Last week’s FOMC meeting resulted in no major surprises, in our view. The Fed used its January meeting to prepare the global financial markets for quantitative easing that would end by March and for its balance sheet to probably shrink later in 2022. But most importantly, Chairman Jerome Powell was quite clear in his statements that interest rates would begin to rise in March and likely do so for most of the year.

In the wake of this meeting, pundits began to speculate about the number of rate increases investors should expect in 2022. In our opinion, these guesstimates are not useful because we agree with the Fed’s comment that tightening policy going forward will be data dependent. Yet, since the Fed is behind the curve, we would not be surprised if the first fed funds rate hike is 50 basis points. This double-hike would help jumpstart the Fed’s inflation-fighting cycle. It might startle the markets, but it will also dampen the expectations of inflation that has become embedded in the economy.

Unfortunately, we would not be surprised if the Fed’s tightening strategy becomes more complicated later in the year with a combination of inflation that remains stubbornly high, coupled with an economy that shows signs of deceleration. We have often discussed the problems that inflation poses to equities — rising interest rates, multiple compression, profit margin weakness — another risk is that it weakens broad-based consumption. For 2022, we are recommending sectors that are relatively insulated from these risks, such as energy, financials, and staples. Part of this reason is that as the cost of necessities such as heating fuel, gasoline, and food continue to rise, consumers will have less and less money to spend on luxuries such as vacations, new clothes, and entertainment. The net result will be declining revenues for a variety of companies. We expect to hear debates about stagflation in the coming months, but there is no reason to expect this to materialize in 2022. The actual definition of stagflation is an economy characterized by rising inflation and rising unemployment. This was last seen in the 1970s during the oil embargo. We do not see unemployment rising; we simply see a challenging time ahead for corporate earnings.

There are some similarities between the 1970s and the current situation, but they are curable. Instead of an oil embargo that created an energy crisis in the 1970s, The Paris Agreement on global climate change signed in 2021, triggered a sharp rise in fossil fuel regulation and a subsequent decline in energy supply. In short, the current situation is different because it is self-imposed, but we are not sure if this matters. The decline in the supply of fossil fuels is a bigger driver of global inflation than supply disruptions, in our judgment. Yet we doubt this will change the minds of our global leaders.

Furthermore, the price of oil is exacerbated by geopolitics and the fear that Russia is planning to invade Ukraine. As a result, the WTI crude oil future, at $88.36 a barrel currently, is up 17.5% since the end of 2021 and up 44% YOY. See page 10. It should also be noted that Russia is a major beneficiary of the rise in oil prices.

This means inflation will be very difficult to control, at least in the first half of this year, and the Fed has a challenging task ahead of it.

The Good News

January closed the month with declines of 3.3%, 5.3%, 9.0%, and 9.7%, in the Dow Jones Industrials, S&P 500, Nasdaq Composite, and Russell 2000 index, respectively. Moreover, the Nasdaq Composite has experienced an 11.3% decline from its all-time high and the Russell 2000 has dropped 17% from its record high. In short, the broad market is clearly in a correction. We expect the large cap stocks will be the last to fall at the end of the decline; but in the near term, a bounce is likely.  

We show the results of the January Barometer for the Dow Jones Industrials on page 3 and for the S&P 500 on page 4. We have faith in this Wall Street adage that states “As goes January, so goes the year” because we believe the liquidity available to the equity market tends to be at its best in January. However, we must admit that the barometer has a far better track record when January posts a gain than when it posts a loss. A January gain in the Dow Jones Industrials has been followed by a full year gain 89% of the time. In the S&P 500, a January gain has produced an annual gain 88% of the time. But declines in January are much less predictive. In the Dow Jones Industrials, a loss in the first month of the year is followed by an annual loss 54% of the time and in the S&P 500, 47% of the time. In sum, one should not be bearish based upon the January Barometer.  

