He’s Behind the Curve … But Not For Long

DJIA:  33,917

He’s behind the curve … but not for long.  They berated poor Powell for being late to deal with inflation and rising market rates.  Then as he seemed to favor the idea of bigger rate hikes in a speech last Thursday, the Dow fell close to 1000 points the next day.  Is it be careful what you wish for, or for the stock market does bad news only matter when the market says it does.  Sure it was just a day, but a different day.  If rates suddenly matter, can’t wait for the day QE turns to QT, long our bigger concern.  In a way we almost find more worrisome last week’s reversal in the commodity stocks.  Sure it was related to China’s problems, but it seems more a matter of the market making the news or, in this case, not looking beyond the news.  Commodity stocks have been the market’s leadership, and when the market leaders stop leading it’s not a good sign.

The market opened higher both Wednesday and Thursday on the numbers from Microsoft (290) and the beleaguered Meta (206).  We briefly thought we had missed the cease-fire in Ukraine, news inflation is under control, and the Fed won’t raise rates, the things that matter.  Markets rally, even bear markets.  However, bear markets don’t end on good news.  They end on bad news because it’s bad news that begets selling and getting the sellers out-of-the-way is what ends bear markets.  Recall the day of the invasion back on February 24.  After a consistent two weeks of decline, the Dow was down more than 800 points before reversing to close higher.  Sellers not buyers make lows, so we particularly don’t like to see up openings.  Regardless of whether the market is sold out, you can argue Tech especially is due for a bounce. Both Microsoft and Meta have rallied back to but not quite through their respective 50-day averages.  These seem key points.   

Together with most commodities, Gold reversed last week and the Gold Miners ETF (GDX-35) dropped below its 50-day average.  The metal itself had made a run at $2000, a level above which it has closed only once, back in August 2020.  The recent weakness makes it easy to dismiss this latest run as just another in a series of such moves over the years.  When most think of Gold they think of inflation and there’s plenty of that.  Gold, however, can be a hedge against many things, just ask your local oligarch.  Back in 1929, a period of deflation, a 10% holding in Homestake Mining would have hedged the rest of your portfolio.  Gold coin sales rose about 48% in 2021 from a year earlier, data from the US mint show, while purchases of gold ETFs hit a record last month, according to a recent Barron’s piece.  Technically speaking, the miners have gone from fewer than 10% above their 200-day average to more than 90%.  Similar cycles over the past 40 years have led to medium to long-term outperformance, according to SentimenTrader.com.

Aerospace/Defense stocks seem a good hedge, perhaps not so much for what’s happening now, as for what may come to pass in terms of an escalation – Nuclear/Bio.  As for what is going on now, we wonder.  The logic is simple enough – war, missiles, these stocks makes sense.  The problem is, who hasn’t thought of that?  The charts here are good enough, so perhaps we shouldn’t go looking for trouble.  Still, we always hesitate when it comes to easy trades, and against the war backdrop, buying Aerospace/Defense stocks has to be up there when it comes to easy trades.  There was a time not all that long ago it was easier to buy Twitter (49) than to buy Tesla (878), and we all know how that worked out.  We also recall losing money in Aerospace/Defense after 9/11 when the stocks initially rallied, and then went dormant, to put it mildly.  It gets back to our basic belief that when it comes to the stock market, what we all know isn’t worth knowing.

It’s one thing to talk about getting the selling out of the way, how do you actually know when the selling is out of the way?  One measure is what they call 90% down days.  These are days when 90% of the volume is in stocks down on the day.  Until last week we had gone more than 350 days without one.  The catch is there is usually more than one of these days before a low, and you need a similar day to the upside to confirm the low.  The theory here is if stocks are sold out, they should move up easily.  Another way to view stocks as being sold out is when extremely few are in uptrends.  On the NASDAQ the other day only 14% of stocks were above their 10-day average.  Unfortunately, there are no magic numbers here and stocks above their 50 and 200-day averages still have room to the downside.  Of course, this doesn’t rule out interim rallies, though they’re likely rallies to sell.  Meanwhile, did Teladoc (33) split 10-for-1?  Stay away from stay-at-home.

Frank D. Gretz

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US Strategy Weekly: Caution is Advised

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 22nd 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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The first quarter of 2022 will probably be remembered for two seminal events: the Federal Reserve’s pivot from quantitative easing to quantitative tightening, and the start of hostilities in Ukraine. While either of these events in and of itself would probably give the markets pause, the combination resulted in a 4.6% decline for the S&P 500. The NASDAQ lost 8.9%.

