US Strategy Weekly: Beware What You Wish For

US job openings in July dropped to the lowest level in nearly two and a half years and equity investors rejoiced. The news triggered a 292.69-point gain in the Dow Jones Industrial Average, carrying the index just 5.3% below its all-time high of 36,799.65 high and to a gain of 5.1% year-to-date. The JOLTS report also showed that the number of people quitting their jobs fell to the lowest level seen since early 2021, which implies jobholders feel that switching jobs has become more difficult. More importantly, the employment report for August will be released at the end of this week and it too could be a market-moving event, particularly if it confirms a below-consensus increase in jobs. However, we would be wary of being bullish about bad economic news since bad news inches the economy closer to a recession and a recession has never been good for corporate earnings or for equity prices.

We have often noted that high inflation has a debilitating impact on consumer purchasing power, corporate profit margins, and price-earnings multiples. It erodes the value of the dollar and of savings. In short, it is bad for all parts of the economy. And this is why we believe the Federal Reserve is likely to be more hawkish than dovish for all of 2023. In our opinion, the Fed understands that an inflation target of 2% will not be that easy to achieve without slowing the economy down. And while Fed Chairman Jerome Powell has danced around the question of whether a recession or no recession is part of the inflation solution, slowing inflation without a recession would be like threading a tiny needle … possible but difficult. 

History shows that whenever inflation has had a rapid rise or has been more than a standard deviation above the norm (6.5%+), like the 9% seen in June 2022, it has always been followed by a recession. A recession is most often the result of tighter monetary policy which has generally ended with a real fed funds rate of at least 400 basis points. Perhaps it will be “different this time” but that is a risky view, in our estimation. See the historical charts on page 3.

For the real fed funds rate to reach 400 basis points today, with a 3% inflation rate, means the fed funds rate would rise to 7%. We are not predicting a 7% rate, but we do believe the fed funds rate is likely to move higher in September and this would be a negative surprise to the consensus. It could also be a dampener to economic activity in the months ahead.

Is Bad News Good News?

In line with the JOLTS report, the regional Federal Reserve activity reports were a mixed bag. The Kansas City Fed Manufacturing Survey was at zero in August, but up from negative 11 in July. The Philadelphia Fed Nonmanufacturing Survey was negative 0.5 in August, down from 2.0 in July. The Richmond Fed Manufacturing Survey was negative 7.0 in August, up from negative 9.0 in July. The Chicago Fed National Activity Index was 0.12 in July, up from negative 0.33 in June. The Texas Manufacturing Outlook Survey was minus 17.2 in August, up from minus 20.0 in July. All in all, these surveys were not a recessionary package, but neither were they a sign of strength.

As interest rates rise the biggest impact may be seen in the housing and auto sectors, two areas that have been a source of strength since the pandemic. New home sales rose 4.4% in July to 714,000, an increase of 31.5% from a year earlier. The median price of a single-family home rose 4.8% in the month to $436,700, but this was down nearly 9% YOY. Home prices and sales have been relatively stable, but primarily due to a lack of inventory. The supply of existing family homes rose fractionally in July to 3.2 months, nevertheless, this is a historically low level. While low supply has been what has supported the residential market, we worry that demand may eventually fall as a result of high prices and interest rates. See page 4. Rising mortgage rates are already hurting housing affordability, which is currently at its lowest level since 1985. This is a concern since housing typically represents 15% to 18% of GDP. See page 5.

The auto industry is also hurt by higher prices and rising interest rates. The post-pandemic auto-buying surge is over, yet vehicle sales rose in July to 16.3 million units. See page 6. However, this remains well below 17-18 million units consistently seen between 2014 and 2020. Autos, along with housing, have been the most unwavering drivers of the US economy. We will be watching closely to see if higher financing rates slow auto sales.

Consumer sentiment can be a guiding indicator of the economy at both peaks and troughs, so it is worth noting that August’s deterioration in sentiment surveys follows months of steady improvement. The University of Michigan consumer sentiment index fell in August, dragged down by future expectations due in large part to rising gas prices. It was the first month-over-month decline since May for this survey. The Conference Board consumer confidence index fell from 114.0 to 106.1 in August as both present conditions and expectations fell significantly. See page 7. We had been hopeful that the improvement seen in real wages in recent months would give a boost to investor sentiment and consumption, however, we may have been too optimistic.

Important economic news will be released this week including the Fed’s favorite inflation benchmark, the personal consumption expenditure deflator. It will be released alongside personal income and real personal consumption for July. Pending home sales may give an insight into whether higher mortgage rates are taking a toll on home buyers. And the week ends on Friday with the employment report, the ISM manufacturing report, and vehicle sales for August. This should give good insight into economic activity and the health of the consumer.