It is also good news that the stock market has not displayed the characteristics of a classic bubble top. The key to a true bubble is leverage and most importantly, an escalation in leverage. While margin debt has grown markedly in the last 24 months, it has not grown at the pace seen at most major tops. See page 5. The 2-month rate of change in margin debt grew more than 15% in December 2020, as we reported at that time, but margin debt actually contracted in November and December of last year. This is positive since it limits the leverage, and risk of margin calls in the current environment.

Economic Releases

In our view, subtle signs of decelerating economic growth are already appearing. For the third consecutive month, January’s ISM manufacturing index fell, declining from 58.8 in December to 57.6. However, it does remain comfortably above the neutral 50 level. Vehicle sales fell more than 4% in December to an annualized rate of 12.45 million and are down a disturbing 32% from the April 2021 pace of 18.78 million units. See page 6. January’s consumer sentiment indices were glum with the Conference Board Confidence index slipping from 115.2 to 113.8 and the University of Michigan headline reading falling from 70.6 to 68.8. The only uptick in sentiment was found in the Conference Board’s present conditions index which moved up from 144.8 to 148.2. See page 7. New home sales came in stronger than expected in December, increasing nearly 12% to 811,000 units. However, this rebound followed a sharp decline in new single-family home sales in 2021. Existing home sales were more resilient than new home sales last year, but there are signs in both data series that prices are rolling over. See page 8. This should not be a surprise given the recent gains in home prices and the fact that interest rates will be moving higher.

Technical Review

There were not a lot of changes in the technical indicators this week, but the 10-day average of daily new highs fell to 54 which is notable. Daily new lows rose to a 10-day average of 505. This indicator is now clearly negative, after tilting negative for several weeks. The NYSE cumulative advance/decline line’s last record high was on November 8, 2021, and it is trading well below this level currently. Volume has not been rising on declines, which is a worrisome trend. On the plus side, AAII bearish sentiment rose 6.2 points to 52.9%, this week and is above the historical average of 30.5% for the tenth consecutive week. This was the highest reading since April 2013. As a result, the AAII bull/bear spread index is positive for the second consecutive week. Note, AAII never displayed the extreme bullishness that is typical of a major, or bubble, peak. This is a good sign for the longer term.

Gail Dudack

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In our January 5, 2022, weekly “On the Verge of a Bubble?” we stated that we thought 2022 would be a decisive year for the equity market. In our view, stocks would either see a significant correction this year, or if a rally continued, it meant an equity bubble, driven purely by liquidity and momentum, was in place. Fortunately, the first few weeks of the year have been decisive. We say fortunately because we believe a correction is a much healthier option for investors. But this means our focus shifts from technical divergences and the risk of an impending top to measuring the potential downside based upon a variety of fundamental benchmarks. We do not believe equities have made their final lows and fundamentals can provide guidance on measuring downside risk.

Valuation Model: The inputs

Most valuation models rely on similar inputs. The inputs to our model are our earnings estimates, the rate of inflation and forecasts for short- and long-term rates. For 2022, we estimate SPX earnings will be $220, inflation will fall to 4.4%, short-term interest rates rise to 0.8% and the 10-year Treasury note yield increases to 2.2%. These inputs give us a projected range as well as a midpoint of the range for the SPX.

In 2015 the SPX shot to the top of our model’s projected fair value range and continued to trade there until 2020. However, trading at the top of the fair value range is acceptable with inflation at, or below, 2% YOY, which it was at that time. Low inflation supports a higher PE multiple. However, in early 2020 the index began to trade well above the fair value range and by the end of the year the disparity between the actual SPX price and the top of the projected range grew to a level last seen during the 2000 bubble. See page 5. Still, with inflation relatively low one might see this as the equity market discounting the economic rebound that was widely expected to materialize in 2021.

Indeed, earnings rebounded strongly after the earnings trough of December 2020, but inflation also began to rise. Earnings growth is worth less in an inflationary environment and as a result, PE multiples slowly began to fall in 2021. However, inflation did not just increase in 2021, it soared to 40- year highs and this is the crux of the market’s problem this year. Inflation of 7% YOY implies much lower multiples and at the same time, monetary policy is apt to be aggressively tight in 2022 to control inflation. This combination makes it a hostile environment for equities.

