This is a week filled with potential market-moving events that include the July FOMC meeting, the first look at second quarter economic activity and 172 earnings results for companies in the S&P 500 index. Each of these events will have important implications for equity investors, but in our view, second quarter earnings results will be the most significant since these will help define where value is found in the equity market.

75-basis points and the Treasury Curve

In terms of monetary policy, the consensus is expecting a 75-basis point increase in the fed funds rate this week and we think this should prove accurate. In recent months the Fed has had a pattern of either matching consensus expectations for monetary policy changes or signaling its intentions well in advance of changes. In short, the Fed displays no desire to surprise, or stress, the financial markets and as a result, the expectation of a 75-basis point hike is probably discounted in current stock prices. However, we are less certain that the longer-term ramifications of a 75-basis point increase has been fully priced into equities, particularly if the economy slips into a recession.

The Treasury yield curve is currently flat, although it is technically inverted between the 6-month and 10-year Treasury note benchmarks. This makes a 75-basis point increase on the short end of the curve important since it is possible that the entire yield curve could invert shortly after the July Fed meeting. Keep in mind that a 75-basis point increase this week and the 75- or 50-basis point increase expected in September could raise the short end of the curve as much as 150 basis points. See page 3.

What makes the Treasury yield curve important at this juncture is that it has been better than most economists in terms of predicting a recession. A long history of the Treasury yield curve, focusing on the 1-year to 10-year curve, shows that in nine of the eleven inversions since 1956, an inverted yield curve has been followed by an economic recession, typically within eight months. (The range has been zero months (1957) to fourteen months (1978).) The only exceptions to this were in September 1966 — when a five-month inversion was not followed by a recession — and in September 1998 — when a four-month inversion did not result in a recession. Yet more recently, as in 2000, 2006 and 2019, inverted yield curves were followed by a recession within six to eight months. See page 4.

Quantitative Tightening and Money Supply

Yet as we focus on the fed funds rate and the yield curve, it is important to point out that rates are not the only tool in the Fed’s arsenal. While the Fed is expected to raise rates at each meeting this year, it also has indicated its intention to shrink its balance sheet. The $1.6 trillion increase in the Fed’s balance sheet between January 2021 and March 2022 was implemented during an expanding economy and it was a contributing factor to the stock market’s advance and current inflation. However, as of June 1, 2022, the Fed began reducing the reinvestment of principal payments in Treasury securities by $30 billion per month and will increase this amount to $60 billion per month beginning September 1^st. For agency debt and agency mortgage-backed securities, the reinvestment reductions are $17.5 billion and $35 billion per month. In short, the liquidity balloon that has been propelling stock prices higher since early 2020 is slowly deflating. But this is important in terms of reducing money in circulation, or money supply.

Another part of the Fed’s stimulus program was the elimination of required reserves for banks. The removal of this requirement in March 2020 resulted in a huge jump in excess reserves in the banking system and a massive increase in money supply. See page 5. This was an unusual tool for the Fed since there are laws that require banks and other depository institutions to hold a certain fraction of their deposits in reserve, in very safe, secure assets. This has been a part of our nation’s banking history for many years and “required” reserves are designed to ensure the liquidity of bank notes and deposits, particularly during times of financial strains.*

Nevertheless, in March 2020 the banking system was suddenly awash in liquidity. The 6-month rate-of-change in M2 (i.e., M2 money stock – a measure of the amount of currency in circulation) jumped to 19.5% in July 2020, an all-time record. The linkage between money supply and inflation is well-known by economists and was surely known by Fed officials. Yet this was the quandary of 2020 and 2021 for economists, strategists, and investors. Money supply fuels inflation but it also fuels stock prices. It was a double-edged sword. However, as liquidity is now being withdrawn to temper inflation, the underlying booster for equities is gone. Unfortunately, the longer-term problem of inflation remains.

GDP and Housing

Second quarter GDP will be released this week and it may answer the question of whether the US is currently in a recession, or on the brink of one. We continue to focus on the housing sector since it represents 17% to 19% of GDP in any given quarter. Unfortunately, recent news releases have not been encouraging. New home sales were 590,000 in June, down 17.4% YOY and down from 642,000 units in May. The average price of a single-family home fell to $456,800 in June, the lowest price in 12 months, but still up 5.8% YOY. The NAR affordability index dropped to 105.2 in May, which was its worst level since August 2006. However, the June, July and August readings are apt to move lower as the impact of rising mortgage rates negatively impacts potential buyers. See page 7.

