Stocks to buy before earning season

This story originally appeared on Best Stocks

Big bank earnings

The indexes are still trading strongly, but within a narrow range. The S&P500 is bouncing around in a 3% band in the contested territory between consolidation and breakdown.

CPI data were close enough to forecasts to avoid a real market scare, but there was enough stickiness in core-inflation categories like rent to prevent a strong relief response. It’s worth noting, however, that just as the crowd is increasingly shifting to the “higher for longer” inflation camp, we’ll be approaching the anniversary of the very hot CPI prints of Q1 2021 in a few months.

Inflation is defined as “this year vs. last year,” so a natural drag will begin early next year, just as the Fed is halfway through the tapering process. It’s a little early to believe that the Fed will be desperately chasing inflation in a year.

The Treasury curve is still pricing in the possibility of an earlier first Fed rate hike (possibly next fall), with the 2-year yield reaching its highest level since March 20, 2020, at one point. A flatter curve reflects the possibility of an inflation-fighting Fed and a muddled growth picture as a result of supply chain/energy headwinds.

Longer-term softness is most likely a cover story for today’s tech rally, which includes both profit-rich FAANG and lottery-ticket expensive-growth specs. Semis have been trading poorly back toward wintertime levels, with only a minor bounce so far today.

The above-mentioned attempt at traction is visible in the continued firmness of market breadth and outperformance by the equal-weighted S&P (+1.5 percent this month vs. +1 percent for the master index). The “average stock” isn’t exactly taking the lead, but it, along with the strength in cyclical groups vs. defensives, gives some ammunition to those who believe we’re just in a seasonal, rotational transition to an economic reacceleration and eventual Q4 equity rally.

Question about supply chain: Are we closer to the middle or end of this theme as a market-moving force when the White House finally steps to the fore on the issue, after cover stories in Barron’s and The Economist have shown alarm over the clogged, shortage-plagued goods economy, and months into a process when auto companies, Walmart, and FedEx have been fashioning workarounds?

Here’s your initial “sell the news” reaction to big bank earnings, which is likely to be worse due to long rate slippage on the same day JPM reports a good quarter. The S&P banks sector is still up 3% this month, with no game changers on the horizon.

Based on this Ned Davis Research sentiment gauge, energy stocks are curling lower after massive runs, crude is taking a breather, there is some talk of demand being pinched globally with the recent price rise, and short-term traders are pretty bullish on the sector:

Ned Davis Investigations

As previously stated, market breadth is adequate. The NYSE + Nasdaq advance/decline line appears to be around 3,800/3,100, with advancing stocks accounting for slightly more than half of the volume. In a few hours, we’ll see if the pattern of late-day fades erodes these numbers.

VIX slipping, near 19, difficult to stay aloft with small daily moves lately, but elevated above “easy, peaceful” levels for another week or so given the short-term six-week downtrend and unsettled seasonal period.

“Today, there are two stock markets. You’ve got the one I grew up with. “I went to business school and learned about discounted cash flows and companies’ ability to pay dividends while growing,” Sternlicht said.

“And then you’ve got a full-fledged casino society.” “It’s a complete, total speculative bubble, whether it’s meme stocks or some of the multiples on tech companies that are unfathomable,” Sternlicht said.

The meteoric rise in meme stocks such as AMC Entertainment and GameStop earlier this year sent shockwaves across Wall Street. A group of retail investors who coordinated trades on social media platforms managed to skyrocket the share prices of these heavily shorted names. This year, GameStop has gained more than 800%, while AMC has gained a whopping 1,600%.

Sternlicht, the chairman and CEO of Starwood Capital, sees echoes of the warning signs that preceded the dotcom bubble burst in the 2000s.

“A large number of companies are losing money even though their market capitalization is at an all-time high.” “There are a lot of warning signs that we’re in the 2000s and 2001 before the Nasdaq fell 82 percent,” Sternlicht said.

The Nasdaq Composite, which is heavily weighted toward technology, is up more than 12% year to date, but is still about 6% below its all-time high set in early September. According to FactSet, the benchmark is trading at more than 28 times forward earnings, down from a multiyear high of 35 times in August 2020.

Earning season is good for boosting stocks 

As has been noted in recent days, the market has been firming beneath the surface since the low early last week (better breadth, cyclical stocks steady, credit spreads unconcerned) even as the big-cap indexes remained stuck, implying that last Monday’s low could be reliable.

We didn’t get the “expected” late-day sell-off yesterday, which suggested there was still room to break the pattern of lower peaks in every bounce attempt. Yesterday, despite a slightly hot CPI print, an Apple production cut, and more supply-chain/energy-shortage hyperventilation, the market failed to break the tape.

I’ve been saying for a few weeks that the September-October downside chop has shifted sentiment from complacent (which is risky for the market) to concerned (which becomes a tailwind for stocks), as overbought growth stocks pulled back and the market worked to price in sticky inflation and a third-quarter slowdown – but also the incipient reacceleration caused by a crash on Covid cases.

The S&P500’s 6% drop belied far more corrective payback beneath the surface, with the vast majority of stocks down 10% or more from highs.

