Looking for a 90% Up Day

There are several extremes appearing in technical data that suggest this bear market is nearing, or already in its final phase. However, few bear market lows are quick or V-shaped. This is particularly true when the low precedes, or is accompanied by, a recession. And we think this one is. Most bear market troughs resemble a checkmark or a W-shape and take weeks or months to complete. In short, we believe it is much too late to be bearish, but we would not be too hasty to re-enter the equity market.

Although the equity market has declined to a level that could generate a short-covering rally, we believe the resistance at SPX 4100 may be a formidable hurdle. This can be seen in the charts of the indices on page 8. The late May rally encountered resistance at the 50-day moving averages in each of the popular indices. And though the last two weeks have generated a number of downside gaps that are likely to be filled in the near future, the 50-day moving average, now at SPX 4102.46, could prove to be a hurdle once again.

And as we noted last week, it would be prudent to wait for a solid 90% up-volume day accompanied by volume that is well above average, before adding to portfolios. Strong volume and at least a 10 to one positive breadth day would be a pivotal sign that panic selling is exhausted and that buyers have come back to the marketplace with conviction. This is particularly important since recent trading sessions have included worrisome signs of a liquidity crisis.

Liquidity Crisis – The Source

The liquidity crisis is not equity-centric and may stem from the volatility seen in the cryptocurrency market. Bitcoin (BTC – $20,825.00), the bellwether of the cryptocurrency market, has seen a 75% decline from its high. The world’s most-traded cryptocurrency, fell from nearly $69,000 last year, to $17,776.75 over the weekend, which led to forced liquidations of many large leveraged bets. Some crypto analysts have been worried about a complete capitulation of the market, particularly after Celsius Network, a private company, and a popular cryptocurrency lender, froze customers’ accounts last week leaving its customers unable to withdraw or transfer funds.

More than $2 trillion has been wiped from the crypto market since its peak last November, according to Yahoo News, and since money is fungible, losses of this size often create a liquidity crisis in the broader securities markets. What is noteworthy is that a liquidity crisis is not unusual at the end of a bear market, and in fact, is another sign that we may be nearing the finale of this cycle. Nevertheless, a liquidity crisis can be vicious. It is completely disconnected from economics, fundamentals, and technicals, and is simply a massive de-leveraging wave.

Again, there are reasons to be optimistic for the second half of the year, but this is still a dangerous time, and it is wise to be cautious.

Recession Talk

In our opinion, it is good news that market watchers have become obsessed with the prospects of a recession. Some economists even agree with me that we may already be in the middle of a recession. This is another ingredient that has been missing for a washed-out market. On the other hand, we have yet to see earnings forecasts come down. That may be the last and final phase of this bear cycle. But analysts tend to be trend followers and rarely identify turning points, so cuts in earnings estimates may not appear until the third quarter.

Similarly, there is good news in investor sentiment indicators. Last week’s AAII readings of 19.4% bulls and 58.3% bears were the third week in which a combination of less than 20% bulls and more than 50% bears has appeared since April 27, 2022. Prior to this string, there were comparable single-week readings on April 11, 2013, and January 10, 2008; however, neither of these readings coincided with a market low. The 4-week AAII bullish reading of 19% on April 27 was the lowest since 1990 and the bearish 52.9% reading of May 18 was the highest since the March 5, 2009 peak of 70.3%. These are some of the most extreme readings seen in years and according to AAII, equity prices tend to be higher in the next six and/or twelve months following such a combination. See page 11.

Recession Watch

Inflation is an insidious problem that eats into household consumption and also erodes corporate profit margins. For example, the charts on page 3 display the difference between nominal and real retail sales. May’s retail sales were disappointing but still rose 8.1% YOY. However, after adjusting for inflation, real retail sales fell 0.4% YOY. Year-over-year real retail sales have been negative for three consecutive months, which suggests that second quarter profits for many retailers may decline from first quarter’s weak results. The weakness in May sales was centered in autos, appliances, and nonretail stores. Gains were seen in necessities such as gas and food. For the month of May, sales from food and beverage stores, food service and drinking places, and gasoline stations totaled 34% of total retail sales. This was actually less than we expected but remember that retail sales measures merchandise and does not include necessities such as housing and healthcare expenses. See pages 3-4.