As expected, in mid-March the Federal Open Market Committee (FOMC) raised its federal funds target rate by one quarter of a percentage point to 0.25%-0.50%. At the same time, the Committee unveiled economic projections with sharply higher inflation and federal funds expectations, while lowering anticipated economic growth for 2022. The numbers were in sharp contrast to those released in December when Omicron, rather than Ukraine, topped the list of worries.

The war in Europe, which so far has proven to be a stalemate and is unlikely to be resolved any time soon, has disrupted activity on a number of fronts. These include upheavals in the markets for energy, food grains, and a number of key materials, all the while further disrupting already stretched global supply chains.

Inflation in the U.S. and in Europe is now above 8%, a 40-year high and well in excess of what was expected as recently as December. More troubling, especially in the U.S., are signs that the underlying drivers of inflation have broadened from goods to services, exacerbated by tight labor market conditions. Inflation psychology has shifted significantly, and while longer-term inflation expectations have not yet become unhinged, they are increasingly at risk of doing so.

The Federal Reserve, now finding itself well behind the curve, has given clear signals that it is shifting to a more aggressive tightening mode, to include more rapid and larger rate hikes as well as balance sheet runoff. The U.S. consumer is still in good shape, but recent wage gains have been overtaken by inflation. Most analysts are still forecasting decent economic and corporate profit growth, both this year and next. We question, however, whether these projections will be realized, given tightening monetary policies, continued conflict, and emerging weakness in other parts of the world. Mortgage rates in excess of 5% are already having an effect on the U.S. housing market.

We ended our January letter with this sentence: “As a practical matter, this outlook requires increased allocations to defensive quality equities and higher cash cushions.” We continue to believe this is the case today. 

                                                                                                                            April 2022

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It Was the Best of Times… Really?

DJIA:  34,792

It was the best of times… really?  Things are so good the market rallied 500 points on Tuesday and another 250 on Wednesday?  Let’s see, there’s been a record surge in credit as consumers resort to almost desperate measures against an inflationary backdrop.  And there were those healthy-looking retail sales numbers which actually would have been down without gasoline sales.  Scarier still, however, might be the 50% drop in trucking activity in a recent week owing to flat retail sales and already excessive inventories.  Some would say all this says recession, as has the thoughtful though often gloomy David Rosenberg. The Consumer Sentiment Surveys say we’re there and have been for some time.  Then, too, is the market looking beyond all this?  Or, is it that some of the best one-day rallies happen in bear markets?  Time will tell, to coin a phrase. We are still pretending to be open-minded.

It’s a market with more than a few cross currents in terms of what’s working and what’s not.  At the start of the year, we sort of divided the world into Tech and Staples, and Staples morphed into Commodities.  After a March fade Staples have come back on again, and then some.  Meanwhile, after their March relief rally, Tech has turned weak again, especially anything to do with stay-at-home.  The other broad area that can’t find its way is Financials.  Not surprisingly, all this has left the overall market background a bit mixed but with a clear negative leaning.  Anytime you have the S&P down only a few percent but only about 40% of stocks above their own 200-day moving average, you know the averages are masking a lot of weakness in the average stock.  This doesn’t end well.

Utilities have been on a tear, something the textbooks used to say was not supposed to happen when rates were rising.  Right now, however, higher yields are the result of the Fed trying to slow economic growth, and that’s making investors think of defensive areas like Utilities.  A slow down would hinder profits in most cyclical sectors, while Utilities earnings should be stable as they can keep raising prices.  Analysts actually expect earnings here to grow almost as fast as the S&P’s 10% rate.  So the fundamentals seem fine and so far so too do the charts.  The problem might simply be too much of a good thing.  The XLU (76) has enjoyed its second largest 30 day rate of change in 20 years, and half the stocks recently reached new highs in a 10-day period.  That’s a 23-year record according to SentimenTrader.com.  Momentum extremes like these, in the past have caused problems – just saying.

If any questions remained about stay-at-home stocks, Netflix (217) answered that.  To look at Disney’s (122) hit, the problem doesn’t seem one of competition.  And to look at Etsy (102) and Peloton (20) before it, it’s the concept and not the companies.  Worried about competition, maybe we should be worried about Tesla (1009), Tesla at least is the only major car company that doesn’t have to spend time transitioning to EVs.  Another big difference, the stay-at-home stocks all have had terrible charts, Tesla does not.  If there’s a silver lining to the Netflix news and the reaction of the stay-at-homes, it does seem tangible evidence of reopening post-Covid.  It also seems a reflection on human nature as it relates to the stock market – investors were pricing stocks that did well in the pandemic on the assumption that lockdown behavior was forever.  Who knew – things change.