All of this being said, the market is now merely rushing to the next “obvious” technical test. Now right at the flattish 50-day average, having broken the short-term downtrend and surpassed last Thursday’s October high for the time being. Also, right in the zone where options dealers are supposed to switch from net sellers to net buyers, though not yet decisively.

Even as yields have cooled, confident/optimistic commentary on consumer activity in bank earnings calls has lifted macro sentiment. As most seem to expect, earnings season will be noisy and hit-or-miss, but weak price action into the reports may be a better set-up than the previous few quarters when we went in at record highs.

Again, for market purposes, the supply chain stuff may be nearly priced in – a shift to services spending now could relieve some of the pressure while still maintaining respectable growth rates. Similarly, the “trade war” drama of 2018-2019 was a nagging background concern, a source of occasionally jarring headlines but not a key driver of overall market direction.

The majority of this is positive, but we now have a more active two-way debate on inflation and whether the Fed will have to tighten policy earlier/quicker than expected. The S&P500 is still only recently returning to levels last seen in early August.

Tactically, today’s bounce is a step forward for the bulls. After we get through this expiration week, seasonal patterns begin to improve. Last year, we got great bounces after the Sept. 2 peak (the same date as this year’s high), but we didn’t get a good low until Oct. 30. I’m not saying we need a rerun; I’m just pointing out the precedent.

Given 1.5 percent index gains, market breadth is good but not overwhelming. Basically, the volume is 3:1 up:down. Credit is rallying nicely, and stocks haven’t budged much in recent weeks.

The VIX reacted appropriately, falling into the 17s. The VIX futures still have a lot of juice (November VIX above 20), indicating hedging demand, which is a net positive for the equity market when things look this good.

“In the coming months, we believe that inflation trends and their impact on the Fed will be the most important drivers of overall market returns, sector rotation, and thematic performance.”

Senyek advised investors to look for companies with strong pricing power when it comes to positioning.

Wolfe Research looked for S&P500 stocks that it believes have the most pricing power, which focuses on companies with high gross margins.

“The screen below includes S&P 500 companies that (1) have produced gross margins in the top quintile of their industry group over the last three years, and (2) reported a gross margin during the 2Q21 earnings season that was higher than their pre-pandemic gross margin reported in 2Q19,” Senyek explained.

Take a look at this list:

Wolfe Research’s screen displays several retailers, including Coach-parent company Tapestry, Ralph Lauren, and e-commerce retailer eBay.

Coca-Cola, McDonald’s, Walmart, and Constellation Brands are among the food companies on the list. Earlier this year, Coca-Cola CEO James Quincey told that the beverage giant would raise prices to offset higher commodity costs.

Wolfe Research believes that Facebook, Adobe, and NetApp are the technology companies with the most pricing power. Adobe has the highest gross margins among the stocks on the list.

Taxes could slow down the market

On Thursday, David Kostin, the firm’s chief U.S. equity strategist, said that stocks will return another 6% this year, bringing the total return for 2021 to more than 20%.

However, he added that stock returns will slow to 4%, while earnings will grow at 2%.

That forecast is based on Goldman’s assumption of a corporate income tax rate of around 25%, up from the current rate of 21%. The bank’s model includes an international tax rate as well.

“That is a pretty modest, pretty muted level of earnings growth,” Kostin said, “and a lot of that is a function of tax reform.” “If we didn’t have tax reform… we’d have earnings growth of around 7%.”

He has previously stated that higher taxes in 2022 are a major concern that investors should take more seriously. To help pay for a $3.5 trillion reconciliation bill, Democrats have proposed raising the corporate tax rate to 26.5 percent. Furthermore, world leaders recently agreed to a global corporate tax rate of 15%.

Kostin believes that despite the tax threat, equities will continue to post gains as supply chain issues are resolved and more companies buy back stock.

Complexity of the supply chain

Companies face more than just the prospect of higher taxes. There are also supply chain issues, which are causing bottlenecks for consumers and endangering a number of businesses.

Investors looking for an opportunity amid supply chain issues, according to Kostin, should look to companies with stable margins. Some technology names have a 15% to 30% upside because they don’t have the supply chain issues that have plagued many software companies, he says. Oracle and Synopsys are two examples given by Kostin.

“The big focus is understanding who is more or less vulnerable to supply chain disruption and whose margins are more at risk,” he said.

He added that some industrial companies are likely to benefit from strong pricing power.

Broadcom gets upgraded

“Given the increasingly uncertain consumer demand and cost environment, we believe Broadcom’s 1) outsized exposure to cloud/enterprise/telecom spending; 2) pricing power (i.e. industry-leading gross margins) supported by its scale advantage and robust competitive position; and 3) FCF generation (i.e. FY22E FCF yield of 7.6 percent) and capital return profile will drive a relative re-rating in the stock,” according to the note.

Chipmakers and their customers have been hampered by a global chip shortage, which has reportedly hampered production of the new iPhone 13, as well as automobiles and other products.

Broadcom’s strong margins should be even more appealing to investors in this current environment, as they seek companies with room for error in cost management, according to Goldman.

“The company’s gross margin reflects management’s intense focus on differentiation and leadership.” Not only does Broadcom have the highest gross margins within our coverage universe, but it has also done so with little variability over the years.

Over the last three months, however, it has outperformed both of those.

Goldman raised its price target on Broadcom from $527 to $589 per share.