Earnings and Valuations

To date, second quarter earnings season has been mixed, but a clearer picture may be available by the end of the week, or once we pass the midpoint of earnings season. We are noticing that many companies are making or exceeding revenue forecasts but are missing estimates on the bottom line. This was to be expected due to the rising cost of labor, transportation, and raw materials, but it is not good for earnings overall. Last week, the S&P Dow Jones consensus earnings estimates for 2022 and 2023 fell $2.48 and $0.36, respectively. Refinitiv IBES consensus earnings forecasts rose $0.01 and fell $0.76, respectively. This disparity between S&P Dow Jones and IBES is typical in the second half of the year since S&P adjusts earnings for GAAP accounting while IBES simply aggregates estimates. We measure “value” in the equity market by the S&P Dow Jones data.

Following S&P’s cut in its 2022 forecast to $220.21 this estimate is now in line with our forecast of $220, a 5.7% YOY increase from $208.19 in 2021. This earnings quarter will be important, and we will be looking closely at margins and the impact margin pressure may have on our $220 forecast.

All in all, none of this changes our view that the equity market is bottoming but may not have found its ultimate low. We continue to emphasize that recession/inflation proof segments of the market like energy, staples, defense-related stocks, and utilities where earnings are most predictable in this difficult environment. *https://www.federalreserve.gov/monetarypolicy/0693lead.pdf

Gail Dudack

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The July 19, 2022 trading session was notable, not just for the 754-point gain in the Dow Jones Industrial Average, but because preliminary NYSE data shows that 92% of the day’s total volume was in advancing stocks. We have been waiting for a 90% up day to appear in breadth data which would show that downside risk is minimized. Yet while we are pleased for the near term, we are not impressed for the longer term.

This was the first “90% up-volume day” since the 92% up-volume day recorded on May 13. The May 13 session materialized right after the S&P 500 dropped below the 4000 level, which in our view, was a sign that value was returning once prices fell below the SPX 4000 mark. However, on both May 13 and July 19, total NYSE volume was average, or in the case of July 19, below the 10-day average. This is unfortunate since below-average volume weakens the signal in terms of defining a major bear market low. Nevertheless, the July 19 trading session is important since it denotes a return of buying pressure and it represents another step in the market’s bottoming process. We expect more follow-through to this rebound in prices.

In concert with the 90% up day, all the broad equity indices moved above their 50-day moving averages for the first time since April. It is quite normal for a bear market rebound to retest the 100-day or 200-day moving average. However, the 50-day moving averages have been a ceiling for prices in all the indices since early April. At this juncture, it would be normal for momentum to carry stock prices to at least the 100-day moving average lines. These averages equate to Dow Jones Industrial Average 32,840; S&P 500 4,148; Nasdaq Composite 12,470 and Russell 2000 1,890. See page 9.

Another technical indicator we will focus on in coming weeks is our 25-day up/down volume oscillator. It has amazed us that despite the substantial declines in prices this year, there have been few oversold readings in this indicator. But in the last two weeks the oscillator was oversold in six of eight consecutive trading sessions. The deepest oversold reading was on July 14 at negative 5.17, the most extreme oversold reading since March 27, 2020. At a classic bear market trough pattern, stock prices may fall to a new low in price, but this oscillator will have a less extreme oversold condition. This would be a sign of waning selling pressure and be favorable. So, in coming weeks, a new low, but a less severe oversold reading would be a positive sign.

The Week Ahead

The equity market is way overdue for a rebound; however, there are several land mines in the immediate future. Next week is the July FOMC meeting and there is a vigorous debate about whether the Fed will raise the fed funds rate 75 basis points or 100 basis points. Fed Chair Powell will be announcing the decision on July 27. A rate hike is widely expected; yet history has shown that when the Fed raises interest rates substantially, it increases the value of the dollar. Rising interest rates coupled with a strong dollar can have repercussions on global finances, particularly in subprime credit markets, in ways that are unexpected.

On July 28, the Bureau of Economic Analysis will release its preliminary estimate for second quarter GDP. As we have previously stated, we would not be surprised if it is a weak number, or a negative reading. A negative GDP number could ironically be a major plus for investors since it would confirm a recession — and stock markets tend to bottom in the second half of a recession. In short, the next few days should be interesting.

Inflation, the Fed, and the Consumer

Barring signs of an immediate recession, recent economic releases show the Fed is way behind the curve and has a lot of work ahead of it.

Inflation accelerated in June. Headline CPI rose 9.1% YOY, up from 8.5% in May and core CPI increased 5.9% YOY, in line with the 6% recorded a month earlier. Although the administration and many economists are highlighting the small decline seen in gasoline prices recently, the outlook for inflation is not good for the rest of the year. For example, homeowners’ equivalent rent increased 5.5% in June, up from 5.1% in May. Rent prices are apt to rise further since rents tend to lag the trend in home prices, and home prices are still rising at a double-digit rate. The median price of an existing single-family home rose 15% in June. See page 3.

