A Stock Picker’s Market … Let’s Hope Not

DJIA:  34,715

A stock picker’s market … let’s hope not.  The idea of a “stock picker’s” market seems one which is narrow and selective, one in which we are supposed to be smart enough to pick the relatively few winners.  To that we say – good luck.  In Barron’s 2021 forecasting challenge, the toughest question was predict the best Dow stock.  Mind you, we’re not talking about the whole market, just 30 stocks.  It was Home Depot (350), which less than one percent got right.  Under 2% correctly forecast the worst, Disney (148).  Forget stock picking – it’s hard.  Give us instead those days of 2000-3000 stocks up every day.  That’s when we’re all good stock pickers.  Those days may be gone for now, yet the concept could be alive and well in a somewhat different format.  It could be easy to be a good stock picker provided you’re picking a Regional Bank, Oil or a Staple.  There are plenty of stocks here, and they all look higher.

It’s a bit of a stretch to expect most to back off of Tech – there’s not even a 12 step program.  And it’s probably not all Tech, it’s the price to sales Tech you probably want to avoid.  And if Tech underperforms, it’s likely the S&P will as well.  If you find that hard to believe, there are studies about the first week of the year that seem even more of a stretch – the idea that five days have predictive value for the year.  The numbers, however, back that up.  In this year’s first week Energy was up 11%, Financials 5%.  The rest of the year Energy was up 90% of the time for a median gain of 19%.  Defensive stocks were up 82% of the time for median gain of 14%.  Against this backdrop the S&P had median loss of 2.3%, according to SentimenTrader.com.

If Tech/Growth is to underperform, a flat to down S&P would hardly come as a surprise.  Last year to outperform you had to over own the five or six stocks that made up 25% of the S&P market cap.  If they come in flat this year that would make outperformance easier especially if Oil, Staples and Financials follow the pattern described above.  But there’s more to this than just relative performance, this year should offer some real upside, provided you’re in the right areas. Those areas, however, could be very different than those last year.  In chart form, what rather dramatically says it all are the Invesco Pure Value ETF (RPV-83) versus the Pure Growth ETF (RPG-183).  The Value Index might be compared to the SPDR ETF (XLP-76) and the growth matches up with any number of those for Tech.  The other area to look to is financials, preferably ex stocks like Goldman (348) and JP Morgan (148).  The SPDR Regional Bank ETF (KRE-73) would seem to work here.

Money has come out of bonds and doesn’t seem to have gone to Crypto.  That’s not much of a surprise since Crypto seems a world unto itself, unrelated to rates or the dollar. We thought the bond money could go to Gold because they’re both inflation related, but that hadn’t been the case until this Wednesday, when most precious metal shares were at least able to move above their 50 day averages.  Like oil, this is a fairly homogeneous group, where getting the trend right is more important than stock picking.  Now that they at least are above the 50 day, the uptrend has a start, and the dynamic nature of the moves Wednesday also seems a positive sign.  As it happens, should we be right, money from inflation fearing bonds could move to inflation loving Gold.  The difference in the size of those markets would result in a significant move in Gold.

The Advance-Decline Index peaked in early November while the market averages subsequently continued to bounce around their highs.  Divergences here don’t end well.  Hope may spring eternal, but rarely are these divergences self-correcting.  Divergences can linger however, and last week’s 3-to-1 up day and Thursday’s 400 point decline with modestly negative A/D’s made a trading range a possibility.  This week’s 5-to-1 and 3-to-1down days, and the break in the NAZ and Russell, suggest a low will await more pessimistic extremes – a VIX (26) in the low to mid 20s won’t get it done, despite an already oversold market.  Tech and, therefore, the NAZ is where the greatest weakness lies.  Thursday’s rally was impressive, while it lasted.  Bear in mind, and the pun is intended, most of the best one day rallies happen in bear markets

Frank D. Gretz

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It’s a Market of Stocks … But This Year Those Stocks Could be Different

DJIA:  36,113

It’s a market of stocks … but this year those stocks could be different.  Last year Tech drove the market.  More specifically, six Tech stocks drove the market.  Those are the biggest, mostest, fastest, bestest– and they’re not bad.  It’s hard to say an unkind word about Tech, the companies.  The problem is most don’t distinguish between the companies and their stocks.  Most understand Tech is where you want to be.  The problem is most know it to the point they’re already there.  If six stocks are close to 25% of the S&P market cap, do you really think they’re on their way to 35–40%?  Anything is possible, but it’s also possible that everyone who wants in, is in.  Meanwhile, raise your hand if you own Hewlett-Packard Enterprise (18) or, for that matter, stocks like Cisco (62) or IBM (135). These aren’t exactly over-owned and have better charts than most of Tech. Emphasis in the stock market is always changing, and it could be doing so again.

Change in this market is more than just about Tech.  Change has had a lot to do with the bond market.  Bonds have correlated quite well with stock prices recently in that higher yields have meant lower prices.  Now that bonds seem in a clear downtrend, that should be a problem for stocks.  And the higher yields have been blamed for much of the trouble in Tech, though our view is over ownership is the problem.  And if a problem for Tech, higher rates have been a boon to all that is financial.  As you may recall, we don’t like banks – if they’re not lending to some Third World country they’re trying to rig LIBOR – really?  That said, we do like making money, and the banks and other financials look higher.  Going through the charts, there are maybe 50 or 60 you have to buy.  A couple of ETFs here are the SPDR Financial (XLF-41) and the SPDR Bank (KRE-78).  Somewhat forgotten is Berkshire Hathaway (321), the largest holding in XLF, a financial with a 20 percent holding in Apple.

