A Bit of History

The media is filled with headlines stating that the S&P 500, the Dow Jones Industrial Average, and the Nasdaq Composite Index have booked nine consecutive weekly gains — the longest weekly winning streak for the S&P 500 since January 2004, and the longest stretch for the Dow Jones Industrial Average and the Nasdaq Composite Index since early 2019. Many in the media have then suggested that this strong run means more gains are ahead. Indeed, double-digit gains in the equity indices don’t suggest a bear market … unless there are three years in a row of double-digit gains. But as you can see from page 7, the full year 2004 had a fairly mediocre performance after its early advance. In 2019 an early advance in the first quarter stalled, then rallied, and in November, COVID-19 became a global pandemic, making comparisons difficult.

However, the parallel between 2004 and 2024 is not only due to the nine weekly gains, but that both are presidential election years. And they are years ending in “4.” Depending upon which market index one uses, the presidential election year has the third or fourth best performance of the four-year cycle. In short, election years tend to be mediocre. The pre-election year is the year with the biggest stock gains in the four-year cycle. This is probably due to fiscal stimulus done early in the year to help the economy and to help the incumbent president win votes due to a strong economy. This pattern seems to fit the current cycle, even though it is a most unusual economic cycle.

However, one of the most interesting things about an election year is that it has some ability to predict the outcome of the presidential election. When the incumbent is about to win, equities tend to be weakest in May in July. The May decline sets up a classic summer rally which is followed by a weak July. Typically, July is the fourth best performing month of the year, so this works against seasonality. In years when the incumbent loses, the weakest months of the year tend to appear in January, February, September, and October. January has a history of being the sixth best performing month, on the heels of good gains in November and December. So, this too, goes against seasonality and weakness early in the year is a bad omen for an incumbent president. In both cases, or most election years, the strongest months tend to be November and December. See page 8.

This is also a year ending in 4, and the decennial pattern suggests it will be a year with an average gain of 7.1%, leaving it tied for fifth place in the 10-year cycle. Still, “4” years have produced gains in nine of the last 14 cycles, so there is a bullish bias to years ending in 4. See page 6. All in all, history points to an up year, but more in line with a single-digit gain than a double-digit gain.

Liquidity

The dramatic gains seen at the end of 2023 were driven by the widely held belief that interest rates are coming down in 2024. Federal Reserve Chairman Jerome Powell attempted to dampen these expectations in subsequent days, however, his comments after the last FOMC meeting did indicate that rate cuts were likely in 2024. This suggestion triggered a swift decline in long-term interest rates and a rush out of cash and into equities. The momentum of the equity market is strong, and this is seen in our technical indicators. However, behind good momentum tends to be good liquidity. For this, we looked at Federal Reserve data on commercial banks. What we found was that banks hold nearly $19 trillion in customers’ liquid short-term assets. This number is the sum of $4.99 trillion in demand deposits, $1.7 trillion in retail money market funds, $1.0 trillion in small-denomination time deposits, and nearly $11 trillion in other liquid deposits. See page 4. In recent years, money flowed into short-term assets as interest rates rose and the threat of recession was looming. Powell’s “pivot” on interest rates created a “pivot” in investor sentiment and their opinion of cash. In a Cinderella world of falling interest rates, declining inflation, and no recession, $19 trillion is a substantial amount of potential demand for equities. Moreover, we know that the cash held at commercial banks is a majority, but not all inclusive, of household cash coffers.

Nevertheless, we have experienced liquidity-driven markets in the past and have learned that it is important to put any “liquidity cache” in perspective to the size of the overall market. If we compare current cash assets to total US market capitalization, we find that it represents 38% of total US market capitalization. This is a substantial, but not historic ratio, of cash. See page 4. Most secular bull cycles began when cash equals 50% or more of market capitalization. In short, cash levels support a strong momentum-driven market for a while, but do not suggest this is the start of a major secular bull market.

