Did the Dow Jones Industrial Average actually plunge 1,920 points in the last four trading days without a catalyst? In our opinion, the decline was a long time in coming, but the most obvious answer to this question is that there were many catalysts, but the final straw was first quarter earnings results.

First Quarter Earnings Season

It has been our long-held view that first quarter earnings season could be a market-moving event. Earnings are always the underpinning of a stock market advance or decline, and as the first quarter of 2022 ended, it seemed like first quarter earnings results were the only hope investors had for good news. There was plenty of bad news. It has been clear for months that interest rates would be moving higher, and this would challenge equities and likely lower PE multiples. The Russia-Ukraine conflict which began in late February does not appear to be coming to a quick resolution. The longer the war persists, the more likely the world will see shortages of energy, grains, and metals, and as a result, more inflation. China is experiencing another COVID variant outbreak and by shutting down Shanghai and Beijing, fears of supply chain shortages are reappearing. The only real positive on the horizon for equities was that corporate America could overcome all these challenges and produce solid earnings results.

Unfortunately, to date, the results are mixed. Global banks reported profit challenges such as a decline in the investment banking business and loan-loss reserves against possible Russian debt defaults. A variety of companies like GE (GE – $80.59), Texas Instruments (TXN – $168.44), Mondelez International (MDLZ – $64.04), United Parcel (UPS – $183.05), and Raytheon Technologies (RTX -$99.19) reported profit challenges from rising inflation, supply chain snarls, and an increasingly cautious consumer. But adding to the market’s fears has been the sudden awakening that the Federal Reserve plans to raise rates significantly and quickly. Fed Chairman Jerome Powell has indicated that rates could increase 50 by basis points at each of the next two FOMC meetings. In real terms, this means short-term rates will jump 100 basis points in the next seven weeks! This would be one of the steepest increases in history. And it will take a toll on the economy, particularly on the housing and auto sectors.

Housing and Interest Rates

Home prices accelerated during the pandemic and newly released data for March showed that they reached all-time highs. The S&P/Shiller Case 10-city composite indicated a 19% YOY gain, and the 20-city composite index climbed over 20% YOY. One of the key underlying supports for home prices has been an extremely low level of supply. Inventory for existing single-family homes rose from 740,000 to 830,000 in March, and months of supply rose from 1.7 to 1.9; however, even with March’s increases, these levels remain among the lowest levels in history. See page 3.

And though both new home and existing home prices have been soaring for the last 18 months, the current cyclical peak in sales occurred months ago. In March, existing home sales were 14% below their October 2020 cyclical peak. New home sales in March were 23% below their January 2021 peak. These are significant declines however it is important to note that they appeared prior to the recent rise in mortgage rates. Lower sales imply a decrease in demand, something that could escalate as interest rates rise. See page 4.

The National Association of Realtors (NAR) housing affordability index fell from 143.1 in January to 135.4 in February. Although median family income rose in February, the falloff was due to rising home prices and higher mortgage rates. Note that the average 30-year fixed mortgage rate was 3.83% in February during the NAR survey, and it is currently 5.11%. Moreover, since the Fed plans to raise short-term rates 100 basis points in the next six to eight weeks, rates are apt to climb surprisingly quickly. In sum, due to tightening Fed policy, the housing sector is apt to suffer a meaningful slowdown in 2022. Although this should be expected after such a strong cycle, it will be a substantial hit on the US economy. According to the NAHB, housing contributes 15% to 19% to GDP. See page 5. The preliminary release of first quarter GDP is scheduled for April 28, and it will be an important benchmark for investors. Yet, regardless of how well or poorly the economy performed in the first quarter, economic momentum is apt to slow considerably in the next three quarters.

The angst in the housing sector is not new and has been evident in the NAHB home builder confidence survey all year. In fact, confidence peaked with the cyclical high in new home sales in late 2020 and has been falling somewhat erratically, ever since. See page 6.

