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Everyone working off same “Fed gameplan” which we expect to change as inflation breaking to downside
The Thanksgiving holiday has ended and now markets are entering the final key weeks of 2022. It has been a tremendously difficult year for markets and much of the carnage is owed to the seeming unstoppable surge in inflation.
- this has forced the Fed to pursue a “hurry to get higher” strategy
- and because of the uncertainty of inflation’s path caused markets, CEOs and public to fall in line with Fed gameplan
- Fed is setting consensus views on inflation
- but Fed is not “all seeing” and thus, if the path of inflation changes
- so will Fed and so will market consensus
- this is a key point that I feel is often lost in the market narrative
- if inflation softens, this would be a “change” in Fed view (which argued there has been no progress on inflation)
- as we noted in prior comments, we see the soft Oct CPI as repeatable and expect Nov CPI (released 12/13) to be similarly soft
- October CPI was a “game changer” in our view
- Nov CPI will be the “game changer-er” or further solidify that inflation’s back is broken
Thus, while many may be tempted to “close the books” for the year, we think the final 5 weeks will be “fireworks”.
11 Headwinds of 2022 have already turned into Tailwinds
More importantly, the 11 headwinds for 2022, in our view, are turning into 11 tailwinds. Take a look at the 11 headwinds of 2022:
- these have collectively worked to take S&P 500 from 4,800 to 3,490 (early October)
- each of these headwinds progressively shifted the market narrative from “economy strong”
- to “we are worse off than 1980s stagflation”
…Take a step back
But take step an objective step back. And take a deep breath.
- Take inspiration from Frank Constanza (below)
The headwinds indeed already turned into tailwinds
- the 11 headwinds of 2022 have all flipped
- the turn has already happened
- each headwind is now a tailwind
- please take a step back and see this
If this is the case, then market positioning needs to change. Think about that.
Institutions and Retail are positioned bearishly, but they are “risk-off” as tailwinds underway
One doesn’t have to search far to see how institutional investors are full “risk-off”
- BofA Fund Manager Survey shows risk appetite is the lowest ever
JPMorgan’s Flows and Liquidity shows asset manager positioning is the lowest in more than a decade:
- funds are de-risked lower than 2016 low and below 2020
Even DB consolidated equity positioning shows investors heavily risk-off:
- Z-score of positioning is -1.0 below average
And look at retail investor sentiment. AAII Bull-Bear spread, the 52-week average, is the lowest ever:
- retail investors have never been this “entrenched bearish”
STRATEGY: Do you see the setup into YE?
So do you see the setup? It all comes down to whether inflation is convincingly cooling. The job market certainly is. We will have more on this Tuesday ahead of the November jobs report. We have a lot of good stuff.
Sure, there are challenges still ahead but many of these are getting better now…
- EPS estimates –> too high? maybe but markets bottom 11 months ahead of EPS
- Labor market is tight –> this is no longer true
- Fed drives economy “off the cliff” –> yes, if Fed keeps looking at “hard data”
- Recession risk –> yes
STRATEGY: Given the above, we see possibility of S&P 500 reaching 4,400-4,500 by YE
We think this rally has more support compared to the June “false pivot” rally to 4,325 (see below).
- thus, we see S&P 500 rallying above that level towards 4,400-4,500
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 $MOVE) and this is a point made repeatedly by one of macro clients (HA in NYC, who works at a major pod of macro HF). Similarly, Tony Pasquariello of Goldman Sachs notes bond volatility “is one asset that every other asset is priced off.” For perspective, TLT Vol ($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.
37 GRANNY SHOTS: Updated list is below
The revised 37 Granny shots are shown below. The list is sorted by the most attractive (most frequently cited) to least. To be a “Granny shot” the stock needs to appear in at least two portfolios:
- $AAPL in 4 of 6 portfolios
- $GOOGL $MSFT in 3 of 6 portfolios
- $AMZN $META in at least 2
- This reinforces our favorable view of FANG in 2H2022
37 Granny Shot Ideas:
Communication Services: $GOOGL, $META
Consumer Discretionary: $AMZN, $AZO, $GPC, $GRMN, $ORLY, $TSLA
Consumer Staples: $BF/B, $MNST, $PG, $PM
Energy: $CVX, $DVN, $EOG, $PSX, $XOM
Financials: $ALL, $AXP
Health Care: $AMGN, $HUM, $UNH
Information Technology: $AAPL, $AMD, $AVGO, $CSCO, $KLAC, $MSFT, $NVDA, $PYPL, $QCOM
Materials: $CF, $FCX, $LIN
Real Estate: $AMT, $CCI, $EXR