Direct From Dudack: Downside Risk Guidance


From both a technical and fundamental perspective there are two areas of downside risk/support for the equity market. The first of these is roughly the SPX 4000 area which is being challenged this week. However, all lows tend to be retested and are often broken temporarily. The second area of support identified by fundamental and technical measures falls within a range of SPX 3470-3700. This implies a fall below SPX 3700 would be a favorable/low risk entry point. The fallout of the Russian invasion of Ukraine could be known within a matter of days, however there is also the possibility that China may take advantage of the geopolitical scene to make moves on Taiwan. Therefore, identifying these short and longer-term entry points in advance is prudent. In the near term the energy, financial, and staples sectors are favored. Defense stocks are also apt to do well given the risk of war in Europe. Longer-term we see this sell-off as a great opportunity to buy technology at “value” levels.


When inflation is above its long-term average of 3.5%, it is normal for PE multiples to fall to their long-term average of 15.8 times or lower. Applying a 15.8 multiple to our $220 earnings estimate for 2022 equates to a downside of SPX 3476, or the SPX 3500 area.

Our valuation model suggests an average PE of 15.8 for 2022 and a range of 13.2 to 18.3 times, assuming inflation falls to 4.4% this year. Inflation is questionable with crude oil at $100 a barrel. However, these PE multiples couple with our $220 earnings forecast equate to an SPX low, mid, and high range of 2905, 3470, and 4035.

The head and shoulders top has broken the neckline support and now generates downside targets of roughly SPX 4000 and 3700. More specifically, the neckline at SPX 4222, less the 574 points to the record high of SPX 4796.56 yields a full downside count of SPX 3648 and a midpoint count of SPX 3844.

Gail Dudack

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US Strategy Weekly: Black Swan or Inevitable

Nearly a year ago the US economy was recovering well from the pandemic shutdown. The Fed continued to stimulate an expanding economy and Congress worked on passing more pandemic stimulus. Crude oil prices began to escalate in response to the post-pandemic recovery and the amplified regulations on fossil fuels following the US reentering The Paris Agreement in February 2021. Rising inflation was inevitable, and unlikely to be transitory due to global standards put in place for the reduction of fossil fuels. Earnings were booming in 2021 but estimates for 2022 showed single-digit growth versus difficult comparisons. All in all, it was clear one year ago that inflation would rise but earnings growth would slow in 2022. This combination is a hostile environment for equities and one we expected would translate into both margin compression and lower PE multiples.

In addition, in November 2021, newspapers and new casts displayed satellite photos of Russia mustering troops on the Ukraine border, but NATO said and did nothing. Therefore, the current crisis on the Ukrainian border is also not a revelation. In short, the sell-off that shaved 1392 points off the DJIA in the last four trading sessions should not have come as a surprise to investors.

Black Swan or Inevitable

Investopedia defines a black swan as “an unpredictable event that is beyond what is normally expected of a situation and has potentially severe consequences. Black swan events are characterized by their extreme rarity, severe impact, and the widespread insistence they were obvious in hindsight.”

Given this definition, we do not believe one could call the Russia/Ukraine border crisis a Black Swan. It was predictable and, in our opinion, the Russia/Ukraine crisis has merely been a catalyst for investors to reassess the inevitable — that the equity landscape has become increasingly risky, and areas of the market had become quite overvalued. Nevertheless, it does have a negative impact on the global economy. For the US it will mean higher energy costs which will make the job of the Federal Reserve more difficult than ever.

Assessing Downside Risk

To date, the declines in the Dow Jones Industrial Average, the S&P 500, the Nasdaq Composite, the Russell 2000, and the Wilshire 5000 have been 8.7%, 10.25%, 16.7%, 18.9%, and 11.4%, respectively. The SPX is therefore in correction territory with a 10.25% decline, while the RUT with its 18.9% sell-off is close to bear market territory. Many individual stocks have already had declines of 20% or more. Given the extent of recent price declines we believe we should now start looking for signs of a bottom.

A classic sign of a major low is a high-volume sell-off day, where 90% or more of the volume is in declining stocks and volume may rise to twice the normal daily pace. A major low may have a string of such days, followed by a rebound, and a retest. Typically, this high volume sell-off is due to a sharp rise in margin debt that then triggers margin calls once stock prices begin to decline. However, it is not likely that a margin call washout will occur in the current cycle. We have been monitoring monthly margin debt numbers and they have been declining, not rising as prices peaked in recent months. Combined margin debt in January was $798.6 billion, down 12.2% from December’s $910.0 billion and unchanged from a year earlier. The 2-month rate of change in margin debt was negative 13.1% in January and as a percentage of total market cap it was 1.4%, down from 1.53% in December and down from 1.7% from a year earlier. In short, the leverage that is usually unwound at the end of bear cycle is simply not as substantial as that seen in previous cycles. See page 7. This being true, the end of the correction may not be as dramatic.