Plus, there is plenty of inflation in the pipeline. The PPI for finished goods rose 18.6% YOY in June. Core PPI increased 8.8%. The PPI for final demand rose 11.2% in June, up from 10.8% in May. These price gains in the PPI indicate consumers face more price increases ahead or businesses face more margin pressure. One or both of these trends are likely in coming months. See page 4.

The persuasive argument for a recession is directly linked to inflation because inflation has increased more than wages. See page 4. As a result, real wages are declining and so is purchasing power. The way to stall or reverse inflation is to raise interest rates, but that too, will hurt consumers through higher mortgage and loan rates. It will impact small businesses by weakening profit margins, making credit more expensive and in some cases unavailable. Unfortunately, the Fed allowed inflation to get too high before responding. The gap between inflation, now at 9.1% YOY, and fed funds, now at 1.75%, means the fed funds rate is 863 basis points below inflation, or the “neutral” level. The Fed’s forecasts show that they expect inflation to slowly decline in 2022 which would make this gap a bit smaller. But that may be wishful thinking.

While a weaker economy and therefore lower inflation is a possibility, it also means a recession is already here. We think there are signs of an imminent recession in recent retail sales data. Total retail and food service sales increased 8.4% YOY in June, which may sound like the consumer is strong and vibrant. However, once sales are adjusted for inflation, year-over-year real retail sales (measured in $1982-1984) have been negative for four consecutive months. See page 5. Negative year-over-year real retail sales have been highly correlated with recessions in the past.

Auto sales are a major part of retail sales, and though there was a pickup in June; the longer-term trend remains negative. Moreover, as interest rates and prices rise, we expect auto sales to remain sluggish in the second half of the year. Gas station sales have been a boost to retail sales, but these gains are due only to the high price of fuel and it is shutting out other areas of consumption. Housing is also weak. The National Association of Home Builders survey for July dropped from 67 to 55. Traffic of potential buyers fell from a weak reading of 48 in June to an even weaker reading of 37 in July. In sum, many areas of the economy are showing weakness and it may not all be factored into equities as yet.

Gail Dudack

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Downside Volume

We believe it is likely that equities are on the verge of establishing a new low. The good news is this may be an important part of a defining low in this bear market. The main reason for our near-term concern is the action of our NYSE 25-day up/down volume oscillator. The 25-day up/down volume oscillator declined to negative 3.7 this week, recording its third oversold day in the last five trading sessions. The decline was sudden and the pattern in the oscillator suggests downside volume is gaining momentum. In fact, the July 6 reading of minus 4.09 was the most oversold reading recorded since April 1, 2020. And though some might think that an oversold reading is positive, we would point out that in March and April of 2020, the market dropped to oversold and remained in oversold territory for 25 of 28 consecutive trading sessions. See page 12. Sometimes negative momentum begets more negative momentum.

Inflation

This acceleration in downside volume is coming just ahead of the releases of June CPI and PPI data. And it may reflect the concern investors now have regarding inflation. Unfortunately, we believe the consensus may be disappointed in the results. To be specific, the May headline CPI release showed prices rising 8.5% YOY, the highest pace in 40 years. See page 9. What we believe is important is that if the CPI were to remain unchanged in June, the pace of inflation would still remain high at 7.6% YOY. However, an unchanged CPI seems unlikely since even at the lower prices for WTI crude oil (CLc1 – $95.84) seen currently, WTI is up 29% YOY.

And as previously noted, housing represents 42% of the CPI’s weighting and housing rose 6.9% YOY in May. The median price of an existing single-family home rose nearly 15% YOY in May, and while 15% YOY is down from a peak rate of 26% YOY a year earlier, housing will still add to inflationary pressure. Meanwhile, rents, which represent nearly 24% of the CPI weighting, tend to follow the trend in home prices, but with a sizable lag. Given this backdrop, it is difficult to see inflation falling much in June. We have also pointed out that medical care prices have been offsetting some of the larger increases seen in transportation costs. Medical care rose a “modest” 3.7% in May, but health insurance pricing is seasonal, and we expect medical insurance, and the medical care segment of the CPI, will add to inflation in coming months.

The PPI represents the pricing pressure in the pipeline that will eventually shift to consumer prices. The PPI for final demand rose 10.7% YOY in May. If prices were unchanged in June, the year-over-year pace only falls to 9.8%. In short, there is some simple math behind the CPI and PPI data that suggests the June inflation data will not soothe investors’ nerves.

