Market strategist: 'It's not going to be smooth sailing' for energy and other cyclicals

Verdence Capital Advisors Director of Portfolio Strategy Megan Horneman and RiverFront Investment Group Senior Market Strategist Rebecca Felton join Yahoo Finance Live to discuss what to expect in markets this week.

Video Transcript

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ADAM SHAPIRO: All right, just about two minutes-- just under-- to the closing bell. Let's bring in our panel. Megan Horneman, Verdence Capital Advisors' director of portfolio strategy; also, Rebecca Felton, RiverFront Investment Group senior market strategist. Good to have you both here. Rebecca, can you help us understand, when you say to your clients that this is the year companies are going to have to earn premium valuations, what is investors-- and we only have about a minute. I apologize. But what does that mean for us?

REBECCA FELTON: We are looking for companies with consistent ability to grow not only earnings, but cash flow, the strong balance sheet. So we are still leaning into growth. We have obviously added back some value. But we are taking the barbell and we believe that companies are going to deserve a premium if they can earn their way through this period.

ADAM SHAPIRO: That sounds intriguing, and I want to follow up with that. But we're going to take a pause now to set up for the closing bell, because let's see where these markets are going to settle. It looks as if the Dow is going to be up just under half a percent, up 159 points. We'll have the S&P 500 gaining, as well, almost a full percent. We'll see if it can push in the last 30 seconds of trading. It's up 40 points. NASDAQ is going to be up about 1%, 1.4%, up about 200 points.

And when you take a look at sector action, we've been talking a lot about energy. It is up big time today, up 3.2%. Last 52 weeks energy is up almost 59%. Here's the closing bell.

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- And that is the closing bell this Tuesday, January 11. Taking a look at where markets are looking like they'll settle, looks like a green day across the board here. The NASDAQ composite, the outperformer, up about 1.4%. Definitely a reversal of what we saw earlier this week, as well, here. The Dow Jones Industrial Average up about 116 points or about 1/2%. The S&P 500 up nearly 1%.

And then diving a little bit deeper in terms of what is leading the Dow today, Adam was just talking about the S&P 500 sector action. With the Dow components, taking a look here at the outperformers, we have Boeing, Salesforce, and Chevron leading the way higher during today's session.

Well, let's turn back over to our panel now for a deeper dive on today's trading action. Megan, I want to turn to you. And as Adam was talking about the sector outperformance , here energy was again the outperformer during today's session. Crude oil prices also rallying in the US. Do you think this strength in the cyclicals, and in energy, in particular, can continue?

ADAM SHAPIRO: [AUDIO OUT] I think it's not going to be a smooth sailing rise higher across the cyclicals, I still do think you'll get some tug of war, like you saw today, where some money may rotate back into those growth sectors when you see interest rates decline or the Fed put some inflation fears at ease. But in the long run, over the next year, I still think from an evaluation and a fundamental basis, the best place to be is in those cyclicals.

Energy, I think, the selectivity is very important here because they have had such a significant run. They were up over 50% last year alone. But some other areas in the value or cyclical sectors are financials. They should do better as interest rates rise. Industrials should do better as the world continues to recover. So we still do think and have a little bit more of a tilt towards that area of the market.

ADAM SHAPIRO: Based on what Megan just said, Rebecca, with a rising interest rate environment and inflation-- I mean, we're going to get the read tomorrow on CPI-- not all cyclicals are the same. Some of them would be susceptible to consumers who might be afraid to spend money or might feel they have to spend money now before prices go up even higher.

REBECCA FELTON: Well, again, there's probably room for both. We do expect these headline numbers to be somewhat unsettling, if you will, tomorrow. But we do expect inflation to normalize by the end of the year in a 2 and 1/2%, 3 and 1/2% range. So we have added back to our financial, as well as industrial exposure, particularly in areas exposed to infrastructure.

But we still have a healthy mix of growth, specifically technology, software, services, and that sort of thing, because we do believe that there will be volatility as we continue to move through the recovery. And it's best to, you know, sort of [AUDIO OUT] go into these slowly, in terms of not going too far into cyclicals at this point.

- Megan, speaking of inflation, I also want to ask about Fed Chair Jerome Powell's testimony before Congress earlier today. And a key quote from that was, "If we have to raise rates more over time, we will." Put this in context for us. Do you think these remarks signal anything about how willing the Fed might be at this point to raise rates by more than the three times that the Fed has previously telegraphed?

MEGAN HORNEMAN: I think he has to be a little bit hawkish here in this committee because the biggest fear right now is that the Fed's behind the curve on inflation. Whether or not they end up doing that, I think it's way too early to tell. The one thing that might put some people's mind at ease is, yes, this week, I think we'll get some ugly numbers again. But let's see. In the next couple months, I think you're going to have a lot of volatility around not just the inflation numbers, but also maybe some of the spending numbers from the consumer side, confidence numbers-- all of these being temporarily impacted by Omicron.

