With the Nasdaq Composite and Russell 2000 down 20% from their all-time highs and many individual stocks, including most of the FAANG stocks, down much more than 20% (for example, Netflix, Inc. [NFLX – $341.76] has had a 50% decline), we believe it is only proper to define the current sell-off as a bear market.

The fact that the S&P 500 and the Dow Jones Industrial Average have declined only 13% and 11.3%, respectively, is a mere technicality, in our opinion; and listening to financial news anchors talk about the S&P reaching “correction territory” makes us scratch our head. As history has shown us, the large-capitalization stocks are often the last to fall in a bear market, so the outperformance of the DJIA and the SPX is not unusual or consoling. And unfortunately, we do not believe the lows have yet been found. Neither technical nor fundamental guidelines give us comfort this week, and both sets of indicators suggest there is more downside risk in the market.

In our annual outlook forecasts for 2021 and 2022, we indicated that inflation would be the biggest hurdle facing equity investors in the months and years ahead and this finally became widely accepted late last year. Russia’s invasion of Ukraine is a new factor that could make inflation even more crippling than we anticipated. Although crude oil and energy stocks broke out of major base patterns prior to the Russian invasion, and the energy sector has been the best performing sector all year, WTI has soared an additional 38% on a closing price basis and 50% on an intra-day trading basis in recent days. It is well-known that Russia is a major oil exporter, but Ukraine and Russia are also major exporters of wheat and corn. Russia is a major producer of nickel, palladium, and fertilizer. And as the conflict continues into its second week without any hope of an easy or quick resolution, commodity prices have begun to soar. It now appears that shortages of commodities will be global and will continue well into the future. This is not good news for inflation or most of the world economies. As a result, the Russian invasion appears to be escalating the existing shift in the underlying market from growth to value. However, the conflict is also triggering a shift from technology to energy, commodities, and defense stocks. Last week we noted the shift to defense and aerospace and downgraded the financial sector from overweight to neutral and upgraded the industrial sector from neutral to overweight. We have an overweight recommendation of the staples sector where food-related stocks are found, but the S&P 500 does not include pure commodity plays where many of the breakouts in chart patterns exist. Nevertheless, this week we are upgrading the materials sector from underweight to neutral and downgrading the communication services sector from neutral to underweight. We would not be surprised if there is also a shift in leadership within the technology sector and would emphasize cybersecurity and cyber-defense-related stocks. See page 14.    

Fundamentals are not encouraging

Fundamentals are important in a bearish market since they help define levels of value and identify potential lows in both stocks and the indices. With this in mind, we turn to our valuation model where we have a 2022 earnings estimate for the S&P 500 of $220, a 7% increase. Currently our forecast for inflation suggests prices will decelerate to a 4.4% pace, but recent developments suggest this may be too optimistic. Our interest rate forecasts indicate yields should rise to 0.8% in the 3-month Treasury and 2.2% in the 10-year Treasury note. This combination of inputs results in a forecasted “average” PE multiple of 15.8 times for 2022. Note that a 15.8 multiple is also equal to the average PE seen over the last 75 years. Our $220 earnings estimate coupled with a 15.8 multiple yields an SPX target of 3476. In short, our model predicts a decline of 27.5% in the SPX would be required to return the broad indices to “fair value.” This is an uncomfortable forecast but reasonable given the number of uncertainties that lie ahead for investors if the Russian/Ukrainian conflict is not resolved soon.

Prior to the Russian invasion, we believed the equity market had begun a correction that would bring prices and PE multiples back in line with traditional fundamental benchmarks. Unfortunately, the Russian invasion has upset the financial and economic landscape and puts even our modest forecasts for earnings, inflation, and interest rates at great risk. For example, higher commodity costs are likely to pressure profit margins and lower revenues for many companies and could make our $220 earnings estimate too optimistic.