We are monitoring a number of technical charts to assess overall market risk. One of these is the SPX which may be in the process of forming a substantial head and shoulders top pattern. Some technical analysts have already noted this pattern. The important level to watch is the neckline support that is found at the SPX 4300 level on a closing basis and at SPX 4222 on an intra-day basis. The SPX 4300 level is currently being tested. From a technical perspective, a break of the SPX 4300 area creates downside targets of SPX 4000 and SPX 3800. See page 9. Since algo traders use support and resistance levels for intra-day trading, we would expect a drop in the SPX below 4300 would likely trigger more selling.

It intrigues us that a small-capitalization stock index and one of the largest capitalization companies in the S&P 500 have similar chart patterns. And we have already written about the parallels in the charts of Amazon (AMZN – $3003.95) and the Russell 2000 index. In both charts, the breakdowns from lengthy trading ranges, materialized within days of each other and preceded the decline in the overall market. Since both were leaders in terms of market weakness, we are now monitoring them for signs of stabilization in hope that this would imply a low has been found. To date, there is no confirmation from these charts. See page 10.

The economy and the equity market face uncertainty as long as inflation continues to trend higher. Therefore, the chart of WTI futures is another risk factor. Unfortunately, once the crude oil future bettered the $77 level, the technical chart indicated potential targets of $90, $100, and $110. With crude futures now at $91.91 the risk of inflation continues and will make the Federal Reserve’s job more difficult. This implies multiple interest rate hikes in the months ahead. Stabilization in the WTI futures chart would relieve the current certainty of higher inflation, reduce the burden on the Fed, and lower the risk that the yield curve may invert later this year. These are the risks that the Russia/Ukraine border crisis poses to the world – more inflation and its consequences. See page 8.

Valuation Benchmarks

Technical indicators are often the best tools for defining a market top, but valuation tools can best determine where downside risk is minimized. Our model is forecasting an average PE of 15.8 for year-end 2022 and a PE range of 13.2 times to 18.3 times. These low, mid, and high PEs coupled with our earnings forecast of $220 (a 7% YOY growth rate) equates to SPX valuation targets of 2904, 3469, and 4026. These are fairly frightening downside SPX targets. We prefer to use the long-term average PE of 16.5 X as the appropriate multiple given the current level of inflation which creates a worst-case scenario of SPX 3630. Another approach would be the 2000-2022 average PE of 19.5 times to define fair value and probably downside risk. This equates to an SPX target of 4290. In our view, this combination implies that “value” is found directly below the SPX 4000 level. In the interim, energy, financial and staples remain our favorite sectors for the current environment, along with individual stocks that can weather the inflationary environment and have dividends in excess of 2%. Nonetheless, the 2022 sell-off is apt to provide an excellent long-term buying opportunity in the technology stocks so this is a time to have a list of favorite buys on hand if the SPX should fall below the 4000 level. Be cautious but be alert for opportunities.

Gail Dudack

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Good News is Nice … But It’s Not How Lows Are Made

DJIA:  34,312

Good news is nice … but it’s not how lows are made.  Peace in Vietnam, or wherever it is this time, we’ve seen before.  Peace rallies never seem to last.  Start bombing, then maybe you have something.  Lows after all, are made by the sellers rather than the buyers – bad news begets the selling.  Still, Tuesday’s rally was noteworthy not for its 400 DJ points, but for the 3-to-1 A/Ds.  One day is just that, but in real bear markets technically good days are not so easy to come by.  Wednesday was impressive in a different way – weak averages but positive breadth most of the day.  We doubt this changes anything in the grand scheme of things – even bear markets don’t go straight down.  Beware an outbreak of peace, whereas conflict likely would provide a better turn.

Despite some surprising strength this week, the overall downtrend should be the focus.  Then, too, had we seen decent upside in the averages and flat or negative A/Ds, that would have made it easy – weakness in an already weak trend.  Should that pattern yet come to pass, and we suspect it will, that should be a real warning.  And by the way, don’t expect those commodity stocks to survive a big downtrend.  Oil had an even better rally in the summer of 2008, amidst talk of $200 crude.  We know how that ended.  Things can change quickly in the direction of the overall trend.  Meanwhile, we may just see a blow off sort of move in some of these commodity stocks, a tantalizing temptation.  To paraphrase The Usual Suspects, the greatest trick a bear market can play is make you think it doesn’t exist.

Barron’s refers to Deere (380) as the “Tesla of farming.”  With a long-term perspective, it could be the Tesla (876) of charts. Having recently hit an all-time high, part of the strength has to do with comments from competitor Case New Holland. That company noted the average fleet age for farm equipment is at a 20 year high, so demand for new equipment is set to rise.  Aside from its own higher guidance in November, Deere unveiled an autonomous tractor in January at, of all places, the Consumer Electronics Show in Las Vegas.  According to Barron’s Jacob Sonenshine, industrial companies such as Deere are often able to pass on higher material costs, particularly as Deere’s tech-enabled offerings come with greater efficiency.  Meanwhile, while the stock is trying to come out of a little consolidation just at the 400 breakout point, it’s the longer-term chart we find intriguing.  The stock broke out of a multiyear base back in 2020 and more than doubled by mid-2021.  It since has been consolidating, but now looks poised to extend the overall uptrend.

