It’s Tough to Beat the S&P 500…Even S&P Stocks Can’t Do it

DJIA: 35,085 It’s tough to beat the S&P 500… even S&P stocks can’t do it. We’re thinking here of the S&P 500 Index as we know it, versus the 500 or so stocks which comprise it – the S&P Equal Weight Index (RSP-153) where market cap is not a factor. The S&P makes new highs seemingly most days, the equal weight version has gone nowhere since early May. The Russell 2000 (IWM-223), that measure of secondary stocks that everyone loves to love, has gone nowhere since February. So where is the big bull market? Arguably it’s in five stocks, Apple (146), Amazon (3592), Alphabet (2733), Facebook (359) and Microsoft (287). As of last Friday these five account for 22.9% of the S&P‘s market cap, the highest combined market cap of any five ever. Given all five are pushing twelve-month highs, and given their market cap weight, you kind of have to join ‘em to beat ‘em, or to even keep up. There are stocks and groups which have outperformed from time to time, but the frequent rotation has made it difficult to keep up. And, realistically, it’s not what most do. Is piling into five stocks healthy? In the early 70‘s at least there were 50 of these little darlings. And the dot.com’s obviously saw many more. The answer, of course, is it’s not healthy – extremes rarely are. Divergences, in this case within the S&P itself, are never healthy. And they’re not without risk. If you don’t care about valuations, how about simple supply and demand – after a while, who is left to buy? Certainly these all are great companies, but so too were GE (13) and Cisco (55) back in 1999 when they were among the S&P‘s top-five by market cap. The saving grace now, what makes this time different, dare we say, is the overall background, specifically the Advance-Decline index. Unlike those other periods, this market still has decent, though deteriorating, participation. Facebook beats! The most advertised or anticipated “beat” in the history of markets? Who is to say, but if the stock can survive this kind of anticipation and the temptation to “sell on the news,” indeed, we will be impressed. We pointed out many times, stocks that outperform are those where analyst estimates are too low and, of course, vice versa. So is a match as good as a beat? As it is one of the chosen, could be. If instead it is priced in/discounted, that tells us something as well. It’s the market that makes the news, even for the chosen few. When good news isn’t good news, it’s time to think about it. By definition, in divergent markets the strongest are the last to give it up – therefore, the market averages versus the AD’s. If Facebook and Apple can’t right themselves after these little reporting setbacks, it’s something to think about. Then, too, a little rest for these will not hurt. Investor sentiment or psychology is always difficult to measure. Even indicators like the VIX (18) which seems objective, over the years has ranged from 30 to 80 at market lows. And when it comes to the investment surveys, they are notoriously early. By the time it’s time to worry, most have stopped doing so. We’re also thinking here of those intangibles which escape measure altogether and, hence, no pretense of objectivity. How, for example, would you have measured the bubble that was the “nifty 50” or the dot.com’s? Being there you couldn’t help but know it, but with no objective measure it was easy to ignore. This seems the case now, one could argue we’ve seen several bubbles – the SPACs, the MEME stocks and even bitcoin. Easy to think Robin Hood will be some seminal event, but we suspect it’s more the big picture – the top five of the S&P reach 30% plus? A final thought on bubbles. From the King Report, banks are giving families with wealth of 100 million or more the ability to borrow at less than 1%. We remember, or think we do, back in the days of “Japan Inc.,” a business woman being denied a loan. The same bank a couple years later approached her with double the amount if she wanted to join a golf club. There are plenty excesses in the market and the economy. Problems in the technical background are increasing, including the recent lag in financial stocks. The ratio of financials to the S&P is at a 90 day low, a condition that typically has bled into the overall market over the next 2 to 4 weeks. Despite the strength in Tech, there were more twelve-month new lows than new highs on the NASDAQ last week, and despite the S&P strength, only about half the stocks there are above their 50 day. Most important seems the lagging A/D‘s. It would be nice to get back to those days when most stocks went up.

Frank D. Gretz

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More Clouds on the Horizon

The second quarter of 2021 was a good one for the popular averages, but—similar to the first—was notable for its rotation from value to growth, and small capitalized companies to large, then back again. Volatility and speculation picked up, adding to the difficulty for portfolio and fund managers to outperform, and most did not.

