Stocks are on the path towards new records, even with Fed and inflation worries increasing

Traders working at the New York Stock Exchange (NYSE), today, Wednesday, April 21, 2021.

Source: NYSE

Even with headwinds from the Fed and inflation, a booming economy and strong earnings should send the market to a series of new highs this summer.

The S&P 500 was lower Monday as the market meanders ahead of next week’s Fed meeting. The S&P 500 was slightly less than 20 points below the May 7 high of 4,238 in early afternoon trading.

“I’m pretty optimistic about U.S. equities,” said Adam Parker, founder of Trivariate Research. He said there are four reasons, including an accelerating economy, strong earnings growth, an accommodative Fed and stimulus.

A sure tell that the market has a ways to go is the very behavior of corporate managements, Parker said.

“In terms of the things that usually make somebody successful at calling a market top, I would think it’s hubris and debt; management arrogance gone awry; too much capital spending; too much inventory; fancy new headquarters; hiring all the Harvard MBAs at the top of the cycle,” he said. “Those things defined management behavior at the top. You don’t see any of that today. I don’t see any signs of corporate excess.”

Tech boost?

The S&P 500 has been edging near its high and got a boost Friday after the May jobs report. Tech rallied but it lost steam Monday on news that G-7 agrees to a minimum corporate tax rate of 15%, more than some big cap tech companies now pay. The sector was down about a quarter percent. The worst performing major sector Monday was materials, off 1.2%.

Scott Redler, who follows the market’s short-term technicals, said he expects the S&P to make new highs shortly, but tech needs to give it a boost.

“Hot numbers, sell tech. Mediocre numbers, stay in line with tech. Soft numbers, buy a little extra tech. That’s been the flow of funds,” he said. “It’s not a perfect trading world and stock selection matters. You had a double bottom in the S&P…it’s been a very tradeable market since the double bottom was confirmed May 19.”

He said that low of 4,056 is now a strong area of support. He said the next couple of days will be important to see whether tech can pick up and follow through with the boost it got from the jobs report. The 559,000 payrolls added in May was stronger than April, but less than expected and unlikely to prompt the Fed to move off of its easy policies.

Inflation trade

Parker said he likes cyclical sectors – energy and materials – the most as inflation plays.

“They have good price momentum, upward revisions and attractive valuations versus history. That’s the triple crown,” he said. “The stars haven’t aligned this much in the last 10 years.”

He said there’s also a place for big cap tech like FANG and Microsoft in the portfolio though some investors have been paring back.

“I like businesses that are beating number, that are reasonably cheap, and that have dominant franchises. They are 20% of the market…They’re probably undervalued,” he said.

Inflation has been a top concern for investors, as the economy heats up and corporations discuss shortages and rising materials costs. The consumer price index is reported Thursday and the headline number is expected to reach 4.7% on an annual basis, according to Dow Jones.

Fed officials have argued that the hot inflation data is temporary, due to short-term supply chain issues and comparisons to last year’s weakness. The current quarter’s GDP growth is expected to be the strongest this year, with economists expecting average growth above 9%.

The Fed’s June 15 and 16 meeting has been hanging over the market, as investors wonder what Fed officials will now say about inflation. Some investors worry the central bank could hint that it is getting ready to begin the process of stepping away from its bond buying program sooner than expected.

If the Fed moves towards paring back its $120 billion a month in Treasury and mortgage securities, the process is expected to take months. But it is seen as a precursor to an eventual interest rate hike, expected by the market in 2023.

“I think the Fed could catalyze a rotation within the market,” Parker said. If the market believes the Fed that inflation is just a transitory trend, investors could sell some of the cyclical inflationary names. If the Fed is hawkish, some tech and growth names could be hurt.

“Don’t own growth stocks that have negative cash flow or don’t have margin expansion,” Parker said. “That’s the stuff that’s going to be hurt most if you have a directly hawkish Fed.”

Ed Keon, chief investment strategist at QMA, does not expect the Fed to ruffle the market next week.

“I think their position is crystal clear,” said Keon. He said the Fed will not move toward tapering its asset purchases yet, and it has emphasized it will keep policy easy while the economy improves. It also has indicated it will tolerate inflation above its 2% target for a period of time, and whether inflation is transitory is yet to be seen.

“Some of us are worried it may be more than transitory and that’s going to depend on the job market,” he said. The labor picture and outlook for wage inflation may become more clear as some states back away from extended unemployment benefits, and the extent of the labor shortage is known, he said.

Keon agrees that earnings strength will continue to fuel the market for now. His personal forecast is for 40% earnings growth his year. “When you’re getting that kind of earnings growth, it’s hard not get a bull market and rates continue to stay low. Low interest rates, booming earnings. You can still have a strong stock market and price to earnings falls over the course of the year,” he said.

Rising earnings could make the market appear cheaper, based on the price-to-earnings ratio.

“The basics are extraordinary earnings growth, a strong economy, low interest rates. That makes for a bull market. Even though there are things to worry about, this is still a bull market,” he said. “A lot of folks freak out when the market goes down 3%. On average, the stock market has a 10% pull back once or twice a year. It’s not an unusual thing.”

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