US Strategy Weekly: A Clear and Present Danger

Given the uncertainty of the current geopolitical environment, first-quarter earnings season will be very closely monitored and more important than usual. The atmosphere is rife with risk. Noting “seismic waves” from Russia’s invasion of Ukraine and warning that inflation was now a “clear and present danger,” The International Monetary Fund cut its forecast for global economic growth by nearly a full percentage point this week. The IMF also indicated that Ukraine’s GDP could collapse by 35% this year and Russia’s economy could shrink by 8.5%. Emerging and developing Europe (which includes both Russia and Ukraine) are forecasted to decline by 2.9%. The IMF also pointed out that these forecasts are in jeopardy for many reasons, including the likelihood of more sanctions on Russia, global food shortages, and tightening monetary policies. With this backdrop, investors will be riveted, not only on first-quarter results, but on corporate guidance for the rest of 2022.

To date, first-quarter earnings results are mixed. International Business Machine (IBM – $129.15) reported it expects to hit the top end of its revenue growth forecast for 2022 even though it expects a hit of a “few hundred million dollars” from the suspension of its business in Russia. Johnson & Johnson (JNJ -$183.08) cut both ends of its full-year profit forecast by 25 cents lowering expectations to $10.15 to $10.35 per share. JNJ cited currency fluctuations rather than fundamental business issues for the decline, and simultaneously raised its dividend by 6.6%. Meanwhile, Netflix Inc. (NFLX – $348.61) cratered 24% after the bell when it reported that subscriber numbers had declined for the first time in a decade. The streaming company lost 200,000 subscribers in the first quarter; but more disturbingly, it expects to lose an additional 2 million subscribers due to competition from Apple Inc. (AAPL – $167.40) and Walt Disney (DIS – $131.90). Account sharing and other challenges are also having a negative impact. Tesla (TSLA – $1028.15) reports earnings on Wednesday and investors will be watching and listening, not only for earnings results but to hear if Elon Musk discusses his bid for Twitter Inc. (TWTR -$46.16). On April 14, Musk offered to buy all Twitter shares for $54.20 per share and take the company private. This bid has been the most-followed story of the last week and the company responded by adopting a poison pill to thwart Musk. Twitter, which reports earnings on April 28, is listed by IBES Refinitiv as one of several companies likely to have a negative earnings surprise this quarter.

Stock Prices, Rising Interest Rates and Earnings

IBES Refinitiv is currently forecasting first-quarter earnings growth for the S&P 500 to be 6.3% YOY but excluding the energy sector – where profits are expected to rise 241.2% YOY — growth falls to 0.7% YOY. In short, 2022 is likely to be a difficult year for most companies and as we have been indicating in recent weeks, earnings growth needs to be substantial to counter the negative impact of rising inflation and interest rates.

There is much confusion about rising interest rates and stock market performance. Stocks can, and often have rallied in a rising interest rate environment. In fact, rising interests rates and a strong economy typically go hand-in-hand and as a result, good earnings growth offsets the negative impact of rising interest rates and PE compression. This explains why first-quarter results and corporate guidance will be important this season. If PE multiples cannot expand, the only driving force for equities will be rising earnings.

Meanwhile, it appears that the Fed is warning us that interest rates are about to rise quickly and substantially this year. St. Louis Federal Reserve Bank President James Bullard recently stated that he believes the fed funds rate needs to rise to 3.5% by the end of the year in order to slow the current 40-year-high inflation pace. He also said he would not rule out a 75-basis point rate hike in May, although his preferred rate path would be 50 basis-point hikes at each of the six remaining FOMC meetings this year. Separately, Chicago Federal Reserve Bank President Charles Evans said the Fed should raise its target range to 2.25%-2.5% by year end and then take stock of the state of the economy. If inflation remained high, the Fed could hike rates further. We have noted that most Fed policymakers estimate neutral to be somewhere between 2.25% and 2.5%.

All in all, these various comments by current Fed governors are tempering the markets for the Fed’s next move and to date, investors are responding well to the fact that rates will soon rise at least 50 basis points. We do not sense any panic, but we fear this could be temporary. In our opinion, the Fed is aware that it needs to slow the economy, and in order to tame inflation, they must tap the breaks on the housing market and auto sales. Unfortunately, steering the economy to a soft landing may be extremely difficult, particularly with the tenuous situation in Europe. We remain cautious and continue to emphasize areas of the market that benefit from inflation or can weather inflation such as energy, utilities, defense stocks, and staples. See page 12. Plus, stocks with solid dividends are good substitutes for bonds in a rising rate landscape.

Economic Releases

The NAHB single-family confidence survey for April revealed that homebuilders have had a slow, but steady decline in conviction for the first four months of the year. Housing starts and housing permits were higher in March, up 3.9% and 6.7% YOY, respectively; but unfortunately, the increase in both series was in multi-unit housing. Single-family permits and housing starts, which account for the biggest share of homebuilding, fell in March. See page 3.

Industrial production for March rose to a record high, edging above the August 2018 peak. March’s gain was driven by a rebound in auto and truck manufacturing where production had been weak for most of 2021 due to semiconductor supply problems. Electric & gas capacity utilization eased in March. Whereas electric & gas capacity utilization used to be a benchmark for defining activity in the manufacturing sector, the steady decline in utilization since May 1970 is a display of the energy efficiencies seen in the US over the last five decades. See page 4.

In March, total retail & food sales rose 6.9% YOY. Excluding autos, sales rose 9.1%, and excluding autos and gas, retail sales rose 6.2%. The volatility in retail sales in early 2021 makes year-over-year comparisons difficult and less meaningful. Still, with inflation up 8.6% YOY in the same time period that retail sales rose 6.9% YOY, this means real sales were negative in March. Equally important, gas station sales rose 17.1% YOY in the month as a result of soaring gas prices. See page 5.

Technical Updates

Stock prices appear to be in the midst of a rally, but due to a convergence of moving averages, important resistance levels are directly overhead in all the indices. This convergence/resistance is most apparent in the SPX at 4500 and in the DJIA at 35,000. The Nasdaq Composite Index and Russell 2000 have weaker charts and remain well below their 200-day moving averages. See page 8. Last week AAII bullish sentiment fell 8.9 points to 15.8%, the lowest since September 1992. Sentiment has been unusually volatile this year, but this low bullish sentiment is a positive for the longer term.

