US Strategy Weekly: All Icing, No Cake

If you are focusing on the recent gains in the S&P 500 and the Nasdaq Composite index, you might think a major equity rally is underway. However, with the exception of seven technology stocks, the S&P 500 is unchanged this year as seen by the SPX equal-weighted index which is down 0.35% year-to-date. Viewed another way, the Nasdaq Composite is up 24% year-to-date, while the Dow Jones Industrial Average is down 0.3%. Our favorite index for monitoring the market is the small-cap Russell 2000 index which is up 0.3%, or essentially flat. In short, the 2023 stock market is all icing, no cake.

Most of the recent excitement in the stock market comes down to one stock — Nvidia Corp. (NVDA – $401.11) – up 30% in the last three trading sessions as a result of the billions of dollars expected to be invested in artificial intelligence in coming years. We have no doubt that there will be a lot of investment dollars directed at AI in the years ahead, but a mania seems to be the best description of the action in NVDA this week.


And there are other interesting market trends that should be noted. A recent Wall Street Journal article titled U.S. Stock Market Stays Calm With Help From Quant Buying, suggests that the equity market remains calm in the face of the debt-ceiling debate due to demand from quant funds. The article states: “At the end of March, quant-focused hedge funds held about $1.13 trillion in assets, according to research firm HFR, hovering just below last year’s record high. That represents about 29% of all hedge-fund assets.”

“It’s rules-based trading,” said Charlie McElligott, a managing director at Nomura Securities International. “There’s no emotion involved.” Data from McElligott shows quants tend to move together quickly when volatility strikes. Take, for example, the stock market selloff of May 2019, when the S&P 500 slid some 7% as investors panicked about U.S.-China trade tensions. McElligott estimates that CTAs unloaded $35 billion worth of equities over the course of a month.”

However, rather than being a calming influence on the equity market, we believe this concentration of quantitative investments could prove to be risky down the road. It is reminiscent of another memorable event in equity history – Volmageddon — which is a blend of the words volatility and Armageddon. Volmageddon refers to the unusual activity that occurred on February 5, 2018. On this day, after about a year of rising stock prices and low stock market price volatility, the CBOE Volatility Index (VIX – 17.46) soared from an opening value of 18.44 to 37.32 at close. Unfortunately, the low volatility that characterized the 2017 stock market had generated huge demand in leveraged short volatility trades, especially in the Velocity Shares Daily Inverse VIX Short-Term note, whose ticker was XIV. The XIV (no longer traded) shrank from $1.9 billion in assets to $63 million in one day due to the jump in the VIX. The SPX only fell 5% on February 5, 2018, but February 5, 2018 proved to be just the beginning of a volatile year that ended in a large December sell-off, a 6.2% decline in the SPX and a 12.2% loss in the Russell 2000 index.

In short, this big increase in quant-based investment can have a calming impact on equity prices today, but if sentiment changes, it can also trigger a lot of volatility, illiquidity, and serious damage to stock prices in the future. In sum, we would not chase this rally and remain focused on recession resistant stocks with predictable earnings streams.

Economics review

After hitting cyclical lows in June or July of 2022 and rebounding to 12-month highs in February 2023, both the University of Michigan and the Conference Board sentiment surveys dropped in the month of May. The declines were across the board including the overall index, present conditions, and future expectations. May employment will be reported on Friday, and it will be interesting to see if these declines in sentiment are a leading indicator of job market weakness. See page 3.

June’s FOMC meeting is only two weeks away. Another month of inflation data will be available in early June, but April’s inflation data could support another rate hike. Both headline and core CPI were relatively unchanged at 4.9% YOY and 5.5%, respectively. Service sector inflation fell from 7.3% to 6.8%, services less rent fell from 6.1% to 5.2%, services less medical care fell from 8% to 7.6%, while other services rose from 4.4% to 4.7%. Nevertheless, all service sector inflation data remains high and well above the Fed’s 2% target. See page 4.  

However, small declines in inflation are helping households. April’s personal income rose 5.4% and CPI rose 4.9% which means real personal income is improving. Moreover, disposable income rose nearly 8% as tax payments fell and this produced a 3.4% YOY gain in real disposable income. April became the fourth consecutive monthly gain seen in real personal disposable income. See page 5. Personal consumption expenditures (PCE) rose 6.7% in April. Although expenditures are positive on a year-over-year basis, there are clear signs of deceleration in all categories including durable goods, nondurable goods, and services. See page 6. 

Several financial commentators have stated that the current savings rate is “average”, but this is far from accurate. The current savings rate of 4.1% compares to the historical average of 8.8% or the 22-year average of 6.6%. In short, savings are well below average. And while the savings rate did soar to 33.8% in April 2020 as a result of pandemic stimulus checks, that buffer has been depleted. Therefore, it is not surprising that personal consumption expenditures are also decelerating. See page 7. 