Earnings Season

Moreover, second quarter earnings season begins in earnest this week, and this could be a market moving event. A number of brokerage houses are bringing their 2022 earnings estimate for the S&P 500 index down to our $220 forecast and that is a plus. But as we noted in our March 9, 2022 (“A Bear is a Bear is a Bear”) “higher commodity costs are likely to pressure profit margins and lower revenues for many companies and could make our $220 earnings estimate too optimistic.” We still believe this is true. Our $220 estimate represents a 5.7% YOY increase from 2021, and we feel it is conservative considering that earnings for the energy sector are expected to increase between 120% YOY (IBES) and 137% YOY (S&P Dow Jones) this year. Excluding the energy and perhaps the materials sectors, we expect earnings will decline in 2022. In a week or so, investors will have a better idea of second quarter earnings results.

PepsiCo, Inc. (PEP – $169.50) released earnings results this week and its second quarter core earnings rose 8.1% YOY, but reported earnings fell 39.4% YOY due to a write-off related to the Russia-Ukraine conflict. A key takeaway from the company’s earnings call was that it planned price increases and cost management. A main part of our strategy for 2022 is to focus on companies and sectors that will be most immune to both inflation and recession. This includes necessities like food, staples, energy, utilities, and we also include the defense-related industrial stocks given the increase in funding of national defense by Western countries as a result of the Russian invasion of Ukraine.

Worrisome Economic Data

The June jobs report indicated an increase of 372,000 jobs and an unchanged unemployment rate of 3.6%. However, total employment in the US is yet to exceed its previous peak which is unusual for an expansion that is now over two years old. We think this is a weakness in the employment data that most economists have overlooked. See page 3. And employment gains have been a story of the haves and have-nots. Unemployment for those with less than a high school degree has risen in the last four months from 4.3% to 5.8%. Economists may be disregarding this factor since this segment represents only 6.4% of the workforce. However, the only group that has made significant gains in employment in the last two years has been those with a bachelor’s degree or higher, which represents 43% of the working public. The remaining 47% have not seen the same gains. See page 4.

Both the manufacturing and nonmanufacturing ISM indices fell in June, and were down 13% YOY and 9% YOY, respectively. However, take note that both surveys show their employment indices falling below the 50 neutral level, indicating a decline in employment. This could be a leading indicator for the BLS employment data. See page 5.

In June, the NFIB small business optimism index fell to 89.5, its lowest reading since the 88.8 seen in January 2013. The outlook for the next six months fell to negative 61, the lowest reading on record. All ten components fell in June, including plans to expand business, to increase capital expenditures, to increase employment, or to add to inventories. The only positive seen in June’s survey was that 50% of owners indicated they had unfilled job openings. See page 6.

A number of markets are trading as if a recession is approaching. As previously mentioned, the price of crude oil has collapsed from a high of $122.11 in early June to $95.84, this week. This appears to be due to a fear of a global recession. Nevertheless, oil is still up 29% from July 2021. Also falling is the 10-year Treasury note yield which had reached a high of 3.48% in June, before dropping to 2.95% this week. This decline is not a good sign since the Treasury yield curve is now inverted from the one-year note yield to the 10-year note yield. Keep in mind that the Fed expects to raise the fed funds rate to 3.5% or higher which would invert the entire yield curve in a classic sign of a recession. See page 7. Valuation can be deceiving when not put into perspective. The current trailing PE of 17.7 X looks low, relative to the 50-year and post-1947 averages, but the PE will rise if EPS forecasts are too high. Plus, the impact of inflation is best seen in the charts on page 9. When inflation moved above average (3.5% YOY) in the 1972-1982 period, PE multiples fell to single-digits and below the standard deviation range. Another way of measuring inflation is the Rule of 23, which sums inflation and PE multiples. The market has traded above 23 for the last two years and the sum is currently 24.8. Unfortunately, based on this historical benchmark, the market remains expensive. See page 9.

Gail Dudack

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The Right Environment for a Low

Second quarter earnings season will begin in earnest in mid-July, and it could be a market-moving event. First quarter earnings results disappointed the consensus in April, and this setback contributed to a sharp decline in the averages. However, GDP was negative in the first quarter, therefore, poor earnings results for the S&P 500 stocks should not have been a surprise to investors.

This month, the start of second quarter earnings season will be quickly followed by the Bureau of Economic Analysis’s report of its first estimate for second quarter GDP growth, scheduled for release on July 28. This crucial combination of earnings and economic activity should be a meaningful time for investors.