The NAHB Housing index has been declining every month this year and in May it hit its lowest level since the pandemic shutdown in early 2020. Existing median home prices, however, reached a cyclical high of $414,200, up 15% YOY. Unfortunately, with prices and mortgage rates rising rapidly, this means many prospective buyers will be priced out of the market. Note that in May single-family existing home sales were down 8.6% YOY. This decline may steepen in coming months which is unfortunate since the housing sector typically represents 15% to 18% of US GDP. See page 5.

Rates for a typical 30-year mortgage, which were hovering just above 3.1% at the beginning of the year, are now close to 6%. And rates are apt to go higher as the Fed continues to raise the fed funds rate. Investors are focusing on the Fed’s “terminal” fed funds rate which the consensus expects to be near 4%. But, with inflation currently at 8.6%, this still equates to a negative (i.e., easy) fed funds rate, which means the Fed may need to lift rates even higher than 4% to really curtail inflation. See page 6. When we look at the history of inflation and the fed funds rate it becomes clear that whenever inflation reaches 4% YOY, a recession has always followed. More importantly, history shows that it often takes more than one tightening cycle and more than one recession to truly reverse an inflation cycle once headline CPI exceeds the 4% YOY level. See page 6. In short, we may not see a buy-and-hold cycle in equities for a very long time.

Gail Dudack

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Our view has been that based upon fundamentals, the equity market begins to find value at the SPX 3850 level. A head and shoulders top formation also implied a downside target of SPX 3800. As a result, SPX 3850 has been our 2022 target for the year. However, now that the SPX is trading below this level, it may be wise to wait for two things to materialize before substantially adding to portfolios. The first factor would be a solid 90% up-volume day that is accompanied by volume that is well above average. This would be an important sign that panic selling is exhausted and that buyers with conviction have reentered the marketplace. Second, we would wait for the results of the Federal Reserve June meeting since this announcement could be a market-moving event.

The recent down leg in prices was triggered by the “bad news” found in last week’s May CPI report coupled with the fear of higher interest rates and a possible recession. In our opinion, it was naïve to think inflation had “peaked” in May. For one thing, any inflation rate above the long-term average of 3.4% is destructive to an economy and the stock market. Moreover, a deceleration in the pace of inflation is not the same as saying the problem is solved. For another, next month’s June CPI report is also likely to be disappointing given the current environment. With crude oil currently at $122, up 65% year over year, with headline PPI up 10.8% year-over-year, with housing and rents (42% of the CPI weighting) on the rise given the recent 16.7% year-over-year gain in single-family median home prices, and with the world facing a probable food shortage this summer due to Russia’s invasion of Ukraine, it is difficult to see how inflation is going to abate significantly in the near-term.  

Policy Error

Many investors are worried that the Fed will make a policy mistake in the coming months; however, in our view, the policy mistakes have already been made. Maintaining easy monetary and fiscal policies during the post-pandemic expansion was an Econ 101 textbook recipe for inflation. This may explain why it is important for the Federal Reserve to be a non-partisan independent body that is not driven by political bias or pressures. We are not saying Chairman Powell was being political last year, but he did repeat the administration’s view that inflation would be transitory. This proved erroneous. Regardless, the FOMC has the responsibility to balance the risks of inflation and unemployment and be unimpeded in using its tools of quantitative easing and interest rates to maintain a level-handed strategy. They did not address inflation in 2021. Remember: monetary and fiscal policy mistakes were made well before Russia invaded Ukraine in February of this year.

100 Means Business

In sum, the Fed is way behind the curve in terms of fighting inflation, and equally important, they have lost the confidence of investors. It is time to admit they were wrong and very late regarding inflation and announce a 100-basis point rate hike. Markets have already sent a “lack of faith” message to the Fed by discounting a 75-basis point fed funds rate hike this week; a 100-basis point move may be a shock to markets, but it could also restore investors’ confidence and signal the world that the Fed is serious about taming inflation. The only caveat to a 100-basis point hike would be the responsibility the Fed has to not upset the fixed income markets and to protect the liquidity in these markets. Yet, all things considered, it is time to rip off the band-aid.

Many fear that an increase in interest rates will trigger a recession but we believe a recession is now inevitable. History has shown that when inflation reaches levels as high as today, the end result has always been a recession. This should not be a surprise since inflation requires the Fed to raise interest rates multiple times, or until it significantly reduces consumption. In fact, in the period between 1973 and 1983, there were three recessions in ten years. See page 4. Most of this was due to the multiple tightening cycles enacted by the Fed. In that cycle, headline CPI peaked at 14.6% in March 1980 and the inflationary trend finally turned when Fed Chairman Paul Volcker raised the fed funds rate to 14% in May 1981. See page 6.

