US Strategy Weekly: Watching the Debt Markets and Technicals

After a long delay, the equity market finally realized that the Federal Reserve has much more work to do in the months ahead in order to combat inflation. It has become clear that the focus on the timing of a “peak fed funds rate” was premature. Last week the Fed raised the fed funds rate 75 basis points to a range of 3% to 3.25%, and the November meeting could see another 75-basis point increase which would carry this benchmark to 4%. The December meeting will be data-dependent, but it could also result in short-term rates moving higher. This combination of rate increases has had a dramatic impact on all interest rates and on the dollar, while keeping the government yield curve relatively inverted. See page 3.

However, the chart of government interest rates on page 3 shows another important detail which is how much interest rates have risen since the end of August. In particular, the two-year Treasury note yield has jumped 105 basis points in less than a month. To date, this is the largest monthly increase in the two-year Treasury note yield since the 1980 to 1981 era, which is an interesting era to compare to today’s situation, since inflation is also the highest in 40 years. In that inflationary period, inflation peaked at 14.8% YOY in March 1980, fell to 9.6% YOY in June 1981, but quickly rebounded to 11% YOY in September 1981. The Fed first raised rates dramatically until the effective fed funds rate hit 17.6% in April 1980. The Fed then cut rates due to a recession (January 1980 to July 1980) and the effective fed funds rate fell to 9% in July 1980. But when inflation reignited, the Fed boosted rates once again and the effective fed funds rate rose to 19.1% by June 1981. This hawkish policy triggered a second recession between July 1981 and November 1982.

We believe the current Fed hopes to avoid the erratic tightening policy of the 1980-1981 timeframe and will therefore continue to steadily raise rates until data shows prices are not simply decelerating, but in fact, the inflation cycle has been broken. This will take time and unfortunately, it is likely to result in a full-blown undeniable recession.

Canary in the Coal Mine

We have been watching the debt markets more carefully in recent days since the spike in the dollar can have consequences in areas least expected. The SPDR Bloomberg High Yield Bond ETF (JNK – $87.57) tracks the US high yield corporate bond market and it is spiraling downward, approaching the March 23, 2020 closing low of $84.57, which tested the March 2009 low of $77.55. However, while the bond market is displaying substantial concern about the future, the VIX is at $32.60, and remains well below its $82.69 close of March 16, 2020. See page 4. In our view, the equity market is too complacent about the current combination of rising interest rates, a higher dollar, and declining earnings.

Moreover, the bond market is more closely connected to the global environment where the mixture of rising debt loads (both sovereign and corporate), higher interest rates, and a strong dollar can be an explosive combination. In short, the decline in the high yield market concerns us and we fear the next unexpected event may materialize outside the US and be related to defaults.

Earnings Reality

Despite some comments by well-respected analysts, earnings estimates for 2022 and 2023 are falling. This week S&P Dow Jones consensus earnings estimates for 2022 and 2023 fell $0.78 and $1.33, respectively. Refinitiv IBES consensus earnings forecasts fell $1.50 and $1.24. The S&P consensus EPS estimate for 2022 is now $208.21 and the IBES estimate fell to $223.83, bringing EPS growth rates for 2022 to 0.3% and 7.5%, respectively. See pages 6 and 13.

We recently reduced our 2022 S&P 500 earnings estimate from $218 to $209 and for 2023 our estimate declines from $237 to $229. However, we must admit that we fear we may have to lower these estimates after third quarter earnings season. Nevertheless, our $209 estimate coupled with our valuation model which suggests that a 14 X multiple is appropriate for this environment creates a downside target of roughly SPX 2915. The yearend range is SPX 3452 to SPX 2380. This implies that there is more risk in the market. An alternative method would be to take an average PE of 15.8 X with our $209 estimate, and this equates to SPX 3302. See page 5. Either way, the market has not yet reached a level of table-pounding good value.

Technical Indicators may be weakening

Technical indicators have not been reassuring this week – quite the opposite. The charts of the popular indices look quite similar this week, unfortunately, all four of the popular indices appear to be in the midst of a capitulation-style decline. As we have indicated in recent weeks, the key to defining this bear market’s low will be whether breadth data is less negative on a new low in price. If so, it would be a positive sign of a bottoming formation. The alternative is not favorable for the intermediate term. See page 7.

At the moment, the jury is still out, but recent breadth data is not encouraging. The 25-day up/down volume oscillator is now at negative 4.35 and recording its sixth consecutive day in oversold territory, i.e., a reading of negative 3.0 or less. (On September 26, 2022, the 25-day indicator also hit a low of negative 4.95.) Since this oscillator was in oversold territory for six of eight consecutive sessions between July 6 and July 15 and hit an extreme oversold reading of negative 5.17 on July 14, 2022, a successful test of the June lows would require a shorter and/or less intense oversold reading on any new low in price in the S&P 500. Although the oscillator is slightly less oversold than it was in June, it is by a very narrow and tenuous margin. Another extreme sell-off day would take this indicator to a deeper oversold reading, turning this indicator negative, and indicate that lower lows may be ahead. In short, the market could be only a day or two away from an unsuccessful test of the June low.  See page 8.

In addition, the 10-day average of daily new highs is 32 and daily new lows are 896. This combination is negative with new highs below 100, and new lows above the 100 benchmark. More importantly, the 10-day moving average of new lows at 896 has now exceeded the previous peak of 604 made in early May. Again, the market is showing underlying weakness. The advance/decline line fell below the June low on September 22 just prior to the SPX breaking its June low. The NYSE cumulative advance/decline line is currently 53,150 net advancing issues from its 11/8/21 high – a large number and a negative sign for the near term. See page 9. On a more positive note, last week’s AAII readings showed a decrease of 8.4% in bulls to 17.7% and an increase of 14.9% in bears to 60.9%. The 17.7% reading is among the 20 lowest readings since the survey began in 1987. Optimism was at a similar level in May. Equity prices tend to be higher in the next six and/or twelve months following such extreme readings in sentiment. See page 10.  

Gail Dudack

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US Strategy Weekly: Lowering EPS Estimates

For the second time in six weeks, we are lowering our 2022 and 2023 earnings estimates for the S&P 500. For 2022, our forecast falls from $218 to $209, and for 2023 our estimate declines from $237 to $229. See pages 9 and 16. These estimates now translate into earnings growth rates of 0.4% this year and 9.6% next year. Both cuts in estimates were the result of disappointing earnings in the last two quarters. But more importantly, a weakening economy could put these reduced estimates in jeopardy.

It is worth pointing out that consensus estimates for 2022 have dropped precipitously as well. In particular, the S&P Dow Jones consensus estimate for 2022 was $227.51 in late April and fell to $209.66 last week, a 7.8% decline. The IBES Refinitiv consensus estimate hit a high of $229.57 in June and was $225.33 last week, a 1.8% decline. So, despite the misleading headlines suggesting that second quarter earnings season was better than analysts expected, earnings have disappointed in each reporting quarter this year. (Note that media headlines are never comparing earnings results on a year-over-year basis, but instead, compare results to the consensus estimate which may have been dramatically reduced just a few days earlier.) Moreover, most economists are now forecasting a recession for 2023, yet this does not seem to be reflected in current earnings estimates. Until this happens the door is open for more disappointments.

This earnings review of the first half of the year may explain why the market has been so weak as we approach the September FOMC meeting. Excluding the energy sector, earnings results for the S&P 500 are in the red for the first half of the year. Nevertheless, the Fed is expected to make the economic backdrop less friendly for corporate earnings in the coming months. It is likely that the Fed will raise interest rates 75 basis points this week, although it makes little difference if it is 75 basis points or 100 basis points, in our view. The bigger picture suggests that while the high of the fed funds range is currently at 2.5%, it is apt to reach 4% to 4.5% after the next few Fed meetings. In short, the Fed is undoubtedly going to trigger a recession, and this has not yet been fully factored into stock prices.