Technical Indicators

The Dow Jones Industrial Average, the S&P 500 index, and the Nasdaq Composite index have all tested their 100-day moving averages and are rebounding. This is favorable. The Russell 2000 index tested its 200-day moving average and is also rebounding. We would rate these tests as tentatively positive; but even if successful, the longer-term pattern remains characteristic of a long-term neutral trading range. See page 9.

The 25-day up/down volume oscillator is at a negative 1.10 reading this week, relatively unchanged from a week ago, and at the lower end of its neutral range. This oscillator generated overbought readings in 10 of 22 trading sessions prior to August 1. However, none of these overbought readings lasted the minimum of five consecutive trading days required to confirm an advance in the averages. Strong rallies should also include at least one extremely overbought day which was also missing. However, it is also important to note that the recent rally did not generate new highs in the indices. In short, the recent rally is, to date, an advance within a larger neutral trading range. That is what this indicator has been implying for over twelve months. In our view, this trading range is a substitute for a bear market, and it is likely to persist until inflation is under control and/or earnings growth becomes more predictable and stable.

Gail Dudack

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If it’s a Low … Is it an Uptrend? 

DJIA:  34,099

If it’s a low … is it an uptrend?  They may seem the same, but they are not always so.  By historical standards a low should be close – bull market corrections typically fall in the 6% range.  The S&P has taken out its 50-day, as have most of the Averages, but this says little more than we are in a correction phase.  What does seem consequential is that the S&P had remained above its 50-day for close to 100 days. This sort of trend doesn’t happen in bear markets.  When the trend does end, on average the correction again tends to be about 6%.  We don’t really like data like this because often there’s “always something.”  Suffice it to say for now the weakness seems normal, if there is such a thing.  The rub comes in the new uptrend.  After breaking the 50-day sorting things out typically takes a month or so, new highs usually come a couple months later.  Even market lows can be a process.  

Banking may be a fine profession, it’s the bankers that give us trouble.  If not lending to Third World countries, or to see-through office buildings, they’re trying to rig LIBOR.  For now it’s the Regionals that are between a rock and a hard place.  They’re caught in the equivalent strategy of buying High, selling Low, and making it up on volume – a strategy we’ve tried with stocks from time to time.  Of course it’s not like rising rates were a big secret, and isn’t rate stuff what banks do?  What is done is done but not without some implications for the overall market.  There are a lot of banks and that has implications for market breadth, that is, the A/D Index.  It also helps explain why the Russell 2000, what we call love among the rejects, acts as badly as it does.  It’s 20% Regionals.

One non-reject in the Russell happens to be its largest holding, Super Micro Computer (263).  By our calculation, back in early August SMCI had outperformed Nvidia (472) year-to-date, then came the collapse – a 50-point downside gap, followed by an additional 50-point decline.  In Tech land, things sometimes change fast.  And things seem to be changing yet again. You can argue the overall uptrend was never threatened, and it was a much-needed correction, as they like to say.  What seems important in the here and now is the stock has re-taken the 50-day.  Buying stocks in overall or long-term uptrends is best.  When they correct, however, you never know.  Best to buy some if you must, and the rest when they retake the 50-day.

Tech gets all the attention, rightly so since they are what got us here, bull market-wise.  It is a bit ironic, however, that with the exception of Nvidia few Techs have been above their 50-day recently.  Meanwhile, the seemingly forgotten Oil shares have cycled from fewer than 15% above their 200-day to more than 90%.  This kind of momentum change has resulted in higher prices more than 80% of the time.  Then there are the unscathed, the stocks which have come through the correction with little or no damage.  Everyone likes to buy bargains, but often the stocks that give up little are those that lead in the next phase of rally.  We’re thinking here of stocks like Quanta (201), Eaton (221), Ingersoll (68) and Roper (489).  In Tech, Arista (179) has a pattern we particularly like – gap up and a high-level consolidation.

That Thursday was a “sell on the news day” was not completely surprising.  If more than just that it would be surprising, and not good.  We’ve been waiting for the market to ignore bad news, and there have been hopeful signs.  For sure, good markets don’t ignore good news.  Wednesday’s 3-to-1 up day, the first in more than a month, also was encouraging.  However, one day is just that, what is needed is a pattern of better A/Ds, especially on those days when the Averages are up.  Stocks aren’t cheap, rates are rising and Powell’s speech at this time last year took the market down some 19%.  A recovery is not guaranteed, but despite Thursday seems likely.  The S&P’s duration above the 50-day suggests this remains a bull market correction.

