SPY - Betting Big: Fed Mayhem And My Personal Picks For 2024

2023-12-15 09:25:00 ET

Summary

• The Fed's dovish shift, signaling rate cuts, fueled a market rally. Investors are optimistic about returning to a more normal economic scenario. However, this comes with (hidden) risks.
• With a subdued market outlook, I focus on quality dividend stocks, emphasizing energy, cyclical, and defense sectors, while cautiously approaching specific growth stocks.
• Despite the rally, I stay vigilant on risk/reward dynamics. The S&P 500's top-heavy structure and volatile rate expectations pose challenges and risks of a subdued long-term total return.

Introduction

Earlier this month, I had the pleasure of writing a 2024 outlook with Seeking Alpha. In addition to my economic expectations for the new year, the Q&A-style article included my view on the Federal Reserve and my investment strategy.

After receiving many requests, I decided to dig a bit deeper and provide investors with a more detailed overview of my investment strategy, including sectors and specific picks.

On top of that, I'm combining this with the recent decision of the Fed to clearly communicate its intent to cut rates three times in the new year, which has provided more fuel for the ongoing stock price rally.

Although I have consistently added to my favorite investments this year, I have also increased my war chest, giving me the biggest cash position since I started my long-term portfolio.

Currently, I'm sitting on 14%, which excludes my reserves for the tax man.

In this article, I'll explain how I'm planning on investing my cash and what we need to make of the current Fed-fueled stock market rally.

I'm planning on deploying more cash in 2024 and in any prior year.

So, let's get to it!

Predicting Stuff Is Tough

Trying to predict anything is tricky. The more variables we're dealing with, the tougher it becomes.

Generally speaking, I believe that humans are incapable of making consistent long-term predictions - regardless of whether you're a multi-billion dollar fund manager or a hobby investor with an account balance of less than $10,0009.

Nonetheless, we continue to try to predict the market. After all, without an opinion, we cannot make any trades or investments.

Imagine if I answered "I have no idea" if someone asked me why I'm buying stock XYZ!

The problem is that even if we were to be able to completely nail the economic forecast a few times in our lives, there's another layer to it: picking the right stocks.

To quote one of my favorite investors, this is what Howard Marks wrote in his memo titled The Illusion of Knowledge :

The truth is that humans can hold only a few things in their minds at any given time. It's hard to factor in a large number of considerations and especially to understand how a large number of things will interact (correlation is always the real stumper).

Even if you somehow manage to get an economic forecast correct, that's only half the battle. You still need to anticipate how that economic activity will translate into a market outcome. This requires an entirely different forecast, also involving innumerable variables, many of which pertain to psychology and thus are practically unknowable. According to his student Warren Buffett, Ben Graham said, "In the short run, the market is a voting machine, but in the long run, it is a weighing machine." How can investors' short-run choices be predicted? Some economic forecasters correctly concluded that the actions of the Fed and Treasury announced in March 2020 would rescue the U.S. economy and trigger an economic recovery. But I'm not aware of anyone who predicted the torrid bull market that lifted off well before the recovery got underway .

Having that said, I make predictions all the time, which is contrary to what I just said.

However, when I make predictions, I try to make low-risk predictions that help me make portfolio decisions.

For example, even if I were to predict a steep market correction, I would not go short or sell any of my long-term investments. After all, if there's one thing that has made investors money, it's the fact that time in the market beats timing the market!

For traders, other rules apply.

Furthermore, I focus on the big picture. I do not really care what my investments do on a mid-term basis. I also do not care about daily swings and I'm convinced that we only need to focus on less than 1% of the news that is thrown out way each day.

When I make predictions, I mainly try to find which sectors may do well and what I can expect from the long-term risk/reward for the stock market.

In 2020, for example, I aggressively bought undervalued energy and value stocks, as I expected massive stimulus and economic reopenings to fuel inflation.

That turned into reality, allowing me to outperform the market over the past three years.

I also focus on leading economic indicators that indicate at what point of the economic cycle we may be. This includes the leading ISM Manufacturing Index, regional surveys, consumer sentiment, and related indices.

This matters because the year-over-year performance of the S&P 500 is highly correlated to the ISM index, as we can see in the chart below.

However, because this is such a reliable indicator, investors are increasingly trying to time the bottom and peaks, leading to a situation where investors can only generate alpha if they buy before a bottom pattern becomes obvious.

Even worse is that the Federal Reserve has become increasingly important in the past few decades. Currently, making stock market predictions involves betting on what the Fed may be up to next, which brings me to the next part of this article (before I tell you what I'm buying in 2024).

