Weekly Warm-up: Classic Mid-Cycle
In line with our long-standing views, earnings strength has offset valuation compression. This is a hallmark of a mid-cycle transition as is quality leadership, which we expect to continue. We view the Fed hike as credibility-enhancing, with energy prices still the near-term risk.
- Strong Earnings Have Offset A Meaningful Valuation Correction. While the S&P 500 remains near its highs, more than 40% of Russell 3000 stocks have fallen 20% or more since June, while the S&P's forward P/E has compressed to 19x—the March lows. Meanwhile, earnings remain quite strong, in line with our long-standing outlook for this year. Specifically, median stock EPS growth is in the mid-teens, and revisions breadth for the high quality S&P 500 is back near cycle highs, helping explain why the index price damage has been contained.
- The Fed Hike Can Be Credibility-Enhancing. With a hike largely priced into last week’s FOMC meeting, the more important signal was Warsh’s willingness to follow through on his prior comments around bringing inflation back to target. In our view, acting early can reduce inflation uncertainty and term premium, meaning a higher policy rate does not necessarily translate into higher long-term financing costs. The August core inflation print exceeded expectations, but the internals were not uniformly hot, giving Warsh room to deliver a credibility-enhancing hike without forcing markets to extrapolate a 2022-style tightening. The larger unanswered question and risk for markets centers on his monetarist philosophy, and how he plans to manage the Fed's balance sheet going forward, in our view.
- Stick with Large-Cap Quality as the Mid-Cycle Rotation Plays Out. Quality and operating-efficiency factors continue to lead, with high sales-per-employee among the strongest recent performers. This leadership aligns with our constructive view on AI adopters, where margin expectations continue to improve. Meanwhile, momentum factor composition is rotating toward quality, as well as services-oriented and asset-light industries. Our prime brokerage data shows that investors agree with our recommendation as positioning has shifted toward large cap quality in the past few weeks. As we head into earnings season, we highlight a new screen of quality stocks with improving earnings revisions.
- Energy Prices and Mid-Terms Remain the Near-Term Risks for Equities. Another leg higher in oil or little relief in product prices would likely pressure the expected policy path, back-end yields and bond volatility, particularly with physical markets already absorbing an unusually broad set of disruptions. The buffers that helped absorb these shocks over the last six months are also thinning as inventories have drawn, Chinese buying is picking up and European product and gas stocks remain tight. We maintain our 8,000 year-end S&P 500 target driven by earnings resiliency, while acknowledging higher crude and refined product prices as the primary near-term risk along with the historical trading patterns heading into mid-term elections. We still view 7000-7100 as a tactical downside case should these risks emerge over the next 3-5 weeks, but this would not prevent the market from reaching our year-end target even in this risk scenario.
Classic Mid-Cycle
While some view the equity market as being complacent—the S&P 500 is just 2% from all-time highs despite the risks from a more hawkish Fed, elevated energy prices, and peaking Semis earnings revisions—we continue to argue a lot of damage has occurred both under the surface of the market and from a valuation perspective. For one, more than 40% of Russell 3000 members have fallen 20% or more since June. Further, the S&P 500 forward P/E ratio is now just 19x—the March low reached during the height of the Iran conflict. Strong nominal GDP and earnings growth as the Fed tightens are the primary ingredients of a classic mid-cycle investment regime.
We remind readers of our messaging from this spring, when market internals and valuation also pointed to a much more evolved correction than index-level price action suggested: "Beneath the surface, more than half of the stocks in the Russell 3000 have dropped 20% or more. To us, that’s not complacency, but a market that has appropriately and surgically discounted the risks both at the index and stock level that include private credit and AI disruption concerns as well. Importantly, earnings growth is moving in the right direction, which explains why the price damage has been contained...that combination—falling multiples with improving earnings growth—is a classic bull market correction..."
That earnings momentum has continued undeterred, with median stock EPS growth reaching the mid-teens range, and index-level EPS revisions breadth climbing toward cycle highs. This strength has almost fully offset the multiple compression we've seen since May, a sign that the discounting process for the aforementioned risks is well advanced, as it was earlier this year. While the Semis sell-off played a role in the de-rating, so did higher rates, which breached a familiar threshold. Specifically, the peak in valuation for the S&P coincided with the 10-year yield's breach of 4.50%, the threshold we have long pointed to as the level at which rate sensitivity increases meaningfully for stocks.
