It’s not the bad down days … it’s the bad up days

DJIA:  34,196

It’s not the bad down days … it’s the bad up days.  For most of this year there have been few bad days either up or down.  That changed a bit last week when there was what you might call real selling, both Thursday and, especially, Friday.  The three day Dow loss of 1000 points is not the issue, it’s the one sided A/Ds, especially Friday’s 3-to-1 down day.  Weakness happens, especially when amidst complacency the Fed comes along with a little surprise.  Markets get over it, but it’s about how they get over it.  A big Dow comeback without commensurate A/Ds, doesn’t do the trick.  Indeed, that’s what we mean when we talk about a bad up day.  As it happens, so far so good.  Monday saw a near 600 point Dow up day with A/Ds near 3-to-1 – far from a bad up day.  The A/Ds don’t stand alone.  Analytically they need to be related to the market.  It’s important that those numbers keep pace with the market averages.

It doesn’t seem the Fed has killed the market, but did they kill the inflation/reflation trade?  While these shares did pull back, and in some cases more than we expected, we doubt they’re done.  Most of that area has been stalled since early May, pretty much coinciding in the stall in the S&P itself.  The Fed seems an excuse for the market to do another little rotation, something that he has been doing all year.  In the process, Growth/Tech has reemerged, something that had begun just as the inflation trade was stalling.  We will take rotation over everything going down any time.  We don’t see this as something unhealthy, especially had you hedged those oil positions with a little Microsoft (266).  To Look at XOP (98), the SPDR Oil and Gas Exploration ETF, oil seems to have come through this little correction in good shape, which should prove a positive going forward.

Speaking of rotation, Cathie is back.  Well, not completely back, but those ARK funds at least are back above their respective 50 day averages.  The recovery hasn’t just been on the back of Tesla (680), though it, too, is above the 50 day.  If anything it has been on the back of Roku (424), which figures prominently in many of her ETFs.  That these are performing so much better seems testimony to the idea there’s little that’s still weak, a positive for the market overall.  This is even more dramatically clear looking at solar stocks.  As measured by TAN (85), the Invesco ETF, after a big run those stocks peaked back in January and fell more than 40%.  Among the better component charts there are SolarEdge (267) and Sunrun (53).  Both of which have broken their own steep downtrends.   Those other Tech stocks, Biotechs, also seem much improved.

Sentiment is always difficult to measure, and even more difficult to act on.  Investors are right in between, but wrong at the extremes.  And how do you know an extreme, especially when you’re part of it?  None of us are immune to good old greed and fear.  Theoretically, there are some measures thought to be objective, like the Put/Call ratios and investment surveys.  When it comes to market peaks, however, these can be over the top and stay that way until you just stop caring.  Worse still, these measures often improve before the market peaks. When it comes to speculative markets like this one, the speculation often peaks before the market averages.  That was the case in 2000 when the NAZ and dot.coms peaked before the S&P really started down, and it was true in 2007 when a little oil bubble peaked before the overall market.  This time around we have seen a peak in the SPACs and likely Bitcoin.  The MEME stocks should be next.

So the Fed may raise rates as soon as late next year.  Granted we sometimes tend to be short term in our view of markets, but exactly how do “soon” and “late next year” go together?  This week the market seemed to agree.  If anything, after Powell’s diatribe, the market may have become reassured they are not off the reservation.  A so-called taper is another matter, but taper does not mean stop.  More importantly, there seems no tantrum.  It also seems that if your particular stocks aren’t going up, just wait a week and they probably will – the rotation is such.  The rotation they will tell you is the market trying to work out the implication of the Fed’s seeming shift in emphasis.  Naturally, we have to listen to the Fed, but even recently it has paid to concentrate on the numbers.  This week again, most days most stocks went up, not how markets get into important trouble.

