The Upside: June market moves with Denise Chisholm

 

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Hello, and welcome to The Upside. I'm Jordan Chevalier.

 

 

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As global markets continue to shift what is the relationship between the

 

 

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earnings cycle and the ongoing rate story?

 

 

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Will higher rates cause some disruption in key sectors like tech?

 

 

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Joining me today to share her expertise as well as her top and bottom sectors

 

 

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is Fidelity Director of Quantitative Market Strategy, Denise Chisholm.

 

 

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Welcome, Denise. It's great to see you as always.

 

 

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Hey, it's great to be back, Jordan. Thank you.

 

 

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The first question we have here, Denise, I'd like to start with earnings.

 

 

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Now, despite everything going on globally there are some uncertainties.

 

 

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The S&P 500 is projected to deliver solid double-digit growth

 

 

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this year. Can you update the audience on exactly sort of where we're at at

 

 

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this stage of the earnings cycle?

 

 

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It's historically rare for numbers to actually come up through the course of

 

 

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the year. Usually they start off optimistic and come down through the year.

 

 

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That isn't usually predictive of what the stock market does but that is the

 

 

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historical trend. I mean, what's interesting is that you've really seen a

 

 

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strong inflection which many investors are cautious about given the fact that

 

 

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stocks are up a lot and earnings growth in an aggregate perspective has been

 

 

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quite good for the last couple of years, is this sort of the end or is

 

 

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this some sort of peak in earnings that we saw during

 

 

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the dot-com bubble? The interesting part is a lot was going on under the

 

 

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surface that was covered up by a small group of companies, by small I mean

 

 

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10 to 15%, that were growing earnings very strongly.

 

 

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The average company, actually on a trailing basis, that's not

 

 

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including these forward numbers, peaked from an earnings perspective in 2018.

 

 

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This has been the longest duration that the average or median company

 

 

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in the S&P 500 has not seen prior peak

 

 

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profits that they were.

 

 

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We certainly saw a bigger magnitude of contraction in the financial crisis

 

 

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and even in the dot-com bust. We certainly saw that during COVID.

 

 

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Even after the resurgence in average profits during COVID we still haven't

 

 

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surpassed that 2018 peak.

 

 

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It's been essentially six years of stagnant earnings.

 

 

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The interesting part  when you look historically there's a positive

 

 

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correlation, especially since the '80s.

 

 

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The longer the duration of the contraction the more likely the

 

 

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duration of the recovery is to be longer and higher.

 

 

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So much so that if you look back and say, okay, well, let's put forward

 

 

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earnings in there and say we're gonna get back to prior peaks this year, after

 

 

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you finally get back to prior peaks how long does the earnings cycle tend

 

 

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to last, it lasts on average four years.

 

 

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That is the math behind the fact that I think that there is more legs to the

 

 

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stool in terms of earnings growth.

 

 

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For the average or median company the earnings cycle could actually be in

 

 

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the early innings of something not the late innings.

 

 

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The next question we have here is are we at a peak but you're saying not only

 

 

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are we not in a peak we could in a much different situation.

 

 

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Right, and that's important as it relates to stocks because secular bull

 

 

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markets are driven by secular earnings cycles.

 

 

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The duration of the earnings recovery matters a lot and in some ways matters

 

 

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a lot more than the growth in any given year.

 

 

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If you say, well, you know, earnings growth, Denise, let's focus on, is it

 

 

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going to be 15, is it going to be 20?

 

 

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In retrospect when you look at long cycles what matters most

 

 

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is how long it lasts before it contracts.

 

 

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Does it last another two years? Does it last another five years?

 

 

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This will last another 10 years? That duration means that the longer that

 

 

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mid-cycle is, the further out it is, the more likely stocks

 

 

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are maybe expensive now but actually cheaper than you thought when we

 

 

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look back in history. This data set shows that it might, in fact,

 

 

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be a much longer cycle than you think.

 

 

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This is a good news story for investors, if I understand correctly.

 

 

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Amazing. Let's focus now on the rate story a little bit deeper.

 

 

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Do you see these higher rates and borrowing costs that are sort of expected

 

 

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in the US later this year, is there a potential that they could stall or

 

 

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even kill this mid-cycle that we're talking about today?

 

 

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That's what we were taught in Econ 101. If borrowing costs go up therefore

 

 

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you're costing corporate American more money and they're much less likely to

 

 

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hire. The interesting part about the historical data that I do is to see

 

 

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how often that holding all else equal will end up with that

 

 

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same answer. If you look through time you'd be interested to

 

 

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know that if you're an equity market investor what would you rather be

 

 

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happening, the Fed hiking or the Fed cutting rates?

 

 

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Most people pick the Fed cutting rates.

 

 

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Since 1950 on a rolling one-year basis it's actually the Fed hiking.

 

 

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Now, it's threadbare margins so you could definitely say, well, actually, in

 

 

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all the cycles over any one-year timeframe it's not the Fed that matters, it's

 

 

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probably earnings that matter. But if you had to pick one it would be hiking,

 

 

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which shows you what a lot of the data shows you.

 

 

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If the Fed is hiking because growth is higher the equity market has had

 

 

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historically no problem with it.

 

 

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The pace of advance is important as well, how much they hike, how much interest

 

 

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rates go up. 2022 is certainly the exception that proves the rule.

 

 

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When you see something like that that tends to be bad for markets.

 

 

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The sweet spot from a probability perspective is when the Fed is raising rates

 

 

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over any given year by about, let's call it, 25 to 100 basis

 

 

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points. Those are your higher odds from what the Fed does and

 

 

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what interest rates do. What's even more interesting is when you look

 

 

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at oil shocks historically there's not a clear perspective that they pass

 

 

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through into core inflation.

