US Strategy Weekly: Three Points of Caution

We believe a significant low could materialize in the next few months; however, we would not be too hasty to fully re-enter the equity market at this juncture. The first reason for our caution is that despite the market’s oversold condition and the perpendicular declines in the charts of the major indices, equities seem unable to find any upside traction this week. This is a sign of weakness, and it displays a lack of underlying demand for equities at current prices.

The second reason is, while there are many open discussions regarding a recession and the possibility that the economy is already in a recession, we have not yet seen any economist actually forecast a recession for 2022 or 2023. Most economists are fiddling with GDP targets depicting slowing “growth.” This is an important distinction because, in our experience, Wall Street’s industry analysts and strategists rarely, and are sometimes unable, to factor a recession into their industry or macro earnings estimates until their economist has forecasted a recession.

And it may not surprise readers that most economists fail to recognize a recession until it is almost, or completely, over. Therefore, this implies that earnings forecasts may be too high for 2022 and 2023 and are apt to come down in time. Ironically, we would be more confident that the lows have been found if earnings forecasts were incorporating the possibility of a recession; but to date, this has not happened. Our earnings forecast for 2022 S&P 500 earnings has been a negative outlier at $220; nevertheless, we are fearful that this too may still prove to be too optimistic.

Third, July could be the month of changes. The Bureau of Economic Analysis releases its final estimate for first quarter GDP this week. Growth is currently estimated to be negative 1.5% in the first quarter of the year, indicating a decline in economic activity. On July 28, the BEA is expected to release its advance estimate for second quarter GDP. This single data point could be pivotal since a recession is defined as two consecutive quarters of negative GDP. Another negative number would confirm that the US economy is currently in a recession. Yet even if second quarter GDP displays very weak growth it could be enough to prompt economists to dramatically lower their economic forecasts for the year.

July is also important since second quarter earnings season will begin mid-month. Most earnings quarters begin in earnest with the release of money center bank earnings, which are scheduled to start on July 13. Keep in mind that retailers have fiscal years and quarters that end a month later than most companies, so these results will not be available until August. But it was not just a coincidence that the equity market broke below the SPX 4000 level shortly after Walmart Inc. (WMT – $122.37), reported earnings below expectations on May 17, 2022. Its next earnings report is scheduled for August 16, 2022.

In sum, the bear market finale is likely to include a realization that earnings will be lower than expected for 2022 and 2023. This could happen in late July. And from a technical perspective, it would be wise to wait for an impressive high-volume 90% up day to confirm that buyers have returned to the equity market in earnest.

Housing – the Canary in the Coal Mine

It is clear that the housing market is slowing. Existing home sales, which represent the bulk of the overall housing market, were 5.41 million units in May, down 8.6% YOY. This pace was also down 20% from the October 2020 peak and the slowest pace since June 2020. New home sales were 696,000 in May up from April but down nearly 6% YOY, and down 30% from the January 2021 peak. See page 3.

Homeownership has been relatively stable at 65.4% for the last four quarters and has been hovering just slightly above the long-term average of 62.9%. This implies there is neither pent-up demand nor excessive ownership in the housing market. However, the median price of an existing home reached a record $414,200 in May, up nearly 15% YOY. These high house prices are the result of many things such as an emphasis on the home and homeownership during the 2020 pandemic shutdown, historically high household liquidity in 2020 due to a series of fiscal stimulus packages, historically low interest rates due to monetary stimulus, and a booming stock market. All of this made housing attractive and affordable. However, this is all changing. Moreover, while the median price of an existing single-family home rose 15% YOY, personal income increased only up 2.6% YOY in April, and real disposable income fell 6.2% YOY. This is a bad combination. See page 4.

The National Association of Realtors (NAR) housing affordability composite index fell from 124.2 in March to 109.2 in April. This was the lowest reading since the 106.9 recorded in July 2007. More importantly, this index is likely to decline further as the fed raises interest rates and mortgage rates move up in unison. The headline NAR housing market index has been falling all year, but in June the traffic of potential buyers index, fell to 48, its lowest reading since June 2020. It is a sign of dwindling demand. See page 5.

Pending home sales inched up to 99.9 in May, from 99.2 in April; however, both April and May’s readings were the lowest since the 70 recorded in April 2020 during the recession. These cumulative signs of deterioration in the housing market are extremely important since the housing market represented 16.8% of GDP in 2021. Residential fixed investment contributed 4.7% and housing services represented 12.1% of GDP. However, there are other “non-housing” factors such as furniture, carpeting, appliances, etc. that also help to boost economic activity during a housing boom. We expect all of these industries to slow in the second half of the year. See page 6.

