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 February 3 2024 --------------------------------------------------------------- Stocks have continued last year's positive momentum into the New Year, pushing the major indexes into record territory. Driving this shift in sentiment appears to be optimism about Fed policy and a corporate earnings picture that continues to defy the skeptics. Many in the market expect the Fed to start easing monetary policy in the next few months. Improved visibility on this front has prompted many in the market to turn positive in their stock market outlook. This narrative is sanguine about the Fed and inflation and sees nothing egregious with valuations, particularly in light of the improved outlook for interest rates and earnings. Market bears see this emerging optimism in the market as without a solid basis and view the positive stock market gains as nothing more than a bear-market rally in a long-term downtrend. This line of thinking sees inflation as 'stickier', leaving the Fed no room to loosen policy any time soon. 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 the inflation issue as effectively resolved at this stage, with the steadily decelerating trend of the past year putting us on track to reach the Fed's desired level in the coming months. It is hard to argue with the bulls' view that the elevated Covid-driven 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 as the logistical snarls have been addressed. The recent Red Sea shipping problems in the wake of the Middle East tensions remain a risk to global supply chains. But the issue appears contained and unlikely to have a negative bearing on inflation trends. The Fed question on the market's collective mind is about the timing of the first-rate cut and the number of subsequent cuts. In addition to direct Fed guidance, investors are looking at incoming economic data through the prism of what it tells them about inflation and growth. The odds of a March rate cut have come down lately, but there is an overwhelming expectation that the process will be well underway before we reach the year's mid-point. The stock market optimism in recent days, which coincided with seemingly reassuring Q4 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. 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Previous editions have racked up gains of +143.0%, +498.3%, and even +673.0%. Deadline to download the new report is midnight Sunday, February 4. [See Stocks Now »]( The Economy's Strong Foundation: The strong Q4 GDP report notwithstanding, the U.S. economy’s growth trajectory has shifted gears in response to Fed-driven higher interest rates and the runoff in elevated government spending. 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 Q4 GDP report's price deflator reading. A segment of the market still remains worried about recession risks, but the U.S. economy's resilient performance in 2023 in the face of extraordinary Fed tightening has significantly increased the soft-landing odds. Underpinning this view is the rock-solid labor market characterized by strong hiring, a record-low unemployment rate, and steady wage gains. 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, even though most of the Covid savings have largely been used up by now. This combination of labor market strength and steady wage gains should help keep consumer spending in positive territory in the coming quarters. While estimates for the coming periods have been coming down, the Zacks economic team is projecting below-trend but nevertheless positive GDP growth in 2024. 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 look attractive given the expected interest rate trajectory. The S&P 500 index is currently trading at 20.4X forward 12-month earnings estimates, up from 15.6X at the end of September 2022 but down -15.6% from the peak multiple of 24.1X some time back. It is hard to consider this valuation level as excessive or stretched, particularly given the coming Fed easing cycle. The appropriateness or otherwise of valuation multiples has to be seen in the context of interest rate outlook. Valuation multiples typically expand when the Fed is easing policy, particularly when the catalyst for the loosened policy is confidence on the inflation front instead of growth fears. Earnings outlook is a key part of the valuation discussion. Contrary to the earlier doom-and-gloom fears, the ongoing 2023 Q4 earnings season is reaffirming the resilience and stability of the corporate profitability picture, with the growth pace expected to steadily improve in the coming quarters. What we are seeing this earnings season is that while companies in a number of industries are unable to have adequate visibility in their business, there are many others that continue to drive sales and earnings growth even in this environment. We are seeing many of these leaders from a variety of sectors, including Technology, come out with strong quarterly results and describe trends in their businesses in favorable terms. Current consensus expectations for this year and next reflect a resumption of strong growth after two years of below-trend profitability growth. While it is reasonable to expect some 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 easing Fed policy. Let's see what the Bears have to say in response. The Market's Fed Exuberance: The consensus