Frank D. Gretz

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US Strategy Weekly: We Were Not Surprised

At last week’s FOMC meeting, Fed officials implied they may raise interest rates as soon as 2023, perhaps a year earlier than anticipated. We were not surprised. And during a post-meeting news conference, Fed Chair Jerome Powell said that the central bank was starting talks about when to pare down its monthly $120 billion of purchases of government bonds and securities put in place last year to support the recovery. Again, we were not surprised. But in Tuesday’s appearance before Congress, Powell reaffirmed the central bank’s commitment to encourage a “broad and inclusive recovery” in the job market and indicated the Fed would avoid raising interest rates too early based only on the fear of future inflation. Subsequent trading in inflation-protected and other securities implied investors are betting the Fed will change its policies faster than projected and we would agree. And in our view, Powell’s commitment to a “broad and inclusive recovery” was simply pandering to a Democratic majority in Congress. We assume Powell understands the limits of Fed policy and what it can and cannot achieve. The Fed’s tools are both broad and blunt. It is unable to target areas of the economy to support job growth. It can only increase liquidity in the system and hope that this will lift all boats. It has not. It is the role of the administration and Congress, not the Fed, to target areas of the economy.

Only Congress can target economic areas of greatest need by encouraging business investment, by lowering the restrictions and taxes on small businesses and inspiring job growth. Unfortunately, they are not doing this. We are not surprised. However, related to President Biden’s $1.9 trillion American Rescue plan, on July 15, the IRS will begin sending out monthly payments to around 36 million families as part of an expanded child tax credit program. Families will get an $1,800 supplemental child tax credit divided into six payments that will be sent out through December. If you qualify, you will get $300 per month for each child under the age of six and $250 per month for every child between the ages of six and 17. To qualify you must be a single taxpayer with an income up to $75,000, a head of a household with an income up to $112,500, or a married couple filing jointly, a qualified widow, or widower, with an income of up to $150,000. Families with higher incomes will receive $50 less per $1,000 earned. Payments will be phased out for people who make roughly $20,000 more than the relevant threshold. However, we were surprised to read that a family of four making less than $150,000 could see more than $14,000 in pandemic relief this year from the expanded child tax credit and $1,400 stimulus checks to both adults and children. This means some households could receive government checks totaling as much as $16,800! For a family making $149,000 a year this is a potential 11.3% increase in income. For some families, it could actually double annual household income this year. It is significant for a large number of families in the US.

We applaud the effort to assist the millions of families with children that that have fallen below the poverty line as a result of last year’s government shutdowns. Nevertheless, this is a stop gap program. Households could be permanently lifted out of poverty if they had more opportunities for better paying jobs and if they did, they could also make plans and have hope for a better future. This could be accomplished by putting government money into job training, childcare, tax exempt small business loans, creating public/private opportunity zones in areas blighted by the pandemic, and removing restrictions and lowering taxes on new small business owners. This type of constructive fiscal policy would have a positive long-term impact on household financial and mental health. It is the role of our elected officials. It is not the role of the Federal Reserve. But it is not happening. We are not surprised.

Fed Policy Is Pivotal

There are a number of reasons why we believe the Fed will be forced to change its policy this year. And as seen by the market’s reaction after last week’s FOMC meeting, a change could have an immediate and negative impact on the securities markets. Since the end of 2019, or just prior to the pandemic, the Federal Reserve’s balance sheet has grown by $3.85 trillion, the equivalent of 17% of nominal GDP. In short, an amazing amount of liquidity has been pumped into the banking system and the pumping has not ended. The Fed plans to continue its $120 billion in asset purchases each month. See page 3. However, in our view, quantitative easing is apt to be the first change in monetary policy and it will not surprise us if the Fed slows or ends its asset purchases in the second half of the year.

Yet while the Fed has been stimulating the economy with a soaring balance sheet and low interest rates, households have been hoarding cash. Since the end of 2019 through to May 3, demand deposits at commercial banks have increased a stunning $2.22 trillion to $4.0 trillion. See page 4. This cash hoarding could become a liquidity trap for the Fed, since it means the Fed’s actions are not having the positive impact on the economy it had intended. More stimuli could simply become pushing on a string, i.e., a true liquidity trap, and investors will lose faith in the Fed. In our view, this would be due to poor fiscal policy that provides households with ever more cash but does not emphasize future job growth. Households may simply be boosting savings for the rainy day they see ahead. This could explain why both the small business and consumer confidence surveys recently saw significant declines in “future expectations” even though current conditions remained stable.

