How to Make the Most of Today's Market

[Zacks | Our Research. Your Success.] WeekendWisdom Tactics that Work in Good Markets and Bad [Kevin Matras - Editor] How to Make the Most of Today's Market By: Sheraz Mian August 5, 2023 --------------------------------------------------------------- Stocks have enjoyed a very positive run this year. Driving this shift, in sentiment, appears to be optimism about Fed policy and a corporate earnings picture that is far better than many feared. Many in the market justifiably see the Fed moving towards concluding its extraordinary cycle in the next few months. 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 steadily heading in the right direction and views nothing egregious with valuations, given improved visibility for interest rates and a stable 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 the path of interest rates and economic growth represent the biggest points of difference between market bulls and bears at this point in time. The bulls see favorable developments on the inflation question, with the steadily decelerating trend of the last many months as confirmation of progress towards the Fed's goal. We saw proof of this in the internals of the recent Q2 GDP report and consensus expectations for the coming period 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 favorable developments on the supply side of the equation and reversal of China's zero-Covid policies, with continued disruptions caused by the war on Ukraine partly offsetting the gains. With interest rates already at or past the neutral level, investors are looking at incoming economic data through the prism of what it tells them about inflation and growth. The market correctly sees the Fed's July 26th rate hike as effectively concluding this tightening cycle even though the central bank can't publicly acknowledge it. In other words, we are at the 'pivot' stage already, without the Fed explicitly telling us in so many words. After the July 26th hike, they will be 25 bps away from their indicated peak rate, meaning at most one more increase at the following meeting. The stock market optimism in recent months, that has been reinforced by the reassuring Q2 earnings results, is likely an early attempt to do just that 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. Each pick is the single favorite of a Zacks expert with the best chance to gain +100% and more in the months ahead: Stock #1: a global leader in clean energy; Stock #2: creatively changing the way businesses communicate; Stock #3: iconic company looking to refresh its brand; Stock #4: reinventing how we look at transportation and energy; Stock #5: changing the way the world pays for goods and services These stocks can far more than double. Previous editions have racked up gains of +176%, +498%, and even +673%. Deadline to download the new report is midnight Sunday, August 6. [See Stocks Now »]( The Economy's Strong Foundation: The seemingly strong Q2 GDP report notwithstanding, the U.S. economy's growth trajectory has shifted gears in response to the combined effects of aggressive Fed tightening, the runoff in the government's Covid spending and some lingering logistical bottlenecks. 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 Q2 GDP report's price deflator reading. Many in the market are legitimately concerned about recession risks as a result of the unprecedented Fed tightening. While such risks are undoubtedly real, 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 ample savings cushion should help keep consumer spending in positive territory in the coming quarters. While questions remain about the economy's growth trajectory over the next few quarters, estimates for the current period (2023 Q3) have been going up lately and currently represent a modest acceleration from the first half's pace. 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. Valuation & Earnings: Tied to the economic and interest rate outlook is the question of stock market valuations that still remain attractive after the gains in the first half of the year. The S&P 500 index is currently trading at 20.1X forward 12-month earnings estimates, up from 15.5X at the end of September 2022, but down -12.1% from the peak multiple of 24X some time back. It is hard to consider this valuation level as excessive or stretched, particularly given aforementioned optimism on the Fed front. Granted there are parts of the market that have gotten rerated as the full effects of the Fed's tightening cycle have diffused into the economy, resulting in cooling consumer and business demand and moderating economic growth. But not all sectors are exposed to the Fed-centric 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 have been seeing this bifurcation in earnings outlook in recent earnings reporting cycles, including the ongoing Q2 earnings season, 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 strong quarterly results in recent days. Contrary to fears ahead of the start of the Q2 earnings results, the actual results are turning out to be fairly stable and resilient. Earnings estimates came down steadily after peaking in April last year. The latest development on the revisions front has been a notable stabilization since the start of Q2, with estimates for a number of key sectors including Technology actually reversing course and starting to go up again. 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 recent Q2 GDP report showed that the U.S. economy was still far too strong to ease the Fed's inflation worries. While a big part of the strong 'headline' GDP growth number was due to factors that tend to be volatile, the report nevertheless showed plenty of strength in household and business spending. The decline in inflation readings in recent months has resulted from pullback in commodity prices, the easing of logistical bottlenecks and moderation in demand for the 'goods' part of the economy. The much tougher part of the inflation fight is on the 'services' side of the economy. Given ongoing trends in wages, inflation is likely a lot stickier than most people assume. Many in the market believe that the Fed's tough policy stance last year was meant to counteract the damage to its inflation-fighting credentials as a result of its earlier 'transitory' narrative. Given this, the central bank simply can't afford to declare a premature victory and risk the inflation scourge to reemerge. The Valuation Reality Check: A big driver of the stock market's earlier bull run was 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 double the pre-Covid size. Fed tightening and the associated higher interest rates have a direct impact on the prices of all asset classes, stocks included. The 'higher-for-longer' view of interest rates in light of much stickier inflation means that investors need to adjust to an extended period of above-average interest rates. 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 higher 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 assume that the Fed is successful in executing a 'soft landing' for the U.S. economy. This favorable view has been strengthened by resilient GDP growth readings even as inflation has steadily come down. 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 at present, 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, the level of interest rates is at the 'neutral' policy level already, when Fed policy is neither 'stimulating' nor 'restricting' economic activities. Estimating an accurate level for 'neutral' policy is very difficult in real time, but most analysts believe that we will be getting into 'restrictive' territory after the July 26th hike. While the Fed has left another rate hike as a possibility, we think they are most likely done tightening at this stage, particularly if incoming data continues to show progress 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 positive momentum in the stock market in recent months 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 resilient, with the steady downward revisions to estimates since the April 2022 peak having brought them in-line with the economic ground reality. In the coming months, the market will start looking past this year's moderating earnings growth picture to the eventual recovery on that front. The market's recent positivity reflects a growing convergence to our favorable views on the Fed and the growth questions. We don't envision these questions to be put to rest next week, but we do see investors eventually coming around to our view of inflation, earnings and the much more positive 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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Plus, it includes Zacks Premium research so you can find winning stocks, ETFs and mutual funds on your own. Last year alone, they closed 42 double and triple-digit wins. Gains reached as high as +188.3%, +348.7%, and even a remarkable +995.2%.¹ Keep in mind, the opportunity to download our 5 Stocks Set to Double Special Report ends at midnight Sunday, August 6. [Look into 5 Stocks Set to Double and Zacks Investor Collection now »]( Thanks and good trading, [sheraz-main - 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](). 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