Energy

This week both President Biden and several administration officials stated that US energy production is currently at record levels. However, we doubted this was true due to restrictions and regulations placed on the energy sector after the 2020 election. Data from the US Energy Information Administration (EIA) contradicts the administration’s statements. On page 3 we display an EIA chart with annual data that shows the US energy production peaked in 2019. A second chart shows weekly field production of crude oil in the US that confirms US oil production peaked in 2019. Industrial production data from the Federal Reserve Board of St. Louis also confirms that energy production peaked in 2019, fell during the pandemic, recovered, but is still well below 2019 production levels. In short, US production is not at peak levels and there is much more potential for energy production. If this were encouraged, Americans would not have to suffer the extreme prices currently seen at the pump and in energy bills.

The price of WTI crude oil jumped $20 this week and briefly touched $130 a barrel, exceeding the price target of $110 we noted last week. Some strategists are suggesting prices can move considerably higher, particularly after the Biden administration indicated the US will not buy Russian oil. Regrettably, there was not a simultaneous decision to increase US production. We expect the FOMC will decide to raise rates 25 basis points at the March meeting. And though the 10-year yield rose from 1.7% to 1.82% in the past week, the risk of an inverted yield curve in 2022, and a recession, continues to grow, in our view. See page 7.

Technical Death Crosses

We are not ardent followers of technical configurations called golden crosses or death crosses, but they are followed by many technicians and traders and are therefore worth noting. A golden cross occurs when a short-term moving average, such as the 50-day moving average, crosses above a long-term moving average like the 200-day moving average. A death cross is the opposite configuration. The first index to have experienced a death cross in the current bear market was the Russell 2000 index. This was followed by the Nasdaq Composite index, and this week, the Dow Jones Industrial Average is close to joining the group. Even the Wilshire 5000 index has formed a death cross. Interestingly, out of the five FAANG stocks, the only one that does not display a death cross is Apple, Inc. (AAPL – $157.44). The main reason we are not ardent followers of this technical pattern is that both the death cross and golden cross tend to appear late in a trend. Still, the importance of these death crosses is that the 200-day moving average becomes major long-term upside resistance in each stock and index. We continue to favor stocks over bonds and believe that stocks with a history of increasing dividends and yields in excess of 2.2% can best weather the volatility that is apt to continue in the first half of the year.

Gail Dudack

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As we go to print, we are also preparing for President Joseph Biden’s first State of the Union address to Congress. It could be a pivotal speech and a crucial time for Biden because at the same time, a massive Russian convoy is spotted outside Ukraine’s capital Kyiv and Russian aggression continues for the sixth consecutive day. Insights into President Putin’s actions were revealed in remarks made prior to his invasion when he claimed his actions were to achieve “demilitarization and denazification” of the neighboring nation. Clearly Putin expected an easy takeover of Ukraine since the Russian state-aligned media outlet RIA posted, but quickly deleted, an article on 8 AM February 26th that hailed Vladimir Putin for victory over Ukraine as Russia helps usher in a supposed “new world.” The RIA article can be found here: https://web.archive.org/web/20220226051154/https://ria.ru/were20220226/rossiya-1775162336.html.

The geopolitical and financial backdrop could quickly evolve this week, but to a large extent, there is no change from the “Direct from Dudack” (Downside Risk Guidance) sent on February 24, 2022, in which we reviewed the downside potential of the equity market from both a technical and fundamental perspective. To date, the declines from recent peaks have been 9.97%, 11.9%, 18.8%, 20.4%, and 13.2% in the Dow Jones Industrial Average, S&P 500, Nasdaq Composite, Russell 2000, and Wilshire 5000 composite, respectively.