Valuation

If the equity market is on the verge of a bubble market, we will know fairly quickly since bubbles are driven by sentiment, liquidity, and leverage, not by earnings or fundamentals. At present, the fundamentals are not supportive of the bulls. There are many ways to measure valuation, but most show the market to be richly valued today. On page 9, we show the Rule of 23, which implies that when the sum of the trailing PE and inflation exceeds 23.8, the stock market is extended and overvalued. The current trailing PE is 22.3 times and the S&P PE based on 2024 earnings estimates is 19.6 times. With inflation at 3.2% and potentially easing, when coupled with the trailing PE of 22.3, the sum of 25.5 is well above the dangerous 23.8 level. Perhaps more importantly, if we add the estimated 2024 forward PE ratio of 19.6 times to inflation of 3.2%, the sum of 22.8 is only two points below the 23.8 danger level. In short, the stock market’s valuation has already discounted a substantial decline in inflation and all of this year’s potential earnings growth. This implies that every CPI report and every earnings reporting season has the potential to be a market-moving event.

Bullish Technicals

What keeps us from getting too negative about valuation too soon is the significant change in our technical indicators. The breakouts in all four charts of the popular indices are both perpendicular and dramatic, but to date, only the DJIA has managed to make a new all-time high. The SPX is most interesting at this juncture since it has been fractionally away from a new record high for several sessions but is yet to better its January 3, 2022 peak of 4796.56. The Russell 2000, after beating key resistance at the 2000 level, is now testing this level as support. If the Russell begins to trade below 2000 once again, it could neutralize what is now a very bullish technical pattern. See page 11. The 25-day up/down volume oscillator is at 3.45 this week and has been in overbought territory of 3.0 or higher for 19 of the last 22 consecutive trading days. To confirm the recent advance this indicator needed to remain in overbought territory for a minimum of five consecutive trading sessions, which means the oscillator has definitely confirmed the recent uptrend as “significant.” The current 19-day overbought reading is far better than the 11-day reading seen between January 25, 2022 and February 8, 2022. The only missing ingredient to the current strength of this indicator is an overbought reading in excess of 5.0. Extreme overbought readings of 5.0 or more are often seen at the start of a new bull market cycle. However, this is not a requirement for a significant advance. What will be important is that any pullback in the equity market ends once this indicator approaches an oversold reading. In a bull market oversold readings tend to be brief or nonexistent.  

Gail Dudack

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The yield on the 10-year Treasury note plummeted over 50 basis points during November and expectations for a fed funds rate cut shifted from late in 2024 to the first quarter of the new year. This sentiment shift supported a rally in US equities and in gold since gold tends to move inversely to interest rates. In other words, the market has been pricing in a Goldilocks scenario that consists of lower inflation, a soft landing or non-recession, Fed easing early in 2023, and a rebound in corporate earnings in 2024. However, as Mohamed El-Erian noted on CNBC this week, believing this scenario is possible in the current complicated environment is the equivalent of believing a pilot could land a jumbo jet without any passenger feeling any landing at all. The risks are therefore high, that the consensus will be proven wrong.

China/Debt/Gold

Perhaps if the US were functioning on its own, a soft landing might be possible. But there are risks on the horizon. The largest of these could be China. We have often written about the problems facing the Chinese economy in terms of its property crisis, but this week Moody’s lowered its rating on China’s A1 debt rating from stable to negative. This was the first rating shift on Chinese debt by Moody’s since 2017 and the company commented that the costs to bail out local governments and state firms while controlling its property crisis would weigh heavily on China’s massive economy. China’s total outstanding off-balance sheet debt is estimated to be somewhere between $7 trillion and $11 trillion, according to the International Monetary Fund. This figure would include corporate bonds issued by thousands of local government financing vehicles which borrowed money to build roads, bridges, and other infrastructure. According to a senior economist at UBS, most local government financing vehicles currently depend on capital injections from local governments, government subsidies, and external funding because they do not generate enough cash from their operations to cover the interest payments. The longer-term risk is that this massive debt problem becomes systemic to the Chinese banking system and becomes a global banking problem.

