Forget Bifurcated…This Market is Trifurcated.  

DJIA:  32,859

Forget bifurcated…this market is trifurcated.  When someone says what’s the market doing, even in terms of the Averages you almost have to ask, which one?  There’s the NASDAQ 100, not to be confused with the NASDAQ Composite, which is in its own bull market of sorts. The NAZ 100, also known as the Triple- Qs, is home to Tech to the tune of some 80%.  For now at least, Tech is seen as a safe haven of all things, immune to the news in banking.  The S&P 500, in turn, seems held together by its own heavy weighting in Tech, names like Microsoft (284), Apple (162) and the like. The problem for the S&P is its own more than fair share of Financials, and Industrials that have suffered recently in the wake of the banking mess. Finally, there’s the Russell 2000, where Regional Banks are some 17% of market cap.  Throw in ancillary financials like REITs and Insurance, and you can see why the chart looks as it does.

Bank shares, whether large or small, have been crushed.  The unanimity of the decline doesn’t happen very often, and it usually means bad things for those all around.  When banks fall relative to everything else, as they have recently, everything else tends to follow.  It seems banks do matter to the economy.  When they’re in trouble most of the economy has trouble as well.  The counterpart here is that this will lead to lower rates and hence the overall market’s somewhat indifference.  There is, however, a fine line here.  If troubled banks damage the economy, it will only be because of that rates fall.  We would like to think that last year’s 20% decline and multiple contraction may have discounted declining profits, but only time will tell.

In the long run earnings of course matter, but the long run is just that, and many things come into play in the interim.  An obvious example is last year when earnings were up and the market was down, that because of the Fed’s tightening.  Suppose this year the Fed is close to being done?  Or, suppose the “E” In P/E is not for earnings but is instead for efficiency.  Look what efficiency did for Meta (208).  Or suppose like Baba (103) more companies decide to divide.  It was worth more than 10% to Baba’s stock on Tuesday.  Sure this is all more than a little far-fetched, but earnings are not alone in driving stock prices.  When the market wants to go higher it always seems to find a way.  Maybe prices will drive higher when we all give money to someone to buy something about which we know nothing.  Come to think of it, we’ve already done that.

The problem for now is not earnings, it’s the technical background.  We’ve been in this correction since early February, exacerbated by the banking mess.  You might say all things considered the market has held together reasonably well, and to a degree that’s true.  Still, holding up isn’t going up, and many stocks haven’t been holding.  Our measure here is not so much the Averages but what most stocks are doing.  During this correction NYSE stocks above their 200-day average have gone from 74% in early February to last week’s low of 36%.  If this is a decent proxy for stocks in uptrends, it means almost 2/3 of stocks are in downtrends.  And that means it’s hard to make money.  There’s no magic number here, it simply has to turn back up again.

The recent action has been more encouraging.  While we make light of it, we always take note when the market has its chance to do something but does not, in this case, go down.  And the Advance-Decline numbers recently have held together pretty well.  We especially like days like Tuesday when the Dow and the S&P showed modest losses, but the A/Ds were positive.  This should be a prelude to improvement in stocks above their 200-day and, therefore, a better market.  While Tech clearly leads, the Econ sensitive stocks seem to be regrouping.  To look at a stock like Cintas (468), which should have its finger on the pulse of the economy, you might ask what recession.  While history says the banks drag down the rest, maybe this time Tech drags up the rest.

Frank D. Gretz

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US Strategy Weekly: Short-term Relief?

As expected, the Federal Reserve did raise the fed funds rate by 25 basis points to a range of 4.75% to 5.00% last week. However, in reality, the Fed’s overall tightening policy is being offset by its need to increase liquidity in the banking system which has been under intense pressure since regulators took control of Silicon Valley Bank (SVB Financial Group – SIVBQ – $0.40) on March 10.

Short-term Rally?

As the central bank moved quickly to add reserves to the banking system in the form of primary loans and through the new Bank Term Funding Program (BTFP), the Fed’s balance sheet expanded by nearly $350 billion dollars in recent weeks. See page 3. This quick response appears to have assuaged depositors who were concerned about the stability of regional banks. And while the crisis seems becalmed for the moment, the Fed’s action may also provide a few better days for investors. History shows that there has been a strong relationship between the Fed increasing its balance sheet (adding liquidity to the banking system) and rising stock prices. In sum, equity prices could rise in the near term.

However, we worry this will only deliver short-term comfort. The banking crisis could also result in tighter credit conditions for consumers and businesses and many forecasters are now suggesting that the Fed will cut rates in the second half of the year. This is a possibility, but only if it becomes clear that the economy is spiraling into a recession (which means corporate earnings will collapse!). Even so, the Fed may not cut rates quickly since history shows that high inflation has only been corrected by a recession. Unfortunately, the relationship between inflationary cycles and recessions is a strong one. Whenever inflation has risen more than two-standard deviations above the norm, or above 6.5%, the economy has suffered, not one, but a series of recessions. See page 4.

Higher for Longer

It is obvious that headline inflation has begun to decelerate but core inflation remains stubbornly high. Core CPI was only down 0.1% in February to 5.5% and this reflects the fact that pricing pressure is now concentrated in the service sector. In the CPI, service inflation was unchanged in February at 7.6% YOY. Service sector inflation less rent was 6.9% and pet services inflation rose 10.9% YOY. These are worrisome figures. The PCE deflator for February will be released Friday and it will be closely analyzed for any signs of service sector relief.