Consumer confidence can be a critical component of an economic cycle, and it can also be the canary in the coal mine that predicts a recession – even when economists fail to see it. Conference Board consumer confidence fell to 98.7 in June, its lowest level since February 2021. The survey showed that expectations fell to 66.4, the lowest point since October 2011. The University of Michigan consumer sentiment index fell to 50 in June, the lowest headline reading on record, and lower than any time during the recessions of 1980, 1982, 1990, 2001, 2008-2009, or 2020. Expectations fell to 47.5, the lowest reading since August 2011 (47.4) or May 1980 (45.3). In short, in both surveys, consumer confidence is at levels last seen during a recession. And we would remind readers that last week we pointed out that whenever inflation has reached 5% or more, it has been followed not by one recession, but by a series of tightening cycles and recessions. See “Liquidity Crisis” June 22, 2022; page 6. The market lows in June were the beginning of the discounting of a recession, in our view. But it may not be over.

Gail Dudack

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US Strategy Weekly: Liquidity Crisis

Looking for a 90% Up Day

There are several extremes appearing in technical data that suggest this bear market is nearing, or already in its final phase. However, few bear market lows are quick or V-shaped. This is particularly true when the low precedes, or is accompanied by, a recession. And we think this one is. Most bear market troughs resemble a checkmark or a W-shape and take weeks or months to complete. In short, we believe it is much too late to be bearish, but we would not be too hasty to re-enter the equity market.

Although the equity market has declined to a level that could generate a short-covering rally, we believe the resistance at SPX 4100 may be a formidable hurdle. This can be seen in the charts of the indices on page 8. The late May rally encountered resistance at the 50-day moving averages in each of the popular indices. And though the last two weeks have generated a number of downside gaps that are likely to be filled in the near future, the 50-day moving average, now at SPX 4102.46, could prove to be a hurdle once again.

And as we noted last week, it would be prudent to wait for a solid 90% up-volume day accompanied by volume that is well above average, before adding to portfolios. Strong volume and at least a 10 to one positive breadth day would be a pivotal sign that panic selling is exhausted and that buyers have come back to the marketplace with conviction. This is particularly important since recent trading sessions have included worrisome signs of a liquidity crisis.

Liquidity Crisis – The Source

The liquidity crisis is not equity-centric and may stem from the volatility seen in the cryptocurrency market. Bitcoin (BTC – $20,825.00), the bellwether of the cryptocurrency market, has seen a 75% decline from its high. The world’s most-traded cryptocurrency, fell from nearly $69,000 last year, to $17,776.75 over the weekend, which led to forced liquidations of many large leveraged bets. Some crypto analysts have been worried about a complete capitulation of the market, particularly after Celsius Network, a private company, and a popular cryptocurrency lender, froze customers’ accounts last week leaving its customers unable to withdraw or transfer funds.

More than $2 trillion has been wiped from the crypto market since its peak last November, according to Yahoo News, and since money is fungible, losses of this size often create a liquidity crisis in the broader securities markets. What is noteworthy is that a liquidity crisis is not unusual at the end of a bear market, and in fact, is another sign that we may be nearing the finale of this cycle. Nevertheless, a liquidity crisis can be vicious. It is completely disconnected from economics, fundamentals, and technicals, and is simply a massive de-leveraging wave.

Again, there are reasons to be optimistic for the second half of the year, but this is still a dangerous time, and it is wise to be cautious.

Recession Talk

In our opinion, it is good news that market watchers have become obsessed with the prospects of a recession. Some economists even agree with me that we may already be in the middle of a recession. This is another ingredient that has been missing for a washed-out market. On the other hand, we have yet to see earnings forecasts come down. That may be the last and final phase of this bear cycle. But analysts tend to be trend followers and rarely identify turning points, so cuts in earnings estimates may not appear until the third quarter.

Similarly, there is good news in investor sentiment indicators. Last week’s AAII readings of 19.4% bulls and 58.3% bears were the third week in which a combination of less than 20% bulls and more than 50% bears has appeared since April 27, 2022. Prior to this string, there were comparable single-week readings on April 11, 2013, and January 10, 2008; however, neither of these readings coincided with a market low. The 4-week AAII bullish reading of 19% on April 27 was the lowest since 1990 and the bearish 52.9% reading of May 18 was the highest since the March 5, 2009 peak of 70.3%. These are some of the most extreme readings seen in years and according to AAII, equity prices tend to be higher in the next six and/or twelve months following such a combination. See page 11.