Meanwhile, China’s CSI 300 Index (000300.SS – 3,394.26 CNY) is trading at its lowest level in nearly five years. This backdrop of falling real estate prices, risk of debt defaults, falling stock market prices, and a weakening currency, explains why Chinese consumers are actively buying gold (GC=F $2038.30). According to the latest Chinese retail sales data, gold and silver jewelry have been among the best-performing consumer goods in China this year, with a 12% rise in value year-on-year in January-October and outpaced only by garments. A Chinese consumer survey released in late October found that 70% of consumers between the ages of 18 and 40 intend to purchase pure gold jewelry. Together, China and India, the world’s two biggest gold buyers, account for more than half of total global demand. And according to commodity analysts, China is the world’s top buyer of physical gold has been an increasingly important driver behind this year’s rally in global spot gold prices. Gold has clearly become the safe haven trade for Chinese investors. Perhaps the rally in bitcoin (BTC – $43,886.05) is also a result of Chinese investors looking to protect themselves from a weakening currency and falling stock and property prices.

Pivotal Points in Technical Indicators

As we noted last week, the technical charts of the popular equity indices remain bullish with the first level of resistance encountered at the July highs and the second, and most important resistance, found at the all-time highs. Only the DJIA has exceeded its July high on the recent advance, touted by many to be the start of a new multi-year bull market. The July highs of 4600 in the SPX and 14,500 In the Nasdaq Composite have not been bettered and stock prices retreated as they tested those levels. The Russell 2000 index, which is our personal favorite for defining the broad marketplace, broke above its 100-day and 200-day moving averages last week, but the index remains neutral in its long-standing trading range between 1650 and 2000. In sum, the recent uptrend is unconfirmed. See page 8.

The 25-day up/down volume oscillator is at a positive 3.49 reading this week and has been in overbought territory of 3.0 or higher for four consecutive trading days. This is a positive development, but to confirm the recent advance this indicator should remain in overbought territory for a minimum of five consecutive trading sessions. In short, this indicator is close, but has not yet corroborated the recent uptrend as a significant trend. To date, both downtrends and uptrends have failed to sustain oversold or overbought readings for a minimum of five consecutive trading sessions. See page 9. However, this is in line with our long-held view that the stock market is in a broad trading range, which is a substitute for a bear market. We expect this range, best seen in the Russell 2000 index, to remain in force until inflation has been clearly brought under control.

The American Association of Individual Investors (AAII) survey showed a 3.5% increase in bullishness (48.8%), and a 4.0% decrease in bearishness (19.6%) last week. Bullish sentiment remains above average for the fourth consecutive week and bearishness is also below average for the fourth consecutive week. But more importantly, bearishness is at its lowest level since the January 3, 2018 reading of 15.6%. This extreme bearish reading in 2018 was followed by a 10% decline in the S&P 500 by February 8, a 13.6% advance by September 20, and a 19.8% decline by December 24. For the full year, the S&P 500 fell 6.2% in 2018. This too supports a view of a volatile trading range marketplace.

An Economic Mix

The headline ISM manufacturing index was unchanged in November, but six of the 10 components fell. The backlog of orders component declined to 39.3, its lowest reading since May 2020. The non-manufacturing index rose from 51.8 to 52.7, but the rise was mostly due to a buildup in inventories to 55.4. Order backlog also fell from 50.9 to 49.1. Readings below 50 indicate a contraction. See page 3.

The 5.2% GDP pace in the third quarter was the fastest rate recorded in nearly two years. Inventory build was a big contributor, consumption rebounded from a weak second quarter, and trade was a drag. However, this was the fourth consecutive quarter of negative real retail sales, which is typically associated with a recession. The key risk factor for the 2024 economy will be the strength of the consumer. See page 4.