We believe the Fed governors when they state that they do not foresee an interest rate cut later this year. And the reasons are many. The Federal Reserve has never been this far behind the curve in terms of fighting inflation. Historically, a Fed tightening cycle began at the first sign of inflation and it ended with a real fed funds rate reaching at least 400 basis points. This latter point is quite different from the consensus view. What it means is that if inflation should fall to 3% this year (which we deem unlikely) the fed funds rate could rise to 7% by year end! See page 5. We doubt that interest rates will get this high, but we do expect the Fed to keep interest rates higher for longer than the consensus currently believes.

Using Technical Guidance

Most of the broad market indices are trading at prices that are close to levels representing the convergence of the 50, 100, and 200-day moving averages. See page 8. This convergence of moving averages should function as good support for the recent sell-off, however, as support, it is also pivotal. If the indices break below current levels it would likely trigger more selling. In other words, the next several weeks should be an interesting time for technical analysts; however, as we previously noted, the Fed’s recent quantitative easing should provide some near-term support for equities.

Meanwhile, our 25-day up/down volume oscillator is at negative 1.91 this week, which is a neutral reading after being in oversold territory for 12 consecutive trading days. This oversold reading follows an eleven-day overbought reading that ended February 8, and which represented a shift from a bearish to a positive trend, or at least from a bearish to a neutral trend. This new oversold reading clearly defines the market’s trend as being neither bullish, nor bearish, but in a long-term sideways trading range. See page 9. Keep in mind that in this 25-day oscillator, bull markets rarely reach oversold territory and bear market rallies rarely reach overbought readings. The current market is oscillating between overbought and oversold and therefore neutral. Other technical indicators such as the 10-day average of daily new highs and lows are more negative. We use 100 per day as the definition of a trend and new highs are currently averaging a weak 35 per day and new lows are averaging 189. See page 11.

The best example of the trading range we are expecting for the intermediate term is seen in the Russell 2000 index. See page 10. The Russell 2000 is heavily weighted in regional bank stocks, which some might say should make it a less predictive indicator; nevertheless, a bull market has never materialized without the participation of the financial sector. It is core to the economy. Therefore, we are closely monitoring a well-defined trading range in the Russell 2000 between support at 1650 and resistance at 2000. The RUT’s current price of 1753 is 6% from support and 14% from resistance, implying a slightly positive short-term risk/reward ratio.

S&P GICS Changes

ETF’s have become popular trading vehicles recently and we expect this to continue particularly since the trading range market we are expecting should see a continuous rotation of sector leadership. Therefore, we have reprinted a summary of GICS classification changes that took place in March. We expect these changes will impact not only the price performance of some SPDR ETF’s but it will also change the earnings in several categories. See page 7 for details.

The largest change will be seen within Information Technology, where eight constituents will move to the Financials sector and three constituents will move into the Industrials sector. From a market cap perspective, Visa Inc. (V – $220.33) and Mastercard Inc. (MC – $354.33) will be the largest changes and they will now rank as the 3rd and 4th largest constituents in the Financial sector and move into a newly created sub-industry titled ‘Transaction & Payment Processing Services’. The other sector impacted is Consumer Discretionary, which will see Target Corp. (TGT – $159.77), Dollar General Corp. (DG – $208.13), and Dollar Tree Inc. (DLTR – $141.66) all move into the Consumer Staples sector and the ‘Consumer Staples Merchandise Retail’ sub-industry. Target Corp. now ranks as the 9th largest constituent in the Consumer Staples sector. Financials will see the largest increase in earnings weight next quarter, rising from 17.6% to 19.7% (+2.1 ppt) due to Visa Inc. and Mastercard Inc., followed by Industrials (+0.3 ppt), which will be offset by the decline in Information Technology (-2.6 ppt). Consumer Staples will see its earnings weight rise moderately (+0.4 ppt) which will be offset by Consumer Discretionary (-0.3 ppt).

Gail Dudack

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Funny, We Were All Good Traders Back in January… But Not So Much Now

DJIA:  32105

Funny, we were all good traders back in January… but not so much now.  It’s hard to overstate the importance of the market’s overall trend.  Academic studies long have held as much as three quarters of a stock’s movement is a function of market trend.  With the growing importance of ETFs we suspect it’s even more – buy one thing, move 10.  Back in January 74% of stocks were above their 200-day, that is, in uptrends.  Now it’s only 47%.  Your odds of having the market at your back are less than 50-50.  When we hear it’s a stock picker’s market we cringe.  Stock picking is hard.  Give us January when most stocks went up, when “stock picking” was easy.  We are still in this correction that began in early February, though considering the news it could be worse.  At least 3840 on the S&P has held, and that seems important.

Going through the bank charts – what’s March Madness for – it comes as little surprise how poor they are.  The surprise, and there are almost 400 of them, is how uniform those charts have become.  And by the way, that includes the money center banks who would seem had something to gain here.  The stocks for now have stabilized and that’s important for the market’s sake.  We don’t see them storming back but that’s fine, stable will do.  What is of concern is the ancillary fallout.  In terms of markets. Regional Banks are a big part of the Russell so that wouldn’t seem to bode well for that Index.  And Regional Banks are behind some 80% of lending to commercial real estate, another place you might want to avoid.  Seems it’s a tangled web they weave.