Recession Watch

Inflation is an insidious problem that eats into household consumption and also erodes corporate profit margins. For example, the charts on page 3 display the difference between nominal and real retail sales. May’s retail sales were disappointing but still rose 8.1% YOY. However, after adjusting for inflation, real retail sales fell 0.4% YOY. Year-over-year real retail sales have been negative for three consecutive months, which suggests that second quarter profits for many retailers may decline from first quarter’s weak results. The weakness in May sales was centered in autos, appliances, and nonretail stores. Gains were seen in necessities such as gas and food. For the month of May, sales from food and beverage stores, food service and drinking places, and gasoline stations totaled 34% of total retail sales. This was actually less than we expected but remember that retail sales measures merchandise and does not include necessities such as housing and healthcare expenses. See pages 3-4.

The NAHB Housing index has been declining every month this year and in May it hit its lowest level since the pandemic shutdown in early 2020. Existing median home prices, however, reached a cyclical high of $414,200, up 15% YOY. Unfortunately, with prices and mortgage rates rising rapidly, this means many prospective buyers will be priced out of the market. Note that in May single-family existing home sales were down 8.6% YOY. This decline may steepen in coming months which is unfortunate since the housing sector typically represents 15% to 18% of US GDP. See page 5.

Rates for a typical 30-year mortgage, which were hovering just above 3.1% at the beginning of the year, are now close to 6%. And rates are apt to go higher as the Fed continues to raise the fed funds rate. Investors are focusing on the Fed’s “terminal” fed funds rate which the consensus expects to be near 4%. But, with inflation currently at 8.6%, this still equates to a negative (i.e., easy) fed funds rate, which means the Fed may need to lift rates even higher than 4% to really curtail inflation. See page 6. When we look at the history of inflation and the fed funds rate it becomes clear that whenever inflation reaches 4% YOY, a recession has always followed. More importantly, history shows that it often takes more than one tightening cycle and more than one recession to truly reverse an inflation cycle once headline CPI exceeds the 4% YOY level. See page 6. In short, we may not see a buy-and-hold cycle in equities for a very long time.

Gail Dudack

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Sometimes You Get the Bear… And You Know the Rest

DJIA:  29,927

Sometimes you get the bear… and you know the rest.  The rest was last Thursday and Friday, and Monday as well – the kind of pattern typically indicative of a bear market.  A few weeks ago 12-month New Lows showed a market that look to be washed out, and the pre-Memorial Day buying seemed to confirm that – but, apparently not.  It was one of the fastest ever reversals of a 7% recovery, also indicative of a bear market.  While the bear market seems alive and well, it doesn’t necessarily mean we accelerate to the downside just now, at least if past patterns like this are any guide.  Measures that address oversold levels aren’t of much help in markets like this.  However, the idea that only 1%, that’s one %, of S&P stocks are above their 10-day average tells you prices are stretched.  While bear markets will do what they do, they also don’t necessarily go straight down.

At issue is whether this is another case where it’s so bad it’s good?  More than 98% of volume was in declining stocks on Monday.  Only 16 other days since 1962 saw such overwhelming selling, after which the S&P rose 14 times, according to  The three day up volume dropped below 7% for only the second time in 60 years.  To get to numbers like this takes some pretty bad news and not just inflation, which may have taken its toll last week.  Monday it was crypto’s turn, the last of the market’s many bubbles to finally give it up.  Whether crypto is fraud or real we don’t much care.  We do know the weakness has its impact, at least psychologically.  Then, too, whatever it takes to get the selling out of the way is a good thing.

The market usually isn’t slow to catch on, so to speak.  Indeed, it typically discounts well ahead.  Until recently, however, the market seemed to miss the likely problem for the home builders and ancillary businesses.  It was almost as though the market was listening to homebuyers, and their clamor to buy.  For sure the stocks are well off their highs but after several months, only this week have the shares moved to New Lows.  Of course, this follows a 22-year low in mortgage applications, given rates that hardly seems a surprise.  The builders, of course, have poor charts, but so too do shares of companies like Sherwin Williams (219).  Meanwhile, when it comes to shares of Home Depot (273) and Lowes (172) we’re not quite sure if they’re suffering along with the builders, or whether they are suffering from the stay-at-home hangover, but they’re suffering.

