Stocks have seen a year-end rally in each of the last six years and this phenomenon can be explained by a number of seasonal factors such as the end of tax-loss selling, mutual fund window dressing, and stock purchases due to liquidity from year-end and Christmas bonuses, among other things. However, we believe a year-end rally may be less robust than usual since thoughts of 2023 and its various hurdles could weigh on investor sentiment.

Recent market action suggests that investors are very willing to look on the bright side of the street. We prefer to be optimistic ourselves, however, the financial media is persistently focused on news that would suggest peak interest rates are directly ahead. This is viewed as a reason to expect the worst to be over and that a market advance is at hand. In some situations, it might be profitable to look past the economic valley of 2023 and look to invest for the longer term; but this time we think the valley may be deeper and wider than expected. For this reason, we remain prudent and look to keep our portfolio concentrated in necessities, recession resistant companies and sectors and stocks with predictable earnings streams and above average dividend yields.

Lowering Earnings Forecasts

The probability of higher interest rates and the likelihood of a recession in 2023 is high, in our opinion. Though we have been expecting a recession, we have not fully addressed it in our earnings forecasts. Our economic forecast included a weak first half of 2023 followed by an economic rebound, but even that may be too hopeful. This week we are lowering this year’s S&P 500 earnings forecast from $202 to $200 to reflect the decline seen in the third quarter earnings results. And since the typical recession results in a 10% decline in corporate earnings, we are lowering our 2023 estimate from $204 to $180.

Looking for an Average Recession

Since WWII, the last twelve recessions have persisted for an average of 10 months, have generated a 2% decline in real GDP, resulted in a loss of an average of 4 million jobs and led to a 10% decline in corporate earnings. Few recessions “match” the average, however, we believe inflation is more embedded in the economy than even the Fed would like to admit. If so, it means interest rates will remain higher for longer than expected. Chairman Jerome Powell was late to address inflation; however, we expect he has studied the last inflationary cycle that began in 1968 and continued until 1982. The error that Federal Reserve Chairman Arthur Burns made in the 1970 decade was to not keep interest rates high enough or long enough to get control over inflation. As a result, there were four recessions between 1970 and 1982, until inflation finally began to recede.

With this in mind, it follows that interest rates will remain higher for longer next year than many expect. If so, the 2023 recession may last for more than two quarters and have a more debilitating impact on corporate earnings. For all these reasons, we are lowering our earnings estimate once again.

The Inflation Problem

November’s CPI came in softer than expectations, and while the peak level of inflation may be behind us, the underlying details of November’s report are not as favorable as some market commentators seem to believe. Much of the decline in prices is the result of decelerating energy prices (which are still rising 13.1% YOY!); meanwhile, food and beverage prices are rising at a double-digit pace, and housing, transportation, and “other goods and services” inflation are increasing 7% YOY or more. See page 3.

It is very likely that headline inflation peaked at 9% YOY in April 2022, but the Fed’s lack of attention in 2021 to stimulus-driven inflation allowed price increases to become embedded in the economy. This is making inflation difficult to combat. As a result, core CPI has been hovering between 6.0% YOY and 6.5% YOY for several months — the highest in 40 years — and is far from the 2% target rate indicated by the Fed. See page 4. And inflation is no longer driven solely by the price of energy, nor is it a problem linked primarily to the rise in owners’ equivalent rent. The current drivers of the CPI include food and beverage pricing and a wide range of consumer services. See page 5.

It should be noted that prices for services have been on the rise since early 2021. The composite service component of the CPI rose 7.2% YOY in November, rose 7.2% YOY in October, and fell only slightly from the peak rate of 7.4% YOY recorded in September. With inflation now embedded in the largest segment of the economy, the Fed’s job has become more difficult than most expect. And as seen in the chart on page 6, the price of WTI crude oil has typically had a direct impact on inflation when it rises but has had less of an impact when prices fall. In our view, the consensus remains too sanguine about the path of inflation over the next 12 months. 

Moreover, 32% of small business owners indicated that inflation was their single biggest problem. The small business optimism index rose 0.6 points in November to 91.9, but this is the 11^th month below the 49-year average of 98. Of the 10 components, 6 increased and 4 decreased in November. The percentage of owners that plan to raise prices was more than 50% earlier in the year but now sits at 35%. Owners who think it is a good time to expand improved one point to six in November, but this is well below the long-term average of 13. See page 7.

2023: The Year of Earnings Adjustment

In 2022, investors began to take inflation seriously and focused on tightening monetary policy. As a result, there has been a steady decline in price earnings multiples this year. But the adjustments are not over. In our view, the challenge in 2023 will be the reality of a recession and the negative impact it will have on earnings.

