials, and Financials. Even the initial responses to Tech earnings were mitigated. Amazon regained much of what it lost in after-hours trading. The company was down on weak guidance for the coming holiday quarter. Apple, which was initially sold off on a minor miss for iPhones sales, rallied furiously on Friday. The company had its biggest one-day gain since April 2020.

The Fed is meeting next week, and it seems a foregone conclusion that they will conduct their fourth consecutive 75-bps hike. However, the real focus will be on the press conference following the meeting where Fed watchers will look for any signs of a dovish pivot. The rhetoric of even the most hawkish members of the FOMC has been evolving to suggest consideration of a pause of some sort. The European Central Bank and Canadian Central Bank both gave some indications of a gentler path. Republicans are also looking on track to have a good midterm election and will likely at least capture the House.

Inflation expectations, which have been far worse for self-identified Republicans, may get a little help with the election outcome. Furthermore, bloated inventory levels at big box retailers like Walmart that serve disproportionately rural and red communities will likely spark aggressive promotions to offload inventory. The American consumer has shown resilient strength in the face of rising prices and some holiday discounts will be welcome. Consumer sentiment has been improving since June lows, and our team’s analysis of the leading data suggests that the persistently high inflation expectations that are closely watched by the Fed may come down.

The week began with major political events abroad. At the National Congress of the Chinese Communist Party, Xi Jinping retained his leadership roles for a third five-year term. China’s positive economic report was overshadowed by investor worries regarding Mr. Xi’s power consolidation, part of which involved removing free-market proponents like Premier Li Keqiang and Wang Yang from the Politburo and replacing them with Xi loyalists. If there were hopes that Xi’s more secure grip on power might make it feasible for him to walk back his zero COVID policies for the sake of China’s economy, they did not materialize this week, with new lockdowns throughout China, including parts of Wuhan and Guangzhou. 

In the United Kingdom, Rishi Sunak on Tuesday officially became Britain’s third Prime Minister in two months. He ascended just a few weeks after a failed bid for the post in which he made prescient criticisms of opponent Liz Truss’s economic ideas, which ultimately toppled her from leadership. Stock markets had little reaction to the expected ascension, but gilt yields dropped sharply on Monday and Tuesday.

All three major indices climbed steadily in the first half of the week, notching gains until Wednesday, even in the face of troubling results from Microsoft and Alphabet. Disappointing results by Meta and Amazon sent the Nasdaq into a tailspin the second half of the week, though the Dow continued to climb on a growing belief that the Fed might be re-orienting in a more dovish direction, albeit gradually and with caveats. Intel was Friday’s biggest gainer on major cost cuts.

Q3 GDP numbers released on Wednesday showed economic growth at an annualized 2.6% after two consecutive quarters of contraction, with strong exports fueled by a strong dollar and constrained imports due to a post-pandemic inventory glut. However, the numbers also showed a cooling down of the housing market. We have been pointing to mounting weakness in the housing market with focus on leading data. Several other statistics released this week also show this trend: The National Association of Realtors reported that pending home sales fell by 10.2% in September MoM, far more than the 4% expected. Sales were down almost a third on a YoY basis. The CoreLogic CaseSchiller Index released Tuesday also pointed toward a cooldown, specifically a deceleration in home price increases.

Source: Bloomberg Intelligence

S&P Global reported that its flash U.S. Composite PMI Output Index fell to 47.3 from 49.5 last month, showing a private-sector contraction. S&P Chief Business Economist Chris Williamson said, "The decline was led by a downward lurch in services activity, fueled by the rising cost of living and tightening financial conditions."

