Not a 'Confidence at the Lows' moment...yet

Readers of this space know that “Humility at the Highs” is one of my most important lessons of over 40 years navigating volatile equity markets. Its twin virtue is “Confidence at the Lows,” which is often even harder to execute when markets are panicking and the talking heads are lighting their collective hair on fire. So, having cut our equity overweights by 40% just three weeks ago, and with the large-cap growth stocks that we sold down almost 12% since, clients are naturally asking, “Is this a ‘Confidence at the Lows’ Moment? Should we go back in, or should we get out completely?” Our answer is we are confident enough to hold to our remaining equity overweights in small cap, large cap value and emerging markets, but not enough to move the money we put into money markets back into the market. Call it a time to be cautiously confident.

Reviewing the market balance sheet, we see enough negatives still out there to remain cautious, while noticing that a number of new positives have encouragingly emerged. Let’s review both lists.

Ongoing issues

1. Too many people are calling for an “emergency” Fed rate cut that won’t happen. Although the Fed is clearly behind the curve (much as they were in 2021 when again—waiting for “data”—they were too slow to hike), they typically don’t do emergency cuts unless the credit markets start freezing up. Fortunately, that hasn’t happened and seems unlikely given how strong the banking system is. But the catalyst of the initial rate cut, now probably 50 basis points, not 25, in the September meeting, is still almost six weeks away.
2. A recession could very well be on the way, though we think it’s more likely another “rocky landing.” A lot of internal indicators, such as the internal numbers of last week’s manufacturing ISM and Friday’s employment numbers, suggest the economy is softening. On the other hand, yesterday’s services number held up pretty well, consumers have jobs, corporate profits are high and rising, and the banking system remains solid. So an economic crash landing is not happening. Maybe another round of last year’s “rocky landing,” but not worse than that.
3. Economic softness is not just a U.S. phenomenon. Often in the past, when one part of the global economy was weakening, another was strengthening. This time, in an echo of the synchronous covid global lockdown and simultaneous global recovery, everywhere is soft. China is in deflation and policymakers seem disinclined to stimulate dramatically. Europe is bogged down in political shifts and the slowdown in China hurts it. Japan is just now entering a rate hiking cycle. If the U.S. decelerates, there doesn’t seem to be any other large country or region around to pick up the slack.
4. The unwinding of leveraged positions in yen, ETFs and other assets is not over. The so-called yen carry trade has been going on for several years and like most “sure things,” seems to have attracted an incalculable amount of leveraged players funding speculative long positions in the AI trade and other assets in yen. In my experience, one day doesn’t end these things; there is simply too much money trying to exit the burning theater at the same time. My guess is this will take weeks, not days. But no one really knows; most of the activity has happened outside the traditional, regulated banking system. Only time will tell.
5. Every action has an equal and opposite reaction. Momentum trades, which we cited as our reason to sell growth three weeks ago (see Approaching a Humility at the Highs Moment?), often carry a good fundamental story to dramatically overvalued heights. When they reverse, the same often happens to the downside. Just as complaining that Nvidia was trading at 35 to 40x 2025 earnings was no help to the AI bears as the stampede into this trade built steam. Yelling that it’s now a more reasonable 25 to 30x won’t protect the bulls. There’s a lot of energy in this downward move and a one day rally is unlikely to stop it.
6. The S&P 500 has just arrived at our year-end target (from above). Our S&P target for this year of 5200 (6000 for 2025), was based on what was viewed at the time as an optimistic forward earnings outlook ($275 for 2025) and an optimistic forward valuation multiple (19x). One could quibble about whether these estimates remain too optimistic or not, but the point is that the present level of the S&P is not extraordinarily cheap.
7. Election uncertainty is on the rise. With Vice President Harris having replaced President Biden on the Democratic ticket, the race has changed dramatically in three weeks. What seemed like a Trump runaway is now a toss-up. Given the radical policy differences and likely regulatory practices between the two candidates, capital allocation decisions within the broader economy are now being put on hold. This could temporarily exacerbate the rocky landing we are currently in.
8. The VIX is elevated and in the past, once it has spiked, it takes a while to come back down. The recent spike in the VIX was dramatic. Historically, such spikes rarely turnaround on a dime. It usually takes a process of risk unwinding to get the market back to safe harbors, and our guess is this instance will be no different.