Valuation Model Woes

We have been reporting on the repercussions of inflation for a long while – the reduction in purchasing power of households, the pressure on profit margins and the negative impact on PE multiples – and the market is finally beginning to confront these issues. However, the combination of lower earnings growth and lower PE multiples is a toxic mix for equity valuation. When we combine our new assumptions of $209 earnings in 2022, with short-term interest rates rising to 4% and inflation falling to 6.2% by year-end, we get some distressing results in our valuation model. See page 8. First, our model suggests that a PE multiple slightly below 14 times is appropriate for the 2022 environment and coupled with our earnings estimate of $209, it produces a target of SPX 2915. The year-end range shows a high of SPX 3452 and a low of SPX 2380. Keep in mind that periods of high inflation typically result in the SPX trading in the lower half of the range because earnings are worth less in an inflationary environment. This is one of the many miseries of high inflation.

Alternatively, we could use the long-term average PE multiple of 15.8 times to find value in the equity market. With our $209 earnings estimate this generates a downside target of SPX 3302, which is less disconcerting, but still 14% below current prices. Either way, we believe the market has further downside risk. See page 8.

History also shows us that periods of inflation tend to place a ceiling on stock prices until the inflationary cycle is under control. See page 7. We believe the Federal Reserve understands this. And though they were late to address the inflation problem, we believe they will be steadfast and aggressive in the near term to counter inflation as best they can. See page 6. Other countries face the same inflationary issues, and their central banks are following the Fed’s lead, as seen by Sweden’s central bank which raised interest rates 100 basis points this week.  

One can see the impact of inflation everywhere. Retail sales were up a robust 9.1% YOY in August, but up only 1.5% YOY after inflation is considered. Although August’s gain in real retail sales was not substantial, it was nonetheless a positive gain which is a favorable shift. Real retail sales were negative in three of the four months between March and June, which concerned us because months of negative real sales are a classic sign of an economic recession. And even though retail sales rose 0.3% in August on a month-over-month seasonally adjusted basis, nominal retail sales in US dollars in August were below the level reported in June. See page 3.

Average weekly earnings grew at a healthy 5.1% YOY pace in August, but inflation rose 8.2% YOY, which means purchasing power actually fell 3.1% on a year-over-year basis. And after nearly two years of rising prices, energy is no longer the driver of inflation. As seen in the chart on page 5 of core CPI, PPI and PCE, these indices rose 6.5%, 8.8%, and 4.6%, respectively in August. All core inflation measures were the highest is 40 years. This explains why a 75-basis point or a 100-basis point hike in interest rates is irrelevant. Interest rates must go much higher to curb the current inflationary problem.

Technical Update

The 25-day up/down volume oscillator fell to negative 3.02 this week which is the first oversold reading of negative 3.0 or less since July. Remember that this oscillator was in oversold territory for six of eight consecutive sessions between July 6 and July 15 and hit an extreme oversold reading of negative 5.17 on July 14, 2022. A successful test of the June lows would require a shorter and/or less intense oversold reading with or without a new low in price in the indices. This is an important juncture for this oscillator.

The key to a successful retest of a bear market low is whether or not a new low in price also generates a new low in breadth. A successful retest will show there is less selling pressure – a less severe oversold reading — despite a lower low in price. We think this is a possibility in the final months of the year, but it means that this indicator should not fall below negative 5.17 or remain oversold for more than six to eight consecutive days. If it does, it would be negative for the intermediate-term outlook. The charts of the popular indices are quite similar this week. All four of the popular indices appear to be on the verge of testing the June lows and we would not be surprised, or concerned if all four indices break these lows. The key will be whether or not breadth data is stronger on this new low than it was in June. Remember: in terms of seasonality, September tends to be the weakest month of the year and that seems to be proving true in 2022. However, October has the reputation of being a “bear killer” and a turnaround month. We will be monitoring our indicators for signs that this will also prove true in 2022.

Gail Dudack

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US Strategy Weekly: Inflation Basics

The past week has been filled with global events, although none as historic as the sudden passing of Queen Elizabeth II of Great Britain on September 8 at the age of 96. She was Britain’s longest-reigning monarch, who guided her country for decades with grace and diplomacy, held an audience with 15 British Prime Ministers and spanned a timeframe that included 14 US presidents, from Harry Truman to Joe Biden. Closer to home, Ken Starr, lead prosecutor in the Clinton-Lewinsky investigation which led to the impeachment of President Bill Clinton, died at age 76.  

Ukraine regained ground in the Russia/Ukraine conflict in what could be a pivotal shift in momentum in the war. The Ukrainian counteroffensive in the northeastern part of the country made impressive gains and, in some cases, pushed Russian soldiers back behind the Russian border. President Zelensky reported that his troops captured more territory in the last week than Russia did in the last five months. German Chancellor Olaf Scholz called on Russian President Vladimir Putin to find a diplomatic solution as soon as possible, based upon a ceasefire, complete withdrawal of Russian troops, and respect for the territorial integrity and sovereignty of Ukraine. This is a developing situation that could have significant implications for geopolitical and economic events in the months ahead.

Peiter “Mudge” Zatko, a famed hacker who served as Twitter’s (TWTR – $41.74) head of security until his firing in January, testified before the Senate Judiciary Committee this week in what could also be a turning point for both Twitter and Elon Musk. Zatko said that in the week before he was fired from Twitter, he learned the FBI told the company that an agent of China’s Ministry of State Security (MSS), the country’s main espionage agency, was on the payroll at Twitter. “This was a big internal conundrum,” according to Zatko since China is Twitter’s fastest growing overseas market for ad revenue. Musk and Twitter head to trial next month to determine whether the billionaire’s $44 billion takeover deal should be completed.

In an odd bit of timing, President Joe Biden celebrated his $430 billion climate change and drug pricing bill, mislabeled as, The Inflation Reduction Act, on the same day that the Bureau of Labor Statistics reported that inflation did not decline in August as expected but in fact rose 0.1%. This squashed burgeoning hopes that inflation was cooling. All three major stock indices turned sharply lower and notched their biggest one-day loss since the throes of the pandemic in June 2020. The Dow Jones Industrial Average fell 1,276.37 points, or 3.94%, to 31,104.97, the S&P 500 lost 177.72 points, or 4.32%, to 3,932.69 and the Nasdaq Composite dropped 632.84 points, or 5.16%, to 11,633.57. All 11 major sectors of the S&P 500 ended the session deep in red territory.

The Basics of Inflation

The stock market’s dramatic reaction to the inflation report was both startling and revealing, in our view. We were surprised at the market’s intense reaction to the fact that neither headline nor core CPI declined on a month-over-month basis. It reveals that neither economists nor investors understand the underpinnings of inflation or the composition of the consumer price index. It also reveals that much of the recent advance was based upon the expectations that inflation was moderating simply because gasoline prices had declined. Again, these were naïve or premature presumptions.

As we have been writing for the last 18 months, the combination of historic monetary and fiscal stimulus in 2021 during an economic recovery, coupled the with signing of The Paris Climate Agreement and reducing carbon fuel supplies, and the Russian invasion of Ukraine was a volatile mix for the world for the following reasons: 1.) Stimulus, monetary or fiscal, during a recovery is inflationary. 2.) Reducing carbon fuels without an immediate plan to replace these energy supplies is foolish and will immediately increase fuel prices. 3.) Russia, a major source of fuel for Europe, has weaponized oil and restricted energy supplies to Europe which is increasing fuel prices. 4.) Ukraine, the breadbasket of Europe, has been demolished and this will result in critical food shortages in the world and raise food prices in coming months.