With the fed funds rate at 0.1% and May’s inflation as measured by the CPI at 5%, the real fed funds rate is negative 4.9%, or its lowest level in over 70 years. This is worrisome since it is an extremely dovish policy for a non-recessionary, and expanding environment. According to the Fed, the economy is recovering and if so, monetary policy should change. See page 5. Plus, the economic backdrop is not good for the Fed or households. Core CPI and PPI are up 3.8% YOY and 2.9%, respectively. The PCE index is up 3.6% YOY. Headline CPI and PPI are up 5% and 8.7%, respectively. Prices are rising in most areas of the economy, and we doubt this is transient inflation. In our view, a small change by the Fed now could prevent the need for huge interest rate hikes in the future. Moreover, inflation is the equivalent of a tax on consumers, and this too is adding to the anxiety households have about their financial future. See page 6.

Housing and autos were the center of the economic recovery in 2020. This year auto sales remain strong, and prices of old and new cars are rising. Housing, on the other hand, may be about to plateau for a variety of reasons. May’s median existing home price rose to $350,300, a 24% YOY increase and the biggest gain on record since 1999. Yet, mortgage applications fell 17% YOY and existing home sales fell to 5.8 million units, down 0.9% month-over-month, but still up 45% YOY. Rising prices and falling sales could be due to a lack of supply since months of supply remained low at 2.5. But we believe first home buyers are being priced out of the market since house prices are rising faster than incomes. This could be more than a short-term situation. Remember: there were 7.6 million fewer people employed in May than in February 2020. Little has changed in the market’s technical condition. The 25-day up/down volume oscillator is in neutral and falling – a sign of weakening demand for equities. The NYSE advance decline line made a new high June 11. The Nasdaq Composite index eked out a new high this week and this index bears watching. The IXIC has been trading in a range of 12,995 to 14,200 most of this year. If this week’s move to 14,253 is indeed a breakout it could propel equities higher. If it becomes another failed rally attempt, it may be a short-term warning sign for investors. Stay alert.  

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There go those bonds again … trying to tell stocks what to do

DJIA:  33,823

There go those bonds again … trying to tell stocks what to do.  The economy is recovering, rates should go higher, bond prices lower.  Recently, it hasn’t quite worked that way.  The 10-year treasury yield had fallen to 1.5% from the 2021 peak around 1.75% in March, this amidst what seemed an inflation scare.  Investors it seems had come to believe the Fed, of all people.  As they say, the market isn’t always right, but when you go against it we’ve noticed they don’t give you your money back.  The consequence of this rate perception had been twofold for equities.  It means banks are between a rock and a hard place – the gap had narrowed between what they can charge for loans and what they pay on deposits or other short-term borrowings.  Another consequence of the changed rate structure was a recent better performance by Tech.  Tech is growth but who needs growth stocks when growth is everywhere. When growth is not there, then go to the companies that grow.

This is not to say the rally in cyclicals or commodities is over.  They have performed well and are entitled to a little respite.  While energy had lagged relative to spikes in copper and steel, it has performed well recently, suggesting the issue is not with the economic recovery.  This just seems about more rotation and rotation seems the year’s defining characteristic.  The market hasn’t had a 5% correction since last fall and, as we like to say, most days most stocks go up.  It seems the often annoying rotation has in its own way kept the market technically healthy.  Meanwhile, the option speculators of February are back, and “rumor” has it – to translate MEME to the Latin.  The VIX has dwindled to a pandemic era low of 15.7, suggesting complacency more than speculation may be the worry.  Then, too, the A/D index reached a new high just a few days ago, and momentum trumps sentiment.

To listen to the homebuilders, things could not be better.  The only reason they can’t sell more homes is shortages.  Somehow that doesn’t seem to fit with the recent collapse in lumber, but what do we know?  Then, too, back in 2007 their story over and over was they didn’t see a bubble, so what do they know?  Speaking of 2007, a ratio of home prices to rental prices is higher now than it was back then.  This could reflect the pandemic induced city exodus but still, stretched prices don’t usually stay stretched.  Meanwhile, the charts are looking a little the worse for wear, even including associated stocks as disparate as Home Depot (303) and Masco (59).  Getting back to lumber, the price of lumber is crashing relative to gold.  Lumber is considered a proxy for economic growth, while gold is considered a safe haven.  Previous extremes did tend to precede further declines in lumber prices as well as home building stocks, according to SentimenTrader.com.  Those homebuilding charts have begun to suggest the same could happen this time.