The story for the year may be the rapid rebound in the U.S. economy, but earnings growth has been and still is the story for most companies as we enter the second half of 2021. It has been nothing short of remarkable. Before the pandemic, 2021 earnings growth was expected to be just shy of 11%. But thanks to unprecedented massive government stimulus, these expectations were rapidly revised higher. At the start of the year consensus estimates were for growth of about 23%. Today earnings growth is approaching 40%. These numbers are obviously unsustainable, and 2021 earnings may be beginning to eat into 2022’s growth rate. From an historical standpoint, since 1950 the compound annual growth rate for S&P 500 earnings has been slightly above 6%.  Similar to how earnings growth has been robust, equity market returns have far exceeded their historical compounded returns of just shy of 8% since 1950.

Our April letter pointed to a robust equity market but with clouds in the future. Since then we think these clouds have intensified. Without further enactments, the effects of fiscal policy stimulus are fading, a divided Congress is pushing its own priorities, monetary policy is becoming more confusing, COVID-19 variants are emerging, regulators are becoming more aggressive, and geopolitical challenges are building.

We continue to believe the fading fiscal policy tailwind is one of the more important of these impacts on the economy, corporate profits, and equity prices. Regardless of what happens with the infrastructure package, the U.S. will have at least a $1.5 trillion fiscal drop in 2022. This is primarily because infrastructure spending takes years to be distributed, new social spending is just offsetting what has been spent, and tax increases, if included, are immediate. $2 trillion of COVID aid is not the same as $2 trillion of infrastructure spending. The net impact, under the most optimistic scenario, is roughly $130 billion of new spending, which hardly dents the $1.8 trillion run-off. Without a new round of rebate checks going out, there is the possibility that the U.S. is headed for its largest fiscal contraction since the drawdown of WWII.

Of course, a lot of this is conjecture at this point, and will remain so until we see what actually comes out of Washington D.C. There are also offsets to the fiscal cliff: corporations and U.S. consumers are flush with cash, jobs are plentiful and wages are rising, U.S. corporations are increasing cap-ex intentions to meet resurgent demand and the realignment of global supply chains. Importantly, productivity is surging, thanks to technology and automation investments, partly caused by the COVID shutdown.

We continue to believe that we are in a secular bull market that is characterized by higher corporate profits and lower long term inflation. There are enough uncertainties, however, that near term caution is advised.  

July 2021

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US Strategy Weekly: Pluses and Minuses

Not surprisingly, the second half of the year is proving to be more volatile than the first half and we believe this is due to several reasons. On the positive side is the strength seen in first and second quarter earnings results for the S&P 500 companies. This encouraging news on earnings is coupled with extremely easy monetary policy which includes low interest rates and $120 billion of monthly security purchases by the Fed, and child tax credits and a potential infrastructure bill in terms of fiscal stimulus.

On the negative side is the fact that earnings growth may be peaking. Although earnings growth should remain positive, the growth rates of 143% YOY in the first quarter and an estimated 65% YOY in the second quarter are unsustainable in the long term. In fact, consensus earnings forecasts suggest that earnings growth in the final quarters of the year will be less than half the pace seen in the second quarter. This decline in the growth rate is not a big negative; however, it does suggest that PE multiples may also have peaked. PE multiples tend to move higher when earnings growth is rising, but a decline in the earnings growth rate will not justify any further multiple expansion. PE multiples could also come under pressure in the second half given the extremely high levels of inflation recorded by all the inflation benchmarks.

Also on the negative side is the fact that monetary policy is apt to change in the second half. Although the Fed insists that inflation is temporary, it is unlikely to decrease soon, and this could force the Fed to alter its quantitative easing. There have already been some innuendos that the Fed may change its tone on inflation at this week’s post-meeting press conference. It has been our view that the Fed would initiate the discussion of reducing quantitative easing at its August symposium. The significance of this potential shift cannot be underestimated. The Fed has been flooding the US banking system with liquidity for more than 17 months. This historic level of liquidity has supported the economy, but it has also supported equities since March 2020. It has helped boost stock prices and investment in general. The absence of this support will not hurt stock prices per se, but investors will no longer have the wind at their backs.

Yet it is important to note that history has shown that the anticipation of a change in Fed policy can have a bigger and more immediate impact on stock prices and investor psychology. Therefore, any hint of a change in the Fed’s monthly purchases is apt to trigger a correction. In sum, expect more volatility ahead. Assuming this is true, some of the safest investments in the second half could be stocks with lower-than-average PE multiples and higher than average dividend yields.  