The banking mess and its attendant implications for growth, has put a dent in most of those stocks we have termed economically sensitive.  While Grainger (665) and Cintas (433) didn’t seem to notice, on the whole some dust needs to settle here.  A quick rebound would be the ideal, but that seems unlikely without some new leg up in the overall market.  Certainly it seems important the recent lows hold, both for the sake of the stocks and for implications for the economy.  GE (92), by the way, is another name that didn’t seem to notice.  Meanwhile, there continues to be a shift to Big Tech on the perception they are somehow immune, and perhaps they are.  This includes most of the Semis, Microsoft (278), Apple (159), Meta (204), and now Amazon (99) looks better.  Tesla (192) also appears to have turned up again.

If we had to choose a word for the Fed meeting – yawn comes to mind.  After the most aggressive tightening in years, does a quarter point really matter?  We can see a half a point might have mattered, though a rally on that news would’ve been really bullish.  And had they paused, would it have signaled a lack of confidence in the financial system?  Back in 1984 when Continental Illinois failed, tough guy Volcker did pause.  That was May and by July- August the market rallied sharply.  Events like the Fed meeting always seem not so much about the event but the market’s reaction to the event.  We know these meetings usually come with their share of volatility, but Wednesday we found a little over the top.  Reaction, dare we say seems more about manipulation.

A theoretical trade might be, long the NAZ and short the Russell.  By the NAZ we mean the NASDAQ 100 where the large-cap growth stocks live, and are for now the market’s best acting stocks.  The Russell, in turn, is 17% home to Regional Banks.  It’s not just Regional Banks that are the problem.  Over the last few weeks a ratio of small-cap to large-cap stocks has cycled from a 200-day high to a 200-day low, a change that seems more than just about the recent weakness in Regionals.  In theory this is a warning sign for the economy.  For stocks, it tended to precede some additional small-cap weakness, while the S&P tended to hold together reasonably well.  We don’t really believe in these so-called “pair trades,” being right once is hard enough. The concept, however, does seem valid.  The Regionals will take time to dig themselves out while large-cap growth, of all things, seems a safe haven.

Frank D. Gretz

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US Strategy Weekly: Raise, Pause, or Pivot

In our opinion, the Federal Reserve will raise the fed funds rate by 25 basis points this week to a target range of 4 ¾% to 5%. And we say this even though we agree with those who say it makes no sense to raise rates during a time of global banking distress. However, the Federal Reserve has backed itself into a corner this week and any move it makes – raise, pause, or pivot — is apt to draw criticism. As a result, Chairman Powell is likely to take the easiest road and follow the consensus view of a 25-basis point increase.

Unfortunately, the Fed is boxed in between a number of bad choices and finds itself in a lose-lose situation. Still, it is a situation of its own making. First, for too long the Fed ignored an inflation problem exacerbated by its prolonged zero interest rate policy and then it rushed to fix its error by raising interest rates 425 basis points in 10 months. The sharp rise in interest rates coupled with the most inverted government yield curve since 1981 proved difficult to handle for some, particularly, for those with no experience with inflation or inverted yield curves. The disruption seen in the banking industry is no surprise to us; although we would have expected the liquidity problems to first appear outside the US and not inside.

It is possible that a 25-basis point increase will soothe the markets. A pause could suggest that the Fed sees too much instability in the banking system to raise rates. A 50-basis point increase could certainly add to the pressure already seen in global banking. Thus, 25-basis points may prove to be the best choice. But it is unclear whether the global banking system has truly stabilized. Clearly, the Fed and the Swiss government stepped in to calm the jitters caused by runs at three regional banks in the US and at Credit Suisse Group AG (CS – $0.97) in Switzerland. Consequently, the tightening policies that were in place are now in conflict and diluted by the emergency liquidity measures put into place to save the banks. Our longer-term concern is that banks will continue to face pressure this year from an inverted yield curve, a shaky commercial real estate market, and rising credit card debt. History suggests that sustainable rallies in equities are not likely without participation from the financial sector. In short, we remain cautious.

Monitoring the risk in the debt markets will be important in the days ahead, even for equity investors. One benchmark we have followed is the ICE BofA MOVE Index (.MOVE – $162.31) which is a measure of expected volatility in US Treasuries. Last week it surged close to $200, its highest level since the financial crisis of 2008. It has since retreated to $162.31 but remains elevated and is a cause for concern. See page 2.

According to History

By studying the relationship between inflation and the economy over the last 80 years, it becomes clear that whenever inflation, as measured by the CPI or PPI, has reached 9% or more, it has been followed by not one, but by a series of recessions. This was true in the post-World War II era as well as the double-digit inflation seen in the 1970 decade. It is possible that the two negative quarters of GDP seen in the first half of 2022 was the first, in what may become a series of economic slowdowns. See page 4.

And it is also important to note that there is a unique difference between past inflation cycles and the current environment. The Federal Reserve has never let inflation rise this far before raising rates. In past cycles, the Fed increased interest rates as soon as inflation began to climb and kept rates in line with inflation. The Fed is way behind the curve in today’s cycle which could make inflation more difficult to control. History also shows that in tightening cycles with very high inflation, monetary policy was interrupted by the onset of a recession. This forced the Fed to lower rates temporarily. Unfortunately, after a decline of a year or more, inflation reappeared, and the Fed’s tightening cycle resumed, lifting interest rates to even higher levels. This is the backdrop for a series of economic recessions. We believe Chairman Powell understands this and will try to avoid the historic pattern of stop-and-go tightening. But he is walking an economic tightrope and it will not be easy. See page 5.