Oil isn’t really new, the stocks had a great year in 2021.  Still with all the focus on EVs, and at only 3–4% of the S&P by market cap, the stocks still look dramatically under-owned.  The good charts here run the gamut, from Chevron (129) to Vermilion Energy (15). The other area that makes sense this year is Staples.  While Staples sounds defensive, there are those with growth stock long-term patterns, without the volatility.  If Tech generally underperforms this year, these stocks, and especially those in long-term uptrends, could do quite well.  Obvious names include Coke (61) and Pepsi (174), as well as Church and Dwight (104), Procter & Gamble (158), Hershey (197) and the like.  Last year it was all but impossible to beat the S&P unless you over-owned the five or six stocks that dominated that average.  This year could be quite different – it could be easy to beat the S&P.  If those five or six stocks underperform, that’s bad for the S&P.  If out of favor Tech, Banks, Staples and, especially, Energy outperform, they will hardly move the S&P needle, though there’s plenty of money to be made.

Amazon (3224) has become a bit controversial after its relatively poor performance last year.  And most technicians will tell you don’t look at the chart while dining.  But that’s the daily chart – each bar one day.  The monthly chart – each bar one month – is much different, and to our thinking a better way to look at the FANG and other stocks that trade erratically.  On that basis, it’s a consolidation, not unlike the pattern between late 2018, and early 2020.  Since the overall trend is up we would assume that like the last time the current consolidation will resolve to the upside, but we don’t anticipate.  We buy breakouts.  If we were to anticipate, we at least would wait for move above the 50 day around 3450.  Last time we listed a number of stocks in long-term /multi-year uptrends.  Even here we would buy when the stocks are above or recover to be above their 50 day average.  Included this week is Edwards Life (120) which seems to meet that criteria.

When it comes to the market overall, we’re still cautious.  We all know the first couple rate hikes the market typically ignores, but typically the market doesn’t ignore a taper, let alone a halt to stimulus.  Meanwhile, the Advance-Decline Index peaked in early November and fewer than 50% of stocks are above their 200 day average, that is, in medium term uptrends.  Against the averages, which are only a few percent from their highs, that’s quite a divergence, and divergences don’t end well.  There are many Financial and Energy stocks, and they are acting well.  If you’re thinking these may serve to correct the divergences, it’s possible but that would be unusual.  That said, divergences can linger, and that may well be the case this time.  Tuesday’s 3-to-1 up day leaves the feeling of a market with a divergence, but not diverging.  While the overall market trend is where we tend to place our emphasis, the money may well be in being in the right areas, hopefully the aforementioned retro-Techs, Staples, Financials and Energy stocks.

Frank D. Gretz

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US Strategy Weekly: Watch Your FANGs

The new year arrived, and with it came a new and revised perspective on the equity market. This is understandable. In 2021, the financial markets were insulated from downside risk given the extremely friendly posture of the Federal Reserve and the potential of more fiscal stimulus. Monetary policy would keep interest rates low and safeguard speculators while fiscal stimulus would support economic activity. With these two safety nets as backing, one could ignore inflation without consequences. But the Fed, many economists, and bankers are now addressing the strain that rising prices has had on consumers in 2021 and many are suddenly, although belatedly, calling for quick action. At the same time, more fiscal stimulus is looking less likely. Thus, both safety nets are disappearing in 2022.

In terms of fiscal policy, the logjam in Congress is no surprise. However, the shift in monetary policy came about amazingly quickly. At the June FOMC meeting, Fed officials — or the dot plot — forecasted no fed funds rate increases until 2023. In September, the dot plot changed to include one possible rate hike at the end of 2022. December’s dot plot implied three possible rate hikes in 2022. This week the consensus expectation has changed once again to include four or five fed funds rate hikes this year, or at least one increase per quarter. This is a startling turnaround, albeit a necessary one. We believed inflation would be a big hurdle for equities last year. It proved not to be. But this year as the Fed addresses the existence of inflation, the significance of price increases is apt to become quite apparent. Keep in mind that four fed fund rate hikes within a twelve-month period tends to produce a down market in the subsequent six months. We will discuss Fed rate hikes in future weeklies.

Independent of monetary and fiscal policy, the new year begins under a dark cloud. As we have often noted, three consecutive years of double-digit gains in the indices are often followed by a year of losses. The one exception to this precedent was the five double-digit up years that led into the 2000 peak. However, this historic rise was a stock market bubble, and it was followed by three consecutive years of losses. See page 3. Therefore, if history is any guide, 2022 may a defining year – either it is a down year or it is the beginning of an equity bubble. We think the first quarter will be revealing and may provide the answer.

January and Liquidity

Wall Street adages are typically built upon some fundamental or economic premise and the January Barometer is one of these. The concept of the first five days of the year and/or the first month of the year having predictive value for the overall year is based upon liquidity. The end of the year and the beginning of any year is a unique time for liquidity. A grouping of pension funding, IRA funding, tax loss selling proceeds, bonus payments and salary increases tends to cluster in the December/January period and makes this time unique in terms of providing potential demand for equities. If equities fail to rise during this time, it may be a signal of trouble ahead. Overall, it is a warning.

January is off to a weak start this year, with a 1.9% decline in the S&P 500 index and a 0.3% decline in the Dow Jones Industrial Average. And as shown on page 5, ten of the last 17 post-election-year markets were flat to down years. However, it is important to point out that the early January Barometer has a poor record of predicting annual declines. Early January losses have only been followed by annual declines 42% of the time in the S&P 500 and 46% of the time in the DJIA. A decline in the month of January has been more accurate. January declines have been followed by annual declines 69% and 66% of the time in the S&P 500 and DJIA, respectively. All in all, the January Barometer has been a better guide in predicting up years after January gains. See pages 4 and 5. Still, we do think it would be a bad omen for January to be weak in face of the obstacles we see for equities.      