Nice to see the market is doing its job if, as they say, the market’s job is to confuse the most number of people.  It was certainly easy to be impressed by Tuesday’s 500-point Dow rally, backed up by Wednesday’s 250-point gain.  And both saw advancing issues near 2-to-1 versus those declining, not blowout numbers but decent.  It wasn’t quite clear why the strength just as it wasn’t quite clear why Thursday’s weakness.  Perhaps most disturbing about Thursday’s weakness is it met our criteria for a bear market – they sold our stocks, the commodity stocks.  One day is just that, but this could mean we’ve entered a new phase of the bear market.  The better than 4-to-1 declining issues also suggests a seeming new urgency to sell.  This is the way markets go.  Bonds have been weak for a while now.  It’s not as though we don’t know rates are going higher.  Sometimes things just don’t matter until they do.

Frank D. Gretz

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US Strategy Weekly: A Clear and Present Danger

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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US Strategy Weekly: Is Recession Inevitable?

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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Elon Musk A Passive Investor … And Do You Wanna Buy A Bridge?

DJIA:  34,584

Elon Musk a passive investor … and do you wanna buy a bridge?  Can’t wait to hit that edit button.  His 9% position in Twitter, the ultimate tweet of sorts, helped the NDX by 2% on Monday, rendering new hope for the forgotten, downtrodden, etc., that is, beaten up Tech.  Not quite the same as landing a rocket on a dime, but impressive.  And the other company, Tesla is it, isn’t doing so badly as well.  Names like Tesla (1057), Amazon (3153) and Google (2717) pretty much all peaked late last year.  After their hibernation, the irony might be they come back to outperform in a poor market, not exactly what most would expect.  That said, we still see what we’re calling the commodity stocks the likely ongoing leadership.  Exacerbated by the war, commodities across a broad range are in short supply.  The stocks themselves have another edge, they’re in short supply, that is, they’re under owned. News of Russian coal sent those stocks higher Tuesday, while not that long ago the Coal ETF was dissolved for lack of interest.

You say either we say ither. The debate eternal always seems to be between growth and value. You might also debate just what is a value stock and what is a growth stock. The good people at Invesco have done this for us with the Pure Value ETF (RPV-85) and the Pure Growth ETF (RPG-180).  As it happens we don’t particularly agree with either list, but at least here is something objective and from a credible source.  To look at the charts, clearly value is kicking growth, and we suspect it will continue to do so.  Our idea of growth is a bit more techie, and our idea of value is a bit more about commodities.  We should add some defensive names like Hershey (223) and Church & Dwight (103) act well.  If you compare the Tech Software ETF (IGV-336) with the Metals and Mining ETF (XME-60) the picture is the same, though the XME outperformance is more dramatic.  Again, we expect this to continue.

We have long thought where the stock market tells its economic story is the Transports.  Originally, and the theory behind the Dow Theory, both the industrials and the transports were supposed to tell the story.  This, of course, was when the Industrials were industrials, hardly the case these days.  Granted the “Transports” aren’t exactly the rails of old, they still pretty much get the stuff around.  Looking at the Transports relative to the S&P, last Friday’s weakness was the seventh worst day against the broader market since 1928.  When looking at other occurrences, this kind of move was associated with the most traumatic episodes in US market and economic history, according to Bloomberg strategist Cameron Crise.  While last Friday’s otherwise up day didn’t seem that traumatic, the trauma may be yet to come.  Meanwhile, as a proxy for economic activity in the US, the weakness in the transports is of some concern.

They say the consumer is in good shape.  That’s not exactly what those consumer sentiment surveys say.  They’re worried how high prices are going, and everywhere.  Even demand for products which target a more affluent consumer recently has fallen.  It’s a mystery what keeps home prices so high when you look at those homebuilder charts and associated names like Home Depot (303).  Wage increases, while enough to pressure businesses and keep pressure on the Fed, aren’t enough for consumers to keep up with inflation that is running close to 8%.  A report also shows real, or inflation adjusted disposable personal income per capita fell for the seventh straight month as rising prices outpaced employment and wage gains.  And they say we’re not even in a recession, though based on those consumer sentiment numbers, we would contend we are.  And while there are “soft landings,” there are none we know of when inflation was above 5%.