Retail sales rose a mere 0.15% YOY in April and real retail sales fell 3.2% YOY. Much of this was due to a decline in auto sales which fell 5.8% in the month and 3.4% YOY. However, a lack of motor vehicle inventory has hampered auto sales due to supply chain disruptions; but auto sales face a new hurdle from rising interest rates which will increase the cost of leases and auto loans. See page 8.

Technical Indicators The charts of the S&P 500, DJIA, and Nasdaq Composite are technically positive, but the SPX and DJIA failed to better critical resistance at SPX 4,200 and DJIA 34,500. The Nasdaq bettered the 12,500 resistance, but this was due primarily to Nvidia Corp. (NVDA – $401.11). The Russell 2000 remains our favorite guide for the broader marketplace and it remains well within a defined range with support at 1,650 and resistance at 2000. See page 12. The 10-day average of daily new highs is 94 and new lows are 109, making this combination negative since new highs are below 100 and new lows are above 100. See page 14. With the debt ceiling vote still incomplete, the Russian/Ukraine conflict escalating, Chinese GDP expected to slow from the first quarter’s 4.5%, Friday’s job report, and the FOMC meeting on June 14, there are many ways sentiment could change. Note that there was renewed weakness in crude oil and gasoline prices this week which implies fear of an economic slowdown may be increasing. We remain cautious.  

Gail Dudack

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A Yogi Berra Market… Not Over Until It’s Over

DJIA:  32,764

A Yogi Berra market… not over until it’s over.  Without question this is the most divergent market we’ve seen in some time.  That everyone seems to get it doesn’t make it less so.  And seeing it also doesn’t make its negative implication less so.  Narrow markets are a reflection of the liquidity and its decline.  There isn’t enough to push up as many stocks as there once was.  This shows up in the A/D Index, the Equal Weight S&P, and perhaps most clearly in stocks above the 200-day, a decent proxy for stocks in uptrends.  Currently around 40%, it’s down from 74% in February but it’s relative.  The S&P now is higher than it was in February, meaning the performance gap between big cap stocks and the average stock has significantly widened.  This kind of divergence doesn’t end well.  Still, there’s no magic timing or levels here, it can go on until it doesn’t.

History has its examples of markets like this outlasting the naysayers, 1972 and 1999–2000 being prime examples.  Both had their themes, 1972 the Nifty 50, and 2000 of course the Dot-com’s.  What is often forgotten about both, and especially the Dot-com period, was how poorly everything else performed.  During this market phase it wasn’t just that only the Dot-coms were going up, the rest of the market was not only not going up, it was going down.  This past Monday we thought we were back there again – Pepsi (184), down five points and Tech up, the Dow down more than 150 points. and the NAZ up 50 points.  Back in 2000 everyone saw the divergence to the point they named it “old economy” versus “new economy,” which is beginning to look familiar.  Still, the divergence went on, the NAZ continued higher though the Dow did not. 

In these diverging markets, at least one of the major Averages moves higher – the Dow in 1972, the NAZ in 2000.   The leaders, the few, drive the Averages, in this case the NAZ.  The insidious part of this is that it offers hope for the rest, the poor, the downtrodden, the huddled masses – the Equal Weight S&P.  The history isn’t promising here, likely because the liquidity just isn’t there to pull up the rest.   It’s not just that the leaders lead, in this case Tech, it’s pretty much them and little else.  AI no doubt will change the world just as Cisco (49) did back in 1999–2000, when it sold for 80 and change, roughly double where it has sold since then.   On the plus side, just like the Nifty 50 and the Dot-com’s in their day, there’s money to be made in this market, provided of course you’re pretty much focused on Tech.

After that diatribe on Tech, we should point out a couple of other areas acting better.  The Saudi‘s have said don’t short oil, which would be interesting if you thought you could believe anything the Saudi’s say.  We do believe price action, however, and USO (64) seems about to cross above its 50-day, which should drag equities higher as well.  The other area to come alive recently is Biotech, though not the Amgen‘s (217) and other household names.  If you look at the iShares ETF (IBB-127), it’s market cap-weighted whereas the Equal Weight SPDR (XBI-84) shows a much different and better picture.  Unlike the overall market, here small seems better, perhaps anticipating more consolidation.  You might also look to the Ark ETF (ARKG-31) which has a number of positive charts.

The Kabuki dance that is the debt ceiling negotiations has put a damper on the market, and rightly so.  The odds of an unfavorable outcome are low, but so too are the odds of an unfavorable outcome in Russian roulette.  In both cases, the consequences of a losing outcome are severe.  The good news is that good news should be met with a make-up rally, and then we can get back to normal worries like the Fed’s next move, employment numbers, and the mess in banking.  Although we’ve been doing this for a while now, we really don’t recall a stock more loved than Nvidia (380), and apparently rightly so.  Not to rain on a parade that should continue, we’re always reminded that stocks are pieces of paper, not companies.  Overloved stocks become over owned stocks, and eventually who’s left to buy?  But there’s that word again, eventually.  The A/Ds, you might have noticed, were almost 2-to-1 down and the Equal Weight S&P unchanged amidst Thursday’s euphoria.    