Frank D. Gretz

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US Strategy Weekly: Fed Minutes – Inflation is Unacceptably High

Fitch downgraded its credit rating for long-term US government securities from AAA to AA+ on August 1, 2023, citing an erosion of fiscal governance and rising general government deficits. Moody’s cut the ratings on 10 mid-sized lenders on August 8th. The Fitch Ratings service warned of a downgrade on more than a dozen banks on August 15th and S&P Global Rating downgraded five regional banks on August 21st, focusing on lenders with commercial real estate exposure. All these rating agencies indicated that some banks face a future risk to their balance sheets due to potential bad debts in the commercial real estate area, but all banks are dealing with liquidity pressure since many portfolios are drawing interest income of 2.5% to 4.5%, while needing to pay depositors 4.5% to 5.5% in savings and money market accounts. This may seem like an isolated problem within the banking sector, but it is not. Although there is no immediate crisis in the banking sector, there are strains in the system that are likely to continue longer than some expect. More importantly, the US economy cannot do well if the banking sector is not doing well. It never has. So, in our view, with this backdrop, it is not surprising that stock prices have been in a correction in August.

Trading Ranges Defined

The last year has produced a series of issues that have chastened both optimists and pessimists. From a longer-term perspective, the last 18 months have been frustrating for both the bulls and the bears. Our long-held view is that the stock market is in a broad sideways trading range, best defined by the Russell 2000 between support at 1650 and resistance at the 2000 level. The other indices have less obvious trading ranges, although it is clear that price action has been contained by resistance at the January 2022 peaks and support at the October 2022 lows.

Long-term trading ranges are not unique in equity history, but they have not materialized in a while. Since the March 2009 low, equities have been in a relatively consistent uptrend. In short, for most of the last 14 years, stock prices have been “trending” and as result, new investors might be unfamiliar with rallies that have limited leadership and declines that lack follow through. However, trading ranges are not unusual, and in our view the current trading range is a substitute for a more dramatic bear market.

Classic bear markets are often triggered by an unexpected event that shakes investors’ confidence and this event becomes the catalyst for an unforeseen earnings decline. A dramatic bear market ensues and produces a relatively sudden but quick repricing of risk. A trading range is simply another way of repricing risk and can be a subtle substitute for a bear market.

In the current environment, a trading range is a way for earnings to catch up with prices. Earnings for the S&P 500 declined on a year-over-year basis during the second, third, and fourth quarters of last year. Earnings are now expected to grow modestly from these much-reduced levels; nevertheless, the outlook for earnings growth remains uncertain.

If we look at S&P Dow Jones operating earnings data, it shows that the four-quarter sum in earnings peaked in March 2022 at $210.16. The S&P Dow Jones consensus estimates show that four-quarter earnings could reach a new high by the end of the 2023 third-quarter earnings season, with earnings of $212.89. However, these are estimates and data shows essentially no earnings growth for most of 2022 and 2023. In sum, prices moved higher in 2023, but the fundamentals did not. The recent trading range is a way for earnings to eventually catch up with stock prices. In our view, the catalyst needed for stocks to break out of this trading range is for the Fed to successfully tame inflation and this will take more time. In the interim, we believe focusing on stocks with reliable earnings streams and reasonable PE multiples will be the best way of managing through this environment. 

FOMC September 20

One reason to believe the Federal Reserve will keep interest rates higher for longer is that they were so late to address the inflation problem. As seen on page 3, in previous cycles, the fed funds rate typically increased ahead of, or in line with, the level of inflation. In this cycle, the Fed was 12 to 18 months behind the inflationary trend, and this allowed inflation to become ingrained in the service sector. Since service sector inflation is less commodity driven and more salary driven, it is more difficult for the Fed to control. It also explains the Fed’s attention to service sector inflation. Meanwhile, it is important to note that the real fed funds rate usually reaches 400 basis points in a tightening cycle, and though the real rate has been rising, it is now only at 230 basis points. In short, we believe another rate hike is likely on September 20 and we do not believe this is discounted in stock prices.

The path of interest rates is important to the economy since it will impact both the auto industry (see page 4) and the residential housing market. The National Association of Home Builder Confidence index fell from 56 to 50 in August, which is not surprising, since the June NAR Housing Affordability index fell from 93.7 to 87.8, the lowest level since January 1984. This decline in affordability was before the Fed’s July rate hike! The June decline was attributed to a combination of median family income ratcheting down to $91,319, the median price of a single-family home rising to $416,000 and the NAR mortgage rate increasing 28 basis points to 6.79%. See page 5.

Although the housing market has been in a slump for almost two years, it is possible that housing is about to slow further as interest rates rise and remain high. This risk can be seen in the fact that both existing and new home prices have stopped increasing and in recent months have registered year-over-year declines. Also interesting is the fact that home prices and retail sales have been highly correlated over the last 60 years, and both appear to be on the cusp of a negative cycle. See page 7. Some may think that these are reasons for the Fed to pause, but underlying these risks are a tight labor market and wage growth that recently has exceeded the pace of inflation. We believe the Fed will remain higher for longer in order to be confident that inflation will reach its target of 2%. 

Technical Update

As a result of the recent weakness in the equity market, all the popular indices are currently trading below their 50-day moving averages and are about to test their 100-day moving averages. However, the Russell 2000, is about to test its 200-day moving average which is now at 1843. We would not be surprised if all these moving averages were broken in the near term since this would be typical of a long-term neutral trading range environment. See page 9. 

