The Fed could cause a stock market 'flush out' and create a buying opportunity, Evercore ISI says

Published Mon, May 2 20223:16 PM EDTUpdated Mon, May 2 202210:36 PM EDT

Patti Domm @in/patti-domm-9224884/@pattidomm

The Federal Reserve could cause a "cathartic flush out" in stocks this week, taking the market to a tradeable low and creating a buying opportunity, according to Evercore ISI's Julian Emanuel. The Fed is widely expected to raise interest rates by a half-percentage point Wednesday afternoon, following its two-day meeting. That would be the second rate hike in three years, after the quarter-point increase in March. Emanuel, who heads equity, derivatives and quantitative strategy at Evercore ISI, said the central bank's message is going to be a difficult one to communicate and for the market to digest. Fed officials are expected to reinforce that more hikes are coming, against a backdrop where last week's report of negative U.S. gross domestic product spooked some investors. "If I'm a retail investor, I could see negative GDP and I see huge inflation, and I think stagflation," Emanuel said, adding investors may not be considering the one-off hit to net exports. That makes the Fed's communications efforts more complicated. First-quarter GDP contracted by 1.4%, while economists had expected a gain. Overall foreign trade reduced growth by 3.2 percentage points, according to JPMorgan. But economists expect a bounce back and an average growth rate of 3.2% in the second quarter, according to a CNBC/Moody's Analytics survey of economists. Fed Chair Jerome Powell is expected to reiterate the central bank's message that it will be open to raising rates at a more aggressive pace, if necessary, to combat inflation. The Fed also is expected to announce its plans to pare back its nearly $9 trillion balance sheet, opening another avenue of policy tightening. "When you think about the task that Powell has to do, it literally is like walking across Niagara Falls on a tight rope in a thunderstorm," Emanuel said. Emanuel expects whatever message the Fed delivers could rattle already nervous retail investors. That could create a "cathartic flush out whereby very underinvested institutional investors perceive values in an environment where the U.S. economy is not going into a recession despite the fact that external weakness from both China and Europe has been rising." He said he would be a buyer at that point since earnings continue to grow. "We're buyers of that because basically earnings continue to be only modestly affected by the external shocks going on. That's a function of the insularity of the U.S. economy, which continues to be strong," he said. Emanuel said rising bond yields could also cause more selling. The benchmark 10-year Treasury yield on Monday traded above the psychological important 3% level for the first time since late 2018. A first sign of the stock market flush out would be a jump in the VIX above 40, he said. The Cboe Volatility Index, which is based on puts and calls in the S & P 500, rose to more than 36 on Monday. Emanuel said he has no specific target for a low in the S & P 500 , should the Fed trigger a downdraft. "Trying to pick an exact number is very difficult. We have consistently said if the market were to get defensive enough, you could in theory trade down to a price where we think the Fed's put is located, which is 3,670," Emanuel said, noting that was not his base case. "Our base case is this week you're making a tradeable low, which is in the context of a year-end price target of 4,800." Emanuel said investors could add some stocks now but should look to buy more after a bottom is struck. He favors value stocks over the longer term. Evercore ISI created a list of stocks that could provide some buying opportunities. These names have high short interest and have raised their earnings guidance. They also have been trading toward the low end of their five-year valuations. Tech stocks on the list include Qualcomm, NXP Semiconductors and Arrow Electronics ; industrial names Ryder System and XPO Logistics were also included. Companies on the list from the hard-hit consumer discretionary sector include PulteGroup, Williams-Sonoma and AutoNation. Health-care companies include Laboratory Corporation of America Holdings and ICU Medical.

The Federal Reserve could cause a "cathartic flush out" in stocks this week, taking the market to a tradeable low and creating a buying opportunity, according to Evercore ISI's Julian Emanuel.