On May 13, 2022, the NYSE volume statistics reported a 92% up day. As we have been reporting, a 90% up day is significant after a series of 90% down days in terms of defining downside market risk. Extreme volume readings with 90% of the day’s volume in declining stocks (90% down days) reflect panic and a 90% up day indicates that the worst of the panic selling may have occurred. It does not define the low, but it implies that the downside risk is diminished.

For example, the last series of 90% down days began on February 20, 2020, with a 91% down day and the SPX closed at 3373.23. There were six more 90% down days followed by a 92% up day on March 13, 2020, when the SPX closed at 2711.02.

This was followed by two more 90% down days. The ultimate low of SPX 2237.40 was recorded on March 23, 2020, with a 94% up day on March 24, 2020. Note that the total 2020 decline in the SPX was 34%, and there was a 17% decline in the six trading sessions between the first 90% up day and the final low.

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, is the beginning of a bottoming phase. As a reminder, we have been using a 17.5 multiple and our $220 earnings forecast for the S&P 500 as defining “value” in the broad market. That equates to SPX 3850.  

Gail Dudack

Click to Download

The Good News

According to NYSE volume statistics, recent trading sessions have included three significant 90% down days: April 22: 90%; May 5: 93%; and May 9: 92%. History suggests that these extreme downside volume readings usually come in a series and reflect underlying investor panic. The good news is that a series of 90% down days is also a characteristic of a late-stage bear market cycle. Unfortunately, there is no consistent pattern to how many extreme down days may occur; however, the first indication that selling pressure and panic is becoming exhausted is seen when a 90% up day appears. Hopefully, a 90% up day will be on the horizon.

As a result of recent extreme breadth days, the 25-day up/down volume oscillator dropped to negative 3.80 this week, its most oversold reading since April 1, 2020. But to put this into context, in March and April of 2020, the market was in oversold territory for 25 of 28 consecutive trading sessions and reached an oversold reading of negative 7.32 on March 23, 2020, the same day the stock market bottomed at SPX 2237.40. See page 8. In short, there is no telling how long selling pressure may last.

The other bit of good news has been sentiment indicators. The American Association of Individual Investors (AAII) sentiment survey was revealing two weeks ago when the survey showed 16.5% bullishness and 59.4% bearishness. This bearish reading was the highest percentage since the March 5, 2009, reading of 70.3%. This week’s survey results of 26.9% bullishness and 52.9% bearishness are also relatively extreme, and the AAII Bull/Bear Spread remains in positive territory. See page 10. Low bullish sentiment is typical of the end of a decline; therefore, investors should be wary of becoming too negative at this juncture.

Over the last twelve months, we have pointed out a pattern of sequential weakness in the popular indices. This trend can be seen in charts of the DJIA, SPX, IXIC, and RUT, in that order, where the declines from their recent peaks has been 12.6%, 16.6%, 26.9%, and 27.9%, respectively. What has been notable during this time, is that the Russell 2000 index has been the best forecaster for the overall market. It was an early leader at the top and it may lead at the low as well. We will continue to monitor these charts, but at present the RUT shows no signs of bottoming. See page 7.

Many investors are focused on the CBOE Volatility index (.VIX – $32.99) which has moved up from a recent low of $18.50 to a high of $35. The VIX is a measure of volatility, and it often spikes at the end of a bear market cycle, just like volatility does. But overall, we find the VIX to be an unreliable indicator since there is no level that actually defines a peak in volatility, and conversely, a low in prices. For example, at the end of corrections in 2010, 2011, 2015 and 2018, the VIX rose to levels in excess of 45. But it reached 85 at the 2020 low and 82 at the 2008 low. In short, the VIX would have to more than double from current readings to suggest the bear market cycle is over.

The Bad News

The bad news is that first quarter earnings season is not going well. Last week S&P Dow Jones lowered its 2022 S&P 500 earnings forecast by $2.45 to $225.06 and IBES Refinitiv lowered its consensus forecast by $1.14 to $227.60. Yet as bad as these reductions appear, consensus estimates are merely returning to where they were a few months ago. Nonetheless, we have noticed that several strategists are lowering their 2022 earnings estimates as first quarter earnings season is ending. As a result, my 2022 earnings forecast of $220 is no longer a downside outlier. This is important to keep in mind because valuation is an important factor at the end of a bear market cycle.

In most bear market cycles, earnings growth, or lack thereof, is usually an issue. We have expected this to be true in the current cycle as well. Regrettably, the fundamental factors that are most predictable today are inflation and short-term interest rates, both of which are rising. Rising inflation and interest rates are a drag on earnings, and we fear that analysts may have underestimated the impact.