Gail Dudack

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US Strategy Weekly: Is Recession Inevitable?

According to Reuters, as soon as Wednesday, President Joe Biden’s administration could announce it is extending another $750 million in military assistance for Ukraine’s fight against the Russian invasion. Separately, the Pentagon is hosting leaders from eight weapons and defense manufacturers to discuss the industry’s capacity to meet Ukraine’s needs in case the war with Russia lasts for years.

These announcements are just one indication of how the world, the financial markets, and potentially, our futures have changed in the last two months. There is no denying that energy prices were trending higher well before Russia invaded Ukraine in late February. However, energy, grains, metals, Russia, Ukraine, inflation, financial markets, and politics are now irrefutably intertwined in an inflationary quagmire. This war-induced combination is not really something the Fed has the tools to fix. And in our opinion, this is why the consensus has flipped from optimism to pessimism about the US economy and is worried about a Fed-induced recession. We are too.

Other headlines are also disconcerting: the possibility of Russia using chemical weapons in Ukraine, eurozone banks becoming risk averse and tightening corporate credit, and China shutting down Shanghai due to the spread of a COVID variant. It is a mixed collection of news, but individually and together, it points to substantially weaker growth or potentially a global recession.

Stay Defensive

We contemplated raising cash this week, however, we still believe select stocks can do well despite these challenges. In fact, some companies will benefit. Therefore, we remain overweight the energy sector, industrials (with an emphasis on defense stocks), consumer staples, and utilities. Each of these sectors is a direct, or indirect, beneficiary of the current world condition. Utilities are not a direct beneficiary, but they are defensive, can pass on costs to consumers and are preferable to bonds in an era of rising interest rates.

Inflation continues to Roar

The March CPI report was filled with bad news. Headline inflation exceeded expectations showing prices rising 8.5% YOY with core inflation up 6.5% YOY. Both series displayed the highest inflation in 40 years. Energy rose 32.2% YOY, up from 25.7% in February. Food prices rose 8.8% YOY, up from 7.9% in February. Services rose 4.7% YOY, up from 4.4% YOY. Goods inflation “moderated” to 11.7% YOY, down from 12.4% YOY in February. See page 3. The March CPI report indicates why the average household is struggling to keep up with normal expenses even though average weekly earnings rose 4.6% YOY in March. After inflation, the purchasing power of consumers fell nearly 4% YOY in March.

All the large segments of the CPI – housing, food & beverages, medical care, and transportation – have been experiencing escalating price increases over the last six months. See page 4. Many economists, like Larry Summers, are voicing concerns about the probability of a recession in the next two years; and not surprisingly, most strategists fear the Fed will trigger a recession by raising interest rates too much or too fast.

A History Lesson

However, history suggests that today’s inflation rate has reached a level that may make a recession inevitable. On page 4, we show a long-term chart of the S&P 500, various inflation benchmarks, and recessions. It shows that the last time inflation began to soar at this pace was during the oil embargo of 1973. That inflation was followed by three recessions in the subsequent ten years.

This era was called the “great inflation” and it began in late 1972 and did not end until the early 1980s. In his book Stocks for the Long Run: A Guide for Long-Term Growth (1994), our friend Wharton Professor Jeremy Siegel, called it “the greatest failure of American macroeconomic policy in the postwar period.” This decade-long inflation era has been blamed on many things: oil prices, the end of the gold standard in 1973, funding of The Great Society legislation, greedy businessmen, food shortages due to bad weather, and avaricious union leaders. But, according to Professor Siegel, the root cause of the great inflation was monetary policies that financed massive budget deficits driven by political leaders and their legislation. This should sound familiar.

The great inflation ended with Paul Volcker, Chair of the Federal Reserve from 1979 to 1987. Volker made financial history in March 1980 when he raised the fed funds rate from 14% to 20%, its highest level on record. It was tough love but needed in order to end years of crippling double-digit inflation. Volker also moved the fed funds rate back to 20% in May 1981 when inflation began to creep higher. Although widely criticized at the time, the March 1980 “Volker Shock” is now seen as a courageous and wise act. Both rate hikes to 20% were followed by recessions, but in the end, it finally broke the back of a dangerous inflationary cycle.

Perhaps this was the history lesson discussed at the March FOMC meeting. If so, it would explain why dovish Fed governors like Lael Brainard suddenly become monetary hawks. The current Fed seems determined to enforce tough love on the economy in 2022 by raising interest rates and contracting its balance sheet. We believe both are needed. Unfortunately, it also raises the risk of recession.

Earnings Season

This week kicks off first quarter earnings season, and while all earnings seasons are important, this time analysts will be listening carefully to hear what corporate leaders have to say about revenues and margins. As we show on page 6, inflation is apt to pressure margins this year and we already discussed how inflation will decrease the purchasing power of households. IBES currently is forecasting earnings growth in the first quarter of 6.1% YOY but excluding energy growth falls to 0.6%. Clearly, any disappointments this quarter could tip the balance to negative for the quarter. Again, we would emphasize companies that benefit from the current environment, have predictable earnings streams, and safe dividend yields.

Technical Events

In our view, the most meaningful technical event of the last week was the inability of the DJIA to better the resistance found at 35,000. A convergence of three key moving averages made this a critical point for the index, and the DJIA not only failed to break through but has been noticeably weak in recent sessions. All the popular indices have a similar pattern, but it was most clearly seen in the DJIA. In short, all major indices continue to trade below their 200-day moving averages in a classic bearish pattern. AAII sentiment has been unusually volatile. Last week, bullish sentiment fell 7.2 points to 24.7% while bearish sentiment jumped 13.9 points to 41.4%. Pessimism has been above 40% for nine of the last 12 weeks. Optimism has been below 27.9% for 10 of the last 13 weeks. Neutral has been above average for the third consecutive week. Overall, the AAII bull/bear spread remains positive.   

Gail Dudack

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Elon Musk A Passive Investor … And Do You Wanna Buy A Bridge?

