US Strategy Weekly: Weakening Underpinnings

In a recent US Strategy Weekly (“Earnings Estimates and Inflation” August 25, 2021) we wrote that we thought the trend of the 2021 equity market could be simplified into two main positive components: 1.) a strong earnings rebound and 2.) historically easy monetary policy. Therefore, we are not surprised by this week’s sell-off since both of these underpinnings are currently coming under pressure.

Earnings

As we noted last week, consensus earnings forecasts may have made an important shift in late August. Very simply, after more than a year of steadily rising earnings estimates, forecasts are beginning to edge lower. And while estimates still reflect a positive growth rate for 2021 and 2022, these growth rates are falling, and this is noteworthy. Steadily rising earnings estimates have provided a continuous incentive to buy stocks while also providing good fundamental support in the event of any negative news shock. But now, with estimates drifting lower, downside support is less definable and reliable. This change could result in less demand for stocks and could make speculators more cautious in the final quarter of the year.

As an example of the current earnings shift, the S&P Dow Jones and IBES Refinitiv estimates for 2021 decreased $0.30 and $0.40, to $198.32 and $200.63, respectively, this week. Similarly, estimates for 2022 fell $0.35 and $0.42, bringing full year forecasts to $217.69 and $219.93, respectively. According to IBES estimates, with the SPX at 4360, the market is trading at 23.4 times trailing 12-month and 19.8 times next calendar year’s earnings forecasts. Neither multiple is cheap when compared to its respective long-term PE average of 15.8 times trailing or 17.7 times forward earnings. And unfortunately, estimates are being shaved just ahead of third quarter earnings season, which will make third quarter results and CEO comments on future earnings growth more important than ever. Also, analysts have theorized that the proposed Biden corporate tax rate changes could shave an additional 5% off earnings in 2022 which would make current 2022 estimates too high. In sum, investors may no longer be able to rely on rising earnings growth to boost stock prices in the months ahead.

Monetary Policy

In another turnaround, Federal Reserve Chairman Jerome Powell, in remarks delivered to the Senate Banking Committee on Tuesday, cautioned legislators that inflation is higher and lasting longer than he anticipated. In fact, Powell noted that as the economy continues to recover from the pandemic the increase in demand is putting more upward pressure on prices and supply bottlenecks in a number of sectors have not abated as expected. In our opinion, Powell’s comments should not have surprised investors since we saw few signs that inflation was indeed temporary. Yet it did seem to catch investors off guard, and the 10-year Treasury note yield jumped from 1.48% to 1.53%. Technology stocks swooned in response to the rise in interest rates which is a normal reaction for growth stocks. In most valuation models, the 3-month or 10-year Treasury yield is used as the risk-free rate to measure the relative attractiveness of equities to bonds. As interest rates rise, stocks with higher PE multiples and little or no dividend yield will look less attractive in these models. Along with Chairman Powell’s comments this week are comments from other Fed governors that monetary policy is about to change. At separate speaking engagements this week, Fed Governor Lael Brainard and regional presidents John Williams of New York and Charles Evans of Chicago all indicated that they are comfortable with a first phase of tapering and that a gradual pullback of monthly bond buying is appropriate. Quantitative easing has helped to support markets and the economy since March 2020. But comments from Chairman Powell and other Fed officials this week suggest investors may no longer be able to rely on monetary policy to support stock prices in the months ahead.

Geopolitical Backdrop

Neither a slowdown in earnings growth nor a shift in monetary policy are insurmountable hurdles for equities; however, both changes suggest the “easy” part of the bull market may be over. Meanwhile, a number of issues in the geopolitical/economic environment could become major problems. Perhaps the most worrisome is China’s power crunch which has been triggered by a shortage of coal supplies. At least 20 Chinese provinces and regions which make up more than 66% of the country’s gross domestic product, have announced some form of power cuts, mostly targeted at heavy industrial users. These power cuts have halted production at numerous factories including those that supply Apple (AAPL – $141.91), Tesla (TSLA – $777.56), and Toyota (TM -$184.85) and is expected to impact the production of steel, aluminum, and cement. It will reverberate through many global sectors including chemical producers, carmakers, building supplies and shipping companies. Overall, this could easily become a much bigger problem than the Evergrande crisis which continues to overhang the Chinese property market.

Plus, China’s energy shortage it is putting pressure on oil prices and lifted WTI (CLc1 – $74.26) over $75 a barrel this week which will put more pressure on global inflation. In short, China’s energy/property crises could easily slow global growth and increase inflation around the world. In the US, potential monetary policy changes are pushing interest rates higher at a time when Congress is threatening individuals and corporations with higher tax rates. Both will slow growth. Bull markets are known to “climb a wall of worry,” and it appears there will be many worries in the fourth quarter.

