Earnings season will begin later this week as financial stocks begin to report third quarter results. And for the first time this year, investors seem to be taking a close look at the quality of earnings and earnings guidance. Expectations turned lower for the banking sector after several global banks indicated they plan to raise reserves in anticipation of a weakening economy. Friday will be our first look at how the financial sector managed in the third quarter.

Global Woes

But the economic backdrop for earnings has come under review recently. This week The International Monetary Fund warned that “colliding pressures from inflation, war-driven energy and food crises and sharply higher interest rates were pushing the world to the brink of recession and threatening financial market stability.” Citing new 2023 global growth forecasts from its World Economic Outlook, the IMF said that countries representing a third of the world’s output could be in a recession next year. More disturbingly, the IMF highlighted that financial stability risks have increased, and it warned of disorderly repricing in markets.

Disorderly markets are not new news actually. Instability has already appeared in Britain. Last week the Bank of England expanded its program of daily bond purchases to include inflation-linked debt. It noted a “material risk” to British financial stability and “the prospect of self-reinforcing ‘fire sale’ dynamics” leading to chaos in its gilt market. The Bank pledged as much as 65 billion pounds of long-dated government bonds to allow for a more orderly disposal of assets in the pension fund sector. However, the risk continues, and investors are watching to see what happens when, or if, the Bank of England ends its purchasing program, perhaps as soon as later this week. History has shown how disorderly markets often reflect illiquidity and this instability can ripple through the global financial markets in unexpected ways. This is one of our main concerns for the latter part of the year.

It is important to note that these financial problems emanate partly from the US. The combination of inflation and rising interest rates in the US has driven the trade-weighted dollar to its highest level in 20 years. The Federal Reserve’s new nominal broad dollar index is currently at a 50-year high. See page 7. The strength in the dollar, coupled with rising interest rates, means that other central banks, like the Bank of England, will have to raise their interest rates to prevent their currencies from collapsing. In cases like England, where economic growth is already weak, rising interest rates compound the problem it already faces from higher energy costs, inflation, and a weakening economy. It can become a circular problem that is difficult to solve. Moreover, since crude oil is priced in dollars, energy becomes more expensive to non-US buyers, adding to inflation.  

Exacerbating these financial woes were reports from China that Shanghai and other cities have seen COVID-19 infections rise. Some local authorities began to close schools and entertainment venues, reigniting fears of more shutdowns, slower Chinese growth, and global supply shortages. Again, there are a number of issues outside the US that could have a significant impact on our financial markets in the remaining months of the year. This keeps us cautious.

Focus on Earnings

In terms of earnings, FedEx Corp. (FDX – $152.08) shocked investors last week when it revealed that it was preparing for a further decline in the number of e-commerce packages it would handle in the upcoming holiday season. The stock is down nearly 30% in the last month.

This week S&P Dow Jones consensus earnings estimates for 2022 and 2023 fell $0.63 and $0.25, respectively. Refinitiv IBES consensus earnings forecasts fell $0.38 and $0.86. But the most important news of the week was that the S&P consensus earnings estimate for 2022 declined to $208.12 and is now below 2021’s level of $208.17. This means that if economists are correct about a recession in 2023, investors could be facing two consecutive years of little or no earnings growth in equities. However, keep in mind that earnings in the energy sector continues to be strong, and when excluded from the S&P total, earnings growth in 2022 is already negative. We want to reinforce our view that investors should continue to focus on recession resistant stocks, such as energy, utilities, consumer staples, and special areas like defense-related companies.

Technical Indicator Update

The charts of the popular indices are quite similar this week with all four of the popular indices trading below all their moving averages. This is bearish. However, the one positive sign is the Russell 2000 index which is outperforming the other indices at the moment since the June lows have not been decisively broken. We focus on this small capitalization index since it was an early leader at the market top, and it could also be an early leader at the lows. Conversely, the Nasdaq Composite is the worst performing chart in a major decline. See page 10.

The 25-day up/down volume oscillator can be one of the best technical indicators at defining peaks and troughs. The oscillator fell to an oversold reading of negative 5.6 on September 30 which was a deeper oversold reading than the one seen at the June low, and it was in oversold territory for 10 consecutive trading sessions. This was longer than the oversold reading for six of eight consecutive trading sessions in June. In short, the test of the June lows was unsuccessful by this measure, and the bear market continues. The 25-day up/down oscillator is currently neutral with a reading of negative 2.93 but this is close to an oversold reading. A second oversold reading of greater than five consecutive days would confirm the market has not yet found its capitulation low. See page 11.

