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Unless Fed moves “goal posts” on 2/1, equity markets starting to play a different game, focused on easing financial conditions. The “cancelled” buy the dip might be making a come back
The most important Fed meeting of 2023 will announce its rate decision on 2/1 at 2pm ET. The consensus pundits and media argue the Fed will be “hawkish” pushing back on the rise in stock prices, meaning they expect Powell to crush the equity rally YTD of >6%. But we think the market has shifted to a different game altogether.
In our view, the emerging central narrative for equities is as follows:
- inflation broadly hit a wall in October, now visible given the tanking in Dec CPI and PCE (core)
- wage pressures also tanking evidenced by the 4Q22 ECI (employment cost index) coming in at 1%, down from 1.4% 2Q2022 and within “spitting distance” of 0.9% needed to achieve 2% overall inflation (3.5% wages offset by 1.5% productivity)
- even the Fed preferred “core services ex-housing” is running at <4% annualized (3M) within striking distance of 2.5%-3.0% needed to achieve 2% inflation
- bond markets are now sensing Fed has to “course correct” by either pausing sooner (Feb last hike) or by cutting rates later in 2023 (breakevens see this).
- this is leading to a sustained easing of financial conditions (FCI) via tightening credit spreads and via lower bond/stock volatility
- the key is volatility for bonds and equities collapsing, and as long as VIX averages less than 25 in 2023, implies stocks gain >20%
- there are two risks to this positive view. First and most importantly, Fed could move the “goal post” and either try to hammer/threaten “higher for longer” if FCIs ease beyond what Fed would tolerate. Second, Fed simply makes a policy error and keeps tightening beyond what is necessary due to an anchored focus on traditional Philips curve measures of employment and inflation.
- I suppose the other risks remain such as Russia-Ukraine war and the risks to calamity and inflation. But recall, last year, the “panick-istas” said there was a 10% chance of global nuclear war. Come on. And look at oil and natural gas, hardly cause for inflationary worries.
- Lastly, January 2023 is a positive month with >6% gain. Wow. Nasdaq is even stronger with >11% and FANG up >19%.
- Since 1938, there are only 9 similar instances when: (i) negative return prior year; (ii) rule of 1st 5 days >1.4% and (iii) Jan positive month. 1H median gain 10% and FY median gain 20%
- See? The base case for 2023 is >20% gain for S&P 500 and possibly >30% for Nasdaq and Technology.
Bottom line. October 12, 2022 was the low.
We think the conditions are warranting a return of “buy the dip” even with a Fed which is increasingly looking behind the curve. The Fed is likely to be hawkish on 2/1 press conference, but we think any market weakness stemming from this might be short-lived. Only if inflation surges would this be a risk but we see the risks as diminished.
4Q22 ECI came in at 1.0%, undershooting consensus 1.1% = Fed running out of arguments to be hawkish
On 1/31, the 4Q22 employment cost index was released coming in at 1.0%, undershooting consensus of 1.1% and as the chart below highlights:
- ECI has been absolutely tanking down from 1.4% in 2Q22
- Fed would like to see ECI at 0.9%, so this 1.0% now places ECI within spitting distance of Fed target
- Does Fed need to be “higher for longer” is ECI is at 0.9%??
Similarly, recall Dec PCE Core Services ex-housing has been easing towards 4%, which is not too far from Fed target of 2.5%-3.0% for this component. This component is wage sensitive and is ~30% of Core PCE.
- and with ECI falling towards Fed target, it is not entirely clear why Fed would need to stay so hawkish
Importantly, we need to be mindful that this inflation surge started with Energy. And take a look at gasoline and at natural gas.
- both are down sharply from the highs for gasoline/natural gas -30%/-75% respectively
- YoY gains have vanished as gasoline and nat gas showed eye-popping gains in 2021 and 2022
- those are gone
- just gone
STRATEGY: January gain (positive) solidifies why base case is >20% gain for equities
There are many rules around the predictive power of January returns for the full year. This is on ample display below:
- Since 1938,
- when Jan is up, stocks gain full year 86% of time with median return of 16%
- when Jan is down, stocks gain full year only 44% of time with median return of -1.8%
BUT, layer in the two key things we highlighted earlier this year
- when Jan is up, PLUS prior year negative PLUS rule of 1st 5 days >1.4%
- stocks gain full year 100% of time with median gain of 20%
- 1H +9.9% and 2H +9.8%
So, this strengthens our argument that the base case for stocks in 2023 is a gain of >20%. Seriously, where is consensus? Consensus is calling for a flat year for markets.
STRATEGY: Technology is primary beneficiary of Fed “course correction”
The best way to play easing financial conditions, in our view, is owning Technology and even small-caps. As the charts below highlight, both $QQQ and $IWM are breaking out decisively
- IWM is more evident as the breakout was 1/11
- QQQ breaking out on a relative basis and just crossed above the 200D
And Technology remains a group where there are many down and out names.