And there are more international concerns. In the UK, a combination of the pandemic and the county’s departure from the European Union are resulting in a shortage of tanker drivers to transport fuel across the country. Media reports of a handful of gas stations closing due to dwindling supplies triggered panic buying in Britain and created massive lines at gas stations. In Germany, a lack of clarity about the composition of the next government following Merkel’s departure, is creating a crisis for the European Union. Without a clear government in Germany a range of decisions from economic policy to defense are being delayed in the EU. In the background, many countries in East Asia and the Pacific continue to face major setbacks in their recovery from the coronavirus. There is no shortage of worries in the globe.

The debt ceiling will become a major financial topic in coming days. But keep in mind that the US government has been shut down several times due to a debt ceiling crisis, most notably in 1995 (one 5 day and one 21 day stretch), 2011 (when Treasury Secretary Timothy Geithner utilized “extraordinary measures” such as the sale of assets from the Civil Service Retirement and Disability Fund and the G Fund of the Thrift Savings Plan to acquire funds) and 2013 (which stretched on for months and also included “extraordinary measures” to pay obligations). Typically, a government shutdown includes the closure of national parks and any other nonessential personnel to save cash flow for social security payments and payments on debt. In general, the debt ceiling debate has been a political game of hot potato.

Technical Wrap Up There was little change in the technical condition of the equity market this week. However, the popular indices and their moving averages may be the most interesting of all technical indicators. The SPX and Nasdaq Composite are currently testing their 100-day moving averages which is normal in a bull market. The DJIA has broken its 50 and 100-day moving averages but still trades above its 200-day MA. The Russell 2000 is the most important index in our view having broken below its long-term 200-day moving average last week yet is holding slightly above this level (now 2213) currently. The RUT is the best representation of the broad-based market; therefore, holding above this 200-day moving average may be critical for the overall market. In general, the underpinnings of the equity market appear to be deteriorating and a defensive position including holding energy or financial and those stocks with good dividend yields and lower-than-average PE multiples may be the best strategy for the fourth quarter.     

Gail Dudack

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They Blame China for Monday’s Selloff … Why not Blame Mother Teresa

DJIA:  34,764

They blame China for Monday’s selloff … why not blame Mother Teresa.  Sure China has a problem, in fact, a few problems.  The Evergrande problem has been in front of everyone for a month now, why on Monday did it become a problem worthy of a 3% selloff?  This isn’t the worst technical backdrop but it has worsened.  If you look at stocks above their 200 day moving average, that is, stocks in uptrends, it varies from 64% for the S&P stocks, 59% for NYSE stocks and only 42% for some broader databases.  On average, then, only a little more than half of the universe of stocks are in uptrends.  The market, not the averages but the average stock, already is in a correction.  Against this kind of backdrop days like Monday are just looking for an excuse to happen.  Blame China, whatever, in poor markets there’s always something.

As you know, we place a great deal of emphasis on the number of advancing versus declining issues, what we think of as the behavior of the average stock , versus the stock averages.  Everyone watches the averages, but it’s the average stock that tells the real story when it comes to the market’s health.  The cumulative total of the net number of advancing versus declining issues gives you the Advance/Decline index.  While the A/D index offers an insight into the behavior of the average stock, its analytical value comes when it is compared to the stock averages like the Dow.  In a healthy market the two should be in sync, so to speak, and problems arise when the A/D index lags the big cap averages.  The A/D index reached a new high on September 2 or, depending on your data source, it’s close.  That’s an important positive.

We are concerned, however, that the A/D index doesn’t seem to be telling the whole story when it comes to the average stock.  This index of advancing and declining issues is a measure of direction only, with no accounting for price change.  If you look at the number of stocks above their 200 day average, then you take account of price change and the direction of that change.  As suggested above, the numbers will depend on the database, NYSE stocks, S&P stocks and so on.  If we go with the NYSE stocks, the number at the end of last week was 59%.  While “rules” and the stock market are things that don’t usually go together, the rule is that when this 200 day number drops from above 80% to below 60%, it usually goes below 30%.  Forgetting that, the real point is that while most stocks may be advancing, barely more than half are advancing enough to be in uptrends.  With the market just a few percent below its highs, this is a concern.

Evergrande – now there’s a misnomer.  Monday’s decline was laid at the feet of this company, though Wednesday’s rally made that seem almost silly.  We wonder now if the pendulum may not have swung too far, in this case toward insouciance.  Most of the research suggests Evergrande won’t be China’s “Lehman moment” – investors are confident that a default or bankruptcy can’t trigger a crisis on the scale of the disaster that followed the Lehman Brothers collapse in 2008.  That said, BCA Research shows non-financial corporate debt in China is now on an even bigger scale than Japanese corporate debt before its economy lapsed into crisis in the 1990s.  According to Bloomberg’s John Authers, you can also draw a comparison with the peak in debt for South Korea and Taiwan in the late 1990s, on the eve of the Asian crisis.  Certainly most believe the Chinese authorities are determined to ensure some form of orderly workout, and they have the ability to do so.  Then, too, that just could be what most complacently want to believe.