None of the above are temporary, and only monetary policy is controllable by the Federal Reserve. Nevertheless, the Federal Reserve is responsible for reducing inflation and it will continue to do so by reducing money supply and increasing interest rates. Both will slow the economy and the combination will increase the risk of recession. In our opinion, the Fed will raise rates 75 basis points later this month, with the hopes that inflation will begin to slow, and rates will continue to decrease economic activity.

However, the Fed has been late, and inflation has become systemic, in our view. As we show on page 3, prices are rising in all areas of the economy particularly in housing, food, and medical care. Owners’ equivalent rent has a hefty 23.65% weighting in the CPI, and it rose 6.3% YOY in August. This series tends to move in line with housing prices, but with a multi-month lag, which means rents are likely to continue to rise along with housing and add to inflation even as gasoline prices fall. Auto and lodging prices rose less dramatically in August, but medical prices are seasonal which means they will now switch from tempering inflation to adding to inflation. Note that medical insurance prices tend to rise annually in the fourth quarter when corporate and Medicare contracts are finalized. See page 4. A broadening of inflation can be seen by the fact that while headline inflation fell from July’s 8.5% YOY to August’s 8.3% YOY, core inflation rose from July’s 5.9% YOY to August’s 6.3% YOY.

All of this was predictable for anyone who understands the concept of supply and demand and the composition of CPI. Note that all but one component of CPI is currently growing at multiples of the Fed’s target rate of 2%. See page 5. This indicates the difficulty facing the FOMC in coming months. The US Treasury yield curve is not fully inverted, but it is inverted between the 1-year Treasury and the 10-year Treasury note. And even after a 75-basis point increase in the fed funds rate later this month, the effective fed funds rate would be 3.08% and would still be lower than the current 10-year Treasury yield of roughly 3.42%. Yet what concerns us is the historically large spread between the inflation rate and the 10-year Treasury yield. In the inflationary cycle of 1968 to 1982, inflation exceeded the Treasury yield, but was not broken until the Treasury yield matched the inflation rate – with a lag. Hopefully, it will be different this time and inflation will ease as interest rates rise. But the risk of recession remains high in most any scenario. See page 6.  

There was some good news in sentiment indicators this week. AAII readings showed a decrease of 3.8% in bulls to 18.1% and an increase of 2.9% in bears to 53.3%. These results are in line with the five weeks of less than 20% bulls and more than 50% bears between April 27, 2022 and July 7, 2022. Equity prices tend to be higher in the next six and/or twelve months following such a reading. See page 14. In sum, we remain cautious, particularly in September, and remain focused on sectors and stocks with recession resistant earnings such as energy, utilities, staples, and defense stocks.

Gail Dudack

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US Strategy Weekly: Canary in the Coal Mine

Right after the G-7 agreed to implement a price cap on Russian oil, Russia indicated it would halt gas supplies through Gazprom’s Nord Stream 1 pipeline, Europe’s major supply route, for an indefinite period of time. This was done under the ruse that Siemens Energy (ENR.TI – $14.14), needed to repair faulty equipment. Siemens Energy, which is headquartered in Munich, Germany, said it did not understand Gazprom’s presentation of the situation because it was not currently commissioned by Gazprom to do maintenance work on the turbine with the reported leak, nevertheless, the company would be on standby. This is just one example of how Russia is using energy as a weapon against Europe.

And the Nord Stream pipeline is important because all of Europe is facing a deepening energy crisis which could also become a financial and humanitarian disaster. The humanitarian element of this crisis will hopefully be avoided, but it will play out as cold weather hits Europe and fuel becomes both scarce and expensive.

Canary in the Coal Mine

On the financial side, we see a number of worrisome developments for Europe which are linked to energy. Finland’s Fortum Oyj (FORTUM.HE – 9.2 euro) recently signed a bridge financing arrangement with the Finnish government for 2.35 billion euros ($2.34 billion). Fortum Oyj is a Finnish state-owned energy company that operates power plants and generates and sells electricity and heat throughout Europe. The loan, which carries a steep 14.2% interest rate, was made to cover soaring collateral needs in the Nordic power derivatives market. Over the weekend, the Finnish government had already announced a 10-billion-euro package of credit for the Finnish power industry. CNBC recently discussed the fact that eurozone may require as much as $1.2 trillion in backing for the EU energy derivatives markets as the energy industry faces immense challenges. In short, it is possible that the energy derivatives market may be the canary in the coal mine for a financial crisis in the next twelve months. It is worth monitoring. Meanwhile, it is very clear that European countries are creating major programs that will increase sovereign debt.

Another example is the newly installed UK Prime Minister Liz Truss, who ran on a program to cap energy costs in Great Britain at a cost of $116 billion to the government. Closer to home and totally separate from Europe’s energy predicament, President Joe Biden signed a $1.2 trillion Infrastructure Investment and Jobs Act bill on November 15, 2021 and combined with his $1.85 trillion Build Back Better Act, which became the Inflation Reduction Act of 2022, requires Congress to invest over $3 trillion in national infrastructure and social programs. The impact of these bills on the US deficit is debatable and unknown. Nonetheless, it is no surprise that interest rates are on the rise.

The US Treasury yield curve is not yet fully inverted, but it has been inverted between the 1-year Treasury and the 10-year Treasury note for a few months and this is a warning of an impending recession. But in the last week interest rates have been rising as much as 30 basis points along the curve. This is apt to continue as the Fed increases rates and sovereigns continue to increase debt. See page 3.

Economic Roundup

The ISM manufacturing index was unchanged in August at 52.8 and the non-manufacturing index rose 0.2 to 56.9. Both indices are well below their 2021 peaks. The best component in both surveys was new orders, which rose from 48.0 to 51.3 in manufacturing and from 59.9 to 61.8 in the non-manufacturing survey. Employment was 54.2 in manufacturing and 50.2 in non-manufacturing, and both above 50 for the first time since March. In sum, these were slight improvements. See page 4.

Many feel that the August payroll report was the perfect combination for the Federal Reserve of “not too hot, not too cold” with a job gain of 315,000 and an unemployment rate that ratcheted up to 3.7%. But in our opinion, job growth has been subpar for a while. For the first time in this economic “expansion,” the seasonally adjusted level of employment in the establishment survey exceeded the peak employment level reached in February 2020, but only by a modest level of 240,000. Still, as seen on page 5, the not-seasonally-adjusted level of employment was 152.57 million in August and remained below the November 2019 peak level of 153.1 million.

In short, the monthly numbers do not tell the whole story. There has not been job “growth” in this expansion, in reality, there has barely been a job catch-up to pre-COVID levels. We see this as a critical weakness of the post-pandemic expansion. A normal economic expansion will see new peaks in employment and an accompanying increase in household income and consumption; but in fact, there are fewer people employed today than prior to the COVID shutdown. See page 5. We also noticed that there is a declining trend in the number of people who are “not in the labor force and do not want a job” and a corresponding rising trend in those “not in the labor force but want a job.” See page 6. This desire to return to work may be a sign of financial pressure in many households as the combination of inflation and rising taxes erodes purchasing power.


September is a great month in many ways, but it has a long history of poor stock market performance. Since 1950, the month is the weakest of all 12 months averaging a loss of 0.4%. Data going back to 1931, shows September to be the weakest month with an average loss of 0.9%. Either way, seasonality suggests September is a time to be cautious, particularly since it will include another Fed funds rate hike, earnings warning season, and dollar strength increases the cost of energy for all non-US entities and intensifies the pressure on the European economy.    