Another possible negative in the second half relates to China. There are already signs that China’s growth is beginning to slow and profit margins are being negatively impacted by higher raw material costs. But the larger risk regarding China may be its increasingly aggressive posture towards corporations inside of China and its posture with the US. Beijing has begun a sweeping crackdown on companies such as Tencent Holdings (0700.HK – $446.00) which it ordered to give up exclusive music licensing rights. China fined Alibaba Group Holdings (BABA.K – $186.07) for anti-monopoly violations. And it denied Huya Inc.’s (HUYA.K – $11.96) planned game streaming merger with DouYu International Holdings (DOYU.O – $3.77). Yet, most disturbing, is China’s increasingly aggressive stance with the US. This week’s meeting between US deputy Secretary of State Wendy Sherman and Chinese Foreign Minister Wang Yi ended with Chinese officials accusing the US of “coercive diplomacy,” and warned the US to stop meddling in Taiwan or Xinjiang issues. They also presented deputy Secretary Sherman with two lists of action. These included revoking sanctions on Communist Party officials, lifting visa bans for students, making life easier for state-affiliated journalists and reopening the door for Confucius Institutes. This meeting, which took place in the Chinese city of Tianjin, was not open to foreign press, although the Chinese press were allowed. All in all, this suggests that issues with Hong Kong and Taiwan may continue to escalate.

Economic News

New-home sales in June fell for a third month in a row as homebuilders contend with high construction costs and a burgeoning pipeline of single-family projects. New-home sales fell 6.6% to 676,000 annualized units in June, which was the lowest level since April 2020. We noticed that builders show that inventory for new homes for sale are currently low, but new homes under construction are up strongly. An even sharper uptrend can be seen in new home construction yet-to-be started.

Existing-home sales rose 1.4% in June to 5.86 million units annualized, fully reversing May’s losses, and breaking the four-month losing streak registered since the start of the year. The recent dip in mortgage rates along with a rebounding labor market contributed to the pickup in home sales. Single-family sales and condo/co-op-sales both rose 1.4% from the previous month. Sales were higher in all census regions except the South, where they were flat from the prior month.

Sentiment indicators are mixed with the Conference Board showing July gains in the broad index, present conditions and a flat reading in expectations. The University of Michigan sentiment reported losses in all indices and a particularly large drop from 83.5 to 78.4 in expectations. The difference may be due to timing of the surveys and the dispensing of stimulus checks. See page 3.

Technical Update

The 25-day up/down volume oscillator is at negative 1.27 and neutral this week after recording one day in oversold territory on July 19. This is an unusually low value for this oscillator particularly since there have been two 90% up volume days in the last 25 trading sessions. We do not remember ever seeing strong 90% up days with our oscillator remaining in the negative half of the neutral zone. This means that over the last 25 days there has been more volume in stocks declining than in those advancing.

The last time the 25-day up/down volume oscillator showed strong buying pressure was when it recorded one day in overbought territory on April 29. Prior to that there was a minimal five consecutive trading days in overbought territory between February 4 and February 10. In sum, the February readings confirmed the record highs in the broad indices at that time; but since then, there have been no confirmations of recent highs. The July 19 drop to negative 3.49 was the first oversold reading since the pandemic, or in March-April 2020.

Our 25-day up down volume oscillator is warning that demand is fading, and investors are selling into strength. The longer this volume non-confirmation of new highs continues the greater the downside risk to the broader market. In short, the recent erratic trend in the market has been expected and should be considered healthy. However, if a new rally fails to generate a new overbought reading, it would be a signal that the major trend is weakening. Should a future pullback in the equity market generate an oversold reading without an intervening overbought reading, it will confirm that the major cycle has shifted from bullish to bearish.