April’s inflation data will be released this week and it could take a toll on the market. Some economists are calling for a deceleration in the pace of inflation, but we checked our files and found that if headline CPI were unchanged in the month of April, the year-over-year pace would still be 7.7%, down from 8.5%. Similarly, core inflation would be 5.6%, down from 6.5%. PPI would be 14.5%, down from 15.2% and PPI final demand would be 10.1%, down from 11.2%. In other words, we expect inflation will remain high and continue to be a problem for the Federal Reserve. Unless data suggests inflation is under control the Fed has been extremely clear on its intentions of raising the fed funds rate 50 basis points at each of the next five meetings. In sum, the fed funds rate could rise as high at 3.5% by the end of this year. If it does, it could be a huge drag on the economy and earnings or it could trigger a recession. As we noted last week, given that first quarter GDP was already negative, is it possible we are already halfway through a recession of two consecutive quarters of negative growth? Either way, earnings growth is at risk in 2022.

Because earnings are usually in danger in a major correction of a bear market, we use trailing operating earnings to help us define “value” and the potential downside risk for equities. In short, we are defining value, absent any earnings growth. Analysts typically measure value for the S&P 500 based upon a price-earnings multiple. But PE multiples can vary depending upon perspective. For example, when the SPX closed at 3991.24 on May 9, the 12-month trailing PE fell to 18.7. This was clearly below the 5, 10, and 30-year average PE multiples, but just barely below the 20-year average of 18.9 times. Yet 18.7 times is still above the 50-year or 74-year averages of 16.6 and 15.8 times, respectively. See page 3. In short, valuation is a matter of perspective. We have been using a PE of 17.5 with our $220 earnings estimate to define “value” in the market. This equates to a level at, or below, SPX 3850. This view is unchanged. The sum of the trailing PE and inflation is called the Rule of 23, and the current sum of 25.53 remains well above the normal range of 14.8 to 23.8. To return to the normal range, the SPX would need to fall to a 17.5 multiple while inflation declines to 5.5%. We believe this combination is possible in the coming months. Sadly, there is a more bearish case for equities, and it is best displayed by our valuation model. Even at the May 9 close of SPX 3991.24, the market remained 8.5% above our model’s predicted fair value range of SPX 2575-3676. This range rises to SPX 2734-3865 by year end which is closer to our target of SPX 3850. Nevertheless, most benchmarks point to value appearing 5% to 10% below the SPX 4000 level.

Gail Dudack

Click to Download

The Federal Reserve is expected to raise the fed funds rate 50 basis points this week, but this move is widely expected and unlikely to impact stock prices, in our view. What was not expected was last week’s GDP report that showed first quarter economic activity fell 1.4% SAAR.

First, it is important to remember how real GDP is calculated. Economic activity is measured on a quarter-over-quarter basis, adjusted for inflation, and annualized. Since real GDP in the fourth quarter of 2021 grew at a robust 6.9% rate, it is not surprising that the first quarter of 2022 slowed from that level. Nevertheless, an actual decline in growth was not expected.

We were surprised by this negative number, and we will remind you that last week we wrote that whatever the GDP report revealed for the first quarter’s economy, the second quarter was apt to be slower. Our thought process was that the Fed is expected to raise short-term interest rates by 100 to 150 basis points during the second quarter and more in the second half of the year. These rate hikes will weigh heavily on economic activity, particularly in the housing and auto sectors. We also reported that there were indications that residential real estate and vehicle sales were already decelerating in March. Higher financing costs would lower demand for housing and autos even further and the deceleration in these key sectors would continue.

Given this backdrop and the negative GDP seen in the first quarter, the obvious question becomes – are we already in the midst of a recession? The Bureau of Economic Research states we have already had one quarter of negative growth, yet surprisingly, we do not hear economists questioning whether or not we are IN a recession right now. The silence is deafening. And this is a concern.

There are two reasons why negative growth in the current second quarter is not totally predictable. The first is that GDP was already negative in the first quarter. It is easier to “calculate” a slowdown from a strong GDP quarter than it is from a weak GDP quarter. Simple math indicates that economic activity would have to decelerate even more in the current quarter for GDP to remain negative. This may not be probable, but it is possible, and we certainly would not rule it out. A second point is that weakness in the first quarter was centered in poor trade data, inventory depletion, and lower government spending. Notably, the strength seen in the fourth quarter of 2021 was due to an inventory build. See page 4. The March ISM manufacturing survey also pointed to low inventories which gives us hope that manufacturing and trade may return to positive in the second quarter and add to GDP. Yet, all in all, we remain cautious on the outlook for the economy and the stock market in the coming months.