The 25-day up/down volume oscillator is at negative 2.05 this week, which is at the bottom of the neutral range. It is close to registering an oversold reading of negative 3.0 or less, which would neutralize the recent unsustained overbought readings. Meanwhile, the 10-day average of daily new highs is 54 and new lows are 111. This combination turned negative this week since new highs fell below 100 and new lows rose above 100. All of the above is normal for a trading range market.

Gail Dudack

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The Correction…

DJIA:  34,413

The correction has been more than expected – or perhaps just different than expected.  While just a few percent in the S&P, it has hit the seemingly unstoppable Tech the hardest.  Best to be wary when they start giving things a name – one-decision stocks, dot-com’s, Magnificent Seven.  What’s done is done – now a couple things need to change.  Good markets ignore bad news, this market has ignored some market friendly news – the Jobs number, and more recently the CPI.  The market has to start ignoring bad news.  More importantly, the spate of recent days with the Dow up and the A/D’s flat or down needs to not only change, it needs to reverse.  More than any level in the Averages, what’s needed is a sign of a buying interest, a couple of days with 3-to-1 up.

Frank D. Gretz

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US Strategy Weekly: Global Banking Sector Angst

In last week’s US Strategy Weekly (Things to Ponder; August 8, 2023), we wrote “we do believe the recent rally is fragile since it has been driven by the new consensus view that the economy will have a soft landing or no landing. This view is coupled with the belief that there is no interest rate hike in September. We think the Fed will hike in September, unless economic data becomes very weak in the interim. What is clear is that this week’s CPI and PPI reports will be center stage and could be market moving.” In truth, there was not a big reaction to last week’s CPI report. See page 3. But the PPI report, which showed intermediate service sector inflation rose from June’s 4.4% YOY to 4.6% YOY, seemed to make investors anxious. And in a market priced for perfection, any unpleasant or unexpected news will make equities vulnerable.

There were a few other developments this week. Chinese economic reports for industrial production, retail sales, and property investment were weaker than expected. More importantly, the combination of this data reflected an economy that is potentially faltering. The PBOC responded by lowering key interest rates by 15 basis points. Yet the real concern is China’s real estate sector, which is estimated to represent as much as 30% of China’s GDP, and which has already weathered a string of defaults by residential property developers. This week the focus is on Country Garden Holdings Co. Ltd. (2007.HK: 0.81), a giant Chinese real estate developer that is expected to deliver nearly a million apartments in hundreds of cities throughout China. Unfortunately, Country Garden has not been paying its bills, indicated it would report a loss of as much as $7.6 billion in the first six months of the year, and in August skipped two interest payments on loans. A default is possible in September. The big concern is the exposure of China’s $3 trillion shadow banking sector to this potential real estate risk, as well as the risk to the broader Chinese economy.

Separately, Russia’s central bank raised its key interest rate from 8.5% to 12% to help stop the slide in its currency which has lost more than a third of its value since the beginning of the year. The ruble passed 101 to the US dollar earlier this week and continues to weaken due to capital outflows, big government spending on the Ukraine war, and a shrinking current account surplus as a result of Western sanctions on Russian oil and gas. Inflation reached 7.6% over the past three months, and according to Russia’s central bank, inflation is expected to keep rising, noting that the fall in the ruble is adding to the inflation risk.

Closer to home the Fitch Ratings service warned that the agency could downgrade more than a dozen banks, including some major Wall Street lenders. Fitch already lowered the score of the “operating environment” for banks to AA- from AA at the end of June – although this went largely unnoticed. And Fitch’s warning comes weeks after Moody’s cut the ratings of 10 mid-sized lenders, citing funding risks, weaker profitability, and increased risk from the commercial real estate sector.

Retail Sales

Advance estimates for July retail sales showed a month-to-month gain of 0.7% and the May and June estimates were revised from up 0.2% to up 0.3%. This acceleration in retail sales concerned investors who had been expecting a Fed pause, since economic momentum opens the door for a rate hike in September. On a seasonally adjusted basis, retail sales rose 3.2% YOY in July; on a non-seasonally adjusted basis, sales were up 2.5% YOY. However, when adjusting for inflation, real retail & food service sales, based on 1982 dollars, fell 0.1% YOY. See page 5. In other words, despite a month-to-month acceleration in sales, real YOY retail sales declined and have been negative for nine of the last 10 months. This pattern is a classic sign of an economic recession, not strength. See page 6.

Historically, a negative trend in retail sales is tied in with a decline in nominal GDP and that is true in this cycle as well. On page 7 we show a table that highlights, in red, all the months since January 1968 that have experienced below average retail sales. This table is important because a string of below average sales has always defined a recession and negative real retail sales in any year has also characterized recessions. The current string of “red” is the longest since 2008-2009, and to date, real retail sales are averaging negative 1.3% in 2023. Nonetheless, GDP continues to grow. It is uncanny. Still, we would not describe July’s retail sales report as strong.