Gail Dudack

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From Worst…to First

DJIA: 34,823 From worst … to first. That was the pattern Monday and Tuesday. The 700 point Dow loss on Monday made the headlines, but as always we are more about the average stock than the stock averages. Monday’s bashing saw Advance-Declines 5-to-1 down, and up volume less than 15%. This, of course, cannot be called a complete surprise. The A/D numbers had flattened recently, negatively diverging from the averages like the Dow. The S&P was making new highs with fewer than 40% of components there above their own 50 day average. On the NASDAQ, a new high with more 12 month new lows was another warning. This deterioration simply caught up with the market on Monday. Monday did see a spike in Put/Call ratios and the S&P did hold its own 50 day average. Then pretty much out of the blue came Tuesday’s rally. It was not your dead cat bounce. The Advance-Declines cycled to 4.5-to-1up and up volume was greater than 85%. Since 1962, this kind of reversal has led to higher prices a month later every time, according to SentimenTrader.com. Covid seemed to catch the blame for Monday’s selloff, though we easily could have blamed China. Covid isn’t new, why was it important Monday? That’s just the way the market works – news follows price. The selloff was about the technical deterioration, specifically those A/D numbers. It’s important to look at them in conjunction with the averages. If the Dow is down 200 points the A/D’s will be negative, and they should be. If the Dow is up 200 points and the A/D’s are flat, let alone negative, that’s a problem – Thursday was that kind of negative day. As we pointed out last time, the performance of the “average stock” has been the best feature of the technical background, and now that seems to have changed. This also shows up in the Equal Weight S&P which has gone nowhere since early May, and the Russell 2000, a measure of small caps, which has gone nowhere since mid-March. Both are concerns, but alone are not uptrend killers. Rightly or wrongly, the Dow Theory doesn’t get much attention these days. Wrongly, because over time it has been quite often accurate. Rightly, because in recent years, not so much. The concept is sound enough – if you’re making the stuff you should be shipping the stuff. The transports should confirm the industrials. These days, of course, the Industrials are as much financials and the Transports have their airlines. And while the concept is simple enough, the nuances of the theory are a bit more complex. In any event, what seems important is that the transports peaked in early May, pretty much when the reflation trade peaked. If not a good indicator of market direction, they have seemed a good indicator of leadership, broadly speaking. Looking at the 20 component stocks, it’s a stretch to find a good chart. That’s even true of the truckers, which should come as a surprise if you have driven the Northeast Corridor lately. Breaking the downtrend here might suggest a move back to that reflation trade. The rotation, meanwhile, has become seemingly daily. Some of this, of course, is Covid related. The recent better action in Procter & Gamble (138) is a reminder of those bad old days. Most of the other staples aren’t on a par here, though Coke (56) and Pepsi (155) both have had upside breakouts. Seasonally it’s a good time for staples generally. Yet to get going are stocks like Zoom Video (361) and Teledoc (152) – guess they’re just not Domino’s (544). The industrials have had a tough go of it, but have come through so far more neutral than negative – see for example, XLI (103). It’s the metals and energy stocks that have taking the biggest hit. Together with bonds, a seeming telling commentary on inflation. Somewhat contradictory, economically sensitive real estate has done quite well. All hail the 50 day! Where would we be without it? That’s easy – lower. We are referring to the S&P and its 50 day moving average, though most apply it to individual stocks as well. Including a few minor dips below it, the S&P has bounced off its 50 day 13 times in the past year. It’s enough to make you wonder – could there be more chart guys than funnymental guys? You have to pay attention if only because most do. It’s with rare exception that we buy or hold a stock below its 50 day. Everyone likes to talk about the 200 day, but in an uptrend like this, by the time you get to the 200 day you have given up, or lost a lot of money. That said, the 200 day is important. It’s important in that it’s your last chance to remain solvent. The S&P remains some 11% above its 200 day, versus an average 13% in this year‘s first six months. Perhaps more importantly, the 50 day is some 8% above the 200 day. All the money is made against this backdrop – the 50 day above the 200 day. Frank D. Gretz

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US Strategy Weekly: Volatility