Obstacles

One of the issues facing equities is the potential slowdown in earnings growth. After what we expect will be a high double-digit earnings growth rate in 2021, the pace is expected to slow to a single digit level this year. Currently, IBES Refinitiv and S&P/Dow Jones have 2022 earnings growth rates of 8.5% YOY and 9.0% YOY, respectively. Our estimate is for a 10% YOY growth rate, but only because our 2021 earnings estimate is below the consensus view. See page 7 and 16. Nevertheless, earnings are facing tough comparisons in 2022 and earnings will not provide the fundamental support it did over the last twelve months.

Higher inflation also pressures price-earnings multiples. Unless inflation falls well below the 4% level this year, we expect multiples to fall from the current level of 20+ to the average of 17.5 times. But inflation dropping to less than 4% seems unlikely in the near term, particularly with crude oil futures rising once again. The charts of both WTI and gasoline futures point to higher prices this year. See page 8. This implies inflation and multiple risk in coming months.

Plus, it is easy to become too insular and forget about the geopolitical problems that could upset the financial markets. Political hotspots include North Korea which launched two ballistic missiles off its East Coast in the last week, US forces in Iraq and Syria suffering three separate rocket attacks in recent days, Russian troops hovering ominously on the Ukrainian border and China becoming increasingly assertive in controlling both Hong Kong and Taiwan. All of these have the potential of upending the financial applecart.

FANG stocks

High PE stocks face the biggest threat in an environment of soaring inflation and rising interest rates. And we expect technology stocks could bear the brunt of any correction in 2022. With this in mind we looked at the charts of the FANG stocks this week and found some patterns that deserve monitoring. We have comments on Amazon (AMZN – $3307.24), Meta Platform (FB – $334.37) and Alphabet (GOOG – $2800.35) on page 9. Each of these stocks have critical support levels that if broken, could trigger further selling. In sum, we would be defensive in the short run; but a sell-off in 2022 could produce an excellent long-term buying opportunity. Meanwhile, there are pockets of safety in the market in areas such as energy, banks, and staples, which all have modest multiples and good dividend yields.

Technical Indicators The Russell 2000 index also has a pattern similar to the aforementioned FANG stocks in that the 2100 support level is important to the index. If this level is broken it would be extremely bearish for the RUT and a negative omen for the market. See page 10. Most other technical indicators are neutral or indecisive this week. The 25-day up/down volume oscillator is at 2.06 this week and above the midpoint of the neutral range, but still has not confirmed any market highs since February 2021. This implies that investors have been selling into rallies. Both the 10-day averages of new highs and new lows are above 100, leaving the “trend” of the market ambiguous. The NYSE cumulative advance/decline line made its last record high on November 8. Sentiment indicators like the AAII bull bear survey and the ISE call/put volume index are neutral. All in all, we remain cautious for the near term.  

Gail Dudack

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A Year of Reckoning

A year ago, we stated that despite denials from the Federal Reserve Board and the administration, inflation would become a big problem for consumers and the securities markets in 2021. We did not believe that rising prices would be transient or mild because monetary and fiscal policy had remained too stimulative for too long. Investors managed to ignore inflation for most of 2021, but at the December 2021 FOMC meeting, with consumer prices rising 6.9% year-over-year and producer prices for finished goods rising more than 13% year-over-year, Chairman Jerome Powell did accept the existence of inflation. He stated quite clearly that monetary policy needed to change in 2022 and that quantitative easing would end by March and interest rates could increase two or three times this year. This is a pivotal switch.

Fed Policy in the Crosshairs

However, the Federal Reserve appears to be behind the curve in terms of fighting inflation since big price hikes are now widely accepted and widespread. As a result, the shift from easy to tightening monetary policy might need to be longer and more frequent than if it had begun sooner. And though this policy adjustment will be the big challenge for investors in 2022, it is a necessary move. The asset inflation seen in housing, commodities, securities, energy, and all forms of collectibles has been the result of too much money chasing too few goods and this is due to the Fed feeding the banking system with too much cash. The alternative would fuel an asset bubble environment.

Quantitative easing and/or falling interest rates have usually been a positive for equities and this is the source of the Wall Street adage “Don’t Fight the Fed.” The end of quantitative easing (QE) has no predictive value for equities. However, one could say that without quantitative easing equities no longer have the wind at their back and would need a new catalyst to move higher. What is more likely to pose a problem for equities is the Fed’s transition from historically low to higher interest rates. Bonds and stocks compete as investments, therefore as interest rates rise, the pendulum of risk shifts from bonds to equities. Higher interest rates raise the bar for equities in valuation models.

Investing in a Changing Environment

In an era of rising inflation and higher interest rates, equites can still perform well but portfolios may need some adjustments. It is important to note that inflation and interest rates pressure high PE stocks since they represent the highest-risk segment of the market. This explains the recent selling pressure in high-flying tech stocks. In 2022, investors should look to protect portfolios from these risks. The best insulation would be balanced portfolios that include stocks with earnings shielded from the pressures of inflation, price earnings multiples at or below the S&P 500 average, and stocks with dividend yields greater than 1.5%.

A number of sectors should do well in 2022 despite rising prices and interest rates. For example, energy stocks have been the beneficiaries of inflation. The sector recorded a gain of 47.7% before dividends in 2021 which made them the best performing sector in the S&P 500. However, gasoline demand should continue to increase as the pandemic fades and the United States Energy Information Administration (EIA) expects global consumption of petroleum and liquid fuels to increase by 3.5 million barrels per day in 2022 to average 100.5 million barrels per day. It follows that energy sector earnings should be strong in 2022. Moreover, energy stocks tend to have low PE multiples and many stocks have dividend yields that are double the current rate in the 10-year Treasury note.