Rebound

The Dow Jones Industrial Average lost more than 2000 points in the last nine trading sessions. As a result, our technical breadth indicators are as oversold as they were in March of this year. From this perspective, we would not be surprised if stock prices rebounded from current levels. However, it is clear from the charts and from statistics, that equities are in a bear market. In short, we would consider any near-term rally to be a rebound within a bear market cycle.

From a technical perspective, the 90% down day recorded on April 22^nd was the first extreme breadth day recorded since June 24, 2020. The good news is that this is a sign of panic and panic is characteristic of a late-stage bear market. The bad news is that 90% panic days tend to come in a series.

To date, we have not seen another 90% down day, although there was an 88% down day on April 26^th and an 89% down day on April 29^th. Still, historically, 90% down days tend to appear in clusters and it is likely that there will be more. Panic days also tend to be high volume days, and while the 90%, 89%, and 88% down days we experienced recently were accompanied by higher volume, it was not a significant increase in volume. One could not say the current market is “washed out.”

Lastly, the first telltale sign that selling pressure is becoming exhausted is when a 90% up day appears. A 90% up day may not appear at the exact low, but it tends to appear near the tail end of a bear market. It is usually a sign that downside risk is minimal. Unfortunately, that is yet to be found.

Technical update

There are some technical indicators that are more favorable, particularly the AAII sentiment survey. AAII bullish sentiment fell 2.5 points to 16.4% last week and has been below 20% for three consecutive weeks. This was only the 34th time in AAII history that bullishness fell below 20%. Bearish sentiment jumped 15.5 points to 59.4% and is at its highest level since a March 5, 2009, reading of 70.3%. This combination of extreme sentiment readings is favorable. Unfortunately, sentiment indicators have rarely been good timing tools, but they do tend to keep investors from becoming too bullish or too bearish. In the current case, sentiment indicators are warning us not to become too bearish for the longer term.

Still, the charts of the major indices are worrisome. With the exception of the DJIA, all the popular indices broke to new cyclical lows this week. And while the steepness of recent declines suggest a rebound from current levels, the chart patterns are uniformly negative. See page 7.

Valuation Benchmarks Technical indicators can be especially useful at market tops, but we find fundamental tools to be best at defining “potential” bottoms. Earlier this year we wrote that the current level of inflation was a warning that PE multiples could fall to their long-term average or lower. The long-term average PE multiple is 17.5 times. Our S&P 500 earnings estimate is $220, which is conservative and below the general consensus. But applying a PE multiple of 17.5 to our $220 earnings estimate suggests that value in the broad equity market is found near the SPX 3850 level. This is important to keep in mind if we get a series of 90% down days and the market becomes emotional. SPX 3850 sounded extremely bearish earlier this year, but it is less than 8% below current prices. With many of the technology darlings, like Apple (AAPL – $159.48) also coming under selling pressure in recent days we believe it is time to start looking for a possible turnaround. In a classic bear market cycle, the large capitalization darlings of the previous bull market cycle tend to be the last to fall.

Gail Dudack

Click to Download

Did the Dow Jones Industrial Average actually plunge 1,920 points in the last four trading days without a catalyst? In our opinion, the decline was a long time in coming, but the most obvious answer to this question is that there were many catalysts, but the final straw was first quarter earnings results.

First Quarter Earnings Season

It has been our long-held view that first quarter earnings season could be a market-moving event. Earnings are always the underpinning of a stock market advance or decline, and as the first quarter of 2022 ended, it seemed like first quarter earnings results were the only hope investors had for good news. There was plenty of bad news. It has been clear for months that interest rates would be moving higher, and this would challenge equities and likely lower PE multiples. The Russia-Ukraine conflict which began in late February does not appear to be coming to a quick resolution. The longer the war persists, the more likely the world will see shortages of energy, grains, and metals, and as a result, more inflation. China is experiencing another COVID variant outbreak and by shutting down Shanghai and Beijing, fears of supply chain shortages are reappearing. The only real positive on the horizon for equities was that corporate America could overcome all these challenges and produce solid earnings results.

Unfortunately, to date, the results are mixed. Global banks reported profit challenges such as a decline in the investment banking business and loan-loss reserves against possible Russian debt defaults. A variety of companies like GE (GE – $80.59), Texas Instruments (TXN – $168.44), Mondelez International (MDLZ – $64.04), United Parcel (UPS – $183.05), and Raytheon Technologies (RTX -$99.19) reported profit challenges from rising inflation, supply chain snarls, and an increasingly cautious consumer. But adding to the market’s fears has been the sudden awakening that the Federal Reserve plans to raise rates significantly and quickly. Fed Chairman Jerome Powell has indicated that rates could increase 50 by basis points at each of the next two FOMC meetings. In real terms, this means short-term rates will jump 100 basis points in the next seven weeks! This would be one of the steepest increases in history. And it will take a toll on the economy, particularly on the housing and auto sectors.

