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Stock market rout is a ‘tidy story’ about the Fed: Analyst

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Ross Mayfield, Baird Investment Strategy Analyst, and Jack Murphy, Easterly Investment Partners Portfolio Manager & Co-CIO, join Yahoo Finance Live to discuss recession risks amid rising inflation and the Fed's 75 basis point interest rate hike, market reactions to recent economic data, and the outlook on a market bottom.

Video Transcript

INES FERRE: Here's the closing bell for today, Thursday, June 16, at the New York Stock Exchange.

[MUSIC PLAYING]

[BELL]

DAVE BRIGGS: And that was your closing bell, sponsored by Tastyworks. The markets just taking an absolute beating. As Ines said, 738 point loss on the Dow. The S&P dropping 120 points, more than 3%. The NASDAQ the big loser on the day, 453 point drop, 4 plus percent. For more on the markets, let's bring in Ross Mayfield, Baird Investment strategist analyst, and Jack Murphy, Easterly Investment Partners portfolio manager and co-CIO. Nice to have you both on. Ross, we'll start with you. What just happened, and why?

ROSS MAYFIELD: Well, I think the market is reevaluating the odds that we'll see a recession in the next 12 to 18 months. And that stems from a more aggressive than expected Fed at the recent meeting. This really is a just all in the last week development. You had the big CPI miss on Friday, which led to the Fed pivot to a bigger rate hike and more hawkish tenor at Wednesday's meeting, which has led to some renewed selling pressure.

So, really, this is, to me, the market reevaluating what the odds of a recession are in the near-term and what the actual downside on earnings and what the recession will really look like. But to me, it's a fairly kind of tidy story about higher interest rates, more aggressive Fed, and multiple times in the past that leads to some sort of financial crisis or recession. I think the market's trying to price the odds of that.

RACHELLE AKUFFO: And Jack, we did see that that 75 basis point hike did appear to already be baked in, in that final week leading up to the Fed decision. So going forward here, what signals are the markets going to be watching for when it comes to the things that are giving them this uncertainty?

JACK MURPHY: Well, I think the market's focused on a recession. And we can talk about whether it's going to be a hard or a soft one, and whether it's going to be here in three weeks or six months. But I think, obviously, the markets are doing a good job discounting the likelihood we're going to have some kind of slowdown here.

And look, I think that's what the market's focused on. You talk to corporations, and we talk to companies every day. They're focused on price [? row ?] and supply chain and what's going on internationally and the availability of energy. So I don't think they've actually seen it yet when you speak to corporations.

But, you know, I think what you see here is going in-- what people are worried about is the next earnings cycle. I think second quarter earnings are going to be fine. But I think the guides that people are going to give as we look forward are going to be very cautious because no one's going to be a hero with so much uncertainty in your P&L and then the macro overlay that I don't think people will be aggressive at all. And I suspect companies will-- the average earnings will probably slightly beat expectations. And then the second half guide down is going to be-- it's going to be a concern for people.

SEANA SMITH: So Jack, what does that mean then for the markets? I guess when you take a look at it-- I don't want to predict-- ask you to predict where we'll be in one to two to three months from now. But could that potentially, I guess, stoke a larger selloff than the magnitude that we've seen over the past couple of weeks?

JACK MURPHY: Well, I mean, look, we kind of think of companies as opposed to the overall market. And I think about if we think about sectors, I think you leave your energy chips on the table here because there's an undersupply of energy globally. I think the consumer is going to be worse off going forward than the industrial part of the economy would be. And we're not interested in bottom fishing technology stocks. Most of them we still think on free cash flow multiples. They are still overly expensive in spite of the hard selloff.

I think what you want to focus on here are sort of good companies. And everybody's going to use quality, but we say low beta, good dividend yield, and companies that have the balance sheets they can use to defend themselves. And usually, that will turn itself into share repurchase. I know we're in a blackout period right now for a lot of share repurchases.