The Dow Jones Industrial Average rose 549.95 points, or 1.62% on Tuesday after falling 725.81 points, or 2.1%, on Monday. This surge in volatility drove the VIX index (VIX – $19.73) over 25 earlier this week which was a concern to many investors, perhaps because many call the VIX the “fear index.” We are not surprised if the level of fear is increasing among investors given the spread of the Delta virus, the rich level of equity valuations and the potential of a change in monetary policy. However, the VIX is not a good short-term indicator in our opinion. It is actually most useful at the end of a bear market when fear is at its highest. VIX readings between 45 and 85 have marked recent bear market lows. This being true, a high VIX reading, particularly above 80, can denote a buying opportunity. See page 6. In comparison the recent readings of 25 are mild and are not a worry. Keep in mind that fear is emotional and often unpredictable, and this may be the message in the VIX’s rise – more volatility ahead. It has been our view that the second half of 2021 will be more volatile and is likely to include a correction of 10% or more.
In terms of technical indicators, we are more concerned about breadth data and specifically volume in advancing stocks. The last time the 25-day up/down volume oscillator showed strong and consistent buying pressure was when it recorded a single day in overbought territory on April 29. Prior to that there was a modest five consecutive trading days in overbought territory between February 4 and February 10. The February readings were a confirmation of the record highs made at that time. But since mid-February, there has not been any volume confirmation of recent highs. Currently, the 25-day up/down volume oscillator is at negative 2.19 after recording a negative 3.49 reading earlier this week. Monday’s drop to negative 3.49 was the first oversold reading since March-April 2020, or during the depths of the global pandemic.
In short, since early February, our 25-day up down volume oscillator has been showing us that as the indices were moving to new record highs, volume in advancing stocks was declining and volume in declining stocks was increasing. This is a sign of waning demand and/or investors selling into strength. The longer this non-confirmation of new highs continues, the greater the downside risk to the broader market. From this perspective, the recent selloff was expected and should be considered healthy.
Nevertheless, after any brief oversold reading, a bull market should rise to new highs and have an accompanying overbought reading. This demonstrates solid buying pressure. If not, and if a rally fails to generate a new overbought reading, it would be a signal that the major trend is weakening or changing. If a subsequent decline in the indices generates a second oversold reading without an intervening overbought reading, it would indicate that the major cycle has shifted from bullish to bearish. In sum, these are the scenarios that concern us. These are the patterns we will be monitoring in coming weeks.
In June, major inflation benchmarks were rising at hefty year-over-year rates: CPI 5.3%, PPI 9.4%, GDP deflator 2.0% (March), import prices index 11.2%, and import prices excluding petroleum 6.8%. And core benchmarks were CPI 4.5%, PPI 3.6%, and core PCE deflator 3.4%. In short, inflation is widespread, and as high, or higher, than it was in 2008 and it is not apt to end soon. This pressures current monetary policy.
Plus, easy monetary policy tends to fuel inflation and the real fed funds rate is already at an all-time low. Most importantly, stock prices have not performed well during periods of high inflation. In fact, the chart on page 3 shows that high inflation and stocks prices tend to be inversely correlated. Also noticeable in this chart is that high inflation tends to precede recessions. All in all, it is not surprising that fear is rising.

Gail Dudack

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All good things must end…the odds are

DJIA:  34,987

All good things must end … the odds are.  The good thing in this case is the pattern in the S&P.  The index has spent the entire first half above its 200 day, by an average of some 13%.  This has happened only 34 times since 1929, according to Bank of America’s Steven Suttmeier.  The problem is only 13 times did the pattern continue through the second half.  The odds, of course, are often to be defied.  It is a concern, though, that only about 60% of S&P stocks are above their 50 day average, indicating weakness short-term versus the longer-term strength.  This becomes even more worrisome against the backdrop of new highs in the index itself.  Another little divergence comes in the form of the Equal Weight S&P, which has gone nowhere since early to mid-May.  None of this is reason to sell everything, but together it’s beginning to add up to an increased likelihood of a correction.

The divergence that most concerns us is one which has developed between the Dow and the Advance-Decline index.  What’s going on in the “average stock” as measured by the A/D index, we consider of greater importance than what’s going on in the stock averages.  The A/D index recently failed to match the highs in the averages.  Granted this is very short term stuff, and last Friday’s 3-to-1 up day wasn’t exactly the feel of a divergence.  Still, the divergence is there, and what seems important is the change.  The A/D‘s had been outperforming the averages, now they’re lagging.  It is relatively minor – a strong, broad rally would resolve the problem. Then, too, back in October 2000 it took only three days of this kind of action to lead to a 20% correction.  There also are concerns about the NASDAQ, despite growth’s clear revival.  Last week’s new high saw only 31% of stocks advance, and more twelve-month new lows than new highs.  That’s a pretty thin new high, and worrisome.