It wasn’t that long ago that $100 oil seemed almost laughable.  After all, the world was in lockdown, the roads empty, and flights virtually nonexistent.  Even now, $100 oil seems a stretch.  Yet Brent already has moved to $73, its highest level in two years.  It’s not that demand is that great, though it is growing, it’s more that new supplies have been slow in coming.  We’ve gone from 15 years of reserves to 10, and capital expenditures have gone to $100 billion a year from $400 billion 5 years ago, according to FT.   Jeremy Weir, executive chair of Trafigura, one of the world’s largest independent oil traders, told the FT Commodities Global Summit that the lack of spending on new supply was concerning, because the world is not ready to make the leap to clean energy and complete electrification.  Oil stocks, of course, have been on to this for some time.  Despite their performance this year they still seem underloved and, therefore, underowned.  Since opinions typically follow price, this seems likely to change.

So they’re talking about talking about.  Wednesday’s Fed meeting has resulted in a change in expectations, like everyone expected rates to stay low forever.  What it didn’t do was signal any real retreat from pandemic crisis measures, for now and for some time.  As seems his intention, Powell has plenty of justification to stay the course – employment is yet to improve that much and much of the inflation does seem about bottlenecks that should prove transitory.  That yields had fallen in the last three months, and did so again even on Thursday indicates what seems a prevailing belief the Fed won’t be panicked into tightening.  Similar market reactions – 0.5% declines in stocks, bonds and gold – followed other FOMC announcements in the past.  After some short term consolidation, what followed was higher prices.  Keep in mind, too, we came into this with a better than good pattern in the A/D’s, a pattern of higher lows versus the pattern of lower lows in the averages.  If you want to see a market with real credit restrictions, take a look at China.

Frank D. Gretz

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Hedge fund, or … hedge fun

DJIA:  34,466

Hedge fund, or … hedge fun. Back when we frequented the Hamptons, we were impressed by those hedges surrounding, though not quite completely hiding, the Estates.  We also were impressed to learn the price of a trim, so to speak.  So much so, we came up with a name for our new, though theoretical business, something to do with fun.   The two things that worry us are not about technical analysis.  We worry about a cyber 9/11 and a variant the vaccines don’t overcome.  Both, of course, would do significant damage to share prices.  It’s a bull market, making hedging very difficult.  The cyber security stocks and ETF’s seem to make sense when it comes to hedging the likely ongoing threat there.  HACK, the Prime Cyber Security ETF (HACK-61) and CIBR (46), the First Trust Security ETF should be useful there.  As for a Covid problem, the VAC makers BioNTech (240) and Moderna (217) should be useful.

If be bearish you must, Goldman Sachs has a model which predicts the probability of a bear market.  The model is cleverly named the Bear Market Probability Model, and consists of unemployment, ISM manufacturing, the yield curve, inflation rate and P/E‘s.  As the model cycles from below 40% to above 65% the odds of a bear market are said to increase.  When above 65% the S&P has returned an annualized +3.4%, according to SentimenTrader.com, which hardly sounds like a bear market to us.  Then, too, that’s only a sixth of the return when the probability is below 40%.  Currently around 67%, the model is not high enough to be a major concern, but the model has cycled from below 40% to above 65% in just 11 months, the fastest turnaround ever.  The model, obviously, is based on those funnymentals.  As we mentioned last time, were we one of those types we likely would be more concerned about the Cyclically Adjusted P/E.  Instead, with the Advance-Decline index making new highs and 80% of stocks above the 200 day, that is, in uptrends, we think any bear market is yet some time away.

Energy is the best performing sector this year.  Like anything up, especially anything at 45%, most aren’t interested when you are positive.  This proved true in a recent discussion when the retort was just that – they’re up too much.  When we asked how many oil stocks this person owned, the answer was none.  And there it is.  When it comes to the oil stocks most own little or none.  They’re under-owned and that’s why they’ll keep going.  Add to that, as is always the case, now the news is getting better.  Activists are leaning on big oil to drill less, the rig count is down 35% from pre-Covid levels, oil inventories are below their five-year average – all this as demand continues to climb.  The news is better but the stocks are up too much to buy, most think.  When the stocks keep going the news will become almost compelling, to the point that you have to buy.  It’s just the way the market works. XOP (97), the SPDR Oil and Gas ETF is a good start.

