The Week Behind

PCE was soft; Powell was dovish; it was a good week for stocks even if the S&P and NASDAQ experienced flat weeks. My optimism stems from the Dow’s 2.5% gain this week. The Dow’s outperformance, following a period of underperformance, indicates the market’s breadth is expanding, which is a positive indicator for a durable rally. This broadening allows for underappreciated stocks to catch up as the hottest stocks in the market catch their breath before potentially advancing further. 

Highlights 

• Q3 GDP was revised up to 5.2%, surpassing consensus by 0.2% and the preliminary reading by 0.3%. Typically, an upward revision would stoke inflation concerns and pressure stocks. However, the net-upward revision showed a decrease in consumer spending but an increase in productivity, which portrays a relatively benign inflationary scenario.
• PCE aligned with expectations, providing additional support for the Fed to maintain interest rates at December’s FOMC meeting.
• The market responded favorably to Powell’s Friday commentary. He acknowledged positive inflation trends but emphatically rejected expectations for interest rate cuts in 2024.

Opportunity in Rotation

While the major indices closed the week in positive territory, the Magnificent Seven (M7) experienced a rare dip. Rather than raising the alarm, the slight weakness can be interpreted as a healthy pause, prompted by investors taking profits to explore opportunities with more upside.

Where can this upside be found? Three broad areas come to mind.

Small and Mid Cap: Once considered too risky relative to the M7, these stocks now appear as prime catch-up trade candidates. With the “easy money” made in the M7 and a more certain macroenvironment, the thesis for small and mid-caps becomes more compelling. I believe the best way to tap into this potential is through a low-fee ETF.

Personally, I am long VTWO, Vanguard’s Russell 2000 ETF.

Consumer Discretionary: Black Friday and Cyber Monday sales figures suggest a robust holiday season ahead. The bustling crowds and lengthy store lines I encountered during my Black Friday shopping even tempted me to consider a retail darling that could catch a bid into year-end as the holiday sales narrative gains traction.

I don’t currently hold any positions in consumer discretionary stocks related to this opportunity.

Bond Proxies: REITs and utilities faced pressure as the US10Y hit multi-year highs in October. With yield concerns easing as the Fed pauses, typical bond equivalents may experience a positive rerating (multiple expansions), especially if yields decline further. Stay away from REITs with office exposure due to default concerns surrounding office tenants in a post-COVID environment.

In the REIT space, I am long Federal Realty (FRT) and Realty Income (O). Regarding utilities, I am long NextEra (NEE).

The Week Ahead

As we approach year-end, activity tends to slow down. Earnings season is behind us, institutional managers are preparing for annual client reviews, analysts are busy publishing their 2024 outlooks, and the Fed is currently in a blackout period. Nevertheless, this week’s jobs data demands attention. “Bad news is good news” is likely to remain the bull’s motto, as such a scenario would solidify the Fed’s commitment to a pause.

Macro Releases:

• Job Openings (JOLTs, Tuesday): The median forecast anticipates 9.4 million job openings. In the previous month, JOLTs reported 9.55 million open positions.

• ADP Employment (Wednesday): Although the headline job creation is forecasted at 120k, up from the prior month’s 113k, the spotlight will likely be on wage statistics for “job stayers” and “job changers.” Ideally, wage inflation continues its trend of compression observed since late last year.

• Nonfarm Payrolls (Friday): Three key metrics – job creation, unemployment, and hourly wages. Consensus expects job creation to reach 190k, a significant increase from the 150k reported last month. Unemployment is projected to remain steady at 3.9%. Average hourly earnings are expected at 3.9% on a yearly basis and 0.3% on a monthly basis.

Micro Releases: 

• Toll Brother (TOL, Tuesday): TOL, a residential and commercial property builder in the luxury segment, may not be the primary source of relief for housing costs, but their quarter and commentary provide insight into housing trends and, by extension, inflation.

• Broadcom (AVGO, Thursday): Ranking second only to Nvidia, AVGO holds a strong position to benefit from AI spending. Despite the recent VMware (VMW) acquisition, AVGO sits 7% off its recent high. Concerns linger about Michael Dell, who owned 41% of VMW after Dell (DELL) spun it off in 2021, potentially selling his new stake in AVGO. If I were Michael Dell, choosing to convert my VMW to AVGO instead of opting for the cash offer, I would likely view AVGO as too cheap to sell at this point. I expect AVGO’s earnings to remind us of how inexpensive the stock is relative to its growth potential, propelling the stock higher.

A Nice Window

We are at the beginning of a favorable period for stocks: the Fed appears finished, and the associated impacts have yet to materially impede economic growth. Consequently, the Fed is no longer the central narrative or a direct adversary for stockholders. That is not to say yields have lost influence. After all, the recent surge was prompted by concerns over government debt, not Fed policy. Unless inflation brings the Fed back into the equation, the primary narrative will become “recession watch”, particularly as the yield curve reverts.

From my perspective, this grants companies greater control over their stocks’ destinies. A neutral Fed affords earnings performance and guidance the benefit of the doubt. Without the Fed as a trump card for bears, it becomes significantly more challenging to dismiss robust earnings as fleeting.

Of course, all good things must come to an end. This window will close as we approach the first interest rate cut, which will occur in one of two ways. First, if inflation recedes enough for the Fed to declare a definitive victory, the Fed will cut to bring the currently “restrictive” policy into a “neutral” stance. Second, if unmistakable signs of a recession, likely via unemployment, surface, the Fed may cut to safeguard the economy.

Undoubtedly, we hope for the first option. Regardless of the outcome, I anticipate many institutional managers will sell in response to the first cut. To be fair, envisioning a straightforward scenario is challenging. Straightforward and the stock market sometimes feel mutually exclusive. Historical analogs advise “sell the first cut”. Even though this cycle doesn’t neatly align with any prior analog, the risk-reward for professional managers is clear. A misjudgment against the analog could jeopardize a career; a correct call might yield a relatively obscure industry award. The potential career upside doesn’t compare to the downside, underscoring the importance of acquiring enough knowledge to either manage your portfolio or monitor those entrusted with the task.