What Did Powell Just Do? Are We Back To Normal?

If there's one thing this market wants, it's going back to normal. In this case, "normal" implies the economic situation we had between the Great Financial Crisis and the pandemic.

This mainly included subdued inflation, consistent economic growth, and supportive central banks in the U.S., Europe, the U.K., and Japan.

Now, it seems like we're going back to normal, at least according to the market.

Although markets have been betting on a pivot for a few months, the most recent press conference from Fed Chairman Powell caused investors to bet on a rebound.

As reported by Bloomberg , after years of discord, Wall Street traders and the Federal Reserve find themselves in rare alignment, anticipating a monumental monetary shift in the world's largest economy.

The Federal Reserve's announcement of a definitive end to its historic tightening campaign, coupled with projections for more aggressive interest rate cuts in 2024, set off one of the most significant post-meeting rallies in nearly 15 years.

Essentially, the Fed is telling the market "You guys are right, it's time to cut rates."

Or, to put it a bit more professionally:

"The Fed delivered a satisfying year-end finale for both bond and equity bulls. It suggests smooth sailing for risk assets into the end of the year not only in the US but also across emerging markets." - Macro Strategist Mary Nicola (via Bloomberg)

What's interesting is the Fed's dot plot, which shows what FOMC members expect to happen to rates down the road.

As we can see in the chart below (made by market expert John Authers ), the Fed has become very dovish over the past three months. Its rate expectations for 2024 have significantly shifted lower. Nobody expects rates to be above 5.5% anymore.

As one can imagine, Chairman Powell's press conference played a pivotal role in signaling the Fed's shift.

Powell acknowledged that the Fed was now in "restrictive territory," emphasized the need to start cutting rates before inflation hits the 2% target, and expressed a heightened focus on the risk of keeping rates too high for too long.

Going back to the dot plot, this is what the long-term dot plot looks like:

As we can see above, the Fed (the green line) expects rates to gradually decline to 2.5% after 2026.

Even more interesting, the Fed seems to be more dovish than the market after 2025 as Fed funds futures (the white/grey line) are roughly 50 basis points higher for 2026.

Speaking of the market, for 2024, the market is way more dovish than the Fed.

Looking at the chart below (based on Fed funds futures), we see that the market expects no less than six hikes.

The market is very euphoric as it sees a chance for everything to go back to normal. I think the market believes it has gotten the go-ahead to jump into everything that benefits from low rates again.

For example, my Extra Space Storage ( EXR ) investment was down more than 30% just three months ago. Now, I'm up more than 3%. It's up more than 27% since my most recent bullish article .

On a side note, it's a stock I want to buy much more of if I get another correction opportunity!

Having said all of this, we need to be careful here. Very careful!

For starters, rate expectations are very volatile.

The chart below shows the implied probability of >4.50% on Sept. 18, 2024. Currently, that number is below 20%. It was close to 100% in September and October. During the spring months, it was at zero.

In other words, these expectations are volatile in general.

The belief that inflation may remain sticky could send these odds soaring again.

Here's another perfect example of markets having no clue about the future (why I just discussed about our inability to predict the future):

Furthermore, the expectations of lower rates are inflationary. After all, it results in a weaker dollar, which supports dollar-denominated commodities (among other reasons).

The last time the dollar weakened (I'm using the EUR/USD in the chart below), it caused oil to rally to more than $90.

Right now, financial conditions (as measured by Goldman Sachs) are back to normal levels.

Meanwhile, core inflation is still at 4%!

To reiterate, the market is expecting six rate cuts in an environment where tech stocks are flying, the dollar is weakening, financial conditions have normalized, and core inflation is 200 basis points above the Fed's target.

That's a tough pill to swallow for an investor like me who wants to deploy cash at a good risk/reward.

What Am I Buying?

Don't get me wrong, I'm not salty about this rally or bearish. As I always say, I have no shorts, and my portfolio has outperformed the market in recent weeks.

No, what bothers me is what this does to the risk/reward.

As I wrote in my 2024 outlook article, the market has reached a valuation that makes a subdued long-term performance likely.

The current S&P 500 P/E ratio suggests a long-term annual total return of less than 5%. This is mainly to blame on the strong performance of the "magnificent 7." Without these tech stocks, the market would have a much more attractive valuation.

The top 10 holdings of the S&P 500 currently have a 32% weighting.