Fundamental Perspective

Although technical indicators tend to be best at forecasting market peaks, fundamentals become increasingly important in a bearish decline, in our view. They are tools that can help define levels of value, project best long-term buying opportunities and identify potential lows in both stocks and indices. For a fundamental perspective, we first turn to our valuation model. Models can only be as good as their inputs and for transparency, our estimates for 2022 begin with a forecast of $220 for S&P 500 earnings which equates to a 7% increase. We also expect inflation to abate in 2022, but only to a 4.4% pace. Our interest rate forecasts expect yields to rise to 0.8% for the 3-month Treasury and 2.2% for the 10-year Treasury note. Our model indicates that with this financial backdrop, the appropriate “average” PE multiple should be 15.8 times. Surprisingly, a 15.8 multiple is also equal to the average PE seen over the last 75 years. Applying our $220 earnings estimate to a 15.8 multiple yields an SPX target of 3476. In short, our model predicts a decline of 27.5% in the SPX is required to return to “fair value.” See page 4. Since our $220 earnings estimate is in line with the consensus, this also means that every earnings reporting season will be critical for the market. Positive or negative earnings surprises during earnings season could become market-moving events which could shift the perception of where “value” is found in the market. See page 5.

Technical Perspective

Many of our volume/breadth indicators revealed weakness in the latter half of 2021 and most of these indicators continue to point to a bearish trend. However, the chart of the S&P is of particular interest in the near term since a head and shoulders top formation has developed over the last three quarters. A head and shoulders top only becomes important once the “neckline” of the formation has been broken. The neckline in the SPX’s head and shoulders is irregular and can be drawn at several different levels, but we show the neckline at SPX 4300. See page 7. A break below the neckline of a head and shoulders formation triggers two separate downside targets – the difference between the height of the shoulder to the neckline and the difference between the head and the neckline. The first of these downside targets implies SPX 4000, which was nearly tested on an intra-day basis, in recent sessions. The second downside target is SPX 3800 which equates to a 20% correction. Note that a 20% correction in the SPX appears quite possible, and perhaps reasonable, given that the Russell 2000 index has already experienced a 20% decline from its record high.

The charts of Amazon.com (AMZN – $3022.84) and the Russell 2000 index (RUT – $2008.51) continue to intrigue us since they are ironically similar. See page 9. Both charts experienced sharp declines within days of each other and led the overall market weakness. Both are currently trading below all key moving averages. The recent rebound in AMZN after the company reported good earnings, failed to better the first level of resistance at $3223; however, this remains a key level to watch on rally days. However, the charts continue to parallel each other and after initial precipitous declines, both show that these lows were retested. To date, these tests have been successful. This is a favorable development and the longer the initial lows hold in both charts, it is a sign that the overall market is beginning to test and define significant lows. The support levels to monitor are $2700 in Amazon and $1900 in the RUT.

Federal Reserve Policy

Although we are only two weeks away from the important FOMC March meeting, it is being overshadowed by geopolitical events. In the current environment it is unlikely that the Fed will raise interest rates 50 basis points to fight inflation, but we do believe a 25-basis point hike is prudent. Still, the Fed has a very difficult job ahead of them. The fallout from Russia’s invasion of Ukraine is impacting them in two ways. First, commodity prices are spiking. The bullish crude oil chart has fulfilled upside targets of $90 and $100 and appears headed for a third target and key level of resistance at $110. See page 6. Rising energy and commodity prices make the Fed’s job of controlling inflation extremely difficult. Second, a flight to safety is taking 10-year Treasury note yields lower. The 10-year note yield is currently at 1.7%, down from a recent high of 2%, which makes the risk of an inverted yield curve in 2022 more likely as the Fed increases short-term rates. An inverted yield curve has been the best forecaster of economic recessions, and therefore the risk of recession appears to be growing.

Sector Shifts

The invasion of Ukraine impacts the US in a variety of ways but primarily it will raise inflation and thereby reduce household spending power. This could impact corporate earnings in 2022 which is why we continue to recommend an overweight rating in energy and staples. The sanctions imposed on Russia are necessary, but they do have the risk of impacting the global banking system, including US banks. For this reason, we are downgrading the financial sector from a recommended overweight to a neutral weight. Meanwhile, Russia has awakened the Western world to the risks of war and Germany responded by indicating they will spend 2% of their GDP on military defense. As a result, defense stocks are viewed as an area of the market that should have increasing revenues and better than expected earnings. The charts of many of the US defense corporations display bullish breakouts from long-term sideways patterns. We are upgrading the industrials from a neutral weighting to an overweight. In these uncertain times we still believe equities are the best holdings. We continue to also overweight energy and staples, but a balanced portfolio is emphasized. Companies with a history of increasing dividends and with yields in excess of 2.2% can best weather the volatility that is apt to dominate the first half of the year.

