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- Will last week’s enormous rally hold? Our view is yes – as long as investors believe the Federal Reserve (Fed) really is on hold and finished raising rates.
- Whether and how long that perception lasts depends on incoming economic data.
- All things considered, we think it will take a significant shock – whether strong data or weakening earnings outlooks – to shake investor confidence.
- The latest earnings suggest companies are continuing to invest in high-tech manufacturing equipment and that concerns are rising about a subpar holiday shopping season.
- About 130 companies report this week, with the biggest draws being Walt Disney Co. and Uber Technologies.
- We still like holding or overweighting interest-sensitive ETFs, including homebuilders (XHB), regional banks (KRE), REITS (XLRE), and residential mortgages (MBB).
- The easy money has been made here but we expect these securities can continue outperforming the S&P 500 (SPX) if – as we expect – the rally holds. The risk here is a significant rise in Treasury rates.
What We Learned Last Week
Harking back to TV game shows of yore, the $64,000 dollar question of the day must be whether last week’s equity rally was for real or a head fake. For the record, SPX gained 5.9%; the NASDAQ 100 (NDX) jumped 6.6%; and the ever-challenged Russell 2000 (RTY) leaped 7.8% off a low last seen before the 2020 US presidential election.
The answer? It depends on perception.
- The Fed has not changed its tune – it will raise rates if necessary – but given the softer-than-expected jobs report, investors gained confidence that the Fed is indeed done.
- Other pluses remain in place – the economy is rolling along, unemployment is low, companies are mostly beating earnings forecasts by comfortable margins, and the earnings outlook is positive.
If those perceptions last, equities should hold last week’s gains, but any further rally will likely be a grinding affair.
What could change perceptions?
- Incoming economic data that rekindles concerns about a more hawkish Fed.
- A significant slowdown in the economy or earnings – although the question here is whether the Fed responds by cutting rates sooner or elects to remain on hold for longer.
Earnings on a Roll
Q3 earnings season continues to surprise on the upside. SPX shows a 7.6% earnings surprise, versus expectations of a 2% increase. The NDX is super impressive, with surprises coming in at 10% – on top of expectations for a 10% increase. Even RTY has posted a 10.2% surprise.
More broadly, all three major indices appear to be resuming an upward earnings trajectory after nearly two years of flat or declining earnings (Chart 1). Currently, analysts project that earnings will continue to rise over the next two years.
On the other hand, sales surprises are only coming around 1% – lower than in recent quarters. We have no good explanation for this, except that analysts may assume higher inflation than many companies are experiencing. It may also be that companies have learned to be very efficient in the current environment.
What Companies Are Saying
We continue seeing a pattern of investors looking past strong earnings and focusing on any signs of weakness – whether in soft outlooks, rising inventories, or continued supply chain problems. However, after last week’s rally, more investors may turn back to potential upside rather than downside.
High-Tech Manufacturing – Several companies that produce high-tech manufacturing equipment posted strong earnings and rising outlooks, including Eaton Corp. (ETN), Flowserve (FLS), and Howmet Aerospace (HWM). One takeaway is that companies are still investing in advanced manufacturing systems despite various headwinds in anticipation of rising onshoring.
Advertising Upswing – Another constructive development is companies dependent on advertising are reporting strong demand and earnings. These include Fox Corp. (FOX), Spotify (SPOT), and Alphabet (GOOG) (although GOOG got clobbered because of slower-than-expected growth in its cloud business and AI prospects). A small caveat is that GOOG and SPOT mentioned that advertising demand appeared to slow after the 7 October Hamas attack on Israel.
Holiday Slowdown – Apple (AAPL) followed toy makers Hasbro Inc. (HAS) and Mattel Inc. (MAT) in forecasting a soft holiday season for their respective goods. We know people are shifting spending from goods to services, so no surprise there. That said, Halloween spending for 2023 was up some 15% over 2022, so clearly people are willing to spend on special events. Still, these are the first warnings we have seen about holiday spending, so is something to watch going forward.
We still like holding interest sensitive ETFs in anticipation of further declines in Treasury rates. Last week, we said we like overweighting ETFs for homebuilders (XHB) and regional banks (KRE). They are up 2.7% and 3.6% versus 0.9% for SPX. We add the SPX real estate sector ETF XLRE and mortgage ETF MBB to the list.
We concede that the easy money has been made here. Aggressive trading-oriented investors may want to unwind positions to see how the market trades into next week.
For buy and hold investors, we are comfortable that these ETFs can outperform SPX if we do not return to a sharply rising rates environment or face a sudden economic or earnings slowdown. The risk is that Treasury rates rise significantly.
We move our overweight in consumer staples ETF (XLP) to market perform.
The Week Ahead
The flow of earnings slows this week from 300+ reports to a still-hefty 130 reports from companies in our Russell 1000 universe. It is not a week for major bellwethers. Companies attracting the most interest will be Uber Technologies (Tuesday); Walt Disney, and The New York Times (Wednesday); and News Corp. and Tapastry (Thursday).
We will watch closely to see if investors become more receptive to the positives in earnings reports.
- DiamondBack Energy (FANG).
- TripAdvisor Inc. (TRIP).
- Air Products and Chemicals (APD).
- Choice Hotels (CHH).
- Devon Energy Co. (DVN).
- DR Horton (DHI).
- Gilead Sciences (GILD).
- KKR & Co Inc. (KKR).
- Lucid Group (LCID).
- Planet Fitness (PLNT).
- Uber Technologies (UBER).
- AMC Entertainment (AMC).
- LYFT Inc. (LYFT).
- MGM Resorts International (MGM).
- The New York Times (NYT).
- U-Haul Holding Co. (UHAL).
- Under Armour (UAA).
- Walt Disney Co. (DIS).
- WK Kellogg Co. (KLG).
- News Corp. (NWSA).
- Tapastry Inc. (TPR).
- Wynn Resorts LTD (WYNN).
- Quiet day.