As noted, we are lowering our S&P 500 2022 earnings estimate slightly to $200 and taking our 2023 estimate down $180 to reflect a 10% decline. However, even without a recession in 2023, S&P 500 earnings have been extremely high relative to the trend in nominal GDP. Earnings growth and nominal GDP tend to be highly correlated and the relative outperformance of S&P earnings versus economic activity in 2021 and 2022 is an unsustainable trend. A period of earnings outperformance has usually been followed by a decline in earnings. See page 8.

The recent earnings outperformance in this cycle is easily explained by the historic level of stimulus pumped into the economy both during and after the Covid shutdown. In short, corporate earnings were artificially elevated. As stimulus fades, earnings are apt to underperform, even without a recession in 2023. However, we expect the Fed will remain on track to raise short-term rates to 5% or higher next year and this makes a recession a high probability in the next twelve months. As we have often noted, inflation in excess of 4% has characteristically resulted in a recession. Double-digit inflation has historically been followed by multi-year rolling recessions. In sum, 2022 was a year of multiple compression and 2023 is apt to be the year of earnings deterioration. We remain cautious.

Gail Dudack

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When we look at the history of inflation, the history of Federal Reserve policy, and recent economic data, it is easy to conclude that a recession is either at hand, or at least on the horizon. But before we explain why we believe a recession is likely, it is also important to point out that the next recession should be different than those recently experienced, and hopefully more manageable. The main reason for this optimism is the healthy financial condition of the US banking sector. Just the opposite was true of the 2008 financial crisis and the severely weakened state of the US banking system was a major risk for the overall economy. Today, not only are the banks’ balance sheets in good condition, but we find that household balance sheets are also in fine shape. And even though corporate debt has been on the rise, corporate America is not overextended. This is important since it suggests that any recession should be relatively short and contained.  

The one area of concern is the federal government where stimulus packages have added trillions of dollars to the national debt in a short period of time. Congress approved the $2 trillion CARES Act in March 2020, which was followed by a $900 billion Covid-19 relief package in December 2020. Some of this was necessary. During the mandatory shut down of the economy very few Americans could go back to work and collect a paycheck. Businesses were forced to remain closed. Plus, the mandatory Covid vaccinations and tests were paid for by the US government to prevent the spread of the virus.

This was less true in 2021, yet in March 2021 President Biden’s Build Back Better plan became the American Rescue Plan Act of 2021 which was an additional $1.9 trillion stimulus package. In total, the national debt increased by nearly $5 trillion, or nearly 25% of GDP, in a short 12-month period. As of October, the US debt stands at $31.12 trillion, which means the federal debt load is currently more than 120% of GDP — estimated to be $25.7 trillion at the end of the third quarter.

Unfortunately, interest rates are now on the rise and the cost of carrying this debt will become ever more costly. And the US is not the only country that increased its national debt during the pandemic. This was true of many countries impacted by Covid-19. In short, if there is a weakness, or a problem in the next recession it could be centered in the sovereign debt markets.

Inflation and Recession

We have written in previous weeklies that whenever inflation has been above average (3.5%), an economic recession has followed. More worrisome is the fact that the last time inflation was as high as it is in the current cycle, or a standard deviation above the norm (6.2%), the economy suffered a series of recessions. This is best represented by the 1968-1982 era. In the current cycle, the Federal Reserve has been very tardy in addressing inflation and as a result, a recession has been delayed. But this may only make inflation more difficult to tame today and keep interest rates higher for longer than expected. Historically, the fed funds rate rose ahead of, or in line with, inflation. See page 3. In our view, this is why it is imperative that the Federal Reserve Board be an independent, nonpolitical body. Raising interest rates during a presidential election year, for example, might be a difficult policy to follow; but failure to do so could be debilitating for many American households in the longer run.

Inflation is deceptive because it silently diminishes the purchasing power of households. Some economists worry that hourly earnings rose 0.6% in November; however, average weekly earnings rose 4.9% YOY in November while inflation rose 7.8% YOY in October. In short, inflation has exceeded the growth in wages for most of the last 18 months. Rising wages are not a source of inflation in our view. In fact, the fact that real hourly earnings are negative on a year-over-year basis is another indication a recession is ahead. See page 4.