When was the last time you thought about buying Oracle (69)?  Looking at the chart, it’s understandable.  The stock was one of Thursday’s best performers, up nearly 10% on a beat.  It seems worth noting the stock held up that day, despite an otherwise volatile market.  We are not here so much to praise Oracle – it’s still a poor chart.  It brings to mind, however, another large cap with little attention which does have an improved chart – IBM (136).  As you cringe, we realize there have been more than a few false dawns here.  But consider the price action especially relative to that of the market, and Tech.  Speaking of Tech they were great when they were on our side, but not so much now.  Stocks like Apple (130), Microsoft (245), Nvidia (156), seven altogether, have accounted for more than 40% of the points lost in the S&P since January.  Maybe it’s time for an IBM type of Tech.

So the Fed meets and there’s something for everyone – something for everyone not to like.  The attention grabbers wanted a full point, some more thoughtful believe inflation through natural forces will be peaking, and too much tightening runs its own risk.  The Fed has a “dual mandate,” but seems to have decided its sole task is to limit inflation.  They admitted inflation is a problem, and seem prepared to raise rates to eliminate it even if it means higher unemployment.  Yet Powell is good at managing expectations.  The last eight FOMC decision days saw good gains on six and flat action the other two.  Then, too, this is within the context of a 20% decline in the S&P.  Rising rates are not good.

Frank D. Gretz

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US Strategy Weekly: Rip Off the Band-Aid!

Our view has been that based upon fundamentals, the equity market begins to find value at the SPX 3850 level. A head and shoulders top formation also implied a downside target of SPX 3800. As a result, SPX 3850 has been our 2022 target for the year. However, now that the SPX is trading below this level, it may be wise to wait for two things to materialize before substantially adding to portfolios. The first factor would be a solid 90% up-volume day that is accompanied by volume that is well above average. This would be an important sign that panic selling is exhausted and that buyers with conviction have reentered the marketplace. Second, we would wait for the results of the Federal Reserve June meeting since this announcement could be a market-moving event.

The recent down leg in prices was triggered by the “bad news” found in last week’s May CPI report coupled with the fear of higher interest rates and a possible recession. In our opinion, it was naïve to think inflation had “peaked” in May. For one thing, any inflation rate above the long-term average of 3.4% is destructive to an economy and the stock market. Moreover, a deceleration in the pace of inflation is not the same as saying the problem is solved. For another, next month’s June CPI report is also likely to be disappointing given the current environment. With crude oil currently at $122, up 65% year over year, with headline PPI up 10.8% year-over-year, with housing and rents (42% of the CPI weighting) on the rise given the recent 16.7% year-over-year gain in single-family median home prices, and with the world facing a probable food shortage this summer due to Russia’s invasion of Ukraine, it is difficult to see how inflation is going to abate significantly in the near-term.  

Policy Error

Many investors are worried that the Fed will make a policy mistake in the coming months; however, in our view, the policy mistakes have already been made. Maintaining easy monetary and fiscal policies during the post-pandemic expansion was an Econ 101 textbook recipe for inflation. This may explain why it is important for the Federal Reserve to be a non-partisan independent body that is not driven by political bias or pressures. We are not saying Chairman Powell was being political last year, but he did repeat the administration’s view that inflation would be transitory. This proved erroneous. Regardless, the FOMC has the responsibility to balance the risks of inflation and unemployment and be unimpeded in using its tools of quantitative easing and interest rates to maintain a level-handed strategy. They did not address inflation in 2021. Remember: monetary and fiscal policy mistakes were made well before Russia invaded Ukraine in February of this year.

100 Means Business

In sum, the Fed is way behind the curve in terms of fighting inflation, and equally important, they have lost the confidence of investors. It is time to admit they were wrong and very late regarding inflation and announce a 100-basis point rate hike. Markets have already sent a “lack of faith” message to the Fed by discounting a 75-basis point fed funds rate hike this week; a 100-basis point move may be a shock to markets, but it could also restore investors’ confidence and signal the world that the Fed is serious about taming inflation. The only caveat to a 100-basis point hike would be the responsibility the Fed has to not upset the fixed income markets and to protect the liquidity in these markets. Yet, all things considered, it is time to rip off the band-aid.

Many fear that an increase in interest rates will trigger a recession but we believe a recession is now inevitable. History has shown that when inflation reaches levels as high as today, the end result has always been a recession. This should not be a surprise since inflation requires the Fed to raise interest rates multiple times, or until it significantly reduces consumption. In fact, in the period between 1973 and 1983, there were three recessions in ten years. See page 4. Most of this was due to the multiple tightening cycles enacted by the Fed. In that cycle, headline CPI peaked at 14.6% in March 1980 and the inflationary trend finally turned when Fed Chairman Paul Volcker raised the fed funds rate to 14% in May 1981. See page 6.

