How to Make the Most of Today’s Market

[Zacks | Our Research. Your Success.] WeekendWisdom Tactics that Work in Good Markets and Bad [Sheraz Mian - Editor] How to Make the Most of Today’s Market By: Sheraz Mian October 29, 2022 --------------------------------------------------------------- Stocks have enjoyed a few positive sessions in recent days. Driving this shift, in sentiment, appears to be optimism about Fed policy and a corporate earnings picture that is far better than many in the market were fearing. The Fed’s accelerated tightening moves have raised hopes that the bulk of the rate hikes may now be behind us. Improved visibility on this front has prompted many in the market to buy quality stocks at discounts. This narrative is sanguine about the Fed, sees inflation as having already peaked and sees nothing egregious with valuations, given improved visibility for interest rates and an earnings outlook that has smoothly adjusted lower. Market bears see this emerging optimism in the market as without a solid basis and view the positive stock market gains of recent days as nothing more than a bear-market rally in a long-term downtrend. This line of thinking sees inflation as far ‘stickier’, which requires the Fed to continue tightening for a while. Valuation worries also figure prominently in the bearish view of the market. The interplay of these competing views will determine how the market performs in the coming months and quarters. To that end, let’s examine the landscape of bullish and bearish arguments to help you make up your own mind. Let's talk about the Bull case first. Inflation & the Fed: The outlook for inflation and what that means for Fed policy is the biggest point of difference between market bulls and bears at this point in time. The bulls see peak inflation readings to be in the rearview mirror at this stage, with a steadily decelerating trend emerging in the coming months. Declines in commodity prices and signs of cooling demand as a result of moderating economic activities provide confirmation of this favorable inflation view. We saw proof of this in the decelerating trend in Thursday’s Q3 PCE price index reading. It is hard to argue with the bulls’ view that the heightened post-lockdown demand in a number of product and service categories was bound to eventually normalize, with its attendant beneficial effect on prices. Related to the above argument are expected favorable developments on the supply side of the equation as the worst of the supply-chain snarls ease. Partly delaying this expected normalization are Covid-related developments in China and disruptions caused by the war on Ukraine. With interest rates already close to the neutral level, investors are looking at incoming economic data through the prism of what it tells them about inflation and growth. The market sees the Fed coming out with another rate hike of 75 basis points at next week’s meeting, but expects them to start pivoting by the December meeting. Underpinning this Fed outlook is the expectation that we will have seen more data by the December meeting that confirms the decelerating trend in inflation. No one expects the Fed to declare victory over inflation; rather, they expect it to pivot into a wait-and-see mode from the current aggressive tightening one. Continued . . . [5 Stocks Set to Double: Sunday Deadline]( There's still time to get in on our just-released 5 Stocks Set to Double Special Report. 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This is beneficial to the central bank’s inflation fight, particularly the demand-driven part of pricing pressures, as we saw in the decelerating trend in the Q3 GDP report’s price deflator reading. Many in the market are legitimately concerned about rising recession risks as a result of the unprecedented Fed tightening. While such risks have undoubtedly increased, a recession is by no means the only or even most likely outcome for the U.S. economy. Underpinning this view is the rock-solid labor market characterized by strong hiring and a record low unemployment rate. It is hard to envision a recession without joblessness. The purchasing power of lower-income households has likely been eroded by inflationary pressures, as confirmed by a number of companies during their earnings calls. But household balance sheets in the aggregate are in excellent shape, with plenty of savings still left from the Covid days. This combination of labor market strength and plenty of savings cushion should help keep consumer spending in positive territory in the back half of the year and beyond. The Q3 GDP growth resumption confirms that the U.S. economy’s sub-par growth readings in the first half of the year reflected short-lived technical factors. All in all, the strong pillars of the U.S. economic foundation run contrary to what are typically signs of trouble ahead on the horizon. While estimates for the coming periods have been coming down, the Zacks economic team is projecting 2022 GDP growth at +1.7%. Valuation & Earnings: Tied to the economic and interest rate outlook is the question of