Personal income has been in a steady uptrend for the last two years, but due to soaring inflation, just the opposite is true of disposable income or real disposable income. As a result, as of October, personal consumption expenditures have been exceeding income for 19 straight months. It is an unsustainable situation. See page 5. Not surprisingly, the savings rate declined to 2.3% in November, which is the lowest rate recorded by the BLS since the 2.1% reported in July 2005. However, in 2005, the savings rate quickly rebounded to 2.6% in August. We doubt that will happen in this cycle. Also noteworthy is the fact that the unemployment rate was unchanged in November at 3.7%, a historically low number. This gives the appearance of a strong economy, but we believe it is an economy of the haves and have-nots. Middle America is struggling. See page 6.

This combination of data suggests to us that the Federal Reserve will continue to raise interest rates in order to battle the now-ingrained inflation seen in this cycle. As a result, the economy is apt to slip into a recession in 2023. In recent months the Treasury yield curve has become inverted which is a classic financial sign of a recession on the horizon. See page 8.

Inflation and Equity Performance

We often look at history to see how stocks have performed whenever inflation has remained above average for a lengthy period of time. The most instructive period of time would be the 1968-to-1982-time frame when headline CPI remained consistently above 4%. The chart on page 9 is a quarterly chart and only records the S&P 500 index at the end of each quarter. But what it shows is that the S&P 500 Composite closed at 103.86 in December 1968 and closed at 102.09 in March 1980. In other words, the index was in a broad trading range and made no upward progress for over eleven years — or until inflation was brought back under control.

The experience of this previous era of inflation is why we believe the Fed may need to keep interest rates higher for longer than the consensus expects. The failure to get inflation under control in the first tightening cycle could result in multiple Fed tightening cycles — and recessions – like what was seen in the 1968 to 1982 period.

There are some markets that are already warning of a recession. The weakness in crude oil prices implies that traders expect energy demand to weaken as global economies slide into a recession. The decline in the 10-year Treasury bond yield represents a flight to safety in long-duration US Treasury bonds. See page 10. For all of these reasons, we believe the best strategy is to focus on recession resistance companies or areas of the economy that represent “necessities” to households, corporations, and governments. Sectors that represent these characteristics include energy, utilities, food, staples, and aerospace. See page 16.

Gail Dudack

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Not a lot happened during the shortened holiday week. Economic releases were sparse, and earnings revisions were minor. Stock prices were erratic, but our indicators ended the week relatively unchanged. The months of November through January have historically been the strongest three-month period for stock prices and this favorable seasonality trait is dominating much of the discussion regarding equities. But in every cycle, ultimately the market’s trend will be determined by earnings growth, and unfortunately, earnings growth for the next twelve months remains questionable.

Energized Earnings

Energy has been a major contributor to S&P 500 earnings growth all year and yet the sector continues to have the lowest PE multiple of all eleven sectors at 8.4 times. Recent S&P Dow Jones data shows that energy is the only sector with a PE to growth multiple (PEG ratio) of less than one, which reflects value. This low PEG ratio arises from S&P’s estimate for energy’s 5-year growth rate of 10.3% and the sector’s current price-earnings multiple of 8.4 times.

According to Refinitiv IBES, the estimated earnings growth rate for the S&P 500 for the fourth quarter is negative 0.4%, but if the energy sector is excluded, the S&P 500 growth rate declines to negative 5.4%. Energy has the highest estimated earnings growth rate for the quarter at 72.8% and is expected to earn $50.1 billion in the last three months of the year versus earnings of $29.0 billion a year earlier. The second highest percentage is found in the industrials sector with an estimated 42.3% earnings growth rate, where earnings are anticipated to be $37.4 billion in the current quarter versus $26.3 billion a year earlier. The only other S&P sectors expected to have positive earnings growth in the fourth quarter are real estate (6.9%) and utilities (5.0%). In comparison, IBES estimates that technology earnings will decline 7.8% in the quarter. The materials sector comes in last with the lowest estimated earnings growth rate of negative 21.3%. When we look at these estimates for fourth quarter earnings, we do not see any positive catalyst for stocks in the near term; but keep in mind that fourth quarter earnings season does not begin until mid-January 2023.

Economic Backdrop

November’s employment report will be released on Friday, and this could be a market moving event. Expectations are for 190,000-200,000 new jobs and a relatively unchanged unemployment rate. Anything showing stronger job growth could trigger angst about monetary policy being tighter than expected. Anything showing extremely weak job growth will incite fears of a recession. However, it does appear that the economy is either in a recession or a recession is likely in 2023. The only questions are how deep and how long the recession will be.

It is very conceivable that the housing sector is already in a recession, and we believe this weakness will spread to other parts of the economy in coming quarters. We tend to look at sentiment indicators for guidance in uncertain times and unfortunately, this data is not reassuring. The bigger picture shows that there are 3-year downtrends in all sentiment benchmarks, and this resembles the pattern seen prior to or during all previous recessions since 1965. The Conference Board consumer confidence for November fell from 102.2 to 100.2 in November, the lowest since July, and the index for present conditions recorded an 18-month low. The University of Michigan sentiment indices were all down in November but remained above the cyclical lows recorded in the months of June and July 2022. See page 3.