DJIA:  34,584

Elon Musk a passive investor … and do you wanna buy a bridge?  Can’t wait to hit that edit button.  His 9% position in Twitter, the ultimate tweet of sorts, helped the NDX by 2% on Monday, rendering new hope for the forgotten, downtrodden, etc., that is, beaten up Tech.  Not quite the same as landing a rocket on a dime, but impressive.  And the other company, Tesla is it, isn’t doing so badly as well.  Names like Tesla (1057), Amazon (3153) and Google (2717) pretty much all peaked late last year.  After their hibernation, the irony might be they come back to outperform in a poor market, not exactly what most would expect.  That said, we still see what we’re calling the commodity stocks the likely ongoing leadership.  Exacerbated by the war, commodities across a broad range are in short supply.  The stocks themselves have another edge, they’re in short supply, that is, they’re under owned. News of Russian coal sent those stocks higher Tuesday, while not that long ago the Coal ETF was dissolved for lack of interest.

You say either we say ither. The debate eternal always seems to be between growth and value. You might also debate just what is a value stock and what is a growth stock. The good people at Invesco have done this for us with the Pure Value ETF (RPV-85) and the Pure Growth ETF (RPG-180).  As it happens we don’t particularly agree with either list, but at least here is something objective and from a credible source.  To look at the charts, clearly value is kicking growth, and we suspect it will continue to do so.  Our idea of growth is a bit more techie, and our idea of value is a bit more about commodities.  We should add some defensive names like Hershey (223) and Church & Dwight (103) act well.  If you compare the Tech Software ETF (IGV-336) with the Metals and Mining ETF (XME-60) the picture is the same, though the XME outperformance is more dramatic.  Again, we expect this to continue.

We have long thought where the stock market tells its economic story is the Transports.  Originally, and the theory behind the Dow Theory, both the industrials and the transports were supposed to tell the story.  This, of course, was when the Industrials were industrials, hardly the case these days.  Granted the “Transports” aren’t exactly the rails of old, they still pretty much get the stuff around.  Looking at the Transports relative to the S&P, last Friday’s weakness was the seventh worst day against the broader market since 1928.  When looking at other occurrences, this kind of move was associated with the most traumatic episodes in US market and economic history, according to Bloomberg strategist Cameron Crise.  While last Friday’s otherwise up day didn’t seem that traumatic, the trauma may be yet to come.  Meanwhile, as a proxy for economic activity in the US, the weakness in the transports is of some concern.

They say the consumer is in good shape.  That’s not exactly what those consumer sentiment surveys say.  They’re worried how high prices are going, and everywhere.  Even demand for products which target a more affluent consumer recently has fallen.  It’s a mystery what keeps home prices so high when you look at those homebuilder charts and associated names like Home Depot (303).  Wage increases, while enough to pressure businesses and keep pressure on the Fed, aren’t enough for consumers to keep up with inflation that is running close to 8%.  A report also shows real, or inflation adjusted disposable personal income per capita fell for the seventh straight month as rising prices outpaced employment and wage gains.  And they say we’re not even in a recession, though based on those consumer sentiment numbers, we would contend we are.  And while there are “soft landings,” there are none we know of when inflation was above 5%.

We’ve seen this recovery as a rally in a downtrend, a rally in a bear market.  We also see this rally, technically speaking, as better than we might have expected.  Then, too, bear market rallies usually make you wonder.  As often happens in these recoveries, things change quickly as was the case this week, going to a 4-to-1 down day Wednesday versus a 4-to-1 up day last Tuesday.  There were no divergences going into this weakness, weak up days, for example, so that may be yet to come.  Or this time was that hit to the Transports the warning.  Where would we be without Lael Brainard to tell us rates are going higher? Though, the mention of QT might have been the real culprit.  Whatever the case, the market lost something this week, and if a bear market rally that’s particularly worrisome.  Meanwhile, just say YES to drugs, those made by Lilly (309), Pfizer (55) and others part of the XLV (142) ETF.

Frank D. Gretz

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US Strategy Weekly: Russian Defaults and Weighting Shifts

The Russian war on Ukraine continues and the news from the battlefronts are disturbing. Global sanctions on Russia, Russian companies, and their corporate leaders and oligarchs escalated this week as well with the hope that the financial pain inflicted by sanctions may deter President Putin from his aggressive path. In a lengthy statement this week, US Treasury Department listed companies and individual corporate leaders known to be used to evade recent sanctions, and imposed measures to close loopholes and prevent them from operating or procuring western technology. All property, interests in property, and assets in the US, including all financial assets in US banks, of individuals listed by the Treasury, are now frozen and cannot be used to pay interest on loans or perform any business transactions. Injunctions were expanded to include aerospace, marine, and electronics sectors.

In addition, the US and Germany jointly sanctioned the world’s largest and most prominent darknet market, Hydra Market, in a coordinated effort to disrupt malicious cybercrime services, sales of dangerous drugs, or other illegal offerings available on the Russian-based site. German Federal Criminal Police shut down Hydra servers in Germany and seized $25 million worth of bitcoin. Garantex, a ransomware-enabling virtual currency exchange founded in late 2019, was also sanctioned. All of these measures, and the sanctions ordered before this week, are meant to cripple Russia’s economy and provoke sovereign and corporate debt defaults.

Meanwhile, Britain ordered a report into shale gas fracking on Tuesday, less than three years after banning the practice, saying all options should be available in light of a Ukraine crisis-fueled surge in gas prices. We applaud this shift, but it also reveals the misjudgment of the UN-sponsored Paris Agreement on climate change. Western countries made major steps to decrease fossil fuel production, but these steps only opened the door for oil-rich countries like Russia to take control of the world’s energy markets. In our view, the path to renewable fuel should have been done in conjunction with the US remaining energy independent, not before.

Yield Curve Fears

However, none of these issues reversed the March rally. Instead, it was Federal Reserve Governor Lael Brainard, one of the Fed’s most dovish governors. She stated that a combination of interest rate hikes and balance sheet runoffs were needed to quickly move monetary policy to a more neutral position this year. The implication was that the Fed is clearly set on a hawkish path in 2022 to contain inflation. This week’s release of the March FOMC meeting minutes is expected to provide more details of the Fed’s plans.