Financial stocks are another sector that can not only weather inflation but do well as interest rates rise. Banks, in particular, can benefit from a steepening yield curve. Assuming COVID-19 and its variants fade into history in 2022, global economic activity will expand, and financial stocks will benefit from this increased activity. In addition, the sector tends to have modest valuation multiples and solid dividend yields. But note that as the world of finance continues to change, so does the composition of the S&P financials sector. Many fin-tech stocks were added to the S&P financial sector in December, such as PayPal (PYPL – $187.60), Fiserv Inc. (FISV – $108.83), and Jack Henry & Associates (JKHY – $169.75). Although bank stocks tend to have healthy PE multiples and yields, these new additions will have higher earnings growth potential but higher PE multiples. This will raise the average PE and lower the yield of the overall sector.

Consumer staples should also fare well in a volatile and changing environment. Staples are a defensive play that should demonstrate growth as the global economy recovers. Valuations for staples are modest, and the yields are above average. Note that in December S&P added Target Corp. (TGT – $230.78), Dollar General (DG – $238.37), and Dollar Tree Inc. (DLTR – $140.96) to its staples sector. We find these interesting additions. In an environment of rising inflation, when households are acutely price sensitive, these three retailers are known for providing quality products at low prices. They are attracting consumers from all income brackets. Again, investors should be looking for companies that can not only survive, but thrive, in an inflationary environment.

The Technology Sector

Technology stocks may come under pressure in 2022 as interest rates rise. But, in our view a correction in the technology sector would provide a long-term buying opportunity. In other words, be patient when adding technology stocks to portfolios.

As a final note, history has shown that three consecutive years of double-digit gains – as seen in the S&P 500 and Nasdaq Composite index — have been followed by a down year. This implies the S&P 500 and Nasdaq Composite index, which are heavily influenced by the largest market capitalization stocks, may come under pressure in coming months. But declines are a normal part of any equity cycle. The S&P 500 has more than doubled since the March 2020 low without as much as a 10% correction. A correction in the next twelve months should be viewed as a healthy and stabilizing event for the longer term.

*Closing prices as of 1/7/2022

Gail Dudack, Chief Strategist

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Disclosure: The information herein has been prepared by Dudack Research Group (“DRG”), a division of Wellington Shields & Co. The material is based on data from sources considered to be reliable; however, DRG does not guarantee or warrant the accuracy or completeness of the information. It is published for informational purposes only and should not be used as the primary basis of investment decisions. Neither the information nor any opinion expressed constitutes an offer, or the solicitation of an offer, to buy or sell any security. The opinions and estimates expressed reflect the current judgment of DRG and are subject to change without notice. Actual results may differ from any forward-looking statements. This letter is not intended to provide personal investment advice and it does not consider the specific investment objectives, financial situation and the specific needs of any person or entity.

This communication is intended solely for use by Wellington Shields clients. The recipient agrees not to forward or copy the information to any other person without the express written consent of DRG.

Copyright © Dudack Research Group, 2022.

Wellington Shields is a member of FINRA and SIPC

STOCKS IN LONG-TERM UPTRENDS

DJIA:  36,236

Whether a trader or an investor, there’s reason to look to stocks in relatively consistent long-term uptrends.  The very term investing implies a need for stocks you really can buy and hold.  It only makes sense those are stocks in long-term uptrends.  Trading of course is anything but long-term.  Still having the long-term trend at your back simply adds to the probability of short-term success.

Frank D. Gretz

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US Strategy Weekly: On the Verge of a Bubble?

Stocks performed well in 2021, but while gains were widespread, it was not easy to outperform some of the indices. The best performing index in 2021 was the Dow Jones Transportation Average which rose 31.8% for the year. The SPX was second with a gain of 26.9%, followed by the Wilshire 5000 index which rallied 22.8%.

The Dow Jones Industrial Average had an 18.7% gain in 2021 and in most years, this would have been an exceptional performance, but for last year it made the index a laggard. The Russell 2000 index rose roughly half of the SPX at 13.7% for the year and performed just slightly better than the Dow Jones Utility Average which rose 13.4%. However, on a total return basis, the Dow Jones Utility Average clearly outperformed the Russell small cap index.

One might wonder about the amazing outperformance of the Dow Jones Transportation Average given the weak performance of the airlines during the pandemic, but airlines were offset by strong performances in some unexpected components like Avis Budget Group, Inc. (CAR – $202.53), and the various shipping and freight components such as, Expeditors International of Washington, Inc. (EXPD – $130.06), C. H. Robinson Worldwide, Inc. (CHRW – $110.38), J.B. Hunt Transport Services, Inc. (JBHT – $207.66), or the marine shipping company, Matson, Inc. (MATX – $91.15). Despite the angst about transportation logjams and the disaster at the Port of Los Angeles, many transportation stocks performed well last year.

However, for most individual investors and many money managers, 2021 proved to be a challenging time to outperform the SPX. The reason for this is the emergence of a few stocks that are beginning to dominate the cap-weighted benchmark indices like the S&P 500 and the Nasdaq 100. In our December 15, 2021 weekly (“Monetary Policy Shift Ahead”) we displayed a table of the eight stocks that represented 63% of the total market capitalization of the Nasdaq 100 at that time. These stocks are Apple, Inc. (AAPL – $179.70), Microsoft Corp. (MSFT – $329.01), Alphabet Inc. Class C (GOOG.0 – $2888.33), Alphabet Inc. Class A (GOOGL.O – $2887.99), Amazon.com, Inc. (AMZN – $3350.44), Tesla Inc. (TSLA – $1149.59), Meta Platforms, Inc. Class A (FB – $336.53) and Nvidia Corp. (NVDA – $292.90). This week, as Apple, Inc. approached an historic $3 trillion market capitalization, S&P wrote that a mere five stocks currently represent 26% of the market weight of the SPX (AAPL, MSFT, GOOG, AMZN and FB).