Technical Breakdowns

Over the last twelve months, we have noted several technical patterns in the charts of the popular indices we thought had predictive significance. In the fourth quarter of 2021, we remarked on the severe underperformance of the Russell 2000 index and the warning that posed for the overall marketplace. Two weeks ago, we pointed to the convergence of the 50-day, 100-day, and 200-day moving averages in the Dow Jones Industrial Average at 35,000, and how this could be a pivotal level for the index and the broader market. Last week, the DJIA was unable to better the resistance at 35,000 and this foreshadowed the sell-off seen in recent days.

This week we are disturbed by the breaks of support seen in both the Nasdaq Composite Index and the Russell 2000. Both indices broke the lower end of trading ranges that have contained market sell-offs this year. These technical breaks imply a new downdraft in the popular indices should be expected. See page 9.

In addition, on April 22, 2022, when the DJIA fell 809 points, the NYSE volume data revealed the first extreme 90% down day since June 24, 2020. However, the June 2020 reading was actually the last in a series of 90% down days. The first one appeared in February 2020. In short, the April 22^nd 90% down day was the first sign of panic selling, but it is unlikely to be the last. History shows that 90% down days usually come in a series. Typically, after a series of 90% down days, a 90% up day will appear. This would be the first sign that the market may be stabilizing. We will keep you posted. On the positive side of the ledger, AAII bullish sentiment rose 3.0 points to 18.9% this week, but bullishness remained below 20% for the second consecutive week. These were the first two consecutively low bullish readings since May 2016. It is also only the 33rd time in history that bullishness fell below 20%. Extremely low bullishness is positive. Bearish sentiment decreased 4.5 points to 43.9% and has been above 40% for 12 of the last 14 weeks. It would be favorable if bearishness rose above 50% at the same time that bullishness is below 20%. We will see what next week brings. Overall, sentiment readings are favorable. Nonetheless, we would remain very cautious in the near term since the breaks in the Nasdaq and Russell suggest lower prices ahead.

Gail Dudack

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Given the uncertainty of the current geopolitical environment, first-quarter earnings season will be very closely monitored and more important than usual. The atmosphere is rife with risk. Noting “seismic waves” from Russia’s invasion of Ukraine and warning that inflation was now a “clear and present danger,” The International Monetary Fund cut its forecast for global economic growth by nearly a full percentage point this week. The IMF also indicated that Ukraine’s GDP could collapse by 35% this year and Russia’s economy could shrink by 8.5%. Emerging and developing Europe (which includes both Russia and Ukraine) are forecasted to decline by 2.9%. The IMF also pointed out that these forecasts are in jeopardy for many reasons, including the likelihood of more sanctions on Russia, global food shortages, and tightening monetary policies. With this backdrop, investors will be riveted, not only on first-quarter results, but on corporate guidance for the rest of 2022.

To date, first-quarter earnings results are mixed. International Business Machine (IBM – $129.15) reported it expects to hit the top end of its revenue growth forecast for 2022 even though it expects a hit of a “few hundred million dollars” from the suspension of its business in Russia. Johnson & Johnson (JNJ -$183.08) cut both ends of its full-year profit forecast by 25 cents lowering expectations to $10.15 to $10.35 per share. JNJ cited currency fluctuations rather than fundamental business issues for the decline, and simultaneously raised its dividend by 6.6%. Meanwhile, Netflix Inc. (NFLX – $348.61) cratered 24% after the bell when it reported that subscriber numbers had declined for the first time in a decade. The streaming company lost 200,000 subscribers in the first quarter; but more disturbingly, it expects to lose an additional 2 million subscribers due to competition from Apple Inc. (AAPL – $167.40) and Walt Disney (DIS – $131.90). Account sharing and other challenges are also having a negative impact. Tesla (TSLA – $1028.15) reports earnings on Wednesday and investors will be watching and listening, not only for earnings results but to hear if Elon Musk discusses his bid for Twitter Inc. (TWTR -$46.16). On April 14, Musk offered to buy all Twitter shares for $54.20 per share and take the company private. This bid has been the most-followed story of the last week and the company responded by adopting a poison pill to thwart Musk. Twitter, which reports earnings on April 28, is listed by IBES Refinitiv as one of several companies likely to have a negative earnings surprise this quarter.