Frank D. Gretz

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Buy the S&P or Sell the S&P… Yes!  

DJIA:  33,535

Buy the S&P or sell the S&P… Yes!  And you thought we couldn’t take hedging to a new level.  There is, of course, the S&P Index and it is pretty much the benchmark for the world.  The other S&P to which we are referring is the so-called Equal Weight S&P, where all stocks are created equal by market cap.  In this case equal isn’t such a good thing since it’s the larger cap stocks that are in favor.  These dominate the Averages by virtue of their market weight construction.  If you’re thinking Tech for the most part you ‘re right, but don’t forget a few names like McDonald’s (294).  The distinction between these two measures of the S&P these days is a bit dramatic.  The Index has traded in a range since mid-April, just below the early February high.  The Equal Weight Index by contrast is below its April peak which, in turn, is below the January peak.  It’s a narrow market favoring the big.

Good markets always have their leadership, and that leadership by definition outperforms and like now sometimes significantly so.  It’s not something to lose sleep over, some stocks will always be better than others and the better tend to dominate.  So when 5 or 10 stocks account for most of the gain in the S&P, it happens.  When it’s a problem is when the rest of the Index isn’t following – when the rest of the Index is moving down.   Measures like the Advance-Decline Index and stocks above the 200-day average show this as well.  Stocks above their 200-day are hovering around 40% while the averages dance around their highs, a rather dramatic discrepancy.  We wish we could say there’s some magic number here, but there is not.  We can say the many eventually drag down the few, but the key word here might well be eventually.

They like to call this market a trading range, but which market?  The NASDAQ certainly isn’t a trading range, even the Composite let alone the NDX.  The Russell 2000 has been in a trading range since its mid-March low, but that range is well down from its earlier February high.  The S&P has been range bound of late, but well up from the March low, which in turn was up from the December low.  If you look at the series higher lows from last October, it’s an uptrend.  The problem is the average stock is different.  NASDAQ A/Ds made a new low not long ago.  If the NAZ is literally 100 stocks, let’s further refine it to 10 via the Micro Sectors FANG Plus Index, FNGU (133).   It’s clear what’s working, and you have to be careful with the rest.  When the Averages are doing well, it’s easy to hope the others will come along, but you know what they say about hope as an investment strategy.

So why can’t the few drag up the many?  In theory we suppose they could, it just never seems to work that way.  The explanation here we suspect is sideline buying power – there isn’t enough to continue to push up all stocks, just enough to push up strong stocks and eventually not even enough for them.  Sideline buying power or liquidity is only restored in an eventual market correction.  Meanwhile, enjoy it while you can.  These diverging markets can last for a while, including through 1972 and 1999.  There was money to be made as long as you were in the Nifty 50 or the Dot-com’s.  The leaders will be the last to give it up as will the big-cap beverages they include.  There’s an old Wall Street story about a wonderful party, everyone was having a good time and no one wanted to leave, yet they knew it would end – but the clock had no hands.

The Advance-Decline Index is another proxy for the average stock versus the stock averages. It peaked in early February, had a lower peak in mid-April, and a pattern of lower peaks since then.  In other words, it’s very similar to the unweighted S&P, and other measures showing the bifurcation.  Recently, however, the A/D numbers have been mixed.  We have long pointed out it’s not bad down days but bad up days that cause problems.  Recently we saw a day with the Dow basically unchanged and 700 net declining issues – not a good day.  Then there was a modestly up day with 1300 net advancing issues.  Given how selective the market has been we are almost surprised the numbers haven’t been worse.  That said you don’t want to see them become worse.  Those up days with poor A/Ds are a warning. 

Frank D. Gretz

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US Strategy Weekly: Take Your Pick

Economic Mish Mash

One could build a case today for either a strong or weak economy based on recent data releases or from financial headlines. And it could be difficult to say who is right or wrong. In terms of economic strength, financial headlines noted that the US consumer is strong and resilient as seen by April’s total retail sales which rose 0.4%, the second month-to-month increase in the last six months. Industrial production increased 0.2% YOY in April led by a 16% YOY increase in auto and truck production. In terms of housing, the NAHB/Wells Fargo Housing Market Index (HMI) rose to 55 in May, a 10-month high. This NAHB survey of homebuilders is designed to take the pulse of the single-family housing market and it appears that housing may be on the mend. In general, economic activity appears healthy.

