In our January 5, 2022, weekly “On the Verge of a Bubble?” we stated that we thought 2022 would be a decisive year for the equity market. In our view, stocks would either see a significant correction this year, or if a rally continued, it meant an equity bubble, driven purely by liquidity and momentum, was in place. Fortunately, the first few weeks of the year have been decisive. We say fortunately because we believe a correction is a much healthier option for investors. But this means our focus shifts from technical divergences and the risk of an impending top to measuring the potential downside based upon a variety of fundamental benchmarks. We do not believe equities have made their final lows and fundamentals can provide guidance on measuring downside risk.

Valuation Model: The inputs

Most valuation models rely on similar inputs. The inputs to our model are our earnings estimates, the rate of inflation and forecasts for short- and long-term rates. For 2022, we estimate SPX earnings will be $220, inflation will fall to 4.4%, short-term interest rates rise to 0.8% and the 10-year Treasury note yield increases to 2.2%. These inputs give us a projected range as well as a midpoint of the range for the SPX.

In 2015 the SPX shot to the top of our model’s projected fair value range and continued to trade there until 2020. However, trading at the top of the fair value range is acceptable with inflation at, or below, 2% YOY, which it was at that time. Low inflation supports a higher PE multiple. However, in early 2020 the index began to trade well above the fair value range and by the end of the year the disparity between the actual SPX price and the top of the projected range grew to a level last seen during the 2000 bubble. See page 5. Still, with inflation relatively low one might see this as the equity market discounting the economic rebound that was widely expected to materialize in 2021.

Indeed, earnings rebounded strongly after the earnings trough of December 2020, but inflation also began to rise. Earnings growth is worth less in an inflationary environment and as a result, PE multiples slowly began to fall in 2021. However, inflation did not just increase in 2021, it soared to 40- year highs and this is the crux of the market’s problem this year. Inflation of 7% YOY implies much lower multiples and at the same time, monetary policy is apt to be aggressively tight in 2022 to control inflation. This combination makes it a hostile environment for equities.

Valuation Model: Inflation

Our model demonstrates the pressure inflation places on equities. For example, in 2020 when inflation was 1.4%, our model indicated that the average PE should be 17.7 times. However, at the end of 2021, with inflation at 7%, the model forecasted an average multiple of 14.5 times. In 2022, we estimate inflation will fall to 4.4% — which is still above the long-term average inflation rate of 3.6% — and our valuation model suggests the average PE multiple should rise to 15.8 times. The high end of the PE range lifts to 18.4 times by December. Nonetheless, the current trailing SPX PE multiple is 21.4 times.

The impact of inflation on PE multiples can be seen in the chart on page 8. Although the trailing PE multiple has been declining toward 20 times in recent months, the rise in inflation has lowered the forecast for the high-end PE from roughly 20 times to 18 times. In short, more multiple compression lies ahead.

Calculating Downside Risk

One way of measuring downside market risk is to see what the trailing PE has been at previous market troughs. Although the PE at the end of a major decline is also impacted by inflation, we noticed that the last two market troughs occurred with a trailing PE multiple of 16.5 times. Applying this to our $220 earnings estimate for this year yields a downside market risk to SPX 3630. Similarly, if we applied an 18 multiple to our earnings estimate, the downside risk for the SPX is 3960. These two scenarios imply that the market begins to find “value” below SPX 4000. Note that a drop to SPX 3960 is the equivalent of a 17% decline from the record high of 4796.56 made on January 3, 2022. See page 4. This does not appear unreasonable, particularly since the Russell 2000 index has already declined 18.6% from its record high.

In our view, the worst-case scenario would be a decline to the midpoint of our model’s projected range. This means a PE of 15.8 with our $220 earnings estimate or the equivalent of SPX 3475. This midpoint would be a bear market decline of 28%. We cannot rule this out, but we would also point out that the pandemic decline in 2020 produced an even greater 34% decline in the SPX. Yet earnings and stocks rebounded smartly after the pandemic-driven recession of 2020. To insulate portfolios from risk, we continue to focus on stocks and sectors that can weather the inflationary environment of 2022. This includes energy, staples, and financials. Nevertheless, as we have been indicating, technology stocks are expected to bear the brunt of the correction, but this decline will also create an excellent opportunity for growth stocks. A break below SPX 4000 may create such an opportunity.