It is noteworthy that with a $3 trillion market capitalization, Apple would singularly represent 7.8% of the S&P 500 index. This market cap dominance easily exceeds the 6.4% weighting seen by International Business Machine (IBM – $138.02) in 1985. There are many theories about what happens to a stock when it becomes a dominant part of the index, and most theories suggest that dominance is not long-lived. However, there is another important aspect to the fact that a small group of stocks are driving the SPX. Particularly those money managers pegged to the SPX, the fact that AAPL is 7.8% of the SPX market capitalization, you risk underperforming your benchmark if you are not similarly weighted in AAPL. If you are not, this equates to a large bet against AAPL doing well. We expect there was a lot of portfolio adjustments going on at year end.

What we find disturbing about the dominance of a few stocks driving the major benchmark indices is that it reminds us of the Nifty Fifty era that preceded the top in 1970. The nifty fifty stocks included companies like Polaroid, Eastman Kodak, Digital Equipment and S.S. Kresge (Kmart), Sears and Roebuck, and Xerox (XRX – $23.76). Most of which do not exist in their previous form. It is also similar to the dot-com bubble that led to the 2000 peak. Global Crossing was part of the dot-com bubble. It was a telecommunications company founded in 1997 that reached a market capitalization of $47 billion in February 2000 before filing bankruptcy in January 2002. In both of these previous cases the momentum of the market was driven by a relatively small number of popular growth stocks that represented the future to most investors. They were the disruptors of their era. But over time, if a few stocks are driving market performance, fundamentals and valuation models are replaced by momentum models. Momentum models simply drive more investors into a small group of outperforming stocks. We do not believe we are currently in a bubble; but having lived through the aftermath of both the 1970 and 2000 tops, the seeds of a bubble do exist, in our view. If we are on the verge of a bubble, 2022 may be the decisive year. Many indicators point to a correction that is greater than 10% over the next twelve months. But if this does not materialize, it is quite possible that a new set of investors, who have never lived through the humbling experience of a bear market may continue to follow momentum and drive stock prices higher.

The last three years have been good to investors. The SPX has had consecutive annual gains of 28.9%, 16.3% and 26.9%. The Nasdaq Composite has been even stronger with gains of 35.2%, 43.6% and 21.4%. The DJIA has not quite kept up, yet in the last three years it has had gains of 22.3%, 7.2% and 18.7%. History has shown that three consecutive years of double-digit gains in the indices has been followed by a negative year. Since 1901 there has been only one exception to this pattern: the five double-digit up years that lead into the 2000 peak. See page 3. However, as we noted, 2000 was a bubble peak and March 2000 was followed by three consecutive years of losses.

In sum, 2022 is apt to be a pivotal and defining year. A down year should be expected and it would be stabilizing for the longer run. But if stocks continue to advance strongly, it would be a likely sign of an emerging bubble. Fundamentals do not work in a bubble, but technical indicators are helpful. The NYSE cumulative advance decline line peaked in late 1997, yet the indices continued to move higher for more than two years. This was a massive two-plus year divergence. We have found that the divergence between the advance decline line and the indices is a simple way of gauging future downside risk in the marketplace. At present, the NYSE cumulative advance decline line made its last record high on November 8. This 8-week divergence is not unusual, and it suggests a correction of 10% or more. But the longer the divergence persists, the more the downside risk in the market grows as seen in 2000.

One of the warning signs that a bubble is reaching its peak is a surge in leverage. Massive borrowing against stocks is what will produce an eventual selling surge as leverage is unwound. For this reason, we are keeping a watch on margin debt growth. But total margin debt fell $17.3 billion in November to $918.6 billion. See page 4. As a percentage of total market capitalization margin debt was unchanged at just under 1.8%. This is a high ratio but not a record. November’s 2-month rate-of-change in margin debt was a modest 1.7% and compares to a 1.4% gain in the Wilshire 5000. Prior to market peaks margin debt can rise to 15.3% or more, yet barely move equity prices higher. From this perspective, the equity market appears to be in good shape. Earnings are expected to increase 8% to 9% this year, but we fear inflation could erode this more than expected. The Santa Claus rally implies 2022 could be a good year and the first five trading days of January is off to a good start. The early January market has had an accuracy rate of 79% of predicting the annual trend. See page 5. We will follow up on this next week but overall, a diversified portfolio is the best way to manage through what may be a tumultuous year. Our favorite sectors for diversification are technology, financials, energy and staples — a mixture of growth, value, and yield.  

Gail Dudack

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It Has Been a Great Year … It’s Hard to Expect Another?

DJIA:  36,398

It has been a great year … it’s hard to expect another?  The market hasn’t had more than a 5% correction in the last two years, can you expect another?  With inflation a serious practical problem for the first time in a generation, can you assume that still, “there is no alternative” for stocks?  Then there’s the taper.  In 2011, just hints from the Fed that it wouldn’t expand its asset purchase program preceded a 19% drop in the S&P.  In 2015 talk of a balance sheet shrinkage came before a 12% decline.  In 2018, a comment about balance sheet unwind on “auto pilot” coincided with the near death of the bull market.  On the technical front, while the averages are at or near highs, the average stock has lagged.  Less than half of NYSE stocks are above their 200-day moving average, that is, in medium term uptrends.  All these things leave us cautious.  It’s ironic that everyone likes to make predictions this time of year when this time of year itself often offers important insights.  It’s a good time of year to be observing rather than predicting.  Besides, the best prophet, Thomas Hobbes once wrote, is the best guesser.