So it's going to be really difficult to get a good gauge of what's truly going on in the economy. These should all fade in the second half of this year, but I don't doubt that in the next few months that there will be some volatility in the economic data. So the Fed's got to kind of straddle themselves on both sides of it, that they're not behind the curve on inflation and that they can be flexible, if they need to be, if the economic outlook doesn't pan out the way that they expect.

ADAM SHAPIRO: Rebecca, you've also pointed out that you're underweight fixed income and your balance strategies. The primary purpose that most of us would perhaps go to fixed income is some kind of protection against, you know, volatility in equities. Do you see that-- there's going to be a lot of volatility in 2022. So our instinct's going to be to run to underperforming bonds. I mean, what do you do?

REBECCA FELTON: We're not there yet, Adam. In our most recent risk reduction moves, we actually put some money back into cash, because we expect that there will be more opportunities to put money to work. So we are remaining fixed in our fixed income underweight.

- Megan I want to ask you the same question here. As we think about where Treasury yields, where bonds and fixed income may actually be heading this year, do you think it is time for investors to be allocating potentially a little bit more heavily into this space, especially as we have this rising interest rate environment.

MEGAN HORNEMAN: No, I would agree with the other guest. I think it's way too early. I actually would still be very defensive on the fixed income positioning. I think interest rates are going to rise throughout 2022. And what happens in 2023 will be dependent on how far and fast the Fed has had to go with interest rates, what it looks like for balance sheet reduction, what the economic outlook looks like, and then if the inflation numbers do come down the way that most estimates do forecast.

But right now, I think your positioning in fixed income is not to neglect it altogether, because it is a portfolio diversifier, but be defensive. I agree, as well, with the prior guests. There's nothing wrong with cash. I know no one likes it. It's not earning you anything. But it's going to be there in times of volatility to make adjustments to your portfolio. So we like to have a little bit of dry powder from the cash position.

Over the past six months, we have been taking the opportunity to shorten up our duration in our portfolios. So we are underweight duration to our benchmarks. We favor those floating-rate instruments and short-duration fixed income, as opposed to being in even intermediate at this point.

ADAM SHAPIRO: Megan, following up on that, we had Jared posing the possibility that what we witnessed today in the equity markets might be a dead cat bounce. What are you looking for, as far as to deploy that cash in the future, so that if today was a dead cat bounce, that these anomalies get behind us?

MEGAN HORNEMAN: I still do think that there's a good portion of the market that's overvalued-- significantly overvalued. I would like to see interest rates back up a bit and see how the market washes itself out there, because I do think that there's more room for interest rates to rise. And I think it puts some of those those tech-heavy indices and also those growth names at risk. That may pose some opportunities for the long run, depending on how far and-- how far that they fall.

I think that from the value side, we're well-positioned there. So we're looking more, is there opportunity to get a little bit more diversified in the US? But really, the one area that's been neglected by global investors is the international market. We like the developed international market. We have an overweight there. The emerging markets, I think it's a little too soon to add into into those areas, but they will-- I think they're still a good investment for the long run. So we're looking for more opportunities there.

From the developed international side, keep in mind that we're going to have a diverging monetary policy between the US and its developed market counterparts. That tends to be good for international equities. So we're looking for maybe some more opportunities to maybe make some decisions there.

- Rebecca, as we head into quarterly earnings season, I do want to ask. You did mention in your notes that the Street is going to be focused on mentions of inflation, shortages, or suggestions that demand is slowing. Where or what sectors do you think some of these concerns might be most pronounced and might actually be starting to be alleviated?

REBECCA FELTON: Well, you know, folks who are going to be watching transcripts-- we saw in December how inflation mentions had gone up, and that's what everybody's going to be keying on. Certainly, labor costs are going to be of issue. That's going to be very prevalent in the transcripts, for the services area, in particular. So it's going to be likely that companies that miss or are very pessimistic in their outlooks will probably be punished in this area.

But we are still expecting, net-net, for earnings growth to be positive, not just in Q1, but throughout the remainder of 2022.

ADAM SHAPIRO: We talk about these kinds of issues and we always root the question, here at Yahoo Finance, with, help us understand how we and the people watching can make money. And Megan Horneman and Rebecca Felton, you've both helped us answer that question a little bit as people try to make their strategies for 2022 just want to remind you, Megan Horneman is Verdence Capital Advisors director of portfolio strategy. Rebecca Felton is RiverFront Investment Group senior market strategist.