Oh, my Russell

The popular indices exhibit surprisingly different chart characteristics this week. The SPX looks best since it is trading modestly below its 200-day moving average, but all of its moving averages are rising. The DJIA appears second best. It is trading below its 200-day moving average and the moving averages have not crossed below each other. The Nasdaq Composite index is the weakest of this grouping, trading below all its moving averages and the 50-day moving average is at risk of falling below the 100-day moving average. See page 11.

The Russell 2000 index has been our bellwether index for the market since early 2021 and as we noted last week, this chart is very bearish. The 50-day moving average has broken below all other moving averages and this “death cross” configuration is attracting attention. More importantly, the Russell 2000 broke below the 8-month trading range last week that contained most of 2021’s trading action. This consolidation range has become a large top and there is no support in the chart prior to 1700. What is also surprising is how much the chart of Amazon (AMZN – $2799.72) looks like the Russell 2000 index. Note, AMZN is not in the Russell 2000 index yet ironically the chart patterns are very similar, and worrisome. Despite all the media buzz about the market being oversold, we find our 25-day up/down volume oscillator at a modest negative 0.21 reading this week. Typically, major market troughs are characterized by panic, and this is measured by extreme levels of breadth, for example, days with 90% or more of the daily volume in declining stocks. The huge intra-day swings this week and the rebounds from early session lows have kept breadth data fairly moderate at the end of each session. We do not see this as a good thing. It implies that the panic may still lie ahead; therefore, we would be cautious in the coming weeks. But danger equates to opportunity, so we are also looking to acquire technology stocks at lower levels.

Gail Dudack

Click to download

In this week’s title, “the chickens” refers to inflation. After ignoring inflation for much of 2021, in early 2022, the actual toll of rising prices is finally becoming headline news. In our mind, this was inevitable. But the saddest part of the current inflation cycle is that it could have been avoided. Inflation was a predictable outcome of keeping monetary policy extremely easy despite the fact that the economy was already recovering from COVID. Inflation was also stoked by a too liberal fiscal policy that flooded the system with money even after stores and businesses were getting back to work. It is never good policy to add fuel to an economic rebound. In short, too much money chasing too few goods is always inflationary – yet Washington DC ignored rising prices for the first three quarters of 2021. Now inflation is coming home to roost.

And this is seen in many ways. Goldman Sachs Group (GS – $354.40) missed its earnings target this week and it triggered a wide-ranging sell-off in the marketplace. The company noted that its profit miss was due to weaker trading revenues and rising expenses. In our opinion, Goldman may be a bellwether for the broader economy. After pumping historic sums of liquidity into the capital markets for 18 months to offset the impact of the pandemic, the Fed has just begun to slow its purchases and indicates it will end quantitative easing by March. The Fed’s quantitative easing fueled trading activity in stocks and bonds and Goldman was a big beneficiary of the market’s rise since March 2020. But trading has already begun to slow. Goldman’s quarterly profits were also hurt by a 23% rise in operating expenses, mainly reflecting higher compensation and benefits costs. This combination of slower top line growth and profit margin contraction will be true of many companies this year and it is a concern to us.

Reverberations

Headline CPI jumped more than 7% YOY in December and this represented a 40-year high in inflation. Core CPI rose 5.5%, the highest pace in 30 years. The fact that we have not seen prices rise at this magnitude for so many decades means that many of today’s investors have had little or no experience with inflation and its various implications. Economists and analysts ignored the dark side of inflation in 2021 but we doubt that this complacency will continue in 2022. The most obvious reason is that a shift in Fed policy changes the environment for investors and inflation will now determine what the Fed must do in the coming months.