The idea that we could see three rate hikes next year so far has left the market surprisingly undaunted.  Then, too, we’re more concerned about the taper than the hikes.  Monetary policy may only shift to merely easy versus extremely easy, but what counts is the change at the margin, rather than the absolute level of stimulus.  Mike Wilson points out the Fed will go from a $1.4 trillion annualized pace of asset purchases to zero in four months.  This reversal of the extraordinary fiscal and monetary stimulus applied to fight the pandemic almost certainly will have an impact on multiples.  Beyond the Fed’s massive securities purchases since March 2020, Felix Zulauf points to the largely unrecognized impact of the Treasury’s sharp drawdown in its balance at the Fed.  The reduction, which has injected liquidity into the economy, is about to reverse.  At the same time, China isn’t recycling its US dollar holdings as it used to, further reducing global dollar liquidity.  Seems a bit esoteric, but not really.  It’s at the core of technical analysis, that is, supply and demand.

When someone says they’re bearish, we always ask does that mean you own few or no stocks?  Invariably the answer is – well, we do own stocks, but …  If you are really bearish you own few stocks.  Investor sentiment peaked earlier in the year amidst the speculative binge around meme stocks.  Many of these stocks peaked back then as well, of course the averages did not.  As the averages have moved higher, speculative buying as measured by Call buying has surged a couple of times.  One sentiment measure that has remained unimpressed is the AAII Bull Ratio, a survey of, shall we say, more sedate investors.  The AAII Bull Ratio has held below 50% for five straight weeks.  When below 45% while the S&P is above a rising 50 week moving average, the S&P has gained 91% of the time over the next three months, according to SentimenTrader.com.  And this is only the second time since the inception of the survey the ratio was negative for the first four weeks of December.  A possible caveat, their talking the talk – survey shows respondents cautious, but with a high allocation to stocks.

The S&P healthcare sector has pretty much kept up with the S&P Index itself.  Biotech ETFs, however, are not even in the black this year.  The XBI, an Equal Weight Index which focuses on small and mid-caps, is down more than 20%, and more than 28% from its 2021 high.  And the median stock in the group is down 50%.  Recently, fewer than 10% of the stocks were above the ten-day average, fewer than 15% were above their 50-day average, and fewer than 20% were above the 200-day average.  All these are within a few percent of all readings historically.  This says washed out.  Then, too, washed out is one thing, new uptrends can be another.  If washed out, the IBB (154) and XBI (113) should do something right, as we like to say.  For both, that would be a move above their respective 50-day averages.  For IBB, that would be above 156 which also would break the downtrend in place since September.  The XBI has broken the downtrend, but remains below the 50-day around 120.  A new wave of M&A could serve as a catalyst here.

Historically, it has been difficult to bring inflation under control unless interest rates rise to the point they’re above the rate of inflation.  That’s should mean lower bond prices.  The money out of bonds could flow to gold, not crypto, as an inflation hedge.  Bond prices have turned down, gold prices seem undecided.  In an inflationary environment oil should have another good year.  The spread between Staples and NASDAQ stocks in terms of their 50-day averages, 90% and 25%, respectively, is the most in 30 years.  We believe in Staples but leadership in the New Year is often unclear – back to observing versus predicting.  Insiders stand selling – assuming they know value, it’s not a good sign.  Tesla (1070) may be the greatest new economy stock but when the founder starts selling, for whatever reason, it doesn’t seem a good thing.  Like this year, where you’re in likely will be more important than whether you’re in.  Generally speaking, we like stocks in long-term uptrends regardless of their group or industry. An example we haven’t mentioned before is Prologis (168).  Meanwhile, with a divergence already in place, the Advance-Decline numbers will remain important.

Frank D. Gretz

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Sure it’s the End of the World … But We Think it’s Discounted

DJIA:  35,897

Sure it’s the end of the world … but we think it’s discounted.  A hawkish Fed is not the end of the world, and we do think it is discounted – at least it should be.  If you didn’t know it had become a more hawkish fed, you have to be under that proverbial rock.  And when it comes to the stock market, what we all know isn’t worth knowing – it’s discounted.  Sure the market could have reacted negatively to the meeting, after all, you never know.  But having sold off in the days prior to the meeting that seemed unlikely.  And the market could have taken the bad news as the bad news it really is, but that’s on the market – the market makes the news.  Half the news in a bull market is bad news but the market ignores it.  That the market seems to have ignored this particular bad news is a good sign, at least for now.  But it is bad news.  Don’t fight the Fed, and all that.

We first became involved with the technical analysis for a simple reason – we noticed when “the market” went up we made money, and in market corrections we lost money.  We decided a better understanding of what moves markets might be helpful, so we enrolled in the Bob Farrell school of technical analysis.  We’ve become somewhat proficient at recognizing market trends, not so good at recognizing their duration.  In any event, we believe things have changed, in part at least because of the significant degree of passive investing.  Back in the day market trend was most important – academic studies showed the overall trend accounted for as much as 50 to 60% of the movement in any individual stock.  Group performance was another 20% and fundamentals the rest.  We’ve seen no recent academic studies, but our take is those numbers may well be reversed.  Group behavior now seems to dominate.  Where you’re in has become more important than whether you’re in.