Whatever happened to the rebounding post pandemic recovery?  Since the beginning of last month bonds have rallied and the yield curve flattened, suggesting little inflation and a less robust economy.  For stocks, value has outperformed growth for the year to date, but concerns about that trade have come to the fore.  Clear examples are the airlines, hotels, resorts and cruise lines.  All were hit by the pandemic and sold off sharply last year, but rebounded strongly in February.  Since then they have seriously lagged the S&P.  Meanwhile, growth stocks, bought when growth is thought to be scarce, have performed well compared to value.  Whether correctly or not, concerns about the economy and, therefore, about the reopening trade now seem to dominate the thinking.  Time will tell, to coin a phrase, but there’s reason not to give up on the value/reflation trade.  Over the last month or so the ratio of value to growth stocks has plunged.  The drop, however, is in the context of a long-term trend.  Previous drops have tended to resolve in the direction of that trend.

The background worries seem obvious – the economy, inflation, cyber and Covid.  These we all know.  What always seems to cause the problems, we’ve noticed, are the worries we don’t know or we know but don’t consider worries.  We’re thinking here of China.  Recent headlines have been full of China’s latest clampdowns on companies and their listings, its growing attempt to eradicate bitcoin and the hassles for Tesla (651).  The impact on stocks like BABA (215) and the others has been noticeable, not to mention the recently listed DiDi (12).  To look at both manufacturing and services data, one could conclude China’s rebound is over.  As the country that led the US, Europe and the rest of the world into the Covid-related slow down and out of it, and as the driver of much of the world’s growth, this is not good news.  Technical patterns there, of course, have turned very weak.

It has been a good market, but not always good when it comes to making money.  Many hedge funds, for example, have had a tough start to the year.  From the Wall Street Journal, “Morgan Stanley and Goldman Sachs showed that fundamental stock-picking hedge funds posted negative alpha – trader talk for poor performance – in the first half of the year.  Part of the challenge for professional stock-pickers is that markets have been heavily rotational, several hedge funds said.  Markets this year have whipped back and forth between growth stocks and value stocks, making it difficult for managers to find winning trades.”  For now growth seems to hold the upper hand – see, for example, the SPDR ETF (XLK – 152) where Apple (148) and Microsoft (281) dominate.  And the recent breakouts in Amazon (3631) and Google (2540) are impressive.  In market corrections, however, it’s rare they don’t get to everything.  Meanwhile, bubbles are coming undone – the SPACS, Bitcoin, AMC (36).

Frank D. Gretz

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Welcome the Bump in the Road

The S&P 500 and the Wilshire 5000 both rose to record highs at the end of June capping a wonderful first six months of 2021 for equity investors. Most broad market indices had year-to-date advances of 14%, which for most calendar years would be considered a terrific performance. One historical tidbit suggests that solid gains in the first half of the year tend to be followed by further advances in the second half, so there is reason to be optimistic for the intermediate term. But more importantly, the main characteristic of the 2021 stock market to date was the shift away from the perennial leadership of technology and growth stocks and to a range of stocks that can best be described as inflation driven. Sectors such as energy, REITs, materials, industrials, and financials outperformed the S&P Composite by a wide margin in the first six months of the year. And given the outlook for inflation, this performance may continue in the second half.

More Inflation Ahead

Some of this leadership shift was due to the belief that the global economy is conquering the spread of COVID-19 and the new Delta virus, which suggests that most trade and business activities will soon return to normal. To a large extent, this has encouraged investors to invest in economically sensitive, or cyclical stocks. However, a more significant driver of this leadership shift was a ubiquitous rise in prices. Soaring costs for energy, lumber, semiconductors, and a variety of raw materials are expected to be transient according to the Federal Reserve. But in our view, the dislocations from production and shipping that developed during the shutdown in 2020 will take quite a while to return to their typical standard. Energy prices are rising from a combination of green energy policies imposed by governments globally, a breakdown in OPEC discussions and a simultaneous rise in demand. Semiconductors are in short supply due to an increase in demand but more importantly, a concentration of manufacturing in one area of the world – Taiwan. This has exposed the semiconductor industry to a risk in terms of production and geopolitics. These are just some of the reasons why price increases are broadly based and may not be transient. General Mills’ (GIS – $59.99) recently announced that as a result of more expensive ingredients, packaging, trucking and labor costs, the company expects wholesale costs will be about 7% higher over the next year or so. These costs will be passed on to consumers. Therefore, it seems inevitable that households will be facing higher expenses throughout the second half of 2021, and this could alter consumption patterns. Investors should therefore focus on companies that will benefit from higher pricing.