Unfortunately, the price moves seen in crude oil, the CPI and the PPI are at or near the peaks seen in 1982. The good news is that neither core CPI nor core PPI is at similar levels. This could be a silver lining for the current cycle in terms of curbing inflation — if the Fed acts quickly and decisively.

Halfway through a recession

In a recent report (“Halfway Through a Recession,” May 3, 2022) we questioned whether or not we are already in a recession. A recession is measured as a minimum of two consecutive quarters of negative GDP growth and is confirmed by the National Bureau of Economic Research (NBER) usually after the fact. As a result, it is not unusual to not know if the economy is undergoing a recession until it is over, or at least half over. However, being in a recession is the good news. Stock markets tend to bottom in the middle of a recession, and this would put the current market weakness in a different light.

What makes us feel a recession will appear sooner rather than later is that higher interest rates are apt to slow the already decelerating housing and auto markets. The average interest rate for a standard 30-year fixed mortgage is now 5.87%, which is an increase of 36 basis points from one week ago. Rates are apt to go even higher and therefore, housing and auto activity, two important segments of the economy, may slow quickly. Moreover, the US is a consumption-driven economy, and the household sector has seen real purchasing power turn negative this year due to soaring inflation.

Meanwhile, consumer sentiment is floundering. June’s preliminary University of Michigan sentiment index fell to 50.2 from 58.4 and is below the record low set during the 1980 recession. Consumer expectations led the decline, dropping from 55.2 to 46.8, a new cyclical low. Current conditions fell from 63.3 to 55.4 reaching a new record low. The May NFIB Optimism Index fell 0.1 to 93.1, the fifth consecutive month below the 48-year average of 98. Small business owners expecting better business conditions over the next six months decreased four points to a net negative 54%, the lowest level recorded in the 48-year-old survey. Expectations for better business conditions have deteriorated every month since January. In short, there are signs of recession if one dares to look. We apologize for being so glum, but we believe it is wise to remain cautious a bit longer, or until the market can produce a convincing 90% up day. The good news is that discussions about the possibility of recession are now on the rise. The bad news is that this has not yet been factored into earnings forecasts. After the market close of SPX 3735.48, the market has dipped within our valuation model’s year-end fair value range of SPX 2735-3866. It is only 13% above the mid-range of our model (SPX 3300) which would be a great buying opportunity. See page 7. In short, equity prices are reaching good long-term valuation levels, but prices could still fall a bit more.

Gail Dudack

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We do not believe the bear market is over. In our view, the repercussions from potential energy and food shortages this summer, relentless inflation, and rising interest rates will weigh heavily on the economy, profit margins, and earnings in 2022. Still, the peak to trough declines made in the broad indices recently, have been significant. The Dow Jones Industrial Average, the S&P Composite, the Nasdaq Composite, and the Russell 2000 have had selloffs of 15.0%, 18.7%, 29.8%, and 27.8%, respectively. Now that earnings season is nearly over, we think the opportunity for a rebound in equities is materializing. The only risk this week is the release of May’s CPI report on June 10 which most economists expect will display a deceleration in inflation. This is possible but with crude oil prices up 62% YOY we doubt that inflation can moderate much in the near term. While it is feasible that headline CPI could decelerate a bit from April’s 8.2% YOY pace, we expect inflation to remain stickier and more persist than most expect. This will be a major problem for the Federal Reserve and the economy.

Nevertheless, the technical charts of companies like Walmart, Inc. (WMT – $123.37), Costco (COST – $471.78) and Target Corp. (TGT – $155.98) suggest that a lot of bad news regarding profit margin pressures and earnings weakness is being priced into segments of the marketplace. See page 3. This builds a foundation for a rebound rally.

But in general, we still believe an overweight position in inflation-resistant stocks is the best policy for investors. In the longer term, the risk of a recession increases, and we doubt that this has been fully discounted by equities. Nevertheless, our favored sectors also are recession resistant and thereby serve both purposes. In short, our suggested overweight sectors remain energy, staples, industrials (emphasizing defense stocks), and utilities. See page 13. We consider these to be core portfolio holdings.

