This strategist believes interest rate cuts are coming. Here is what he would be buying (and when).

It's that time of the quarter. US quarterly earnings season kicks off this evening with the major banks (Bank of America, JPMorgan, Citigroup, BlackRock) handing down their numbers. The Wall Street behemoths will be declaring those results amid a backdrop of layoffs, earnings contractions, and a looming economic downturn. 

It's that downturn that has CFRA Chief Investment Strategist Sam Stovall in two minds about the performance of equities this year. In his recent outlook webinar, Stovall argued the best of the year's gains won't be seen until the second half and that valuations are still rich.

But given he has a year-end forecast for the S&P 500 of 4,575, Stovall is also the definition of a classic optimist. He doesn't expect the bad taste of 2022 to linger for much longer.

In this wire, I'll share with you the best of my interview with Stovall conducted today and ahead of US earnings season. We'll discuss:

• Why he believes this time will be different
• Whether he believes the bar for the US earnings season has been set too low
• The sectors he is eyeing for 2023

There is good reason to be this optimistic

By his own admission, Stovall is a guy who likes turning lemons into whiskey sours. But he has good reason to be bullish despite how unprecedented 2022 was for equity markets. The reason is simply history. Consider these statistics:

• Since 1946, the S&P 500's average return increased by nearly 10% and prices rose 73% of the time.
• After down years, the S&P 500's average return gained 14% and prices rose 80% over time.
• In addition, every year that a "first five days" rule and a Santa Claus rally have occurred, market prices have increased by 92% of the time.

All this is a long way of saying - history doesn't repeat itself but it does often rhyme (in this case, on the side of the bulls).

...But the good gains won't come at first

Stovall hastens to add that a turnaround in equities may not come immediately. The reasoning for that, unsurprisingly, will come down to how the Federal Reserve handles interest rates.

"Our belief is that they will be raising rates through the first quarter then hit the pause button," Stovall says before adding "the real question is what they do after that". 

While some believe the Federal Reserve will hold interest rates at a high level indefinitely, the bond market (and Stovall) is betting that there will be cuts to interest rates by the end of 2022. 

"Nine months after the Fed has stopped raising rates, they tend to start lowering interest rates," Stovall says. 

Reconciling the earnings vs economic recession question

It's here that Stovall disagrees with his economics team. The economics team are backing a Fed-induced soft landing but Stovall is on the side of history - arguing an earnings and economic recession generally come together.

"Because of supply chain disruptions, higher interest rates, higher inflation, and the challenge of passing along these higher costs to consumers, all of these factors together will cause an earnings recession," Stovall says. The research team led by him is expecting positive earnings growth in only three of the S&P 500's 11 sectors. 

He also says the earnings recession will likely lead the economic recession but that it will be mild in both cases.

"The recession will likely be mild. As a result, investors will feel they can weather this tempest and look across the valley into 2023," he adds.

Previewing crunch time

As mentioned in the introduction, crunch time for US corporates starts tonight with the major bank reports. Wall Street analysts are notorious for setting low bars for earnings expectations - a fact only exacerbated given the experience of 2022. But Stovall believes that expectations are now actually too low.

"That is certainly a possibility," Stovall says. "In 52 of the last 53 quarters, the actual earnings have exceeded end-of-quarter estimates." 

Despite this, Stovall is also adamant that US equity indices are still too expensive by historical standards. Going into tonight's results, the S&P 500 is sitting on 18 times earnings (or put another way, a 6.5% premium to historical standards). 

"Valuations are looking rather hefty," Stovall notes. "Typically in a bear market associated with recessions, we see a one-third trimming of earnings ratios."

We'll find out starting tonight if that historical precedent continues to be upheld.

The sectors Stovall would be watching

Over the next few months, Stovall is employing the 'worst to first' approach in buying sectors and stocks within those sectors. That is, sticking to the winners of 2022 (energy, utilities, and industrials among them) will only last until the Federal Reserve decides it's time to pause rate hikes.

"As we move forward into the year and as we see an improvement in the outlook for rates and possibly earnings, we're already seeing a rotation out of cyclicals and defensives," Stovall says. 

In contrast, consumer discretionary and big tech stocks are starting to see moves to the upside after a torrid last twelve months.

Stovall's reasoning mirrors this trend. 

"If you're looking tactically, stay defensive for the short term but strategically, look towards groups that were beaten up like communication services, real estate, consumer discretionary and big tech," Stovall says.