The Federal Reserve made its latest policy announcement on Wednesday, reiterating that it is optimistic about economic growth despite potential inflation pressures. For our technical experts, John Jagerson and Wade Hansen, one of the key takeaways from the announcement was the Fed’s assertion that inflation is transitory, or temporary. While John and Wade mostly agree with this premise, they’re not assuming inflation is never going to be a problem. In today’s Digest, let’s turn to John’s and Wade’s latest Strategic Trader update to get their entire post-mortem on the Fed’s announcement and its inflation implications. We’ll also learn where they’re seeing overlooked opportunities in the stock market today. Plus, the update provides a fantastic lens into the way that expert options-traders view the market. Lots to cover, so I’ll let John and Wade take it from here. Have a good weekend, Jeff Remsburg

Finding Value in Overlooked Sectors

By John Jagerson and Wade Hansen

The Federal Reserve met today before issuing a decision on interest rates that surprised no one.

The overnight target rate will remain at 0.25%, and bond traders are currently pricing in a less than 13% chance that the rate will change before December.

The Fed also expressed confidence in the board’s positive outlook for the economy as the effects of the pandemic fade.

To us, it’s interesting how this contrasts with inflation expectations. Based on headlines in the financial press, the risk of inflation is a huge problem for the market. If inflation rises, then interest rates will go up as well, which could constrain growth.

However, we feel that the Fed’s statement today contradicts that concern, or at least indicates that this is not an issue the Fed is worried about in the short term. The Fed is asserting that current inflationary pressures are transitory, and we tend to agree.

Despite segments of the market, such as building materials (e.g. lumber has doubled in price), that have seen huge price increases, wages and aggregate price pressures remain relatively low. In our view, inflation risks are overblown, and we don’t expect to see any big changes in interest rates… yet.

Growth and Earnings

The source of much of our optimism about the market is this quarter’s earnings.

Already running ahead of expectations, key tech stocks like Microsoft (MSFT) and Alphabet (GOOGL) reported numbers above estimates on Tuesday evening and should continue to provide support for the market.

According to Factset, the S&P 500 is set to report its third-highest quarterly profit margin since 2008.

There is some risk that once the stimulus payments are “spent,” profits could cool down in some sectors like retail, but we expect most groups to continue their profit growth trends this year.

Overlooked Areas

As we discussed last week, the market is at a valuation level where corrections are more common.

We provided two charts in our last update to illustrate that three out of the last five times the market has had this many stocks trading above their 200-day moving average, a correction appeared within weeks.

We stand by our argument that the growth fundamentals this time look more like 2013 and 2014 when the percentage above the 200-day moving average was extreme, but stocks continued to perform well despite high valuations.

Part of the reason why the market avoided a big drawdown in 2013 and 2014 was because economic fundamentals were stable enough to motivate a shift into overlooked groups in large retail, consumer staples and income stocks when the growth rate slowed slightly.

The so-called “safety sectors” started performing very well because they had been overlooked while traders were rushing into the big momentum plays.

As you can see in the following chart, the performance of the Consumer Staples Sector SPDR Fund (XLP) in 2013 and 2014 was nearly identical to the much more exciting small-cap iShares Russell 2000 ETF (IWM).

When adjusted for a year’s worth of dividends, the consumer staples sector outperformed small-caps with much less volatility.

Fig. 1 – Comparison Chart of Consumer Staples Sector SPDR Fund (XLP) & iShares Russell 2000 ETF (IWM) — Chart Source: TradingView

Traders move into more stable stocks, not because they are worried about a decline, but because they suspect that growth cycles will ebb and flow. They want to take advantage of income and stability when the market looks to be at an extreme.

This shift in capital flows does not send the market lower, it just rearranges the leaderboard a little.

This is an advantage for us as income traders. When we write puts on a stock, we profit if the stock rises, trades flat or declines a little. In other words, boring but bullish is our bread and butter.

One of the reasons these stocks tend to outperform in periods like this is that demand for their shares has been low – regardless of profitability – when compared to other opportunities, so there is less downside risk from profit-taking and rebalancing.

We just recommended short puts on Coca-Cola (KO) on Tuesday for all the reasons we have outlined so far. Here is another interesting example:

Constellation Brands (STZ) is another favorite of ours, not because they have skyrocketing growth, but because they have a strategy to produce steady and reliable growth.

Acquisitions of smaller imported beer brands, the creation of new markets with seltzers and holding one of the best potential opportunities to benefit from the cannabis business in future years have all increased STZ’s intrinsic value.

However, the stock is valued roughly where it was when revenues were much smaller prior to the pandemic crash.

From a technical perspective, STZ has completed a long-term inverted head-and-shoulders pattern and is teasing a potential breakout from a bullish broadening pattern formed this year.

While this doesn’t look as exciting as Tesla (TSLA) did last year, for example, our objective is to examine patterns that emerged in the past that can identify stocks that will be stable or bullish before the trend breakout.

Fig. 2 – Weekly Chart of Constellation Brands (STZ) — Chart Source: TradingView

Consumer staples isn’t the only sector that should start to see more interest from buyers this year.

At this point in the business cycle, heavy industrial, energy services and even defense stocks start performing better as well.

If our objective is to earn income on stocks that are the least volatile and the most likely to remain stable, a rotation like we saw in 2013 and 2014 would be most beneficial for these overlooked groups.

First-quarter earnings growth is extremely impressive but unlikely to continue at this pace.

Therefore, the potential for low-risk income is likely to be easier to find in the safer sectors. We don’t plan to completely avoid tech (MSFT could be very interesting after this week’s dip), but our bias will likely shift a little towards more exposure to undervalued groups rather than the big momentum leaders.

The Bottom Line

Now that we are past the Fed’s announcement and earnings season continues to look good, we can start to plan for the labor report next Friday.

Despite the good economic news, unemployment remains a big “X-factor” for the market. If there are any signs of slowing, we will have to start shifting our strategy even faster than we have discussed.

For now, we remain optimistic about the report, but because so much depends on the trend of hiring, this is the most important event to watch in the short term.

Sincerely,

John Jagerson and Wade Hansen