That brings us to last week's FOMC meeting. In our view, Warsh got the inflation data that allowed him to attempt a credibility-enhancing hike without leading markets to extrapolate a 2022-style tightening cycle. Core CPI rose 0.29% in August, but much of the upside relative to expectations was concentrated in a handful of categories, shelter remained relatively soft, and tariff pass-through appears to be fading. The data were firm enough to justify following through on the reaction function he has spent several months trying to establish, without suggesting the Fed had fallen dramatically behind the curve as it had in 2021. With the probability of a hike already close to 90% heading into last week's FOMC meeting, the relevant information was less the 25 basis points itself than Warsh’s willingness to enforce that framework. In our view, that makes the move credibility-enhancing: a higher policy rate can reduce inflation uncertainty and term premium if it convinces investors that the Fed is acting early enough to avoid a more disruptive tightening later.
Having said that, Warsh's long standing position/philosophy leans much more in the monetarist direction than prior Fed Chairs and the current members of the FOMC. Warsh has been less committal on this front, in our view, as he takes over the reigns and tries to build cohesion within the committee. As a result, we don't really know how aggressive he will be with the Fed's balance sheet going forward as he waits for important conclusions from his numerous task forces trying to determine the real causes of inflation, and why it has been so persistent since the COVID pandemic. The point of bringing this up again today is that we think the bigger risk to financial markets from the Warsh-led Fed stems from its eventual decisions on the Fed's balance sheet and how it reacts to money supply/credit growth in the private economy. In other words, a 25 bps hike last week followed by perhaps a few more over the next 6-12 months is unlikely to end this bull market, but a more hawkish approach to money supply/credit growth is likely to be a greater risk in that regard. On this score, Warsh's resolve is less certain, and more importantly, his ability to influence the rest of the committee in this regard is even less so given the institution's history.
Crude remains the swing factor in the near-term. Another leg higher in oil and refined products would likely put renewed upward pressure on the expected policy path, back-end yields and bond volatility. The symmetry with 2024 is worth noting: cutting the policy rate then did not ensure lower long-term financing costs; today, raising it need not ensure higher long-term nominal financing costs, particularly if doing so reduces longer run inflation uncertainty. In short, stocks have valuation support here, and earnings remain strong. We remain convicted in our year-end S&P 500 target of 8,000, though we acknowledge rising crude and refined product prices as the primary near-term risk to the index. Should the correction in valuation take a turn for the worse in the near term due to a further tightening of financial conditions and/or materially higher energy prices (the near-term risk scenario), we think the S&P 500 could trade as low as 7100 before the bull market resumes into year end. Bear in mind that we remain in the middle of the mid-term election seasonality which often ends with a 5-10% correction in the index versus the current 2%.
Our preference under the surface of the market remains consistent as the mid-cycle rotation we have been focused on continues to play out—stick with large cap quality stocks. Our factor work continues to show quality-oriented factors such as high free cash flow yield and low accruals leading the market (Exhibit 6). Interestingly, as Exhibit 6 shows, factors tied to operating efficiency are also seeing clear outperformance, with the high sales-per-employee factor up 5% over the last month. In our view, this ties directly to our constructive call on AI adopters. As Exhibit 7 illustrates, profit margin expectations for AI adopters continue to accelerate and are now 400 bps above those for the overall market. Consistent with this rotation, the closely followed momentum factor is also seeing its leadership shift toward quality and services-oriented, asset-light and fee-based industries. Unsurprisingly, these industry groups are also among the best-positioned areas of the market from an AI adoption perspective, based on our Research department's AI mapping work. Lastly, as discussed last week, our work shows that the quality factor continues to outperform following the first rate hike of the cycle (Exhibit 8), further supporting our rationale for owning this cohort. As we head into earnings season, we recommend focusing on quality stocks with improving earnings revisions. Exhibit 11 in the section below includes this screen.
Screens
Quality + Strong EPS Revisions Screen:
- Stock is a member of top 1000 by market cap.
- Stock is in top tercile of quality composite score.
- Stock's NTM EPS has improved from 3 months ago.
- Stock is rated as Overweight by Morgan Stanley analyst.
Given recent interest rate moves and developments, we thought it would be helpful to look at rate-sensitive equities.
Most Positively / Inversely Correlated to 10Y Yield Screens: Stock is member of top 1000 by market cap. The most positively or inversely correlated to 10y yield based on trailing 63d daily change.