Equity Solutions for Financial Markets

  by Scott Martindale
  President & CEO, Sabrient Systems LLC

I mentioned early last month that it had been quite a long stretch since the market had seen even a -5% correction, but we finally got it, with the S&P 500 falling -6% (intraday). Although many commentators (including myself) felt we needed even more of a correction in the major market indexes to really wring out some excesses and the “weak” holders, the underlying internals tell a different story of a much harsher “stealth” correction. Alpine Macro reported that 90% of the stocks in the S&P 500 have fallen at least -10% from their recent highs, with an average decline of -17% … and -38% in the Nasdaq Composite! A casual observer might not have noticed this since these individual stock corrections didn’t occur all at once, but rather in more of a rolling fashion as various industries fell in and out of favor at different times. The masking by the major indexes of these underlying corrections is the magic of passive index investing, as the diversification limits downside (albeit upside as well, of course).

Moreover, while the cap-weighted indexes have surged to new highs as recently as early September, the equal-weight and small-cap indexes have been trading sideways since March. Regardless, investors took the September correction as a buyable dip. Last Thursday-Friday provided two bullish breakout gaps, and in fact Thursday was the strongest day for the S&P 500 since March. Looking ahead, the question is whether the rapid 2-day surge is sustainable, or if there is some technical consolidation (aka “backing & filling”) to be done – or perhaps something much worse, as several prominent Wall Street veterans have predicted.

No doubt, economic challenges abound. Energy prices are surging. COVID persists in much of the world, especially emerging markets, which is at least partly responsible for the persistent supply chain issues and labor shortages in the manufacturing and transportation segments that are proving slow to resolve. Retail and restaurant industries continue to have difficulty filling jobs (and they are seeing a high rate of “quits”). And now we are seeing fiscal and monetary tightening in China – likely leading to lower GDP growth (if not a “hard landing”) – due to long-festering financial leverage and “shadow banking” finally coming to roost (witness the Evergrande property development debacle, and now it appears developer Modern Land is next). Indeed, we see many similarities with Q4 2018 (including the S&P 500 price chart), when the market endured a nasty selloff. Investors should be mindful of these risks. So, although TINA-minded (“there is no alternative”) equity investors continue to pour money into stocks, and an exuberant FOMO (“fear of missing out”) melt-up is possible going into year-end, there likely will be elevated volatility.

I write in greater depth about oil prices and China’s troubles in this article.

Q3 earnings reporting season is now underway, and I expect the number and magnitude of upside surprises and forward guidance will determine the next directional trend. In any case, we continue to like the Energy sector, even after its recent run (in fact, you will find a couple of oil exploration & production firms in the new Baker’s Dozen coming out this week). Wall Street estimates in the sector still appear to be too low based on projected prices, and the dividend yields are attractive. Sabrient’s SectorCast ETF rankings continue to show Energy at or near the top. Actually, from a broader perspective, the “deep cyclical” sectors (especially Energy, Materials, and Industrials), with their more volatile revenue streams but relatively fixed (albeit high) cost structure (and high earnings leverage), remain well positioned to show strong sales growth and, by extension, upside earnings surprises.

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 is somewhat mixed; and our sector rotation model has regained its bullish posture (pending technical confirmation early this week).

By the way, Sabrient’s new Q4 2021 Baker’s Dozen launches on Wednesday, 10/20/21. As a reminder, our newer portfolios – including Baker’s Dozen, Small Cap Growth, Dividend, and Forward Looking Value – all reflect the process enhancements we implemented in December 2019 in response to the unprecedented market distortions that created historic Value/Growth and Small/Large performance divergences. Our enhanced growth-at-a-reasonable-price (aka GARP) approach combines value, growth, and quality factors while seeking a balance between secular growth and cyclical/value stocks and across market caps.  Read on....

  by Scott Martindale
  President & CEO, Sabrient Systems LLC

As earnings season gets going, I believe we will see impressive reports reflecting stunning YOY growth in both top and bottom lines. According to Bloomberg, sell-side analysts' consensus YOY EPS growth estimate for the S&P 500 is north of 63% for Q2, 36% for full-year 2021, and 12% for 2022. But I still consider this to be somewhat conservative, with plenty of upside surprises likely. However, the market’s reaction to each earnings release will be more predicated on forward guidance, as investors are always forward-looking. To me, this is the bigger risk, but I am optimistic. Today’s lofty valuations are pricing in the expectation of both current “beats” and raised guidance, so as the speculative phase of the recovery moves into a more rational expansionary phase, I expect some multiple contraction such that further share price appreciation will depend upon companies “growing into” their valuations rather than through further multiple expansion, i.e., the earnings growth rate (through revenue growth, cost reduction, and rising productivity) will need to outpace the share price growth rate.

Despite the lofty valuations, investors seem to be betting on another blow-out quarter for earnings reports, along with increased forward guidance. On a technical basis, the market seems to be extended, with unfilled “gaps” on the chart. But while small caps, value stocks, cyclical sectors, and equal-weight indexes have pulled back significantly and consolidated gains since early June, the major indexes like S&P 500 and Nasdaq that are dominated by the mega caps haven’t wanted to correct very much. This appears to reinforce the notion that investors today see these juggernaut companies as defensive “safe havens.” So, while “reflation trade” market segments and the broader market in general have taken a 6-week risk-off breather from their torrid run and pulled back, Treasuries have caught a bid and the cap-weighted indexes have hit new highs as the big secular-growth mega-caps have been treated as a place to park money for relatively safe returns.

It also should be noted that the stock market has gone quite a long time without a significant correction, and I think such a correction could be in the cards at some point soon, perhaps to as low as 4,000 on the S&P 500, where there are some unfilled bullish gaps (at 4,020 and 3,973). However, if it happens, I would look at it as a long-term buying opportunity – and perhaps mark official transition to a stock-picker’s market.

The past several years created historic divergences in Value/Growth and Small/Large performance ratios with narrow market leadership. But after a COVID-selloff recovery rally, fueled by a $13.5 trillion increase in US household wealth in 2020 (compared to an $8.0 trillion decrease in 2008 during the Financial Crisis), that pushed abundant cheap capital into speculative market segments, SPACs, altcoins, NFTs, meme stocks, and other high-risk investments (or “mal-investments”), it appears that the divergences are converging, leadership is broadening, and Quality is ready for a comeback. A scary correction might be just the catalyst for the Quality factor to reassert itself. It also should allow for active selection, strategic beta, and equal weighting to thrive once again over the passive, cap-weighted indexes, which also would favor the cyclical sectors (Financial, Industrial, Materials, Energy) and high-quality dividend payers (e.g., “Dividend Aristocrats”). But I wouldn’t dismiss secular-growth Technology names that still sport relatively attractive valuations (Note: the new Q3 2021 Baker’s Dozen includes four such names).

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 sector rankings reflect a solidly bullish bias; the technicals picture has been strong for the cap-weighted major indexes but is looking like it is setting up for a significant (but buyable) correction; and our sector rotation model retains its bullish posture.

As a reminder, Sabrient’s newer portfolios – including Small Cap Growth, Dividend, Forward Looking Value (launched on 7/7/21), and the upcoming Q3 2021 Baker’s Dozen (launches on 7/20/21) – all reflect the process enhancements that we implemented in December 2019 in response to the unprecedented market distortions that created historic Value/Growth and Small/Large performance divergences. With a better balance between cyclical and secular growth and across market caps, most of our newer portfolios once again have shown solid performance relative to the benchmark (with some substantially outperforming) during quite a range of evolving market conditions. (Note: we post my latest presentation slide deck and Baker’s Dozen commentary on our public website.)  Read on….