The 10-day average of daily new highs is 29 and daily new lows are 547. This combination is negative with new highs below 100, and new lows above the 100 benchmark. More importantly, the 10-day moving average of new lows was 1038 on September 26 and exceeded the previous peak of 604 made in early May. In addition, NYSE the advance/decline line fell below the June low on September 22 – is currently 56,191 net advancing issues from its 11/8/21 high – a negative sign. See page 12.

Jobs The increase of 263,000 jobs in September and a decline in the unemployment rate to the post-pandemic low of 3.5% was enough for investors to believe that the next Fed meeting will result in a 75-basis point increase. However, the number of people no longer counted in the labor force – 229,000 –increased nearly as much as job growth. This led to the participation rate falling 0.1 to 62.3% in September. Data also shows that 5.7% of those no longer counted in the labor force want a job. See page 5. And it is important to note that this is an economy of “haves” and “have-nots.” College educated workers are seeing growth in employment while those with less than a college degree struggle. But all workers are seeing a negative trend in real weekly earnings this year due to high inflation. See page 6.

Gail Dudack

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The S&P 500 index jumped nearly 6% in the first two days of October, as investors once again focused on the possibility that a Fed “pivot” is near. The incessant focus on a Fed pivot lacks an understanding of how difficult the Fed’s job is in terms of conquering an inflationary trend that has persisted for two years and reached double-digit levels. In our view, the Fed pivot mania is an attempt to simplify a global financial environment that is getting more complicated by the day. More importantly, it could be a misguided and potentially dangerous strategy for a number of reasons.

Forget the Pivot

First, it underestimates the Federal Reserve’s commitment to fight inflation. Most Fed governors have indicated that they are serious about lowering inflation and that they will remain vigilant and steadfast until it gets back to the Fed’s 2% goal. That will take a long time. Second, even if prices remain unchanged for the next several months, headline CPI will still be above the 6% level. This is far from nearing the Fed’s goal. The one piece of good news for inflation is that oil prices appear to be stabilizing at lower levels. But this will not be enough to get to lower levels of inflation. Even with WTI futures (CLc1 – $86.35) below $90 a barrel and down 25% from its May closing high, WTI is up 3.3% on a year-over-year basis. And in the background, OPEC+ is discussing cutting output. In short, the CPI is unlikely to come down substantially until 2023. Third, what could get the Fed to “pivot” on interest rates would be a financial crisis, or more specifically, a liquidity crisis in the banking system. However, such an event would be a disaster and rather than sparking an equity rally it would likely trigger a sizeable selloff. Unfortunately, this risk cannot be ruled out, particularly in an environment of rising rates and a strengthening dollar. There is instability in the global system as seen by the fact that the Bank of England had to employ emergency gilt purchases when British pension funds were swamped by margin calls. There are rumors of liquidity issues at Credit Suisse Group AG (CSGN.S – $4.29) and the government of Finland had to extend credit packages totaling 3.55 trillion euros to stabilize the power industry and the energy debt derivative sector, due to a deteriorating debt market. These events may seem unrelated, but we have seen lesser matters ripple through the global banking system and create chaos. It brings back memories of the financial crisis of 2008.

In other words, the focus on a Fed pivot is not a practical exercise in our opinion. Even if the Fed were to pause rate increases, it would not necessarily reflect a change in monetary policy and bring back the easy money policies that had encouraged speculators to the markets. All in all, it is a very short-term view. But it did spark an impressive two-day rally, to date.

A Focus on Earnings

We think a more appropriate focus for investors would be on corporate earnings. Although the financial press places its emphasis on whether or not a company has beaten its quarterly consensus earnings forecast, we think it would be more insightful to focus on whether quarterly earnings growth is positive or negative on a year-over-year basis. Companies have been beating consensus earnings, but that is a bit of a charade since corporations have lowered guidance and analysts have reduced estimates as earnings season approaches. Therefore, the charts from Refinitiv on page 10 are important. They show that the earnings estimate revision trend has been negative for most weeks at least since the middle of July. For the week ending September 30, the earnings revisions for S&P 500 companies were 67% negative and 33% positive. For all US companies, revisions for the week were 62% negative and 38% positive. And it is important to note that since April, according to S&P Dow Jones consensus estimates, the 2022 forecast has declined 8.2% and the 2023 forecast has decreased 4.4%. At present, the S&P Dow Jones earnings growth rates for this year and next are 0.3% and 14.3%. Both of these numbers include earnings for the energy sector which is providing most of the growth.

