The stock market has staged an impressive recovery by officially exiting the bear market and entering a new bull market.  A bull market can be defined as a 20%+ increase, and although we are measuring from the bottom, it is nonetheless impressive given the mood of investors to start the year.

But the ‘ball game’ isn’t quite over yet. The market continues to climb the wall of worry with ‘sticky’ inflation, an unstable banking & commercial real estate industry, a Fed that continues to spew hawkish rhetoric, a potential visit from the recessionary ‘boogeyman,’ and valuation concerns around large cap technology. Yet, despite these worries, the market continues to show resilience, and our view is it could continue to grind higher. Have I just jinxed this new bull market!?  Probably.

If one was previously hesitant to invest and just recently entered the market, the temptation to liquidate your positions at the first sign of market weakness will be strong. The bear market of 2022 is still fresh in everyone’s mind, and so it would not take much convincing to believe the latest rally was just a head fake after all. In these moments, the market can find an excuse to reverse momentum. The market could take one new negative data print and extrapolate it to a myriad of negative scenarios. Renewed geo-political tensions could also be a trigger. Even a single ‘hawkish’ media interview from a FOMC member could spark a sell off. So, what is an investor to do? Below are certain market fundamentals that we believe investors can use to help them ride through any immediate pullbacks.

Inflation & Interest Rates

In our view, the market has been anchored towards the narrative of “inverted yield curves” and “don’t fight the fed.” In other words, a recession is imminent, and investors should wait. However, perhaps this is not the classic “Fed cycle” where the Fed will only pivot from economic tightening after something breaks.  Rather, we submit that the Fed has been fighting an inflation war, and under this story arc, the fed can pivot when inflation has been broken. It is difficult to know how much inflation needs to “break” before the Fed feels they are back in control. However, the most recent May CPI print of 4% YoY is convincing to us that the peak inflation of 9.1% in June 2022 will be reliably in the rear-view mirror. Should this trend continue, the latest ‘pause’ in interest rate hikes could last longer than expected, which should skew markets even higher.

Our friends at Fundstrat Research have pointed out that next month, headline inflation YoY is set to drop significantly. Every month, the ‘oldest’ of the last 12 monthly data points are excluded from the calculation. Hence, the next data point from June 2022 will be dropped. As depicted below, June 2022 was an extremely high and banner month for inflation. Its’ exclusion could lower the June 2023 CPI number by as much as 0.5% to 1%. Would an inflation number with a ‘3’ handle convince the Fed and the public that inflation has been broken? If so, markets could react positively.

Earnings

In the heat of the moment, investors sometimes forget that the stock market is inherently a discounting mechanism. Hence, big events tend to get priced in ahead of time. During most of 2022, the market priced in challenges to the economy and to earnings, which we are witnessing now. Despite declining economic growth and negative earnings growth, the results have been better than the prognosticating that was done in 2022. Therefore, markets have responded favorably. As we approach the second half of the year, it is not too early for the market to start pricing in expectations for 2024. As of now, the rate of upward Earnings Per Share (EPS) estimate revisions has improved to 57% in early June. In other words, 57% of the companies in the S&P500 are having their profits revised higher. History tells us that these EPS revisions tend to go above 50% around 3-6 months after the market has hit the bottom. Hence, this suggests that the market low of October 2022 was the low for the cycle.  From a sector perspective, as shown below, most sectors in the S&P500 are experiencing improving profit and revenue forecasts for 2024.

VIX and Valuations

We had discussed at the beginning of the year that the key indicator to watch was the VIX index (aka. Volatility Index). This indicator represents the market’s expectations for volatility over the next 30 days.  History has shown that after a money losing year, the returns for the following year have been connected to the trend in VIX. As shown in the table below, if the VIX continues to rise, investors have experienced further losses. However, if the VIX falls relative to the previous year, the markets have historically recovered with strength.

Despite all the negative headlines of banking failures, debt ceiling, commercial real estate downturns, and “higher interest rates for longer”, the VIX has staked an impressively stable reading of 14. Last year, in 2022, the VIX spent most of its time in the neighborhood of 25-30. Hence, the implication is that the recovery has begun.

Finally, market valuations also seem to be justifiable. With the recent rally in large cap technology, the 2024 forward PE valuation of the S&P500 has grown to 18.4X. This is a premium to the long-term average of 16X, yet hardly in the territory of a “bubble”. Interestingly, if one were to exclude the major tech/FAANG names from the calculation, the average valuation sits in the 14-15X range. Although most of the S&P500’s returns in 2023 have been attributed to 7 technology-oriented companies, therein lies the opportunity for markets to melt up. Should market breadth begin to broaden out and other sectors participate in the recovery, the index could continue to march higher.

Taking everything above, we feel investors have reason to feel more constructive on the market. The VIX, earnings revisions, and inflation trends signal to us that it would take something more ominous than “hawkish Fed talk” and “calls for soft landings” to cause a revisit to the lows of October 2022. As a result, market dips can be bought. As mentioned previously, this is not to reject the possibility of an uncomfortable pullback. We accept the market may be sensitive to the current chorus of an overstretched market. However, we would see these pullbacks as an opportunity to look longer term and to add to those equities that previously seemed too ‘expensive’.