Unfortunately, we expect inflation will get worse before it gets better later this year. This is obvious to us in several ways. First, the producer price index for finished goods, which feeds into the consumer price index, rose 12.2% YOY in December and unfortunately there are still no signs of it peaking. Second, homeowners’ equivalent rent (HER) has a weighting of 23.5% in the CPI. Since prices for single-family homes were up 15% YOY in December, it is very likely that homeowners’ equivalent rent will move much higher than the 3.8% YOY seen in December. Rental fees tend to follow home prices in every neighborhood. See pages 3 and 4. Plus, WTI futures have already risen 15.5% year-to-date and this will keep gasoline and transportation prices rising in the early months of 2022. Moreover, this week’s move to $86.50 in the WTI future is a breakout from an 8-year base pattern and from a technical perspective, the chart shows the potential of moving higher. See page 9.

With headline inflation at 7% and the fed funds rate at zero to 0.25%, the real fed funds rate is nearly negative 7%. This is due to “easy” monetary policy. Reducing the disparity between the fed funds rate and the CPI is necessary to tame inflation. Unfortunately, it means the FOMC would have to raise rates significantly in 2022. Rising interest rates will be a difficult hurdle for equities since stocks and bonds compete in terms of valuation. Rising interest rates also raises the bar for speculators who are likely to leave the marketplace.

Corporations and all businesses will be facing an uphill battle with raw material, and intermediate good prices rising much faster than prices to consumers. Rising prices is also putting pressure on wages, as seen by Goldman Sachs report, and this adds to expenses. The net result of this is a major erosion in profit margins. All in all, it puts earnings at risk. See page 5.

In addition, profits are less valuable in an inflationary environment, and this puts pressure on PE multiples. In the low inflationary environment of 2008-2020, our valuation model indicated that PE’s could remain as high as 20 times. But as inflation moves above 4% this changes. Given our assumption that inflation decelerates to 5.5% YOY and 10-year Treasury note yields rise to 2.2%, the high-end of the PE range should drop to 18 times. See page 6. In short, 2022 could be a challenging year. There will be pressure on households from inflation and consumption patterns will change. Corporations may suffer from top line growth. Businesses will also be pressured by higher raw material and wage costs, crimping profit margins. And rising interest rates and inflation could also produce a decline in PE multiples.

Again, this means investors should try to insulate themselves from these risks by focusing on areas of the market that can weather this changing environment. We believe that suggests sectors such as energy, financials, and staples. It may also be wise to hold some cash in order to look to buy some high growth technology stocks later in the year.

Technical Charts and Indicators

The charts of the main indices are worrisome this week since there are signs of weakening trends. The SPX is the best-looking chart of all the main indices since it has only broken its 50-day moving average and is currently testing its 100-day moving average. Its uptrend appears intact. The DJIA looks less positive. The price trend is decelerating, and the index is below its 50-day and 100-day moving averages, but it is still above its 200-day moving average. The Nasdaq Composite index fell below all its moving averages this week and needs to rebound sharply in coming sessions to maintain a positive long-term trend. The Russell 2000 index is the weakest chart of all, having broken below all moving averages, but more importantly falling below the bottom of the 8-month trading range seen for much of 2021. This breakdown has very negative implications for the index and the overall marketplace. See page 10. The 10-day average of daily new highs fell to 174 this week and daily new lows rose to 244. This combination of both averages being above 100 per day is neutral, but the indicator tilts negative since new lows are exceeding new highs. The NYSE cumulative advance/decline line’s last record high was on November 8, 2021, and it is trading well below this level currently. The current disparity between the AD line and the SPX totals to 8-weeks, which is not uncommon, but typically indicates a correction of 10% to 15% lies ahead. Note that the longer this disparity persists, the deeper the eventual correction might be. Volume has not been rising on rally days, which is a worrisome trend. All in all, we are not surprised by this week’s weakness and would point out that the Nasdaq Composite and Russell 2000 are already trading 9.7% and 14.2%, respectively, from the record highs.    

Gail Dudack

Click to Download

The new year arrived, and with it came a new and revised perspective on the equity market. This is understandable. In 2021, the financial markets were insulated from downside risk given the extremely friendly posture of the Federal Reserve and the potential of more fiscal stimulus. Monetary policy would keep interest rates low and safeguard speculators while fiscal stimulus would support economic activity. With these two safety nets as backing, one could ignore inflation without consequences. But the Fed, many economists, and bankers are now addressing the strain that rising prices has had on consumers in 2021 and many are suddenly, although belatedly, calling for quick action. At the same time, more fiscal stimulus is looking less likely. Thus, both safety nets are disappearing in 2022.