Once the rally encountered resistance at the 200-day moving averages, the indices all plunged below all other shorter moving averages. It is a sign that the lows are apt to be tested in the near term. And keep in mind that it is not unusual for a test of bear market lows to generate a new low in price. In our opinion, it is the FANG-type stocks and the stay-at-home stocks that look the weakest currently. This is in line with the fact that the key to a successful retest of a bear market low is whether or not a new low in price also generates a new low in breadth. A successful retest will show there is less selling pressure – a less severe oversold reading — despite a lower low in price. We think this is a possibility in the final months of the year. See page 13. Since we believe there could be disappointments in September in terms of monetary policy, earnings, and a festering energy crisis/recession in Europe, and these risks have not been fully priced into equities, portfolios should be concentrated in sectors where earnings are most predictable and are both inflation and recession resistant. These include areas such as energy, utilities, defense-related stocks, staples, and select healthcare. 

Gail Dudack

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US Strategy Weekly: See You in September

In last week’s Strategy Weekly, we wrote (“Neither Bear nor Bull” – August 24, 2022): “While technical indicators have their bright spots, we feel investors may have become too optimistic too soon. Re-emergence of meme stock investors is one sign that speculation has returned to the market too quickly. Expectations of a Fed pivot this year are quite likely to be wrong, or at least premature. Economic indicators are mixed but many are showing definitive signs of weakness and the possibility of a recession.

Although we were skeptical of the recent rally, from a broad macro perspective, we still believe the equity market is in a bottoming phase. However, we should explain what this means. Toward the end of a classic bear market decline, equities often suffer an intense sell-off on heavy volume which is often accompanied by margin calls. June had many of these characteristics. In subsequent months, bear market lows are typically retested, and it is normal to see the popular averages hit a lower low which can trigger more selling panic. But the distinctive feature of a successful bottoming process in a bear market cycle is that breadth indicators show that the new lower low was made on less volume, accompanied by less selling pressure, with less extreme oversold readings, and with less extreme breadth statistics in general. These are all signs of a waning bear market and a successful test of the low. The rebound from this lower low should also contain a series of 90% up-volume days as further confirmation that the final low has been made.

With this as a historical backdrop, one should expect the June lows to be retested in the second half of the year. And keep in mind that the August-September months tend to be a seasonally weak period for equity prices. Actually, September ranks as the weakest of all twelve months averaging a 0.7% loss over the last 71 years. Although October has a bad reputation and is associated with bear markets, the truth is that October tends to be a “bear killer” or a turnaround month. Twelve of the last 48 declines of 10% or more in the S&P 500 were made in October, far more than any other month. Next in line is March with eight lows and June with seven.


Seasonality does not always work as planned, and it can be overridden by geopolitical or financial events. Still, it is wise to be aware of the seasonal tendencies of equity markets. A retest of the lows in the September/October timeframe makes sense to us for many reasons in addition to seasonality. First, it will be the start of another important earnings reporting season. Despite recent headlines suggesting that second quarter earnings results were “better than expected” the reality is that they were better than the very worst expectations. In truth, earnings for this year and next year came down substantially in recent weeks. The S&P Dow Jones consensus earnings estimate for 2022 fell $13.68 since the end of June. The IBES consensus estimate for 2022 fell $4.21 in the same period. As a result, our recently reduced forecast of $218 for the S&P 500 for this year is under review and may be in jeopardy.

Second, the next FOMC meeting is scheduled for September 20-21, and this will be followed by another meeting on November 1-2. The final Federal Reserve meeting of the year is set for December 13-14. However, the September meeting is the one we expect will set the tone for monetary policy for the rest of the year in terms of how much tightening the Federal Reserve expects it will do in the final months of 2022. More importantly, we believe the consensus will continue to be disappointed regarding monetary policy in 2023. For example, New York Federal Reserve Bank President John Williams recently stated that the Fed will “likely need to get its policy rate above 3.5% and is unlikely to cut interest rates at all next year as it wages a battle against far too high inflation.” That means no “Fed pivot” in the next sixteen months!

Third, September could be the month in which the energy crisis in Europe unravels and heating fuel is rationed. Unrest in Iraq could negatively impact energy supplies. China’s economy appears to be weakening despite several attempts to stimulate activity. Plus, as a result of a landmark audit deal between Beijing and US regulators, Alibaba Group Holdings (BABA – $93.84) will be the first Chinese company to be audited by US audit watchdog – Public Company Accounting Oversight Board (PCAOB) – in Hong Kong in mid-September. In sum, September has the potential of being a very important and eventful month.

Economic Review

The first revision for second quarter GDP indicated growth declined 0.6% versus the initial 0.9% decline. Nonetheless, economic activity weakened for two quarters in a row. Economists denying the first half of the year was a recession may be overlooking the debilitating impact of inflation. On page 3 we show the GDP deflator, which is currently at its highest level since December 1981. Note that similarly high inflation between 1970 and 1984 was a period marked by four separate recessions.

The most important data series, in our view, is real personal disposable income since this is the best measure of potential household demand. Fiscal stimulus bills boosted household income significantly in April 2020 and even more in March 2021, but these gains in personal income were one-time events and artificial. Real personal disposable income per capita was $45,464 in July, down noticeably from the pre-pandemic January 2020 level of $45,747 and down significantly from the stimulus-boosted level of $57,752 in March 2021. Government stimulus in 2021 simply added to inflationary pressures and households are now experiencing both higher prices and relatively lower income. It is a bad combination. Note that personal consumption has increased more than personal income in recent months and is a trend that is unsustainable. See page 5.

Technical Summary

All the popular indices tested their 200-day moving averages last week, but this resistance proved to be overwhelming. Unfortunately, neither the 100-day nor the 50-day moving averages provided support on the subsequent sell-off in the S&P 500, Dow Jones Industrial Average, or the Nasdaq Composite index which implies the June lows are apt to be tested. The 25-day up/down volume oscillator fell to 1.63 and is neutral this week after its mid-August overbought reading for seven of eight consecutive trading sessions. However, the August 26 session was a 91% down day coupled with a 1,008-point decline in the DJIA.

In sum, we expect there will be disappointments ahead in terms of monetary policy and earnings results, and in our view, these risks have not been fully priced into equities. We believe portfolios should be concentrated in sectors where earnings are most predictable and are both inflation and recession-resistant. These include areas such as energy, utilities, defense-related stocks, staples, and healthcare. 

Gail Dudack

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US Strategy Weekly: Neither Bull Nor Bear

Market peaks and troughs are often confusing intervals because both are periods of transition, volatility, and mixed signals. And at risk of oversimplifying the current environment, we expect confusion will heighten among investors and market forecasters based upon the facts that the technical condition of the equity market has been improving while the economic condition of the economy has been deteriorating. This is not an unusual combination at a major low.

It has been our view that the first half of the year was a recession or a recessionary period. This is the good news and the bad news. History shows that stocks tend to bottom out midway or in the latter half of a recession. If we are right about the economy this precedent is positive for today’s investors. However, a recession is also destructive to earnings and while many stocks have discounted a significant decline in earnings growth, this is not true of all stocks. In short, risk remains, and optimism may be a bit premature, especially at recent elevated prices. Although short-term trading opportunities will continue to present themselves, we believe portfolio holdings should be concentrated in sectors and companies that are both inflation and recession resistant, such as energy, utilities, defense-related industrials, staples and healthcare.