Speaking of Tesla, much like the FANG stocks our take depends on your perspective.  Tesla is below the 50-day, so from that perspective we would take a pass, at least for now.  The same can be said of Amazon (3093) which, despite the big rally, has seen fit to stop just below its own 50-day.  To look at Tesla on a monthly chart, each bar one month, it’s close to the support of the last base/consolidation around 800, and it all looks to be another consolidation in the uptrend.  Amazon, on a long-term chart, appears to have broken below its own consolidation or base, and only has rallied back to it – a time will tell pattern.  We’re always inclined to give the overall trend the benefit of the doubt, and the gap higher was impressive.  The real point is that for these stocks especially, perspective seems important.  If you’re a long-term investor, the long-term pictures should be where you’re looking.

A recent Bank of America survey of global fund managers showed their greatest worry was that central banks would go too far.  Their second greatest worry was they would not go far enough.  Contrary thinkers should take heart– they just might get it right?  In this case contrary thinking goes against most of the Fed’s history, and also the recently released minutes.  They show the risk of inflation tilted to the upside, and seem more prepared to hike too much than too little.  That should make for a tough environment for stocks, though the market’s reaction to the minutes on Wednesday was surprisingly positive.  Key in all of this, of course, is inflation, and positive action in commodity stocks is everywhere, even Coal.  Speaking of contrary opinion, Coal is so out of favor they killed the ETF for lack of interest.  There is still one for Steel (SLX-57) and Copper, (COPX-41) which seems particularly positive.  And so Gold, finally, and as always Oil.

Frank D. Gretz

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US Strategy Weekly: Geopolitics Upstaging the Fed

Stocks plunged, then surged. Oil surged, then slipped. It was all a reaction to Russia assembling more than 100,000 troops on the border of Ukraine, threatening to invade and then as a token of appeasement, pulling back some soldiers on Tuesday. However, Western leaders remained skeptical of Putin’s de-escalation move since Russian military equipment was left behind. After the pullback, Ukraine was hit by a cyber-attack and blamed it on Russia. From a global perspective, airlines, and the leasing companies, controlling billions of dollars worth of passenger jets, are by necessity, drawing up contingency plans for a freeze in business with Russia if the standoff on Ukraine’s border boils over into a military conflict. Flight paths will also have to be changed if war breaks out. It all is reminiscent of the Cold War we thought was left behind.

Closer to home, Canadian Prime Minister Justin Trudeau employed emergency powers in an attempt to control the trucker-led Freedom Convoy movement that is now in its third week. The convoy, protesting vaccine mandates and other Covid measures, has blocked downtown Ottawa and major bridges and crossings into the US. On day 19 of the protest, the Chief of Police of Ottawa resigned. The convoy has paralyzed Canada’s capital city and is having an economic impact on both Canada and the US.

On US soil, Senate action on President Joe Biden’s five nominees to the Federal Reserve became stalled after Republicans boycotted a key vote over objections to Sarah Bloom Raskin, the White House’s pick to be the central bank’s Wall Street regulator. Raskin has been criticized over her past statements expressing support for using financial rules to support and police climate change. Failure to advance these nominations will further delay regulatory changes that have been in limbo since October.

All of this is background noise as the US economy struggles with inflation and the likelihood of higher interest rates. And it is taking a toll on consumers. The preview for February’s University of Michigan consumer sentiment readings revealed a series of cyclical lows. The headline index fell 5.5 points to 61.7. The survey on present conditions fell 3.5 to 68.5. The expectations index fell 6.7 points to 57.4, the lowest level since 2011.

Inflation Woes

Inflation data showed that price increases accelerated in January and the CPI jumped from December’s 7.0% YOY to 7.5% YOY. This headline rate was the highest inflation pace in 40 years. And inflation was broadly based, with most CPI sub-indices showing gains well above the Fed’s 2% target rate. The only exception was education and communication which rose 1.6% YOY. The greatest price gains were the transportation sector, up 20.8% YOY. Fuels and utilities rose 12%. Prices for food at home rose 7.4% and apparel rose 5.3%. See page 3.

All the heavyweight components of the CPI are trending sharply higher although the transportation segment has been hovering around the 20% YOY level for several months. Housing – which is a significant 42.4% of the CPI weighting — saw prices rising 5.7% YOY in January. Household furnishings rose 9% and operations increased 4%. See page 4.

At $91.99 a barrel, WTI futures are up over 50% YOY which denotes future inflation numbers will remain high and worrisome. January’s PPI numbers were also higher than predicted with headline rising 12.2% YOY and PPI final demand prices rising 8.5%. December’s import prices excluding oil fell but were still up 6.8% YOY. See page 5. Clearly, inflation has become widespread and embedded in the economy.