Housing and Interest Rates

Home prices accelerated during the pandemic and newly released data for March showed that they reached all-time highs. The S&P/Shiller Case 10-city composite indicated a 19% YOY gain, and the 20-city composite index climbed over 20% YOY. One of the key underlying supports for home prices has been an extremely low level of supply. Inventory for existing single-family homes rose from 740,000 to 830,000 in March, and months of supply rose from 1.7 to 1.9; however, even with March’s increases, these levels remain among the lowest levels in history. See page 3.

And though both new home and existing home prices have been soaring for the last 18 months, the current cyclical peak in sales occurred months ago. In March, existing home sales were 14% below their October 2020 cyclical peak. New home sales in March were 23% below their January 2021 peak. These are significant declines however it is important to note that they appeared prior to the recent rise in mortgage rates. Lower sales imply a decrease in demand, something that could escalate as interest rates rise. See page 4.

The National Association of Realtors (NAR) housing affordability index fell from 143.1 in January to 135.4 in February. Although median family income rose in February, the falloff was due to rising home prices and higher mortgage rates. Note that the average 30-year fixed mortgage rate was 3.83% in February during the NAR survey, and it is currently 5.11%. Moreover, since the Fed plans to raise short-term rates 100 basis points in the next six to eight weeks, rates are apt to climb surprisingly quickly. In sum, due to tightening Fed policy, the housing sector is apt to suffer a meaningful slowdown in 2022. Although this should be expected after such a strong cycle, it will be a substantial hit on the US economy. According to the NAHB, housing contributes 15% to 19% to GDP. See page 5. The preliminary release of first quarter GDP is scheduled for April 28, and it will be an important benchmark for investors. Yet, regardless of how well or poorly the economy performed in the first quarter, economic momentum is apt to slow considerably in the next three quarters.

The angst in the housing sector is not new and has been evident in the NAHB home builder confidence survey all year. In fact, confidence peaked with the cyclical high in new home sales in late 2020 and has been falling somewhat erratically, ever since. See page 6.

Technical Breakdowns

Over the last twelve months, we have noted several technical patterns in the charts of the popular indices we thought had predictive significance. In the fourth quarter of 2021, we remarked on the severe underperformance of the Russell 2000 index and the warning that posed for the overall marketplace. Two weeks ago, we pointed to the convergence of the 50-day, 100-day, and 200-day moving averages in the Dow Jones Industrial Average at 35,000, and how this could be a pivotal level for the index and the broader market. Last week, the DJIA was unable to better the resistance at 35,000 and this foreshadowed the sell-off seen in recent days.

This week we are disturbed by the breaks of support seen in both the Nasdaq Composite Index and the Russell 2000. Both indices broke the lower end of trading ranges that have contained market sell-offs this year. These technical breaks imply a new downdraft in the popular indices should be expected. See page 9.

In addition, on April 22, 2022, when the DJIA fell 809 points, the NYSE volume data revealed the first extreme 90% down day since June 24, 2020. However, the June 2020 reading was actually the last in a series of 90% down days. The first one appeared in February 2020. In short, the April 22^nd 90% down day was the first sign of panic selling, but it is unlikely to be the last. History shows that 90% down days usually come in a series. Typically, after a series of 90% down days, a 90% up day will appear. This would be the first sign that the market may be stabilizing. We will keep you posted. On the positive side of the ledger, AAII bullish sentiment rose 3.0 points to 18.9% this week, but bullishness remained below 20% for the second consecutive week. These were the first two consecutively low bullish readings since May 2016. It is also only the 33rd time in history that bullishness fell below 20%. Extremely low bullishness is positive. Bearish sentiment decreased 4.5 points to 43.9% and has been above 40% for 12 of the last 14 weeks. It would be favorable if bearishness rose above 50% at the same time that bullishness is below 20%. We will see what next week brings. Overall, sentiment readings are favorable. Nonetheless, we would remain very cautious in the near term since the breaks in the Nasdaq and Russell suggest lower prices ahead.

Gail Dudack

Click to Download

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

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

Stock Prices, Rising Interest Rates and Earnings

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

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

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

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

Economic Releases

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

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

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

Technical Updates

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

Gail Dudack

Click to Download

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

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

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

Stay Defensive

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

Inflation continues to Roar

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

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

A History Lesson

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

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

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

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

Earnings Season

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

Technical Events

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

Gail Dudack

Click to Download