Unfortunately, the price moves seen in crude oil, the CPI and the PPI are at or near the peaks seen in 1982. The good news is that neither core CPI nor core PPI is at similar levels. This could be a silver lining for the current cycle in terms of curbing inflation — if the Fed acts quickly and decisively.

Halfway through a recession

In a recent report (“Halfway Through a Recession,” May 3, 2022) we questioned whether or not we are already in a recession. A recession is measured as a minimum of two consecutive quarters of negative GDP growth and is confirmed by the National Bureau of Economic Research (NBER) usually after the fact. As a result, it is not unusual to not know if the economy is undergoing a recession until it is over, or at least half over. However, being in a recession is the good news. Stock markets tend to bottom in the middle of a recession, and this would put the current market weakness in a different light.

What makes us feel a recession will appear sooner rather than later is that higher interest rates are apt to slow the already decelerating housing and auto markets. The average interest rate for a standard 30-year fixed mortgage is now 5.87%, which is an increase of 36 basis points from one week ago. Rates are apt to go even higher and therefore, housing and auto activity, two important segments of the economy, may slow quickly. Moreover, the US is a consumption-driven economy, and the household sector has seen real purchasing power turn negative this year due to soaring inflation.

Meanwhile, consumer sentiment is floundering. June’s preliminary University of Michigan sentiment index fell to 50.2 from 58.4 and is below the record low set during the 1980 recession. Consumer expectations led the decline, dropping from 55.2 to 46.8, a new cyclical low. Current conditions fell from 63.3 to 55.4 reaching a new record low. The May NFIB Optimism Index fell 0.1 to 93.1, the fifth consecutive month below the 48-year average of 98. Small business owners expecting better business conditions over the next six months decreased four points to a net negative 54%, the lowest level recorded in the 48-year-old survey. Expectations for better business conditions have deteriorated every month since January. In short, there are signs of recession if one dares to look. We apologize for being so glum, but we believe it is wise to remain cautious a bit longer, or until the market can produce a convincing 90% up day. The good news is that discussions about the possibility of recession are now on the rise. The bad news is that this has not yet been factored into earnings forecasts. After the market close of SPX 3735.48, the market has dipped within our valuation model’s year-end fair value range of SPX 2735-3866. It is only 13% above the mid-range of our model (SPX 3300) which would be a great buying opportunity. See page 7. In short, equity prices are reaching good long-term valuation levels, but prices could still fall a bit more.

Gail Dudack

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A Bear Market Rally… Isn’t That How Every Bull Market Starts?

DJIA:  32,272

A bear market rally… isn’t that how every bull market starts?  We agree any strength in coming weeks is likely a bear market rally, but we are struck by the seeming universality of the call.  As such it seems one based on the crummy fundamentals – record inflation, rising rates, a war, the pandemic, the China rivalry and so on.  What’s to like?  Then, too, that’s why the S&P has had a 20% decline and the average stock even more.  The news is never good at a low, and that’s how stocks become washed out/sold out.  And it’s selling that makes a low.  We’re just not sure stocks are bear market sold out.  Stocks above their 200-day only got down to 24% versus a more typical 18%.  And the bear market is unwinding five or more bubbles, something that seems unlikely complete in just a five month decline in the S&P.  Then, too, they do seem washed out enough for more rally, maybe even enough to question, it’s a bear market rally.

Remember global investing?  How’s that going?  Yet here we are with an office full of globes, looking more vintage all the time.  Or how is diversification working for you?  It has been a tough year, even for those diversified.  As an example, Ruffer LLP looks at returns from a range of 11 different global indexes of stocks and bonds, including the S&P, the Russell, the 30 Year Treasury, the MSCI World Index, and so on.  The first quarter of this year was the first in more than three decades none of them gained.  Duncan MacInnis of Ruffer has called this the illusion of diversification – the balanced portfolios were not balanced.  The diversification turned out to have higher cross asset correlations than thought.  They were all subject to the same problem, the problem being inflation and the pressure it put on rates.  That has had a negative effect on everything except inflationary beneficiaries like oil and commodities generally.

Bloomberg’s John Authers argues this pattern of rising rates and rising commodities can’t keep going on.  Were commodity prices to continue higher it would become that much more difficult to contain inflation.  And higher prices would stifle demand, as would higher rates.  All too true though, again, it’s about the timing.  Argue as you might what a peak in oil prices might look like, so-called fair value is likely a poor guide.  Sentiment or psychology likely will play a bigger role.  In the summer of 2008, in the midst of that bear market, it wasn’t until you started to hear of $150-200 that oil peaked.  We don’t think we’re quite there yet.  And back then there was plenty of speculation.  You can’t exactly call oil stocks undiscovered, but unlike back then they’re not exactly parabolic either.  And there’s a bit of an exogenous factor this time around, oil this time around is still only about 4% of the S&P by market cap.