Valuation Model: Inflation

Our model demonstrates the pressure inflation places on equities. For example, in 2020 when inflation was 1.4%, our model indicated that the average PE should be 17.7 times. However, at the end of 2021, with inflation at 7%, the model forecasted an average multiple of 14.5 times. In 2022, we estimate inflation will fall to 4.4% — which is still above the long-term average inflation rate of 3.6% — and our valuation model suggests the average PE multiple should rise to 15.8 times. The high end of the PE range lifts to 18.4 times by December. Nonetheless, the current trailing SPX PE multiple is 21.4 times.

The impact of inflation on PE multiples can be seen in the chart on page 8. Although the trailing PE multiple has been declining toward 20 times in recent months, the rise in inflation has lowered the forecast for the high-end PE from roughly 20 times to 18 times. In short, more multiple compression lies ahead.

Calculating Downside Risk

One way of measuring downside market risk is to see what the trailing PE has been at previous market troughs. Although the PE at the end of a major decline is also impacted by inflation, we noticed that the last two market troughs occurred with a trailing PE multiple of 16.5 times. Applying this to our $220 earnings estimate for this year yields a downside market risk to SPX 3630. Similarly, if we applied an 18 multiple to our earnings estimate, the downside risk for the SPX is 3960. These two scenarios imply that the market begins to find “value” below SPX 4000. Note that a drop to SPX 3960 is the equivalent of a 17% decline from the record high of 4796.56 made on January 3, 2022. See page 4. This does not appear unreasonable, particularly since the Russell 2000 index has already declined 18.6% from its record high.

In our view, the worst-case scenario would be a decline to the midpoint of our model’s projected range. This means a PE of 15.8 with our $220 earnings estimate or the equivalent of SPX 3475. This midpoint would be a bear market decline of 28%. We cannot rule this out, but we would also point out that the pandemic decline in 2020 produced an even greater 34% decline in the SPX. Yet earnings and stocks rebounded smartly after the pandemic-driven recession of 2020. To insulate portfolios from risk, we continue to focus on stocks and sectors that can weather the inflationary environment of 2022. This includes energy, staples, and financials. Nevertheless, as we have been indicating, technology stocks are expected to bear the brunt of the correction, but this decline will also create an excellent opportunity for growth stocks. A break below SPX 4000 may create such an opportunity.

Oh, my Russell

The popular indices exhibit surprisingly different chart characteristics this week. The SPX looks best since it is trading modestly below its 200-day moving average, but all of its moving averages are rising. The DJIA appears second best. It is trading below its 200-day moving average and the moving averages have not crossed below each other. The Nasdaq Composite index is the weakest of this grouping, trading below all its moving averages and the 50-day moving average is at risk of falling below the 100-day moving average. See page 11.

The Russell 2000 index has been our bellwether index for the market since early 2021 and as we noted last week, this chart is very bearish. The 50-day moving average has broken below all other moving averages and this “death cross” configuration is attracting attention. More importantly, the Russell 2000 broke below the 8-month trading range last week that contained most of 2021’s trading action. This consolidation range has become a large top and there is no support in the chart prior to 1700. What is also surprising is how much the chart of Amazon (AMZN – $2799.72) looks like the Russell 2000 index. Note, AMZN is not in the Russell 2000 index yet ironically the chart patterns are very similar, and worrisome. Despite all the media buzz about the market being oversold, we find our 25-day up/down volume oscillator at a modest negative 0.21 reading this week. Typically, major market troughs are characterized by panic, and this is measured by extreme levels of breadth, for example, days with 90% or more of the daily volume in declining stocks. The huge intra-day swings this week and the rebounds from early session lows have kept breadth data fairly moderate at the end of each session. We do not see this as a good thing. It implies that the panic may still lie ahead; therefore, we would be cautious in the coming weeks. But danger equates to opportunity, so we are also looking to acquire technology stocks at lower levels.