Gail Dudack

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Summary

From both a technical and fundamental perspective there are two areas of downside risk/support for the equity market. The first of these is roughly the SPX 4000 area which is being challenged this week. However, all lows tend to be retested and are often broken temporarily. The second area of support identified by fundamental and technical measures falls within a range of SPX 3470-3700. This implies a fall below SPX 3700 would be a favorable/low risk entry point. The fallout of the Russian invasion of Ukraine could be known within a matter of days, however there is also the possibility that China may take advantage of the geopolitical scene to make moves on Taiwan. Therefore, identifying these short and longer-term entry points in advance is prudent. In the near term the energy, financial, and staples sectors are favored. Defense stocks are also apt to do well given the risk of war in Europe. Longer-term we see this sell-off as a great opportunity to buy technology at “value” levels.

Valuation

When inflation is above its long-term average of 3.5%, it is normal for PE multiples to fall to their long-term average of 15.8 times or lower. Applying a 15.8 multiple to our $220 earnings estimate for 2022 equates to a downside of SPX 3476, or the SPX 3500 area.

Our valuation model suggests an average PE of 15.8 for 2022 and a range of 13.2 to 18.3 times, assuming inflation falls to 4.4% this year. Inflation is questionable with crude oil at $100 a barrel. However, these PE multiples couple with our $220 earnings forecast equate to an SPX low, mid, and high range of 2905, 3470, and 4035.

The head and shoulders top has broken the neckline support and now generates downside targets of roughly SPX 4000 and 3700. More specifically, the neckline at SPX 4222, less the 574 points to the record high of SPX 4796.56 yields a full downside count of SPX 3648 and a midpoint count of SPX 3844.

Gail Dudack

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Nearly a year ago the US economy was recovering well from the pandemic shutdown. The Fed continued to stimulate an expanding economy and Congress worked on passing more pandemic stimulus. Crude oil prices began to escalate in response to the post-pandemic recovery and the amplified regulations on fossil fuels following the US reentering The Paris Agreement in February 2021. Rising inflation was inevitable, and unlikely to be transitory due to global standards put in place for the reduction of fossil fuels. Earnings were booming in 2021 but estimates for 2022 showed single-digit growth versus difficult comparisons. All in all, it was clear one year ago that inflation would rise but earnings growth would slow in 2022. This combination is a hostile environment for equities and one we expected would translate into both margin compression and lower PE multiples.

In addition, in November 2021, newspapers and new casts displayed satellite photos of Russia mustering troops on the Ukraine border, but NATO said and did nothing. Therefore, the current crisis on the Ukrainian border is also not a revelation. In short, the sell-off that shaved 1392 points off the DJIA in the last four trading sessions should not have come as a surprise to investors.

Black Swan or Inevitable

Investopedia defines a black swan as “an unpredictable event that is beyond what is normally expected of a situation and has potentially severe consequences. Black swan events are characterized by their extreme rarity, severe impact, and the widespread insistence they were obvious in hindsight.”

Given this definition, we do not believe one could call the Russia/Ukraine border crisis a Black Swan. It was predictable and, in our opinion, the Russia/Ukraine crisis has merely been a catalyst for investors to reassess the inevitable — that the equity landscape has become increasingly risky, and areas of the market had become quite overvalued. Nevertheless, it does have a negative impact on the global economy. For the US it will mean higher energy costs which will make the job of the Federal Reserve more difficult than ever.