We’ve seen this recovery as a rally in a downtrend, a rally in a bear market.  We also see this rally, technically speaking, as better than we might have expected.  Then, too, bear market rallies usually make you wonder.  As often happens in these recoveries, things change quickly as was the case this week, going to a 4-to-1 down day Wednesday versus a 4-to-1 up day last Tuesday.  There were no divergences going into this weakness, weak up days, for example, so that may be yet to come.  Or this time was that hit to the Transports the warning.  Where would we be without Lael Brainard to tell us rates are going higher? Though, the mention of QT might have been the real culprit.  Whatever the case, the market lost something this week, and if a bear market rally that’s particularly worrisome.  Meanwhile, just say YES to drugs, those made by Lilly (309), Pfizer (55) and others part of the XLV (142) ETF.

Frank D. Gretz

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US Strategy Weekly: Russian Defaults and Weighting Shifts

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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Stagflation or Recession?

To date, 2022 has been a rough year for equity investors. After seven consecutive quarters of solid price gains, the first quarter of the year ended with a loss of 4.9% in the S&P 500 index, a fall of 4.6% in the Dow Jones Industrial Average and a larger 9.1% decline in the Nasdaq Composite index. These were the first 3-month declines in the indices in exactly two years, or since early 2020, when the COVID-19 global shutdown triggered a global recession.

Still, considering the alarming invasion and bombing of Ukraine by Russia in late February, we believe the decline in stocks has been remarkably orderly. Particularly since this attack has catapulted the world economic and geopolitical environments into turmoil. In addition, February’s inflation benchmarks revealed that consumer prices were soaring 7.9% year-over-year – a forty year high — and Russia’s conflict with Ukraine is expected to exacerbate prices in fuel, grain, and fertilizer for the foreseeable future.

Last, but far from least, in mid-March the long awaited, yet decisive shift from a monetary policy of extreme ease to tightening began. This shift by the Fed reverses the historic liquidity boost that has been supporting stock prices for the last 24 months. In addition, following the FOMC meeting, Chairman Jerome Powell indicated there will be many more interest rate increased before year-end and the consensus is now forecasting rate hikes in each of the next six FOMC meetings this year. There is no doubt that a shift in monetary policy will impact the US economy. The only question is how much. Will the Federal Reserve be able to manage a soft landing for the economy? Or will the shift trigger stagflation or a recession? The next few months should be telling.

Changing Landscape for Investors

In short, the environment for equities has changed and the Fed’s shift to a tightening policy will be pivotal. Expectations of multiple rate hikes have triggered fears of an inverted yield curve and a recession. While we believe this fear is real, we also believe it is premature. First, inverted yield curves can be measured in many ways, but in our opinion, a truly inverted yield curve requires the 3-month

A truly inverted yield curve requires the 3-month Treasury bill yield to exceed the yield on the 10-year Treasury note yield. This is not in place and is unlikely to appear in coming months.  

Treasury bill yield to exceed the yield on the 10-year Treasury note yield. Given the present level of short-term rates, all things being equal, it would take eight 25 basis point rate hikes by the Fed to invert the yield curve. This is unlikely to materialize in coming months.

Second, history shows that markets usually rally following early rate hikes and begin to weaken only after four consecutive rate hikes take place within a twelve-month period. This implies the actual risk associated with inverted yield curve will appear later in the year.

In our view, the 10-year Treasury note market is a huge global market, is not under the Fed’s control, and due to its global reach, can be an excellent predictor of future economic strength. Yields often fall, sometimes precipitously once investors expect rising interest rates will significantly damage economic activity. We would remain alert to this possibility, but do not expect it soon. And remember, the curve usually inverts six to twelve months prior to the start of a recession.

Earnings will be the key to investments

Balanced portfolios should include stocks with a predictable earnings stream shielded from inflation, price earnings multiples at or below the S&P 500 average and dividend yields greater than 1.5%.  

Whether the Russia-Ukraine conflict increases or diminishes, whether inflation grows or weakens, earnings growth, or the lack thereof, is the true foundation of any market trend. With this in mind, the upcoming first quarter earnings season will be important since it will indicate how well, or how poorly, companies have weathered the various difficulties of supply constraints, inflation, and rising interest rates, of the first quarter. First quarter earnings season begins this month, and it could become a market moving event.

Beneficiaries of inflation such as energy, food, and staples are expected to do best and outperform this year. The Russian invasion has been the catalyst for many Western countries to increase their defense budgets and this increase in spending will benefit defense stocks and the industrial sector. Cybersecurity is another sector that is likely to see more capital investment and rising demand from consumers. Conversely, we will be watching company statements from housing and auto companies to see how corporate leaders respond to the prospect of rising interest rates and waning demand.