Personal income rose 4.5% YOY in October, down from 4.8%. Disposable income rose nearly 7% YOY, down from 7.4%. Real disposable income increased 3.85% YOY, unchanged from September. Personal savings were $768.6 billion, up $19.6 billion, and the savings rate rose from 3.7% to 3.8%. But this remains well below the average long-term savings rate of 5.7%. See page 5.

Personal consumption expenditures rose 5.3% YOY in October and personal disposable income rose nearly 7% YOY. This marked the tenth consecutive month in which income exceeded consumption and it follows 21 consecutive months of consumption exceeding disposable income. Note that wage growth is decelerating for most employee sectors of the economy, except government, where wage growth was 8% YOY in October. See page 6.

Gail Dudack

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Media Hyperbole

It is widely known that there is political bias in the mass media, but we continually see signs of bias in the financial press as well. The bias tends to be bullish or optimistic, which may seem constructive and comforting, but it can also be dangerous if it is misleading to the public and/or investors. We have pointed out several situations in the past and there was more this week. In particular, we just read a headline from an international news source that shouted in bold letters “US consumer confidence rebounds, house prices maintain upward trend.” We had just finished writing the back pages of this report, so we knew what these economic releases contained, and this headline did not match what we learned from the data.

This headline sounded like the economy was on the verge of an economic rebound. However, within the article it did state that “the Conference Board said its consumer confidence index increased to 102.0 this month from a downwardly revised 99.1 in October. Economists polled by Reuters had forecast the index dipping to 101.0. The improvement in confidence was concentrated mostly among households aged 55 and up. Consumers in the 35-54 age group were less optimistic about their prospects.”

The fact that the 35-54 age group was less optimistic than those over 55 is noteworthy since this age group is of prime working age and has children in school, a combination that makes them core consumers and important drivers of the economy.

What was not made transparent in this article was that October’s index had initially been reported to be 102.6. This means the consensus estimate for November was 101.0 implying a decline in sentiment. And the only reason November’s index of 102.0 was better than forecasted was the large negative revision in October’s index, to 99.1. In our opinion, there is a bit of a sleight of hand to say that November’s confidence was a positive surprise and/or represented a rebound. Plus, the University of Michigan consumer sentiment index for November showed consumers were clearly worried, especially about higher inflation. The main index fell 2.5 to 61.3, present conditions were 2.3 lower to 68.3, and expectations fell 2.5 to 56.8. All in all, none of this supports a headline that says consumer confidence is rebounding, in our opinion. See page 6.

In terms of suggesting there is an upward trend in house prices, it is more of the same. The article was referencing housing data from the Federal Housing Finance Agency (FHFA) which does not measure home prices but calculates an index (1991=100) which is defined as a weighted repeat-sales index, meaning that it measures average price changes in repeat sales or refinancings on the same properties. It is a broad-based index but does not represent actual home prices. We doubt that the journalist understood this. Moreover, the FHFA index is released a month later than most other home price data, i.e., the article was referencing September data when data for October and surveys for November had already been released. See page 5.

As for the trend in new home sales and prices, according to data from the Census Bureau, sales were lower in October versus September, but up 17.7% YOY. New house inventories were at their highest level since January and the total months of supply of housing was 7.8, back to August’s level. But in terms of home prices, Census data showed that the average new single-family home price fell 10.4% YOY to $487,000 while the median price fell nearly 18% YOY to $409,300. This data does not support the international news article, but it does support the negative NAHB survey results reported for October and November. See page 4. In sum, do not believe everything you read.

Media Neglect

Not getting much attention by the media are the risks appearing in the Chinese economy. Most investors know about China’s property crisis and its impact across China is immense and ongoing. However, foreign investors have been souring on China for most of this year, and recent data shows strong evidence that the global trend of diversifying supply chains and other de-risking strategies are having a negative impact on the world’s second-largest economy. In the July-September period, China recorded its first-ever quarterly deficit in foreign direct investment, a sign of capital outflow pressure. See page 7. According to Rhodium Group (www.rhg.com), the value of announced US and European greenfield investment into China dropped to less than $20 billion last year, from a peak of $120 billion in 2018, while investment into India shot up by some $65 billion or 400% between 2021 and 2022.