However, if one unpacks the April retail sales data it is easy to see that total retail & food services rose 1.6% on a year-over-year basis, a deceleration from the 2.4% YOY gain seen in March. Moreover, this 1.6% YOY increase was well below the level of inflation, which rose 4.9% YOY in April. In other words, real retail sales are negative and are decelerating which does not suggest the consumer is improving. In addition, a deceleration in sales implies corporate margins could be squeezed as consumption declines. What was notable in April’s report is that the standout segment of retail sales was, and continues to be, food services and drinking places, which rose 8.3% YOY before adjustments and 9.4% YOY after seasonal adjustments. See page 3. But in our view, this is not a broadly encouraging picture for an economy that is consumer driven.

Plus, offsetting the nice rebound in homebuilder sentiment was the University of Michigan consumer sentiment index for May. The headline consumer sentiment index tumbled to 57.7 from 63.5 in April. The decline was led by expectations, which fell a sizeable 7.1 points to 53.4. Current conditions also fell 3.7 points and as a result, each component is in recessionary territory. See page 5. In our view, the University of Michigan sentiment indices could be a warning for the homebuilders, since this survey is for May and the homebuilder survey was for April.

In terms of being either strong or weak, inflation data for April was also a tale of two cities. Headline CPI was 4.9% YOY in April, down only slightly from 5% in March. Core CPI was 5.5%, nearly unchanged from the 5.6% reported in March. More importantly, core service CPI was 6.8% versus 7.1% in March and remains stubbornly high.

The producer price index data was much the same. PPI for finished goods was 2.6%, down from 3% in March and final demand PPI was 2.4%, down from 2.8% in March. However, final demand PPI for the service sector was 3%, up from the 2.8% reported in March. Core PPI was also down from the 6.4% YOY pace seen in March, but it nonetheless remains high at 5.4% YOY. See page 4.

The importance of the stubbornly high inflation seen in the service sector is that it gives the FOMC a reason to worry about the embedded inflation in the economy, and to possibly raise rates again in June. This has not been the consensus view, but it has been something that several Federal Reserve governors have hinted at in recent discussions.

Earnings and Valuation

As earning season nears completion, and with over 91% of the S&P 500 companies having reported results, the S&P Dow Jones consensus estimates for 2023 and 2024 are $218.86 and $244.26, which rose $1.15 and fell $0.59, respectively, this week. Refinitiv IBES earnings estimates for 2023 and 2024 are $220.09 and $245.83, falling $0.78 and $0.60, respectively. See page 7.

We match our historic estimates to the S&P Dow Jones estimates since they have the longest historical database and because S&P is careful to see that estimates are uniform and reflect GAAP standards. [GD1] Nevertheless, our 2023 forecast of $180 for the S&P 500 is currently well below both the S&P Dow Jones consensus estimate of $218.86 and the IBES Refinitiv consensus estimate of $220.09. But this does not change the basic valuation standing of the market.

On page 6 we show two versions of our valuation model, one with the S&P Dow Jones estimate of $218.86 for this year and one with our $180 forecast. Surprisingly, there is little difference between these various estimates in terms of whether the equity market is currently overvalued, fairly valued, or undervalued. With both estimates, equities were overvalued prior to the surge in inflation in 2021 and became even more overvalued as interest rates rose in the last twelve months. The only difference is how much the fair value range increases, or not, by the end of the year. In both cases, our other model inputs for 2023 include an inflation target of 3.6% at year end and a fed funds target of 5.25%. We can envision scenarios in which inflation is better or worse in the second half of the year, but we believe our estimates are relatively sensible.

Still, the bottom line is that the equity market appears quite overvalued at current prices when using both the S&P estimates and our forecast. The main difference is that with S&P estimates the midpoint for the 2023 year-end fair value range rises from the year-end level of SPX 2700 to SPX 3235. Using DRG estimates, the midpoint of the fair value range falls from the year-end level of SPX 2700 to SPX 2660. We may be too pessimistic in our earnings estimate; but it is worth pointing out that even with the S&P estimates of an 11% increase in earnings this year and a 12% increase next year, coupled with inflation falling to 2.4% by the end of 2024, our model shows the midpoint of the fair value range to be SPX 3860 at the end of 2024.

In sum, this exercise shows that many things would have to go much better than expected for the stock market to move significantly higher from current levels. This is one of the reasons we remain cautious and would focus on companies and stocks with the most predictable earnings and reliable dividend payouts.

Technical Update

The charts of the S& P 500, Dow Jones Industrial Average, and Nasdaq Composite are technically positive, but each has failed to better critical resistance just above current prices. These levels are: SPX 4,200; DJIA 34,500; and Nasdaq 12,500. The Russell 2000 remains our favorite guide for the broader marketplace since it remains well within a defined range with support at 1,650 and resistance at 2000. See page 9. The 25-day up/down volume oscillator fell to a negative 1.99 reading this week but it is still in neutral territory. The oscillator recorded one-day overbought readings of 3.0 or higher on April 18, April 24, and April 28, but was unable to maintain an overbought reading on a rally. These failed overbought readings revealed a weakness in underlying buying pressure, i.e., demand. See page 10.  