However, if the Fed continues its tightening policy the risk of recession increases and earnings forecasts for 2023 are apt to fall from positive to negative. In our opinion, this is where the financial press, analysts, and investors should concentrate. And this is what keeps us cautious.

Technical Breakdown

The two-day October rally has been impressive and included a 91% and 95% up day in volume. The advance was triggered from a deeply oversold condition and gained momentum on softer economic news and a smaller than expected increase of 25 basis points by the Reserve Bank of Australia. This combination refueled predictions of a Fed pivot. However, despite the strength of the two-day rally, breadth statistics remain negative. Sadly, the 25-day up/down volume oscillator hit an oversold reading of negative 5.6 on September 30 and was in oversold territory for a string of 10 consecutive trading sessions. The current reading is neutral at negative 2.66. Nevertheless, the 10-day oversold reading was more extreme than the oversold reading at the June low. This means September’s test of the June lows was unsuccessful and the bear market continues. See page 12.

This was not the only indicator that broke down at the end of September. The 10-day average of daily new lows reached 1,038, exceeding the previous peak of 604 made in May. The NYSE cumulative advance/decline line fell below its July 2022 low and is now 47,465 net advancing issues away from its all-time high. See page 13. The charts of the indices show prices are well below their 200-day moving averages and could rally back to test their 100-day moving averages. However, the long-term trend would still remain bearish.

The one positive is sentiment. Last week’s AAII bull/bear readings showed a 2.3% increase in bullishness to 20.0% and a 0.1% decrease in bearishness to 60.8%. Last week’s 17.7% bullish reading was among the 20 lowest readings since the survey began in 1987. Sentiment indicators are not good timing indicators, but they do suggest that this is not the time to become too bearish. Equity prices tend to be higher in the next six and/or twelve months following such extreme readings.

Economic Review

Many housing statistics were released in the last week, and they paint a picture of a housing sector experiencing an accelerating slowdown. Pending home sales have been declining since October 2021. Affordability is at its lowest level since 2006. Median home prices reached a record level relative to income in June 2022, and when coupled with rising mortgage rates, make this a difficult time to buy a home. The NAHB confidence index has been falling all year and in the September survey, dropped to levels last seen in 2014. Census Bureau data indicated that building permits fell in August to its lowest level in two years. But in a surprise, housing starts picked up from 1.404 million to 1.575 million in August. The ISM manufacturing index fell from 52.8 in August to 50.9 in September. New orders dropped from 51.3 in August to 47.1 in September and have been below 50 (neutral) for three of the past four months. Employment fell from 54.2 to 48.7 and has been below 50 for four of the last five months. These weak statistics may increase the hope of a Fed pivot, but they will not be good for earnings growth in coming quarters. Stay cautious.

Gail Dudack

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After a long delay, the equity market finally realized that the Federal Reserve has much more work to do in the months ahead in order to combat inflation. It has become clear that the focus on the timing of a “peak fed funds rate” was premature. Last week the Fed raised the fed funds rate 75 basis points to a range of 3% to 3.25%, and the November meeting could see another 75-basis point increase which would carry this benchmark to 4%. The December meeting will be data-dependent, but it could also result in short-term rates moving higher. This combination of rate increases has had a dramatic impact on all interest rates and on the dollar, while keeping the government yield curve relatively inverted. See page 3.

However, the chart of government interest rates on page 3 shows another important detail which is how much interest rates have risen since the end of August. In particular, the two-year Treasury note yield has jumped 105 basis points in less than a month. To date, this is the largest monthly increase in the two-year Treasury note yield since the 1980 to 1981 era, which is an interesting era to compare to today’s situation, since inflation is also the highest in 40 years. In that inflationary period, inflation peaked at 14.8% YOY in March 1980, fell to 9.6% YOY in June 1981, but quickly rebounded to 11% YOY in September 1981. The Fed first raised rates dramatically until the effective fed funds rate hit 17.6% in April 1980. The Fed then cut rates due to a recession (January 1980 to July 1980) and the effective fed funds rate fell to 9% in July 1980. But when inflation reignited, the Fed boosted rates once again and the effective fed funds rate rose to 19.1% by June 1981. This hawkish policy triggered a second recession between July 1981 and November 1982.

