Mitch Zacks' update on the stock market direction - July 1

[dan_s]

What’s Next for the Fed and Interest Rates? It Might Not Matter

For the better part of two years, the Federal Reserve has been the center of attention for investors and market watchers. The most important question every few weeks for many investors was, will the Fed raise rates again, and if so, by how much? The Federal Open Market Committee (FOMC) meetings were, for many, the single most important factor determining the fate and direction of stocks.1

Today, the debate centers around whether the Fed will raise rates at their next meeting by 25 basis points. Beyond the next meeting, investors are trying to forecast whether rates will hold steady at 5.25% - 5.50%, whether they may tick slightly higher, or whether the Fed may eventually start cutting rates.

But at this point, I’m not sure these particular details matter all that much to the economy or stocks, as I’ll explain below. I think it’s time to shift focus.

The stock market may be the clearest indicator telling investors it’s time to move on. As seen in the chart of the S&P 500 below, the Federal Reserve has raised rates by a cumulative 275 basis points since September 2022. In that time, stocks have rallied considerably, rising nearly +20% from the October lows (as I write). If interest rate increases and monetary tightening really mattered as much to the markets as many purport, shouldn’t stocks have continued to struggle over the last seven months?

In my view, the message here is that stocks are now looking past remaining Fed decisions for 2023, and investors may be starting to price-in expected economic and earnings growth well into 2024. < This is why I believe that more investors will start looking at the energy sector again. Q2 results will still be good for all of the companies in our three model portfolios (not as good as Q1) and oil & gas prices appear to be heading higher.

Now, there’s a reasonable argument that stocks’ rally to date has been too narrow – focused only on mega-cap names that play into surging enthusiasm about artificial intelligence. But this argument has weakened as breadth expands and more stocks begin to participate in the rally. Small-cap stocks as measured by the Russell 2000 are also up double-digits from October lows, for instance.

What will matter most to stocks from here, in my opinion, is how U.S. economic growth in the coming quarters measures up to past and current expectations. The broad consensus is that a recession is looming, but just about everyone has been wrong about this point so far. As seen in the Q2 2023 GDP forecasts from the Atlanta Fed (GDPNow) versus the top and bottom 10 economic forecasts, the U.S. economy is likely going to outperform what almost everyone expected in Q2. This outperformance has been happening for almost a year now.

Markets tend to respond positively to ‘better-than-expected’ scenarios, and vice versa. If the U.S. economy continues to expand even just modestly in the second half of the year, supported by a resilient jobs market, falling inflation, and steady consumer spending, then I would expect this market rally to continue apace – perhaps even more strongly than many expect.

Conversely, if the U.S. economy sputters in the second half or early 2024, and suffers a recession that is deeper and longer than economists are currently anticipating, then I would see a case for the market retesting October’s bear market lows. I certainly would not rule out this possibility, but I also think it’s the least likely to occur.

The final scenario is the possibility that a U.S. recession is more of a ‘garden variety’ economic contraction – a slight pullback in output coupled with modest increases in the unemployment rate, say to 5% - 6% or so. If that were to be the case, I would argue that the stock market would not be negatively surprised. This is the type of recession I think was already baked into stocks’ decline in 2022, so it would just be the realization of what stocks were pricing in for the economy last year.

Bottom Line for Investors

As laid out above, what I think matters most for markets today is whether a U.S. economic recession turns out to be worse, better, or largely in line with what investors, economists, and market watchers are expecting. The only scenario I see as negative for stocks is if a downturn is deeper and longer than expected, which I also do not think is likely. Any other outcome – even one where the U.S. economy enters a mild recession – should not have a meaningful negative impact on stocks.

This is also why I think the outcome of the next few Fed meetings is largely inconsequential, and why I think investors should move on. Whether the Fed raises rates by another 25, 50, or even 75 basis points is not likely to alter the direction of the U.S. economy in the next year, which I think means investors should place focus elsewhere. Earnings forecasts for 2024 are a good place to start.

Instead of focusing too intently on Fed rate raises, I recommend keeping an eye on key data points and fundamentals that could have an impact on the market.

[moke]

Well written article, what is not emphasized is the tightening of credit. Which is how companies grow.

800 companies of the Russell 2000 are not profitable. That is 40%. If they have to roll their loans over at some pint, the prime rate is now 81/4 %, borrowing can come in at 10%, how many can afford that? They are coming from low interest loans rolling to a high interest loans if they can quality for the credit. The question is how many companies have to roll their loans over in the next two years.

Withholding taxes have been coming down for month, so the government stats on employment numbers are suspect. Biden’s lapdogs always revise the numbers down the following month. One reason could be the high paid people are getting laid off and finding jobs paying much less.

Consumers are falling behind on their car loans, first; time in history the finance companies are rewriting the loans, lowering the payments and extending the length.


Biden bragging about new business startups. Uber and Lift drivers have all gone to LLP’s not what you call new business start-ups for growth.

Rising interest rates have a lag effect on the economy not sure where we are on all them.

I agree the market is bullish now and the market has baked in all the news that is currently available, a credit crunch can change the market direction rather quickly without notice. Currently banks are tightening credit.

I do think a recession is coming and I have no idea when. Some market pundits say if you are in equities now they should be at least a discount of 30% to fair value.

Be careful listening to me I am just a country guy.
Clearly that fella knows more than i do.

[ChuckGeb]

Thanks for posting your thoughts. These are challenging times where it is very difficult to make sense. When in doubt buy Fang or EOG. Would be thrilled to see Dan’s projections thru 2024 come to fruition. Energy seems like it is set up nicely for some sidelines cash or rotation from fully/overvalued sectors. Caveat being a 4.5% mma seems like a safe place to hold some funds till upward trends can be confirmed.

[dan_s]

Thanks for posting the comments about debt. During 2022 our model portfolio companies paid off a lot of debt and they are still paying down debt. None of them have near-term debt problems unless there is a big decline in oil & gas prices.

Those that do have debt can layer on hedges to reduce their risk.

The upstream industry has change a lot in the last few years. No more "Drill Baby Drill". Living within cash flow is the new rule.

I really like the companies in our High Yield Income Portfolio and the three Canadian Juniors (HMENF, IPOOF and ZPTAF) that now offer dividend yields over 7%. At my age, I am putting most of my portfolio into dividend paying companies. All four of our Mineral / Royalty companies are solid and pay nice dividends, BSM is almost debt free.

[aja57]

David Hay posted an excellent substack article on the direction of the market last week which was quite enlightening regarding energy. I had no idea that the oil paper traders market is 30x larger than the physical oil market and that most paper/ physical commodities have a ratio of 2-3. Anyway the article has some great insights . Worth the read.

https://haymaker.substack.com/p/haymaker-friday-edition-a44?utm_source=post-email-title&publication_id=846890&post_id=130130536&isFreemail=true&utm_medium=email

[Fraser921]

Good stuff!

Ty pmoquist