 

 

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If they do not, and if inflation is not a problem from a cost push perspective,

 

 

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like the way we saw in 2022, and really what the underlying dynamic

 

 

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is behind this rate rise is the fact that growth is better.

 

 

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Durable goods orders are actually in their top quartile of history since the

 

 

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1990s. We're seeing earnings numbers come up.

 

 

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If it's because of growth and jobs end up coming through,

 

 

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if it's because of growth, that's actually a good thing for the market not a

 

 

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bad thing. It's a good thing for growth because more often than not, which is

 

 

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not to say every time, these higher rates are actually a reflection

 

 

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of growth, not usually what you highlighted in the beginning,

 

 

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a deterrent to it.

 

 

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Denise, that's very interesting. Thank you very much for sharing that insight.

 

 

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The next question here, what does all of this sort of mean for tech?

 

 

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Investments in AI infrastructure, they're still driving tech sector growth

 

 

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but we've seen a bit of a sell-off continue this week.

 

 

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Question coming in here, what are your thoughts on how all of this affects the

 

 

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tech sector in the US?

 

 

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There is a general belief that the tech sector is interest rate sensitive.

 

 

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Certainly, now that they are borrowing more you could make that argument that

 

 

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it might be different. Although when you look at all the free cash flow they

 

 

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generated they're still generating more free cash flow than the entire sector

 

 

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is spending on CapEx.

 

 

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Yes, there are individual companies that you see that being different but for

 

 

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the entire sector you just don't see that spending trend.

 

 

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What's interesting ... I got a chart that was forwarded to me by I think 15 to

 

 

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20 portfolio managers that shows this very short term correlation of

 

 

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inverted interest rates and the technology sector and you have this massive

 

 

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gap. Before the sell-off over the last couple of days you saw technology

 

 

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stocks being straight up and interest rates also being up.

 

 

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That was very different from any correlation that we experienced over the past,

 

 

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let's call it 16 to 18 months.

 

 

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The interesting part for charts like that is you kind of assume when you see

 

 

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them, your eye, that has to close in what could be something like an

 

 

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aggressive correction. But we don't have to guess, we can look at the data and

 

 

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we can say how often those short term correlations don't actually impact and

 

 

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don't end up being sticky into a long term correlation, or

 

 

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the gaps close in a different way that you think, or there was some confounding

 

 

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variables, that's all statistical speak.

 

 

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Anyway, when you look back in history from the 1990s and you say, well,

 

 

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technology's got good growth now, we know that, and let's just assume that we

 

 

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know what's going to happen to rates. Rates are going to be higher or rates are

 

 

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going to be lower. How does the tech sector do?

 

 

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We have good growth now, higher rates.

 

 

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It generally outperforms by about 500 basis points on average with 61%

 

 

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odds.

 

 

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The interesting thing in terms of the verticals of the data is that higher

 

 

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rates are better than lower rates.

 

 

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In fact, the worst position when you look on any rolling one-year basis

 

 

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for technology stocks is actually good growth with

 

 

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rates going down, which is the exact opposite I think what

 

 

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many investors would expect.

 

 

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The interesting part is almost that rates ...

 

 

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back to the first question you're asked, or the second question ...

 

 

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confirm the cycle rather than deter

 

 

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the cycle or end up in the borrowing cost.

 

 

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The final thing that I'll say, especially with the pullback that earnings

 

 

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are still coming up, you're seeing tech stocks do something that they certainly

 

 

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didn't do in the bubble, they're in the bottom half of their distribution on

 

 

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relative forward P/E. So they are, I would call it statistically cheap, in

 

 

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the bottom half of the distribution. That adds to that 500 basis points of

 

 

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alpha by about another almost 500 basis points and raises your

 

 

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odds from 60% odds of outperformance being tech leadership to close

 

 

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to 80. Look, 80% is not 100, there's no guarantees in investing,

 

 

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but I would say based on the data that I'm seeing higher interest rates do

 

 

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not need to be a headwind to technology stocks when you look through history.

 

 

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Denise, that's very interesting. A great place I think to end here, as always,

 

 

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is the top and bottom sectors.

 

 

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I'm guessing if we start with the top sector we might stay with tech but over

 

 

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to you, I don't want to keep you.

 

 

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So top sectors and then we'll go to bottom.

 

 

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It's interesting. Every time I say that maybe there's something better for tech

 

 

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to buy it gives me a sell-off which increases the valuation.

 

 

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I'll say number one and two, technology and industrials.

 

 

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Industrials are really intriguing. Much like that average earnings contraction

 

 

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the manufacturing economy has also been stagnant for the better part of three

 

 

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years and now starting to recover.

 

 

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That's closest tie to the industrial sector.

 

 

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This is going to be a twist because I haven't said this third one before, some

 

 

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parts of the material sector are looking interesting to me for the first time

 

 

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in a very long time, steel and copper.

 

 

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I say that because they're having the opposite of a CapEx cycle.

 

 

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They're starting to cut CapEx at trough margins or trough

 

 

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profitability. It's very likely with that combination that they're to

 

 

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generate more free cash flow in the future, better profitability in the

 

 

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future, and that improves the risk-reward. So top three are technology,

 

 

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industrials and some parts of the material sector.

 

 

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Bottom three is still energy. We've talked about that before.

 

 

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I still think that the risk-reward is negative.

 

 

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I'm still gonna pick on the defensive sectors like utilities and consumer

 

 

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staples. I think the risk-reward is still negative there as well.

 

 

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Denise, as always, thank you very much for sharing your insights with us today.

 

 

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Great to be here.

 

 

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Okay, we'll see you next time. Thanks again.

 

 

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