Tech has been the place to be this year, as it was for much of the 1990s, but it hasn’t always been that way.  Consumer stocks dominated the 1980s and back in the 1970s when inflation ruled, it was mining and energy stocks that performed well.  Coca-Cola (59) sold for 40x earnings in 1972 and only 9x earnings in 1981.  Had you bought Coke at the end of 1972 – a real buy and hold stock – you didn’t break even until 1985.  Leadership in the stock market does change, and we think an important one likely has begun.  We’re not saying sell your Apple (172) and Microsoft (325), but “multiple of sales” Tech is likely to lose out as consumer staples stocks likely continue to outperform.  Of the 33 stocks in the XLP (77), the Consumer Staples ETF, 10 have very positive charts – PepsiCo (172), CVS (101), Hershey (192), Procter & Gamble (161), Estee Lauder (363), Costco (533), you get the picture.  As for XLP itself, it has cycled from fewer than 5% of component stocks above their 10 day average to more than 95%.  That typically signals the start of an important move.

Aside from being in the right groups or sectors, the easiest way to make money in stocks is to be on the right side of the trend.  In this case we’re talking about the long-term trend.  Many claim to be long-term investors, yet they own stocks in long-term trading ranges.  You don’t need to predict here, just look for stocks in five year steady uptrends.  Those trends tend to persist.  And when your timing is a little off, the trend bails you out.  There are ample examples even in consumer staples, including Pepsi, Costco and Procter & Gamble.  Two others that qualify here are Accenture (401), which gapped higher Thursday, and Intuit (634) which is consolidating.  Even for those of us who don’t know the meaning of “long term,” trend is important.  The easiest way to make 50% trading is to trade stocks in the process of doubling.

In November the market worried inflation was out of control, now the market is worried the Fed will be out of control.  Despite the apparent demise of Evergrande, still no worry about China.  And still no worry about Russia and the Ukraine, though we keep checking those defense stocks for a sign.  It seems doubtful that financial conditions can tighten without some sort of market accident, and the technical back drop has begun to bear that out.  The A/D Index peaked in early November, this measure of the average stock typically does so well before the averages themselves.  More importantly, with fewer stocks advancing and in uptrends, it has become even more difficult in this already difficult year.  The for sale sign on most of Tech here at year end may seem a dirty trick, but more likely is simply about crowded trades.  And, did we mention, leadership does change.  Meanwhile, with the Fed worry out of the way, we expect the market for now to muddle through, including Tech.

Frank D. Gretz

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US Strategy Weekly: Monetary Policy Shift Ahead

This week could be pivotal for equity investors since the December Federal Reserve Board meeting is expected to result in a well-telegraphed reversal in monetary policy. The details and timing of quantitative easing and interest rate changes will be most important. Quantitative easing is expected to slow, perhaps more quickly than previously thought, but reversing QE has rarely had a negative impact on equity trends. The crucial part of monetary policy is the raising or lowering of interest rates. History shows that three or more fed funds rate hikes within a 12-month period has been followed by equity declines. The faster the rate hikes are made, the bigger the negative affect on the stock market. Therefore, the real focus this week will be on Chairman Jerome Powell’s comments and the possible timing of interest rates increases.

Unfortunately, we believe the Federal Reserve is already behind the curve. More importantly, one could opine that the current wave of inflation is man-made. A combination of historically large fiscal and monetary stimulus during an economic recovery is a perfect recipe for inflation — as any basic economic textbook would attest. Ironically, this was ignored by most economists, politicians and surprisingly by the Federal Reserve. And though equity investors have ignored soaring inflation numbers for months, recent data has made it more difficult to ignore. In our view, by ignoring inflation, the Fed has allowed it to become more embedded in the system. As a result, it could take more rate hikes to reverse than if it had been addressed earlier this year.

November’s inflation numbers were disconcerting. Headline CPI rose 6.8% YOY, the highest pace since the 7.1% YOY recorded in June 1982. Core CPI rose 4.9% YOY, the highest since the 5.0% pace in June 1991. See page 6. Headline PPI rose 13.3% YOY, the highest since October 1980. Core PPI, excluding food & energy, PPI jumped 5.9% YOY, the highest since March 1982 and final demand PPI rose 9.7% YOY, the highest on record. In other words, November’s inflation was the highest in thirty years which means many of today’s young investors have never dealt with inflation or understand its many repercussions.

Rising prices have spread throughout the economy and although fuel prices are no longer the main driver of US inflation, energy remains one of the most important triggers for future inflation. The good news is that WTI crude oil prices are down 16% from their October 26 peak of $84.65. The bad news is that WTI is still up 46% year-over-year. Gasoline prices are down a similar 16% from their high of $2.52 also made on October 26. See page 10.  

As we have discussed in previous reports, inflation of 4% or more tends to have a deleterious impact on price earnings multiples. For this reason, it is not surprising to see that many large capitalization technology stocks have encountered selling pressure this week. Technology stocks tend to have high multiples which become a high-risk asset as inflation rises. Also note that the following ten stocks in the Nasdaq 100 composite index represent 63% of the total market capitalization of the index and a significant percent of the S&P 500. During market weakness, or whenever selling pressure creates a liquidity crisis, large cap stocks become the most liquid and therefore bear the brunt of selling pressure.

We believe the best strategy for the next several months is avoid high PE stocks and tilt toward stocks with predictable earnings streams, modest PE multiples and dividend yields greater than the current 10-year Treasury bond yield of 1.4%. The recent gains in the consumer staples sector are an example of this transition. We expect a better buying opportunity for large cap technology stocks will appear in the first half of 2022.

Households Balance Sheet and Sentiment

US household net worth rose 1.7% in the third quarter to a record $144.7 trillion, which was an impressive 10.5% increase year-to-date. During the quarter, nonfinancial assets rose 3.7% and corporate equities fell slightly. Year-to-date, nonfinancial assets rose a sturdy 11.7% versus 15.7% for equities. Equity assets directly held by households, versus indirectly through pension funds for example, rose 18.6% in the first nine months of the year. However, household real estate gained 11.4% this year to date, and owners’ equity in real estate rose an impressive 14.7% in the first three quarters reaching 68.8%, the highest level since 1988! This suggests many households benefited from a rise in residential real estate values in 2021. See page 3. It may also explain why Christmas shopping appears to be setting a record this year.