Our strategic view has been that 1.) the stock market began a bottoming phase in June, 2.) the major indices have probably seen their bear market lows, but 3.) the lows will be retested in coming months. Our optimism is supported by the fact that some technical indicators are defining a likely shift in long-term momentum from bearish to, at a minimum, neutral.


While technical indicators have their bright spots, we feel investors may have become too optimistic too soon. Re-emergence of meme stock investors is one sign that speculation has returned to the market too quickly. Expectations of a Fed pivot this year are quite likely to be wrong, or at least premature. Economic indicators are mixed but many are showing definitive signs of weakness and the possibility of a recession. A good example of this is this week’s S&P Global Flash US Composite PMI Index which fell to 45.0 in August, down from 47.7 in July. This was the second successive monthly decrease in total business activity, below 50 (contractionary), and was at a 27-month low. Excluding the period between March and May 2020, the decline in total output was the steepest seen since the series began nearly 13 years ago.

The S&P Global Flash US Services Business Activity Index was 44.1 in August, down from 47.3 in July, and the fastest decrease in business activity since May 2020. Service providers noted that hikes in interest rates and inflation dampened customer spending because disposable incomes were squeezed. This decline in spending was predictable in our view. As we have often noted, inflation destroys the purchasing power of consumers, higher fuel, transportation, and raw material costs pressure corporate margins, and while inflation has a negative impact on both consumption and earnings, it also lowers PE multiples. In sum, inflation is a triple threat to investors.

Some economic news was better than expected. Total retail & food service sales were $686.8 billion in July, a 10.3% YOY increase. Excluding motor vehicles and parts, sales were $557.9 billion, a 12.3% YOY gain. Sales of motor vehicles and parts dealers were $124.95 billion in July, a 2.1% YOY gain, and the first real year-over-year gain in autos since February 2022. See page 3. However, after adjusting for inflation, i.e., priced in 1982 dollars, real retail & food services sales were $231.25 billion in July, a much more modest 1.7% YOY gain. Nonetheless, this was the first positive year-over-year gain in real retail sales since February. But in terms of investments, it is important to note the changing composition of retail sales. There have been relative gains for gas stations, food services & drinking places, and nonstore retailers. But as a percentage of monthly retail sales, the losers have been autos, general merchandise, food & beverage, and clothing & clothing accessories stores. See page 4. These shifts in consumption are also reflected in sector performances with energy and utilities the only S&P 500 sectors to show year-to-date gains.

Meanwhile, the housing slump continues. Census data shows new home sales fell from 585,000 units in June to 511,000 units in July, the lowest level since October 2015 and 30% below a year earlier. Existing home sales fell from 5.1 million in June to 4.81 million in July, a 20% drop below the July 2021 level. Nonetheless, the median price of a new home rose from $414,900 to $439,400 in July, up 8% from a year earlier making homes less affordable in a rising interest rate environment. See page 5. And as home sales have been slowing, inventories have been rising. Existing home inventories have increased from the January 2022 low of 850,000 to 1.31 million units in July and the supply of single-family homes increased from 1.5 to 3.3 months in the same time period. Not surprisingly, building permits and starts have been falling in recent months. See page 6.


The S&P Dow Jones consensus EPS estimates for 2022 and 2023 rose $0.06 and fell $0.02, respectively, this week. Refinitiv IBES consensus EPS forecasts rose $0.16 and fell $0.03 respectively. However, the nominal earnings range for 2022 changed to $210.56 to $225.50 and earnings growth rates for this year were unchanged at 1.1% and 8.4%, respectively. But we want to point out that our DRG 2022 estimate was lowered from $220 to $218 in early August, and given the results of the second quarter, and the S&P estimate of $210.50 for this year, our estimate could still be too optimistic. See page 8.


The charts of the popular indices show that stocks had a convincing rally to their 200-day moving averages but have since retreated. See page 9. A test of the 200-day moving average is typical of a bear market rally and is not predictive; but other indicators suggest that the underlying momentum of the rally points to a weakening bear cycle and the possibility that the lows for many stocks may have been made in June.

The 25-day up/down volume oscillator fell to 2.19 this week but it was overbought for seven of eight consecutive days between August 10th and August 19th. It also reached a peak overbought reading of 5.26 on August 18th, the highest overbought reading since December 10, 2020. This is important since extreme and/or long overbought readings are rare in a bear market and if they appear, the readings tend to be brief, or less than six consecutive trading days recently seen. It is also important to note that the last two 90% days were up days on July 19, 2022 (92%) and August 10 (91%), an indication that momentum could be shifting from a bear cycle to, at worst, neutral. Still, the near-term market appears extended. In our view, investors are currently too optimistic that Fed tightening is nearly over, and this could change with Chairman Powell’s speech this week at Jackson Hole, WY. We would remain invested but concentrate on companies with predictable earnings streams and/or above average dividend yields.

Gail Dudack

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US Strategy: Expectations

The current rebound has carried the broad indices between 14% (Dow Jones Industrial Average) and 23% (Nasdaq Composite Index) above their June lows and the rally has created a number of positive technical changes in our indicators. These technical changes are encouraging for the intermediate-to-longer term. Still, we would not be chasing the rally at this juncture. Walmart’s (WMT – $139.37) better-than-feared earnings report for the second quarter, was a sign that some companies are beginning to adjust to the hurdles facing them in this difficult economic environment. But while WMT jumped more than 5% for the day, its earnings report did not suggest the economy and the consumer are about to return to normal. In fact, Walmart’s results suggest that higher income families have shifted to Walmart to buy groceries. This is not a sign of consumer strength, in fact, it appears to be the opposite.

Plus, there are numerous signs that speculation is returning to the equity market. In particular, the performance of meme stocks during the August 16th trading session suggests that “risk” is back in vogue. Bed Bath and Beyond (BBBY – $20.65), halted at least twice for volatility during the day, rose 29%. GameStop (GME – $42.19), also halted for volatility, ended the day with a gain of 6.3%. Meme favorite AMC Entertainment Holdings (AMC – $24.81) rose 2.5%, fuboTV (FUBO – $6.35) jumped 45% and Vinco Ventures (BBIG – $1.13) soared 58.8%. Meme favorites tend to be beaten down stocks with high short interest levels that attract speculators looking for high risk and quick gains. In short, this activity does not represent true equity investors and it is a short-term negative.

We continue to have an overweight rating in stocks and sectors that have the most predictable earnings streams, and these areas also tend to be equities that are both inflation and recession resistant. Sectors such as energy, utilities, staples, and defense-related stocks in the industrial sector have these characteristics. Healthcare, where we have a neutral weighting, is also a “necessity” for most households and also tends to be inflation and recession resistant.  


The return of the speculators suggests that some investors feel the worst is behind us and the economy is about to rebound after a weak and recessionary first half of the year. The University of Michigan consumer sentiment indicator for August suggests there is some truth to that thought. The August reading of 55.1, was up from July’s 51.5 reading and was a nice rebound from the record low of 50 recorded in June. Expectations also rose from a very weak reading of 47.3 in July to 54.9 in August. But strangely, the current conditions index fell from 58.1 in July to 55.5 in August. See page 7. In other words, consumers are not feeling great at the moment, but are hopeful that the future will get better. This may have a lot to do with the decline in gasoline prices in the last four weeks.

This optimism may be supported or upturned by the retails sales report coming out this week. We will be watching to see if real retail and food services sales can turn positive and show gains even after being adjusted for inflation. The last four consecutive months of negative growth in real retail sales is a classic sign of margin pressure on retailers, and a sign that consumers are actually consuming less in real terms. Moreover, it tends to be a sign of a recession. See page 7.