Still, trading opportunities will appear in other sectors and individual stocks from time to time. For example, the retail sector is currently deeply oversold and could rebound substantially from recent lows. But we would view these situations as short-term trading opportunities.

Risk of Recession

Most economists are now discussing the possibility of a recession in late 2023, but we think the risk could be sooner though many experts disagree. Treasury Secretary Janet Yellen testified before the Senate Finance Committee this week and she apologized for being wrong about her stance on inflation which she described as being “transitory” last year. And we find ourselves disagreeing with her once again. In her testimony, she described the economy as being in “good shape” and households as being “resilient due to their high savings rate.” Unfortunately, the Treasury Secretary does not seem to realize that the personal savings rate fell to 4.4% in April, its lowest level since September of 2008! Keep in mind that the economy was in a recession from December 2007 to June 2009. In sum, it is difficult to have confidence in the economy if the administration does not have a grip on inflation or the state of the consumer.

Red Flags

Our nature is to be bullish, however, we see a number of red flags on the horizon that are being ignored and this concerns us. For example, the ISM indices for the month of May were disappointing. The ISM manufacturing index inched up to 56.1 in May, nonetheless, May was the second lowest reading in 20 months. The ISM nonmanufacturing index fell to 55.9 and it was the worst reading in 15 months. However, both main indices remain above 50 which is a sign of a good, albeit not robust, economy. More worrisome were the employment indices. The employment index fell to 49.6 in the manufacturing survey and down to 50.2 in nonmanufacturing. A number below 50 is a sign of contraction in activity. See page 4.

Two key areas of the US economy are housing and autos, both of which are on our radar since they will be negatively impacted by rising interest rates as the Federal Reserve continues its tightening policy this year. Housing has already shown signs of sluggishness in recent months, particularly in homebuilder sentiment and homebuyer traffic data. Last week’s data for May’s auto sales was also a disappointment. Total light vehicle unit sales were 12.7 million, on a seasonally adjusted annualized rate (SAAR), which was 25% below the pace a year earlier and 12.6% below April’s level. A lack of inventory contributed to this decline, but that is not an easy problem to solve. According to a 2021 report from the Boston Consulting Group and the Semiconductor Industry Association, 92% of the world’s most advanced semiconductors are manufactured in Taiwan, with the other 8% being manufactured in South Korea. In short, the semiconductor shortage is not a post-pandemic problem but is in reality a long-term problem in search of a solution. It is another sign that inflation may be difficult for the Fed to control.

But in terms of auto sales, keep in mind that they are a large component of retail sales. And as we discussed last week, retail sales have been an excellent lead indicator of the US economy and a particularly good predictor of a recession. In fact, over the last 50 years, a decline in year-over-year real retail sales, when measured on a quarterly basis, has accurately predicted every recession. There have already been two consecutive months of negative real retail sales; but if this trend continues, it will increase the prospect of a recession later this year. See page 5.

Inflation, the Fed, and recession are incontrovertibly linked in 2022. In April, headline CPI was 8.2% YOY and even after two fed rate hikes, short-term interest rates remain at an historically negative (and easy) level of negative 7.2%. The Fed has indicated that it wants to get to a neutral fed funds rate, but even if we assume the year-end inflation moderates to 5%, the fed funds rate would have to increase 400 basis points to simply match inflation. If a 5% fed funds rate materializes, we expect the housing market would slow quickly and hurt economic activity meaningfully. It would also increase the odds of an inverted yield curve — another sign of a pending recession. See page 6. In short, we see danger from both inflation and recession this year and the Fed is caught in the middle.

Technical Rebound The odds of a rebound in prices are high with most of the indices trading well below important moving averages. It would be normal for the indices to test their 100-day moving averages at this juncture. For reference, these levels are 33,905 in the Dow Jones Industrial Average, 4323 in the S&P Composite, 13,230 in the Nasdaq Composite and 1971 in the Russell 2000 index. See page 9.

Gail Dudack

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Stay Nimble

We do not believe the lows of the current bear market cycle have been found; however, technical indicators suggest a rebound in prices is likely in the near term. Supporting a short-term rally scenario is the fact that both the Nasdaq Composite and the Russell 2000 traded more than 20% below their 200-day moving averages in mid-May. A 20% or greater spread between price and the 200-day moving average, is extreme, even in a bear market, and it is typically followed by a reflex rally. However, to date, we have not been impressed by recent rally attempts; volume has decelerated on rally days and while there have been positive breadth days, no 90% up days — a sign of buying conviction — have appeared. In sum, traders should remain nimble, and investors should remain cautious.

