Blowout Earnings, Low Interest Rates, And Dovish Fed, But Have Stocks Hit A Peak?

Another positive month for the major indexes, despite plenty of new bricks in the proverbial Wall of Worry. That makes 7 months in a row – the longest streak in over 30 years – and 14 of the past 17 months (since the pandemic low). From a technical (chart) perspective, the S&P 500 has tested its 50-day simple moving average seven times this year, each time going on to hit a new high. And it’s not just the cap-weighted index (SPY) as the equal-weight version (RSP) has been moving in lockstep, illustrating good market breadth and confirming market conviction. Stocks seem to have already priced in some modest tapering of asset purchases by year-end, so in the wake of Fed chairman Powell’s late-August speech in Jackson Hole indicating no plans for rate hikes, stocks surged yet again. Indeed, it has become a parabolic “melt-up,” which of course cannot go on forever.

Many investors have been patiently awaiting a significant market correction to use as a buying opportunity, but it remains elusive. What happened to the typical August low-volume technical correction? The big money institutions and hedge funds certainly have stuck to the script by reducing equity exposure and increasing exposure to volatility. But retail investors didn’t get the memo as every time it appears the correction has begun, they treat it like a buyable dip – not just in meme stocks but also the disruptive, secular-growth Tech stocks that so dominate total market cap and the cap-weighted, broad-market indexes. It seems like yet another market distortion caused by government intervention and de facto Modern Monetary Theory (MMT) that has flooded the economy with free money and kept workers at home to troll on social media, gamble on DraftKings, and speculate in Dogecoin, NFTs, SPACs, and meme stocks.

Will September finally bring a significant (and overdue) correction, or will the dip buyers, led by an active, brash, and risk-loving retail investor, continue to scare off the short-sellers and prop up the market? Is this week’s pullback yet another head fake? And regardless, will the S&P 500 (both cap-weight and equal-weight) finish the year higher than last week’s all-time highs?

There is little doubt in my mind that the big institutional investors continue to wait patiently in the tall grass like a cheetah to pounce on any significant market weakness, like a 10+% selloff. Valuations are dependent on earnings, interest rates, and the equity risk premium (ERP, i.e., earnings yield minus the risk-free rate), and today we have robust corporate earnings, rising forward guidance, persistently low interest rates, a dovish Fed, and a low ERP – which is related to inflation expectations that are much lower than recent CPI readings would have you expect. I continue to expect inflation to moderate in 2022 while interest rates remain constrained by a stable dollar and Treasury demand. The Fed’s ongoing asset purchases (despite some expected tapering) along with robust demand among global investors (due to global QE and low comparative yields) has put a bid under bonds and kept nominal long term yields low (albeit with negative real yields). Indeed, bond yields today are less sensitive to inflationary signals compared to the past.

In this periodic update, I provide a comprehensive market commentary, offer my technical analysis of the S&P 500 chart, review Sabrient’s latest fundamentals-based SectorCast quant rankings of the ten US business sectors, and serve up some actionable ETF trading ideas. To summarize, our SectorCast rankings reflect a solidly bullish bias; the technical picture has been strong but remains in dire need of significant (but healthy and buyable, in my view) correction; and our sector rotation model retains its bullish posture. We continue to believe in having a balance between value/cyclicals and secular growth stocks and across market caps, although defensive investors may prefer an overweight on large-cap, secular-growth Tech, and high-quality dividend payers.

Commentary:

The second estimate of Q2 GDP from the BEA came in at an annual rate of 6.6%, versus the consensus estimate of 8.4%. And with job growth disappointing last week and the COVID Delta variant spreading, the Federal Reserve is in no hurry to tighten its accommodative policy of low interest rates and asset purchases (despite suggesting some modest tapering), which has helped keep the bull train running. However, the GDP miss was largely due to inventory drawdown rather than dwindling consumer demand, so given order backlogs and unfulfilled pent-up demand, it bodes well for continued GDP growth. Looking toward Q3, the Atlanta Fed’s GDPNow estimate for annualized real GDP growth is 3.7% as of 9/2/21 (down from 5.3%).

Q2 corporate earnings reports showed that 87% of S&P 500 companies beat revenue expectations, which was the highest percentage since 2008. Strong EPS growth and raised guidance has allowed the forward P/E multiple to contract even as share prices have gone parabolic. For 2022, the most recent bottom-up full-year EPS estimate for the S&P 500 I have seen is $212/share, but it will likely be higher if estimates continue to prove cautious and companies continue with the big beats. Technology (including the reclassified juggernauts like Google, Amazon, and Facebook) and Healthcare sectors accounted for almost all that strong earnings growth. Energy and Materials were strong as well, but they are the two lowest weighted sectors in the index, so their impact on the total was minimal. But moving forward, the rest of “the team” is going to have to start pulling its weight as well, especially Consumer, Financial, and Industrial sectors.

For the S&P 500 to hit 5,000 at a reasonable forward P/E of 20, it requires full-year earnings of $250/share. But given that revenue growth in 2021 is only about 3% higher than pre-pandemic 2019 while earnings growth is closer to 23% – thanks to rising productivity, operating leverage, and ROE – investors should be asking whether earnings leverage alone can continue to fuel strong earnings growth and support valuations going forward. I think stronger top-line growth will be needed.

A number of Wall Street heavyweights like Savita Subramanian of BofA, Mike Wilson of MS, and Barry Bannister of Stifel are quite bearish on stocks right now, each with year-end S&P 500 price targets in the 3,800-4,000 range. In fact, the average Wall Street target is 4,240, which is about 6% lower than today’s price. Their bearish views seem to be tied primarily to rising bond yields and inflationary pressures. Although a priority for capital preservation might suggest heeding their defensiveness, I’m not at all convinced that yields are on the verge of spiking or that inflation will spiral – in fact, quite the opposite. Let me explain.

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Disclosure: At the time of this writing, among the securities mentioned, the author held a long position in APPS and protective puts on SPY and IWM.

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