Assessing Downside Risk

To date, the declines in the Dow Jones Industrial Average, the S&P 500, the Nasdaq Composite, the Russell 2000, and the Wilshire 5000 have been 8.7%, 10.25%, 16.7%, 18.9%, and 11.4%, respectively. The SPX is therefore in correction territory with a 10.25% decline, while the RUT with its 18.9% sell-off is close to bear market territory. Many individual stocks have already had declines of 20% or more. Given the extent of recent price declines we believe we should now start looking for signs of a bottom.

A classic sign of a major low is a high-volume sell-off day, where 90% or more of the volume is in declining stocks and volume may rise to twice the normal daily pace. A major low may have a string of such days, followed by a rebound, and a retest. Typically, this high volume sell-off is due to a sharp rise in margin debt that then triggers margin calls once stock prices begin to decline. However, it is not likely that a margin call washout will occur in the current cycle. We have been monitoring monthly margin debt numbers and they have been declining, not rising as prices peaked in recent months. Combined margin debt in January was $798.6 billion, down 12.2% from December’s $910.0 billion and unchanged from a year earlier. The 2-month rate of change in margin debt was negative 13.1% in January and as a percentage of total market cap it was 1.4%, down from 1.53% in December and down from 1.7% from a year earlier. In short, the leverage that is usually unwound at the end of bear cycle is simply not as substantial as that seen in previous cycles. See page 7. This being true, the end of the correction may not be as dramatic.

We are monitoring a number of technical charts to assess overall market risk. One of these is the SPX which may be in the process of forming a substantial head and shoulders top pattern. Some technical analysts have already noted this pattern. The important level to watch is the neckline support that is found at the SPX 4300 level on a closing basis and at SPX 4222 on an intra-day basis. The SPX 4300 level is currently being tested. From a technical perspective, a break of the SPX 4300 area creates downside targets of SPX 4000 and SPX 3800. See page 9. Since algo traders use support and resistance levels for intra-day trading, we would expect a drop in the SPX below 4300 would likely trigger more selling.

It intrigues us that a small-capitalization stock index and one of the largest capitalization companies in the S&P 500 have similar chart patterns. And we have already written about the parallels in the charts of Amazon (AMZN – $3003.95) and the Russell 2000 index. In both charts, the breakdowns from lengthy trading ranges, materialized within days of each other and preceded the decline in the overall market. Since both were leaders in terms of market weakness, we are now monitoring them for signs of stabilization in hope that this would imply a low has been found. To date, there is no confirmation from these charts. See page 10.

The economy and the equity market face uncertainty as long as inflation continues to trend higher. Therefore, the chart of WTI futures is another risk factor. Unfortunately, once the crude oil future bettered the $77 level, the technical chart indicated potential targets of $90, $100, and $110. With crude futures now at $91.91 the risk of inflation continues and will make the Federal Reserve’s job more difficult. This implies multiple interest rate hikes in the months ahead. Stabilization in the WTI futures chart would relieve the current certainty of higher inflation, reduce the burden on the Fed, and lower the risk that the yield curve may invert later this year. These are the risks that the Russia/Ukraine border crisis poses to the world – more inflation and its consequences. See page 8.

Valuation Benchmarks

Technical indicators are often the best tools for defining a market top, but valuation tools can best determine where downside risk is minimized. Our model is forecasting an average PE of 15.8 for year-end 2022 and a PE range of 13.2 times to 18.3 times. These low, mid, and high PEs coupled with our earnings forecast of $220 (a 7% YOY growth rate) equates to SPX valuation targets of 2904, 3469, and 4026. These are fairly frightening downside SPX targets. We prefer to use the long-term average PE of 16.5 X as the appropriate multiple given the current level of inflation which creates a worst-case scenario of SPX 3630. Another approach would be the 2000-2022 average PE of 19.5 times to define fair value and probably downside risk. This equates to an SPX target of 4290. In our view, this combination implies that “value” is found directly below the SPX 4000 level. In the interim, energy, financial and staples remain our favorite sectors for the current environment, along with individual stocks that can weather the inflationary environment and have dividends in excess of 2%. Nonetheless, the 2022 sell-off is apt to provide an excellent long-term buying opportunity in the technology stocks so this is a time to have a list of favorite buys on hand if the SPX should fall below the 4000 level. Be cautious but be alert for opportunities.