Inflation Abating

Recent inflation data has been somewhat encouraging. In February, headline CPI fell from 6.4% to 6.0% YOY. Core CPI ratcheted down from 5.6% to 5.5%. Finished goods PPI improved the most falling from 8.7% to 6.4% YOY; while final demand PPI dropped from 5.7% to 4.6%. But the concern is service sector PPI which was unchanged at 5.5% YOY. All in all, these were well above the long-term average pace of 3.4%. See page 6.

The best inflation news was found in trade-related benchmarks. Import prices fell from 0.9% YOY to negative 1.1%. Imports less petroleum eased from 1.4% to 0.2% YOY and export prices dropped from 2.2% YOY to negative 0.8% YOY. But while inflation has moderated by most measures, the real fed funds rate remains 80 basis points below the PCE deflator (5.4%) and 150 basis points below the CPI. See page 7. This is the most compelling reason for the Fed to still raise interest rates by 25-basis points at this week’s meeting.

To add to this mix of data, there were some green shoots in housing data recently. In particular, the NAHB confidence index rose from 42 in January to 44 in February. Yet, despite these gains, all components are still below the 50-equilibrium level. At the same time, existing home sales increased from the 4.0-million-unit rate seen in January to 4.58 million in February. Again, despite this gain, sales were nearly 23% below the rate seen a year earlier. See page 8.

In February the median existing home price rose to $367,500 from $365,400 in January. This was a 0.7% YOY decline and the first year-over-year decline since September 2011. The price of a new home also declined in February and the 3-month average dropped to 3.5% YOY. But while year-over-year declines in home prices are good for future inflation data, total retail sales have a strong relationship to home prices. This suggests that retail sales could also be weak this year. See page 9.

Watch the Russell

We think the Russell 2000 index remains the best technical guide for market direction in the near and intermediate terms. Our forecast has been for a trading range marker and the Russell index is the best example since it continues to trade between support at 1650 and resistance near 2000. The current price of 1777 is just slightly below the midpoint of the range, which could be viewed as slightly positive, i.e., allowing for a brief short-term rally. See page 11. But we remain cautious and would continue to focus on recession and inflation proof stocks with solid earnings and dividend growth. Note: this week we have lowered our 2022 earnings forecast of $200 to $196.82 to match the S&P Dow Jones estimate. See pages 10 and 17.

Gail Dudack

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Who Loses Money in the World’s Safest Investment … Banks of Course

DJIA:  32246

Who loses money in the world’s safest investment … banks of course.  So how does this work again – rates go up, bond prices go down?  Having tired of lending money to Third World countries, trying to rig LIBOR, writing “liar loans,” the banks have found yet another way to screw up.  Still, there was a perverse predictability to SVB, no one was looking there, and that’s what usually comes back to bite you.  Scary/disappointing as it all might be, it’s an ill wind, and all that.  SVB and the rest just may have done the Fed’s job for it.  At the very least, it should help ease the Fed’s foot off the rate hike pedal.  The idea that the futures were up prior to the CPI release Tuesday morning tells you inflation is less of a worry.  Now it’s about a loss of confidence, and that takes time to resolve.

After Tuesday’s calm came Wednesday’s turmoil, thanks to those almost forgotten problems at Credit Suisse (2).  Tempting to say let those problems remain forgotten, but that didn’t turn out so well in the case of Bear Stearns or Lehman.  The latter were seen as being small enough to allow to fail, though in retrospect they were not.  It seems clear that bank profits will be hurt, which means lower share prices.  What’s not clear is that dirty word contagion – to what extent this morphs into further failures and a greater economic impact.  The latter came to the forefront Wednesday with the selling in everything sensitive to economic growth, especially Energy.  As we suggested, this banking problem is doing the Fed’s job for it, but will the Fed see it that way as well. We had thought a pause might be taken as a sign of Fed panic – they must know something.  We now think it would be taken as a sign of Fed reason.

In the midst of layoffs in the auto industry, Walter Reuther once quipped, who do they think buys these things?  Meta (205) plans to cut another 10,000 jobs and leave 5000 openings unfilled.  Investors may not have bought into the metaverse, but they have  bought into the stock.  It was up some 13 points on the news Tuesday, and another 4 points in Wednesday’s weak market.  Seems growth is out and efficiency is in.  Be lean, be mean, layoff more workers and really get that stock going.  Then, too, if this is good it’s a telling commentary on how bloated and poorly run the Company had been all this time.  In any event, we’re not here to praise or to bury Meta, we’re here to praise what has become a very good chart, and one leaving the rest of FANG behind.  And this was prior to the last few days when growth became the new defense.  It’s not just growth at any size, of course, it’s big growth –Microsoft (276), Salesforce (187), Nvidia (255) and Apple (156).