However, as we just pointed out, today’s inflation is not simply a demand-driven cycle that the Fed can contain. It has materialized from a diminished supply of energy, particularly in fossil fuels. It came from a lack of investment. It is policy driven. It is man-made. In short, the Fed will have a difficult time trying to tame current price increases. Moreover, since Russia and Ukraine are the breadbasket of Europe food and meat prices will also rise this summer. This is a raw material inflation cycle, and the Fed does not have the tools to fix it, without perhaps triggering a recession.

In our opinion, the obsession with the yield curve and a possible inversion is really based upon these underlying facts. Yes, the Fed was too slow to change policy to control inflation, but the cycle is now exacerbated by geopolitical events that are not under their control. This is a cause for concern.

Plus, the sanctions imposed on Russia are meant to create defaults on loans, and this too, will have repercussions. JPMorgan Chase CEO Jamie Dimon made two important comments recently. First, he indicated that the Fed could lift interest rates by more than 2.5% this year, more than most expect. Second, he indicated that the bank may need to take as much as a $1 billion of reserves against Russian debt.

Sector Weighting Shifts

Our main concern is that a combination of inflation-induced margin erosion, a rising cost of capital, and write-offs related to Russia, either from corporations exiting businesses in Russia or defaults from Russian debt, will weigh heavily on earnings performance this year. For these reasons, we remain cautious and believe investors should seek safety in areas that are insulated from these risks. These areas include energy, staples, cybersecurity, and aerospace and defense. We are upgrading utilities from underweight to overweight this week because we believe high dividend-paying stocks will be in demand as bond prices fall. Utilities are also able to pass on energy costs to consumers. We are also lowering our weighting on the technology sector from overweight to neutral. This is more in line with our view that technology stocks will be one of the most volatile areas of the market in 2022 and while trading opportunities arise, they may not provide the best intermediate-term strategy – with the exception of cybersecurity. Lastly, we are lowering the REIT sector from neutral to underweight due to the pressures we anticipate from higher interest rates and rising costs. See page 13.

Economic Releases

The final estimate for fourth quarter 2021 GDP growth was 6.9%, a nice improvement from the 2.3% pace seen in the third quarter. However, on page 3 we overlay the real 10-year Treasury note yield on real GDP growth. This shows that real yields are extremely negative, which historically has only been seen during a recession. Recent unnecessary stimulus explains the historic level of inflation we are currently experiencing and points out why interest rates must go much higher this year. The Fed’s task is now extremely difficult and the risk of too much tightening and an inverted yield curve is real.

The major contributor to growth in the fourth quarter was gross private investment, while personal consumption of goods was barely positive, and consumption of services rose modesty. Unfortunately, the largest contributor to private investment was a buildup of inventories, and this could dampen growth in the first quarter of this year.

Staying at home or traveling by car became the norm during the COVID pandemic and this contributed to strength in housing and autos. Auto sales have been a solid contributor to retail sales, but the pandemic boost appears to be over. Unit auto sales have been declining since mid-2021. In March, total unit sales of autos and light vehicles were 13.7 million, down 24% YOY. See page 5. The ISM manufacturing index slipped to 57.1 in March although employment, prices, and inventory rose. The main weakness in manufacturing was found in new orders and backlog of orders. The ISM non-manufacturing index rose slightly to 58.3 in March due primarily to strength in employment, new orders, and exports – all good signs. However, service business activity slipped a point to 55.5 in March. See page 6.

Gail Dudack

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Stagflation or Recession?

To date, 2022 has been a rough year for equity investors. After seven consecutive quarters of solid price gains, the first quarter of the year ended with a loss of 4.9% in the S&P 500 index, a fall of 4.6% in the Dow Jones Industrial Average and a larger 9.1% decline in the Nasdaq Composite index. These were the first 3-month declines in the indices in exactly two years, or since early 2020, when the COVID-19 global shutdown triggered a global recession.

Still, considering the alarming invasion and bombing of Ukraine by Russia in late February, we believe the decline in stocks has been remarkably orderly. Particularly since this attack has catapulted the world economic and geopolitical environments into turmoil. In addition, February’s inflation benchmarks revealed that consumer prices were soaring 7.9% year-over-year – a forty year high — and Russia’s conflict with Ukraine is expected to exacerbate prices in fuel, grain, and fertilizer for the foreseeable future.

Last, but far from least, in mid-March the long awaited, yet decisive shift from a monetary policy of extreme ease to tightening began. This shift by the Fed reverses the historic liquidity boost that has been supporting stock prices for the last 24 months. In addition, following the FOMC meeting, Chairman Jerome Powell indicated there will be many more interest rate increased before year-end and the consensus is now forecasting rate hikes in each of the next six FOMC meetings this year. There is no doubt that a shift in monetary policy will impact the US economy. The only question is how much. Will the Federal Reserve be able to manage a soft landing for the economy? Or will the shift trigger stagflation or a recession? The next few months should be telling.

Changing Landscape for Investors

In short, the environment for equities has changed and the Fed’s shift to a tightening policy will be pivotal. Expectations of multiple rate hikes have triggered fears of an inverted yield curve and a recession. While we believe this fear is real, we also believe it is premature. First, inverted yield curves can be measured in many ways, but in our opinion, a truly inverted yield curve requires the 3-month

A truly inverted yield curve requires the 3-month Treasury bill yield to exceed the yield on the 10-year Treasury note yield. This is not in place and is unlikely to appear in coming months.  

Treasury bill yield to exceed the yield on the 10-year Treasury note yield. Given the present level of short-term rates, all things being equal, it would take eight 25 basis point rate hikes by the Fed to invert the yield curve. This is unlikely to materialize in coming months.

Second, history shows that markets usually rally following early rate hikes and begin to weaken only after four consecutive rate hikes take place within a twelve-month period. This implies the actual risk associated with inverted yield curve will appear later in the year.