Monitoring Yield Curves

With inflation trends escalating, there is great anticipation for the Federal Reserve’s March meeting. We have been expecting a 50-basis point rate hike at this meeting and this is becoming a consensus view. However, it could be that the March meeting will be a lose/lose situation for Chairman Jerome Powell. A 25-basis point hike might be regarded as too little too late, but a 50-basis point rate hike may make the FOMC appear desperate. Already, economists are indicating that they fear the Fed is about to make a mistake that will trigger a recession. For this reason, we have been monitoring the Treasury yield curve to measure financial sentiment. An inverted yield curve has been an accurate precursor of a recession. Although it is worth pointing out that while yield curve inversions have preceded each recession in the last 50 years, the timing is inconsistent and not every inversion has been followed by a recession. Nonetheless, the yield curve is currently normal and that is a godsend.  See page 6.

Technical Indicators

At the top of our inflation concerns is the technical chart of WTI futures. After a major breakout at $77, WTI hit its first upside target of $90. However, this bullish chart pattern also suggests targets of $100 and $110. In our view the Fed’s job of controlling inflation is difficult since domestic and global politics are driving fuel prices. This may contribute to the view that the Fed is at risk of triggering a recession. To date, Treasury note yields have lagged the trend in WTI. But the 10-year Treasury note yield recently exceeded the psychological 2.0% level and is apt to move higher. See page 9. In sum, both inflation and higher interest rates are formidable hurdles for equities this year; but investors can insulate portfolios with stocks that have dividend yields of 2% or more and good earnings prospects.

Despite the recent rally, all the popular indices are trading below all important moving averages. The sole exception is the SPX which is trading above its 200-day moving average this week. The Nasdaq Composite, which has had the deepest correction, is the most oversold; but this is not an unusual pattern in a correction. Large cap stocks are often the last to fall. Therefore, the DJIA and SPX are potentially the most vulnerable indices in coming weeks or months. See page 10.

Amazon (AMZN – $3130.21) which has a chart pattern that resembles the Russell 2000 index, rebounded nicely after in recent swoon, however, it is still trading below all its key moving averages. The first level of resistance is found at $3223 which is a key level to watch. The rebound in AMZN has created a difference between its pattern and the RUT, nevertheless, these chart patterns remain amazingly similar. We will continue to monitor these charts, watching for a bottoming formation that may show that the worst of the correction is behind us. To date, it appears the market’s lows may not have been found. We remain cautious in the near term given the unstable situation with Russia/Ukraine and with the upcoming FOMC meeting. But we continue to favor the energy, financial, and staples sectors and stocks with reliable earnings and dividends.

Gail Dudack

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Pretty Soon You’re Talking Real Money

DJIA:  35,241

Meta drops by $250 billion, Amazon adds back $280 billion… pretty soon you’re talking real money.  They do say it’s a market of stocks.  Still, given they are both part of FANG, the dichotomy here seems a bit bizarre.  Even a bit more bizarre is that Amazon (3180) arguably had the worst chart of the group, though Netflix (406) and FB (228) certainly were no prize.  After its gap higher at the start of the month, Google (2772) landed in resistance and has sold off almost every day since then.  These stocks, of course, have not suffered alone.  High real yields have meant an exit from growth stocks toward value.  While there’s always more to the value/growth story than just rates, over the last few months there has been a close link.  What we find a little disconcerting here is what this means in the overall scheme of things.  Sure these stocks over the years have had their corrections, but more or less they have led the bull market.  If that has changed, it probably isn’t the best sign for the bull market itself.

When the market turns up out of a relatively violent decline like January’s, down the most often turns to up the most – compression rules.  And so it seems so far when it comes to Tech.  Fewer than 25% of Tech shares were above their 200 day a few weeks ago, and after Thursday’s rally the number had recovered to close to 50%.  So, oversold snapback, or sign of an important turn?  As is true of many market indicators, momentum is everything.  Outcomes are better when the numbers are better.  When this number reaches 60% or more, stocks saw their best returns.  No surprise that strength begets strength.  So far it’s still more relief rally than major turn, but the worst should be over for now.  Meanwhile, the better parts of the market, those not compressed, so far have held their own.  This suggests strength in Staples/Value is more than just defensive.

When it comes to leadership, the dichotomy between the Invesco Pure Growth ETF (RPG-185) and the Invesco Pure Value ETF (RPV-85) makes clear what we still believe is an important change.  The charts of stocks like Hershey (203) and McCormick (100) look more “growthy” than your favorite growth stock.  Even in Tuesday’s Tech rally, it was a stock like Coke (61) that made a 12 month new high.  Not be forgotten in this discussion, of course, are the commodity stocks, where strength is pretty much universal.  Oil is obvious, but aluminum, copper and steel have rallied.  Commodities conglomerates like BHP Group (70) also have acted better as has even Ag Commodities.  Meanwhile we’re still waiting on Gold, which could be confused with Waiting for Godot.  Inflation is all the rage yet Gold barely has a pulse.  Those bonds seem to get it, and we wonder when some of that money will be leaking into precious metals.