The overall technical background isn’t as bad as you might think.  The S&P had fallen below its 200-day, but you might notice it often dances around that number.  The 50-day remains above the 200 and is less prone to the dance.  Another trend following indicator we use remains up, provided there’s no weekly close below 3845.  Like most trend following indicators, it’s only right 45% of the time.  Like most trend following indicators, you make four times as much as you lose – you avoid the big losses.  The last buy signal was at the end of October.  There’s no question we have seen selling that can only be described as intense – a spate of 5 days where 3 saw 90% of the S&P components lower.  More important than the recent weakness, however, still seems the momentum surge off of the October low.  Even intense selling did not negate the positive implications of this kind of surge, at least historically.

When things change, Keynes once observed, you should change as well.  Things change but rarely as quickly as they did this week.  While we should be leaving time for the dust to settle, a couple of things seem clear. The economically sensitive stocks fell out of favor this week, on the perception the economy will suffer from the banking debacle.  While perceptions aren’t always reality, in the stock market they often can be more important. At the same time, areas perceived to be immune to such problems were the winners – growth stocks turned to defensive stocks.  And clearly, bigger was better.  The economy won’t fall apart, so stocks like Grainger (681) and Parker Hannifin (314) will recover, as the dust settles.  Gold caught a bid finally, and that “safe haven” Bitcoin did as well.

Frank D. Gretz

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US Strategy Weekly: The Ides of March

The famous soothsayer warning of “beware the Ides of March” to Julius Caesar in Shakespeare’s play of the same name, could be fitting advice for today. In Roman times, March 15 was a day of religious observances and a deadline for settling debts, but it will always be famous as the date of Julius Caesar’s assassination. Wall Street has adopted this phrase because equity performance in the first half of March often begins in a promising way but ends on a weak note. This year a mid-March alert is interesting because it comes at the intersection of February employment statistics, the consumer and producer inflation reports, three bank failures and an important FOMC meeting, among other things.

Bank Failures

However, it is the bank failures that have captured all of the media’s attention. It began with the cryptocurrency-focused Silvergate Bank (holding company Silvergate Capital Corporation SI – $2.21) which announced early in March that it would be forced to liquidate due to large losses in its loan portfolio. On March 10, Silicon Valley Bank (holding company SVB Financial Group SIVB – $106.04), which concentrated its business on technology startup companies and venture capitalists, was seized by regulators to abort a run on the bank. Both of these banks were California-based banks. Signature Bank (SBNY – $70.00*), a New York-based bank with sizeable business with cryptocurrency firms, was closed by regulators on March 12. None of these were small issues; in fact, the collapse of Silicon Valley Bank and Signature Bank marked the second- and third-largest bank failures in the history of the United States. However, all of these, and Silicon Valley Bank in particular, appear to be examples of poor risk management on many levels, and not similar to the 2008 banking crisis, in our view. Still, the risk of contagion still exists, and it could take weeks to understand all the fallout.

Nevertheless, we would like to point out that there were many important announcements taking place this week aside from Silicon Valley Bank. Credit Suisse Group AG (CS – $2.51) was forced to delay its annual report due to questions from the Securities and Exchange Commission. The report, eventually filed on March 14, confirmed there were financial control weaknesses in 2021 and 2022, and the company reported a loss of $8 billion for 2022. This was Credit Suisse’s largest loss since the 2008 financial crisis. Not surprisingly, customers continue to withdraw money from the bank. This is Switzerland’s second largest bank and one of nine global bulge bracket banks providing services in investment banking, private banking, and asset management.

Alaskan Oil

And in an unexpected turnaround, the Biden administration approved the ConocoPhillips (COP – $101.36) oil drilling project in Alaska’s North Slope on March 14. This $8 billion Willow project is expected to produce over 600 million barrels of petroleum over a 30-year period.

*March 10, 2023

The Rise of China

But the most important event of mid-March may have been that Chinese President Xi Jinping brokered a diplomatic truce between Saudi Arabia — a long-standing American ally — and Iran — a long-standing American antagonist. This deal will end seven years of estrangement between these two oil-producing countries, but more importantly, it signals a major increase in China’s influence in a region of the world where the US had been the main power broker. For Iran it eases the international isolation that the country has experienced for years and for Saudi Arabia, it creates more leverage in terms of negotiating with the Biden administration. In the longer run, this deal may prove to have a lasting impact on global politics or become a significant turning point. And it comes as Russia continues to bomb Ukraine and Russian fighter jets clip the propeller of an American spy drone flying over international air space in the Black Sea. The economic significance of all this is unknown at the moment, but we are watching the performance of the dollar. Dollar weakness could persist if the US is perceived to be weakening politically and economically. And a weak dollar makes imports more expensive, i.e., it is inflationary.   


Three bank failures will make next week’s FOMC meeting more interesting than anyone had anticipated. However, the announcement of the Federal Reserve’s lending program might give the Fed the flexibility it needs to raise rates 25 basis points next week. Under the Bank Term Funding Program (BTFP), the Fed will provide banks with one-year loans at the rate of a one-year overnight index swap (OIS) plus 10 basis points. Banks can use eligible government securities like Treasuries and agency mortgage-backed debt to guarantee the loans. And most importantly, the program values these at par rather than at mark-to-market. Selling Treasury bonds as rates were rising is what put pressure on Silicon Valley Bank. We do not expect the Fed to surprise the equity market, but to the extent that traders have already priced in a 25 basis points increase, the Fed is apt to take that opportunity and raise rates.