Gail Dudack

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Stocks plunged, then surged. Oil surged, then slipped. It was all a reaction to Russia assembling more than 100,000 troops on the border of Ukraine, threatening to invade and then as a token of appeasement, pulling back some soldiers on Tuesday. However, Western leaders remained skeptical of Putin’s de-escalation move since Russian military equipment was left behind. After the pullback, Ukraine was hit by a cyber-attack and blamed it on Russia. From a global perspective, airlines, and the leasing companies, controlling billions of dollars worth of passenger jets, are by necessity, drawing up contingency plans for a freeze in business with Russia if the standoff on Ukraine’s border boils over into a military conflict. Flight paths will also have to be changed if war breaks out. It all is reminiscent of the Cold War we thought was left behind.

Closer to home, Canadian Prime Minister Justin Trudeau employed emergency powers in an attempt to control the trucker-led Freedom Convoy movement that is now in its third week. The convoy, protesting vaccine mandates and other Covid measures, has blocked downtown Ottawa and major bridges and crossings into the US. On day 19 of the protest, the Chief of Police of Ottawa resigned. The convoy has paralyzed Canada’s capital city and is having an economic impact on both Canada and the US.

On US soil, Senate action on President Joe Biden’s five nominees to the Federal Reserve became stalled after Republicans boycotted a key vote over objections to Sarah Bloom Raskin, the White House’s pick to be the central bank’s Wall Street regulator. Raskin has been criticized over her past statements expressing support for using financial rules to support and police climate change. Failure to advance these nominations will further delay regulatory changes that have been in limbo since October.

All of this is background noise as the US economy struggles with inflation and the likelihood of higher interest rates. And it is taking a toll on consumers. The preview for February’s University of Michigan consumer sentiment readings revealed a series of cyclical lows. The headline index fell 5.5 points to 61.7. The survey on present conditions fell 3.5 to 68.5. The expectations index fell 6.7 points to 57.4, the lowest level since 2011.

Inflation Woes

Inflation data showed that price increases accelerated in January and the CPI jumped from December’s 7.0% YOY to 7.5% YOY. This headline rate was the highest inflation pace in 40 years. And inflation was broadly based, with most CPI sub-indices showing gains well above the Fed’s 2% target rate. The only exception was education and communication which rose 1.6% YOY. The greatest price gains were the transportation sector, up 20.8% YOY. Fuels and utilities rose 12%. Prices for food at home rose 7.4% and apparel rose 5.3%. See page 3.

All the heavyweight components of the CPI are trending sharply higher although the transportation segment has been hovering around the 20% YOY level for several months. Housing – which is a significant 42.4% of the CPI weighting — saw prices rising 5.7% YOY in January. Household furnishings rose 9% and operations increased 4%. See page 4.

At $91.99 a barrel, WTI futures are up over 50% YOY which denotes future inflation numbers will remain high and worrisome. January’s PPI numbers were also higher than predicted with headline rising 12.2% YOY and PPI final demand prices rising 8.5%. December’s import prices excluding oil fell but were still up 6.8% YOY. See page 5. Clearly, inflation has become widespread and embedded in the economy.

Monitoring Yield Curves

With inflation trends escalating, there is great anticipation for the Federal Reserve’s March meeting. We have been expecting a 50-basis point rate hike at this meeting and this is becoming a consensus view. However, it could be that the March meeting will be a lose/lose situation for Chairman Jerome Powell. A 25-basis point hike might be regarded as too little too late, but a 50-basis point rate hike may make the FOMC appear desperate. Already, economists are indicating that they fear the Fed is about to make a mistake that will trigger a recession. For this reason, we have been monitoring the Treasury yield curve to measure financial sentiment. An inverted yield curve has been an accurate precursor of a recession. Although it is worth pointing out that while yield curve inversions have preceded each recession in the last 50 years, the timing is inconsistent and not every inversion has been followed by a recession. Nonetheless, the yield curve is currently normal and that is a godsend.  See page 6.