Gail Dudack

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Go Big… Or Go Home

DJIA:  33,309

Go big… or go home.  Well, you don’t have to go home, but if you don’t go big you probably want to go to the sidelines.  The ratio of small-cap stocks to large-cap stocks has tumbled to a multiyear low.  This proved a warning sign in 2007, but other years not so much.  Of course, it does speak to where you want to be in this market, if not specific stocks or groups.  It’s as simple as Microsoft (310) and McDonald’s (295), one sells burgers and one sells software but that’s not what matters – they’re big.  It has been a while since we thought of the FANGs as a group, but we have recently.  They have a few things in common as well.  And like Apple (174) and Microsoft, the FANGs have almost taken on the mantle of defensive.  This narrowing in the market rarely ends well, but clearly it has yet to end.

Whatever happened to that China reopening, the one that hopefully was supposed to lift all ships.  A look at Oil pretty much tells you that didn’t happen.  And China itself again seems to be in trouble.  China had a tough time last year, and Tech especially amidst a storm of political controversy.  Shares cratered into October, but in doing so created some noteworthy technical extremes.  The subsequent rally into January was impressive, but since then selling has resumed.  At the time nearly every Tech share was above its 50-day average, but since has fallen to fewer than 7%, according to  Looking at stocks above the 200-day, more than 95% had recovered to that level, but a couple of weeks later fewer than 30% were holding there.  While Chinese stocks clearly have suffered, they probably haven’t reached an extreme that would suggest the high probability of a durable rebound.

When they’re worried about their bank deposits for goodness sake, this should be a more than decent backdrop for Gold.  While there’s only so many bars you can bury in your backyard, there are ample opportunities here including many old fashion mutual funds.  Or, if you’re feeling pretentious, you can always stuff a couple Krugerrands in those penny loafers.  Perhaps the most compelling argument for Gold is what seems an important peak in the dollar, and what seems an imminent further break.  We are always uncomfortable when stocks or markets have an opportunity to go up but fail to do so.  The stocks have done nothing wrong in terms of their patterns, but we didn’t buy them to have them do nothing wrong.  And we sometimes find that if you give charts doing nothing wrong enough time, they will do something wrong.  Realistically, time sometimes takes time and in this case they may need that break in the dollar.  For GDX (34) a move above 36 should extend the uptrend.

Semiconductor stocks were not created equal, and certainly not equal to Nvidia (286), or even AMD (97).  Indeed, to look at the SMH ETF (123) over the last six weeks they haven’t been so wonderful, even dropping modestly below their 50-day average.  This hasn’t been in every case just a drift as the gap lower in Qualcomm (104) a week ago makes clear.  As a key supplier to Apple, it left some surprised at that company’s report.  Skyworks (97) is another whose disappointment resulted in a gap, and there are others.  The point being like the Averages the strength in the Semis is the result of a few, while others have shown surprising weakness.  One of those few is AMD which itself did show some weakness last week.  The break and subsequent sharp recovery, breaking the late march downtrend, in this case has left it with a dynamic looking pattern.

There was nothing in April’s numbers to suggest the Fed should feel it has to keep raising, nothing to suggest they should start cutting.  The futures may be pricing in the latter, but be careful what you wish for here.  The only easy path to easing is if something goes wrong, and something going wrong wouldn’t be good for stocks.  The going wrong, of course, looks to be the Banks and other Financials generally.  Rather than going away, the banking issue seems to feed on itself, or is that why it’s called contagion.  We find it amusing that it’s still about blaming the short sellers rather than the reason for the short selling – the bankers.  Stocks above the 200-day have been hovering around 40% recently, but it’s relative.  With the big-cap Averages hovering around their highs, it’s a big negative. Certainly this number can drift lower as the big-cap dominated Averages continue higher, but you might want to recall the “nifty 50” or the “dot-com” days.  Narrowing or diverging markets eventually end poorly.

Frank D. Gretz

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US Strategy Weekly: Inflation, Recession, and Earnings Math

At the May meeting of the Economics Club of New York, the New York Federal Reserve President John Williams said it is too early to say if the central bank is done raising interest rates. He added that “officials have not yet decided what lies ahead in terms of possible increases in short-term borrowing costs and if more action is needed policymakers won’t hold back.” This is not in line with the consensus which shows a 78% chance that the Fed is likely to pause rate increases at the June meeting. More importantly, fed futures now reflect a 45% chance that interest rates will actually be cut 25 basis points at the September meeting.

Keep in mind that while FOMC just raised the fed funds rate 25 basis points last week and the next FOMC meeting is only five weeks away on June 13-14. Nevertheless, we believe there is a good chance that the consensus could be disappointed, and the Fed could raise interest rates again. This explains why the CPI and PPI data reported this week will be so important. It could have a big impact on sentiment.