Given this backdrop, it is not surprising that Chinese President Xi Jinping recently met with President Biden at the Asia-Pacific-Economic-Cooperation (APEC) Summit in San Francisco. Investment in China has dropped to historic lows, and President Xi attended the Summit in San Francisco to promote China’s economy. However, the data suggests that foreign firms are not only refusing to reinvest their earnings in China but are selling existing investments and repatriating funds. This trend could put further pressure on the yuan and dampen China’s economic growth in the long run. It also reduces China’s need to invest dollar inflows, which helps explain China’s decreasing demand for US Treasury bonds.

In terms of China’s economic activity, a survey released by The Conference Board showed that more than two-thirds of responding CEOs indicated that China’s demand has not returned to pre-COVID levels. Forty percent of respondents are expecting a decrease in capital investments in China and a similar proportion are expecting to cut jobs. In sum, corporations will become more dependent upon US consumers for top-line growth in the future.

Market Update

Not much has changed this week. The charts of the popular equity indices remain bullish with the first level of resistance seen at the July highs and the most important resistance found at the all-time highs. The near-term levels to monitor are 4600 in the SPX (July high) and the 1820-1827 area of the Russell 2000 index where the 100-day and 200-day moving averages merge. These short-term challenges are yet to be tested. However, while moves above these levels would be favorable for a year-end rally, the all-time highs are the real source of resistance. In our view, the longer-term trading ranges remain intact. See page 10.

Beware What You Wish For The consensus believes rate hikes are over and rate cuts, accompanied by a soft landing are in store for 2024. Yet, today’s rapid Fed tightening cycle would be most comparable to the early 1950s or the early 1980s. In both cases, Fed tightening led to multiple recessions. And while the stock market is currently rallying based upon the view that rates have peaked and will soon decline, the decline in interest rates following a tightening cycle has usually appeared in tandem with a recession. In short, the current stock market rally appears to be celebrating the onset of a recession, whether it is aware of it or not.

Gail Dudack

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Happy Thanksgiving to all! We are grateful for many things, but most of all the friendship and loyalty of our clients. Wishing you the best that Thanksgiving represents gratitude, family, friendship, and great food!!

Momentum Shift

After a strong four-week advance off the October lows, US equities retreated this week. Part of the retreat was due to a string of weak earnings reports from retail companies, but stocks also stalled from a lack of news that could move stocks higher. Even a positive earnings report from chip designer, Nvidia Corp. (NVDA – $499.44), failed to impress, and the stock traded lower in after-market trading. Nvidia noted in its earnings report that it faces challenges in both Israel, where employees are being called up for active duty, and in China, where sales will be affected by US export controls. The release of FOMC minutes confirmed the consensus view that the Fed is apt to be on hold, barring any bad news on the inflation front. This is a positive factor, but it has already been discounted by rising stock prices.

However, the technical condition of the market did improve in the last week. Trading on November 14 recorded a 91% up day, i.e., volume in advancing stocks represented 91% of total NYSE volume. In addition, the NYSE total volume for the day rose above the 10-day average. This combination displayed a positive shift in conviction. (Note that our indicators use NYSE volume versus composite volume to separate day trading and professional hedging from actual buyers and sellers.) The 10-day average of daily new highs rose to 122, above the 100 benchmark that helps define an uptrend, while the 10-day average of daily new lows fell to 79, below the 100 benchmark. This combination also reversed a negative trend that had been in place since mid-September. See page 12.

Nevertheless, our 25-day up/down volume oscillator is at a negative 0.40 reading this week and neutral. See page 11. This lackluster response, despite several strong days of upward momentum, does not surprise us since it is in line with our view that the market is long-term trendless. Our view that the equity market will remain in a wide trading range, a substitute for a bear market, has not changed.