In our view, the 10-year Treasury note market is a huge global market, is not under the Fed’s control, and due to its global reach, can be an excellent predictor of future economic strength. Yields often fall, sometimes precipitously once investors expect rising interest rates will significantly damage economic activity. We would remain alert to this possibility, but do not expect it soon. And remember, the curve usually inverts six to twelve months prior to the start of a recession.

Earnings will be the key to investments

Balanced portfolios should include stocks with a predictable earnings stream shielded from inflation, price earnings multiples at or below the S&P 500 average and dividend yields greater than 1.5%.  

Whether the Russia-Ukraine conflict increases or diminishes, whether inflation grows or weakens, earnings growth, or the lack thereof, is the true foundation of any market trend. With this in mind, the upcoming first quarter earnings season will be important since it will indicate how well, or how poorly, companies have weathered the various difficulties of supply constraints, inflation, and rising interest rates, of the first quarter. First quarter earnings season begins this month, and it could become a market moving event.

Beneficiaries of inflation such as energy, food, and staples are expected to do best and outperform this year. The Russian invasion has been the catalyst for many Western countries to increase their defense budgets and this increase in spending will benefit defense stocks and the industrial sector. Cybersecurity is another sector that is likely to see more capital investment and rising demand from consumers. Conversely, we will be watching company statements from housing and auto companies to see how corporate leaders respond to the prospect of rising interest rates and waning demand.

Investing in a new environment

In an era of rising inflation and higher interest rates, equites can still perform well but portfolios need to adjust. The best insulation today would a balanced portfolio 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%.

However, given the geopolitical and policy uncertainties in the current environment; we would not be surprised if equity indices trade within a broad trading range for most of 2022. If so, holding a core portfolio tilted toward value stocks is still advised. But for those willing to be nimble, we expect a trading opportunity may appear in the technology sector in coming months.

Gail Dudack, Chief Strategist

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The Greatest Trick Bear Markets Ever Play… Is Making You Think They Don’t Exist

DJIA:  34,678

The greatest trick bear markets ever play… is making you think they don’t exist. The original line from the “Usual Suspects” was about the devil rather than a bear market, but you can see a certain commonality.  Bear market rallies usually go far enough to make you wonder.  And while the war looks on going, inflation looks on going and rising rates look on going, who are you going to believe?  You are going to believe prices and prices are going up.  Opinions follow price.  We know of no rules as to how far these things can go.  Already through the 50 and 200-day moving averages, it is enough to make you wonder.  And while too good to die here, the rally will die as all do, with technical problems like divergences – when the average stock begins to underperform the stock averages.  So far so good, but look for a change to up in the averages and flat, let alone down in the A/D’s.

It’s that time of the year, or the cycle, when talk of the yield curve fills the air.  The yield curve is almost inverted, and parts of it are already.  We don’t pretend more than a superficial knowledge here and, therefore, have no strong opinions.  We will say, however, when it comes to the stock market anything so talked about rarely comes to much consequence.  It is also a bit ironic that an inverted yield curve and a recession should come to the fore in the midst of this rather spectacular recovery.  Isn’t it the market that’s supposed to be the predictor of such things?  Our two cents, and here you really do get what you pay for, is there will be a recession and the market will get around to predicting it.  In other words, this is a bear market rally.  Rather than the curve, we worry that the start of QT is the bigger concern.  In 2011, 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 balance sheet shrinkage came before a 12% decline and a similar result followed in late 2018.

And then there were two – FANG stocks, that is, that you might want to own.  Amazon (3264) is the only one up on the year, though by the time you read this who knows?  And, who knows, by that time, Google (2781) could be.  We like to look at stocks like this on a monthly rather than daily chart which obviously dispenses with much of the volatility, and unimportant moves.  Amazon is a good example, having looked pretty poor a few weeks ago based on the daily chart.  A monthly chart, however, basically was that of a consolidation in the overall uptrend.  Granted there was a bit of a break in January, but these false moves or breaks often happen in these patterns and, indeed, you can see a lesser but similar break in March 2020.  The key is the stock didn’t linger there, it snapped right back.  What’s needed now is a move through the upper end of the pattern around 3600+.

So when you split a stock does that make it more valuable?  They say no but don’t tell that to Tesla (1078).  Tesla is another stock that always seems to tell a more accurate story on a monthly rather than a daily chart.  In this case, the pullback came to rest right on top of last year‘s eight month consolidation.  The daily chart would have worried you, the monthly not so much.  It is an example, too, that extended stocks do have their corrections – in this case some 500 points.  Meanwhile, is Tesla dragging those utilities with it?  The textbook says rising rates are bad for utilities as they are big borrowers.  While not a “Tesla” chart, XLU (74) has turned into one of the better charts around. As measured by the SPDR Real Estate ETF (XLRE-49), many REITs also are looking better and like XLU, there’s a respectable dividend yield.

Tuesday saw NYSE Advance-Decline numbers of better than 4-to-1.  This followed back to back 4-to-1 numbers a week or so ago.  These are impressive and an example of what we mean when we say the rally is too good to die here.  And it’s not just the strong up days, it’s also the lack of weak up days, those days up in the averages with flat or negative A/D’s.  Down days don’t kill markets, it’s the weak up days that do.  When it comes to that, it’s time to be careful.  Meanwhile, if you’ve been in the market for only the past decade or so this is frustrating.  This period has proven repeatedly that it’s right to be fully invested, and to buy the dips.  We would point out, however, that during the 2007-09 bear market there were 11 10% rallies. Meanwhile, some time ago we published a list of stocks with inconsistent long-term uptrends. One such stock which is now also above its 50-day moving average is Prologis (164).

Frank D. Gretz

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US Strategy Weekly: Housing and Yield Curves

Rumors of improving discussions between Russia and Ukraine helped foster a rally in equities this week. The advance generated changes in our technical indicators as well as in the charts of the popular indices. However, to date, there is nothing to suggest that recent gains are anything more than a short-covering rally coupled with institutional accounts making portfolio adjustments at the end of the first quarter.

At present, both equities and commodities, particularly crude oil, are experiencing tremendous volatility and appear to be captive to ever-changing headlines, but the underlying economy is little changed. Inflation continues to be a major threat; monetary policy is destined to be unfriendly, and the combination is apt to be detrimental to the economy, the consumer, and corporate profits. The real question is how big a hurdle the combination of rising prices and rising interest rates will be for economic activity, particularly for the housing and auto sectors.