Stock Prices, Rising Interest Rates and Earnings

IBES Refinitiv is currently forecasting first-quarter earnings growth for the S&P 500 to be 6.3% YOY but excluding the energy sector – where profits are expected to rise 241.2% YOY — growth falls to 0.7% YOY. In short, 2022 is likely to be a difficult year for most companies and as we have been indicating in recent weeks, earnings growth needs to be substantial to counter the negative impact of rising inflation and interest rates.

There is much confusion about rising interest rates and stock market performance. Stocks can, and often have rallied in a rising interest rate environment. In fact, rising interests rates and a strong economy typically go hand-in-hand and as a result, good earnings growth offsets the negative impact of rising interest rates and PE compression. This explains why first-quarter results and corporate guidance will be important this season. If PE multiples cannot expand, the only driving force for equities will be rising earnings.

Meanwhile, it appears that the Fed is warning us that interest rates are about to rise quickly and substantially this year. St. Louis Federal Reserve Bank President James Bullard recently stated that he believes the fed funds rate needs to rise to 3.5% by the end of the year in order to slow the current 40-year-high inflation pace. He also said he would not rule out a 75-basis point rate hike in May, although his preferred rate path would be 50 basis-point hikes at each of the six remaining FOMC meetings this year. Separately, Chicago Federal Reserve Bank President Charles Evans said the Fed should raise its target range to 2.25%-2.5% by year end and then take stock of the state of the economy. If inflation remained high, the Fed could hike rates further. We have noted that most Fed policymakers estimate neutral to be somewhere between 2.25% and 2.5%.

All in all, these various comments by current Fed governors are tempering the markets for the Fed’s next move and to date, investors are responding well to the fact that rates will soon rise at least 50 basis points. We do not sense any panic, but we fear this could be temporary. In our opinion, the Fed is aware that it needs to slow the economy, and in order to tame inflation, they must tap the breaks on the housing market and auto sales. Unfortunately, steering the economy to a soft landing may be extremely difficult, particularly with the tenuous situation in Europe. We remain cautious and continue to emphasize areas of the market that benefit from inflation or can weather inflation such as energy, utilities, defense stocks, and staples. See page 12. Plus, stocks with solid dividends are good substitutes for bonds in a rising rate landscape.

Economic Releases

The NAHB single-family confidence survey for April revealed that homebuilders have had a slow, but steady decline in conviction for the first four months of the year. Housing starts and housing permits were higher in March, up 3.9% and 6.7% YOY, respectively; but unfortunately, the increase in both series was in multi-unit housing. Single-family permits and housing starts, which account for the biggest share of homebuilding, fell in March. See page 3.

Industrial production for March rose to a record high, edging above the August 2018 peak. March’s gain was driven by a rebound in auto and truck manufacturing where production had been weak for most of 2021 due to semiconductor supply problems. Electric & gas capacity utilization eased in March. Whereas electric & gas capacity utilization used to be a benchmark for defining activity in the manufacturing sector, the steady decline in utilization since May 1970 is a display of the energy efficiencies seen in the US over the last five decades. See page 4.

In March, total retail & food sales rose 6.9% YOY. Excluding autos, sales rose 9.1%, and excluding autos and gas, retail sales rose 6.2%. The volatility in retail sales in early 2021 makes year-over-year comparisons difficult and less meaningful. Still, with inflation up 8.6% YOY in the same time period that retail sales rose 6.9% YOY, this means real sales were negative in March. Equally important, gas station sales rose 17.1% YOY in the month as a result of soaring gas prices. See page 5.