However, Fed data on household balance sheets has also shown that when equity ownership exceeds real estate values, the equity market is at risk. This is true currently. Moreover, in June, equities represented 41.5% of total household financial assets and 29.4% of total assets. Both were new record levels that exceeded the previous peaks recorded in early 2000. In short, equity ownership may be reaching an over-owned condition, and this implies caution. See page 5.

Good news in net worth did not translate into an improvement in consumer sentiment. December’s preliminary consumer sentiment from the University of Michigan showed small gains in the index, yet the survey lingers only modestly above the 2021 lows. The NFIB small business index edged up 0.2 points to 98.4 in November, but most parts of the survey were little changed. On the other hand, the outlook for general business conditions worsened to negative 38, matching its worst level seen November 2012. All in all, soaring inflation appears to be taking a toll on businesses and consumers. There has been little change in technical indicators this week. The 10-day average of daily new highs fell to 82 this week and daily new lows are at 186. This combination — with new lows over 100 per day — was downgraded from neutral to negative last week. The NYSE advance/decline line’s last record high was on November 8, 2021, and it is trading well below this level currently. Volume has been rising on down days and slipping on rally days, which is a worrisome combination. See page 13. The 25-day up/down volume oscillator is at negative 2.5 and approaching an oversold reading which would be a negative omen. And finally, the Russell 2000 index continues to trade below all its moving averages which could be a sign of a trend reversal. All this points to the need to be cautious as 2022 approaches.  

Gail Dudack

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No Cigar … But Close Enough?

DJIA:  35,754

No cigar … but close enough?  Not every sell-off ends in a real washout, and this one did not.  Still, this seems a credible low.  Certainly the decline had its moments, including a couple of near 90% down volume days, important when you consider sellers, not buyers, make lows.  Lacking was an 80% up day or a 5-to-1 A/D day, achievable when sellers are out of the way.  Somewhat ironically, rather than momentum numbers it’s the sentiment or psychology side that says low.  The surge in the VIX (21) and subsequent reversal says there was panic, and it has now ended.  In a complete turnaround, the extreme Call buying turned to Put buying to the highest degree since the pandemic rally began.  And inverse ETF buying, today’s equivalent of short selling, reached 2.2% of NYSE volume, the most ever.  So no washout low, but likely one good enough for now.

The market pretty much played doctor to start Monday’s 600 point rally.  While we didn’t hear anyone screaming the variant is not a problem, the market did just that – the vaccine stocks tanked and oil stocks surged.  This was, of course, just the opposite of the 900 point drubbing a week or so ago, when the markets seemed to be saying all was lost.  Markets are not always right and may not be again this time.  At least they are a reasonably fair game, and the market gets it right more often than most of us.  Hence, our predilection for observing and keeping the predicting to a minimum.  You didn’t have to predict the little correction we’ve been through, you just had to observe the S&P and NASDAQ dancing around their highs while the A/Ds were negative for seven consecutive days – that never ends well.  Even now those numbers will be important.  You don’t want to see strength in the averages against the pattern of weak or negative A/Ds.

Leadership this year has been fickle, to put it kindly.  For the most part there has been a division between stay or go, stay at home or don’t stay at home.  Of late there seems another division within stay at home – don’t get on an international flight or a cruise ship, don’t get on your Peloton but by all means go to McDonald’s.  And what does it mean when MCD (262) is acting better than Microsoft (333)?  Fortunately we’re not afflicted with the problem of figuring out why things are as they are, we just know when they are what they are.  Our two cents, and you get what you pay for, we could be about to see a shift away from stocks selling for a multiple of sales back to stocks selling for a multiple of earnings.  We are not suggesting you sell your Microsoft, but it may be time to take a hard look at stocks like McDonald’s or a Procter & Gamble (153), stocks where the long-term trends resemble that of Microsoft.

This time of year everyone tends to chomp at the bit to predict next year’s returns.  Interesting when you consider few predicted even the recent little setback, and when the start of the calendar year is often a predictor of how it will end – the old, as goes January thing.  Undaunted, and interesting for the call, are predictions of a negative return from institutions as big and influential as Morgan Stanley and B of A, both of whom it would seem have a vested interest in seeing prices higher.  Their concern is inflation and, therefore, rising rates.  As suggested above, we’re not fond of predictions and will wait to see how the now lagging Advance-Decline Index plays out.  Were we to venture on the dark side of funnymentals, it’s not hard to see trouble next year.  Rates seem headed higher, and “don’t fight the Fed” works both ways.  The real worry seems consumer sentiment where the numbers peaked earlier in the year.  They have an excellent record of preceding downturns.

After major declines, stocks bottom together – when the selling is done, it is as though there’s a vacuum on the upside.  Tops are completely different.  Stocks/groups peak a few at a time, typically the big first and, therefore, the divergences between the averages and the A/D Index.  Typical as well, speculative areas peak early.  Where did all those SPACS go, let alone those MEME stocks?  Certainly controversial and certainly an area of speculation is bitcoin.  We’re speaking here of the surrogate equities, like Riot Blockchain (26), Marathon Digital (41) and Coinbase (264).  We know they have survived this look before, but the charts here are not pretty.  As for the market, if the Fed meeting next week is as hawkish as expected, will that be a surprise?  Another time when the market will make the news, and a time to not predict but to observe.  Thursday was one of those bad up days of sorts, Dow flat, A/Ds 3-to-1 down. That’s not gonna get it done.  Down days happen, bad up days are a problem. We seem out of the woods, but watch those A/Ds.

Frank D. Gretz

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