The Week Behind 

It was a tough week for the bull case. August CPI revealed inflation is stickier than the bull’s anticipated, thus implying the FED will need to tighten conditions further, which sent the US2YR to highs not seen since 2007. FedEx (FDX) preannounced ~30% Q1 EPS miss, providing bears their first piece of non-anecdotal evidence that forward earnings need to be revised significantly lower. The daily headwinds generated assertive selling pressure with each consecutive session. The result was an orderly sell-off with meaningful magnitude across the major indices: the Dow lost 4.13%; the S&P 4.77%; and the NASDAQ 5.48%. 

Highlights

• While Headline CPI continued to decline, both Headline and Core came in above consensus. Most core categories increased MoM, suggesting core inflation will be stickier than previously anticipated. 
• CPI sparked speculation of a 100bps hike at September’s FOMC meeting, which sent the US2YR to 3.92%, a 15-year high, and repriced the terminal FED Funds range 25bps higher to 4.00 – 4.25% (was 3.75% – 4.00%). 
• The U.S. railroad union and the Biden Administration secured a tentative deal, averting a strike that would have worsened inflation. U.S. rail workers have agreed to work for the next several weeks while union representatives vote on the tentative deal.  
• Despite ~4-5% losses, the sell-off lacked panic. The VIX was capped at 28, well below levels associated with panic. There was only one intraday instance of 90-10 declining-advancing issues (90% of stock in the red, 10% in the green). 

Are The Low’s In Question?

After another week in the red, the call is growing louder for a retest of June’s lows. The first I heard make this call was Scott Minerd, Global Chief Investment Officer of Guggenheim. He expects we could see a 20% decline by the middle of October, bringing the S&P to between $3,000 – $3,400. At these levels, however, Scott admits he would be a buyer. 

As of Friday’s close, assuming $222 EPS, the S&P500 has a P/E of ~17.5.

Friday: 17.5 x $222 = $3,885. 

With core PCE between 4-5%, as it is now, Scott’s research suggests the S&P500’s P/E should be ~15.2x. 

Scott’s Thesis: 15.2 x $222 = $3,375.

Scott’s Thesis with 10% Reduction to EPS: 15.2 x (222 x 0.90) =~$3000.

In summary, if valuations compress to reflect the inflationary backdrop, the S&P500 would drop ~15%, breaking June’s lows of ~$3600 in the process. While you could argue that earnings will surprise to the upside, thus increasing the $222 EPS, providing a higher S&P500 target, many would argue exactly the opposite. FDX’s 30% EPS miss supports the view that earnings will trend lower. 

That being said, after reading through the report, I think this 30% miss is 60% macro-driven and 40% micro-driven: poor execution at FDX deserves ~40% of the blame. Consequently, while it would be prudent to note the direction of FDX’s earnings, it would be overkill to apply their 30% miss to other S&P500 companies. 

In my view, this is the most compelling case to break June’s low. After all, stock prices follow earnings. However, that tends to be a slow process. For this to happen as rapidly as Scott suggests, there likely needs to be a downside catalyst. 

The Week Ahead

While this week has a healthy dose of earnings, the main event will be Wednesday’s FOMC Meeting: rate hike decision at 2PM; Powell’s presser 2:30PM. The market expects 75bps and is priced for it. Price action will likely depend on perception of the presser. While I expect Powell to maintain a hawkish posture, there is growing concern surrounding overtightening. Interest rate hikes and QT have “long and variable lag”. If the FED includes some language surrounding that caveat, the market may find some comfort. However, if the FED is perceived as unrelentingly or rigidly hawkish, markets likely move lower on worries of a harder, FED-mandated recession. 

As The Facts Change, You Should Change With Them: Treasury’s Time To Shine

As the facts change, you need to change with them. In the past, I have insisted we are range bound. That assumed a certain fact set. This fact set did not include a bellwether company like FDX, whose performance has implications on a broad range of sectors, miss earnings by 30% and call for a global recession. More importantly, it did not include the rapid formation of the most attractive treasury market I have ever witnessed in a matter of weeks while stocks did very little repricing. If we see treasuries continue to become more attractive at all durations, then eventually we can expect yields to reach a level that forces stocks to reprice, breaking June’s lows. 

On one hand, balance sheet reduction, which intensifies at the beginning of October, would put upward pressure on the US5YR and US10YR. Both of which have yet to break out above this year’s highs. It could be a timely catalyst for Scott Minerd’s call. On the other hand, some believe the bond market has gotten ahead of itself, pricing in more tightening than the FED will achieve. 

Concisely, one camp believes the stock market is mispriced; the other believes the bond market is mispriced. One thing is certain, the stock market and bond market do not agree. It is possible both are mispriced, but one needs reprice to better reflect the other.   

I am not sure which camp will win out in the short term. However, I struggle to find any reason why markets should break August highs; whereas, there are potential catalysts mounting that provide justification to break June lows. I think the Q2 playbook, which provides strict criteria for stock selection and capital deployment, I outlined in a previous brief remains viable.

That aside, we now have access to the most attractive U.S. Treasury Market in recent history. Between 1-month and 2-years, treasuries yield ~2.5% to ~4%. Given market volatility, even with inflation where it is, I prefer this investment to certain stocks. While the getting is good, I recommend you get.

I have been rolling ½ my cash position in 3 month treasuries yielding ~3.2%. While I understand inflation is above that mark, I consider these treasuries superior to many utilities and consumer staples, especially those with above-market valuations. Typically, these stocks are owned for their price stability and dividend yield. At current valuations, the price stability of these stocks is in question. The dividends they provide can now be replicated or even beaten by a risk-free treasury.  

Furthermore, in the event the FED causes a steep recession, there is the possibility the FED cut rates. As bond yields go down, their face values go up. In other words, if we do see a recession, chances are you’ll be able to sell your treasuries at a profit on the secondary market before maturity.