Economic Caution

There are many reasons to remain wary of equities at this juncture; but our biggest concerns are the resilience of the economy, the health of the consumer, and the risk this combination puts on earnings growth. First quarter GDP growth was revised from negative 1.4% to negative 1.5% last week. This reduction is significant since it indicates that the first quarter economic growth rate was not only negative, but it also fell below the low end of the standard deviation band – a level that has often indicated a recession is in place. See page 3. Weakness in the first quarter was concentrated in trade and inventories, but consumption was also weak.  

We believe it is wise to be on a “recession watch” and one tool we have found to be helpful in predicting GDP strength or weakness has been real retail sales. In the top chart on page 4, we overlay a 3-month moving average of the year-over-year rate of real retail sales with quarterly GDP. We have found that when the 3-month average of real retail sales turns negative, it has been an indication that a recession is in place. For the month of April, real retail sales were negative 1.55% YOY, but the 3-month average remained positive at 5.2% YOY. However, this means retail sales will be an important series to monitor in the months ahead. Two more months of negative real sales could point to a second quarter of negative GDP, i.e., a recession.

Another statistic that concerns us is the trend in personal income, or more precisely, real disposable personal income. This latter statistic reflects the true amount of money households have to spend. Personal income rose 2.6% YOY in April. Wage and salary disbursement rose a robust 11.7% YOY but government social benefits fell 17.8% YOY and personal current taxes increased 23.8% YOY. As a result, disposable personal income fell 0.27% YOY in April. However, after inflation, real disposable income fell 6.2% YOY in April, all of which is displayed in the bottom chart on page 4. In other words, the purchasing power of households is declining, and this does not bode well for our economy which is 70% consumer-driven.

These statistics explain the recent pressure on retailers and the disappointing first quarter earnings report from Walmart Inc. (WMT – $128.63). Walmart, the largest retailer, and the largest private employer in the US, reported earnings that fell well short of estimates due to rising costs for food, fuel and wages which weighed heavily on profit margins. The stock is currently down 25% from its recent high. And though Walmart reported solid sales in the first quarter, it now faces the choice of raising prices to consumers or continuing to face margin pressure. Moreover, price inflation for food and grains will only get worse due to Russia’s invasion of Ukraine. Since the start of the invasion on the 24^th of February, Reuters reports that “Russia has blockaded all of Ukraine’s seaports and interrupted its grain exports. This in turn has impacted global food prices, caused food insecurity, and affected vulnerable populations.” In short, the summer months could be a time of more global shortages, inflation pressures and geopolitical unrest.

The Bureau of Economic Analysis data showed that even with this year’s steady decline in real personal disposable income, personal spending increased 0.7% in April versus March. However, this spending came at the expense of dipping into personal savings which fell from $922.3 billion to $815.3 billion. In April, the savings rate fell from 5% to 4.4%, its lowest level since the recession of 2008. See page 5.

With this as a backdrop, it is not surprising that consumer sentiment indices fell in May. In both surveys, it was clear that poor consumer sentiment was led by declines in expectations. May’s Conference Board consumer confidence results reversed the gains seen in April. However, the University of Michigan sentiment survey has been extremely weak all year and May’s confidence readings were the lowest reported in 11 years, or since 2011. See page 6. Both consumer surveys are sobering since they are painting a dismal picture for second quarter consumption and economic activity.

Keep in mind that the Federal Reserve will continue to raise interest rates this year. In April, headline CPI was 8.2% YOY, and even after two fed rate hikes, the real fed funds rate remains at an historically negative (and easy) level of negative 7.2%. The Fed has stated that it wants to get to a neutral fed funds rate as quickly as possible. Assuming year-end inflation moderates to 5%, the fed funds rate would have to increase another 400 basis points to simply match inflation and reach a zero cost of capital. If a 5% fed funds rate materializes, we expect the housing market – which we believe is slowing — would slow more dramatically and hurt economic activity meaningfully. See page 7.

