September 21, 2024 – Coming into the Federal Reserve’s first rate cut since March 2020, investors and economists were reading the tea leaves for one key question: 25 or 50?
The central bank put an exclamation point on the undertaking on Wednesday, choosing to “break the glass” with an emergency 50 basis point rate cut, bringing its fed funds rate to a 4.75% – 5.00% target range.
Typically, rate cuts of 50bps or greater were saved for financial crises, panics, or recessions. Nevertheless, the Fed chose to go big despite:
- An above-target inflation rate of 2.5%
- Strong economic growth of 2.8%
- Stock indices at or near all-time highs
- Equity valuations at the 95th percentile most expensive
- A $7.1 trillion Fed balance sheet, double its size compared to four years ago
Despite some post-announcement volatility, investors lapped up the monetary easing, driving the S&P 500 and Dow industrials to new record highs on Thursday.
Bear market predictions and recession forecasts from market prognosticators over the past 18 months have been pushed aside. The global economy and stock market have continued their upward march, defying both the inverted yield curve and the Sahm rule recession signals (for the time being). The Fed’s much-vaunted soft landing for the economy is in play, with Maestro Jay Powell leading the FOMC’s orchestra of central bankers as they attempt to thread the needle and guide the economy out of its inflationary phase without causing a recession. A soft landing was engineered in the mid-1990’s by then Fed Chair Alan Greenspan, and thirty years later, his policy-guiding brethren seek to repeat the performance. Although aggressive, this week’s jumbo rate cut was a good start.
A new dawn is upon allocators as the market’s 5%+ risk free rate begins its forecast slow path downward over the next several years. The Fed’s updated dot plot projections indicated a longer term fed funds range of 2.4% – 3.8%, with the FOMC average settling in at 2.9% (an increase from the latest dot plot released in June). Nonetheless, rates are set to slowly decline over the next 12 to 18 months.
As the fed funds rate rose from nearly 0% in 2022 to above 5% in 2023, capital allocated to money market funds surged. More than $1.5 trillion has flowed into money market funds over the past four years, bringing total assets in cash equivalents above $6 trillion.
Warren Buffett once said, “Interest rates are to asset prices what gravity is to the apple. When there are low interest rates, there is a very low gravitational pull on asset prices.” Just as gravity affects everything on Earth, interest rates impact the value of all financial assets. When interest rates are low, it’s easier for asset prices to rise, much like how reducing gravity makes it easier to lift objects. Conversely, when interest rates rise, the “financial gravity” increases, making it harder for asset prices to stay elevated.
The times they are a-changin’. As the macro environment shifts with declining short term interest rates, with yields on cash set to drop below 4% and sub-3% yields to follow, capital allocators will be busy putting money to work in higher yielding asset classes.
A word of caution regarding investing based on macro forecasts. An upcoming major macro catalyst is the U.S. election on November 5th. While certain administrations could be friendly to or hostile toward specific sectors, an underlying macro thesis may not translate to successful equity investments.
For example, under President Trump, who was against the clean energy industry and in favour of the oil and gas sector, clean energy stocks surged +286% while oil and gas stocks fell -39% during his term. Conversely, under President Biden, who was against oil and gas and pro clean energy, oil and gas stocks rallied +178% while clean energy stocks plunged -48% under his watch.
Macro investing is challenging to say the least.
With that in mind, a diversified approach may be most prudent. Hedging one’s bets in the equity market may be rational, with portfolios including short positions to offset (at least partially) one’s long market exposure to mitigate market risk. With that said, we highlight one top-decile stock expected to outperform and one bottom-decile stock expected to underperform in this month’s AlphaRank Top Stocks.
OUTPERFORM: Toll Brothers Inc. (NYSE: TOL) is a prominent American home construction company specializing in building luxury homes. Founded in 1967, Toll Brothers is known for its high-end residential developments, often targeting affluent buyers in suburban and urban areas. The company operates in various segments of the real estate market, including luxury single-family homes, townhomes, and condos, and has a strong presence in many of the country’s most desirable housing markets. The current macro environment is supportive of TOL shares. Lower interest rates generally increase housing demand by making mortgages more affordable, often leading to a rally in home builder stocks when the U.S. Federal Reserve lowers rates. Toll Brothers has consistently reported strong financial results, with solid revenue growth and profitability. The company’s ability to maintain strong margins in a competitive market is a positive indicator for investors. From a quantitative perspective, TOL stock checks all the boxes: positive share price momentum, attractive valuation, high return on capital, and the company has aggressively been buying back shares and beating quarterly Street expectations. We expect the shares to continue to outperform. Disclosure: Long TOL in the Accelerate Absolute Return Fund (TSX: HDGE, HDGE.U).
UNDERPERFORM: Nikola Corp (NASDAQ: NKLA) specializes in designing and manufacturing zero-emission vehicles, primarily focusing on hydrogen fuel cell electric vehicles and battery-electric vehicles. Founded in 2014, Nikola has aimed to revolutionize the transportation industry with its innovative approach to clean energy vehicles, including semi-trucks, pickup trucks, and other commercial vehicles. However, the company has faced significant challenges and controversies that have affected its stock performance and overall reputation. Nikola was the company that infamously demonstrated its flagship renewable energy semi truck by rolling it down a hill, a fraud that was later unveiled by short sellers. Nikola’s founder and former CEO is currently serving a 4-year prison sentence for securities fraud due to actions at the company. A perennial money-losing, low-quality business with substantial negative momentum, NKLA was one of HDGE’s most successful short positions. However, the Fund previously covered its short position because the share price fell so far. Nonetheless, NKLA still sports a nearly $300 million market capitalization, which is about $300 million too high. We expect the shares to continue to underperform.
The AlphaRank Top and Bottom stock portfolios exhibited mixed performance last month:
- In Canada, the top-ranked AlphaRank portfolio of stocks declined -1.5% compared to the benchmark’s 1.7% gain, while the bottom-ranked portfolio of Canadian stocks fell by -2.6%. The long-short portfolio (top – bottom ranked stocks) generated a return of 1.1% for the month and approximately 140% over the past five years.
- In the U.S., the top-decile ranked equities rose a meager 0.7%, underperforming the S&P 500’s 2.4% gain. Moreover, the bottom-ranked stocks fell by -5.7%, leading to 6.4% of alpha generated for the long-short portfolio. Over the past five years, the top-ranked U.S. equities have gained more than 120% while the bottom-ranked portfolio has dropped by roughly -25%.
AlphaRank Top Stocks represents Accelerate’s predictive equity ranking powered by proven drivers of return. Stocks with the highest AlphaRank are expected to outperform, while stocks with the lowest AlphaRank are anticipated to underperform. AlphaRank assigns a numeric value to each security from zero (bottom-ranked) to 100 (top-ranked) based on selected predictive factors. All Canadian and U.S. stocks priced above $1.50 per share and $100 million in market capitalization are evaluated. In both the Accelerate Absolute Return Fund (TSX: HDGE) and the Accelerate Canadian Long Short Equity Fund (TSX: ATSX), Accelerate funds may be long many top-ranked stocks and short many bottom-ranked stocks. See AccelerateShares.com for more information.