This week we will get data on personal income and personal expenditures for February, March employment, final fourth quarter GDP with corporate profits, plus vehicle sales and the ISM manufacturing report for March. These reports should give investors a better feel for how businesses and consumers are reacting to the Russian invasion, inflation, and rising interest rates. More importantly, in the coming weeks earnings reports for the first quarter will begin and as we have noted in the past, this could become a market-moving event. History has shown that stock markets can perform well in an environment of rising interest rates – the caveat is that earnings must be rising faster than before to compensate. This seems unlikely to us, but if earnings are better than expected, this could provide good downside support for stock prices.

Housing is Weakening

An index of pending home sales fell to 104.9 in February. This was the lowest reading since May 2020 and the fourth consecutive month of declines. Note that monthly new single-family home sales peaked in July 2020 at 85,000 and the year-over-year growth rate in units sold has been negative since June 2021. Unit sales dropped to 65,000 in February. We expect that rising rates will make housing less affordable and unit sales will continue to fall. See page 3.

New home unit sales, including multi-family, single-family and condominiums, were 772,000 in February, a 6% decline from a year earlier. However, while unit sales are slipping, prices are rising, and the average price of a new single-family home rose 25% YOY to $511,000. The median price of a single-family home rose 10.7% YOY to $400,600. These price gains are significant. When we index personal income and home prices to a baseline like 1973 it becomes clear that from 2008 to 2021 personal income was consistently rising faster than home prices. That made homeownership more affordable. Sadly, this changed in 2022 and prices are now rising faster than personal income, and this is one reason homeownership may become more challenging later this year. See page 4.

GDP growth requires rising capital investment, and we fear housing may face a slowdown in the second half of this year. Residential construction spending was $50.3 billion (SAAR) in December, a solid 15.3% YOY increase, although a deceleration from the 31.8% YOY increase recorded at the May 2021 peak. At present, the residential construction market appears solid, but home builder confidence has been slipping in recent months. The National Association of Home Builders survey for single-family sales showed that “expectations for the next six months” fell to 70, the lowest level recorded since September 2019. In general, the survey shows that homebuilder confidence peaked in November 2020 and has been slowly declining since that time. Builders are indicating that pricing pressures and the knowledge that mortgage rates will be rising as factors that make them uncertain about the future. See page 5.

The Yield Curve

The 10-year note yield rose from 2.16% to 2.41% this week yet despite rates rising on the long end, fears of an inverted yield curve are escalating. In our view, an inverted yield curve requires inversion between the fed funds rate and the 10-year Treasury note yield to truly warn of a recession. Moreover, inverted yield curves have historically preceded recessions by six to twelve months, on average, and therefore the angst regarding an inversion today appears to be overdone and too early, in our opinion. However, given the expectations of seven to nine fed fund rate hikes this year, the risk of an inverted yield curve, and a recession in 2022, is a possibility. But keep in mind that the Fed has control over the short end of the curve, but not the long end of the curve. When investors believe the Fed has tightened too much, and a recession is at hand, this is when the long end of the curve collapses and the curve inverts. At present, interest rates are rising on the long end, and we find this a bit reassuring. See page 7.

Technical Indicators and Charts

The major head-and-shoulders top formation that we have been discussing in the S&P 500, that had downside targets of SPX 4000 and SPX 3800, was nullified this week by the advance seen in the SPX. The index rallied above all its moving averages, including the 200-day moving average, which is a positive for the overall market. See page 8.

In terms of technical strength, the SPX displayed the greatest price momentum in recent days. The DJIA also rallied and has edged above key resistance at the DJ 35,000 area. But we believe the DJIA needs to sustain this advance to demonstrate that this is not a false breakout. The Nasdaq Composite has moved up toward its resistance level defined by the combination of its 100-and 200-day moving averages, but it lags its counterparts and is yet to breach this resistance. See page 9.

The charts of the Russell 2000 index (RUT – $2133.10) and (AMZN – $3386.30) continue to look similar and since they were leaders at the top of the market it is also possible that they will be leaders at establishing a low in equities. AMZN is clearly outperforming the RUT; but the RUT is unfortunately the weakest of all the main market indices. It is about to test its 100-day moving average at 2143.85 and 200-day moving average at 2197.08 and we will be watching to see if this index can better resistance. Even so, while the SPX and DJIA have surpassed their respective resistance levels, further gains are required to confirm that these moves are indeed “breakouts” from resistance and not merely a short-covering rally and portfolio window dressing. See page 10. Our 25-day up/down volume oscillator is at 2.38 this week and close to an overbought reading above 3.0. An overbought reading would be surprising and suggest that the market is in a long-term trading range, not a bear market. The 10-day averages of new highs and lows are 133 and 177, respectively. Again, the combination implies a neutral market. Overall, we remain cautious for the near term.

Gail Dudack

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It’s a Rally in a Bear Market… But We’ll Pretend to be Open-Minded