We believe the current Fed hopes to avoid the erratic tightening policy of the 1980-1981 timeframe and will therefore continue to steadily raise rates until data shows prices are not simply decelerating, but in fact, the inflation cycle has been broken. This will take time and unfortunately, it is likely to result in a full-blown undeniable recession.

Canary in the Coal Mine

We have been watching the debt markets more carefully in recent days since the spike in the dollar can have consequences in areas least expected. The SPDR Bloomberg High Yield Bond ETF (JNK – $87.57) tracks the US high yield corporate bond market and it is spiraling downward, approaching the March 23, 2020 closing low of $84.57, which tested the March 2009 low of $77.55. However, while the bond market is displaying substantial concern about the future, the VIX is at $32.60, and remains well below its $82.69 close of March 16, 2020. See page 4. In our view, the equity market is too complacent about the current combination of rising interest rates, a higher dollar, and declining earnings.

Moreover, the bond market is more closely connected to the global environment where the mixture of rising debt loads (both sovereign and corporate), higher interest rates, and a strong dollar can be an explosive combination. In short, the decline in the high yield market concerns us and we fear the next unexpected event may materialize outside the US and be related to defaults.

Earnings Reality

Despite some comments by well-respected analysts, earnings estimates for 2022 and 2023 are falling. This week S&P Dow Jones consensus earnings estimates for 2022 and 2023 fell $0.78 and $1.33, respectively. Refinitiv IBES consensus earnings forecasts fell $1.50 and $1.24. The S&P consensus EPS estimate for 2022 is now $208.21 and the IBES estimate fell to $223.83, bringing EPS growth rates for 2022 to 0.3% and 7.5%, respectively. See pages 6 and 13.

We recently reduced our 2022 S&P 500 earnings estimate from $218 to $209 and for 2023 our estimate declines from $237 to $229. However, we must admit that we fear we may have to lower these estimates after third quarter earnings season. Nevertheless, our $209 estimate coupled with our valuation model which suggests that a 14 X multiple is appropriate for this environment creates a downside target of roughly SPX 2915. The yearend range is SPX 3452 to SPX 2380. This implies that there is more risk in the market. An alternative method would be to take an average PE of 15.8 X with our $209 estimate, and this equates to SPX 3302. See page 5. Either way, the market has not yet reached a level of table-pounding good value.

Technical Indicators may be weakening

Technical indicators have not been reassuring this week – quite the opposite. The charts of the popular indices look quite similar this week, unfortunately, all four of the popular indices appear to be in the midst of a capitulation-style decline. As we have indicated in recent weeks, the key to defining this bear market’s low will be whether breadth data is less negative on a new low in price. If so, it would be a positive sign of a bottoming formation. The alternative is not favorable for the intermediate term. See page 7.

At the moment, the jury is still out, but recent breadth data is not encouraging. The 25-day up/down volume oscillator is now at negative 4.35 and recording its sixth consecutive day in oversold territory, i.e., a reading of negative 3.0 or less. (On September 26, 2022, the 25-day indicator also hit a low of negative 4.95.) Since this oscillator was in oversold territory for six of eight consecutive sessions between July 6 and July 15 and hit an extreme oversold reading of negative 5.17 on July 14, 2022, a successful test of the June lows would require a shorter and/or less intense oversold reading on any new low in price in the S&P 500. Although the oscillator is slightly less oversold than it was in June, it is by a very narrow and tenuous margin. Another extreme sell-off day would take this indicator to a deeper oversold reading, turning this indicator negative, and indicate that lower lows may be ahead. In short, the market could be only a day or two away from an unsuccessful test of the June low.  See page 8.

