Rumors of improving discussions between Russia and Ukraine helped foster a rally in equities this week. The advance generated changes in our technical indicators as well as in the charts of the popular indices. However, to date, there is nothing to suggest that recent gains are anything more than a short-covering rally coupled with institutional accounts making portfolio adjustments at the end of the first quarter.
At present, both equities and commodities, particularly crude oil, are experiencing tremendous volatility and appear to be captive to ever-changing headlines, but the underlying economy is little changed. Inflation continues to be a major threat; monetary policy is destined to be unfriendly, and the combination is apt to be detrimental to the economy, the consumer, and corporate profits. The real question is how big a hurdle the combination of rising prices and rising interest rates will be for economic activity, particularly for the housing and auto sectors.
This week we will get data on personal income and personal expenditures for February, March employment, final fourth quarter GDP with corporate profits, plus vehicle sales and the ISM manufacturing report for March. These reports should give investors a better feel for how businesses and consumers are reacting to the Russian invasion, inflation, and rising interest rates. More importantly, in the coming weeks earnings reports for the first quarter will begin and as we have noted in the past, this could become a market-moving event. History has shown that stock markets can perform well in an environment of rising interest rates – the caveat is that earnings must be rising faster than before to compensate. This seems unlikely to us, but if earnings are better than expected, this could provide good downside support for stock prices.
Housing is Weakening
An index of pending home sales fell to 104.9 in February. This was the lowest reading since May 2020 and the fourth consecutive month of declines. Note that monthly new single-family home sales peaked in July 2020 at 85,000 and the year-over-year growth rate in units sold has been negative since June 2021. Unit sales dropped to 65,000 in February. We expect that rising rates will make housing less affordable and unit sales will continue to fall. See page 3.
New home unit sales, including multi-family, single-family and condominiums, were 772,000 in February, a 6% decline from a year earlier. However, while unit sales are slipping, prices are rising, and the average price of a new single-family home rose 25% YOY to $511,000. The median price of a single-family home rose 10.7% YOY to $400,600. These price gains are significant. When we index personal income and home prices to a baseline like 1973 it becomes clear that from 2008 to 2021 personal income was consistently rising faster than home prices. That made homeownership more affordable. Sadly, this changed in 2022 and prices are now rising faster than personal income, and this is one reason homeownership may become more challenging later this year. See page 4.
GDP growth requires rising capital investment, and we fear housing may face a slowdown in the second half of this year. Residential construction spending was $50.3 billion (SAAR) in December, a solid 15.3% YOY increase, although a deceleration from the 31.8% YOY increase recorded at the May 2021 peak. At present, the residential construction market appears solid, but home builder confidence has been slipping in recent months. The National Association of Home Builders survey for single-family sales showed that “expectations for the next six months” fell to 70, the lowest level recorded since September 2019. In general, the survey shows that homebuilder confidence peaked in November 2020 and has been slowly declining since that time. Builders are indicating that pricing pressures and the knowledge that mortgage rates will be rising as factors that make them uncertain about the future. See page 5.
The Yield Curve
The 10-year note yield rose from 2.16% to 2.41% this week yet despite rates rising on the long end, fears of an inverted yield curve are escalating. In our view, an inverted yield curve requires inversion between the fed funds rate and the 10-year Treasury note yield to truly warn of a recession. Moreover, inverted yield curves have historically preceded recessions by six to twelve months, on average, and therefore the angst regarding an inversion today appears to be overdone and too early, in our opinion. However, given the expectations of seven to nine fed fund rate hikes this year, the risk of an inverted yield curve, and a recession in 2022, is a possibility. But keep in mind that the Fed has control over the short end of the curve, but not the long end of the curve. When investors believe the Fed has tightened too much, and a recession is at hand, this is when the long end of the curve collapses and the curve inverts. At present, interest rates are rising on the long end, and we find this a bit reassuring. See page 7.
Technical Indicators and Charts
The major head-and-shoulders top formation that we have been discussing in the S&P 500, that had downside targets of SPX 4000 and SPX 3800, was nullified this week by the advance seen in the SPX. The index rallied above all its moving averages, including the 200-day moving average, which is a positive for the overall market. See page 8.
In terms of technical strength, the SPX displayed the greatest price momentum in recent days. The DJIA also rallied and has edged above key resistance at the DJ 35,000 area. But we believe the DJIA needs to sustain this advance to demonstrate that this is not a false breakout. The Nasdaq Composite has moved up toward its resistance level defined by the combination of its 100-and 200-day moving averages, but it lags its counterparts and is yet to breach this resistance. See page 9.
The charts of the Russell 2000 index (RUT – $2133.10) and Amazon.com (AMZN – $3386.30) continue to look similar and since they were leaders at the top of the market it is also possible that they will be leaders at establishing a low in equities. AMZN is clearly outperforming the RUT; but the RUT is unfortunately the weakest of all the main market indices. It is about to test its 100-day moving average at 2143.85 and 200-day moving average at 2197.08 and we will be watching to see if this index can better resistance. Even so, while the SPX and DJIA have surpassed their respective resistance levels, further gains are required to confirm that these moves are indeed “breakouts” from resistance and not merely a short-covering rally and portfolio window dressing. See page 10. Our 25-day up/down volume oscillator is at 2.38 this week and close to an overbought reading above 3.0. An overbought reading would be surprising and suggest that the market is in a long-term trading range, not a bear market. The 10-day averages of new highs and lows are 133 and 177, respectively. Again, the combination implies a neutral market. Overall, we remain cautious for the near term.