Technical Updates

Stock prices appear to be in the midst of a rally, but due to a convergence of moving averages, important resistance levels are directly overhead in all the indices. This convergence/resistance is most apparent in the SPX at 4500 and in the DJIA at 35,000. The Nasdaq Composite Index and Russell 2000 have weaker charts and remain well below their 200-day moving averages. See page 8. Last week AAII bullish sentiment fell 8.9 points to 15.8%, the lowest since September 1992. Sentiment has been unusually volatile this year, but this low bullish sentiment is a positive for the longer term.

Gail Dudack

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According to Reuters, as soon as Wednesday, President Joe Biden’s administration could announce it is extending another $750 million in military assistance for Ukraine’s fight against the Russian invasion. Separately, the Pentagon is hosting leaders from eight weapons and defense manufacturers to discuss the industry’s capacity to meet Ukraine’s needs in case the war with Russia lasts for years.

These announcements are just one indication of how the world, the financial markets, and potentially, our futures have changed in the last two months. There is no denying that energy prices were trending higher well before Russia invaded Ukraine in late February. However, energy, grains, metals, Russia, Ukraine, inflation, financial markets, and politics are now irrefutably intertwined in an inflationary quagmire. This war-induced combination is not really something the Fed has the tools to fix. And in our opinion, this is why the consensus has flipped from optimism to pessimism about the US economy and is worried about a Fed-induced recession. We are too.

Other headlines are also disconcerting: the possibility of Russia using chemical weapons in Ukraine, eurozone banks becoming risk averse and tightening corporate credit, and China shutting down Shanghai due to the spread of a COVID variant. It is a mixed collection of news, but individually and together, it points to substantially weaker growth or potentially a global recession.

Stay Defensive

We contemplated raising cash this week, however, we still believe select stocks can do well despite these challenges. In fact, some companies will benefit. Therefore, we remain overweight the energy sector, industrials (with an emphasis on defense stocks), consumer staples, and utilities. Each of these sectors is a direct, or indirect, beneficiary of the current world condition. Utilities are not a direct beneficiary, but they are defensive, can pass on costs to consumers and are preferable to bonds in an era of rising interest rates.

Inflation continues to Roar

The March CPI report was filled with bad news. Headline inflation exceeded expectations showing prices rising 8.5% YOY with core inflation up 6.5% YOY. Both series displayed the highest inflation in 40 years. Energy rose 32.2% YOY, up from 25.7% in February. Food prices rose 8.8% YOY, up from 7.9% in February. Services rose 4.7% YOY, up from 4.4% YOY. Goods inflation “moderated” to 11.7% YOY, down from 12.4% YOY in February. See page 3. The March CPI report indicates why the average household is struggling to keep up with normal expenses even though average weekly earnings rose 4.6% YOY in March. After inflation, the purchasing power of consumers fell nearly 4% YOY in March.

All the large segments of the CPI – housing, food & beverages, medical care, and transportation – have been experiencing escalating price increases over the last six months. See page 4. Many economists, like Larry Summers, are voicing concerns about the probability of a recession in the next two years; and not surprisingly, most strategists fear the Fed will trigger a recession by raising interest rates too much or too fast.

A History Lesson

However, history suggests that today’s inflation rate has reached a level that may make a recession inevitable. On page 4, we show a long-term chart of the S&P 500, various inflation benchmarks, and recessions. It shows that the last time inflation began to soar at this pace was during the oil embargo of 1973. That inflation was followed by three recessions in the subsequent ten years.

This era was called the “great inflation” and it began in late 1972 and did not end until the early 1980s. In his book “Stocks for the Long Run: A Guide for Long-Term Growth“ (1994), our friend Wharton Professor Jeremy Siegel, called it “the greatest failure of American macroeconomic policy in the postwar period.” This decade-long inflation era has been blamed on many things: oil prices, the end of the gold standard in 1973, funding of The Great Society legislation, greedy businessmen, food shortages due to bad weather, and avaricious union leaders. But, according to Professor Siegel, the root cause of the great inflation was monetary policies that financed massive budget deficits driven by political leaders and their legislation. This should sound familiar.