In terms of fiscal policy, the logjam in Congress is no surprise. However, the shift in monetary policy came about amazingly quickly. At the June FOMC meeting, Fed officials — or the dot plot — forecasted no fed funds rate increases until 2023. In September, the dot plot changed to include one possible rate hike at the end of 2022. December’s dot plot implied three possible rate hikes in 2022. This week the consensus expectation has changed once again to include four or five fed funds rate hikes this year, or at least one increase per quarter. This is a startling turnaround, albeit a necessary one. We believed inflation would be a big hurdle for equities last year. It proved not to be. But this year as the Fed addresses the existence of inflation, the significance of price increases is apt to become quite apparent. Keep in mind that four fed fund rate hikes within a twelve-month period tends to produce a down market in the subsequent six months. We will discuss Fed rate hikes in future weeklies.

Independent of monetary and fiscal policy, the new year begins under a dark cloud. As we have often noted, three consecutive years of double-digit gains in the indices are often followed by a year of losses. The one exception to this precedent was the five double-digit up years that led into the 2000 peak. However, this historic rise was a stock market bubble, and it was followed by three consecutive years of losses. See page 3. Therefore, if history is any guide, 2022 may a defining year – either it is a down year or it is the beginning of an equity bubble. We think the first quarter will be revealing and may provide the answer.

January and Liquidity

Wall Street adages are typically built upon some fundamental or economic premise and the January Barometer is one of these. The concept of the first five days of the year and/or the first month of the year having predictive value for the overall year is based upon liquidity. The end of the year and the beginning of any year is a unique time for liquidity. A grouping of pension funding, IRA funding, tax loss selling proceeds, bonus payments and salary increases tends to cluster in the December/January period and makes this time unique in terms of providing potential demand for equities. If equities fail to rise during this time, it may be a signal of trouble ahead. Overall, it is a warning.

January is off to a weak start this year, with a 1.9% decline in the S&P 500 index and a 0.3% decline in the Dow Jones Industrial Average. And as shown on page 5, ten of the last 17 post-election-year markets were flat to down years. However, it is important to point out that the early January Barometer has a poor record of predicting annual declines. Early January losses have only been followed by annual declines 42% of the time in the S&P 500 and 46% of the time in the DJIA. A decline in the month of January has been more accurate. January declines have been followed by annual declines 69% and 66% of the time in the S&P 500 and DJIA, respectively. All in all, the January Barometer has been a better guide in predicting up years after January gains. See pages 4 and 5. Still, we do think it would be a bad omen for January to be weak in face of the obstacles we see for equities.      

Obstacles

One of the issues facing equities is the potential slowdown in earnings growth. After what we expect will be a high double-digit earnings growth rate in 2021, the pace is expected to slow to a single digit level this year. Currently, IBES Refinitiv and S&P/Dow Jones have 2022 earnings growth rates of 8.5% YOY and 9.0% YOY, respectively. Our estimate is for a 10% YOY growth rate, but only because our 2021 earnings estimate is below the consensus view. See page 7 and 16. Nevertheless, earnings are facing tough comparisons in 2022 and earnings will not provide the fundamental support it did over the last twelve months.

Higher inflation also pressures price-earnings multiples. Unless inflation falls well below the 4% level this year, we expect multiples to fall from the current level of 20+ to the average of 17.5 times. But inflation dropping to less than 4% seems unlikely in the near term, particularly with crude oil futures rising once again. The charts of both WTI and gasoline futures point to higher prices this year. See page 8. This implies inflation and multiple risk in coming months.

Plus, it is easy to become too insular and forget about the geopolitical problems that could upset the financial markets. Political hotspots include North Korea which launched two ballistic missiles off its East Coast in the last week, US forces in Iraq and Syria suffering three separate rocket attacks in recent days, Russian troops hovering ominously on the Ukrainian border and China becoming increasingly assertive in controlling both Hong Kong and Taiwan. All of these have the potential of upending the financial applecart.