Monetary Policy Risk

Counterbalancing higher expenses for households and businesses are the ongoing stimulative monetary and fiscal policies seen in the US. Since the pre-pandemic era, or the end of 2019, the Federal Reserve has increased its balance sheet by $3.85 trillion. Additionally, the Fed’s purchases of $120 billion of securities each month are open-ended. Unfortunately, much of this liquidity remains immobile within the banking system. Customer demand deposits at commercial banks increased $2.2 trillion in the same period and commercial bank reserves at the Federal Reserve have been on the rise. In other words, households are not consuming, and businesses are not investing, and cash continues to build within the banking system.

The injection of liquidity into the banking system is only one of the tools used by the Fed to stimulate the economy. The other tool is the fed funds rate. The effective fed funds rate was 0.06% at the end of June. The CPI closed June with a rise of 5% YOY. This combination means the real fed funds rate is negative 4.9% — the lowest, and the most stimulative, fed funds rate seen in 70 years. It is also the lowest rate ever experienced during an economic expansion. An extraordinarily low cost of capital should inspire substantial investment and it has been instrumental in supporting a booming residential housing sector. But low interest rates have done little to inspire strong business investment or commercial loan growth. According to the Bureau of Economic Analysis, there was a rebound in domestic investment in equipment and software in recent months and hopefully this will be a sign of a better trend. Yet while the Fed’s actions have not triggered significant business spending it has supported higher stock prices. And the combination of low interest rates, quantitative easing and fiscal stimulus should continue to support stock prices through the end of the year.

Speed bump

Nevertheless, we would not be surprised if the Fed and the stock market face a speed bump in the second half of the year. The longer the Fed continues its easy monetary policy in the face of an expanding economy, the more it risks fanning the flames of inflation and instigating a stock market bubble. Therefore, we expect the Fed to change its policy sometime in the second half. The Federal Reserve’s prestigious annual Jackson Hole policy symposium will be held on August 26 through August 28, and this may be the perfect opportunity for Fed governors to begin a discussion of lowering or ending quantitative easing and/or changing their forecast for higher interest rates. The significance of a Fed policy change cannot be underestimated. Since April 2020, Fed policies have been extraordinarily supportive of equities. Therefore, the Fed will face a challenge to convince investors that a change in monetary policy from easy to neutral is not the equivalent of a change from easy to tight policy or a hostile Fed.

All in all, an underlying prop for investors is apt to disappear later this year. While a shift in Fed policy could shake investor confidence in the next six months, underlying fundamentals should be able to soothe concerns. Equities are not wildly overvalued, and we do not expect the downside risks for stocks to be extreme if a correction materializes. In fact, earnings growth has been excellent this year. According to IBES data from Refinitiv, S&P 500 earnings grew nearly 53% YOY in the first quarter and in the quarter ending June 2021, earnings are expected to rise 65% from a pandemic-depressed second quarter of 2020. For the full year, IBES is estimating earnings will be $191.37, a gain of 37% YOY. For calendar 2022 the estimate rises to $213.76, a gain of 12% YOY. These are excellent numbers, and they currently translate into PE multiples of 23 times this year’s and 20 times next year’s earnings. PE’s of 20+ are above the long-term average but are in line with multiples seen in recent quarters. However, if inflation continues at or near its current pace of 5% YOY, PE multiples are at risk of contracting substantially. For this reason, a shift in Fed policy, which would help temper inflation going forward, should be viewed as a positive long-term event – even if it produces a bump in the road.   

Gail Dudack, Chief Strategist

strategist@wellingtonshields.com

Disclosure: The information herein has been prepared by Dudack Research Group (“DRG”), a division of Wellington Shields & Co. The material is based on data from sources considered to be reliable; however, DRG does not guarantee or warrant the accuracy or completeness of the information. It is published for informational purposes only and should not be used as the primary basis of investment decisions. Neither the information nor any opinion expressed constitutes an offer, or the solicitation of an offer, to buy or sell any security. The opinions and estimates expressed reflect the current judgment of DRG and are subject to change without notice. Actual results may differ from any forward-looking statements. This letter is not intended to provide personal investment advice and it does not take into account the specific investment objectives, financial situation and the specific needs of any person or entity.