The great inflation ended with Paul Volcker, Chair of the Federal Reserve from 1979 to 1987. Volker made financial history in March 1980 when he raised the fed funds rate from 14% to 20%, its highest level on record. It was tough love but needed in order to end years of crippling double-digit inflation. Volker also moved the fed funds rate back to 20% in May 1981 when inflation began to creep higher. Although widely criticized at the time, the March 1980 “Volker Shock” is now seen as a courageous and wise act. Both rate hikes to 20% were followed by recessions, but in the end, it finally broke the back of a dangerous inflationary cycle.

Perhaps this was the history lesson discussed at the March FOMC meeting. If so, it would explain why dovish Fed governors like Lael Brainard suddenly become monetary hawks. The current Fed seems determined to enforce tough love on the economy in 2022 by raising interest rates and contracting its balance sheet. We believe both are needed. Unfortunately, it also raises the risk of recession.

Earnings Season

This week kicks off first quarter earnings season, and while all earnings seasons are important, this time analysts will be listening carefully to hear what corporate leaders have to say about revenues and margins. As we show on page 6, inflation is apt to pressure margins this year and we already discussed how inflation will decrease the purchasing power of households. IBES currently is forecasting earnings growth in the first quarter of 6.1% YOY but excluding energy growth falls to 0.6%. Clearly, any disappointments this quarter could tip the balance to negative for the quarter. Again, we would emphasize companies that benefit from the current environment, have predictable earnings streams, and safe dividend yields.

Technical Events

In our view, the most meaningful technical event of the last week was the inability of the DJIA to better the resistance found at 35,000. A convergence of three key moving averages made this a critical point for the index, and the DJIA not only failed to break through but has been noticeably weak in recent sessions. All the popular indices have a similar pattern, but it was most clearly seen in the DJIA. In short, all major indices continue to trade below their 200-day moving averages in a classic bearish pattern. AAII sentiment has been unusually volatile. Last week, bullish sentiment fell 7.2 points to 24.7% while bearish sentiment jumped 13.9 points to 41.4%. Pessimism has been above 40% for nine of the last 12 weeks. Optimism has been below 27.9% for 10 of the last 13 weeks. Neutral has been above average for the third consecutive week. Overall, the AAII bull/bear spread remains positive.   

Gail Dudack

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The Russian war on Ukraine continues and the news from the battlefronts are disturbing. Global sanctions on Russia, Russian companies, and their corporate leaders and oligarchs escalated this week as well with the hope that the financial pain inflicted by sanctions may deter President Putin from his aggressive path. In a lengthy statement this week, US Treasury Department listed companies and individual corporate leaders known to be used to evade recent sanctions, and imposed measures to close loopholes and prevent them from operating or procuring western technology. All property, interests in property, and assets in the US, including all financial assets in US banks, of individuals listed by the Treasury, are now frozen and cannot be used to pay interest on loans or perform any business transactions. Injunctions were expanded to include aerospace, marine, and electronics sectors.

In addition, the US and Germany jointly sanctioned the world’s largest and most prominent darknet market, Hydra Market, in a coordinated effort to disrupt malicious cybercrime services, sales of dangerous drugs, or other illegal offerings available on the Russian-based site. German Federal Criminal Police shut down Hydra servers in Germany and seized $25 million worth of bitcoin. Garantex, a ransomware-enabling virtual currency exchange founded in late 2019, was also sanctioned. All of these measures, and the sanctions ordered before this week, are meant to cripple Russia’s economy and provoke sovereign and corporate debt defaults.

Meanwhile, Britain ordered a report into shale gas fracking on Tuesday, less than three years after banning the practice, saying all options should be available in light of a Ukraine crisis-fueled surge in gas prices. We applaud this shift, but it also reveals the misjudgment of the UN-sponsored Paris Agreement on climate change. Western countries made major steps to decrease fossil fuel production, but these steps only opened the door for oil-rich countries like Russia to take control of the world’s energy markets. In our view, the path to renewable fuel should have been done in conjunction with the US remaining energy independent, not before.