Sentiment or market psychology is an important part of technical analysis.  Simply put, traders and even investors tend to be wrong at the extremes.  Sentiment, of course, isn’t easy to measure or to follow.  When bullishness is extreme we are all likely to be part of it, and hesitant to give up that lovin’ feeling that comes with making money.  And at such times, it’s nice to be around those who share a similar sentiment, so to speak.  This might explain the enthusiasm for last weekend’s Crypto conference.  Attendance was 12,000 versus 2,000 the prior year, and the $600 ticket price was selling for $1200 before the conference started – a better investment than Bitcoin recently.  The real concern here is the price action.  Using the Grayscale Bitcoin Trust as a proxy, it’s a look that can’t be described in polite company.  As for the market overall, it’s easy to say sentiment is over the top, but it’s difficult to measure.  Mechanical measures didn’t capture the dot.com’s back then, and now don’t capture Crypto, SPACS, and Memes.  Fortunately, momentum trumps sentiment.

We tend to fixate on the A/D‘s rather than the market averages.  The A/D index is at new highs, and the daily numbers have been positive nine of the last 11 days.  What’s not to like?  That said, even we are surprised at the lack of movement in the S&P – stocks go up most days but not enough to break out the average?  Of course, when they do break out the concern will be about a false breakout, one which quickly reverses.  Ever notice, there’s always something.  What has come to be of a bit more concern than the S&P is the Transports.  They peaked the middle of May and are now teetering on their 50 day average.  This doesn’t seem a concern for the market overall, but it is from a leadership standpoint.  We still believe leadership lies in Cyclicals and Commodities, but we would like a little reassurance from the Transports.  Meanwhile, annoying as the incessant rotation may be, it is at least intriguing.  One of the best acting Tech stocks these days is a little company that makes “business machines.”  And, by the way, war may be nigh to look at the defense stocks.                                                              

Frank D. Gretz

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US Strategy Weekly: Tighten Now or Later

Friday’s employment report will be important since it will set the stage for the Federal Reserve’s next FOMC meeting scheduled for June 15 and 16. The June meeting will be accompanied by a Summary of Economic Projections and economists will be checking this closely to see if estimates have changed and if so, might this mean that a pivot in monetary policy is on the horizon. In short, it could be a market moving event. April’s job report showed a disappointing increase of 266,000 new jobs, which was less that the average gain seen over the previous three or six months. May should see a nice recovery in the labor market since most states are now relaxing or eliminating pandemic restrictions. However, if the release shows an extraordinarily strong job market this could also spook investors who are worried that a strengthening economy, coupled with a high savings rate and pent-up demand, could fan the flames of inflation. We worry about this as well.

Federal Reserve officials continue to emphasize that any inflation will be transitory, but to some market observers this translates into the possibility, or likelihood, that the Fed is apt to fall behind the curve. If so, the Fed would need to raise rates even more aggressively sometime in the future in order to tame inflation. This is an important factor since most economic recessions in the US have been preceded by repeated Fed tightenings. In fact, this is the underlying principle in Edson Gould’s famous “three steps and a stumble rule.” Edson* was a well-respected market technician and stock market historian of the 1930-1980 era, yet some technicians do not believe his rule is valid today. We have found that to make this rule useful it is important to observe the number of Fed fund increases within a rolling twelve-month period. Three or more fed rate hikes, particularly if they are large, within a twelve-month period has always been followed by a weak stock market in the subsequent six and twelve months and it is usually in conjunction with a recession. For this reason, among others, it is important that the Fed not delay in addressing inflation and find itself running to catch up to control the cycle.

In our view, inflation has always been the main risk for equity investors in 2021 since it means both a change from easy monetary policy, a rise in interest rates and a decline in average PE multiples.