DJIA: 34,707 It’s a rally in a bear market… but we’ll pretend to be open-minded. A bear market is being defined these days as a decline in the S&P of 20%. That strikes us more like a definition for a bear market’s end. Down 20%, now you tell me it’s a bear market? And down only 8% or so in the S&P, this isn’t a bear market – tell that to the third of NASDAQ stocks down more than 50%. If you’re looking only at the market averages, you are looking at the wrong thing. And in bear markets looking at the averages is dangerous. Seeing the S&P down only 8% or so, there’s hope for all those losers you hold, hope the averages will drag them up. It doesn’t work that way. Eventually the weak drag down the strong, leaving you there with hope and a lot less money. When it comes to definitions, our favorite for a bear market – it’s when they sell my stocks. So maybe it’s not a bear market, they’re not selling those commodity stocks. Last week’s rally was impressive. It was, however, pretty much a rally in those stocks beaten the most, that is, Tech. We argued that in markets like this, where the weak get overdone on the downside, down the most turns to up the most. That we’ve certainly seen. When this happens it typically becomes either/or, in that what had been acting well falls from the forefront. And Oil and Gold and the other commodities did pull back a bit – but not much. If you look at the Metals and Mining ETF (XME-63), a veritable smorgasbord of commodities, it’s right back to new highs. In terms of leadership, that pretty much says it all. Though admittedly it could still be early. You can’t say the same of even the best of Tech. If there was a misunderstanding of Powell’s comments last week, that wasn’t the case this week – rates are going up. The market went completely unscathed last week and has done pretty much the same this week. And, in our gesture to being open-minded, maybe the market has gotten it right. Powell went to some length to counter the point that the central bank cannot hike rates enough to dampen inflation without causing a recession. And, indeed, there are “soft landings” where rate hikes did not cause recessions. The stock market, however, seems another matter. Higher bond yields tend to be bad news for stocks as they make high stock valuations hard to justify. More than rates, the eventual move to QT from QE could be what really does things in, so to speak. We just keep coming back to the tired but wise old saying, don’t fight the Fed. Let’s say you’re walking down the street doing your oligarchy thing and bam, your money is frozen. You’re probably wishing you had a little of that crypto stuff. We hadn’t looked at bitcoin, the only crypto we follow, in some time. We hadn’t paid much attention because stocks like Marathon Digital (30) and Riot Blockchain (22) have been in downtrends since late last year. Maybe it’s just coincidental with confiscation worries, but over the last few weeks these stocks have acted much better. Of course Gold has acted well and indeed, so too have most commodities. A stock like Archer Daniels (90) is trading at an all-time high, little wonder we suppose when you look at the ETFs for Corn (CORN-27)) and wheat (WEAT-10). After all the volatility in late February, Deere (432) now seems out of its nearly yearlong consolidation. There have been some impressive aspects to the recovery, and we’re not just pretending. When the market reversed a month or so ago, the day of the invasion, we expected a tradable rally, maybe back to the 50-day in the averages. We’ve done that and more in some cases. But it’s not what the market has done, it’s how it has done it. Last week saw back-to-back 4-to-1 up days in NYSE A/D numbers. Sure Wednesday was a bad Dow day, but not for the average stock – more than 1400 stocks advanced. We haven’t seen the kind of weak rally, up in the averages and poor A/Ds we admit to having expected. On the NASDAQ we’ve seen four consecutive 1% up days, very unusual and historically positive. Then there’s the backdrop – VIX down, stocks up, despite the risk of nuclear war? Correcting the speculative bubble of the last few years likely means more than 8–10% correction, but for now there’s likely more upside.

Frank D. Gretz

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US Strategy Weekly: A Russian Bear

Current Reuters headlines include: “Russian strikes turn Mariupol into ashes of a dead land,” “Russia trades barbs at the UN with the US and UK about chemical weapons in Ukraine,” “Traders warn of Russia-related diesel and gas shortages in Europe,” “Fed policymakers lean into bigger rate hikes to fight inflation,” “Biden’s Supreme Court pick Ketanji Jackson defends representing Guantanamo detainees,” “Hackers hit authentication firm Okta (customers include FedEx and Moody’s Corp.),” and “Biden approval rating drops to a new low of 40% – Reuters/Ipsos poll. ” These headlines include a wide range of topics, yet each is individually disturbing. Nevertheless, this is the backdrop for what has been a healthy rally from the March lows.

The rebound has been greatest in technology stocks as seen by the 12% gain in the Nasdaq Composite index, as compared to the gains of 6.7% or 8.1% seen in the Dow Jones Industrial Average or S&P Composite index, respectively. However, the “outperformance” of technology should be expected since it has been the high PE stocks within the technology sector that have declined the most from all-time peaks made over the last five months.

The question, therefore, arises whether the current rally indicates the lows have been found, or if it is simply a short-term rotation of leadership from value to growth, i.e., a bounce within a larger bear market decline. In our opinion, the bear market has not ended even though it is possible that many stocks may have found their lows. Nonetheless, the landscape ahead remains treacherous, and we remain wary. Not only does the future include a hawkish Fed, but the risk of war in Europe, defaults of Russian sovereign debt, a consumer burdened by rampant inflation leaving little discretionary spending after transportation and food expenses, and therefore, a downside risk for earnings.

We have long been of the opinion that equities needed a valuation adjustment due to high inflation spurred on by too much monetary ease. And while equity prices were peaking before Russia invaded Ukraine, the war only exacerbates the existing problems. It translates into tremendous geopolitical uncertainty in the months ahead, and also means that diminished supplies of energy and grain will make the inflationary problem more severe. In short, if equities were facing a bear market in 2022; it is now worsened by the Russian invasion. This is a complex situation for a Federal Reserve, particularly since they were already slow to curb inflation. Strategists are now forecasting several 50 basis point rate hikes by the Fed and the Fed’s own dot-plot implies the fed funds rate will reach 2.8% by 2023. The sum of all this points to the risk of stagflation, the possibility of an inverted yield curve, and/or recession by the end of the year.


In our view, the earnings results for the first quarter and the comments made by companies about earnings prospects for the full year could become a market-moving event. If companies are optimistic about earnings, it will provide fundamental support for equities. If not, pessimism could generate another selling wave. Keep in mind that our valuation model for 2022 indicates that the appropriate PE multiple is 15.8 times earnings, which also happens to be the average trailing PE over the last 75 years. In our view, this is where value is found in the broad equity market. A 15.8 multiple with our $220 earnings estimate for this year equates to a downside risk to SPX 3475. The S&P 500 may not have to fall this far, but to date, we do not believe the lows have been made.

Technically Speaking

From a technical perspective, all the indices have rebounded above their 50-day moving averages, which is well within the characteristics of a bear market rally. More importantly, the 100- and 200-day moving averages are trending on a path that suggests they may soon converge in the indices. If so, this converging will define important resistance points in the near term. In the Dow Jones Industrial Average, the 100-day moving average is 35,145 and the 200-day moving average is at 34,975, implying that the DJIA 35,000 area will be a critical level for the intermediate-term. See page 9. One hopeful sign is found in the S&P 500 index where the move above the 200-day moving average has the potential to negate the major head-and-shoulders top formation we have discussed in recent weeks. If the index betters the 100-day moving average, which is now at SPX 4550, this will help to neutralize this bearish pattern. See page 8.  