The market for now is both good and bad.  The good is stocks have stopped going down.  By that we don’t mean the averages, we mean literally most stocks.  A few weeks ago nearly half of NYSE and NAZ stocks reached 12-month New Lows.  This past week the number was a fraction of that. Surprisingly, there were actually more NYSE new highs versus New Lows last week, unusual in a bear market.  The Advance-Decline Index, another proxy for the average stock, reached a low May 12 and held against lower lows in the Dow and the S&P.  These positive divergences, even those relatively minor, often can be significant.  It’s opposite the pattern back in December and January when the averages moved to new highs against weakness in the A/D’s.  The bad news is that holding up isn’t going up.  Other than the few good days before Memorial Day, and they were good days, the market has been unable to put much together on the upside.

So missing is the MO – not Altria, upside momentum.  Tuesday’s rally was unimpressive, except for its reversal aspect.  And no follow-through.  To borrow from the movie line, it’s time to show me the upside.  Meanwhile, you would be applauding rather than crying at the pump if you owned a little Valero (143) or one of the other refiners.  Then, too, any food stock would leave you crying all around, despite higher prices.  Go figure.  In early January we published a list of stocks in long-term uptrends.  The idea of the list being these are stocks you want to own when they give you a chance.  In the subsequent five months of bear market they’ve given you a chance, and then some. We prefer to buy stocks when they’re above their 50-day moving average and there are a few from the list that fall into that category – Adobe (426) and Estee Lauder (259) have had big declines and are above the 50-day.  Accenture (295) and Intuit (401) also have had significant declines, and are just below their respective 50-day averages.

Frank D. Gretz

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US Strategy Weekly: Inflation and Recession Resistant

We do not believe the bear market is over. In our view, the repercussions from potential energy and food shortages this summer, relentless inflation, and rising interest rates will weigh heavily on the economy, profit margins, and earnings in 2022. Still, the peak to trough declines made in the broad indices recently, have been significant. The Dow Jones Industrial Average, the S&P Composite, the Nasdaq Composite, and the Russell 2000 have had selloffs of 15.0%, 18.7%, 29.8%, and 27.8%, respectively. Now that earnings season is nearly over, we think the opportunity for a rebound in equities is materializing. The only risk this week is the release of May’s CPI report on June 10 which most economists expect will display a deceleration in inflation. This is possible but with crude oil prices up 62% YOY we doubt that inflation can moderate much in the near term. While it is feasible that headline CPI could decelerate a bit from April’s 8.2% YOY pace, we expect inflation to remain stickier and more persist than most expect. This will be a major problem for the Federal Reserve and the economy.

Nevertheless, the technical charts of companies like Walmart, Inc. (WMT – $123.37), Costco (COST – $471.78) and Target Corp. (TGT – $155.98) suggest that a lot of bad news regarding profit margin pressures and earnings weakness is being priced into segments of the marketplace. See page 3. This builds a foundation for a rebound rally.

But in general, we still believe an overweight position in inflation-resistant stocks is the best policy for investors. In the longer term, the risk of a recession increases, and we doubt that this has been fully discounted by equities. Nevertheless, our favored sectors also are recession resistant and thereby serve both purposes. In short, our suggested overweight sectors remain energy, staples, industrials (emphasizing defense stocks), and utilities. See page 13. We consider these to be core portfolio holdings.

Still, trading opportunities will appear in other sectors and individual stocks from time to time. For example, the retail sector is currently deeply oversold and could rebound substantially from recent lows. But we would view these situations as short-term trading opportunities.

Risk of Recession

Most economists are now discussing the possibility of a recession in late 2023, but we think the risk could be sooner though many experts disagree. Treasury Secretary Janet Yellen testified before the Senate Finance Committee this week and she apologized for being wrong about her stance on inflation which she described as being “transitory” last year. And we find ourselves disagreeing with her once again. In her testimony, she described the economy as being in “good shape” and households as being “resilient due to their high savings rate.” Unfortunately, the Treasury Secretary does not seem to realize that the personal savings rate fell to 4.4% in April, its lowest level since September of 2008! Keep in mind that the economy was in a recession from December 2007 to June 2009. In sum, it is difficult to have confidence in the economy if the administration does not have a grip on inflation or the state of the consumer.

