In last week’s Strategy Weekly, we wrote (“Neither Bear nor Bull” – August 24, 2022): “While technical indicators have their bright spots, we feel investors may have become too optimistic too soon. Re-emergence of meme stock investors is one sign that speculation has returned to the market too quickly. Expectations of a Fed pivot this year are quite likely to be wrong, or at least premature. Economic indicators are mixed but many are showing definitive signs of weakness and the possibility of a recession.”
Although we were skeptical of the recent rally, from a broad macro perspective, we still believe the equity market is in a bottoming phase. However, we should explain what this means. Toward the end of a classic bear market decline, equities often suffer an intense sell-off on heavy volume which is often accompanied by margin calls. June had many of these characteristics. In subsequent months, bear market lows are typically retested, and it is normal to see the popular averages hit a lower low which can trigger more selling panic. But the distinctive feature of a successful bottoming process in a bear market cycle is that breadth indicators show that the new lower low was made on less volume, accompanied by less selling pressure, with less extreme oversold readings, and with less extreme breadth statistics in general. These are all signs of a waning bear market and a successful test of the low. The rebound from this lower low should also contain a series of 90% up-volume days as further confirmation that the final low has been made.
With this as a historical backdrop, one should expect the June lows to be retested in the second half of the year. And keep in mind that the August-September months tend to be a seasonally weak period for equity prices. Actually, September ranks as the weakest of all twelve months averaging a 0.7% loss over the last 71 years. Although October has a bad reputation and is associated with bear markets, the truth is that October tends to be a “bear killer” or a turnaround month. Twelve of the last 48 declines of 10% or more in the S&P 500 were made in October, far more than any other month. Next in line is March with eight lows and June with seven.
Seasonality does not always work as planned, and it can be overridden by geopolitical or financial events. Still, it is wise to be aware of the seasonal tendencies of equity markets. A retest of the lows in the September/October timeframe makes sense to us for many reasons in addition to seasonality. First, it will be the start of another important earnings reporting season. Despite recent headlines suggesting that second quarter earnings results were “better than expected” the reality is that they were better than the very worst expectations. In truth, earnings for this year and next year came down substantially in recent weeks. The S&P Dow Jones consensus earnings estimate for 2022 fell $13.68 since the end of June. The IBES consensus estimate for 2022 fell $4.21 in the same period. As a result, our recently reduced forecast of $218 for the S&P 500 for this year is under review and may be in jeopardy.
Second, the next FOMC meeting is scheduled for September 20-21, and this will be followed by another meeting on November 1-2. The final Federal Reserve meeting of the year is set for December 13-14. However, the September meeting is the one we expect will set the tone for monetary policy for the rest of the year in terms of how much tightening the Federal Reserve expects it will do in the final months of 2022. More importantly, we believe the consensus will continue to be disappointed regarding monetary policy in 2023. For example, New York Federal Reserve Bank President John Williams recently stated that the Fed will “likely need to get its policy rate above 3.5% and is unlikely to cut interest rates at all next year as it wages a battle against far too high inflation.” That means no “Fed pivot” in the next sixteen months!
Third, September could be the month in which the energy crisis in Europe unravels and heating fuel is rationed. Unrest in Iraq could negatively impact energy supplies. China’s economy appears to be weakening despite several attempts to stimulate activity. Plus, as a result of a landmark audit deal between Beijing and US regulators, Alibaba Group Holdings (BABA – $93.84) will be the first Chinese company to be audited by US audit watchdog – Public Company Accounting Oversight Board (PCAOB) – in Hong Kong in mid-September. In sum, September has the potential of being a very important and eventful month.
The first revision for second quarter GDP indicated growth declined 0.6% versus the initial 0.9% decline. Nonetheless, economic activity weakened for two quarters in a row. Economists denying the first half of the year was a recession may be overlooking the debilitating impact of inflation. On page 3 we show the GDP deflator, which is currently at its highest level since December 1981. Note that similarly high inflation between 1970 and 1984 was a period marked by four separate recessions.
The most important data series, in our view, is real personal disposable income since this is the best measure of potential household demand. Fiscal stimulus bills boosted household income significantly in April 2020 and even more in March 2021, but these gains in personal income were one-time events and artificial. Real personal disposable income per capita was $45,464 in July, down noticeably from the pre-pandemic January 2020 level of $45,747 and down significantly from the stimulus-boosted level of $57,752 in March 2021. Government stimulus in 2021 simply added to inflationary pressures and households are now experiencing both higher prices and relatively lower income. It is a bad combination. Note that personal consumption has increased more than personal income in recent months and is a trend that is unsustainable. See page 5.
All the popular indices tested their 200-day moving averages last week, but this resistance proved to be overwhelming. Unfortunately, neither the 100-day nor the 50-day moving averages provided support on the subsequent sell-off in the S&P 500, Dow Jones Industrial Average, or the Nasdaq Composite index which implies the June lows are apt to be tested. The 25-day up/down volume oscillator fell to 1.63 and is neutral this week after its mid-August overbought reading for seven of eight consecutive trading sessions. However, the August 26 session was a 91% down day coupled with a 1,008-point decline in the DJIA.
In sum, we expect there will be disappointments ahead in terms of monetary policy and earnings results, and in our view, these risks have not been fully priced into equities. We believe portfolios should be concentrated in sectors where earnings are most predictable and are both inflation and recession-resistant. These include areas such as energy, utilities, defense-related stocks, staples, and healthcare.