However, one reason to believe the Fed will keep interest rates higher for longer is that they were so late to address the inflation problem. As seen on page 4, the fed funds rate typically increases ahead of, or in line with, the level of inflation. In this cycle, the Fed was 12 to 18 months behind the inflationary trend. This suggests more work needs to be done. Moreover, while the real fed funds rate has increased to 200+ basis points, it usually reaches 400 basis points in a tightening cycle.


The second quarter earnings season is close to ending and as is usual, retail stocks are the last to report. Home Depot Inc. (HD – $332.14) beat the consensus estimate for quarterly earnings per share, and though same-store sales fell 2% YOY this was less than the expected 3.5% decline. The company announced a $15 billion share repurchase program and it reiterated its muted forecast for the year. The company noted caution on the part of consumers towards big-ticket items. Walmart Inc. (WMT – $159.18) is expected to raise its full-year earnings forecast this week when it reports quarterly results. A research report by Stifel, Nicolaus & Company estimates more people plan to shop at Walmart compared to Costco and Target, even though they expect to spend 16% less on back-to-school purchases compared to a year ago. Retail is a sector of winners and losers in this environment.

All in all, earnings season has gone better than expected and the S&P Dow Jones consensus estimates for 2023 and 2024 are currently $219.41 and $244.06, up $2.31, and $1.00, respectively. Refinitiv IBES estimates for 2023 and 2024 are $219.09 and $245.55 up $0.41, and down $0.25, respectively. What is notable is that S&P Dow Jones and Refinitiv IBES are both showing a $219 estimate for this year. These two surveys tend to diverge in the second half of the year. Nevertheless, based on this year’s earnings estimate of $219.41, equities remain overvalued with a PE of 20.2 times. The 12-month forward operating earnings PE is 19.0 times, and the December 2024 PE is 18.1 times. When we add inflation of 3.2% to these PE multiples, we get 23.2, 22.2, and 21.2. All of these sums hover just under the 23.8 range that defines an extremely overvalued equity market. This is what explains the market’s nervousness.

Technicals are Slipping

The S&P 500, Nasdaq Composite, and Russell 2000 are all trading below their 50-day moving averages, a key level for some traders. However, the RUT, a useful benchmark for the last 18 months, failed to break above the 2000 resistance level in July, implying that the recent rally was simply part of a much larger neutral trading range. See page 9. The 25-day up/down volume oscillator is at a negative 0.51 reading this week and neutral. The oscillator generated overbought readings in 10 of 22 trading sessions ending August 1, but failed to remain overbought for the minimum of five consecutive trading days required to confirm the advance. This week the 10-day average of daily new highs fell to 88 and new lows rose to 75. This combination turned positive on June 8 when new highs rose above 100 and new lows fell below 100 but it turned neutral this week with both averages now below 100. In short, upside momentum appears broken.

Gail Dudack

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It’s Like Playing Russian Roulette with an Automatic Weapon

DJIA:  35,176

It’s like playing Russian Roulette with an automatic weapon.  That’s the look of these Tech stocks when they report.  If you believe, as we do, the market makes the news, this isn’t exactly what you’d like to see.  Then, too, it’s hard to be surprised they should be vulnerable.  Even Nvidia (424) broached it’s 50-day on Wednesday, a level perhaps too obvious.  For Tech overall, it has cycled from an oversold to overbought level in terms of its 200-day, but to a degree which suggests higher prices into year-end.  The caveat is first a pause like we’re seeing now. Meanwhile, stocks like Eaton (217) and Emerson (96) are consolidating after gapping higher.  United Rentals (482) looks particularly positive, and don’t forget Oil.

Frank D. Gretz

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US Strategy Weekly: Things to Ponder

More Credit Rating Risks

Last week Fitch stunned the financial sector with its downgrade of US Treasury debt. This week Moody’s surprised investors by cutting credit ratings on 10 small- to mid-sized US banks. In addition, Moody’s put six banking giants, including Bank of New York Mellon (BK – $45.72), U.S. Bancorp (USB – $40.23), State Street Corp. (STT – $72.73) and Truist Financial Corp. (TFC – $32.41), on review for potential downgrades. Moody’s indicated there is no immediate crisis, but “banks will find it harder to make money as interest rates remain high, funding costs climb, and a recession looms. Some lenders’ exposure to commercial real estate is a concern.”

Several financial analysts suggested these warnings were unwarranted, however, rating agencies are paid to point out risks and there is no doubt that an unbridled federal debt burden is a long-term hazard, particularly as interest rates rise. For most banks an inverted yield curve combined with the potential of commercial real estate defaults are real risks that should not be ignored.