FANG stocks

High PE stocks face the biggest threat in an environment of soaring inflation and rising interest rates. And we expect technology stocks could bear the brunt of any correction in 2022. With this in mind we looked at the charts of the FANG stocks this week and found some patterns that deserve monitoring. We have comments on Amazon (AMZN – $3307.24), Meta Platform (FB – $334.37) and Alphabet (GOOG – $2800.35) on page 9. Each of these stocks have critical support levels that if broken, could trigger further selling. In sum, we would be defensive in the short run; but a sell-off in 2022 could produce an excellent long-term buying opportunity. Meanwhile, there are pockets of safety in the market in areas such as energy, banks, and staples, which all have modest multiples and good dividend yields.

Technical Indicators The Russell 2000 index also has a pattern similar to the aforementioned FANG stocks in that the 2100 support level is important to the index. If this level is broken it would be extremely bearish for the RUT and a negative omen for the market. See page 10. Most other technical indicators are neutral or indecisive this week. The 25-day up/down volume oscillator is at 2.06 this week and above the midpoint of the neutral range, but still has not confirmed any market highs since February 2021. This implies that investors have been selling into rallies. Both the 10-day averages of new highs and new lows are above 100, leaving the “trend” of the market ambiguous. The NYSE cumulative advance/decline line made its last record high on November 8. Sentiment indicators like the AAII bull bear survey and the ISE call/put volume index are neutral. All in all, we remain cautious for the near term.  

Gail Dudack

Click to Download

Stocks performed well in 2021, but while gains were widespread, it was not easy to outperform some of the indices. The best performing index in 2021 was the Dow Jones Transportation Average which rose 31.8% for the year. The SPX was second with a gain of 26.9%, followed by the Wilshire 5000 index which rallied 22.8%.

The Dow Jones Industrial Average had an 18.7% gain in 2021 and in most years, this would have been an exceptional performance, but for last year it made the index a laggard. The Russell 2000 index rose roughly half of the SPX at 13.7% for the year and performed just slightly better than the Dow Jones Utility Average which rose 13.4%. However, on a total return basis, the Dow Jones Utility Average clearly outperformed the Russell small cap index.

One might wonder about the amazing outperformance of the Dow Jones Transportation Average given the weak performance of the airlines during the pandemic, but airlines were offset by strong performances in some unexpected components like Avis Budget Group, Inc. (CAR – $202.53), and the various shipping and freight components such as, Expeditors International of Washington, Inc. (EXPD – $130.06), C. H. Robinson Worldwide, Inc. (CHRW – $110.38), J.B. Hunt Transport Services, Inc. (JBHT – $207.66), or the marine shipping company, Matson, Inc. (MATX – $91.15). Despite the angst about transportation logjams and the disaster at the Port of Los Angeles, many transportation stocks performed well last year.

However, for most individual investors and many money managers, 2021 proved to be a challenging time to outperform the SPX. The reason for this is the emergence of a few stocks that are beginning to dominate the cap-weighted benchmark indices like the S&P 500 and the Nasdaq 100. In our December 15, 2021 weekly (“Monetary Policy Shift Ahead”) we displayed a table of the eight stocks that represented 63% of the total market capitalization of the Nasdaq 100 at that time. These stocks are Apple, Inc. (AAPL – $179.70), Microsoft Corp. (MSFT – $329.01), Alphabet Inc. Class C (GOOG.0 – $2888.33), Alphabet Inc. Class A (GOOGL.O – $2887.99), Amazon.com, Inc. (AMZN – $3350.44), Tesla Inc. (TSLA – $1149.59), Meta Platforms, Inc. Class A (FB – $336.53) and Nvidia Corp. (NVDA – $292.90). This week, as Apple, Inc. approached an historic $3 trillion market capitalization, S&P wrote that a mere five stocks currently represent 26% of the market weight of the SPX (AAPL, MSFT, GOOG, AMZN and FB).

It is noteworthy that with a $3 trillion market capitalization, Apple would singularly represent 7.8% of the S&P 500 index. This market cap dominance easily exceeds the 6.4% weighting seen by International Business Machine (IBM – $138.02) in 1985. There are many theories about what happens to a stock when it becomes a dominant part of the index, and most theories suggest that dominance is not long-lived. However, there is another important aspect to the fact that a small group of stocks are driving the SPX. Particularly those money managers pegged to the SPX, the fact that AAPL is 7.8% of the SPX market capitalization, you risk underperforming your benchmark if you are not similarly weighted in AAPL. If you are not, this equates to a large bet against AAPL doing well. We expect there was a lot of portfolio adjustments going on at year end.