In addition, the 10-day average of daily new highs is 32 and daily new lows are 896. This combination is negative with new highs below 100, and new lows above the 100 benchmark. More importantly, the 10-day moving average of new lows at 896 has now exceeded the previous peak of 604 made in early May. Again, the market is showing underlying weakness. The advance/decline line fell below the June low on September 22 just prior to the SPX breaking its June low. The NYSE cumulative advance/decline line is currently 53,150 net advancing issues from its 11/8/21 high – a large number and a negative sign for the near term. See page 9. On a more positive note, last week’s AAII readings showed a decrease of 8.4% in bulls to 17.7% and an increase of 14.9% in bears to 60.9%. The 17.7% reading is among the 20 lowest readings since the survey began in 1987. Optimism was at a similar level in May. Equity prices tend to be higher in the next six and/or twelve months following such extreme readings in sentiment. See page 10.  

Gail Dudack

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For the second time in six weeks, we are lowering our 2022 and 2023 earnings estimates for the S&P 500. For 2022, our forecast falls from $218 to $209, and for 2023 our estimate declines from $237 to $229. See pages 9 and 16. These estimates now translate into earnings growth rates of 0.4% this year and 9.6% next year. Both cuts in estimates were the result of disappointing earnings in the last two quarters. But more importantly, a weakening economy could put these reduced estimates in jeopardy.

It is worth pointing out that consensus estimates for 2022 have dropped precipitously as well. In particular, the S&P Dow Jones consensus estimate for 2022 was $227.51 in late April and fell to $209.66 last week, a 7.8% decline. The IBES Refinitiv consensus estimate hit a high of $229.57 in June and was $225.33 last week, a 1.8% decline. So, despite the misleading headlines suggesting that second quarter earnings season was better than analysts expected, earnings have disappointed in each reporting quarter this year. (Note that media headlines are never comparing earnings results on a year-over-year basis, but instead, compare results to the consensus estimate which may have been dramatically reduced just a few days earlier.) Moreover, most economists are now forecasting a recession for 2023, yet this does not seem to be reflected in current earnings estimates. Until this happens the door is open for more disappointments.

This earnings review of the first half of the year may explain why the market has been so weak as we approach the September FOMC meeting. Excluding the energy sector, earnings results for the S&P 500 are in the red for the first half of the year. Nevertheless, the Fed is expected to make the economic backdrop less friendly for corporate earnings in the coming months. It is likely that the Fed will raise interest rates 75 basis points this week, although it makes little difference if it is 75 basis points or 100 basis points, in our view. The bigger picture suggests that while the high of the fed funds range is currently at 2.5%, it is apt to reach 4% to 4.5% after the next few Fed meetings. In short, the Fed is undoubtedly going to trigger a recession, and this has not yet been fully factored into stock prices.

Valuation Model Woes

We have been reporting on the repercussions of inflation for a long while – the reduction in purchasing power of households, the pressure on profit margins and the negative impact on PE multiples – and the market is finally beginning to confront these issues. However, the combination of lower earnings growth and lower PE multiples is a toxic mix for equity valuation. When we combine our new assumptions of $209 earnings in 2022, with short-term interest rates rising to 4% and inflation falling to 6.2% by year-end, we get some distressing results in our valuation model. See page 8. First, our model suggests that a PE multiple slightly below 14 times is appropriate for the 2022 environment and coupled with our earnings estimate of $209, it produces a target of SPX 2915. The year-end range shows a high of SPX 3452 and a low of SPX 2380. Keep in mind that periods of high inflation typically result in the SPX trading in the lower half of the range because earnings are worth less in an inflationary environment. This is one of the many miseries of high inflation.

Alternatively, we could use the long-term average PE multiple of 15.8 times to find value in the equity market. With our $209 earnings estimate this generates a downside target of SPX 3302, which is less disconcerting, but still 14% below current prices. Either way, we believe the market has further downside risk. See page 8.

History also shows us that periods of inflation tend to place a ceiling on stock prices until the inflationary cycle is under control. See page 7. We believe the Federal Reserve understands this. And though they were late to address the inflation problem, we believe they will be steadfast and aggressive in the near term to counter inflation as best they can. See page 6. Other countries face the same inflationary issues, and their central banks are following the Fed’s lead, as seen by Sweden’s central bank which raised interest rates 100 basis points this week.  