With first quarter earnings season nearly complete, we notice that consensus earnings estimates are falling for this year and next year. The S&P Dow Jones and Refinitiv IBES consensus earnings estimates for 2022 fell $0.15 and $0.81, respectively, this week; however, the nominal earnings range is relatively unchanged at $224 to $228. Earnings growth rates for this year are 4.1% and 9.2%, respectively. Our DRG 2022 estimate remains at $220, a 5.7% YOY increase from $208.19 in 2021. As a reminder, we believe value begins with a PE multiple of 17.5 times which equates to SPX 3850 given our $220 earnings estimate. See page 9.

The Good News The best news of the week was found in investor sentiment. The AAII bullish sentiment index fell 6.2 points to 19.8% while bearish sentiment rose 3.1 points to 53.5%. We saw this combination of “less than 20% bulls and more than 50% bears” on April 27, 2022, and it repeated again last week. Prior to these two weekly readings, the combination was last seen on April 11, 2013. Also note, the April 27 bearish reading of 59.4% was the highest bearishness since the March 5, 2009, peak of 70.3%. Sentiment tends to be an inverse indicator and the spread between bullishness and bearishness is the widest since the 1990 low. See page 13. Equity prices tend to be higher in the next six and/or twelve months following these extreme readings. Again, we believe this is the beginning of the end of the bear market, but it is apt to be a multi-month process. We remain cautious, particularly on rallies above SPX 4000.

Gail Dudack

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Late-Stage Bear

Equities are clearly in the throes of a bear market, and we do not believe the lows have yet been found. However, we do believe we are in a late stage of this bear cycle.

In recent weeks there have been four 90% down days — April 22: 90%; May 5: 93%; May 9: 92%; May 18: 93% — and history suggests that these extreme volume days tend to come in a series and reflect investor panic. More importantly, a series of 90% down days is a common characteristic of a later-stage bear market cycle. From a strategic perspective, the first sign of selling exhaustion appears when a 90% up day materializes. A 92% up day did appear on May 13, and while we believe this marked the beginning of the final phase of the current bear market, it does not necessarily define the final low.

Nevertheless, it did not surprise us that a 90% up day appeared immediately after the SPX slipped below the 4000 level. We have been using an average PE multiple of 17.5 coupled with our $220 earnings estimate for the S&P 500 in 2022 to define downside market risk. This combination equates to SPX 3850 and in our view, this is where “value” in the broader marketplace is found. However, a 17.5 PE multiple assumes that inflation will moderate by the end of this year, and it assumes that our $220 earnings forecast proves accurate. This PE estimate is at risk of revision due to inflation and our earnings forecast could be too high if the US economy weakens more than expected. Later this week, the Bureau of Economic Analysis will release an update on first quarter GDP. The initial estimate was a decline of 1.4% and if this number is revised lower it could weigh heavily on investor sentiment given the implications it would have on economic strength and earnings growth.

In the current environment, we believe the best strategy is to overweight sectors and stocks that benefit from, or are immune to, inflation. Areas such as energy, staples, defense stocks, and utilities. Most of these sectors also have excellent dividend yields which provide both income and downside support. Price declines have been intense in the technology sector due to the high PE multiples characteristic of this sector, but we believe good long-term buying opportunities will appear in this area later this year. However, we would not focus on the social media stocks that were the drivers of the past bull market, instead look for opportunities in technology with future growth such as defense, cybersecurity, robotics, and medical technology.      

The Long Cycle

In our work, we like to put the current cycle into an historical perspective. This helps us clarify whether equities are in a secular bull, secular bear, or a massive trading range market, and it can define the appropriate investment strategy. For example, secular bull markets often end as a result of an economic crisis. Over the past 150 years, the source of a major economic crisis has alternated between a debt/default/deflation cycle or an inflationary cycle. Either way, the crisis has typically created a multi-year ceiling for stock prices until the crisis is resolved. For example, in the last cycle, the S&P 500 peaked in March 2000 (1527.46) and again in October 2007 (1565.15). The 2000 peak was triggered by a surge in margin debt and margin calls and in 2008 sovereign debt defaults triggered a global banking crisis. It took years to resolve the global banking crisis and the S&P 500 did not better the 1565 level until 2014. See page 3.

The January 3, 2022 high of SPX 4796.56 materialized during a post-pandemic inflation cycle driven by an historic amount of monetary and fiscal stimulus. In the US, this generated the worst inflationary trend in 40 years. Unfortunately, we do not expect the equity market will be able to better its January 2022 peak until inflation is back under control. In short, both debt and inflation are debilitating to an economy, which is why the Fed’s job of fighting inflation and monitoring debt levels is critical to the economic health of the US. See page 4.

