DAILY STRATEGY: Main Point 1) Fading Low Earnings Vol and other Risk Averse Factors are more interesting NOW. – Last week the market regime, which is based on how factors trade together, was classified as Risk Reverse. Risk Averse regimes are the most frequent internal regime over the past 12 wks. Over that period, uncertainty over the sustainability of the AI build out increased, oil prices increased and most recently, 10yr volatility increased. The Low Earnings Volatility factor delivered the strongest active returns.
Now seems like a good time to fade the Low Earnings Vol or Risk Averse factor outperformance. Earnings Season has lowered near term AI buildout risk and the 10yr increased 4.73%. The highest level in almost two years. We have highlighted the asymmetric risk related to 10yr yields (HERE), and that risk cuts both ways now. Any relief in yields is likely to be associated with upside for fundamental factor (an inline payroll report would be a relief for yields. Consensus estimates are not hawkish). On the fundamentals, Hyperscalers reinforced AI capex estimates and Spot pricing for compute sits near the highs (HERE). From Dauvin Peterson “Demand is growing quickly, and open-source models are increasing the compute needed to host and provide multi-model platforms. Combined with continued downward pressure on token prices, we view this as a net positive for neo-clouds and data-center builders.”
EPS and Sales beats for the Price Momentum factor, which is essentially the same basket as the AI buildout beneficiary baskets, are unusually high. Fundamental factors have unusually strong EPS beat rates as well. A move away from a Risk Averse factor regime would benefit Price Momentum along with Earnings Momentum, Earnings Risk, Growth Momentum and GARP. Its not just a Price Momentum call.
Main Point 2 – As Gerard JUST pointed out in a note (HERE) and we highlight in many charts below, Index level data more than fully confirm the signal from the National Accounts data, that profitability is holding up quite well outside the AI-related leadership. At the same time, the implied equity risk premium has increased (PEs have compressed some). Implied equity risk premium, the expected cash return yield relative to 10yr yields, is above the post COVID median and close to the 75th%tile longer term. The risk is not that the market is overvalued; the risk is a sudden deterioration in EPS growth. Most investors we talk to assume this will come from the circular financing related to AI coming undone (HERE) or a shock move higher in UST yields.
Main Point 3 – Forward rates point to further increases in the 10-year yield and a curve materially steeper than is typically observed during historical Normal regimes, particularly over the next three years. That should be a significant support for Banks, ASSUMING, inflation is not problematic over that same period. Our view of non-problematic is inflation, for the rest of 2026, is below 3.3% on Core PCE. A decrease in supply shocks (Oil prices lower) risk is necessary as well.
Charts…
We have been trading in a risk averse regime. We would fade that now.
The Implied equity risk premium is slightly elevated relative to the post COVID regime…
…but unusually elevated relative to the long term history.
Forward rates point to further increases in the 10-year yield and a curve materially steeper than is typically observed during historical Normal regimes, particularly over the next three years. Good for banks assuming core inflation is “non-problematic”.
Earnings have been unusually strong in 2Q.
58.4% of stocks are beating on EPS and Sales in 2Q. Vs 44.6% historically.
Fundamental factors have unusually high beat rates relative to history. We favor fundamental factors now.
Price Momentum fundamentals are strong.
Healthcare, Industrials and Tech have the highest beat rates by sector.
Dispersion is most interesting in Materials, Industrials and Staples.
OUR PROCESS: Going forward, Monday’s notes will focus on the overall process we anchor to. The below graphic details the medium to longer-term outlook (6+ months) for equity internals based on the current economic backdrop, the modal outcome for the economic backdrop, and the sensitivities of the backdrop. When we mark to market our views based on new market and macro data, and talk about short-term risk management, it is always relative to what our background process implies. Below is an effort to lay out the background process in detail.
