US Strategy Weekly: American Families Plan and Housing

Monetary and fiscal policy will be in the spotlight this week. The FOMC meets Tuesday and Wednesday but no significant changes in monetary policy are expected. Federal Reserve Chairman Jerome Powell’s Wednesday afternoon statement will be followed by President Joe Biden’s first major address later that evening. Biden’s first appearance to a joint Congress takes place on the eve of his 100th day in office. Although newly inaugurated presidents typically address a joint Congress a month after they are inaugurated in January, this administration delayed the address to April due to “complications with the ongoing coronavirus pandemic.”

American Families Plan

Biden’s address will be widely covered, not only because it is his first major speech, but because it will highlight the administration’s American Families Plan, which the financial media expects will detail a $1.8 trillion spending and tax plan. President Biden may focus more on the hundreds of billions of dollars itemized for national childcare, prekindergarten, paid family leave, tuition-free community colleges, subsidies for the Affordable Care Act and other domestic programs. But Wall Street will be listening to hear how this plan will be funded. Most expect about a half-dozen tax hikes on high-income Americans and investors and many of the proposed changes are already eliciting fierce opposition in Congress and on Wall Street.

Keep in mind that this proposal represents the second part of Biden’s “Build Back Better” agenda, and it follows the $2.3 trillion jobs and manufacturing proposal the White House released a few weeks ago. If one includes Biden’s American Rescue Plan Act of 2021, a $1.9 trillion stimulus package which was passed in early March, the three plans total approximately $6 trillion in new spending and would be one of the most ambitious government overhauls of the economy since the Johnson administration.

Capital Gains Tax Hikes

Gathering the most attention and controversy about how the American Families Plan will be financed is the proposed capital gains tax. To finance the proposed spending, the administration hopes to raise the capital gains tax rate for people making more than $1 million from 20% to 39.6%. Note that the Affordable Care Act includes a 3.8% surtax on all capital gains. This would still be in force and would push the real capital gains tax rate to 43.4%. If passed, it would translate into the highest maximum capital gains tax rate in history. See page 3. Unfortunately, what some politicians fail to grasp is that raising the capital gains tax rate rarely, if ever, generates the tax revenue that is predicted. The reason is that tax laws change people’s behavior. Raising the capital gains tax rate may prove to be a boon for tax lawyers and accountants since they will find ways for clients to avoid taxes. Investors will invariably change their investment strategy, shift assets to trusts or move assets out of the US. As a reminder, when the tax laws changed and only made mortgage interest payments tax deductible, investors borrowed against their home to fund colleges, autos, home improvement and other personal loans. Government officials fail to understand this change in behavior. Projected revenue from a tax policy change will rarely be a straight line.

Moreover, a hike in the capital gains tax rate is always bad for stockholders. The reason is that a higher capital gains tax changes the risk-reward ratio for investors, in a negative way. The 39.6% would be the highest rate on capital gains in any global country and this would have a negative impact on foreign investment in the US. This means those who do not make $1 million or more will still be hurt by this potential tax hike. However, most strategists do not believe the bill will pass as proposed. We hope this proves correct.

Housing is On a Roll

March housing data was strong. Although still below the peaks recorded in November 2020, the National Association of Homebuilders’ single-family housing sentiment was generally higher in March. Traffic was the most improved segment of the survey at 75 versus 72 in February. Both new residential permits and housing starts rose in March on a month-over-month and year-over-year basis. Permits hit a record high in January; housing starts reached a record high in March 2021. See page 4. Housing received a big boost in 2020 from fiscal stimulus and stay-at-home restrictions. The massive fiscal stimulus seen in early in 2020 had a direct impact on median existing home prices. See page 5. Housing inventory is currently low, and this lack of supply will continue to support prices in the coming months. New home sales rose 66.8% YOY from a depressed March 2020 level and prices increased 6% YOY. Single-family existing home sales grew 12.3% YOY and prices jumped 11.8% YOY in March. See page 6. However, homeownership hit a cyclical peak of 67.9% in June 2020 and fell to 65.6% at the end of March. And despite the much-touted mass exodus from the Northeast to Florida, the South had the sharpest decline in homeownership, which fell from 71.1% in June 2020 to 67.4% in March. In the same time frame, Northeast homeownership fell merely 0.2%. See page 7. This decline in US homeownership rates is favorable since it implies there is more future demand for housing.