In our view, it is too early to celebrate, or to believe that the Federal Reserve has managed to steer the economy into a soft landing. Monetary policy is as tricky to predict this year as we have seen in many years. Inflation remains a hurdle. July’s CPI was up 8.5% YOY, down from June’s 9.0% YOY, but still extremely high. Core CPI was unchanged at 5.9% YOY last month. PPI for finished goods was 15.5% YOY in July versus 18.5% in June. Core PPI was 8.7% YOY in July versus 8.9% in June. In sum, by all price measures inflation remains well above the long-term average of 3.4% or the Fed’s target of 2%. And though inflation may have decelerated a bit, it remains dangerously high. See page 3. This poses a problem for the Fed. Although the high end of the fed funds target rate has increased from 25 basis points in February to 250 basis points in August, it is likely to go much higher. The reason for this is that the real fed funds rate is still negative 5.2% relative to the CPI and negative 4% relative to the PCE index. This is the equivalent of 520 or 400 basis points, which means it would not be surprising if the fed funds rate increases at least 200 basis points, or more, before it truly impacts inflation. See page 4. Unfortunately, these interest rate hikes will do damage to the economy and to corporate earnings.

Housing is very interest-rate sensitive, and the housing sector’s combined contribution to GDP generally averages a sizeable 15% to 18%. We believe housing is either already in a recession or about to slip into one. And though interest rates may be only halfway through their rise, housing affordability is already at its lowest level since late 1985. The NAHB confidence indices are also plummeting and looking quite bleak. See page 5. Housing prices continue to rise, due in large part to low inventories, but as a result, the median existing home price relative to income per capita at its highest point on record. This, coupled with rising mortgage rates account for the big decline in affordability. Not surprisingly, both building permits and housing starts are rolling over in July, with housing starts falling nearly 10% in the month and down 8% YOY. See page 6. With this as a backdrop, it will be difficult for the Fed to navigate the economy to a soft landing.

Lower crude oil prices will lower inflation in coming months, but this was not a result of monetary policy. Oil prices are down due to signs of progress on the Iran nuclear talks and the possibility that Iran could add a million barrels a day to global production. Also dampening oil prices were the surprisingly weak economic data coming from China (the world’s largest crude oil importer). This was coupled with worries of a global slowdown and signs of massive demand destruction after peak gasoline prices. However, all this could be temporary since the European Union’s embargo on Russian oil is set to take effect in December and could shift the supply/demand balance. In sum, investors may be too optimistic about inflation and a Fed pivot in rates.

We also feel investors are too optimistic about current and future earnings growth. The S&P Dow Jones consensus EPS estimates for 2022 and 2023 fell $6.38 and $1.01, respectively, this week. Refinitiv IBES consensus EPS forecasts rose $0.16 and fell $0.55, respectively, however, IBES does not adjust for actual earnings or adjust for GAAP accounting, which is why we prefer S&P data. Which means with the S&P estimate for 2022 now down to $210.50, a 1.1% YOY gain, we may have to lower our $218 estimate once again. In short, expectations for earnings may be too optimistic.

Technical Indicators Show Promise

The 25-day up/down volume oscillator rose to 4.93 this week, the highest since December 8, 2020, and has been in overbought territory for four of the last five consecutive trading sessions. This is an interesting juncture for this indicator because bear markets rarely record overbought readings and if they do the readings are brief. If this oscillator can remain overbought for five consecutive days this week, it would be a sign that most stocks have already seen their lows and the worst of the bear market is likely behind us. Nonetheless, the current reading of four overbought trading days already implies that the broad market may have seen its worst, and is likely to remain in a wide trading range for the rest of the year. The S&P 500 and Russell 2000 index are currently trading above their 200-day moving averages (MA) and the longer they trade above this key level, the more likely the rally will push higher. However, in all the indices, the 200-day moving average continues to fall, which remains a sign of a bear market trend. At a minimum, we would like to see the 50-day MA better the 100-day MA in each index, to suggest a bottoming trend is in place. In short, things have improved but expectations may be too high. We would not chase stocks here and continue to focus on earnings growth for stock selection.

Gail Dudack

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US Strategy Weekly: TMI (Too Much Information)

This week the BLS will release price data for August, and although we believe it is too little too late, inflation data is getting a lot of attention from market watchers. Investors are hoping that price data will begin to decelerate, and if so, it will ease the pressure on the Federal Reserve to be aggressive in terms of raising interest rates. However, they may be disappointed. A deceleration from the CPI’s 9% YOY pace in June would be nice; yet many are pinning their hopes on the fact that WTI oil futures are down more than 20% from their May close. But this ignores the fact that oil prices are up 33% YOY, a percentage that will continue to add to inflation pressures. Moreover, the geopolitics around energy is complex, volatile, and unpredictable, particularly since the leaders in many oil-producing countries like Brazil, Iraq, Iran, and Russia are facing a multitude of domestic issues, making any long-term forecast for oil prices nearly impossible.

Still, it is clear that inflation data for July and August will be important, and they will set the tone for the next FOMC meeting set for September 20-21. So too will employment data and that is one of our two main topics this week.

Employment Data

The July employment report showed a surprisingly strong monthly increase of 528,000 jobs and an equally surprising dip in the unemployment rate from 3.6% to 3.5%. Given the gloomy backdrop from other surveys such as the ISM manufacturing and nonmanufacturing surveys, this big jump in employment was clearly unexpected.

However, with July’s increase, the total number of people employed in the US rose to 152.54 million, beating the previous record of 152.50 million workers in February 2020 by 32,000. This was important in our view, since the fact that the total level of employment had not exceeded its February 2020 peak was one indication that the post-pandemic recovery was weak. It also helped explain the declines in GDP.

Also in July, the participation rate inched lower to 62.1% while the employment-population ratio rose 0.1 to 60% in July. However, both remained below their respective February 2020 peaks of 63.4% and 61.2%. These ratios show the relationship between the labor force and/or employment to the overall population. What July’s data indicated was that both remain below the 2020 peak levels. See page 3.

One reason for this weakness is that the labor force has been shrinking. In July, those no longer or “not in the labor force” rose to 100.15 million, the highest level seen since October 2021. There can be a variety of reasons for people to leave the labor force, but the percentage of those no longer in the labor force yet indicating they want a job increased to 6.3%, up from the February 2022 level of 5.3%. Separately, discouraged workers jumped from 386,000 to 471,000 in July. Keep in mind that the decline in the labor force is what contributed to the unemployment rate falling in July. See page 4.

Since employment data can have a major impact on monetary policy in coming months, we dug into the data in greater detail and we noticed several interesting things about July’s job report. The establishment survey showed seasonally adjusted employment rising 528,000 to a record 152.54 million, but not-seasonally-adjusted data showed a decrease of 385,000 jobs to 152.25 million. In short, unadjusted employment remained well below its peak of 153.1 million in November 2019. See page 5.

In addition to the establishment survey, the BLS conducts a broader household survey each month. This survey showed July employment at 158.29 million, a bit less than the 158.87 million recorded in February 2020. However, the not-seasonally-adjusted household series showed 159.1 million workers in July, matching the previous October 2019 record. All in all, a deep dive into job data left us questioning whether employment actually reached a record level in July.

And the BLS will add another complication to employment data. On August 24, 2022, the Bureau of Labor Statistics will release a preliminary estimate of the upcoming annual benchmark revision to the establishment survey. These benchmarks are derived from state unemployment insurance tax records that nearly all employers are required to file. A final benchmark revision will be issued with the publication of the January 2023 job report released in February 2023. Since benchmarks adjust data retroactively, it is nearly impossible at this moment to know if employment has really exceeded its February 2020 peak. We are skeptical particularly since seasonal adjustments are done on an active basis and pandemic layoffs have undoubtedly impacted normal seasonal patterns in employment. This may be too much information for some; but since the Fed is required to maintain full employment with moderate inflation, it is important to understand where US employment stands today. We think it could be weaker than the headlines imply.

