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Morning Notes — Forecast for Now

Forecast for Now

June 1, 2020

Dispersion: The recent relative outperformance of cyclical/value sectors (Consumer Discretionary, Industrials Financials, Materials and Energy) is sending a positive signal for the US economy and equities broadly. Defensive sectors (Consumer Staples, Utilities, REITs, Health Care and Communication Services) led new record highs in the SPX last June/July. At the time, we warned that new highs in the broad market based on defensive sector leadership were unsustainable. We gave the same warning in late January/early February of this year just prior to the SPX declined ~30%. In fairness, our expectation was for a more modest pullback. Sector dispersion is an internal indicator that drives our level of conviction in a trending market. Early cyclical/value outperformance actually began in early April on peaking infection rates and expectations for stabilization in manufacturing PMIs the following week. It lasted only about a week, but reemerged in mid-May based on ongoing improvement in high frequency data. The reflationary trade from 2016 lasted more than a year and we’ve seen several head-fakes or short-term blips since. In 2016, bond yields doubled from 1.5% to 3% and oil prices more than doubled from ~$25 to $70.

More: In the short-term, cyclical/value outperformance will continue to follow high frequency data until the release of June flash PMIs on Tuesday, June 23. Because of its depressed starting point, it’s possible June PMIs will become a positive reinforcement for cyclical/value outperformance, but still not signal a lasting reflation trade. Based on the negative impact from current labor market stress, it’s reasonable to assume the recovery will stay relatively incomplete. But you don’t need to believe in a V-shaped recovery to overweight equities. Interest rates are at zero and bond yields are still below 0.70%, so a company’s future earnings are discounted at an extremely low rate. As discussed on Friday, from a present value perspective it doesn’t really matter if the economy recovers in 2020, 2021 or even 2023. A ten-year Discounted Cash Flow (DCF) valuation only cares about normalized cash flow (FCF) over that period and in the current liquidity environment (US money supply up >18% over last two months) normalized FCF estimates should only go higher.

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