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Copyright © Dudack Research Group, 2021.

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Either … or. That pretty much is what the market has become

DJIA:  34,633 Either … or.  That pretty much is what the market has become.  The correlation between growth and value stocks has plunged to the lowest level since 1928, according to SentimenTrader.com.  It is in fact reminiscent of the “old economy” versus “new economy” divergence of 1999 – 2000.  Fortunately, not all divergences or non-correlations have had the same dire consequences as back then.  An important distinction between now and then is the A/D index. We consider divergences there to be most important, and were present then but not now.  Historically these low correlations have not meant much for the market as a whole.  If anything, these non-correlations have been a warning sign for growth – the idea of too much of a good thing.  Small-cap and large-cap stocks also are at their lowest correlation in 20 years.  This hasn’t been a difficult year for the market, but it has been a difficult market because of the non-correlation and rotation.

There’s plenty of speculation in this market, but while speculation may tell you something about potential risk, it alone doesn’t kill uptrends.  In terms of sentiment, what can kill uptrends is complacency, which usually comes when most are fully invested.  It just seems a bit ironic that complacency should be so prevalent when there’s plenty out there to worry about.  Inflation has been much discussed and for now the market is siding with Powell, it’s transitory. Some of the reopening bottlenecks may be transitory, but these labor shortages mean rising wages and inflation is always about wage inflation.  Then, too, were inflation at hand we would expect precious metals to be acting well, and they’re not.  Then there’s the problem of the Covid variants, a problem which seems very much here and now.  The vac maker Moderna (235) has gotten renewed attention and has broken out.  Another problem very much in the here and now is the potential for a cyber 9/11.  ETFs like HACK (61) and CIBR (47) could help.

When it comes to seasonal patterns best known is “sell in May,” though it’s not particularly accurate.  The inverse, ironically, is less emphasized and much more accurate – November–April – is up 80% of the time.  Even without the distortions of the pandemic, seasonal patterns always seem of dubious usefulness.  With this in mind, the period from July 10 to the end of August has produced some noteworthy weakness.  Also of some concern is the recent pattern within the S&P itself.  The index has reached new highs several times recently with less than half of its components above their 50 day average.  Components above the 200 day remain close to 90%, so it’s a divergence between short term and medium term trends.  In the past this also has produced some short term problems.  It’s difficult to place too much emphasis here, however, when the A/D index is bumping up against new highs.  That said, those numbers have flattened a bit as well.

In this past week’s Barron’s there was an article about Chart Industries (147).  A colleague is very positive on the stock, so we are familiar with the story despite it being that funnymental stuff.  Chart specializes in taking volatile gases and processing them so they can be contained and exported.  The interesting part is this profitable business is combined with the opportunity to bet on hydrogen and carbon capture as well.  The bad news, of all things, is the technical pattern.  It’s not that the chart is bad, it’s that it is in a trading range, and has been since early this year – not the worst thing, but still.  As we like to buy strength and sell weakness, this is the kind of pattern whose purpose is to take our money.  You might have made a fortune trading the stock from 130 to 160, but that kind of mean reversion trading eventually doesn’t work.  Those trades can be right 80% of the time, but eventually you lose 80% of your money, when finally there’s a big move up or down and you are on the wrong side.  Patience doesn’t happen to be one of our virtues, but we are waiting for a move above 160 – 165.  To see the potential here, look at a monthly chart, that is, a long term chart. 

Kicking and screaming, the S&P managed another new high on the last day of June.  It was lethargic and uneven, and again with more component stocks below their 50 day.  Stocks haven’t exactly surged following their breakout/new high.  Then, too, it’s summer.  What has surged is the buying of speculative call options by the smallest option traders.  Meanwhile, the SKEW (161) has surged, meaning hedge funds or someone is hedging against a decline.  The SKEW tries to measure the price of far out of the money puts versus calls, with high readings suggesting a higher probability of a big decline within the next 30 days. You’ll be glad to know the SKEW isn’t taken too seriously by most, but like the upcoming seasonal pattern, we mention it so you are aware.  More than the S&P, be aware the A/D index also made a new high, perhaps not so dynamically as in the past, but most days most stocks at least still go up.  Not how markets get into important trouble.

Frank D. Gretz

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