Employment data is also a tale of the have’s and have not’s. The unemployment rate for workers with a bachelor’s degree or higher was 2% in July, well below the average, whereas the unemployment rate for workers without a high school degree rose to 5.9% in July, well above the headline 3.5%. The US workforce with a college degree has grown from 26% of all workers to 44% in July. It eclipsed all other groups in 2000. However, since the pandemic it is the only group that recovered to peak levels of employment. This means the other 56% of the workforce is yet to recover to pre-pandemic employment levels. See page 7.

Reducing Earnings Forecasts

Our other deep-dive topic is earnings. As we noted last week, financial headlines are full of reports of better-than-expected earnings results for the second quarter, but this too is misleading. Last week we discussed the difference between consensus estimates and whisper numbers. The whisper numbers, primarily among hedge fund managers, were far worse than the actual consensus earnings expectations and from this perspective, earnings were a positive surprise. Nevertheless, the S&P Dow Jones consensus earnings estimates for 2022 and 2023 fell $1.40 and $1.59, respectively, this week. Refinitiv IBES consensus earnings forecasts fell $1.52 and $1.97, respectively. Over the last seven weeks the S&P Dow Jones estimate for 2022 has dropped $7.36 and for 2023 has declined $6.26. IBES forecasts in the same seven weeks fell $4.07 for 2022 and $7.63 for 2023. As a result, the nominal earnings range for 2022 declined and is now $216.88 (S&P) to $225.50 (IBES). EPS growth rates for this year fell to 4.2% and 8.4%, respectively. To adjust for the weakness seen in second quarter earnings, we are lowering our DRG 2022 estimate from $220 to $218 and our 2023 estimate from $240 to $237, and fear that there may be more downside risk to these estimates. See page 10.   

Technicals Of all the indices the Russell 2000 has had one of the best performances from its June low. This is encouraging. We used the RUT as a leading indicator at the top and it may prove to be a good predictor of the low as well. Our 25-day volume oscillator is approaching an overbought reading. Bear markets rarely have overbought readings, and if they do, they are brief. Therefore, the current rally may be at a turning point. Without follow through in coming sessions and a solid overbought reading in this indicator, we would label the current advance as a bear market rally. We continue to focus on recession-resistant stocks and sectors. See page 15.

Gail Dudack

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US Strategy Weekly: Perception versus Reality

Earnings, and earnings growth, are the bedrock of the equity market. And they can be especially important in an environment like the present where recession fears are plentiful. Therefore, we continue to focus on second quarter earnings results, yet we are having trouble reconciling perception versus reality in this department.

According to Reuters, “US companies are reporting mostly upbeat news this earnings season, surprising investors who had been bracing for a gloomier outlook on both businesses and the economy. More than halfway into the second-quarter reporting period, S&P 500 company earnings are estimated to have increased 8.1% over the year-ago quarter, compared with a 5.6% estimate at the start of July.” However, data from IBES Refinitiv shows that their S&P 500 earnings estimates for 2022 and 2023 fell $1.25 and $2.02, respectively last week, after rising only a penny for 2022 and falling $0.78 for 2023 a week earlier. Similarly, forecasts from S&P Dow Jones indicate earnings estimates fell $2.42 and $2.91, respectively, last week and fell $2.48 and $0.36, respectively, a week earlier. These sharp drops in estimates during peak earnings season hardly support the statement of “better than expected” earnings in the second quarter.

However, Howard Silverblatt, Senior Index Analyst at S&P Dow Jones Indices, may have said it best in the U.S. Equities Market Attributes July 2022 (August 2, 2022) report. He noted that: “while earnings for Q2 2022 were expected to increase 13% over Q1, the whisper numbers were much lower, as was the concern over the second-half guidance. However, actual earnings (72.1% reported) did not make the expected 13% gain and now indicate a 7% gain, which is a headline disappointment for some, but not if you were one of those money managers (or traders) who traded into the whisper numbers (and sold). For them, it was an unexpected beat and a time to reallocate

In other words, hedge funds were positioned for sharp earnings declines and were relieved at the actual numbers, even though they did not beat the consensus estimates. This is quite different in our opinion from an actual increase in earnings growth — which did not materialize. In fact, the nominal dollar earnings range for 2022 fell to $218 (S&P Dow Jones) and $227 (IBES). S&P Dow Jones and IBES earnings growth rates for this year sank to 4.8% and 9.1%, respectively. And while second quarter earnings season is less than 75% complete, we find that our DRG 2022 estimate of $220, a 5.7% YOY increase from $208.19 in 2021, is at risk and is currently under review. See pages 11 and 18.

Moreover, what the Reuters article failed to mention is that even though the IBES report shows an overall blended earnings growth estimate of 8.1% for the second quarter, if the energy sector is excluded the earnings growth rate falls to negative 2.5%. This was an important omission. And we would advise monitoring the much-discussed Senate’s Inflation Reduction Act since it would currently reinstate the Superfund tax on crude oil and imported petroleum at 16.4 cents per gallon (indexed to inflation) and increase other taxes and fees on the fossil fuel sector. Obviously, this would hurt S&P earnings since so much of the earnings growth in the last 18 months has come from the energy sector. More broadly, the bill would instate a minimum 15% tax rate on all corporations. This again, would negatively impact earnings. In sum, we are not finding comfort in second quarter earnings results or current fiscal policy.

Monitoring Economic Data

With first quarter GDP growth already inked at negative 1.6% and second quarter falling 0.9%, the US economy is technically in a recession. Many will be debating this issue in coming months, but the calculation for GDP makes it rather difficult to record a negative number after a negative quarter. In short, 2Q22 GDP implies economic activity continued to slide in the April through June period. The GDP price deflator also jumped to 7.5% YOY in the quarter, the highest pace seen in this indicator since the December 1981 report of 8.4%. Note that the December 1981 reading took place in between the 1980 and 1981-1982 recessions. These two recessions were also triggered by Fed rate hikes as monetary policy struggled with an inflationary cycle. See page 3.

The ISM manufacturing index fell to 52.8 in July, the third consecutive monthly decline, the fourth decline in the past six months, and remaining below a six-month average of 55.5. New orders declined from 49.2 in June to 48 which is the second consecutive month that new orders were below the neutral threshold of 50. All in all, this is a display of declining momentum in manufacturing. See page 4.

Homebuilder confidence fell from 67 in June to 55 in July and is at its lowest level since early 2020. The June pending home sales index fell from 99.6 in May to 91.0 in June, which was the lowest reading since the March/April 2020 recession readings and the third lowest since data began in 2018. Still, the homeownership rate edged up to 65.8% from the first quarter reading of 65.4%, with the strongest gains seen in the South and West sections of the country. The housing sector began to slow well before the Fed increased rates this year and we expect it will continue its slump throughout the second half as interest rates continue to rise. See page 5.

The personal savings rate fell from 5.5% to 5.1% in June and sits at its lowest level since the 2008 recession. Real personal disposable income, which was $15.10 trillion in June, remains below its pre-pandemic February 2020 level of $15.16 trillion and is one sign of potential weakness in consumption. And despite recent monthly job reports, this does not tell the whole story. Total employment remains more than half a million jobs below its February 2020 peak level. See page 6. Inflation has also changed household spending patterns. See page 7. In the 18 months ending in June, household spending for gasoline and other energy goods increased 106%, transportation services increased nearly 50% and food services and accommodations rose nearly 45%. These increases have reduced household consumption of things other than energy and food. See page 7.