Thankfully we’re not economists, and we hesitate to walk on that dark side.  That said, there are a few problems out there beyond the technicals.  Pretty basic is the idea recessions have followed 11 of the last 12 Fed tightenings.  And to go by the consumer sentiment numbers, one likely already has begun.  When the pandemic hit, the Fed embarked on massive QE, resulting in 25% money growth.  As Milton Friedman predicted, prices react with a lag.  Like Arthur Burns before them, the current Fed is ignoring a sharp increase in money supply and has tried to blame external factors.  As 2022 begins, inflation is blowing out.  Yet the Fed continues its policy of buying billions of treasuries and mortgage backed securities every month.  Perhaps they remain the “Fed put” realizing if they go to zero asset purchases it’s all but certain to impact multiples.  The technicals offer some reason for optimism now, but it’s important to watch for signs the rally is failing.  As usual, advancing versus declining issues will be important.

We don’t see this turn as the start of a major new uptrend.  Despite the selling, this market never quite made it to extremes typical of a major low.  What we see is what can happen when prices become stretched to the downside, and investor psychology almost historically negative.  And the rally has been good but not great.  Even Wednesday’s 3–to-1 up-day in advancing issues fell short of what you might expect out of a major turn. And, of course, that was followed by Thursday’s better than 3-to-1 downside. Then, too, strength in the averages against flat A/Ds would have been, and still could be, a real warning.  In an unusual pattern, The VIX has dropped 25% from its high, while bond market fear is near 52-week highs. Usually a non-event, this pattern has preceded some significant declines in stocks.

Frank D. Gretz

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US Strategy Weekly: Valuation Readjustment

January’s job growth was well above the consensus estimate and the 467,000 increase was a welcomed event. But this number was in sharp contrast to other economic series also released in the last week. Both of January’s ISM indices are indicating that the recovery is slowing. The ISM manufacturing index fell from 58.8 to 57.6. The manufacturing employment component rose modestly from 53.9 to 54.5, but this and imports, were the only parts of the survey to show any improvement. The ISM service index had consistently been the stronger of the two surveys, but it also fell in January from 62.3 to 59.9. All components in the service group fell with the exception of inventory. In general, both ISM surveys have been deteriorating for the last two months. Not surprisingly, the small business survey, the NFIB Optimism Index, had a large slump in January as small business owners pointed to rising inflation as the number one challenge for their companies and profits. See page 7.

The jobs report also had a counterpoint to the nice job increase in that the unemployment rate ratcheted up from 3.9% to 4.0%. The unemployment rate is part of the BLS household survey which showed that while employment grew strongly in January, so did the number of unemployed. This accounted for the rise in the unemployment rate. The civilian noninstitutional population grew less than the growth in employed and for this reason there was fractional improvement in the participation rate and the employment population ratio. See page 3.

In our opinion, the only employment data point that is important is that there are 2.9 million fewer people employed today than at the peak in February 2020. Typically, total employment will exceed its previous peak level twelve months after a recession ends. Yet, despite all the stimulus and fiscal programs initiated in the last two years, employment remains well below peak levels. There are many reasons for this; but the most significant one may be that the administration has not focused on job growth much at all. Perhaps distracted by COVID-19, the Delta and Omicron variants, vaccines, inflation, North Korean missiles, and the Russia/Ukraine problem, it has not been a focal point.

Inflation is the domestic threat

Inflation is the major threat facing the US economy and its ramifications are clear. One of these is also found in January’s employment report. Average hourly earnings were $26.92 in January, up 6.9% YOY and average weekly earnings rose to $912.59, a 5.4% YOY. These gains are impressive at first glance; however, adjusting for inflation, real weekly earnings were down 1.2% YOY in January. This is the unfortunate part of inflation — it destroys buying power. On page 4 we have a chart of average weekly earnings that are inflation-adjusted to represent 1964 dollars. The chart shows how average real earnings steadily declined throughout the high inflationary period of 1968 to 1990. See page 4. For this and many other reasons, the administration and the Federal Reserve should make fighting inflation their number one domestic priority.

On a positive note, we present the misery index this week. This index is the sum of inflation and unemployment which are the two variables that can impose great hardship on households. The misery index jumped to 15.1% in April 2020 when the unemployment rate jumped to 14.7% and was well above the standard deviation level of 12.7%. However, this was a man-made unemployment level triggered by the pandemic and fiscal stimulus offset much of this “misery” with checks to households and augmented unemployment benefits. Currently, the rise in inflation is wreaking havoc with households but the misery index is at 10.6%. This is well within the long-term “normal” range. See page 6.