History shows that tightening cycles rarely end without the fed funds rate reaching at least 400 basis points above inflation. By these two standards, even if inflation falls to 3% YOY, which is optimistic, we should expect interest rates to move higher and stay high longer than expected. This is most likely to end in a recession. As we have often noted, whenever inflation reaches one standard deviation above the norm, or higher, a series of recessions have followed. One standard deviation above the norm is currently 6.5%. See page 6. In short, we believe investors should focus on defensive and recession-resistant stocks.

Technical Update

Our focus index is the Russell 2000 index this week due to its sizeable exposure to regional bank stocks. Currently, the index is rebounding from a very sharp decline; nonetheless, the overall pattern reveals the index is in a broad trading range. This is much in line with our long-term view. See page 9.

The 25-day up/down volume oscillator is negative 3.36 this week and has been in oversold territory for four consecutive trading days. This follows an eleven-day overbought reading that ended February 8. The February overbought reading was an indication of a shift from a bearish to a positive trend, or at least from bearish to neutral. However, this week’s return to oversold territory clearly defines the current market trend as neutral. See page 10. The 10-day average of daily new highs is 69 and new lows are 131 this week. This combination is now negative since new highs are less than 100 and new lows are above 100. The advance/decline line fell below the June low on September 22 and is currently 40,117 net advancing issues from its November 8, 2021 high. This collection of indicators has shifted from neutral to negative this week.

Gail Dudack

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US Strategy Weekly: If History is a Guide

Economic data has been a tale of two cities in recent months. And after reviewing the latest survey releases, it is clear one could build a case for or against an economic recession in the coming months. However, those arguing that current data is much too strong for a recession should remember that recessions are rarely visible at their onset and are notoriously acknowledged only in hindsight by the National Bureau of Economic Research (NBER).

In terms of data, February’s ISM non-manufacturing index fell 0.1 to 55.1 but remained well above the 49.2 reading in December when it was signaling a decline in economic activity. Five of the nine components deteriorated in February, but business activity declined from 60.4 to 56.3 and accounted for most of the decline. The manufacturing survey was below the 50 benchmark for the fourth consecutive month, yet the components of the index were mixed. The main manufacturing index rose to 47.7, up a notch from January’s 47.4 reading, which was the lowest reading since May 2020. Manufacturing production fell from 48.0 to 47.3 and prices paid rose 6.8 points to 51.3. See page 3.

In the non-manufacturing survey, new orders rebounded from January’s 60.4 to 62.6. In the manufacturing survey, new orders also rose strongly from 42.5 to 47.9, however, the index remained below the 50 benchmark which is a sign of declining economic activity. Employment indices were also mixed. In the non-manufacturing survey, employment rose from 50.0 to 54.0 representing an expansion, while in the manufacturing survey employment fell from 50.6 to 49.1, representing a contraction. In general, both surveys displayed an erratic slowdown in employment during the October to December period. See page 4.


Given the dramatic response of the equity and fixed income markets to Fed Chairman Jerome Powell’s testimony to Congress this week, it seems appropriate to repeat some of our historic charts on inflation and interest rates to see what history can disclose. In our view, a good deal of today’s statistics suggests a recession is ahead and possibly as soon as the second half of this year.

Over the last 80 years, whenever inflation has reached a standard deviation above the norm or greater — for the CPI this equates to a level of 6.5% or more – not one, but a series of recessions has followed. One could say it will be different this time, but we think that would be a high-risk judgment. From our perspective, the two negative quarters which appeared in early 2020 were the first, in what may become a series, of recessions. See page 5.

More importantly, monetary tightening cycles have rarely ended before the fed funds rate was at least 400 basis points above inflation, i.e., reaching a real fed funds yield of 4%. In other words, if inflation falls to 4% this year, a history of fed funds rate cycles suggests the fed funds rate should reach 8%. Clearly, this possibility has not been discounted by the market. But even if the current cycle is different and the economy is more interest rate sensitive than in prior cycles, we should still expect interest rates to move higher than 6% and stay high longer than expected. Unfortunately, this scenario is apt to end in a recession. See page 5.

On a happier note, debt levels in the financial, corporate, and household sectors are not as extreme as those seen in 2007 or at other economic peaks. From this standpoint, any future recession should be relatively mild.

Yield Curves

As already noted, Federal Reserve Chairman Powell’s hawkish testimony to Congress was a wake-up call for those believing interest rates were at or near a peak. And by the end of the trading session, as shorter-term yields soared, the closely watched inversion between yields in the two-year and 10-year Treasuries reached negative 103.1 basis points. It was the largest gap between short- and longer-term yields since September 1981. As a reminder, in September 1981 the economy was in the early months of a recession that would last until November 1982, becoming what was at that time the worst economic decline since the Great Depression. What history shows, and what is obvious in the charts on page 6, is that an inverted yield curve has always been followed by a recession. However, the lag time can be long. Equally important, recessions are always accompanied by an equity decline.


Despite the fact that inflation has declined from the June 2022 peak of 9.1% YOY to January’s 6.4% YOY pace, inflation remains historically high. February data will be released on March 14, and it will be closely followed. In our opinion, investors are underestimating the impact inflation has on equity valuation. A simple way of defining the negative relationship between inflation and PE multiples is expressed by what we call the rule of 23, formerly known as the rule of 21. Historically, if the sum of the S&P’s PE multiple and inflation exceeds 23, the market is extremely overvalued. This typically results in lower stock prices and lower PE multiples. After this week’s sell-off, we estimate the trailing PE of the S&P 500 to be 20.2 and the forward PE to be 21.8. A more optimistic earnings estimate of $220 for this year could bring the 12-month forward PE to 18X, nevertheless, this combination of PE multiples and an optimistic assumption of 4% for the CPI, still places equities at the very top of the fair value range. See page 7. 