With the yield curve nearly inverted, the debate about whether or not more rate hikes will be implemented this year will intensify. Nevertheless, June’s personal consumption expenditures index, the favorite inflation measure of the FOMC, indicated price trends were accelerating and the index rose 6.7% YOY, the highest rate since January 1982. Excluding food and energy, the PCE index is rising at a 5% YOY pace, the highest since records began in 1987. This report implies more rate hikes are required to tame inflation. See page 9.

Multiple Signs of Recession

The WTI crude oil future is at $94.42 and below its 200-day moving average now at $94.70. The longer the future trades below the 200-day MA, the more likely oil prices will fall further to the $80-$85 range. This decline in oil would bring relief to future inflation, but it is not a result of Fed rate hikes. More exactly, energy is falling due to fears of weakness in China’s economy, as a result of shutdowns, weakness in manufacturing and troubles in the real estate sector. Meanwhile, the 10-year Treasury note yield at 2.74%, having recently reached an intra-day low of 2.52%, has become very volatile and is signaling economic weakness. With the fed funds future at 2.5%, a falling 10-year Treasury yield increases the likelihood that the entire Treasury yield curve will invert resulting in a classic sign of a recession.

And lastly, Technicals The recent equity rebound carried all the indices up to their 100-day moving averages which are now at roughly DJIA: 32,719; SPX: 4,119; NAZ: 12,335; and RUT 1,873. However, only the Nasdaq Composite is currently trading above its moving average. These moving averages are only first-level resistance points, yet they could prove to be pivotal for the intermediate term. At present, the market appears to be wobbling at this resistance level. In sum, we continue to maintain a relatively cautious stance focusing on stocks where earnings are most predictable, even in a recession. In general, this equates to energy, staples, utilities, and defense stocks.

Gail Dudack

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US Strategy Weekly: A Fed Primer

This is a week filled with potential market-moving events that include the July FOMC meeting, the first look at second quarter economic activity and 172 earnings results for companies in the S&P 500 index. Each of these events will have important implications for equity investors, but in our view, second quarter earnings results will be the most significant since these will help define where value is found in the equity market.

75-basis points and the Treasury Curve

In terms of monetary policy, the consensus is expecting a 75-basis point increase in the fed funds rate this week and we think this should prove accurate. In recent months the Fed has had a pattern of either matching consensus expectations for monetary policy changes or signaling its intentions well in advance of changes. In short, the Fed displays no desire to surprise, or stress, the financial markets and as a result, the expectation of a 75-basis point hike is probably discounted in current stock prices. However, we are less certain that the longer-term ramifications of a 75-basis point increase has been fully priced into equities, particularly if the economy slips into a recession.

The Treasury yield curve is currently flat, although it is technically inverted between the 6-month and 10-year Treasury note benchmarks. This makes a 75-basis point increase on the short end of the curve important since it is possible that the entire yield curve could invert shortly after the July Fed meeting. Keep in mind that a 75-basis point increase this week and the 75- or 50-basis point increase expected in September could raise the short end of the curve as much as 150 basis points. See page 3.

What makes the Treasury yield curve important at this juncture is that it has been better than most economists in terms of predicting a recession. A long history of the Treasury yield curve, focusing on the 1-year to 10-year curve, shows that in nine of the eleven inversions since 1956, an inverted yield curve has been followed by an economic recession, typically within eight months. (The range has been zero months (1957) to fourteen months (1978).) The only exceptions to this were in September 1966 — when a five-month inversion was not followed by a recession — and in September 1998 — when a four-month inversion did not result in a recession. Yet more recently, as in 2000, 2006 and 2019, inverted yield curves were followed by a recession within six to eight months. See page 4.

Quantitative Tightening and Money Supply

Yet as we focus on the fed funds rate and the yield curve, it is important to point out that rates are not the only tool in the Fed’s arsenal. While the Fed is expected to raise rates at each meeting this year, it also has indicated its intention to shrink its balance sheet. The $1.6 trillion increase in the Fed’s balance sheet between January 2021 and March 2022 was implemented during an expanding economy and it was a contributing factor to the stock market’s advance and current inflation. However, as of June 1, 2022, the Fed began reducing the reinvestment of principal payments in Treasury securities by $30 billion per month and will increase this amount to $60 billion per month beginning September 1st. For agency debt and agency mortgage-backed securities, the reinvestment reductions are $17.5 billion and $35 billion per month. In short, the liquidity balloon that has been propelling stock prices higher since early 2020 is slowly deflating. But this is important in terms of reducing money in circulation, or money supply.

Another part of the Fed’s stimulus program was the elimination of required reserves for banks. The removal of this requirement in March 2020 resulted in a huge jump in excess reserves in the banking system and a massive increase in money supply. See page 5. This was an unusual tool for the Fed since there are laws that require banks and other depository institutions to hold a certain fraction of their deposits in reserve, in very safe, secure assets. This has been a part of our nation’s banking history for many years and “required” reserves are designed to ensure the liquidity of bank notes and deposits, particularly during times of financial strains.*

Nevertheless, in March 2020 the banking system was suddenly awash in liquidity. The 6-month rate-of-change in M2 (i.e., M2 money stock – a measure of the amount of currency in circulation) jumped to 19.5% in July 2020, an all-time record. The linkage between money supply and inflation is well-known by economists and was surely known by Fed officials. Yet this was the quandary of 2020 and 2021 for economists, strategists, and investors. Money supply fuels inflation but it also fuels stock prices. It was a double-edged sword. However, as liquidity is now being withdrawn to temper inflation, the underlying booster for equities is gone. Unfortunately, the longer-term problem of inflation remains.

GDP and Housing

Second quarter GDP will be released this week and it may answer the question of whether the US is currently in a recession, or on the brink of one. We continue to focus on the housing sector since it represents 17% to 19% of GDP in any given quarter. Unfortunately, recent news releases have not been encouraging. New home sales were 590,000 in June, down 17.4% YOY and down from 642,000 units in May. The average price of a single-family home fell to $456,800 in June, the lowest price in 12 months, but still up 5.8% YOY. The NAR affordability index dropped to 105.2 in May, which was its worst level since August 2006. However, the June, July and August readings are apt to move lower as the impact of rising mortgage rates negatively impacts potential buyers. See page 7.

Earnings and Valuations

To date, second quarter earnings season has been mixed, but a clearer picture may be available by the end of the week, or once we pass the midpoint of earnings season. We are noticing that many companies are making or exceeding revenue forecasts but are missing estimates on the bottom line. This was to be expected due to the rising cost of labor, transportation, and raw materials, but it is not good for earnings overall. Last week, the S&P Dow Jones consensus earnings estimates for 2022 and 2023 fell $2.48 and $0.36, respectively. Refinitiv IBES consensus earnings forecasts rose $0.01 and fell $0.76, respectively. This disparity between S&P Dow Jones and IBES is typical in the second half of the year since S&P adjusts earnings for GAAP accounting while IBES simply aggregates estimates. We measure “value” in the equity market by the S&P Dow Jones data.

Following S&P’s cut in its 2022 forecast to $220.21 this estimate is now in line with our forecast of $220, a 5.7% YOY increase from $208.19 in 2021. This earnings quarter will be important, and we will be looking closely at margins and the impact margin pressure may have on our $220 forecast.

All in all, none of this changes our view that the equity market is bottoming but may not have found its ultimate low. We continue to emphasize that recession/inflation proof segments of the market like energy, staples, defense-related stocks, and utilities where earnings are most predictable in this difficult environment. *

Gail Dudack

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