We go into earnings, but we like companies with big kind of yield to shareholders in the form of a combination of dividends and stock buybacks. And you can find a lot of great companies that are still trading at attractive multiples. Sub 18 times free cash flow multiples, good balance sheets, above 2 and 1/2% dividend yields, and companies buying back 2%, 2 and 1/2% of float every quarter-- every year, sorry, excuse me.

DAVE BRIGGS: Ross, are we seeing a bottom in sight or more pain to come?

ROSS MAYFIELD: Well, so far, you've basically seen multiple contraction on higher rates, right? So the actual earnings estimate for future quarters and for 2023 have been up to flat. At this point, I think you have to see-- you'll start to see earnings come in. And so the market is trying to price how much you earn and you have to come down in 2023. Is this a mild recession, more of a slowdown or soft landing versus a pretty hard landing? And that's going to come down to inflation and the Fed.

But at this point, the E part of the equation has held up pretty well. I think if that starts to roll over, or maybe it's this next earnings season when you start to get more negative guidance, that could be the catalyst for another leg down. You know, it's hard to see a catalyst if you want to reverse the question for a renewed bull market or upside to the market until inflation is really under control.

And after Friday, I think that's a higher bar to clear for the market to believe that we've seen a peak in inflation and that the Fed can, at some point in the near term, either stop being so aggressive or ease off the gas a little bit. But I think that's a high bar to clear and not anytime soon.

RACHELLE AKUFFO: So, Jack, what are the top questions that you're getting from clients right now in this rising rate environment?

JACK MURPHY: Well, I think a lot of clients want to know, when are you going to be tempted to bottom fish the previous winners? And we're not a big style drifter. We are contrarian value managers. We always have been. I don't think there's any value in most of these technology stocks right now. We do work on them, but there's no value the way we look at it. And again, we use free cash flow as a multiple.

And then how stable or predictable are your free cash flows? I think if you have sort of a low beta, less cyclical portfolio, the stability of your free cash flows in the second half of 2022 and 2023 are going to be OK. If you want to look in the industrial sector, I'd take long cycle businesses that have sort of an aftermarket or consumable stream versus short cycle companies where they're probably taking a lot of pain right now.

So that's what we hear is, when is this thing going to bottom? When are you going to be tempted to step into things that have gotten hit the hardest? And I would argue stick to quality. Like I said, stick to dividend yield. Stick to companies with good balance sheets. Stick to defensible business models. And I think you'll be better off. I don't know when the bottom is. The bottom will come. We've seen this before in 2000 and 2001. We saw it in 2009. But I think how you get yourself in trouble here is you try to be something that you're not.

SEANA SMITH: And Ross, as we talk-- as we hear more and more talk about recession, we just heard President Biden telling the AP that a recession is, quote, "not inevitable." Do you agree with what Jack was just saying, saying, hey, now's the time to favor some of these more defensive plays. Leave the cyclicals for when we're on a little bit more steady footing.

ROSS MAYFIELD: Yeah, I think near term, the game plan has to be high quality, which, in this case, does mean, yeah, strong free cash flow, returning capital to shareholders in the form of buybacks and dividends, companies that have the cash flow to kind of persevere through this environment. It means defensive sectors that tend to do well in these kind of environments.

And we still-- there are some still cyclical businesses. I think energy continues to be leadership. It's having a tough day today on the prospect of recession and demand destruction. But ultimately, it's leadership in this market. And there's a structurally tight market in most energy commodities. So I do think that that will continue to work.

So I tend to agree. The long duration, kind of high growth stuff has seen a lot of pain. But given that most of that selloff is related to higher interest rates, you know, I don't see a shift anytime soon. And then these businesses that aren't earning any money, you have to prove that they can survive through a much rougher period, where borrowing costs are up and maybe the consumer is a little cautious, given the environment.

SEANA SMITH: All right, well, again, an ugly day here for the market. NASDAQ plunging 4%, lowest level that we've seen at its close since November 2020. Ross Mayfield, Jack Murphy, thanks so much for joining us.