The charts of the popular equity indices continue to be bullish with the first level of resistance seen at the July highs and the second level of resistance found at the all-time highs. The key levels to watch in coming days are 4600 in the S&P 500, which is roughly the July high and the 1830 area of the Russell 2000 index where the 100-day and 200-day moving averages merge. These levels pose near-term challenges for these equity indices and will help define the strength of the current advance. The favorable seasonality of the November, December, and January months are in the stock market’s favor, but it was disappointing that the Russell 2000 index was the worst performing index in this week’s pullback. We do not expect year-end strength to carry the indices to new highs and this suggests that the long-term trading ranges will remain intact.

The Economy is a Tale of Two Cities

Strategists can be broken down into two distinct groups of those looking for a recession and those looking for a soft landing. However, the underlying data drives this division.

The positive factors include October’s headline CPI showing a 3.2% YOY rise, the PPI for finished goods falling 0.4% YOY, and the price of crude oil down 3.8% YOY. This combination makes a lower inflation outlook seem probable. Some inflation benchmarks are still higher with core CPI at 4% and core PPI at 3.2%, but overall, most inflation benchmarks are now below the long-term CPI average of 3.4% YOY. In short, inflation is lower, and if not yet at 2%, it is still below average. See page 3. This coupled with a job environment that is neither robust, nor weak, makes a soft landing credible.

However, this would be the first time in history that inflation at or approaching a double-digit pace, was not followed by a series of recessions. And it would be the first time that the real fed funds rate did not have to rise to 400 basis points before an inflationary trend was reversed. See page 4. We believe the jury is still out whether the current 200 basis points in the real fed funds rate will cure inflation. See page 4.

Neither the last recession nor economic recovery were normal business cycles. The recession was the result of a mandated shutdown of the economy and the recovery was the result of historic stimulus policies by both the administration and the Fed. Does this mean it will be different this time? It is difficult to tell. Inflation is a cruel tax on the lower end of the income spectrum, and this is what sparks a recession. We can see this in the current economy, which is a tale of two cities, i.e., the wealthy and the poor.

Retail sales were down slightly in October, but up 2.5% YOY. However, if adjusted for inflation, real retail sales fell 0.7% YOY in October and were negative for 10 of the last twelve months. Negative real retail sales is typical of a recessionary economy. See page 6.

Consumer credit growth has been decelerating all year, which is not a surprise given the rise in interest rates and interest costs. However, the most disturbing development is the increase in the number of people taking hardship withdrawals from their 401k plans. Wells Fargo & Co. (WFC – $42.60) reported a rise in such withdrawals last week and Fidelity National Information Services Inc. (FIS – $53.90) reported a similar trend this week. These withdrawals are a sign that many households are in very poor financial shape. Moreover, it suggests that future consumption trends will likely slow in the US. This is in line with weak reports from retailers in the third quarter. See page 7.

The housing market had been a boost to the economy in the first half of the year, but that has changed in recent months. Existing home sales were 3.79 million in October, the slowest pace in 13 years. Housing affordability is at its lowest level since 1985 and the NAHB survey is at its lowest levels since the start of the year. It is clear that rising rates are taking a toll on housing. See page 8. The 2023 economy has been a division of the haves and the have-nots, and the question is will higher income families keep the economy afloat in 2024, or not? It is an important question since the recent rally has carried the averages back to a relatively rich level. S&P Dow Jones consensus estimates for 2023 and 2024 are $214.65 and $242.73, respectively, down $0.53, and $0.60, respectively, this week. LSEG IBES estimates for 2023 and 2024 are $220.38 and $244.98, down $0.24, and $0.33, respectively. Based upon the IBES EPS estimate of $220.38 for this year, equities remain overvalued with a PE of 20.6 times and inflation of 3.24%. This sum of 23.84 is fractionally above the 23.8 level that defines an overvalued equity market. Note: based upon the S&P estimate of $214.65, the 2023 PE is even higher at 21.1 times.  

Gail Dudack

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