Although stocks sold off on both credit rating warnings, the pushback from some analysts and even the Biden administration are more disturbing to us than the actual agency warnings. The gains in equity prices this year have been primarily multiple expansion, not earnings gains. According to IBES Refinitiv, earnings in the last two quarters of 2022 and first quarter of this year were 4.4%, negative 3.2%, and 0.1%, respectively, and estimates for calendar 2023 show an S&P 500 earnings growth rate of a measly 1.2%. According to S&P Dow Jones, the last three quarters of 2022 had year-over-year declines in earnings, and though a modest rebound in growth is forecasted for coming quarters, it is coming from a diminished earnings base. Perhaps this lack of earnings power is why investors are flocking into generative AI stocks and looking far into the future for earnings growth. But after massive price gains, these stocks now have extremely high PE multiples and even fans feel the stocks are richly valued.

Things to Ponder

There are three things that we often wonder about although they are not part of our official forecast. The first is a risk that the stock market is on the verge of a bona fide bubble. This thought emanates from the excitement surrounding generative AI, estimates that the AI market will grow to $126.5 billion by 2031, and the massive runup that these stocks have had. AI has created a two-tiered market with the Nasdaq Composite up 33% year-to-date while the DJIA is up only 6.5%. This divergent price action is very reminiscent of the Nifty Fifty era that led to the January 11, 1973 peak and the Dot-com bubble era that ended on January 14, 2000. We have also thought about the fact that there were 27 years between those two market bubble peaks, and we are now 23 years past the 2000 peak. Since bubbles tend to be generational, we are in the right time frame to be on the lookout for a bubble. And the pattern we see of analysts ignoring fundamentals only adds to this worry.

Second, is the fact that bullishness is now consensus and the bears on Wall Street have been converted. Many sentiment indicators, particularly the AAII sentiment indices, are showing extremes last seen between February and May of 2021. The stock market did not peak until January of 2022; however, this is how sentiment indicators work. Sentiment are not timing indicators, rather they tend to be early warnings systems and only point out that risks are rising. See page 13.

Our last consideration is COVID, and the global pandemic it sparked. COVID resulted in an unprecedented manmade global recession in 2020 produced by many government leaders who decided to shut down their economies. It was not a normal economic recession. The subsequent recovery was also unusual, manmade, and manufactured with monetary and fiscal stimulus. This fiscal stimulus continues to drive many segments of the US economy to this day. History is often an excellent guide for economists and equity strategists, but there is no rule book for what has transpired over the last three years. Therefore, perhaps the typical signals of a recession such as an inverted yield curve, the 15-month decline in the Conference Board’s Leading Economic Index (the longest streak of decreases since 2007-2008), and the 7 months of negative real retail sales, are not applicable today. This seems strange to us. Nonetheless, the years of monetary and fiscal stimulus have kept the US economy afloat and it also provides the liquidity that could set off a stock market bubble. Thus, we ponder and worry. However, we do believe the recent rally is fragile since it has been driven by the new consensus view that the economy will have a soft landing or no landing. This view is coupled with the belief that there is no interest rate hike in September. We think the Fed will hike in September, unless economic data becomes very weak in the interim. What is clear is that this week’s CPI and PPI reports will be center stage and could be market moving.

Household Debt: the Good and the Bad

Total household debt rose by $16 billion in the three months ended in June and increased $909 billion in the prior 12 months. In short, household debt rose 5.6% YOY in June versus the 7.6% YOY increase seen in March. Of the $909 billion increase, $627 billion (or 69%) was in mortgages and $144 billion (or 16%) was in credit card debt. Credit card debt grew 16.2% YOY in June exceeding $1 trillion for the first time. As a result, credit card debt now represents 6.0% of total debt versus 5.5% a year earlier. See page 4.

A broader look at household debt shows that debt grew fairly rapidly in 2021 and 2022 but grew at a slower pace in 2023. A large part of the increase in household debt occurred in the under-40 age group and was likely linked with a period of significant increases in new credit card accounts. Note that the 2021-2022 period overlaps with the moratorium on student loan payments and a healthy trend in personal consumption. While the number of credit card accounts grew, the number of outstanding auto loans, mortgages and HELOC loans remained fairly stable in the same period. See page 5.

The good news in household debt data is that delinquencies have not had much of an increase from the low recorded last year. However, there are two big changes on the horizon. First is the massive increase in financing rates seen for revolving credit lines over the last year. This will make credit card debt less viable for many households. Second, the end of the moratorium on student loan payments which begins in October will also reduce liquidity for some households, particularly for middle class borrowers. See page 6.

Fundamentals The current S&P 500 trailing PE multiple is 21.5 times and above all historical averages; in short, the market is priced for perfection. The forward PE is 19.3 times, and when added to inflation of 3%, sums to 22.3, which is just below the standard deviation line of 23.8 denoting an overvalued equity market. In sum, earnings growth is pivotal to the market’s intermediate and longer-term trends. See page 8.