Gail Dudack

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In this week’s title, “the chickens” refers to inflation. After ignoring inflation for much of 2021, in early 2022, the actual toll of rising prices is finally becoming headline news. In our mind, this was inevitable. But the saddest part of the current inflation cycle is that it could have been avoided. Inflation was a predictable outcome of keeping monetary policy extremely easy despite the fact that the economy was already recovering from COVID. Inflation was also stoked by a too liberal fiscal policy that flooded the system with money even after stores and businesses were getting back to work. It is never good policy to add fuel to an economic rebound. In short, too much money chasing too few goods is always inflationary – yet Washington DC ignored rising prices for the first three quarters of 2021. Now inflation is coming home to roost.

And this is seen in many ways. Goldman Sachs Group (GS – $354.40) missed its earnings target this week and it triggered a wide-ranging sell-off in the marketplace. The company noted that its profit miss was due to weaker trading revenues and rising expenses. In our opinion, Goldman may be a bellwether for the broader economy. After pumping historic sums of liquidity into the capital markets for 18 months to offset the impact of the pandemic, the Fed has just begun to slow its purchases and indicates it will end quantitative easing by March. The Fed’s quantitative easing fueled trading activity in stocks and bonds and Goldman was a big beneficiary of the market’s rise since March 2020. But trading has already begun to slow. Goldman’s quarterly profits were also hurt by a 23% rise in operating expenses, mainly reflecting higher compensation and benefits costs. This combination of slower top line growth and profit margin contraction will be true of many companies this year and it is a concern to us.

Reverberations

Headline CPI jumped more than 7% YOY in December and this represented a 40-year high in inflation. Core CPI rose 5.5%, the highest pace in 30 years. The fact that we have not seen prices rise at this magnitude for so many decades means that many of today’s investors have had little or no experience with inflation and its various implications. Economists and analysts ignored the dark side of inflation in 2021 but we doubt that this complacency will continue in 2022. The most obvious reason is that a shift in Fed policy changes the environment for investors and inflation will now determine what the Fed must do in the coming months.

Unfortunately, we expect inflation will get worse before it gets better later this year. This is obvious to us in several ways. First, the producer price index for finished goods, which feeds into the consumer price index, rose 12.2% YOY in December and unfortunately there are still no signs of it peaking. Second, homeowners’ equivalent rent (HER) has a weighting of 23.5% in the CPI. Since prices for single-family homes were up 15% YOY in December, it is very likely that homeowners’ equivalent rent will move much higher than the 3.8% YOY seen in December. Rental fees tend to follow home prices in every neighborhood. See pages 3 and 4. Plus, WTI futures have already risen 15.5% year-to-date and this will keep gasoline and transportation prices rising in the early months of 2022. Moreover, this week’s move to $86.50 in the WTI future is a breakout from an 8-year base pattern and from a technical perspective, the chart shows the potential of moving higher. See page 9.

With headline inflation at 7% and the fed funds rate at zero to 0.25%, the real fed funds rate is nearly negative 7%. This is due to “easy” monetary policy. Reducing the disparity between the fed funds rate and the CPI is necessary to tame inflation. Unfortunately, it means the FOMC would have to raise rates significantly in 2022. Rising interest rates will be a difficult hurdle for equities since stocks and bonds compete in terms of valuation. Rising interest rates also raises the bar for speculators who are likely to leave the marketplace.

Corporations and all businesses will be facing an uphill battle with raw material, and intermediate good prices rising much faster than prices to consumers. Rising prices is also putting pressure on wages, as seen by Goldman Sachs report, and this adds to expenses. The net result of this is a major erosion in profit margins. All in all, it puts earnings at risk. See page 5.

In addition, profits are less valuable in an inflationary environment, and this puts pressure on PE multiples. In the low inflationary environment of 2008-2020, our valuation model indicated that PE’s could remain as high as 20 times. But as inflation moves above 4% this changes. Given our assumption that inflation decelerates to 5.5% YOY and 10-year Treasury note yields rise to 2.2%, the high-end of the PE range should drop to 18 times. See page 6. In short, 2022 could be a challenging year. There will be pressure on households from inflation and consumption patterns will change. Corporations may suffer from top line growth. Businesses will also be pressured by higher raw material and wage costs, crimping profit margins. And rising interest rates and inflation could also produce a decline in PE multiples.