Economic Trends

Recent economic releases should be analyzed with the knowledge that the numbers preceded the Russian invasion of Ukraine, the Fed’s first rate hike, and statements by board governors that the FOMC may become more hawkish in coming months.

On a seasonally adjusted basis, retail sales for February rose 0.3% month-over-month and 17.6% YOY. It should be noted that gas station sales rose 5.3% for the month and 34.6% YOY, which is the impact of higher gasoline prices. When auto and gasoline sales are excluded, retail sales fell 0.4% in the month, but still rose 15.8% YOY. The more interesting tidbit in retail sales data showed that February’s unadjusted retail sales fell 1.55% YOY; however, February or March tend to be the seasonal low point for retail sales. This means that March and April releases should be more revealing about the current status of household spending. See page 3.

The National Association of Home Builder confidence index fell from 81 in February to 79 in March, which marked the third consecutive month of declines. The sharpest decline in sentiment was seen in “sales expectations for the next six months” which fell from 80 to 70, the lowest reading since June 2020 during the pandemic. The pending home sales index is reported with a lag, but the January index fell to 109.5, its third consecutive decline and the lowest level seen since April 2021. Given the NAHB readings, we expect pending home sales will continue to fall. See page 4. Existing home sales for February were an annualized rate of 6.02 million, which was a 7.2% decline for the month and decline of 2.4% YOY. The weakest segment of the market was the northeast where sales were down 11.5% for the month and down 12.7% YOY. Nevertheless, the median sales price of a single-family existing home was $363,800, a gain of 15.5% from a year earlier. See page 5. The housing market will be one of the most important areas of the economy to monitor in the months ahead. Interest rates are clearly headed higher, but inventories remain low, and prices are steady. Wages are increasing, and this could offset some of the increase in housing costs. Still, there have been anecdotal stories of millennials who recently purchased homes but underestimated the cost of maintenance, taxes, and heating. In our opinion, all signals point to a slower housing market in the second half of 2022. And if rates rise quickly, the housing market could come to a quick halt. This will be a drag on GDP and will again, make the Fed’s job of taming inflation without throwing the economy into a recession all the more difficult. We remain cautious.   

Gail Dudack

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Down 20%… Mea Coupa

DJIA: 34,480

Down 20%… mea Coupa. Coupa Software (82) shares fell 20% Thursday after the company gave guidance that was below analysts’ estimates. The company said it was looking for first quarter revenue of $189 – $191 million, while analysts were looking for $191.4 million – quite the miss? Our favorite part in these things is Key Bank cut its price target for the shares to $125 from $175, once again, opinions follow price. To look at the chart, we would simply say welcome to the world of Tech over the last year. Granted Coupa may not be a household name, so try AMD (112) or Nvidia (248), both down some 40% from their highs. Tech is making the S&P look good this year, and the S&P is making commodity/value look even better. For Tech, days like Tuesday and Wednesday make hope spring eternal. Meanwhile, the best one day rallies are found in bear markets. So the market has held the January lows, but there’s a bit more to it than just that. Measures like stocks above their 50-day and 200-day averages, and the level of 12-month new lows held well above their own January lows. Divergences can be positive as well as negative, and in this case signaled diminished selling pressure into the decline. Add to that a market stretched to the downside, oversold as they say, and sentiment of doom and gloom, and you have the ingredients for a rally. We doubt this is more than another bounce in the downtrend, but we will concede the numbers haven’t been bad – 4-to-1 up days like Wednesday always get our attention. Had we seen strength in the averages along with flat A/Ds that would have been a real warning, and would caution in markets like this the numbers could change quickly. Bubbles are hard to recognize when you’re in them. When over, they’re embarrassing to recognize. Here in this happy place called retrospect, it seems clear we’ve had a few, most of which indeed are past tense. That’s not certain when it comes to bitcoin, though using Marathon Digital (27) as a guide, the move from 85 to 25 suggests it could be. Because of its relative obscurity, one of our favorite bubbles was that of the electric vehicle makers. We’re not talking Tesla (872) here, we’re thinking of Lordstown Motors (3), 31 to 3, Fisker (12), 31 to 10, or Canoo (6), 25 to 5. Another favorite would be the SPACS. Give money to someone to buy an unknown something and hope for the best. What could go wrong there? The Next Generation SPAC ETF (SPAK-17) has gone from 35 to 16, while an individual name like Skillz (3) has dropped from 46 to 3. And let’s not forget those Meme stocks. If the measure of bear market risk has to do with the speculation that preceded it, we would suggest there’s still considerable risk out there. Sometimes you have to ask yourself, do you want to be cool, or do you want to make money? We doubt many are comfortable bellying up to the local bar bragging about the utility stocks they own. And maybe that says it all. If you look at the XLU (71) chart on the other side, the SPDR Utilities ETF, you might mistake it for a Tech or, these days, an oil stock. Speaking of oil stocks, if you want an investment strategy that has worked pretty well over the years, follow the nice people at Dow Jones and Co. or, should we say, fade those nice people. They added (210) to the Dow, now down about 35% from its peak, and deleted Exxon (79), recently up some 38%. It’s not the fault of the keepers of the Dow, they’re only human, and human nature typically dictates that you go with what is working at the time. Another reason to worry about Tech, and another reason to think of utilities. The news from the Fed could not have been much worse – seven hikes! Rather than selling on the news, Wednesday saw buying on the news. It seems more that the much anticipated news was discounted, as they say. When the market was in its uptrend and the Fed compliant, the cry was don’t fight the Fed. We suspect that still could be sage advice, especially as quantitative easing turns to quantitative tightening. Meanwhile, peace scares have played a bit of havoc with the commodities trade, that and the idea most of the stocks had become a little stretched. The uptrends remain intact. Particularly given the strength in oil, it has been surprising the solar stocks haven’t acted better. As measured by the Solar ETF (TAN-75), the stocks are down some 25% from their highs. To look at the ETF, however, there is the suggestion that things may be changing. The downtrend has been broken and most of the stocks are above their 50-day.

Frank D. Gretz

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