Beyond The Mag 7 – Positioning For Earnings Peaking and Yields Rising – Liz Ann Sonders

Liz Ann Sonders analyzes the current positioning of major companies like NVIDIA, Micron, and Broadcom, which are positively impacting capital expenditure numbers. However, she warns that earnings growth may face challenges due to base effects, suggesting a cautious outlook for the near term. Sonders anticipates a 25 basis point rate hike from the Federal Reserve, emphasizing that the pace of these increases will be crucial for equity market performance.

She prefers a normalization of yields over the financial oppression experienced during the pandemic but cautions that a disorderly rise in yields could trigger significant volatility in equity markets. Currently, there is a deep negative correlation between bond yields and stock prices, contrasting sharply with the positive correlation seen during the Great Moderation Era. Sonders believes we are reverting to an environment similar to the mid-60s to late 90s, where inflation volatility influenced market dynamics.

Sonders identifies the current inflation issue as primarily supply-side, expressing concern that the Treasury's actions may not align with the Fed's tightening goals. She predicts that combating inflation will take precedence over the Treasury's objectives, which are influenced by the administration. The market's reliance on a "buy the dip" strategy reflects a belief that authorities will intervene in times of trouble.

Looking ahead, Sonders highlights the significance of the months leading to the next FOMC meeting for potential rate hikes. She notes that the average equity market performance one year after the Fed begins a hiking cycle is about 4.5% positive, while rapid hiking cycles can lead to negative outcomes. Economic growth must outpace inflation and debt growth to address deficits, and Sonders warns that if inflation continues to rise, real growth will remain subpar.

Earnings growth is expected to ease from the high levels seen in the second quarter, with rapid sector rotations anticipated. Sonders notes that dislocations in individual stocks are likely to increase, leading to greater performance dispersion. While major tech stocks like NVIDIA show impressive growth, an inflection point may be approaching. Micron is highlighted as a significant contributor to S&P earnings growth, while Tesla's performance lags behind.

The desire to invest in AI has expanded beyond the core group of the Magnificent Seven, and the Russell 2000 has outperformed the S&P year to date. Sonders points out that the top 10 companies account for two-thirds of S&P earnings growth, and she emphasizes that valuation metrics are more relevant for long-term forecasts than for short-term performance. She predicts that the energy sector will outperform the tech sector by 2026.

Sonders notes that the average S&P 500 member has experienced a maximum drawdown of negative 25%, while the NASDAQ has seen a 45% drawdown. She concludes that the current market environment will likely continue to experience rotations rather than a significant drop in the S&P, indicating that this rotation has already begun.

She discusses ongoing volatility in mega-cap tech stocks, acknowledging that while there will be periods of selling, a buy-the-dip mentality remains prevalent among investors. Sonders emphasizes the importance of factor-based investing as a complement to sector-based strategies, noting that performance consistency is generally stronger at the factor level.

Sonders predicts a 75% likelihood that the House of Representatives will change hands in the upcoming midterm elections, with a 40-45% chance for the Senate. She highlights that the market typically experiences increased volatility around midterm elections, which investors should consider.

The current high percentage of household assets allocated to equities suggests a lower return outlook for the next decade. Sonders notes that the wealth effect from rising equity prices significantly influences the U.S. economy but cautions that the timing of any potential market downturn remains uncertain.

She advocates for diversification across and within asset classes in the current market environment and recommends portfolio-based rebalancing to manage performance across asset classes. Sonders expresses concern over a gambling mentality among younger investors, which blurs the lines between investing and gambling, potentially leading to a financial literacy crisis. She contrasts investing, which involves owning a stake in a company's future cash flows, with gambling, which relies on luck for windfalls. Current market sentiment shows signs reminiscent of the 2021 meme stock and SPAC frenzies, indicating a need for caution among investors.