Red Flags

Our nature is to be bullish, however, we see a number of red flags on the horizon that are being ignored and this concerns us. For example, the ISM indices for the month of May were disappointing. The ISM manufacturing index inched up to 56.1 in May, nonetheless, May was the second lowest reading in 20 months. The ISM nonmanufacturing index fell to 55.9 and it was the worst reading in 15 months. However, both main indices remain above 50 which is a sign of a good, albeit not robust, economy. More worrisome were the employment indices. The employment index fell to 49.6 in the manufacturing survey and down to 50.2 in nonmanufacturing. A number below 50 is a sign of contraction in activity. See page 4.

Two key areas of the US economy are housing and autos, both of which are on our radar since they will be negatively impacted by rising interest rates as the Federal Reserve continues its tightening policy this year. Housing has already shown signs of sluggishness in recent months, particularly in homebuilder sentiment and homebuyer traffic data. Last week’s data for May’s auto sales was also a disappointment. Total light vehicle unit sales were 12.7 million, on a seasonally adjusted annualized rate (SAAR), which was 25% below the pace a year earlier and 12.6% below April’s level. A lack of inventory contributed to this decline, but that is not an easy problem to solve. According to a 2021 report from the Boston Consulting Group and the Semiconductor Industry Association, 92% of the world’s most advanced semiconductors are manufactured in Taiwan, with the other 8% being manufactured in South Korea. In short, the semiconductor shortage is not a post-pandemic problem but is in reality a long-term problem in search of a solution. It is another sign that inflation may be difficult for the Fed to control.

But in terms of auto sales, keep in mind that they are a large component of retail sales. And as we discussed last week, retail sales have been an excellent lead indicator of the US economy and a particularly good predictor of a recession. In fact, over the last 50 years, a decline in year-over-year real retail sales, when measured on a quarterly basis, has accurately predicted every recession. There have already been two consecutive months of negative real retail sales; but if this trend continues, it will increase the prospect of a recession later this year. See page 5.

Inflation, the Fed, and recession are incontrovertibly linked in 2022. In April, headline CPI was 8.2% YOY and even after two fed rate hikes, short-term interest rates remain at an historically negative (and easy) level of negative 7.2%. The Fed has indicated that it wants to get to a neutral fed funds rate, but even if we assume the year-end inflation moderates to 5%, the fed funds rate would have to increase 400 basis points to simply match inflation. If a 5% fed funds rate materializes, we expect the housing market would slow quickly and hurt economic activity meaningfully. It would also increase the odds of an inverted yield curve — another sign of a pending recession. See page 6. In short, we see danger from both inflation and recession this year and the Fed is caught in the middle.

Technical Rebound The odds of a rebound in prices are high with most of the indices trading well below important moving averages. It would be normal for the indices to test their 100-day moving averages at this juncture. For reference, these levels are 33,905 in the Dow Jones Industrial Average, 4323 in the S&P Composite, 13,230 in the Nasdaq Composite and 1971 in the Russell 2000 index. See page 9.

Gail Dudack

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US Strategy Weekly: Cautious but Nimble

Stay Nimble

We do not believe the lows of the current bear market cycle have been found; however, technical indicators suggest a rebound in prices is likely in the near term. Supporting a short-term rally scenario is the fact that both the Nasdaq Composite and the Russell 2000 traded more than 20% below their 200-day moving averages in mid-May. A 20% or greater spread between price and the 200-day moving average, is extreme, even in a bear market, and it is typically followed by a reflex rally. However, to date, we have not been impressed by recent rally attempts; volume has decelerated on rally days and while there have been positive breadth days, no 90% up days — a sign of buying conviction — have appeared. In sum, traders should remain nimble, and investors should remain cautious.

Economic Caution

There are many reasons to remain wary of equities at this juncture; but our biggest concerns are the resilience of the economy, the health of the consumer, and the risk this combination puts on earnings growth. First quarter GDP growth was revised from negative 1.4% to negative 1.5% last week. This reduction is significant since it indicates that the first quarter economic growth rate was not only negative, but it also fell below the low end of the standard deviation band – a level that has often indicated a recession is in place. See page 3. Weakness in the first quarter was concentrated in trade and inventories, but consumption was also weak.  

We believe it is wise to be on a “recession watch” and one tool we have found to be helpful in predicting GDP strength or weakness has been real retail sales. In the top chart on page 4, we overlay a 3-month moving average of the year-over-year rate of real retail sales with quarterly GDP. We have found that when the 3-month average of real retail sales turns negative, it has been an indication that a recession is in place. For the month of April, real retail sales were negative 1.55% YOY, but the 3-month average remained positive at 5.2% YOY. However, this means retail sales will be an important series to monitor in the months ahead. Two more months of negative real sales could point to a second quarter of negative GDP, i.e., a recession.