Technical Indicators

At the top of our inflation concerns is the technical chart of WTI futures. After a major breakout at $77, WTI hit its first upside target of $90. However, this bullish chart pattern also suggests targets of $100 and $110. In our view the Fed’s job of controlling inflation is difficult since domestic and global politics are driving fuel prices. This may contribute to the view that the Fed is at risk of triggering a recession. To date, Treasury note yields have lagged the trend in WTI. But the 10-year Treasury note yield recently exceeded the psychological 2.0% level and is apt to move higher. See page 9. In sum, both inflation and higher interest rates are formidable hurdles for equities this year; but investors can insulate portfolios with stocks that have dividend yields of 2% or more and good earnings prospects.

Despite the recent rally, all the popular indices are trading below all important moving averages. The sole exception is the SPX which is trading above its 200-day moving average this week. The Nasdaq Composite, which has had the deepest correction, is the most oversold; but this is not an unusual pattern in a correction. Large cap stocks are often the last to fall. Therefore, the DJIA and SPX are potentially the most vulnerable indices in coming weeks or months. See page 10.

Amazon (AMZN – $3130.21) which has a chart pattern that resembles the Russell 2000 index, rebounded nicely after in recent swoon, however, it is still trading below all its key moving averages. The first level of resistance is found at $3223 which is a key level to watch. The rebound in AMZN has created a difference between its pattern and the RUT, nevertheless, these chart patterns remain amazingly similar. We will continue to monitor these charts, watching for a bottoming formation that may show that the worst of the correction is behind us. To date, it appears the market’s lows may not have been found. We remain cautious in the near term given the unstable situation with Russia/Ukraine and with the upcoming FOMC meeting. But we continue to favor the energy, financial, and staples sectors and stocks with reliable earnings and dividends.

Gail Dudack

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January’s job growth was well above the consensus estimate and the 467,000 increase was a welcomed event. But this number was in sharp contrast to other economic series also released in the last week. Both of January’s ISM indices are indicating that the recovery is slowing. The ISM manufacturing index fell from 58.8 to 57.6. The manufacturing employment component rose modestly from 53.9 to 54.5, but this and imports, were the only parts of the survey to show any improvement. The ISM service index had consistently been the stronger of the two surveys, but it also fell in January from 62.3 to 59.9. All components in the service group fell with the exception of inventory. In general, both ISM surveys have been deteriorating for the last two months. Not surprisingly, the small business survey, the NFIB Optimism Index, had a large slump in January as small business owners pointed to rising inflation as the number one challenge for their companies and profits. See page 7.

The jobs report also had a counterpoint to the nice job increase in that the unemployment rate ratcheted up from 3.9% to 4.0%. The unemployment rate is part of the BLS household survey which showed that while employment grew strongly in January, so did the number of unemployed. This accounted for the rise in the unemployment rate. The civilian noninstitutional population grew less than the growth in employed and for this reason there was fractional improvement in the participation rate and the employment population ratio. See page 3.

In our opinion, the only employment data point that is important is that there are 2.9 million fewer people employed today than at the peak in February 2020. Typically, total employment will exceed its previous peak level twelve months after a recession ends. Yet, despite all the stimulus and fiscal programs initiated in the last two years, employment remains well below peak levels. There are many reasons for this; but the most significant one may be that the administration has not focused on job growth much at all. Perhaps distracted by COVID-19, the Delta and Omicron variants, vaccines, inflation, North Korean missiles, and the Russia/Ukraine problem, it has not been a focal point.