Again, this means investors should try to insulate themselves from these risks by focusing on areas of the market that can weather this changing environment. We believe that suggests sectors such as energy, financials, and staples. It may also be wise to hold some cash in order to look to buy some high growth technology stocks later in the year.

Technical Charts and Indicators

The charts of the main indices are worrisome this week since there are signs of weakening trends. The SPX is the best-looking chart of all the main indices since it has only broken its 50-day moving average and is currently testing its 100-day moving average. Its uptrend appears intact. The DJIA looks less positive. The price trend is decelerating, and the index is below its 50-day and 100-day moving averages, but it is still above its 200-day moving average. The Nasdaq Composite index fell below all its moving averages this week and needs to rebound sharply in coming sessions to maintain a positive long-term trend. The Russell 2000 index is the weakest chart of all, having broken below all moving averages, but more importantly falling below the bottom of the 8-month trading range seen for much of 2021. This breakdown has very negative implications for the index and the overall marketplace. See page 10. The 10-day average of daily new highs fell to 174 this week and daily new lows rose to 244. This combination of both averages being above 100 per day is neutral, but the indicator tilts negative since new lows are exceeding new highs. The NYSE cumulative advance/decline line’s last record high was on November 8, 2021, and it is trading well below this level currently. The current disparity between the AD line and the SPX totals to 8-weeks, which is not uncommon, but typically indicates a correction of 10% to 15% lies ahead. Note that the longer this disparity persists, the deeper the eventual correction might be. Volume has not been rising on rally days, which is a worrisome trend. All in all, we are not surprised by this week’s weakness and would point out that the Nasdaq Composite and Russell 2000 are already trading 9.7% and 14.2%, respectively, from the record highs.    

Gail Dudack

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The new year arrived, and with it came a new and revised perspective on the equity market. This is understandable. In 2021, the financial markets were insulated from downside risk given the extremely friendly posture of the Federal Reserve and the potential of more fiscal stimulus. Monetary policy would keep interest rates low and safeguard speculators while fiscal stimulus would support economic activity. With these two safety nets as backing, one could ignore inflation without consequences. But the Fed, many economists, and bankers are now addressing the strain that rising prices has had on consumers in 2021 and many are suddenly, although belatedly, calling for quick action. At the same time, more fiscal stimulus is looking less likely. Thus, both safety nets are disappearing in 2022.

In terms of fiscal policy, the logjam in Congress is no surprise. However, the shift in monetary policy came about amazingly quickly. At the June FOMC meeting, Fed officials — or the dot plot — forecasted no fed funds rate increases until 2023. In September, the dot plot changed to include one possible rate hike at the end of 2022. December’s dot plot implied three possible rate hikes in 2022. This week the consensus expectation has changed once again to include four or five fed funds rate hikes this year, or at least one increase per quarter. This is a startling turnaround, albeit a necessary one. We believed inflation would be a big hurdle for equities last year. It proved not to be. But this year as the Fed addresses the existence of inflation, the significance of price increases is apt to become quite apparent. Keep in mind that four fed fund rate hikes within a twelve-month period tends to produce a down market in the subsequent six months. We will discuss Fed rate hikes in future weeklies.

Independent of monetary and fiscal policy, the new year begins under a dark cloud. As we have often noted, three consecutive years of double-digit gains in the indices are often followed by a year of losses. The one exception to this precedent was the five double-digit up years that led into the 2000 peak. However, this historic rise was a stock market bubble, and it was followed by three consecutive years of losses. See page 3. Therefore, if history is any guide, 2022 may a defining year – either it is a down year or it is the beginning of an equity bubble. We think the first quarter will be revealing and may provide the answer.

