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How to Make the Most of Today’s Market


Stocks have been on a steady uptrend over the last two weeks, with the trend getting a boost in the aftermath of Wednesday’s Fed rate hike.

Driving this rapid shift in sentiment is 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 peaked already and sees nothing egregious with valuations given improved visibility for interest rates and a stable earnings outlook.

Market bears see this emerging optimism in the market as without a solid basis and view the positive stock market gains of the last two weeks as nothing more than a bear-market rally in a long-term downtrend. This line of thinking sees inflation as far more ‘sticky’ that will require the Fed to continue tightening, at least through the end of the year. 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 the growth pace steadily decelerating 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.

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.

The Fed Chairman hinted after the rate-hike announcement on Wednesday that rates were now close to the neutral level, even though he stated that further hikes will likely be needed. The markets justifiably interpreted this as indicating that the bulk of the tightening was now behind us, particularly if the two inflation readings ahead of the September FOMC meeting confirm the expected turn.

Continued . . .

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The Economy’s Strong Foundation: The U.S. economy’s growth pace has shifted gear in response to the combined effects of aggressive Fed tightening, persistent logistical bottlenecks and the run off in the government’s Covid spending. This is beneficial to the central bank’s inflation fight, particularly the demand-driven part of pricing pressures.

At a superficial level, the back-to-back negative GDP prints in the first two quarters of this year can be seen as meeting the basic requirement of a recession. But that will be overly simplistic given the rock-solid labor market characterized by strong hiring in the last six months 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 Q2 earnings calls. But household balance sheets in the aggregate are in excellent shape. According to Moody Analytics as quoted in the Wall Street Journal, U.S. households were sitting on $2.5 trillion in excess savings in May 2022. 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.

Growth is expected to resume from Q3 onwards, as the effects of inventory drawdowns that drove the negative Q2 GDP print start easing. While estimates have been coming down, the Zacks economic team is projecting 2022 GDP growth at +2%.

These 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 have become very alluring after this year’s pullback.

The S&P 500 index is currently trading at 17.3X forward 12-month earnings estimates, up from 16.2X at the end of June, but down -27.8% from the peak multiple of 24X some time back. It is hard to consider a 17-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, with sensitivity to interest rates and the macroeconomy much bigger drivers for some sectors than others.

We are starting to see this bifurcation in earnings outlook in the ongoing Q2 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 Q2 earnings results, actual results are turning out to be fairly stable and resilient. While it is reasonable to expect some downward adjustment to estimates for macroeconomic reasons, the overall earnings outlook remains 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 sub-par ‘headline’ growth rate was not the only notable piece of detail in Thursday’s Q2 GDP report, the second quarter in a row of declining growth, as it also showed a red hot PCE price index reading of 7.1% that was unchanged from the preceding quarter’s multi-decade high level.

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 resulting from the Fed’s super easy monetary policy and excessive fiscal stimulation over the last two years.

With no FOMC meeting in August, market bulls are praying for two sets of favorable inflation and employment readings by the time of the September meeting, allowing the Fed to pivot from the current stance.

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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 continue to tighten policy in September and beyond even if headline inflation readings start trending down.

The Valuation Reality Check: A big driver of the stock market’s bull run had 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 weren’t a big reason for Thursday’s negative GDP print for Q2, the second quarter in a row of GDP decline.

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.

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 has been the case lately, will suggest the need for reigning in growth expectations.

Where Do I Stand?

I am very skeptical of the bearish narrative’s 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 essentially ‘neutral’. In a ‘neutral’ policy setting, the Fed is neither ‘stimulating’ nor ‘restricting’ economic activities.

They are essentially in the vicinity of the ‘neutral’ policy stage after Wednesday’s 75 basis point increase, as the Fed chief himself indicated in the after-meeting presser. With the next meeting not until September, they will have two months of data in hand as they contemplate the question the next time around.

It is reasonable to expect the Fed to start shifting course beyond September 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.

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Previous editions of this report have racked up some huge gains. Examples include Boston Beer Co. +143.0%, NVIDIA +175.9%, Weight Watchers +498.3% and Tesla +673.0%

The earlier you get into these new stocks the higher their profit potential:

Stock #1: A World-Changing Investment
As a leading genome-editing company, it has recently found a bottom much like the Biotech sector. However, they have several world-changing projects in the pipeline, one of which led several bullish analysts to call for buying more shares.

Stock #2: Strong Zacks Rank With a Recurring Revenue Stream
Trusted by a community of 260+ million customers it’s not difficult to see why this global software as a service stock is set to double. It has delivered a trailing four-quarter average earnings surprise of 64.38% and is buoyed by a leading industry group.

Stock #3: Top Dog on a Buying Spree
With two blockbuster deals complete, this company’s expanding product portfolio allows it to package a slew of offerings to its growing list of clients in the enterprise and business software world. It should be no surprise that Wall Street is very high on the stock, with 13 of the 14 brokerage recommendations sitting at “Strong Buys.”

Stock #4: A Technology Titan
Loaded with cutting-edge technology and robust growth rates, this industry leader looks poised to reward investors handsomely. Full-year sales for FY23 are forecasted to come in at $34 billion – a massive 26% jump year-over-year.

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The underlying commodities driving this energy giant’s business are skyrocketing. With huge earnings growth coming down the pipe, incredibly strong cash flow, and a transition plan to greener energy, the dividend paying stock gives investors plenty of reasons to snap up shares.

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Thanks and good trading,

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.


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