Reasons for confidence

1. Dramatic Fed rate cuts lie ahead, and the Fed has plenty of room this cycle. The data of the last two weeks has confirmed, in our view, that a major Fed rate cutting cycle is about to begin. The last big bugaboo of the sticky inflation theory, the tight labor market, is now receding. Assuming inflation comes down to even the 2.5% range (the Fed’s informal target, we think), and assuming 50 basis points of risk premium above that, the fed funds rate is probably heading for 3.0% this cycle. So over 200 basis points of cuts are on their way. This reinversion of the curve would dramatically help revenues and/or earnings in the areas of the economy in the broader stock market that we like: financials, small caps, asset-heavy “Value” stocks, dividend-paying stocks and emerging markets stocks.
2. Key sectors of the economy are poised to re-accelerate once Fed rates go lower. This economic soft patch is odd in that two big sectors that drive economic activity—housing and autos—are both already in recessions caused by too-high financing rates. They are poised to take off once the rate cut cycle starts. Again, this would help the much-maligned Value stocks.
3. The banking system is well-reserved and has already had its crisis. The oncoming economic weakness, if it is oncoming, has been forecasted consistently and prematurely for the last two years. So the banking system is already heavily reserved and balance sheets locked down. Fallout from the recent market volatility is unlikely to extend to banking system weakness. Absent this, a deep and broad recession is very unlikely.
4. The credit markets are behaving rationally and remain liquid. Although our credit market monitors are all bouncing higher, so far at least, we remain within normal ranges and in general, the markets are operating smoothly. We expect them to continue to do so, which again limits the ability of the recent softness in the labor market to cause a more systemic contraction.
5. For all of the above reasons, a deep recession seems very unlikely, and earnings growth ahead remains solid. If our bottom-up earnings growth numbers are still right, and we think they are, market upside to the end of 2025 is now getting attractive: 15% overall, and much more in the neglected value and small-cap sectors. Not enough to be max bullish, but good enough to remain confident.
6. The end game for rate cuts might be lower than we thought. If the labor market softness continues, inflation could drop even lower, perhaps to the 2% level for which the Fed officially aiming. If so, rate cuts ahead could be even greater, giving more juice to stocks. The “juice” of lower rates helps in two ways: it improves earnings for the smaller companies and the asset-heavy businesses that finance themselves off debt markets, and it helps longer-duration growth assets whose discount rates rise as rates fall. A double positive.
7. Valuations are getting more attractive, especially within the “broader market” that we like. The carnage of the last three weeks has certainly improved the valuation argument. Looking forward to 2025 earnings, the S&P has moved from 21x to 19 x; the Russell 1000 Growth Stock Index has dropped from 28x to 25x; Value from 16x to 15x; small caps from 23x to 21x; and emerging markets from 12x to 10x. 
8. A more certain political backdrop, either way, is almost upon us, just three months out. As the Presidential race has entered its last three months, polls have closed and so forward regulatory, tax, trade, and border policy is very much up in the air, as noted above. The good news though is that by mid-November it will be over and decision makers across the economy will have a much more certain outlook n the forward policy environment that will affect their investment decisions. Our view has been, along with many others, that on pure economic policy impact a Trump administration would be better for economic growth and therefore stocks. On the other hand, right now many investment decisions are being held in abeyance pending the election outcome. So simply removing that uncertainty will provide an economic boost, regardless of who wins. This would not be unusual historically. Since WWII, the S&P has responded well to the resolution of election-related uncertainty, rallying 2.3% in the fourth quarter of the election year and 9.2% in the year following the election.
9. The VIX is elevated, and spikes like this often suggest a buying opportunity. Risk indicators like the VIX tend to be contrarian signals over the long haul, and buying stocks during elevated risk periods, particularly for those who have averaged into markets at high risk levels, has been historically rewarding. So even if the precise near term bottom is not yet in, beginning to nibble here, or in our case, holding to our existing modes equity overweight, is likely to prove profitable over the long haul. No promises, but hopeful.

When you add it all up, we think it is too early to buy back the large-cap growth stocks that have been the market darlings for the past seven quarters; we doubt they’ve seen their lows. And until these stocks bottom, the market averages almost by definition cannot bottom, either. However, the market action of the past three weeks has clearly brought more sanity to stock prices, and the Fed for sure will now be fully engaged with a boat load of rate cuts ahead. The list of reasons to be positive about the market outlook, particularly the rotation into the broader market, is expanding. We are holding to our overweights there, and focusing on stock picking where the market volatility is giving our portfolio management teams opportunities to upgrade their portfolios. Our next move is likely to add further to these areas if we get either better levels or the healing effects of time following the recent precipitous drop. Stay tuned. And remain confident.