Corporate Profits

When earnings growth negatively diverges from GDP growth, the gap rarely closes <i>via</i> a rebound in profit growth. The most notable feature of prior episodes is weak corporate pricing power and the current period is no different; an ongoing profit margin squeeze means earnings in the next few months risk being a disappointment.

Stocks are flirting with new highs, courtesy of a gradualist Fed and the reduced threat
of incremental near-term U.S. dollar strength.

Consumer products stocks are likely to move to an even larger valuation premium before the cyclical outperformance phase ends.

Equities are celebrating domestic economic disappointment rather than re-pricing the risk of ongoing profit struggles. This reinforces that liquidity and share price momentum are still the dominant market forces.

The equity rally has been in a holding pattern, with some tactical fraying around the edges.

Shift to a small vs. large cap bias as a stealth way to play the overall equity market overshoot. The oversold bounce in banks is not worth chasing, and buy dips in medical equipment stocks.

Last week's blowout jobs report had the beautiful combination of strong growth and flat/rising underemployment rates. This supports our expectation of a Fed hike in December rather than one in September.Accelerating growth when the economy is approaching full employment suggests that the equity bull market is not over, though we are entering a more volatile phase.

It is dangerous to equate recent equity strength with economic vitality, as history shows that liquidity-fueled equity advances favor non-cyclicals over deep cyclicals. Take profits in gold, buy rails and sell industrial machinery.

Expectations of a prolonged period of abundant liquidity and rising confidence that recession is not imminent have created the conditions for a potential blow-off phase. This week we are fine-tuning our portfolio for peak performance.

Forecast is diverging from strategy for equities. Intermediate-term positives allow for a blowoff to the upside. But we do not expect the rally to have staying power over a 6-12 month horizon.