Yield Curve Fears

However, none of these issues reversed the March rally. Instead, it was Federal Reserve Governor Lael Brainard, one of the Fed’s most dovish governors. She stated that a combination of interest rate hikes and balance sheet runoffs were needed to quickly move monetary policy to a more neutral position this year. The implication was that the Fed is clearly set on a hawkish path in 2022 to contain inflation. This week’s release of the March FOMC meeting minutes is expected to provide more details of the Fed’s plans.

However, as we just pointed out, today’s inflation is not simply a demand-driven cycle that the Fed can contain. It has materialized from a diminished supply of energy, particularly in fossil fuels. It came from a lack of investment. It is policy driven. It is man-made. In short, the Fed will have a difficult time trying to tame current price increases. Moreover, since Russia and Ukraine are the breadbasket of Europe food and meat prices will also rise this summer. This is a raw material inflation cycle, and the Fed does not have the tools to fix it, without perhaps triggering a recession.

In our opinion, the obsession with the yield curve and a possible inversion is really based upon these underlying facts. Yes, the Fed was too slow to change policy to control inflation, but the cycle is now exacerbated by geopolitical events that are not under their control. This is a cause for concern.

Plus, the sanctions imposed on Russia are meant to create defaults on loans, and this too, will have repercussions. JPMorgan Chase CEO Jamie Dimon made two important comments recently. First, he indicated that the Fed could lift interest rates by more than 2.5% this year, more than most expect. Second, he indicated that the bank may need to take as much as a $1 billion of reserves against Russian debt.

Sector Weighting Shifts

Our main concern is that a combination of inflation-induced margin erosion, a rising cost of capital, and write-offs related to Russia, either from corporations exiting businesses in Russia or defaults from Russian debt, will weigh heavily on earnings performance this year. For these reasons, we remain cautious and believe investors should seek safety in areas that are insulated from these risks. These areas include energy, staples, cybersecurity, and aerospace and defense. We are upgrading utilities from underweight to overweight this week because we believe high dividend-paying stocks will be in demand as bond prices fall. Utilities are also able to pass on energy costs to consumers. We are also lowering our weighting on the technology sector from overweight to neutral. This is more in line with our view that technology stocks will be one of the most volatile areas of the market in 2022 and while trading opportunities arise, they may not provide the best intermediate-term strategy – with the exception of cybersecurity. Lastly, we are lowering the REIT sector from neutral to underweight due to the pressures we anticipate from higher interest rates and rising costs. See page 13.

Economic Releases

The final estimate for fourth quarter 2021 GDP growth was 6.9%, a nice improvement from the 2.3% pace seen in the third quarter. However, on page 3 we overlay the real 10-year Treasury note yield on real GDP growth. This shows that real yields are extremely negative, which historically has only been seen during a recession. Recent unnecessary stimulus explains the historic level of inflation we are currently experiencing and points out why interest rates must go much higher this year. The Fed’s task is now extremely difficult and the risk of too much tightening and an inverted yield curve is real.

The major contributor to growth in the fourth quarter was gross private investment, while personal consumption of goods was barely positive, and consumption of services rose modesty. Unfortunately, the largest contributor to private investment was a buildup of inventories, and this could dampen growth in the first quarter of this year.

Staying at home or traveling by car became the norm during the COVID pandemic and this contributed to strength in housing and autos. Auto sales have been a solid contributor to retail sales, but the pandemic boost appears to be over. Unit auto sales have been declining since mid-2021. In March, total unit sales of autos and light vehicles were 13.7 million, down 24% YOY. See page 5. The ISM manufacturing index slipped to 57.1 in March although employment, prices, and inventory rose. The main weakness in manufacturing was found in new orders and backlog of orders. The ISM non-manufacturing index rose slightly to 58.3 in March due primarily to strength in employment, new orders, and exports – all good signs. However, service business activity slipped a point to 55.5 in March. See page 6.

Gail Dudack

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