One of the more colorful corporate takeover events in modern memory culminated this morning with a tweet from Elon Musk that said, "the bird is freed." Remember what Lynyrd Skynyrd said though: And this bird you cannot change. We’re hoping Mr. Musk turns Twitter into a thoughtful public square, but challenges abound. There have been attempts to abandon the deal, lawsuits and countersuits, and colorful exchanges between various parties. It has been a public spectacle that captured attention but now the rubber meets the road. Mr. Musk, a self-described "free-speech absolutist," has offered a vision that prioritizes free speech over the stringent content monitoring efforts that have riled some groups. Mr. Musk immediately fired the company's CEO and CFO. Twitter has experienced a loss in eight of the ten last fiscal years. Like other social media companies, Twitter heavily depends on digital advertising revenue, which has suffered recently as businesses tighten their belts. As finalization of the deal approached, Mr. Musk on Thursday attempted to reassure advertisers that despite his commitment to free speech, Twitter “cannot become a free-for-all hellscape, where anything can be said with no consequences!”

However, Mr. Musk appears to have grand visions for "the bird," as he calls his new company affectionately. He tweeted that his controversial purchase of Twitter was "an accelerant to creating X, the everything app." The idea of a super app is usually associated with the success story of WeChat, which is a one-stop digital shop for hundreds of millions in the Chinese market. WeChat was a humble messaging app that first came to dominate the Chinese attention economy as it layered on gaming, payments, ticketing, and ride-hailing functions. Mr. Musk isn't the only person trying to emulate this success story; it has become a quest around the Valley and other technological innovation clusters worldwide. Many consider such pursuits quixotic, but hey, landing a launched rocket was once considered quixotic too.

Firstly, the super app itself is essentially a technological product of inferior mobile phones used in China during the period of critical development. Chinese phones simply couldn’t support many apps, so these providers let third-party “mini programs” add functionality. These were added at less than half the cost of developing a separate app. The rapid consolidation was also mainly because China primarily used cash and didn’t have a comparable card network to what we have in the West. This was really the fuel for the mass adoption of super apps.

There's much more competition in the US and European developed markets, and even more importantly, more entrenched regulatory regimes and bodies. The unregulated markets and latent consumer needs for payments allowed WeChat to quickly build functionality on its network with little competition or interference from the state. The path in our own backyard would be much more complicated and involve a lot of getting in the mud with regulators and competitors. The other thing is that core groups of US consumers appear not to really want or need a super app. Millennials, for instance, feel comfortable having many apps to manage various areas of their life as you can see below.  Mr. Musk has repeatedly proved doubters wrong, though, and we'll be watching the development of this saga closely and reporting back to you.

Source: Cornerstone Research

Markets have become very bearish in sentiment and this rally is hated by many. However, Tom Lee pointed out in our research huddle this week that if these earnings misses had happened earlier in the year, the rest of the market would likely have been down around 5%. Still, despite this improvement, risks abound and the weakness in big technology does foretell some slowing macroeconomic activity. About $400 billion was wiped off their collective market caps this week. Concerningly, areas that were thought to be more immune like the cloud were not spared. Well, that was fun. On to Fed week friends.

Important Events

JOLTS Job Openings
Tue, Nov 1 10:00 AM ET

Est: 9,625k Prev: 1,0053k

JOLTS defines Job Openings as all positions that are open (not filled) on the last business day of the month.

FOMC Meeting/Rate Decision
Wed, Nov 2 2:00 PM ET

Consensus favors a rate hike of 75 bps.

The Federal Open Market Committee will announce how much it will cut or raise the Federal Funds. The press conference afterwards will provide details as to how the Fed views its progress in fighting multi-decade highs in inflation.

S&P Global US Services PMI
Thu, Nov 3 9:45 PM ET

Est: 46.6 Prev: 46.6

The Purchasing Managers’ Index (PMI) is an index of the prevailing direction of economic trends in manufacturing.

Stock List Performance

Strategy YTD YTD vs S&P 500 Inception vs S&P 500
Granny Shots
+13.09%
+3.05%
+111.51%
View
Sector Allocation
+11.75%
-4.16%
+0.90%
View
Brian’s Dunks
Performance available here.
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