Inflation Math

Yet from a purely mathematical perspective, the peak rate of inflation of 9.1% was recorded in June of last year, and this means it could, or should, be easier for the year-over-year inflation rate to move steadily down as we approach mid-year. When we checked our database, we found that if the headline seasonally adjusted CPI data remained unchanged on a monthly basis for April, May, and for June, headline inflation would fall to 2.4%. This would be a very pleasant surprise for most economists. Either way, new inflation data will be crucial in the coming months.

But first, it will be important to see what headline and core inflation were in April and if there is any moderation in service sector pricing. Inflation data for May will be reported prior to the June FOMC meeting, which means the Fed governors will have several new data points on inflation before their next meeting.

The controversy surrounding the May FOMC meeting was whether the Federal Reserve should raise interest rates in the wake of a banking crisis. However, the crisis appears to be fading. Loans on the Fed’s balance sheet rose by $339 billion at the onset of the March banking crisis, but loans have been on the decline and by early May fell $36.4 billion from the March 22 peak of $354.2 billion. From a broader perspective, the Fed’s total balance sheet has been contracting, which means that quantitative tightening has been reinstated. This is good news since it lowers the risk of inflation in the broad economy, nevertheless, it does remove the positive bias that quantitative easing has for equities. See page 3.

Recession Math

April payrolls increased by 253,000 and the unemployment rate fell 0.1% to 3.39%. This decline in the unemployment rate now matches the low last seen in 1969, or 54 years ago! This robust growth in jobs and a historically low unemployment rate reflect a resilient job market and unfortunately for the Fed, a strong job market will only make its inflation goals more difficult to achieve. The bottom line is that it adds credence to the possibility of another rate hike in June.

Rising interest rates usually increase the risk of a future recession, however, there is another interesting math equation worth pointing out about recessions. The data series we have found to be the best lead indicator of a recession is a year-over-year decline in total employment. In fact, in the eleven recessions recorded since 1950, each was immediately preceded by a decline in total employment. Given that job growth has been robust, the US economy does not appear to be at risk of slipping into a recessionary state in the near future. However, this may also be one reason the Fed will continue to raise rates further than expected. The strong job market should give them a safety blanket, at least in the near term. See page 4.

On the other hand, small business owners are not optimistic about their future. The NFIB optimism index slipped to 89 in April. This was the 16th consecutive month below the long-term average of 98 and it leaves the index at levels typically associated with a recession. Twenty-four percent of business owners indicated that labor quality was the top business problem. Inflation was in second place by one point at 23%. Plans for capex, employment, or to increase inventories have been declining for much of the last twelve months. Expectations for real sales, economic improvement, and better credit conditions also fell in April. See page 5.

Earnings Math

The economy may not be on the brink of a recession, but earnings are already experiencing their own recession. According to IBES, first quarter earnings for this year are currently $438.1 billion, down 0.7% YOY and down 0.4% month-over-month. This marks the second consecutive quarter of negative growth. Earnings declines are expected to continue into the next quarter when estimates suggest a 4.7% YOY decline. See page 7.

Using S&P Dow Jones earnings estimates on a 12-month trailing basis, earnings turned negative in April. When looking at reported earnings, the 12-month trailing earnings stream has been negative since October 2022, i.e., for the last two quarters. See page 6. In short, while the job market may not suggest a recession is in sight, earnings are already experiencing a recession. This is apt to continue since the consumer and small businesses have been crippled by high inflation and rising interest rates this year. All in all, this explains why the stock market has been stuck in a trading range for most of the last twelve months. See page 10.

Technical Roundup

The charts of the S&P 500, Dow Jones Industrial Average, and the Nasdaq Composite are all technically positive, but each faces a critical level of resistance near current levels. These levels are SPX 4,200; DJIA 34,500; and Nasdaq 12,500. The Russell 2000 remains our favorite guide for the market since it remains well within a defined range with support at 1,650 and resistance at the 2000 level. It is worth noting that the Russell 2000 has been underperforming the larger capitalization indices and this is a cause for concern. And even though the index is moving toward the bottom of its range, we remain cautious. Our main near-term concern centers on our lack of faith that the debt ceiling negotiations in Washington DC will be done in good faith and if we are right, it will have a negative impact on the dollar and the securities markets. Most other technical indicators are neutral and inconclusive. The 25-day up/down volume oscillator is at negative 0.62 this week. This is in neutral range, but only after being unsuccessful at sustaining an overbought reading. In sum, we remain cautious and continue to focus on recession-resistant stocks where both earnings and/or dividends are most predictable.

Gail Dudack

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Follow the Soldiers … Not the Generals

DJIA:  33,127

Follow the soldiers … not the generals.  In the stock market the average stock is often likened to the soldiers, the big-cap stocks that dominate the averages the generals.  Where the analogy breaks down is that in the stock market, it’s the soldiers that lead.  It may not always appear that way, but when all is well with Microsoft (305) and the like, it doesn’t mean all is well.  In reality, of late there has been distribution under the guise of strength in the averages.  The Advance-Decline Index is a reasonable proxy for the soldiers, the average stock, and that Index peaked in early February.  An easier and similar look is the percent of stocks above their 200-day average, the equivalent of looking at stocks in medium-term uptrends.  This measure peaked at 74% in February, while the April peak was only 49%.  As the S&P and NASDAQ touched highs on Monday, the number was down to 43%.