On page 8 we show the inputs to the Rule of 23 to demonstrate that PE multiples are well above average despite the fact that inflation is also above average. Historically, double-digit inflation has resulted in single-digit PE multiples. And though the June inflation high of 9% did not reach double digits, it was high enough to put pressure on high PE stocks and in time this should result in PE multiples closer to the long-term average of 15.8 times. See page 8.

The relationship between the S&P price index and earnings is not perfect, but earnings cycles typically lead price cycles. This has been particularly true since 1990 and since 2008 the 5-year rate of change in earnings and the S&P price have been strongly correlated. At present both trends are decelerating, which explains why the next few quarterly earnings reports could be market-moving events. We do not see anything on the horizon that could trigger an acceleration in earnings growth, on the other hand, the persistent rise in interest rates could certainly be a headwind to earnings growth. Last, but far from least, higher inflation means higher interest rates, and at present, the yields on both Treasury bills and notes are close to or higher than the earnings yield on the S&P 500. This makes fixed income an attractive alternative to stocks for the first time since 2000. See page 9. In sum, we remain defensive and would emphasize stocks that are both inflation and recession resistant and/or have attractive dividend yields.

Gail Dudack

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One Thing Leads to Another… Or Does It? 

DJIA:  33003

One thing leads to another… or does it?  Inflation leads to Fed tightening, Fed tightening leads to an economic slowdown, and slowdowns lead to declining earnings – or do they?  Our take is that when it comes to the stock market, what we all know isn’t worth knowing – it’s already discounted.  Tom Lee of Fundstrat has done some work here and what he found is interesting.  The key is what the market did in the previous year, down in the case of 2022.  When earnings were up the following year, the market’s median gain was some 18%.  When earnings were down in the following year, the market’s median gain was 15%.  So earnings didn’t prove an issue even when poor – seems they were discounted by the previous year’s weakness.

We can make the case for a new bull market, though not exactly your father’s bull market.  To buy into this case you have to realize the bear market ended last June, not last October.  Sure the low in the averages was last October, but most stocks made their lows in May-June.  So the October low is what technical analysts call a secondary low, a lower low in the averages but one with less selling pressure – clearly the case when looking at 12-month new lows.  Since then we’ve been in some form of base building, punctuated by the selloff in October and the buying spurt in January.  While we can’t always remember what we had for lunch, we recall pretty well the pattern of most bear markets.  Last year pretty much duplicated 1962, while this year is off to a good start, much like 1963.

January‘s momentum surge was impressive, with a variety of positive implications for future returns.  It did, however, serve to get things a bit overcooked – the near 50% surge in Cathie Wood’s ARK Innovation ETF (ARKK-39) being a prime example of speculative fervor.  After all, the fundamentals of these stocks didn’t change that much in a month. Rather, after a bad year short covering and the end of tax loss selling seen the likely impetus, as well as down the most turning to up the most in rallies.  Most of those names, whatever their financial credentials might be, are tied to their stay-at-home world.  You may want to write this down – things change.  Meanwhile, most of Oil was up big last year, in large part because it was under-owned.  To that point, how much Parker Hannifin (355) or Grainger (684) do you own?

Grainger is a chart we particularly like, and that for two reasons.  Back on February 2 the stock had a price gap – a low that was higher than the previous day’s high.  It takes a lot of buying to cause a price gap, making it our favorite chart pattern.  Gaps of course usually leave patterns somewhat extended, so some consolidation was to be expected.  In Grainger‘s case it has been a very high-level consolidation, with the stock giving up very little.  Yet to happen is the breakout from this pattern.  And that would take place with a move above roughly 680, preferably with a pickup in volume.  Another gap just a few days ago was in Nvidia (233). While a strong pattern, keep in mind a sideways consolidation is preferable to any real pullback, awaiting the eventual follow-through.

The idea of a trading range it’s not so much of a prediction as it is an observation.  The S&P is around 4000, a level where it traded in May, September, and December.  A difference now is the S&P has traded in an uptrend since October, and broke its overall downtrend in December.  The pattern in 1963 was similar, a trading range but with enough of an upper bias to end the year 18 percent higher.  While just about everything is stalled for now, the question as always is what comes out of this as leadership.  We still like the economically sensitive names we’ve mentioned recently, Aerospace and Defense ETFs, XAR (120) and ITA (171), and the Global Infrastructure ETF (PAVE-30) – though components like United Rentals (471) and H&E Equipment Services (55) actually look a bit better.  We would still avoid most of FANG, though META (175) looks betta.

Frank D. Gretz

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US Strategy Weekly: Unraveling the Fed Pivot Theory

Last week was a busy time for economic releases and unfortunately, the data was not favorable for those looking for a Fed pivot. The middle of the week was dominated by the release of minutes from February’s FOMC meeting, and it revealed that a few participants favored a 50-basis point increase. All board members were in favor of continuing rate increases in order to reach their target of inflation of 2% but some members wanted to get to a restrictive stance more quickly. The minutes also disclosed that Fed officials felt wage growth of 3.5% YOY would be compatible with a 2% inflation target.