view on inflation is that we are firmly on track to reach the Fed's target inflation level later this year. With inflation no longer a lingering issue on the macro horizon, the majority of market participants expect the Fed to promptly change course and start easing policy. The odds of a March rate cut had started coming down even before the Fed effectively took it off the table, but many in the market continue to see the easing cycle getting underway in the following session. This Fed view appears at odds with the health of the U.S. economy, which appears to be doing just fine on the back of a tight labor market, keeping strong consumer-spending trends in place. This begs the question as to why the Fed needs to speed up monetary policy easing if there is no imminent threat to the U.S. economy's growth trajectory. The Fed restored its credibility on the inflation question through its extraordinary tightening moves, which made up for its initial lethargy in changing course. It doesn't appear prudent for the central bank to risk its hard-won credibility by prematurely starting to ease policy that they may have to reverse afterward in case inflation starts misbehaving all over again. The Valuation Reality Check: Given the bears' view that the prudent course for the Fed is to be in no hurry to start easing policy in the absence of any issues in the economy, they see no fundamental reason for valuation multiples to expand. Higher-for-longer interest rates should have a direct impact on the prices of all asset classes, stocks included. Everything else is constant, investors will be using 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 Earnings Growth Question: Current consensus earnings estimates show +10.9% growth this year and +12.6% growth in 2025. This would follow the -3.6% earnings decline in 2023, which in turn followed the +6.1% growth in 2022. Market bears see these earnings growth expectations as inconsistent with the soft-landing outlook for the economy. Notwithstanding the contractionary PMI readings and the growth implications of the still inverted yield curve, earnings expectations for this year will need to come down significantly to get in-line with the economic ground reality. Where Do I Stand? I am very skeptical of the higher-for-longer Fed policy view and see this scenario as nothing more than a low-probability event. The current Fed Funds rate level is almost twice what Fed officials see as the 'neutral' policy rate. At the 'neutral' policy rate level, Fed policy is neither 'stimulating' nor 'restricting' economic activities. With inflation already moving towards the Fed's desired level, the central bank has plenty of cushion in its policy arsenal to start easing without adversely affecting its inflation fight. This doesn't mean the imminence of the March rate cut, but it does suggest that they don't need to wait for an extended period to consolidate the inflation gains. This year's electoral calendar also suggests a sooner or rather than later start to the easing policy. In other words, the market's Fed expectations are realistic and justified. Regular readers of my earnings commentary know that the earnings picture continues to be resilient, with last year's downward revisions to estimates having brought them in line with the economic ground reality. Roughly half of this year's expected +10.9% earnings growth is coming from +4.8% revenue growth, with the rest resulting from margins getting back to the 2022 level as inflationary pressures have eased. Please note that revenue growth tracks nominal GDP growth in the long run, which increased +6.3% in 2023 and +9.1% in 2022. As such, the +4.8% top-line growth expected in 2024 is hardly unrealistic. 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 As this positivity unfolds, we can take advantage by building positions in great stocks with solid fundamentals and clear growth prospects. 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. Examples include Boston Beer Co. +143.0%, Weight Watchers +498.3% and Tesla +673.0%.¹ The earlier you get into these new stocks the higher their profit potential: Stock #1: an AI-enabled marketplace for on-demand manufacturing with accelerating revenue growth, suggesting significant demand for its services; Stock #2: a precision oncology company with +20% growth in a crucial new healthcare market for preventative diagnostics, making it a key M&A target; Stock #3: EV automaker with strong brand recognition, shares went on a tear in 2023, up +37.5% in the last year, easily beating the S&P 500 over the same period; Stock #4: a global leader in identity security that's enjoying one of its best financial performances in the company's history and remains ready to capitalize in the AI era; Stock #5: a provider of critical digital infrastructure and continuity solutions, it outpaced NVIDIA over the last 12 months and is positioned to grow alongside the continued expansion of endless data and the AI-super cycle. 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. Last year alone, they closed 32 double and triple-digit wins. Gains reached as high as +107.3%, +183.8%, and +221.2%.¹ Keep in mind, the opportunity to download our 5 Stocks Set to Double Special Report ends at midnight Sunday, February 4. [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. 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