- ~20% of Technology stocks in the broad market index Russell 3000 are >75% off their highs
- That means 1 in 5 technology stocks has been absolutely obliterated
And as shown below, there is a greater bludgeoning in Healthcare and Comm Services (which is essentially TMT).
Similarly, short interest has been rising in Technology. So this rally YTD has been met with investor skepticism and they are increasing their short selling of Technology. To me, this is fuel for further upside.
Technology largest beneficiary of easing FCIs and less correlated to PPI
The two big macro changes to impact 2023, in our view, are:
- easing of financial conditions, of FCIs
- easing of PPI, or easing of cost pressures for producers
- some sectors are negatively impacted by falling PPIs as this spells margin pressure
As shown below, Technology is arguably the greatest beneficiary of each:
- Technology at 88% has the highest correlation to easing FCIs
- and has less exposure to PPIs falling as margin correlation is only 28%
Moreover, Technology technicals seem to be improving:
- $QQQ relative performance of SPY broke above a key trendline
- and QQQ is now closed above the 200D for the first time since April 2022
- So the technical picture has flipped positive
STRATEGY: VIX matters far more for 2023 returns than EPS growth
Our data science team compiled the impact on 2023 equity returns from variables:
- S&P 500 post-negative year (2022)
- the varying impacts of
- VIX or volatility
- USD change
- Interest rates
- EPS growth
- All of the 4 above, positive or negative YoY
- Data is based on rolling quarters and summarized below
The surprising math and conclusions are as follows:
- most impactful is VIX
- Post-negative year (rolling LTM)
- if VIX falls, equity gain is 22% (win ratio 83%, n=23)
- if VIX rises, equity lose -23% (win ratio 14%, n=7)
- I mean, this shows this all comes down to the VIX
- EPS growth has little impact
- If EPS growth is negative YoY (likely), median gain +14.8% (win-ratio 70% n=33)
- If EPS growth is positive YoY, median gain is 15.5% (win-ratio is 78%)
- Hardly a sizable bifurcation
As the scatter below highlights, we can see the sizable influence of the VIX. Even in all years, the VIX is a key factor:
- in our view, if inflation falls sharply
- and wage growth slows
- Fed doesn’t have to cut, but this is a dovish development
- we see VIX falling to sub-20
- hence, >20% upside for stocks
And as shown below, EPS growth has a somewhat important correlation, but hardly as strong as VIX changes.
- the difference in median gain is a mere 70bp (positive vs negative) post-negative year
- the importance of EPS growth is stronger in other years
STRATEGY: Financial conditions should ease in 2023, driving higher equity prices. Technology, Discretionary and Industrials levered to easing FCI
The “base” case for 2023 should be below. That stocks gained >1.4% in the first 5 trading days, and this portends strong gains for the full year:
- Post-neg year + up >1.4% on first 5 days
- Day 5 to first half median gain is 9.5%
- Full year median gain is 26%, implies >4,800 S&P 500
- 7 of 7 years saw gains.
Those 7 precedent years are shown below.
- the range of full year gains is +13% to +38%
- so, this is a VERY STRONG signal
- the two most recent are 2012 and 2019
- we think 2023 will track >20%
The path to higher equity prices is discussed above:
- core inflation falling faster than Fed and consensus expects
- wage inflation is already approaching 3.5% target of Fed (aggregate payrolls)
- Fed could “dovishly” leg down its inflation view
- allowing financial conditions to ease
- bond market has already seen this and is well below Fed on terminal rate
BASE CASE: The “maths” for what to expect in 2023, post a “negative return” year (2022)
Question: how common is a “flat” year? Our team calculated the data and it is shown below:
- since 1950, there are 19 instances of a negative S&P 500 return year. In the following year,
- stocks are “flat” (+/- 5%) only 11% of the time (n=2)
- stocks are up >20% 53% of the time (n=10)
- yup, stocks are 5X more likely to rise 20% than be flat
- and more than half of the instances are >20% gains
So, does a “flat year” still make sense?
As shown below, these probabilities are far higher compared to typical years:
- since 1950, based upon all 73 years
- stocks are “flat” 16% of the time vs 11% post-negative years — BIG DIFFERENCE
- stocks are up >20% 27% of the time vs 53% post-negative years — BIG DIFFERENCE
- see the point? The odds of a >20% gain are double because of the decline in 2022
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. The list of tickers and their respective themes is shown below.
Communication Services: $GOOGL, $META, $OMC
Consumer Discretionary: $AMZN, $GRMN, $TSLA
Consumer Staples: $BF/B, $KO, $MNST, $PG, $PM
Energy: $DVN, $EOG, $MRO, $OXY, $PSX, $VLO, $XOM
Financials: $AXP, $JPM
Health Care: $AMGN, $HUM, $ISRG, $MRK, $UNH
Industrials: $GD, $JCI
Information Technology: $AAPL, $AMD, $CDNS, $CSCO, $KLAC, $MSFT, $NVDA, $PYPL
Real Estate: $AMT