One can see the impact of inflation everywhere. Retail sales were up a robust 9.1% YOY in August, but up only 1.5% YOY after inflation is considered. Although August’s gain in real retail sales was not substantial, it was nonetheless a positive gain which is a favorable shift. Real retail sales were negative in three of the four months between March and June, which concerned us because months of negative real sales are a classic sign of an economic recession. And even though retail sales rose 0.3% in August on a month-over-month seasonally adjusted basis, nominal retail sales in US dollars in August were below the level reported in June. See page 3.

Average weekly earnings grew at a healthy 5.1% YOY pace in August, but inflation rose 8.2% YOY, which means purchasing power actually fell 3.1% on a year-over-year basis. And after nearly two years of rising prices, energy is no longer the driver of inflation. As seen in the chart on page 5 of core CPI, PPI and PCE, these indices rose 6.5%, 8.8%, and 4.6%, respectively in August. All core inflation measures were the highest is 40 years. This explains why a 75-basis point or a 100-basis point hike in interest rates is irrelevant. Interest rates must go much higher to curb the current inflationary problem.

Technical Update

The 25-day up/down volume oscillator fell to negative 3.02 this week which is the first oversold reading of negative 3.0 or less since July. Remember that this oscillator was in oversold territory for six of eight consecutive sessions between July 6 and July 15 and hit an extreme oversold reading of negative 5.17 on July 14, 2022. A successful test of the June lows would require a shorter and/or less intense oversold reading with or without a new low in price in the indices. This is an important juncture for this oscillator.

The key to a successful retest of a bear market low is whether or not a new low in price also generates a new low in breadth. A successful retest will show there is less selling pressure – a less severe oversold reading — despite a lower low in price. We think this is a possibility in the final months of the year, but it means that this indicator should not fall below negative 5.17 or remain oversold for more than six to eight consecutive days. If it does, it would be negative for the intermediate-term outlook. The charts of the popular indices are quite similar this week. All four of the popular indices appear to be on the verge of testing the June lows and we would not be surprised, or concerned if all four indices break these lows. The key will be whether or not breadth data is stronger on this new low than it was in June. Remember: in terms of seasonality, September tends to be the weakest month of the year and that seems to be proving true in 2022. However, October has the reputation of being a “bear killer” and a turnaround month. We will be monitoring our indicators for signs that this will also prove true in 2022.

Gail Dudack

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The past week has been filled with global events, although none as historic as the sudden passing of Queen Elizabeth II of Great Britain on September 8 at the age of 96. She was Britain’s longest-reigning monarch, who guided her country for decades with grace and diplomacy, held an audience with 15 British Prime Ministers and spanned a timeframe that included 14 US presidents, from Harry Truman to Joe Biden. Closer to home, Ken Starr, lead prosecutor in the Clinton-Lewinsky investigation which led to the impeachment of President Bill Clinton, died at age 76.  

Ukraine regained ground in the Russia/Ukraine conflict in what could be a pivotal shift in momentum in the war. The Ukrainian counteroffensive in the northeastern part of the country made impressive gains and, in some cases, pushed Russian soldiers back behind the Russian border. President Zelensky reported that his troops captured more territory in the last week than Russia did in the last five months. German Chancellor Olaf Scholz called on Russian President Vladimir Putin to find a diplomatic solution as soon as possible, based upon a ceasefire, complete withdrawal of Russian troops, and respect for the territorial integrity and sovereignty of Ukraine. This is a developing situation that could have significant implications for geopolitical and economic events in the months ahead.

Peiter “Mudge” Zatko, a famed hacker who served as Twitter’s (TWTR – $41.74) head of security until his firing in January, testified before the Senate Judiciary Committee this week in what could also be a turning point for both Twitter and Elon Musk. Zatko said that in the week before he was fired from Twitter, he learned the FBI told the company that an agent of China’s Ministry of State Security (MSS), the country’s main espionage agency, was on the payroll at Twitter. “This was a big internal conundrum,” according to Zatko since China is Twitter’s fastest growing overseas market for ad revenue. Musk and Twitter head to trial next month to determine whether the billionaire’s $44 billion takeover deal should be completed.