Still, we do not see inflation coming under control very soon. The WTI crude oil future moved above $90 a barrel this week. The $90 level was one of the technical targets we wrote about once crude broke out of an 8-year base pattern in the fourth quarter of 2021. The chart pattern also suggests targets of $100 and $110 are possible in the coming months. This will keep inflation high, put more pressure on households and make the Fed’s job of controlling inflation more difficult. Interest rates are also rising this week and the 10-year Treasury note yield is challenging the psychological 2% level. See page 9. Keep in mind that stocks with dividend yields of 2% or more that also have a predictable earnings stream remain very competitive to bonds.

Valuation readjustment

The combination of rising inflation and rising interest rates is a big hurdle for equities, and it explains why value stocks are outperforming growth stocks in 2022. This shift could continue for most of the year and in simple terms, it is a valuation readjustment. We remain cautious in the near term, primarily for stocks with high multiples. Overall, we believe stocks that benefit from, or are immune to, inflation are the best holdings in the near term. These include sectors such as energy, financials, and staples. Nonetheless, we would not ignore the technology sector since 2022 is likely to provide an excellent long-term buying opportunity.   

As part of the current valuation readjustment, we believe the market’s PE could return to normal levels. As an example of what this means, a PE multiple of 18 coupled with our 2022 earnings forecast of $220 equates to an SPX target of 3960. Applying the long-term average PE multiple of 17.5 to $220 equates to SPX 3850. In both cases, it implies that good long-term value is found at levels directly below SPX 4000.

It would not surprise us if PEG ratios, or a comparison of a stock’s PE to its 5-year earnings growth estimate, came back into style. Historically, a PEG ratio of 1.5 in a growth stock represented table-pounding “value.” Value stocks were typically viewed as excellent buys with PEG ratios of 1.0 or less. Again, these are good benchmarks for uncertain times.

Technical update

We remain intrigued by the similarity in the charts of the Russell 2000 index and Amazon (AMZN – $3228.27). After AMZN reported solid earnings last week, the stock rebounded sharply, generating a small difference in the charts. However, the patterns remain largely similar and AMZN is yet to move above its first level of resistance which is the 50-day moving average now at $3255.86. This will be an interesting level to watch. There are no other major changes in technical indicators. The new high/low averages and cumulative advance/decline line are bearish. Our 25-day up/down volume oscillator remains neutral, which means the market is not washed out on an intermediate-term basis. The AAII bull/bear sentiment indices have shown extreme bearish readings for the last three weeks and as a result, the AAII Bull/Bear Spread index is favorable. The good news is that this AAII survey suggests the market is undergoing a normal correction. The survey never showed the extreme optimism that is typical of a bubble peak. Nonetheless, we believe the current rebound is simply a rebound and we do not believe the lows have been found. It would not surprise us if the Fed increased rates 50 basis points in March and this could trigger a sell-off that could characterize the end of the correction.

Gail Dudack

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We Have Four…Do We Hear Five?

DJIA:  35,111

We have four… do we hear five?  Estimated rate hikes seem where the real growth lies.  It’s almost surprising the market has dealt with the dreaded news this well.  Or has it?  Good markets ignore bad news and all that, but rather than ignore, January seemed to have discounted it.  Pick your term – washed out, sold out, even our least favorite, oversold.  January seems to have checked all the boxes.  Last week the NAZ saw a jump in stocks down 50%, a spike in 12 months new lows and a rise in the number of lows for the S&P.  Add to this a drop in sentiment to historic extremes, including record buying of Inverse ETFs and Put buying.  Extremes can always become more extreme, so you never know.  That said, what we have seen so far is the stuff rallies are made of, but unlikely lasting lows.

When in conversation someone says they’re bearish, we can’t help but ask if that means they own no stocks.  Invariably the answer is well, we own this and that, for this and that reason.  Depending on our mood we think or say well, you’re not really bearish – if you’re really bearish you don’t own stocks.  Technical indicators come in two main varieties.  There are momentum indicators, which measure the strength of a market move, including the A/D Index which measures strength by looking at the breadth of a move.  And then there are sentiment or psychological indicators, which measure investor reaction to a market move.  The sentiment measures themselves can be of two varieties – as per the above, the talkers, and then there are the doers.  We prefer the doers like the Put buyers – small option traders spent a record amount on protective puts last week.  However, the talkers, the various investment surveys, also reached some interesting extremes last week.