Looking at the chart below, we see that the more top heavy the S&P 500 becomes, the more likely it becomes that the equal-weight S&P 500 outperforms the market on a prolonged basis.

Hence, in my 2024 outlook, I wrote that I'm focusing on a few key areas with a general focus on companies with strong balance sheets (preferably rated BBB+ or better).

• Dividend Stocks : In general, I want companies with a decent dividend yield. I'm not necessarily hunting for high-yield plays. However, I want to be prepared in case I'm right and the market has a disappointing long-term total return. In that situation, a big part of the total return will come from dividends.

• Energy Companies: I'm actively buying energy companies to hedge against sticky inflation. My preference lies with those having low breakeven prices, healthy balance sheets, and a commitment to distributing free cash flow to shareholders.

My favorite play in this area is Canadian Natural Resources ( CNQ ), a driller with a multi-decade inventory, low breakeven prices, and the aim to distribute every penny of its free cash flow to shareholders.

I'm also adding to my Devon Energy ( DVN ) investment, which I bought after selling Pioneer Natural Resources ( PXD ), which got a takeover bid from Exxon Mobil ( XOM ).

In general, I believe that energy is a great place to be for high-yield investments, especially if the market shows a disappointing performance on a prolonged basis due to its valuation.

• Cyclical Stocks: I'm strategically investing in beaten-down cyclical stocks, including railroads, machinery companies, and certain consumer stocks with proven track records. This is a gradual process based on valuations offering a significant margin of safety.

While the current stock market surge has ruined some opportunities, I'm looking to add to all of my railroad stocks, my investment in Deere & Company ( DE ) and Caterpillar ( CAT ), as well as cyclical dividend growth stocks that I do not own yet. This includes Rexford Industrial Realty ( REXR ) and Tractor Supply Company ( TSCO ).

• Defense Contractors: I've been aggressive in acquiring defense contractors, drawn to their undervaluation, top-tier balance sheets, anti-cyclical demand, and the advantages associated with increasing global tensions.

I currently have more than 25% defense exposure, which is a lot. I will add to my favorite investments in this area if the market dips. This includes RTX Corp. ( RTX ) and L3Harris Technologies ( LHX ). The two are among my favorite long-term investments.

RTX, for example, has a 17% projected annual total return based on a P/E ratio below the normalized valuation and an expected EPS growth rebound (as seen in the overview below).

• Growth Stocks: I'm cautiously investing in growth stocks as a hedge, particularly those with proven track records, strong balance sheets, and anti-cyclical demand. I avoid companies with lofty valuations and high dependence on speculative stock market sentiment.

In this area, I'm mainly focused on growth at a reasonable price. This includes a lot of healthcare companies. I own Danaher ( DHR ) and hope to double my position next year. I'm also looking to initiate a position in Abbott ( ABT ) and Idexx Laboratories ( IDXX ) if I get the chance.

I'm also hunting for a position in Mastercard ( MA )/Visa ( V ) or Moody's ( MCO ), which I would love to own as well.

However, for that, I need the market to correct.

Furthermore:

• I'm looking to add Texas Instruments ( TXN ) to my portfolio, which comes with both a good yield and consistent dividend growth/buybacks.
• I'm considering selling my position in Duke Energy ( DUK ) and shifting the proceeds into Antero Midstream ( AM ). Both are safe investments. As much as I love DUK, AM has a 7% yield. It's also equally "boring." However, please note that it takes a lot for me to sell a core holding. Odds are I just buy AM without selling DUK.

To reiterate: In terms of my portfolio strategy, I'm maintaining a dedicated focus on quality dividend (growth) stocks. I exclusively purchase stocks with very healthy balance sheets for my long-term portfolio.

Additionally, I'm allocating more funds to higher-yielding stocks and maintaining a larger cash position to seize opportunities during market corrections.

I believe this positions me well for whatever may come.

Even if I don't buy new stocks due to the current rally, I will be collecting dividends.

If I'm right and the market gets a setback due to the realization that we may have overreacted a bit, I'm in a fantastic position to deploy cash in stocks that, I expect, give me a great shot at outperforming the market on a long-term basis.

Also, needless to say, as I write articles on Seeking Alpha almost daily, investors will always be up-to-date on my plans. So, even if something changes, readers will know what I'm up to.

With all of this in mind, I'm very excited for 2024, and I believe that my strategy will continue to suit me well, as I feel that I'm protected against anything Mr. Market may throw my way.

For further details see:

Betting Big: Fed Mayhem And My Personal Picks For 2024