Bulls running out of air; bears running out of time

With earnings season nearly through, and the Federal Reserve’s probable final rate hike this cycle coming next week, the market is likely to enter a period of digestion. On the one hand, the 15% rally off the October lows, led by under-loved large-cap tech, has chastised the bears and caused them to retreat. (I would note that much of the market commentary has shifted our way, from “Recession” with a big “R” to something more like “mild recession,” “temporary slowdown” and even “bumpy period.”) Bears are running out of time. The sunnier days of 2024 are growing closer, and the market will increasingly look through to those as the summer progresses. Big pullbacks are likely to be bought.

On the other hand, the run up in tech—even as earnings have declined and forward expectations been tempered--has left valuations there nearing heady territory again, limiting near-term upside. The rest of the market is much cheaper, though lingering worries about the impact of the ongoing credit contraction and the decelerating economy are clouding their outlook. Bottom line, we see a period of consolidation ahead, meaning a 10-12% grind down toward our long-end S&P 500 target of 3600 is possible before we can move toward our 4400 year-end target. A nuanced view, for sure. Here are further thoughts:

• So far, a bank crisis has been avoided and time has been purchased. But some zombie banks need to be addressed. The good news for the bulls is that the potentially damaging systemic event of a full-blown banking crisis seems to have been avoided for now. I stress systemic rather than idiosyncratic. The current rolling recession/rocky landing that began in tech and housing 12 months ago (and is now rolling through commercial real estate and finance) has lacked a system-wide triggering event that could turn a rocky landing into a deeper and broader recession. For sure, there are still rocks on the runway, most notably First Republic. But the bank run there, while dramatic, is now largely over with the vast bulk of its uninsured deposits in the hands of a consortium of large, stable banks. It’s now a slow zombie bank supported by the Fed’s Bank Term Funding Program. We’ll see how it works out. For now at least, most of the rest of the system appears liquid and solvent. While bank earnings estimates are coming down, that will happen slowly not quickly. Time is on their side. Regulators seem to understand this, yet still the risk is out there that something worse happens at First Republic. 
• Inflation numbers have peaked, and the Fed is near a pause. Virtually all our forward-looking indicators suggest inflation is falling rapidly. Supply chain bottlenecks are behind us, and today’s month-over-month core PCE numbers suggest a current inflation run rate of 3.5%. That’s not the Fed’s target, but way down off the highs. And although wage increase numbers, including today’s Employment Cost Index, remain elevated at a 4.8% annual rate, the numbers are well off their peaks and importantly, layoff announcements are rising and broadening outside of tech and finance. We expect continued declines in the back half of the year, allowing the Fed to pause the hiking cycle and maybe even cut once or twice by year-end.
• The market has enjoyed a big rally, looking through to the Fed pause. Stocks are up nearly 17% from their October lows, with the growth indices up more, 19% on the Russell 1000 Growth. Earnings are off and still falling toward our $190 estimate for this year. There have been occasional idiosyncratic whiffs and the earnings season has been “ok” relative to reduced expectations. We expect numbers to continue to decline through the year. However, everyone, including us, expect a pretty healthy recovery in earnings next year, to somewhere in the range of $230 or $240. And as we progress through the summer, markets likely will look through to these better days, buoying stocks.
• The biggest beneficiaries have been the growth/tech stocks. Nearing the end of their earnings recession, they have fortress-like balance sheets and robust cash flows if the bank crisis spreads, and are long-duration assets that would benefit from Fed cuts. The problem is that, in most cases, their valuations have risen too high—particularly given their now more mature, slower growth status. They are running out of air, and we think likely to consolidate gains from here.
• The cyclicals and defensives have hung in there, with low valuations and strong dividend yields. Many value stocks have exposure to a broader economic slowdown, should it come. That is the cloud hanging over the stocks, but again the closer we come to the much-anticipated “Recession,” the more likely investors will be willing to look through to the recovery. The defensive value stocks, on the other hand, are suffering more from neglect than fundamentals. Most of these names have, in our view, very attractive valuations and dividend yields. They should support the market, we’d guess, in the consolidation period to come.

So buckle up for the summer. We expect more volatility in markets ahead. We are staying defensive here, though still leaning modestly toward stocks over bonds. While the air is getting thinner for sure, the end of this prolonged rocky landing is at least in sight.