stock market valuations that have become very alluring after this year’s pullback. The S&P 500 index is currently trading at 16.8X forward 12-month earnings estimates, up from 16.2X at the end of June, but down -30% from the peak multiple of 24X some time back. It is hard to consider a 16-handle valuation as excessive or stretched, particularly given emerging signs of optimism on the Fed front. Granted there are parts of the market that need to get rerated as the full effects of the Fed’s tightening cycle take hold, resulting in cooling consumer and business demand and moderating economic growth. But not all sectors are exposed to the ongoing Fed-driven negativity in outlook to the same degree, as sensitivity to interest rates and the macroeconomy are much bigger drivers for some sectors than others. We are starting to see this bifurcation in earnings outlook in the ongoing Q3 earnings season already, with operators in the at-risk sectors unable to have adequate visibility in their business. But there are many other companies that continue to drive sales and earnings growth in this environment. We have seen many of these leaders from a variety of sectors and industries, including Technology, come out with blockbuster quarterly results in recent days. Contrary to fears ahead of the start of the Q3 earnings results, the actual results are turning out to be fairly stable and resilient. Estimates for the coming periods have been steadily coming down already, with 2023 earnings outside of the Energy sector now down more than -8% since peaking in April. While it is reasonable to expect some further downward adjustment to estimates for macroeconomic reasons, the overall earnings outlook is now largely in-line with the economic ground reality. In the absence of a nasty economic downturn, the earnings picture can actually serve as a tailwind for the stock market in an environment of diminishing Fed uncertainty. Let's see what the Bears have to say in response. Endemic Inflation & Fed Tightening: The ‘headline’ growth rate in Thursday’s Q3 GDP report was undoubtedly a big improvement after two back-to-back quarters of negative readings. But, the internals of this otherwise positive economic report reconfirmed that inflation remains untamed even though it did show a deceleration from the last two quarterly readings. The Fed risked damaging its hard-won inflation-fighting credentials had it stuck to its ‘price-pressures-are-transitory’ narrative in the face of persistent inflationary readings month after month. Many in the market believe that the central bank took too long to accept this reality, which will necessitate even tighter and more stringent measures than would have otherwise been the case. This line of thinking sees the economy’s ongoing inflation bout as a result of the Fed’s super easy monetary policy and excessive fiscal stimulation over the last two years. The recent pullback in commodity prices, the basis for the bulls’ peak-inflation view, is most likely not enough to have a meaningful impact on price pressures. Given ongoing trends in wages and rents, to name just two areas, inflation is likely a lot stickier than most people assume. Importantly, the Fed’s inflation-fighting credentials essentially guarantee that they will need to continue tightening policy not only through the remaining two FOMC meetings this year, but likely well into the first few meetings in 2023. The Fed will be justifiably hesitant to prematurely declare victory and for the inflationary scourge to reemerge. The Valuation Reality Check: A big driver of the stock market’s bull run has been thanks to the Fed’s ability to flood the market with liquidity. The central bank achieved that by keeping interest rates at zero and buying a boat-load of U.S. treasury and mortgage-backed bonds that expanded its balance sheet to almost $9 trillion a few months back, more than double its size at the start of 2020. Fed tightening and the associated higher interest rates have a direct impact on the prices of all asset classes, stocks included. Everything else constant, investors will be required to use a higher discount rate, a function of interest rates, to value the future cash flows from the companies they want to invest in. This means lower values for stocks in a rising interest rate environment. The Growth Question: Since Fed rate hikes work with a lag, the central bank’s aggressive tightening moves since March 2022 likely haven’t fully seeped into the economy. Current projections of GDP growth for this year and next assume that the Fed is successful in executing a ‘soft landing’ for the U.S. economy as it continues the current policy stance. That said, most projections show the U.S. economy barely in positive territory as it exits 2023. There is no basis for us to doubt this confidence in the central bank’s abilities, but we shouldn’t lose sight of history that tells us that economic growth typically falls victim to the Fed’s inflation-fighting efforts. A handy metric to keep an eye on for growth outlook is the spread between the 2-year and 10-year treasury