Over the last week or so we’ve argued the market had its chance to go up but did not – the benign jobs and CPI numbers.  Now it’s almost the opposite.  Whatever horrors may come out of Evergrande, the market seems good with it.  And it’s not just the market averages.  On a day like Tuesday when the averages gave up their big gain, the A/D’s stayed positive.  And Wednesdays 4-to-1 up day was anything but the weak rally about which we always worry.  The overall backdrop is far from perfect and it is still September, but as it has all year the market seems able to ignore the bad, including what’s bad technically.  Meanwhile, we find ourselves owning the strange combination of oil, lithium and uranium.  Sounds a bit like an inflation trade, but without precious metals.  The vac stocks like BioNtech (353) and Moderna (455) still look higher, if you can take the volatility.

Frank D. Gretz

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And the days, those up-days, dwindle down to a precious few…when you reach September

DJIA:  34,751

And the days, those up-days, dwindle down to a precious few…when you reach September.  A lyric, somewhat paraphrased, that’s borne out by history – September is a tough month for stocks.  How else would you explain a market that goes from 8 of 10 up days through September 2, to 5 consecutive down days.  The disturbing part of this change is it came on news we would argue should have been considered positive – a benign jobs number and, hence, a benign Fed.  The Labor Day holiday saw Europe higher, but no rally when NY reopened Tuesday.  It didn’t get better until Monday which itself was another of those mixed days – Dow up, NAZ down, and down big for some of those strong stocks.  The good news is the rally saw respectable A/D’s on the back of financials and energy stocks, of which there are many.  Still, the numbers are the numbers.  Rotation has characterized this market all year, but in this case risk comes with it.

In this market characterized by rotation, suppose we were to suggest Uranium is the new Bitcoin, and Oil is the new Tech.  We haven’t completely embraced this idea, but we can see the possibility.  To begin, as measured by GBTC (38), Bitcoin is stalled but still seems trending higher.  Meanwhile, Uranium has become the Bitcoin of yore – see, for example, the URA ETF (28) or the go-to stock here, Cameco (24). As for Oil versus Tech, it’s a stretch if not outright dubious, it’s tantamount to buying anti-growth versus growth.  To get there you have to make that leap that’s very difficult for most – you have to distinguish between companies and their stocks.  Not that long ago there were no oil stocks above their 50 day average, in a sector that is down to about a 3% weight in the S&P.  That strikes us as sold out, and that has begun to change – XOP (89), the S&P Oil ETF, now is above its 50 day.  At the other end of the spectrum, five tech stocks are a quarter of the S&P market-cap.

Tech/growth stocks are here to stay, and you can quote that.  The question is, which ones?  For now the FANG stocks and a few others are like bologna on Wonder Bread with Miracle Whip – they’re this market’s comfort food.  As long as the market holds together, it should stay that way.  What is of concern, though, is the idea of “durable technology,” an oxymoron if ever there was one.  RCA really did change the world.  Is it real, or is it Memorex? Burroughs and Digital Equipment – those were go-to stocks. And then there are the zombies of Tech, Xerox (21), Blackberry (10), Hewlett-Packard (28), Nokia (6) and so on.  Even when it comes to the best of Tech, you have to ask, when is too much enough?  Companies are not their stocks, stocks are just pieces of paper.  Even great companies can find their paper without anyone left to buy.

Lithium. It doesn’t quite have the ring of “plastics” in The Graduate.  Yet batteries are all the rage – they even have their own ETF, BATT (18) – and batteries are about lithium.  And yes, there’s an ETF here as well, LIT (84).  The problem here, and with BATT and other of these ETF‘s, many of the components are Chinese companies.  While we doubt Beijing is about to come down on lithium as they have Tech and now Gaming, who needs it.  Companies like Albermarle (231) and Lithium Americas (23) offer attractive alternatives.  Another play on batteries, rather than lithium, is Tesla (757), the largest position in BATT – together with other names you don’t say in polite company.  Somewhat ironically, most of the secondary EV makers, the Fiskers (13), and so on, do not look good.

The recent jobs numbers seemed benign enough to preclude any hasty Fed action. This Tuesday’s less than expected CPI number seemed the same.  Both, in other words, were numbers the market could have taken and run with.  The idea that the market did not and, in Tuesday’s case, declined sharply, is troublesome.  When good news isn’t good news, it’s a bad market.  For the first time in 10 months fewer than 75% of stocks in the S&P 500 are above their 200 day average.  This kind of change doesn’t kill uptrends, but it is a reminder of how dominant the S&P has been.  For all of the NYSE the number is only around 60%, while for an even more extensive database like that of Worden, the number is only 43%.  Wednesday’s rally was respectable – with A/D’s two-to-one up, not the weak rally about which we worry.  Thursday’s mess had the look of an option expiration week, which this is.  September is a tough month, we expect it to stay that way.

Frank D. Gretz

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