Earnings and Economic Concerns

There are many ways to define value in the equity market. As previously stated, we are using an average PE multiple of 17.5 times to define value in the marketplace, but we also have a valuation model that assigns a PE based upon current and forecasted inflation and interest rates. Unfortunately, even at the May 19 close of SPX 3900.79, the market remained 1.0% above the top of the forecasted year-end fair value range of SPX 2730-3860 and 18% above the mid-range of our valuation model. This is because even if inflation falls to 5% YOY, our model suggests a PE range this year of 14.5 times to 15.0 times. Again, this is an example of the debilitating impact of inflation. Again, investors can assume that value is found below the SPX 4000 level. See page 5.

Although there are no signs that the US is in a recession, there are signs of an economic slowdown. April’s retail sales rose 4.7% YOY on a seasonally adjusted basis, and excluding autos, sales rose 6.1%. However, unadjusted retail sales fell 6.8% YOY and excluding autos, sales fell 4.5%. Moreover, seasonally adjusted sales of 4.7%, rose far less than April’s inflation rate of 8.2% YOY. This means real sales were negative in April, and it explains the negative EPS surprises reported by many retailers in the first quarter. See page 6.

New home sales were 591,000 (SAAR) in April, the slowest pace since April 2020, at the height of the shutdown. Existing homes sales were 5.61 million in April, the lowest since June 2020. See page 7. Note that April was the first time the Federal Reserve raised rates and mortgage rates are expected to move much higher in 2022. More importantly, even after two fed rate hikes, short-term interest rates remain at an historically negative (and easy) level of negative 7.2% given headline CPI of 8.2% YOY in April. The Fed has indicated that it wants to get to a neutral fed funds rate. But assuming inflation moderates to 5% by year end, the fed funds rate would need to increase 400 basis points in the coming months. See page 4. This could have a deleterious impact on the housing market.

The significance of a housing slowdown should not be overlooked since housing typically contributes 15% to 18.5% to GDP. Housing affordability declined sharply in April as a result of rising mortgage rates and soaring prices. This trend is expected to worsen, and we are concerned about the effect it will have on GDP and the broad economy. Not surprisingly, homebuilder confidence has been steadily slipping this year. Rising interest rates have not had a noticeable impact on the auto and truck sector, to date, but we believe it is only a matter of time before it does. For all these reasons, we believe portfolios should be insulated against the impact of inflation and rising interest rates to the best of one’s ability. We remain cautious.

Gail Dudack

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Last week we wrote that a series of 90% down days, also known as panic days, is a classic characteristic of a late-stage bear market cycle. This was significant since a string of 90% down days recently appeared on April 22 (90%); May 5 (93%); and May 9 (92%). More importantly, a 90% up day is typically the first sign that the panic and selling pressure that has been driving the bear trend is becoming exhausted. On May 13, 2022, the NYSE volume statistics reported a 92% up day, which we reported on May 16, 2022 (Direct from Dudack “A 92% Up Day”). This was excellent news.

Nevertheless, it is important to note that a single 90% up day does not define the ultimate low. What it does indicate is that downside risk is diminished. For example, the last time the market experienced a series of 90% down days was during the 2020 bear cycle. The series began on February 20, 2020, with a 91% down day when the SPX closed at 3373.23. In subsequent weeks there were six more 90% down days followed by a 92% up day on March 13, 2020, when the SPX closed at 2711.02, recording a 20% decline from the February peak of SPX 3386.15.

This 90% up day was not the end of the cycle; it was followed by two more 90% down days, but the ultimate low of SPX 2237.40 was recorded on March 23, 2020, six trading days later. Another 94% up day materialized on March 24, 2020. In short, while the first 90% up day did not indicate that the bear market was over, it did imply that a major low was on the horizon.

If we dissect the 2020 cycle, we find that the total bear decline in the SPX was 34%. A 90% up day materialized after a 20% decline. This was followed by a 17% decline in the following six trading sessions and the bear cycle ended on March 23, 2020. Overall, we believe the recent 92% up day is a favorable sign and we would also note that it appeared immediately after the SPX fell below the 4000 level. As a reminder, we have been using a 17.5 PE multiple with our $220 earnings forecast for the S&P 500 as a practical way of defining “value” in the broad market. This combination equates to SPX 3850. In sum, the market may not yet have recorded its final low, but we do think that the low of SPX 3930.08 on May 12, 2022, marked the beginning of a bottoming phase.