Gail Dudack

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Sometimes It’s Not About What the Market Does

DJIA:  35,215

Sometimes it’s not about what the market does … it’s about what the market doesn’t do.  These days most stocks go up, and that has been key to the uptrend’s longevity.  Last Thursday was an exception, when despite the Meta (313) news most stocks reversed to close lower by a margin of almost 3-to-1.  We would not have been surprised to see some follow-through the next day, despite the benign inflation number.  Instead, the market retraced most of the previous day’s loss, including in the A/D numbers.  After Thursday’s poor action, Friday easily could’ve seen what we call a weak rally – up in the Averages but poor breadth.  While this speaks to the market’s strength, we may be in for another health check this week.  Tuesday’s positive Dow against A/Ds that were 2-to-1 to the downside is not what you like to see.

Divergences between the DJIA and the A/Ds lead to problems/corrections.  They can but don’t usually happen overnight.  In late 2018 The Dow saw three consecutive days of higher highs against three days of negative A/Ds, and the market quickly fell 20%.  For some reason they like to compare this market to 87, though technically they’re completely different. In 87 the A/Ds peaked in March, and there was a pattern of higher highs in the Dow against a pattern of lower highs in the A/Ds going into the October Crash.  Divergences mean markets have narrowed.  Markets narrow when there’s less sideline cash/buying power.  When that happens the large-cap stocks that dominate the Averages are the last to give it up, which offers hope for the laggards.  You know what they say about hope as an investment strategy.  While all of this is a sort of playbook for a market top, the market recently has broadened, and has too much momentum for important problems.

The upside momentum we have seen in this market brings to mind a trading system which has worked particularly well recently.  The system calls for being long or short at the start of each month, depending on whether the S&P the previous month was up or down, respectively.  Recently that would have meant going long at the end of March and capturing some 500 S&P points by the end of July.  While the system does work, it’s unusual to have the S&P up for five consecutive months.  And to the point of momentum, all streaks end but this kind of momentum doesn’t go away in a hurry.  Another way you might have captured this momentum run is through moving averages. The S&P crossed above its 50-day moving average in early April and has remained above it ever since.  A word of warning about “systems,” they all have their flaws, mainly whipsaws.  And then there’s human nature.  There are good trading systems, but few good systems traders.

Sentiment or investor psychology is often taken just as contrary thinking.  While there is a big part of that in these indicators, that’s very much an oversimplification.  A Wall Street Journal article recently cited an array of indicators suggesting sentiment is over the top.  Those include the AAII Survey, the University of Michigan Survey, P/C Ratios and a disappearing VIX.  How should we put it, investors aren’t stupid.  They would have to be to not be bullish/positive in a market like this.  Our favorite quip about this is that investors are wrong at extremes, but right in between.  So just what is an extreme?  It’s when you’re sitting there wishing you had more money to invest, but you don’t.  Chances are you’re not alone, and tops are about the money.   When it comes to surveys we prefer Investors Intelligence, which is a measure of those drop-dead smart market letter writers.  The record here is a jump often results in a temporary pullback, but then a higher market more than 90% of the time.  

So when you catch a Sovereign downgrade you’re supposed to sell all your Tech?  Or was Tech a bit over-loved and looking for an excuse to correct?  Before this spate of weakness, did you notice how the rally ran in the shorts?  The shorts in this case were not just stocks like TUP (4) and TDOC (26), the shorts included every negative Strategist.  That’s the market, doing what he does best – confounding the most number of people.  Things change, nowhere more than in Bonds and the Dollar – not a good thing.  While not exactly a scientific survey, our take is there have been more surprises down than up, including among the good charts.  That’s not good for job security – in this case our own.  The Market has dug itself into a bit of a hole in terms of the poor recent A/Ds, so we’re likely in this correction phase for a while.

Frank D. Gretz

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US Strategy Weekly: Charges and Changes

Oh Fitch!

As we go to print, the US has formally charged former President Donald Trump with conspiracy to defraud the US, witness tampering, and conspiracy against the rights of citizens. Separately, the ratings agency Fitch downgraded the US government’s top credit rating to AA+ from AAA, citing three years of fiscal deterioration and a high and growing government debt burden. Globally, Russia announced that a drone hit a residential building in Moscow placing responsibility at the feet of Ukraine. A coup against Niger’s elected president is triggering evacuations of US and European partners and a Ukrainian official is alleging that Russia is responsible.

Of these events, the most important for US consumers and investors will be the downgrade of US government bonds. Rating changes can impact the demand for US government bonds at a time that the debt burden is high and the need to issue more debt becomes important. Higher interest rates are good for bondholders, but they also could negatively impact economic activity and PE multiples.