Inflation is the domestic threat

Inflation is the major threat facing the US economy and its ramifications are clear. One of these is also found in January’s employment report. Average hourly earnings were $26.92 in January, up 6.9% YOY and average weekly earnings rose to $912.59, a 5.4% YOY. These gains are impressive at first glance; however, adjusting for inflation, real weekly earnings were down 1.2% YOY in January. This is the unfortunate part of inflation — it destroys buying power. On page 4 we have a chart of average weekly earnings that are inflation-adjusted to represent 1964 dollars. The chart shows how average real earnings steadily declined throughout the high inflationary period of 1968 to 1990. See page 4. For this and many other reasons, the administration and the Federal Reserve should make fighting inflation their number one domestic priority.

On a positive note, we present the misery index this week. This index is the sum of inflation and unemployment which are the two variables that can impose great hardship on households. The misery index jumped to 15.1% in April 2020 when the unemployment rate jumped to 14.7% and was well above the standard deviation level of 12.7%. However, this was a man-made unemployment level triggered by the pandemic and fiscal stimulus offset much of this “misery” with checks to households and augmented unemployment benefits. Currently, the rise in inflation is wreaking havoc with households but the misery index is at 10.6%. This is well within the long-term “normal” range. See page 6.

Still, we do not see inflation coming under control very soon. The WTI crude oil future moved above $90 a barrel this week. The $90 level was one of the technical targets we wrote about once crude broke out of an 8-year base pattern in the fourth quarter of 2021. The chart pattern also suggests targets of $100 and $110 are possible in the coming months. This will keep inflation high, put more pressure on households and make the Fed’s job of controlling inflation more difficult. Interest rates are also rising this week and the 10-year Treasury note yield is challenging the psychological 2% level. See page 9. Keep in mind that stocks with dividend yields of 2% or more that also have a predictable earnings stream remain very competitive to bonds.

Valuation readjustment

The combination of rising inflation and rising interest rates is a big hurdle for equities, and it explains why value stocks are outperforming growth stocks in 2022. This shift could continue for most of the year and in simple terms, it is a valuation readjustment. We remain cautious in the near term, primarily for stocks with high multiples. Overall, we believe stocks that benefit from, or are immune to, inflation are the best holdings in the near term. These include sectors such as energy, financials, and staples. Nonetheless, we would not ignore the technology sector since 2022 is likely to provide an excellent long-term buying opportunity.   

As part of the current valuation readjustment, we believe the market’s PE could return to normal levels. As an example of what this means, a PE multiple of 18 coupled with our 2022 earnings forecast of $220 equates to an SPX target of 3960. Applying the long-term average PE multiple of 17.5 to $220 equates to SPX 3850. In both cases, it implies that good long-term value is found at levels directly below SPX 4000.

It would not surprise us if PEG ratios, or a comparison of a stock’s PE to its 5-year earnings growth estimate, came back into style. Historically, a PEG ratio of 1.5 in a growth stock represented table-pounding “value.” Value stocks were typically viewed as excellent buys with PEG ratios of 1.0 or less. Again, these are good benchmarks for uncertain times.

Technical update

We remain intrigued by the similarity in the charts of the Russell 2000 index and Amazon (AMZN – $3228.27). After AMZN reported solid earnings last week, the stock rebounded sharply, generating a small difference in the charts. However, the patterns remain largely similar and AMZN is yet to move above its first level of resistance which is the 50-day moving average now at $3255.86. This will be an interesting level to watch. There are no other major changes in technical indicators. The new high/low averages and cumulative advance/decline line are bearish. Our 25-day up/down volume oscillator remains neutral, which means the market is not washed out on an intermediate-term basis. The AAII bull/bear sentiment indices have shown extreme bearish readings for the last three weeks and as a result, the AAII Bull/Bear Spread index is favorable. The good news is that this AAII survey suggests the market is undergoing a normal correction. The survey never showed the extreme optimism that is typical of a bubble peak. Nonetheless, we believe the current rebound is simply a rebound and we do not believe the lows have been found. It would not surprise us if the Fed increased rates 50 basis points in March and this could trigger a sell-off that could characterize the end of the correction.

Gail Dudack

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