This is the anatomy of a market peak.  When markets diverge like this, the averages versus the average stock, it doesn’t end well.  Market lows are characterized by big volume and volatility.  Stocks become washed out and make lows pretty much all together.  Market peaks are almost the opposite.  Stocks tend to peak a few at a time or a group and a time – market peaks are a process.  As buying power is depleted, it’s typically the smaller or secondary stocks that give it up first.  It’s the bigger stocks that hold up.  Since these dominate the averages, the averages hold up as well.  This creates the divergences between the averages and measures like the A/D Index and stocks above their 200-day.  It’s tempting to think or hope the averages will drag up the rest, but it doesn’t work that way.  These divergences are about depleted sideline cash, and that’s typically only restored in a correction.

If market peaks are a process that eventually gets around to everything, this includes the big-caps that dominate the averages.  The key word here, of course, is eventually.  You do have to be careful of falling into the trap of thinking these are immune, thinking the few will drag up the many.  History is not on that side.  Meanwhile, there is a bull market in stocks that can only be called defensive – Staples and Healthcare.  It’s easy to think of this as temporary, as just another sign of a weak market and investors seeking shelter from the storm.  While there has to be some of that, it’s not quite that simple.  If you look at many of the long-term charts here, charts of Hershey (275), Lilly (429), Merck (117), Mondelez (77), Pepsi (193) and McDonald’s (295), you’re not exactly hiding out here.  In a really weak market these won’t be immune, but these are stocks you should be comfortable owning in any market.

Seems prudent to be more cautious here, perhaps considerably more cautious.  It’s not every day you see Regional Banks down 10-15% while the same day Brent falls 5%.  If caution seems sage advice, it’s also vague advice.  Regional Banks may be cheap and they may survive, that’s not a reason buy them.  At the risk of dancing on the dark side of funnymentals, their road to profitability seems more than a little difficult.  Ironically they’re likely to be hiring staff – to deal with those new regulations.  It also seems a good time to let go of those “hope stocks,” stocks like Zoom Video (62) where you’re still hoping it will get back to 600.  This seems the case when it comes to all of the stay-at-home stocks.  Bubbles may come and go, but when they go they stay gone.

Some time ago something went wrong in the office, and someone said blame the temp.  Amusingly, it was the temp who said it and who though innocent, didn’t run away from responsibility.  It’s somewhat amusing then that the weakness in bank shares to some extent is being blamed on short sellers.  In his little diatribe the other day Powell reassured us the banks are “sound and resilient,” though any need to reassure somewhat defeats the purpose.  It’s interesting that amongst the Fed there never seems a dissenter – apparently they don’t get out much.  The recent backdrop of course is hospitable to Gold, but we would argue the uptrends here have been well-established.  And we would further argue news often comes along to explain what the charts already were seeing.  Meanwhile, the dollar seems about to break, which would only reinforce Gold’s longevity.

Frank D. Gretz

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US Strategy Weekly: Banks, the Fed and Inflation

Bank Turmoil

Equity investors turned cautious ahead of this week’s FOMC meeting and we are not surprised. For one thing, regional banks continue to be under pressure despite the fact that over the weekend, in a relatively smooth transition, the FDIC stepped in, seized control of First Republic Bank, and sold its assets to JPMorgan Chase & Co. (JPM – $138.92). Yet, this buyout is no guarantee that the banking industry has stabilized. In fact, the stocks of many regional banks continue to suffer from intense selling pressure. There are multiple reasons for this.

Even though the 2023 banking crisis has been managed relatively well so far, it is not a “small event.” The three US banks that collapsed this year (First Republic, Silicon Valley Bank, and Signature Bank of New York) had more combined assets under management than all 25 federally insured lenders that failed in 2008. According to the New York Times, this year’s three failed banks held a massive $532 billion in total assets versus the $526 billion in combined assets of the 25 banks with FDIC insurance that failed in 2008.

Meanwhile, deposits continue to leave the banking industry. In the twelve months ending in late April, commercial bank deposits fell by $960 billion, with $464.0 billion exiting the banking system since the early March banking crisis. And unfortunately, it is questionable if the banking system has stabilized since loans in the Fed’s new Bank Term Funding Program rose to a new high of $81.3 billion on April 26, 2023. This is a sign of illiquidity in the system. At the same time, the Fed’s balance sheet contracted $171 billion in the 5 weeks ended April 26, 2023. See page 3.

In short, the Fed has resumed its monetary tightening at the same time that money is leaving the banking system for higher yielding assets. Confirming this trend is data from Refinitiv Lipper which indicates that investors purchased a net $42.68 billion worth of money market funds in the week ending April 26, which makes the cumulative money market fund inflows for the year $427.4 billion.