Great Economic News

However, equity investors are ignoring such threats and it is not surprising given the recent string of economic releases. It begins with the report that in the second quarter GDP grew 2.4% (SAAR) which was an increase from the 2.0% seen in the first quarter. In short, economic activity accelerated in the second quarter and this was much better than we, and most economists, expected. It was a surprising development particularly since corporate profits, real retail sales, and residential investment continued to decline in the same period. Personal consumption of nondurable goods and services was the source of strength in the second quarter and inventories were less of a drag than they were in previous quarters. See page 3.

As we have often noted, high levels of inflation are typically a precursor to a recession, and this has been a major concern in recent years. For example, the June 2022 GDP price deflator hit a worrisome 7.6% which was the highest level of inflation since the 8.4% reported in December 1981. However, the second quarter GDP report showed that this deflator fell to 3.6% in June, well above the Fed target of 2% but good news, nonetheless. Similarly, the monthly personal consumption expenditure deflator fell from 3.8% in May to 3.0% in June, its lowest level in 2 years. See page 4.

But the best news was found in reports on personal income and consumption. In June, personal income rose 5.3% YOY, disposable income rose a stunning 7.9% YOY, and our favorite benchmark, real personal disposable income, rose 4.75% YOY, up from 4.1% YOY in May. Personal consumption expenditures have been in a downward trend after hitting an unsustainable peak of 30% YOY in April 2021, but in June, PCE remained at a healthy 5.4% YOY pace. More importantly, the June acceleration in real personal disposable income is a positive sign for steady household consumption as we begin the third quarter. See page 5.

All the good news on the inflation front, combined with the 25-basis point hike in the fed funds rate in July, results in the real Fed funds rate increasing from 211 basis points to 236 basis points relative to the CPI. The real fed funds rate is similar when compared to the PCE deflator. What is important is that the combination is getting closer to the 300-400 basis points we believe the Fed is targeting for its monetary policy. But keep in mind that the strength seen in the economy also opens the door for the Fed to raise rates again on September 20 and perhaps even at the November 1 meeting. We believe the Fed will continue to raise rates until the real fed funds rate is at least 300 basis points and we do not believe the consensus agrees. This is a risk.

Politics Plays a Major Role

Equally important is the fact that 2023 is a pre-election year, and as is typical of a pre-election year, the incumbent party tends to pass stimulus bills to boost the economy. In this cycle, it comes in the form of the Inflation Reduction Act (IRA) which is actually a stimulus bill focused on supporting the green economy and technology sectors.

In addition, President Biden has circumvented the Supreme Court’s rejection of his sweeping student loan forgiveness plan and has launched its SAVE plan (Saving on a Valuable Education). This is a revision of a previous income-driven repayment plan, and the revisions include factors that base monthly payments on income. For many borrowers’ previous monthly payments will be cut in half and for some borrowers there will be no monthly bill. It is in fact a loan forgiveness plan of sorts. The Department of Education has stated that borrowers who sign up for the plan this summer will have their application processed before student loan repayments are expected to resume in October. In other words, the negative impact the end of the student loan moratorium might have had in the fourth quarter of 2023 has been eliminated to a large extent.

Given these developments we are raising our S&P 500 earnings estimates for this year from $200 to $212 and for 2024 from $220 to $230. These estimates remain slightly below consensus but are more in line with the fact that a recession in 2023 is less unlikely today than it was a month ago. See page 16.

However, even if we use S&P Dow Jones earnings estimates, which are higher than our forecasts, the current S&P 500 trailing PE multiple is 22 times and sits above all historical averages. We fear this means the equity market is priced for perfection. The 12-month forward estimated PE is 19.7 times, and when added to inflation of 3%, sums to 22.7. This 22.7 level is just below the standard deviation line of 23.8 which denotes an extremely overvalued equity market. See page 8. In other words, a lot of good news has been discounted in current prices. Also,  keep in mind that the earnings season currently being reported took place during the 2.4% GDP economy, which was an improvement over the first quarter’s economic activity. If earnings do not show an improvement, it could dampen investor sentiment.

Technical Tests

The charts of the S&P 500, DJIA, and Nasdaq Composite index are bullish and suggest the indices may, or should, be about to test their all-time highs. However, the Russell 2000 index has failed to break above the 2000 resistance despite numerous attempts in recent sessions. This is not conclusive, and the RUT may still break out, but it does leave the overall look of the market somewhat pivotal and uncertain at the moment. See page 10.

Similarly, the 25-day up/down volume oscillator is at a 4.03 reading this week and overbought for the third consecutive trading session. The good news is that the oscillator has had overbought readings for 10 of the last 21 trading sessions; however, to date, none of these overbought readings have lasted the minimum of five consecutive days needed to confirm the advance in the averages. Strong rallies should also include at least one extremely overbought day. Nonetheless, these requirements are what should be seen at a new market high and none of the indices have recorded new record highs. The rally has only produced new “cyclical” highs in most indices. See page 11.

Gail Dudack

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