The AAII, or American Association of Individual Investors Survey, seemingly has been around forever, and the rap on it is so have most of those they survey.  That said, there’s always something to be said for a long history.  This is one of the few times in the last decade that bears are more than 50% of respondents.  When not in a recession, the market rallied the next month 21 of 22 times, and that sole loss was reversed the next month.  The AIM Survey looks at a handful of sentiment surveys and calculates the amount of optimism in each.  It is below 50% which represents only one percent of all days since 1990.  When below 5% the annualized return was 72% versus -1.6% when the model was in the top 1%.  This was the first reading of pessimism in three months.  Following similar spikes in pessimism the market rose 11 of 12 times over the next three months, all this according to

The thermos might be the greatest invention ever.  It keeps things hot, it keeps things cold – how does it know?  Second best might be the 50-day moving average.  It stops rallies, it stops declines – how does it know?  Amongst the many examples, most recent is FB (238) – we hesitate to say Meta Platforms, since after Thursday’s performance it may be time for another name change.  In any event, the recent strength here pretty much stopped right at the 50-day.  The 50-day moving average is not the riddle of existence, though at times we wonder.  It’s a tool in what is the riddle of stock market existence – discipline.  Not long ago we spoke well of the Biotech ETF (IBB-130), but cautioned wait for a move above the 50-day, then around 153.  A little discipline here would’ve saved about 20 points.  In this business it’s not the big money you make, it’s often about the big money you avoid losing.  Stay with stocks above the 50- day, certainly those above the 200-day.

Anything worth doing is worth doing to excess, should be the market’s motto.  Markets often go to extremes, and those can become even more extreme.  It’s the nature of markets.  Only 55% of Tech is down 50%, while the last two bear markets saw 80% down that much.  Stocks above their 200-day typically fall to less than 20% and often to 10%, versus the mid- 20s now.  That said, last week’s extremes were enough for a tradable rally and we’ve seen one, which is not to say the rally is over.  We can say the rally was enough to work off some of those extremes, so the easy part likely is over.  We are still bothered by the Ukraine situation – did Putin go to all that trouble just to walk away?  And, therefore, our added interest in oil, in this case as a possible hedge.  As important as the downside is so too is the upside.  Tuesday’s 200+ Dow rally with only flat A/Ds doesn’t exactly scream sold out, on the contrary.  Those A/Ds are still important.  The weakness there and in the Russell is a bear market pattern.

Frank D. Gretz

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US Strategy Weekly: Fed, Russia, Oil, Inflation

Last week’s FOMC meeting resulted in no major surprises, in our view. The Fed used its January meeting to prepare the global financial markets for quantitative easing that would end by March and for its balance sheet to probably shrink later in 2022. But most importantly, Chairman Jerome Powell was quite clear in his statements that interest rates would begin to rise in March and likely do so for most of the year.

In the wake of this meeting, pundits began to speculate about the number of rate increases investors should expect in 2022. In our opinion, these guesstimates are not useful because we agree with the Fed’s comment that tightening policy going forward will be data dependent. Yet, since the Fed is behind the curve, we would not be surprised if the first fed funds rate hike is 50 basis points. This double-hike would help jumpstart the Fed’s inflation-fighting cycle. It might startle the markets, but it will also dampen the expectations of inflation that has become embedded in the economy.

Unfortunately, we would not be surprised if the Fed’s tightening strategy becomes more complicated later in the year with a combination of inflation that remains stubbornly high, coupled with an economy that shows signs of deceleration. We have often discussed the problems that inflation poses to equities — rising interest rates, multiple compression, profit margin weakness — another risk is that it weakens broad-based consumption. For 2022, we are recommending sectors that are relatively insulated from these risks, such as energy, financials, and staples. Part of this reason is that as the cost of necessities such as heating fuel, gasoline, and food continue to rise, consumers will have less and less money to spend on luxuries such as vacations, new clothes, and entertainment. The net result will be declining revenues for a variety of companies. We expect to hear debates about stagflation in the coming months, but there is no reason to expect this to materialize in 2022. The actual definition of stagflation is an economy characterized by rising inflation and rising unemployment. This was last seen in the 1970s during the oil embargo. We do not see unemployment rising; we simply see a challenging time ahead for corporate earnings.

There are some similarities between the 1970s and the current situation, but they are curable. Instead of an oil embargo that created an energy crisis in the 1970s, The Paris Agreement on global climate change signed in 2021, triggered a sharp rise in fossil fuel regulation and a subsequent decline in energy supply. In short, the current situation is different because it is self-imposed, but we are not sure if this matters. The decline in the supply of fossil fuels is a bigger driver of global inflation than supply disruptions, in our judgment. Yet we doubt this will change the minds of our global leaders.

Furthermore, the price of oil is exacerbated by geopolitics and the fear that Russia is planning to invade Ukraine. As a result, the WTI crude oil future, at $88.36 a barrel currently, is up 17.5% since the end of 2021 and up 44% YOY. See page 10. It should also be noted that Russia is a major beneficiary of the rise in oil prices.

This means inflation will be very difficult to control, at least in the first half of this year, and the Fed has a challenging task ahead of it.

The Good News

January closed the month with declines of 3.3%, 5.3%, 9.0%, and 9.7%, in the Dow Jones Industrials, S&P 500, Nasdaq Composite, and Russell 2000 index, respectively. Moreover, the Nasdaq Composite has experienced an 11.3% decline from its all-time high and the Russell 2000 has dropped 17% from its record high. In short, the broad market is clearly in a correction. We expect the large cap stocks will be the last to fall at the end of the decline; but in the near term, a bounce is likely.  