Investing in a new environment

In an era of rising inflation and higher interest rates, equites can still perform well but portfolios need to adjust. The best insulation today would a balanced portfolio that include stocks with earnings shielded from the pressures of inflation, price earnings multiples at or below the S&P 500 average, and stocks with dividend yields greater than 1.5%.

However, given the geopolitical and policy uncertainties in the current environment; we would not be surprised if equity indices trade within a broad trading range for most of 2022. If so, holding a core portfolio tilted toward value stocks is still advised. But for those willing to be nimble, we expect a trading opportunity may appear in the technology sector in coming months.

Gail Dudack, Chief Strategist

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The Greatest Trick Bear Markets Ever Play… Is Making You Think They Don’t Exist

DJIA:  34,678

The greatest trick bear markets ever play… is making you think they don’t exist. The original line from the “Usual Suspects” was about the devil rather than a bear market, but you can see a certain commonality.  Bear market rallies usually go far enough to make you wonder.  And while the war looks on going, inflation looks on going and rising rates look on going, who are you going to believe?  You are going to believe prices and prices are going up.  Opinions follow price.  We know of no rules as to how far these things can go.  Already through the 50 and 200-day moving averages, it is enough to make you wonder.  And while too good to die here, the rally will die as all do, with technical problems like divergences – when the average stock begins to underperform the stock averages.  So far so good, but look for a change to up in the averages and flat, let alone down in the A/D’s.

It’s that time of the year, or the cycle, when talk of the yield curve fills the air.  The yield curve is almost inverted, and parts of it are already.  We don’t pretend more than a superficial knowledge here and, therefore, have no strong opinions.  We will say, however, when it comes to the stock market anything so talked about rarely comes to much consequence.  It is also a bit ironic that an inverted yield curve and a recession should come to the fore in the midst of this rather spectacular recovery.  Isn’t it the market that’s supposed to be the predictor of such things?  Our two cents, and here you really do get what you pay for, is there will be a recession and the market will get around to predicting it.  In other words, this is a bear market rally.  Rather than the curve, we worry that the start of QT is the bigger concern.  In 2011, hints from the Fed that it wouldn’t expand its asset purchase program preceded a 19% drop in the S&P.  In 2015, talk of balance sheet shrinkage came before a 12% decline and a similar result followed in late 2018.

And then there were two – FANG stocks, that is, that you might want to own.  Amazon (3264) is the only one up on the year, though by the time you read this who knows?  And, who knows, by that time, Google (2781) could be.  We like to look at stocks like this on a monthly rather than daily chart which obviously dispenses with much of the volatility, and unimportant moves.  Amazon is a good example, having looked pretty poor a few weeks ago based on the daily chart.  A monthly chart, however, basically was that of a consolidation in the overall uptrend.  Granted there was a bit of a break in January, but these false moves or breaks often happen in these patterns and, indeed, you can see a lesser but similar break in March 2020.  The key is the stock didn’t linger there, it snapped right back.  What’s needed now is a move through the upper end of the pattern around 3600+.

So when you split a stock does that make it more valuable?  They say no but don’t tell that to Tesla (1078).  Tesla is another stock that always seems to tell a more accurate story on a monthly rather than a daily chart.  In this case, the pullback came to rest right on top of last year‘s eight month consolidation.  The daily chart would have worried you, the monthly not so much.  It is an example, too, that extended stocks do have their corrections – in this case some 500 points.  Meanwhile, is Tesla dragging those utilities with it?  The textbook says rising rates are bad for utilities as they are big borrowers.  While not a “Tesla” chart, XLU (74) has turned into one of the better charts around. As measured by the SPDR Real Estate ETF (XLRE-49), many REITs also are looking better and like XLU, there’s a respectable dividend yield.

Tuesday saw NYSE Advance-Decline numbers of better than 4-to-1.  This followed back to back 4-to-1 numbers a week or so ago.  These are impressive and an example of what we mean when we say the rally is too good to die here.  And it’s not just the strong up days, it’s also the lack of weak up days, those days up in the averages with flat or negative A/D’s.  Down days don’t kill markets, it’s the weak up days that do.  When it comes to that, it’s time to be careful.  Meanwhile, if you’ve been in the market for only the past decade or so this is frustrating.  This period has proven repeatedly that it’s right to be fully invested, and to buy the dips.  We would point out, however, that during the 2007-09 bear market there were 11 10% rallies. Meanwhile, some time ago we published a list of stocks with inconsistent long-term uptrends. One such stock which is now also above its 50-day moving average is Prologis (164).

Frank D. Gretz

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