And the commercial banking industry faces the risk of rising bad debts later in the year. The Wall Street Journal recently reported that a 22-story glass and stone tower at 350 California Street in San Francisco, worth about $300 billion in 2019, is now for sale and expected to see bids come in around $60 billion! More surprisingly, life-sciences buildings, typically less vulnerable to the remote-work movement since lab work requires specialized equipment and mechanical systems that can’t be replicated at home, are also coming under pressure. A deluge of new supply in industry hubs such as San Diego, South San Francisco, and the Boston-Cambridge region, is generating a rise in life-sciences vacancies, according to commercial real estate services firm CBRE Group. In short, we expect banking will continue to be under duress from a combination of dwindling deposits, an inverted yield curve, and potential defaults. And note, short-term interest rates have not yet reached their peak.

This week’s FOMC is expected to result in an additional 25-basis point increase in the fed funds rate to a range of 5.00% to 5.25%. However, important information will be found in whether the vote was unanimous for this rate hike or not, and whether or not the Fed’s comments suggest a pause in rates will follow the May increase. Equity investors expect the Fed to be more accommodating in the second half of the year, which means anything slightly hawkish in Chairman Jerome Powell’s comments would be a negative surprise for the market. We expect Chairman Powell will try to be as vague as possible about future monetary policy and will resort to being “data dependent.” And economic data is quite a mix at the moment. Keep in mind that the Fed’s meeting will be followed by expected rate increases by the European Central Bank on Thursday and the Bank of England next week, which means credit conditions are contracting globally. This means equity markets no longer have the wind at their back.

Economic Data Jumble

The March JOLTS report showed 9.6 million job openings, down 2.5 million over the last year and now at the lowest level since April 2021. In another sign that the labor market is cooling, the quits rate edged lower to 2.5%, the lowest point since February 2021.

GDP grew at 1.1% in the first quarter of the year, disappointing consensus expectations, but it is worth noting that personal consumption rose a fairly healthy 3.4%. It was the drag from inventories which contracted 2.3% that lowered GDP. See page 4.

However, the drag from inventories may not be over as seen in recent ISM data. The ISM manufacturing index rose from 46.3 to 47.1 in April but for the sixth consecutive month it remained below the 50 level that shows a contraction in activity. Nine of the 11 components rose in April, and surprisingly two of these, employment and prices paid rose above 50. This is not a good sign for the Fed since it is looking for weakness in both inflation and employment. The major drag on the April ISM index was inventories, which means second quarter GDP is starting on a weak note. See page 5. The ISM services index will be reported later this week.

Personal income rose 6% YOY in March and wages rose a more robust 7% YOY – a sign that wage inflation continues. But after being negative for 19 of the 21 months between April 2021 and December 2022, real personal disposable income increased 4% YOY in March for the third consecutive month this year. This shift is an indication of a gain in purchasing power and it is good news for the consumer. As a side note, March disposable income benefited from a 7.3% YOY decline in tax payments. The savings rate rose from 4.8% to 5.1% in the month and now exceeds $1 trillion. See page 6.

Personal consumption expenditures continue to increase on a year-over-year basis, but the trend is decelerating. Spending on services is highest with an 8% YOY increase, while nondurable spending is growing at a modest 2.6% pace. What surprised us in the data was that personal outlays rose 6.9% YOY in March whereas personal consumption expenditures rose only 6% YOY. Digging through the data we found that interest payments rose a stunning 52% YOY in March, which helps explain the differential. In other words, wages are rising, inflation is moderating, and real personal disposable income is improving. But at the same time, a steady increase in interest rates and interest expenses are eating up a good portion of these gains. In sum, higher interest rates are clearly hurting household consumption. See page 7.

Technical Update

The combination of falling crude oil and gasoline prices, coupled with the relatively positive performance of gold this week, implies that investors have become increasingly worried about a recession. The dollar has been stable in recent sessions despite its weakness since early March, but this is not surprising given that interest rates are expected to rise this week. See page 9.

This year’s equity gains have been concentrated in the most depressed stocks of 2022, the high PE growth stocks. And with interest rates headed higher this week it is not surprising that the April rally hit a roadblock. The Russell 2000 remains the best guide for what we believe is a trading range market as it trades between support at 1650 and resistance at 2000. See page 10. We would point out that the 10-day average of daily new highs is 87 and new lows are 87. This combination is neutral since neither new highs nor new lows are above 100; but the combination is also turning negative as the number of daily new highs declines. See page 12. Although we focused on the risk in the banking industry this week, the looming debt ceiling debate may be the biggest problem for investors in coming weeks. Friday’s employment report is another potential market-moving event. Plus, this is the biggest week for first quarter earnings reports. In the long run, it is valuation that will strengthen or weaken equity prices. We remain cautious.

Gail Dudack

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