We show the results of the January Barometer for the Dow Jones Industrials on page 3 and for the S&P 500 on page 4. We have faith in this Wall Street adage that states “As goes January, so goes the year” because we believe the liquidity available to the equity market tends to be at its best in January. However, we must admit that the barometer has a far better track record when January posts a gain than when it posts a loss. A January gain in the Dow Jones Industrials has been followed by a full year gain 89% of the time. In the S&P 500, a January gain has produced an annual gain 88% of the time. But declines in January are much less predictive. In the Dow Jones Industrials, a loss in the first month of the year is followed by an annual loss 54% of the time and in the S&P 500, 47% of the time. In sum, one should not be bearish based upon the January Barometer.  

It is also good news that the stock market has not displayed the characteristics of a classic bubble top. The key to a true bubble is leverage and most importantly, an escalation in leverage. While margin debt has grown markedly in the last 24 months, it has not grown at the pace seen at most major tops. See page 5. The 2-month rate of change in margin debt grew more than 15% in December 2020, as we reported at that time, but margin debt actually contracted in November and December of last year. This is positive since it limits the leverage, and risk of margin calls in the current environment.

Economic Releases

In our view, subtle signs of decelerating economic growth are already appearing. For the third consecutive month, January’s ISM manufacturing index fell, declining from 58.8 in December to 57.6. However, it does remain comfortably above the neutral 50 level. Vehicle sales fell more than 4% in December to an annualized rate of 12.45 million and are down a disturbing 32% from the April 2021 pace of 18.78 million units. See page 6. January’s consumer sentiment indices were glum with the Conference Board Confidence index slipping from 115.2 to 113.8 and the University of Michigan headline reading falling from 70.6 to 68.8. The only uptick in sentiment was found in the Conference Board’s present conditions index which moved up from 144.8 to 148.2. See page 7. New home sales came in stronger than expected in December, increasing nearly 12% to 811,000 units. However, this rebound followed a sharp decline in new single-family home sales in 2021. Existing home sales were more resilient than new home sales last year, but there are signs in both data series that prices are rolling over. See page 8. This should not be a surprise given the recent gains in home prices and the fact that interest rates will be moving higher.

Technical Review

There were not a lot of changes in the technical indicators this week, but the 10-day average of daily new highs fell to 54 which is notable. Daily new lows rose to a 10-day average of 505. This indicator is now clearly negative, after tilting negative for several weeks. The NYSE cumulative advance/decline line’s last record high was on November 8, 2021, and it is trading well below this level currently. Volume has not been rising on declines, which is a worrisome trend. On the plus side, AAII bearish sentiment rose 6.2 points to 52.9%, this week and is above the historical average of 30.5% for the tenth consecutive week. This was the highest reading since April 2013. As a result, the AAII bull/bear spread index is positive for the second consecutive week. Note, AAII never displayed the extreme bullishness that is typical of a major, or bubble, peak. This is a good sign for the longer term.

Gail Dudack

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2021 was a good year for investors, but dominated by the performance of six large companies. In fact, it was the third good year in a row, and with only minor pullbacks—a highly unusual circumstance.

2022 has not started out on a good note. COVID has caused supply chain disruptions, and a combination of unprecedented fiscal and monetary stimulus has boosted inflation to a thirty-nine year high. Inflation, and the Federal Reserve’s belated policy response to slow it, are battering both stocks and bonds.

Perhaps most importantly, minutes of the December Federal Reserve Open Market Committee disclosed that the Fed will not only be winding down its securities purchases, which have pumped trillions of dollars into the financial system, but will also reduce its holdings of treasury and mortgage–backed securities. These actions, which could begin in March, would tend to drain liquidity and tighten financial conditions.

The Fed’s policy pivot actually looks relatively mild in the face of inflation figures, which on a headline basis has reached in excess of seven percent. If there were three

0.25% rate hikes by year end to 0.75 – 1%, that would still leave the real federal

funds rate in negative territory when measured against some optimistic projections that inflation will cool to less than 3% by the end of the year.

In addition to Federal Reserve policy, Washington D.C seems to be in perpetual turmoil and the fiscal stimulus provided this year will pale in comparison to the last two years. Investors have never liked uncertainty, and we are seeing this both in terms of domestic policy and international turmoil.

On the brighter side, unemployment is low, and both our economy and corporate profits should expand this year. Expected corporate profits may be too high, however, since they assume a smooth reopening of the economy and that inflation will normalize. Market returns have always been influenced by corporate profits and interest rates, and in a higher inflationary environment with rising interest rates, it is the level of corporate profits that may determine equity returns.

As a practical matter, this outlook requires increased allocations to defensive quality equities and higher cash cushions.

January 2022

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