Last week we noted that despite the perpendicular selloffs in the broad averages, to date, the equity market has been unable to sustain a significant or normal rebound. Unfortunately, this is a sign of weakness. Plus, our biggest concern is that analysts have not yet significantly lowered earnings forecasts for this year. And despite multiple signs of deteriorating economic activity, economists are yet to worry about a recession in 2022. It is possible that second quarter earnings results and the BEA’s estimate for second quarter GDP growth could be the catalyst that shifts attitudes and forecasts. If so, it would create the right environment for the stock market to establish a meaningful low.

As we noted last week, the bear market finale is likely to include the realization that earnings will be lower than expected for both 2022 and 2023, and this could happen in late July. From a simple technical perspective, it would be wise to wait for an impressive high-volume 90% up day before committing to equities in a major way. A 90% up day would confirm that buyers have returned to the equity market in earnest.

Hints of Recession

US economists may not be forecasting a recession, but global markets are indicating that recession fears are rising. This week the euro sank to its lowest level against the dollar in over 20 years. The global benchmark for Brent crude collapsed 9.5% in one day. Similarly, the WTI future fell 8.2%. The 10-year Treasury bond index lost nearly 400 basis points in the last four trading sessions. In the Euro zone, purchasing managers’ surveys for June show the manufacturing sector is in a decline and the service sector has suffered a major loss in momentum. China’s growth is becoming questionable after Shanghai said it would begin new rounds of mass testing of its 25 million residents over a three-day period. This is an effort to trace infections linked to an outbreak at a karaoke bar and it stokes fears of another potential lockdown of China’s largest city of 24.5 million people. In sum, we continue to believe the US economy may already be in a recession. The good news is that the equity market tends to find its low midway through a recession.

Real Disposable Income Tells the Story

For most of the last 60 years, personal income has been in a slow steady uptrend, dipping only slightly during recessionary periods. However, in the past two years, even though personal income has inched higher, disposable income has been flat as a result of increases in both personal taxes and government social insurance taxes. This creates financial pressure on many households, and as a result, the personal savings rate fell from a high of 10.5% in July 2021, to 5.4% in May. In April, the savings rate hit a cyclical low of 5.2%, matching its November 2009 level. The savings rates for March and April were revised fairly dramatically in the last release, from 5% to 5.3% and from 4.4% to 5.2%, respectively. Nevertheless, the newly revised savings rates remain the lowest since the 2008-2009 recession. See page 3.

There was a boost in personal income in 2020 and in 2021 due to two pandemic stimulus packages passed by Congress. The 2020 package was done during the pandemic shutdown and recession, but the second stimulus package was larger and implemented during the post-pandemic recovery in 2021. See page 4. This later package in our view, coupled with massive monetary stimulus, was the recipe for the historic inflationary cycle now impacting our economy.

And for the first time in 40 years, consumers and households are seeing inflation rise faster than their income. This results in a decline in purchasing power. To date, personal consumption expenditures remain positive on a year-over-year basis, but the trend is unsustainable and is declining. See page 5. Since the US economy is 70% consumption-driven, this decline in household purchasing power is not a good sign for economic activity in the second half of the year.

The ISM manufacturing index fell from 56.1 to 53.0 in June. Although this index has been steadily declining all year, it still remains slightly above the neutral 50 level. However, the ISM manufacturing employment index was 47.3 in June, its second monthly report below 50, and a sign that employment in manufacturing is shrinking. New orders also fell from 55.1 to 49.2. This fall below 50 indicates a slump in new orders and demonstrates weakness within the manufacturing sector. See page 6.  

Watching the Russell 2000 Again

The Russell 2000 index has dropped to a key support level that is the equivalent of the price peaks made in 2018 and 2020 at the 1700 area. The charts of the other broad indices are different from the Russell, and all the other indices are well above their 2020 peaks. However, for reference the levels equivalent to the 2020 peaks are 29,500 in the Dow Jones Industrial Average, 3,380 in the S&P 500, and 9,800 in the Nasdaq Composite index. See page 8. It will be important for the Russell 2000 to stabilize at the 1700 level and begin to build support. The 25-day up/down volume oscillator declined to negative 2.96 this week and is close to an oversold reading for the first time since mid-May. The lack of a deeply oversold reading in this indicator, like the ones seen in August 2015, February 2016, December 2018, or March 2020, is somewhat bewildering given the seven 90% down days recorded in recent months. However, it implies that the equities market may not yet have found its trough. See page 9. While we believe many stocks may have found their 2022 lows, as in most bear markets, the lows will get retested. For this reason, we remain cautious.

Gail Dudack

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