Inflation does not have to be a disaster for equities, however. Stock prices can rise along with interest rates as long as earnings increase enough to compensate for the rise in the risk-free rate. Good earnings growth appears to be a strong possibility for this year and next; therefore, the greater risk over the next twelve months is more likely to be the Fed. If the Fed delays a shift in monetary policy too long, it could find itself having to tighten more aggressively to stem off inflation; thereby triggering a recession. The Fed’s favorite benchmark for inflation is the personal consumption expenditures (PCE) price index and this revealed a 3.6% YOY rise in April after being up 2.4% YOY in March. We were not surprised by this big jump in the PCE deflator since it puts it in line with all other inflation measures which now uniformly exceed 3% YOY. The implications for monetary policy are potentially huge. To demonstrate the pressure that this places on the Fed we have a chart of the real fed funds rate as compared to the PCE deflator. See page 7. The real fed funds rate is currently negative 3.5% and reflecting the “easiest” policy seen since February 1975, during the 1974-1975 recession. This negative real fed funds rate will prove to be far too stimulative as people go back to work and the economy recovers. It will force the FOMC to change its verbiage and actions.

Only time will tell if inflation is transitory or not. Meanwhile, we believe the healthiest scenario for the equity market would be either a 10% correction or a sideways market over the next few months. If not, the inevitable shift in Fed policy will trigger a correction that could exceed 10% in the SPX. Seasonality also suggests the stock market may be about to take a pause. June tends to be an underperforming month in the annual calendar and ranks 9th or 10th in terms of performance in most indices. See page 9.

A Mix of Economics

Housing has been a main pillar of the economic recovery during the pandemic. However, the pending homes sales index for April fell from 111.1 to 106.2, which was its lowest level since May 2020. April’s survey leaves the index below its long-term average of 108.7. This decline in housing sales is likely to continue, particularly if home prices continue to rise. Buyers are apt to be priced out of the market. In April, the median home price for a single-family home rose 20% YOY, the largest twelve-month increase in National Association of Realtors records going back to 1999. Mortgage rates remain historically low but have also been rising, which will become another handicap for first time buyers. See page 3.

Stimulus checks boosted personal income 30% YOY in March; but in April personal income fell 13.1% month-over-month, which translated into a small 0.5% YOY increase. Disposable personal income rose 33.3% YOY in March but fell 1% YOY in April. The savings rate remains high but erratic at 14.7% in February, 27.7% in March and 14.9% in April. See page 4. The most interesting part of personal income is pre-pandemic total compensation which does not include transfer payments. Total compensation peaked in February 2020 at a seasonally adjusted annualized rate of $11.82 billion; however, despite the drop in employment, we were surprised to find that total compensation achieved a new record of $11.88 billion in November 2020. In April, total compensation rose to an all-time high of $12.3 billion. The same pattern is true if we look solely at wages or supplements for employees in the private sector. This underlying momentum in wages seen since November 2020 challenges the need for further fiscal stimulus in 2021. It also indicates that further stimulus could over-stimulate the economy. See page 5.

Earnings and PE Multiples

Both Refinitiv IBES and S&P Dow Jones consensus EPS estimates for the SPX for 2021 and 2022 continue to rise which is favorable and provides support for the equity market. The current IBES and S&P estimates are $189.61 and $186.59 for 2021 and $212.12 and $209.50 for 2022, respectively. This means the market is rich, but not overvalued, in a low inflation environment where a 20 PE multiple is justifiable. However, if inflation is 3.5% or higher PE multiples are likely to fall back to average or lower. The long-term average PE multiple for the SPX based upon forward earnings has been 18.2 times and on trailing 12-month earnings the average PE is lower at 15.8 times. This points to why inflation is a dilemma.

Market Data

To date, 2021 has been most notable for its leadership shift, away from the technology-laden Nasdaq Composite Index and small capitalization Russell 2000 index and toward cyclically driven inflation sectors such as energy, materials, financials, and REITs. See page 16 for sector performances year-to-date. This shift is producing new highs in the SPX and DJIA and sideways patterns in the IXIC and RUT. See page 12. There are also disparities in macro technical indicators. The NYSE cumulative advance decline line made a record high on June 1 confirming a bull market, whereas the 25-day up/down volume oscillator continues to languish in neutral. At present this indicator is suggesting the indices are moving to new highs but on lower volume and less robust buying pressure. This is a sign of waning investor demand and therefore is a warning. Again, a sideways or correcting market would be the healthiest scenario near term. *https://www.ofeed.com/Star%20Traders/1135

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