In an odd bit of timing, President Joe Biden celebrated his $430 billion climate change and drug pricing bill, mislabeled as, The Inflation Reduction Act, on the same day that the Bureau of Labor Statistics reported that inflation did not decline in August as expected but in fact rose 0.1%. This squashed burgeoning hopes that inflation was cooling. All three major stock indices turned sharply lower and notched their biggest one-day loss since the throes of the pandemic in June 2020. The Dow Jones Industrial Average fell 1,276.37 points, or 3.94%, to 31,104.97, the S&P 500 lost 177.72 points, or 4.32%, to 3,932.69 and the Nasdaq Composite dropped 632.84 points, or 5.16%, to 11,633.57. All 11 major sectors of the S&P 500 ended the session deep in red territory.

The Basics of Inflation

The stock market’s dramatic reaction to the inflation report was both startling and revealing, in our view. We were surprised at the market’s intense reaction to the fact that neither headline nor core CPI declined on a month-over-month basis. It reveals that neither economists nor investors understand the underpinnings of inflation or the composition of the consumer price index. It also reveals that much of the recent advance was based upon the expectations that inflation was moderating simply because gasoline prices had declined. Again, these were naïve or premature presumptions.

As we have been writing for the last 18 months, the combination of historic monetary and fiscal stimulus in 2021 during an economic recovery, coupled the with signing of The Paris Climate Agreement and reducing carbon fuel supplies, and the Russian invasion of Ukraine was a volatile mix for the world for the following reasons: 1.) Stimulus, monetary or fiscal, during a recovery is inflationary. 2.) Reducing carbon fuels without an immediate plan to replace these energy supplies is foolish and will immediately increase fuel prices. 3.) Russia, a major source of fuel for Europe, has weaponized oil and restricted energy supplies to Europe which is increasing fuel prices. 4.) Ukraine, the breadbasket of Europe, has been demolished and this will result in critical food shortages in the world and raise food prices in coming months.

None of the above are temporary, and only monetary policy is controllable by the Federal Reserve. Nevertheless, the Federal Reserve is responsible for reducing inflation and it will continue to do so by reducing money supply and increasing interest rates. Both will slow the economy and the combination will increase the risk of recession. In our opinion, the Fed will raise rates 75 basis points later this month, with the hopes that inflation will begin to slow, and rates will continue to decrease economic activity.

However, the Fed has been late, and inflation has become systemic, in our view. As we show on page 3, prices are rising in all areas of the economy particularly in housing, food, and medical care. Owners’ equivalent rent has a hefty 23.65% weighting in the CPI, and it rose 6.3% YOY in August. This series tends to move in line with housing prices, but with a multi-month lag, which means rents are likely to continue to rise along with housing and add to inflation even as gasoline prices fall. Auto and lodging prices rose less dramatically in August, but medical prices are seasonal which means they will now switch from tempering inflation to adding to inflation. Note that medical insurance prices tend to rise annually in the fourth quarter when corporate and Medicare contracts are finalized. See page 4. A broadening of inflation can be seen by the fact that while headline inflation fell from July’s 8.5% YOY to August’s 8.3% YOY, core inflation rose from July’s 5.9% YOY to August’s 6.3% YOY.

All of this was predictable for anyone who understands the concept of supply and demand and the composition of CPI. Note that all but one component of CPI is currently growing at multiples of the Fed’s target rate of 2%. See page 5. This indicates the difficulty facing the FOMC in coming months. The US Treasury yield curve is not fully inverted, but it is inverted between the 1-year Treasury and the 10-year Treasury note. And even after a 75-basis point increase in the fed funds rate later this month, the effective fed funds rate would be 3.08% and would still be lower than the current 10-year Treasury yield of roughly 3.42%. Yet what concerns us is the historically large spread between the inflation rate and the 10-year Treasury yield. In the inflationary cycle of 1968 to 1982, inflation exceeded the Treasury yield, but was not broken until the Treasury yield matched the inflation rate – with a lag. Hopefully, it will be different this time and inflation will ease as interest rates rise. But the risk of recession remains high in most any scenario. See page 6.  

There was some good news in sentiment indicators this week. AAII readings showed a decrease of 3.8% in bulls to 18.1% and an increase of 2.9% in bears to 53.3%. These results are in line with the five weeks of less than 20% bulls and more than 50% bears between April 27, 2022 and July 7, 2022. Equity prices tend to be higher in the next six and/or twelve months following such a reading. See page 14. In sum, we remain cautious, particularly in September, and remain focused on sectors and stocks with recession resistant earnings such as energy, utilities, staples, and defense stocks.

Gail Dudack

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