What we find disturbing about the dominance of a few stocks driving the major benchmark indices is that it reminds us of the Nifty Fifty era that preceded the top in 1970. The nifty fifty stocks included companies like Polaroid, Eastman Kodak, Digital Equipment and S.S. Kresge (Kmart), Sears and Roebuck, and Xerox (XRX – $23.76). Most of which do not exist in their previous form. It is also similar to the dot-com bubble that led to the 2000 peak. Global Crossing was part of the dot-com bubble. It was a telecommunications company founded in 1997 that reached a market capitalization of $47 billion in February 2000 before filing bankruptcy in January 2002. In both of these previous cases the momentum of the market was driven by a relatively small number of popular growth stocks that represented the future to most investors. They were the disruptors of their era. But over time, if a few stocks are driving market performance, fundamentals and valuation models are replaced by momentum models. Momentum models simply drive more investors into a small group of outperforming stocks. We do not believe we are currently in a bubble; but having lived through the aftermath of both the 1970 and 2000 tops, the seeds of a bubble do exist, in our view. If we are on the verge of a bubble, 2022 may be the decisive year. Many indicators point to a correction that is greater than 10% over the next twelve months. But if this does not materialize, it is quite possible that a new set of investors, who have never lived through the humbling experience of a bear market may continue to follow momentum and drive stock prices higher.

The last three years have been good to investors. The SPX has had consecutive annual gains of 28.9%, 16.3% and 26.9%. The Nasdaq Composite has been even stronger with gains of 35.2%, 43.6% and 21.4%. The DJIA has not quite kept up, yet in the last three years it has had gains of 22.3%, 7.2% and 18.7%. History has shown that three consecutive years of double-digit gains in the indices has been followed by a negative year. Since 1901 there has been only one exception to this pattern: the five double-digit up years that lead into the 2000 peak. See page 3. However, as we noted, 2000 was a bubble peak and March 2000 was followed by three consecutive years of losses.

In sum, 2022 is apt to be a pivotal and defining year. A down year should be expected and it would be stabilizing for the longer run. But if stocks continue to advance strongly, it would be a likely sign of an emerging bubble. Fundamentals do not work in a bubble, but technical indicators are helpful. The NYSE cumulative advance decline line peaked in late 1997, yet the indices continued to move higher for more than two years. This was a massive two-plus year divergence. We have found that the divergence between the advance decline line and the indices is a simple way of gauging future downside risk in the marketplace. At present, the NYSE cumulative advance decline line made its last record high on November 8. This 8-week divergence is not unusual, and it suggests a correction of 10% or more. But the longer the divergence persists, the more the downside risk in the market grows as seen in 2000.

One of the warning signs that a bubble is reaching its peak is a surge in leverage. Massive borrowing against stocks is what will produce an eventual selling surge as leverage is unwound. For this reason, we are keeping a watch on margin debt growth. But total margin debt fell $17.3 billion in November to $918.6 billion. See page 4. As a percentage of total market capitalization margin debt was unchanged at just under 1.8%. This is a high ratio but not a record. November’s 2-month rate-of-change in margin debt was a modest 1.7% and compares to a 1.4% gain in the Wilshire 5000. Prior to market peaks margin debt can rise to 15.3% or more, yet barely move equity prices higher. From this perspective, the equity market appears to be in good shape. Earnings are expected to increase 8% to 9% this year, but we fear inflation could erode this more than expected. The Santa Claus rally implies 2022 could be a good year and the first five trading days of January is off to a good start. The early January market has had an accuracy rate of 79% of predicting the annual trend. See page 5. We will follow up on this next week but overall, a diversified portfolio is the best way to manage through what may be a tumultuous year. Our favorite sectors for diversification are technology, financials, energy and staples — a mixture of growth, value, and yield.  

Gail Dudack

Click to Download