Another statistic that concerns us is the trend in personal income, or more precisely, real disposable personal income. This latter statistic reflects the true amount of money households have to spend. Personal income rose 2.6% YOY in April. Wage and salary disbursement rose a robust 11.7% YOY but government social benefits fell 17.8% YOY and personal current taxes increased 23.8% YOY. As a result, disposable personal income fell 0.27% YOY in April. However, after inflation, real disposable income fell 6.2% YOY in April, all of which is displayed in the bottom chart on page 4. In other words, the purchasing power of households is declining, and this does not bode well for our economy which is 70% consumer-driven.

These statistics explain the recent pressure on retailers and the disappointing first quarter earnings report from Walmart Inc. (WMT – $128.63). Walmart, the largest retailer, and the largest private employer in the US, reported earnings that fell well short of estimates due to rising costs for food, fuel and wages which weighed heavily on profit margins. The stock is currently down 25% from its recent high. And though Walmart reported solid sales in the first quarter, it now faces the choice of raising prices to consumers or continuing to face margin pressure. Moreover, price inflation for food and grains will only get worse due to Russia’s invasion of Ukraine. Since the start of the invasion on the 24th of February, Reuters reports that “Russia has blockaded all of Ukraine’s seaports and interrupted its grain exports. This in turn has impacted global food prices, caused food insecurity, and affected vulnerable populations.” In short, the summer months could be a time of more global shortages, inflation pressures and geopolitical unrest.

The Bureau of Economic Analysis data showed that even with this year’s steady decline in real personal disposable income, personal spending increased 0.7% in April versus March. However, this spending came at the expense of dipping into personal savings which fell from $922.3 billion to $815.3 billion. In April, the savings rate fell from 5% to 4.4%, its lowest level since the recession of 2008. See page 5.

With this as a backdrop, it is not surprising that consumer sentiment indices fell in May. In both surveys, it was clear that poor consumer sentiment was led by declines in expectations. May’s Conference Board consumer confidence results reversed the gains seen in April. However, the University of Michigan sentiment survey has been extremely weak all year and May’s confidence readings were the lowest reported in 11 years, or since 2011. See page 6. Both consumer surveys are sobering since they are painting a dismal picture for second quarter consumption and economic activity.

Keep in mind that the Federal Reserve will continue to raise interest rates this year. In April, headline CPI was 8.2% YOY, and even after two fed rate hikes, the real fed funds rate remains at an historically negative (and easy) level of negative 7.2%. The Fed has stated that it wants to get to a neutral fed funds rate as quickly as possible. Assuming year-end inflation moderates to 5%, the fed funds rate would have to increase another 400 basis points to simply match inflation and reach a zero cost of capital. If a 5% fed funds rate materializes, we expect the housing market – which we believe is slowing — would slow more dramatically and hurt economic activity meaningfully. See page 7.

With first quarter earnings season nearly complete, we notice that consensus earnings estimates are falling for this year and next year. The S&P Dow Jones and Refinitiv IBES consensus earnings estimates for 2022 fell $0.15 and $0.81, respectively, this week; however, the nominal earnings range is relatively unchanged at $224 to $228. Earnings growth rates for this year are 4.1% and 9.2%, respectively. Our DRG 2022 estimate remains at $220, a 5.7% YOY increase from $208.19 in 2021. As a reminder, we believe value begins with a PE multiple of 17.5 times which equates to SPX 3850 given our $220 earnings estimate. See page 9.

The Good News The best news of the week was found in investor sentiment. The AAII bullish sentiment index fell 6.2 points to 19.8% while bearish sentiment rose 3.1 points to 53.5%. We saw this combination of “less than 20% bulls and more than 50% bears” on April 27, 2022, and it repeated again last week. Prior to these two weekly readings, the combination was last seen on April 11, 2013. Also note, the April 27 bearish reading of 59.4% was the highest bearishness since the March 5, 2009, peak of 70.3%. Sentiment tends to be an inverse indicator and the spread between bullishness and bearishness is the widest since the 1990 low. See page 13. Equity prices tend to be higher in the next six and/or twelve months following these extreme readings. Again, we believe this is the beginning of the end of the bear market, but it is apt to be a multi-month process. We remain cautious, particularly on rallies above SPX 4000.

Gail Dudack

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