bond yields. Inversion in this metric, as is the case lately, will suggest the need for reigning in growth expectations. Where Do I Stand? I am very skeptical of the bearish Fed tightening outlook and see this scenario as nothing more than a worst-case or low-probability event. My base case all along, saw the Fed moving from the then ‘stimulative’ policy stance to one that was only modestly ‘restrictive’. Following the already implemented rate hikes, we are at the lower bounds of what is generally considered to be a ‘neutral’ policy stance, when Fed policy is neither ‘stimulating’ nor ‘restricting’ economic activities. The Fed will most likely announce another 75 basis points rate hike at next week’s meeting. But I expect them to start shifting course by the December meeting in the face of favorable data on the inflation front. This appears to be the most plausible scenario given the risks to growth as a result of premature tightening, a threat to the Fed’s second ‘full employment’ mandate. The recent pullback in benchmark treasury yield and positive momentum in the stock market reflects this interpretation. The resulting stability in financial conditions and interest rates should keep the economy’s growth trajectory in place, admittedly at a moderate pace. Regular readers of my earnings commentary know that the earnings picture continues to be stable and resilient. The growth pace is undoubtedly expected to decelerate going forward, but the overall earnings picture will remain favorable. Markets are forward-looking pricing mechanisms and the recent weakness is highlighting this interest rate and growth uncertainty on the horizon. We don’t envision this uncertainty dissipating next week, but we do see investors eventually coming around to our view of inflation, the Fed and great times ahead after a short period of volatility. How to Take Advantage We take advantage of this period of turmoil by slowly building positions in great stocks that are currently available at significant discounts to their true values. That's why I'm inviting you to download our just-released Special Report, [5 Stocks Set to Double](. Each stock was handpicked by a Zacks expert as their personal favorite to have the best chance of gaining +100% and more in the months ahead: Previous editions of this report have racked up some huge gains. 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Stock #3: Huge Potential Reward for Patient Investors Down for the past year, this $250 million biopharmaceutical company could offer a big reward. It may be near a bottom that justifies a risk/reward bet of 50% downside for potential 200% upside over the next 12-18 months. It also just announced an exclusive option and collaboration agreement potentially worth more than $1.7B. Stock #4: Top Producer of In-Demand Lithium The uprising of electric vehicles (EVs) is exciting, with sales doubling and setting a new record in 2021. Sales have continued on a solid uptrend in 2022 leading to the demand for a critical component of EV batteries – lithium. With fully established lithium operations, paired with a long track record of success and a favorable and expanding geographic footprint, this company presents investors a stellar opportunity to profit. Stock #5: Tremendous Relative Strength in a Weak Market After a series of earnings beats, this maker of fiber optic management products hit all-time highs while most stocks suffered their worst performance in a decade. The recent market sell-off brought selling pressure and the stock broke the 50-day moving average. But, the current pullback from highs presents investors an ideal buying opportunity before the next market rally. To put the odds of success even more in your favor, you’ll also gain access to our unique arrangement called [Zacks Investor Collection](. It gives you the picks and commentary from all our long-term portfolios in real time for the next 30 days. Plus, it includes Zacks Premium research so you can find winning stocks, ETFs and mutual funds on your own. This year alone, they have already closed 33 double and triple-digit wins. Recent gains have reached as high as +188.3%, +348.7%, and even +995.2%.¹ Keep in mind, the opportunity to download our 5 Stocks Set to Double Special Report ends at midnight Sunday, October 30. [Look into 5 Stocks Set to Double and Zacks Investor Collection now »]( Thanks and good trading, [Sheraz Mian - signature] Sheraz Sheraz Mian serves as the Director of Research and manages the entire research department. He also manages the Zacks Focus List and Zacks Top 10 Stocks portfolios. He invites you to access [Zacks Investor Collection](. ¹ The results listed above are not (or may not be) representative of the performance of all selections made by Zacks Investment Research's newsletter editors and may represent the partial close of a position. This free resource is being sent by [Zacks.com](). We look for investment resources and inform you of these resources, which you may choose to use in making your own investment decisions. 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