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Equities are proving more resilient than consensus expects…

The strong November jobs report (on 12/2) of +263k vs 200k consensus (plus strong wage growth) gave markets every excuse to sell off sharply:

Strong jobs = Fed needs to tighten further = bad for stocks
S&P 500 opened down -1.2%
but gained throughout Friday and close essentially flat (-0.12%)

Friday trading is an example of equities not conforming to the consensus narrative. The central view in markets is the Fed sees the US economy as too strong, and wants financial conditions to stay tight. Therefore, strong economic prints should imply a strong Fed pushback against easing financial conditions.

The November PPI is set to be released 12/9 at 8:30am and we view this as the second most important inflation report after November CPI, which is to be released 12/13.

Consensus for Nov PPI is +0.2% MoM headline

In the coming week, markets will also pay attention to ISM services 53.3 consensus
U Mich prelim Dec 1Y and 5-10Y inflation expectations are also to be released

The bond market has “sniffed” out inflationary pressures are breaking to the downside

To me, the equity markets are sitting at a key juncture. The headwinds that have savagely brought down P/E in 2022 are fading. And our view is that inflationary pressures are breaking to the downside. And to an extent, this is being “sniffed” out in the bond market. Why do we believe this?

the 10-year yield has fallen from 4.34% to 3.48% (yields fell on Friday)
the 2-year yield has fallen from 4.80% to 4.27% (yields fell on Friday)
even the USD has fallen 9% from its peak in the past 8 weeks and YTD gains cut in half to 9%
S&P 500 close above the 200D for the second consecutive day, the first time since March 2022

Taken at face value, consider how these impact stocks:

lower yields = higher P/E
lower USD = upside to forward EPS as the +20% surge in USD subtracted ~8% from 2022 EPS growth
falling USD = higher P/E support as well
technicals improve if S&P 500 can continue to close above the 200D

We think the above illustrates the need for consensus to rethink the central narrative. The Fed and the bond market are no longer acting as if inflation is as sticky as many expect.

DRAWDOWN: Why is S&P 500 -28% drawdown larger than DAX, China or Japan?

And for those investors still firmly negative on US equities, the global markets are telling us a different story. We know that US has been fundamentally the “best house in a bad neighborhood”:

Europe has suffered from far greater inflation due to surge in oil and commodity prices
China’s economy has suffered from crippling measures associated with zero COVID
Japan has experienced a near catastrophic drop in the yen

Yet, take a look at the equity performance of these markets and their maximum drawdowns:

Germany’s DAX peak drawdown was -27%
China’s Shanghai Composite peak drawdown was -23%
Japan’s Nikkei 225 peak drawdown was -20%
S&P 500 peak drawdown -28%

Does this make sense? Why would the S&P 500 have a worse equity drawdown versus these other regions? And moreover, we know many pundits are now recommending investors OW Europe, China or even Japan on the premise they see these regions on the other side of the crisis.

The US economy might just be more resilient than many appreciate

To me, this overlooks the resilience of the US economy and therefore US markets. After all, the Fed has been far more aggressive on raising interest rates than any major central bank. And yet, the US economy remains fairly healthy.

in fact, take a look at US vs Germany’s CPI
US headline is +7.7% YoY (falling fast)
Germany headline CPI is +10.4% YoY and surging
yet markets expect ECB terminal rate to peak at 2.5% while Fed is expected to take US to >5%
and as the chart below highlights, the US CPI was a far greater problem in the 1970-1980 period compared to Germany

GASOLINE: The entire 2022 surge in gasoline has been erased

This has been widely discussed but bears discussing. Gasoline prices in the US have completely roundtripped.

AAA national prices are back to $3.42, the same level as early 2022
Gasoline surged to >$5 by June 2022 and have since tanked
After rising as much as +65% YoY, gasoline is now basically flat
Higher gasoline fuels inflation throughout the US because all goods and many services ultimately are impacted by higher fuel
Higher gasoline has a major impact on how US consumers perceive inflation
Thus, the fall in gasoline will have an impact on both actual and perceived inflation

Gasoline never eased from 1972 to 1982…

And as we have discussed in the past, this downturn in gasoline was never seen during the inflationary Volcker years.

as shown below
gasoline prices never showed a decline YoY from 1972 to 1982 (unlike today)
and this surge in gasoline is what ultimately drove a structural rise in actual inflation and inflation expectations

STRATEGY: The character of the equity market has improved even as pundits remain bearish

The character of the equity markets have changed. This is something we have noted for several weeks, even as pundits remain stalwart negative. The tweet by @sentimenttrader caught my eye:

they note that >50% of stocks on NYSE are at an 8-month high
since 1942, there forward 12M return of stocks has been positive when this is true
13 of 13 instances

And even Michael Burry, of “The Big Short” fame, has shifted his bearish view. As he notes below:

“I am not short”

Bottom line, in our view, is the equity market has changed character. Stocks are proving to be far more resilient. And we believe the Fed has shifted to become far more predictable, away from the “higher in a hurry.”

STRATEGY: What works if inflation crisis is broken? Tech + Small-caps + High P/E + Heavily Shorted

Here are some thoughts about what could work into YE.

Foremost, for stocks to work into YE, the inflation crisis has to be broken. That is, we think the Nov CPI (12/13) will finally convince investors inflation is falling faster than expected. Falling like a rock.

If so, we see the following things changing in consensus expectations:

yields fall as markets see lower “terminal fed funds” and falling risk premia = 10Y to 3.5% or lower
mortgage rates fall even as well as there is “excess spread” in 30Y fixed rate mortgage which is historically 150bp above 10-yr yield. Thus 30Y mortgage = 5% not 6.5%
USD weakens as markets see Fed pivot
EPS expectations rise as weaker USD reverses 20% rise in USD in 2022, which subtracted 5-8% EPS

What types of stocks work?

heavily shorted names rally
$AMC $CNK $ARKK $COIN $CCL $WYNN $KWEB
high P/E stocks which are down 90%-98% get “rented” to be down only 60% from highs
$ZM $CRWD $SHOP
Technology stocks, which have been hardest hit due to higher rates (lower P/E) surge
$QQQ $AMZN $MSFT $NFLX $SOX $GOOGL
small-caps rally as investors see cyclical recovery
$IWM $ANGI $HOG $SIX $TPX

These are representive tickers and not stock recommendations.

STRATEGY: November CPI likely breaks the 3 most consensus views towards our central view

If someone asked me where my view differs most sharply from consensus, it is the following:

CONSENSUS: inflation “sticky” and will take years to fall to Fed target
CONSENSUS: Fed won’t slow hikes until inflation ~2% or something breaks
CONSENSUS: US economy tipping into a recession
TAKEAWAY: Consensus is bearish and sees no reasons for stocks to sustain a recovery until AFTER a recession.

Our view:

Inflation already breaking to downside and next few CPI prints are 0.2-0.3%, or ~3% annualized.
Fed soon will see “sustained signs” of falling inflation rates and playbook will change. Fed last hike might be December 2022.
US economy has been incredibly resilient and soft landing on tap, driven by a major softening of labor markets but not necessarily rise in unemployment.
TAKEAWAY: So divergent from consensus, when consensus shifts towards this view, stocks will see “near vertical” rally

Our view for 2022 was 1H would be “treacherous” but in 2H, our view for markets is favorable. And given the risk-off positioning of institutional investors and extreme bearish retail sentiment (AAII, etc), there will be an abrupt market adjustment higher.

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.

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

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