January and Liquidity

Wall Street adages are typically built upon some fundamental or economic premise and the January Barometer is one of these. The concept of the first five days of the year and/or the first month of the year having predictive value for the overall year is based upon liquidity. The end of the year and the beginning of any year is a unique time for liquidity. A grouping of pension funding, IRA funding, tax loss selling proceeds, bonus payments and salary increases tends to cluster in the December/January period and makes this time unique in terms of providing potential demand for equities. If equities fail to rise during this time, it may be a signal of trouble ahead. Overall, it is a warning.

January is off to a weak start this year, with a 1.9% decline in the S&P 500 index and a 0.3% decline in the Dow Jones Industrial Average. And as shown on page 5, ten of the last 17 post-election-year markets were flat to down years. However, it is important to point out that the early January Barometer has a poor record of predicting annual declines. Early January losses have only been followed by annual declines 42% of the time in the S&P 500 and 46% of the time in the DJIA. A decline in the month of January has been more accurate. January declines have been followed by annual declines 69% and 66% of the time in the S&P 500 and DJIA, respectively. All in all, the January Barometer has been a better guide in predicting up years after January gains. See pages 4 and 5. Still, we do think it would be a bad omen for January to be weak in face of the obstacles we see for equities.      

Obstacles

One of the issues facing equities is the potential slowdown in earnings growth. After what we expect will be a high double-digit earnings growth rate in 2021, the pace is expected to slow to a single digit level this year. Currently, IBES Refinitiv and S&P/Dow Jones have 2022 earnings growth rates of 8.5% YOY and 9.0% YOY, respectively. Our estimate is for a 10% YOY growth rate, but only because our 2021 earnings estimate is below the consensus view. See page 7 and 16. Nevertheless, earnings are facing tough comparisons in 2022 and earnings will not provide the fundamental support it did over the last twelve months.

Higher inflation also pressures price-earnings multiples. Unless inflation falls well below the 4% level this year, we expect multiples to fall from the current level of 20+ to the average of 17.5 times. But inflation dropping to less than 4% seems unlikely in the near term, particularly with crude oil futures rising once again. The charts of both WTI and gasoline futures point to higher prices this year. See page 8. This implies inflation and multiple risk in coming months.

Plus, it is easy to become too insular and forget about the geopolitical problems that could upset the financial markets. Political hotspots include North Korea which launched two ballistic missiles off its East Coast in the last week, US forces in Iraq and Syria suffering three separate rocket attacks in recent days, Russian troops hovering ominously on the Ukrainian border and China becoming increasingly assertive in controlling both Hong Kong and Taiwan. All of these have the potential of upending the financial applecart.

FANG stocks

High PE stocks face the biggest threat in an environment of soaring inflation and rising interest rates. And we expect technology stocks could bear the brunt of any correction in 2022. With this in mind we looked at the charts of the FANG stocks this week and found some patterns that deserve monitoring. We have comments on Amazon (AMZN – $3307.24), Meta Platform (FB – $334.37) and Alphabet (GOOG – $2800.35) on page 9. Each of these stocks have critical support levels that if broken, could trigger further selling. In sum, we would be defensive in the short run; but a sell-off in 2022 could produce an excellent long-term buying opportunity. Meanwhile, there are pockets of safety in the market in areas such as energy, banks, and staples, which all have modest multiples and good dividend yields.

Technical Indicators The Russell 2000 index also has a pattern similar to the aforementioned FANG stocks in that the 2100 support level is important to the index. If this level is broken it would be extremely bearish for the RUT and a negative omen for the market. See page 10. Most other technical indicators are neutral or indecisive this week. The 25-day up/down volume oscillator is at 2.06 this week and above the midpoint of the neutral range, but still has not confirmed any market highs since February 2021. This implies that investors have been selling into rallies. Both the 10-day averages of new highs and new lows are above 100, leaving the “trend” of the market ambiguous. The NYSE cumulative advance/decline line made its last record high on November 8. Sentiment indicators like the AAII bull bear survey and the ISE call/put volume index are neutral. All in all, we remain cautious for the near term.  

Gail Dudack

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