Consumer credit has been expanding rapidly and attracting the attention of many economists. Total consumer credit hit $4.7 trillion in September, up $270 billion, or 6%, year-to-date and it expanded 8% YOY. Most of the growth in the last twelve months has come from revolving credit (lines of credit and credit cards) which grew nearly 16% YOY. This expansion in credit could be a sign of households using credit cards to spend ahead of the holidays, or to simply pay bills. This possibility is confirmed by the recent decline in the personal savings rate for September which fell from 3.4% to 3.1%. Data for personal income, consumption, and savings for October will be released later this week. But note, if consumers are digging into savings and extending credit lines for consumption, it is an unsustainable trend, particularly as interest rates rise. See page 5.

The correlation between an inverted Treasury yield curve and recessions has been historically strong. And the current yield curve already implies we should be anticipating a recession in 2023. Recent Fed funds rate hikes have had a dramatic influence on the Treasury yield curve; but more importantly, whether December’s rate hike is 50 or 75 basis points, the entire yield curve will soon be fully inverted and looking ominous. In short, consumption and corporate earnings will remain under pressure in 2023 and this is not a good foundation for an equity rally. See page 4.

Technical Ambiguity

The charts of the major equity indices are not uniform and produce a mixed message in terms of the outlook for stocks for the final weeks of the year. The Dow Jones Industrial Average is the only index to have bettered its long-term 200-day moving average and as a result, it appears to be in a relatively stable advance. The Russell 2000 and the S&P 500 are the next best-looking charts; however, they have been testing their 200-day moving averages without success for several weeks. This is an ambiguous pattern. Meanwhile, the Nasdaq Composite index remains in a bearish trend. This index has only exceeded its 50-day moving average and is trading well below its 200-day moving average. This results in a very mixed picture for the overall market. However, it is an interesting display of leadership shifting from growth to value. See page 8.

Our favorite 25-day up/down volume oscillator is currently neutral with a reading of 2.31. It had been in overbought territory for seven of 10 trading days in November, but it was unable to remain in overbought territory for five consecutive trading days. This is significant since bear markets rarely reach overbought territory and if they do the reading is brief. A true overbought reading should persist for at least five to ten consecutive trading days to be significant, therefore, the recent reading in this indicator is another sign of ambiguity in the equity market. Nevertheless, it remains one of our key indicators to monitor in the coming weeks to assess the strength of any advance in prices. See page 9. Similarly, the 10-day average of daily new highs is currently 73 and the 10-day average of daily new lows is 72. This combination is neutral since neither series is averaging more than 100 per day which is the minimum benchmark for defining a trend. Remember: the 10-day moving average of new lows was 1038 on September 26 and exceeded the previous peak of 604 made in early May, which means the October low was a confirmed new low and the bear trend continues. All in all, we remain cautious and suggest emphasizing stocks that have the most reliable earnings streams.

Gail Dudack

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The Dudack Research Group wishes you and your loved ones a happy and healthy 2022 holiday season and a delicious and restful Thanksgiving weekend. We at DRG are grateful for many things and most especially for your continuous support and patronage.

Bear Markets and Transitions

Bear markets have a multitude of catalysts, but history shows that the most significant bear markets are triggered by one of two factors. A bear cycle often begins after an immense accumulation of debt and leverage that leads to massive defaults, a sharp decline in demand, a period of deflation, and falling profits. Or conversely, a bear cycle is triggered by a huge supply/demand imbalance that leads to an inflationary cycle, a loss of purchasing power, profit margin pressure, declining earnings, and lower PE multiples. The inflationary cycles of 1970-1974 and the current bear market were clearly linked to inflation driven by a lack of supply of oil. However, inflation preceded Russia’s invasion of Ukraine and most of today’s price cycle is due to the historic monetary and fiscal stimulus undertaken around the world to combat the worldwide economic shutdowns. In short, political decisions played a large part in today’s inflationary cycle.

But perhaps the most important characteristic of any bear market is that it almost always results in a major shift, or transition, in market leadership. It is this transition in leadership that is the key to outperforming, not only during the bear market, but in the bull market that follows.