But Friday’s economic releases showed that personal income rose 6.4% YOY in January and disposable income rose 8.4% YOY. The big surprise, however, was that real personal disposable income rose 2.8% YOY in the month — the first gain in real personal disposable income since March 2021! January’s CPI was already reported to be 6.4% YOY, so this gain in personal income closed a 21-month gap between inflation and income growth. See page 3. The savings rate also ratcheted up from 4.5% to 4.7% in the first month of the year. This data was better than expected.

While personal income rose 6.4% YOY, personal consumption expenditures rose 7.9% YOY, up nicely from the 7.5% reported in December but down considerably from the stimulus-driven peak rate of 30% YOY in April 2021. However, current household consumption is coming at a price. The Federal Reserve’s Z.1 report for the third quarter of 2022 showed that debt as a percentage of disposable income rose to nearly 103%, the highest level recorded since the end of 2017. See page 4.

Household Debt on the Rise

According to the Federal Reserve of NY’s latest Quarterly Report on Household Debt and Credit, total household debt rose $394 billion, or 2.4%, to $16.9 trillion in the final quarter of 2022. The $394 billion growth in the fourth quarter represented the largest nominal quarterly increase in twenty years according to the FRBNY. The $16.9 trillion total at the end of 4Q 2022 represented a year-over-year gain of 8.5%, the highest pace of debt accumulation since the first quarter of 2008.

Still, credit card balances were the most worrisome segment of debt. Credit card balances rose by $61 billion, the largest increase in FRBNY data going back to 1999. For all of 2022, credit card debt surged by $130 billion, also the largest annual growth in balances. After two years of historically low delinquency rates, the share of debt transitioning into delinquency increased for nearly all debt types. See charts on page 5. Unfortunately, credit card delinquencies are rising the fastest among 18 to 29-year-olds as compared to all age categories. This may become an even greater problem as interest rates rise.

Mortgages and auto loans grew at a relatively moderate pace in the fourth quarter. Mortgage balances rose to $11.92 trillion; auto loans rose to $1.55 trillion, and student loan balances rose to $1.60 trillion.

All in all, the increase in credit card debt and other revolving forms of credit will be unsustainable in a rising interest rate environment and consumption is apt to slow later in the year. But generally, most of January’s data releases pointed to a surge in economic activity. For example, January included an increase in new home sales to 670,000 (SAAR), an 8.1% rise in the pending home sale index to 82.5, and an increase in the University of Michigan consumer sentiment index from 64.0 to 67 in February. This sentiment index was offset a bit by the Conference Board consumer confidence index, also for February, which slipped from 106.0 to 102.9. Nevertheless, the present condition component of the Conference Board survey increased from 151.1 to 152.8.

The Fed Problem

Last week’s final straw was the report on the Fed’s favorite inflation benchmark, the PCE deflator, which rose by 0.1% in January to 5.4%. This aligns with the CPI which had inflation picking up at the start of the year. The combination of good economic statistics and no significant slowdown in prices sent interest rates higher all along the yield curve. Conversely, stocks fell. The decline in equities is understandable. As we show on page 6, the gap between inflation and the fed funds rate has been narrowing, particularly versus the PCE deflator. But without a further slowdown in inflation, the prospects for higher interest rates will become open-ended. With an effective fed funds rate of 4.57% and the PCE deflator of 5.4%, this 100-basis point gap implies more than two 25-basis point hikes will be required in coming months. And if the Fed is serious about attaining a positive real fed funds rate, it could be even more.

The ISM manufacturing and service surveys will be released this week, but in general, there is little in terms of important economic reports until the February employment report scheduled for March 11. In the meantime, investors will continue to ponder earnings reports and the FOMC meeting on March 21-22, 2023.  

Technical Update

Last week we discussed the 2000 level in the Russell 2000 index and its importance. The RUT has been a leader in the recent advance and the 2000 level was the first significant level of resistance. In our view, the 2000 level would be an important test of the strength of the rally. Unfortunately, to date, this level has rebuffed the advance.

Now our attention shifts from the Russell 2000 to the S&P 500 and its confluence of moving averages, but in particular, the 200-day moving average at SPX 3940. This is an important level of support, and if broken, it could trigger further selling in our view. The SPX’s 200-day moving average currently sits between the 50-day moving average at 3,979.23 and the 100-day moving average at 3919.32, creating a significant range of support between SPX 3919 and 3979. If this range does not hold as support, we would expect the optimism that increased during the January rally will dissipate.

Summary As we noted a few weeks ago, the easy part of the rally may be behind us. Our view calls for a broad trading range until inflation is clearly under control. As seen by January’s data, this process could take another 12 to 18 months. Historically, the popular stock indices have spent 50% of the time in flat trends, so this is not unusual. We expect the broad indices will be contained between the January 3, 2022 SPX high of 4796.56 and the October 12, 2022 low of SPX 3577.03. If we are correct about a trading range market, leadership may rotate throughout the year. But note, while “flat” cycles are unable to sustain an advance above the previous market peak, they can include several bull and bear market moves of 20% or more. In short, the days of a “buy and hold” strategy may have ended for a while. Core holdings in portfolios should include inflation and recession resistant companies and stocks with attractive dividend yields and predictable earnings growth.

Gail Dudack

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