Valuation Remains a Concern

With first quarter earnings season 92% complete, there is a growing concern about the durability of earnings growth in 2022. According to Refinitiv IBES, results for S&P 500 earnings in the first quarter are pointing to a gain of 11% YOY, but after excluding the energy sector, this growth rate falls to less than 5%. Full-year growth forecasts, according to IBES, are expected to be 9% to 9.9%; whereas S&P Dow Jones shows earnings growth to be 5.8%. But estimates have been volatile. This week consensus earnings estimates for 2022 according to S&P Dow Jones fell $0.66 while Refinitiv IBES estimates rose $1.08. As a result, the nominal earnings range for 2022 widened to $224 to $228 and earnings growth rates for this year are 5.8% and 9.8%, respectively. (Note: consensus macro-EPS forecasts may differ from four quarter analysts’ forecast sums seen on page 16.)

Our DRG 2022 estimate remains at $220, a 5.7% YOY increase from $208.19 in 2021. We have noticed that strategists have been lowering their 2022 S&P earnings forecasts to $220 and most strategists are forecasting a 10% growth rate in 2023. Keep in mind that a 9% earnings growth rate coupled with inflation of 7.7%, equates to merely 2.3% real growth for this year. This is just one example of the destructive nature of inflation, and it helps to explain why PE multiples will fall during times of inflation.

Unfortunately, even at the May 12 close of SPX 3930.08, the stock market remained 1.8% above the top of our valuation model’s year-end fair value range of SPX 2730-3860 and 16% above the mid-point of the forecasted range, or SPX 3295. See page 5. Even if our $220 EPS estimate for 2021 proves to be too conservative, given current interest rates, our model implies that value is found below the SPX 4000 level. The good news is that the SPX recently dropped below 4000; the bad news is the SPX is currently back above the 4000 level. In sum, while the current oversold reading allows for a near-term rebound, we remain cautious for the intermediate term.

Economic Data

Despite high inflation, consumers keep spending. Retail sales rose a seasonally adjusted 0.9% in April, which was the fourth straight month of higher retail spending. However, the earnings results of retailers have been mixed with Walmart (WMT – $131.35) reporting that quarterly revenue was dented by rising food prices and supply-chain disruptions and Home Depot (HD – $300.95) reporting better than expected earnings, but noting that fewer customers are spending more per shopping trip.

The impact of inflation is found everywhere. From 2014 to 2020, wage growth exceeded inflation, and this helped households since it increased purchasing power. However, in 2021 and 2022 this changed dramatically, and real wage growth turned negative reducing purchasing power. More precisely, in April the year-over-year increase in weekly wages was 5.5% YOY, but CPI rose 7.7% YOY in the same period. As a result, real wages fell 2.2% YOY. This is a 2.2% decline in purchasing power and it is having a negative impact on all households, but most particularly on the poor and those on fixed incomes. See page 4. It is also worth noting that when inflation runs above the long-term average of 3.4% YOY, it has never been good for the stock market. To date, equities have held up better than one might expect but we believe the pressure on margins, earnings, and PE multiples will continue over the next twelve months. See page 4

The NFIB Small Business Optimism Index was unchanged in April at 93.2 and remained below the 48-year average of 98 for the fourth consecutive month. The preliminary University of Michigan consumer survey for May was lower in all categories, including headline and present conditions. Expectations fell from April’s 62.5 to 56.3. See page 3. April’s total industrial production report was a highlight this week, increasing 1.1%. This was the fourth consecutive month of gains of 0.8% or greater. All major market groups recorded gains in April, with most rising around 1%. Production of motor vehicles and parts contributed to increases of 1.5%, 3.3%, and 1.1% in the consumer durables, transit equipment, and durable materials categories, respectively. Business equipment and defense and space equipment each recorded gains of greater than 1%. Keep in mind that one of the contributing factors for the first quarter’s decline of 1.4% in GDP was a decline in inventories. April’s industrial production data suggests that inventories are being rebuilt and will therefore contribute to second quarter GDP in a positive way.

Gail Dudack

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