“Follow the money” is a phrase that solves many financial and political mysteries, but “follow the earnings” is the simplest way to understand the leadership emerging in the current cycle. In 2020 our favorite sectors were those we described as “inflation-resistant” segments of the economy. In 2021 and 2022 we emphasized “recession-resistant” sectors and stocks for outperformance. Not surprisingly, inflation-resistant also tended to be recession-resistant and included sectors such as energy, utilities, staples, defense, and aerospace. These sectors can also be called defensive, household necessities, value, and total return, but they are most importantly the areas that have pricing power and profits in an era of rising costs and shrinking margins. Segments of healthcare can also be defensive and weather both inflation and recession. Technology has defensive segments such as security technologies. But in every case, it is a stock or sector with a predictable earnings stream in what is a difficult and unpredictable economic time.

Earnings Insecurity

The third quarter earnings season seems to have sounded the alarm that earnings are at risk for this year and next. In the last five weeks, the S&P Dow Jones consensus earnings estimate for 2022 has declined 3% — an unusually large decline in a short period of time. However, the erosion in forecasts actually began in April when estimates were 12% higher than they are today. We lowered our 2022 and 2023 earnings estimates two weeks ago to adjust for the weakness seen in the third quarter results. Unfortunately, the S&P Dow Jones estimate has dropped so quickly (it is now $201.58) that it is already below our $202 estimate for the S&P for this year. Although seasonality for the next three and six-month periods tends to be positive, the underlying erosion in earnings could prove to be quicksand for the overall market. Again, safety is equal to finding companies with solid earnings streams. See page 6. Unfortunately, the increase in interest rates and decrease in earnings estimates seen this year has lowered the midpoints of our valuation model to SPX 2625 for 2022 and to SPX 3020 for 2023. See page 7. In short, risk continues in the first half of 2023.

Real Estate Recession

There is little doubt that residential real estate and the homebuilding sector is in a recession. In September, new home sales fell 18%, the median new single-family home price fell 14% YOY, and the average home price fell 10% YOY. Existing home sales fell 28.4% YOY in October and the median existing single-family home price rose 6% YOY. See page 4.

A lack of inventory has been supporting existing home prices this year, however, that too is beginning to change. According to the National Association of Realtors, the months of supply of inventory have increased from the cyclical low of 1.5 in January of this year to 3.3 months in October. Housing starts were down 8.8% YOY in October and new home permits were off 10% from a year earlier. See page 5. And the outlook for the housing sector in 2023 continues to be dim, particularly since the Federal Reserve is expected to continue to raise rates in coming months. Affordability is already at its worst level in 37 years and the NAHB builder confidence survey has been declining for 11 consecutive months. November’s survey fell 5 points to 33, which is well below the neutral benchmark of 50. Both current traffic and the outlook for sales in the next six months are at recessionary levels. See page 6. Keep in mind that these dismal numbers are likely to get worse due to the Fed’s tightening policy in coming months. But, to a large extent this is the Fed’s goal – an economic slowdown.

October’s retail sales were stronger than expected, with total retail and foods service sales increasing 8.3% YOY and total sales excluding autos and gas stations rising 8% YOY. However, retail sales priced in 1982 dollars (adjusted for inflation) rose a mere 0.5%. Still, this small increase was better than the real retail sales data for April and June which were negative on a year-over-year basis. These declines were worrisome since negative YOY retail sales have been characteristic of all previous recessions. See page 3. However, investors should focus on where retail sales have actually been growing. In the post-COVID era. Sales have increased for six segments: gas stations, food service, building materials, sporting goods, miscellaneous and non-store retailers. This is in line with what we are seeing in terms of stock performance. See page 14.

Technical Watch

What we are seeing in terms of earnings performance is playing out in the popular indices. On page 9 we have ordered the indices in terms of their technical strength. The DJIA is by far the best-performing index, seen by the fact that it is now trading above its long-term 200-day moving average and has broken above a downtrend line off the January 4, 2022 peak of 36,799.65. The Russell 2000 index is the second-best performing index and is threatening to break above its 200-day moving average but is yet to do so. The S&P 500 is third best, and while trading above both its 50 and 100-day moving averages, it is trading 60 points below its 200-day moving average. The Nasdaq Composite index is by far the worst-performing index. It has barely exceeded its 50-day moving average and trades well below its 100 and 200-day moving averages. These differences are a display of the shifting leadership we noted earlier. Value has widely outperformed growth year-to-date and during the recent rally. See page 9. The 25-day up/down volume oscillator is neutral at 2.28 but was overbought for five of the last eight trading days. This is significant since bear markets rarely reach overbought territory and if they do the reading is brief. A true overbought reading should persist for at least five to ten consecutive trading days to be significant, therefore, the recent reading is ambiguous. Nevertheless, this will be a key indicator to monitor in the coming weeks to assess the strength of any advance in prices.

Gail Dudack

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