Earnings on a Roll

The best part of the last week has been first quarter earnings season. Early in the year, Refinitiv IBES consensus estimates were forecasting a 14.5% YOY growth rate for the first quarter, but as earnings season progresses, we have seen estimates rising sharply. IBES now assesses earnings will increase over 35% in the first quarter. To date, 85% of companies reporting first quarter results beat expectations. To date, all energy, healthcare, technology, and communications services companies have beaten their forecasts and have had positive surprise factors of 434%, 15%, 12%, and 8.6%, respectively. In aggregate, companies are reporting earnings that are 23% above estimates, which compares to the long-term average surprise factor of 3.7%. This display of earnings power is providing an excellent foundation to the current rally. 

Technical Indicator Review

There are good points to the market’s technical backdrop, and this includes the new highs in the NYSE cumulative advance-decline line on April 26 and the new high list which is averaging a strong 477 new highs per day. But higher prices do not impress us if volume is not supporting the advance. The 25-day up/down volume oscillator is currently 1.99 (preliminary) and neutral this week despite the new highs in the popular indices in recent sessions. This indicator was last overbought for five consecutive trading days between February 4 and February 10 which is when many momentum indicators peaked. At present, our indicator is revealing that the indices are moving to new highs on lower volume – a sign of diminishing demand. The longer this persists, the more worrisome it becomes. However, we should point out that prior to the March 2000 peak, this oscillator had not generated an overbought reading since November 1998 (17 consecutive days in overbought). This 16-month period of price advances without confirmation from advancing volume predicted a significant decline. At present, we have a 10-week non-confirmation, which is concerning, but not a sign of a bear market. Sentiment is also problematic. The AAII bullish sentiment for April 21 fell 1.1 points to 52.7% and has been above average for 21 weeks. Bearishness fell 4.1 points to 20.5% and is below average for the 11th time this year. Historically, periods of above-average bullishness and below-average bearishness have been followed by below-average 6- and 12-month equity performances. In sum, there is good news in the earnings backdrop, potentially negative news in the political scenario, and a mixed bag in the technical condition of the stock market. In our view, equities are apt to see a 5% to 10% correction in the second quarter – and this would be the healthiest development for investors.

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US Strategy Weekly: Does the Market Believe the Fed?

The financial media is asking whether the stock market believes the Fed in terms of its future plans for monetary policy, and we feel the only answer to this question is yes. In fact, the answer is obvious since the indices would not have made all-time highs earlier this week if investors did not believe Chairman Jerome Powell and the Fed. Based upon the unprecedented fiscal and monetary stimulus promised by the federal government and the Federal Reserve, we believe investors should maintain a bullish bias. But at the same time, we remain very alert to anything that could jeopardize the consensus view that the economy will remain strong, interest rates will remain low, and earnings growth will continue to be solid in 2021 and 2022. In our opinion, there are risks to this view and they include the 9.5 million people unemployed, rising crude oil prices and margin pressure threats. So, the better question would be should the market believe the Fed?  

The Fed will be meeting this week and reporting on Wednesday when it will release both economic and interest rate forecasts as well as its statement. These will be closely analyzed by economists. Most expect the Fed’s statement will imply that interest rates are not likely to be raised until 2023. However, the consensus view regarding the end of quantitative easing has shifted to this November from November 2022. We do not expect the Fed will upset the consensus this week, particularly with a new administration in office for barely two months. But recent data shows there could be a growing inflation scare materializing in coming months. In sum, be bullish, but stay on high alert.

Inflation Can Bite

February’s inflation data was comfortably benign on the surface with headline CPI rising 1.7% YOY and core CPI rising a subdued 1.3% YOY. However, as seen in the table on page 3, February’s inflation was restrained by the 3.6% decline in apparel. Meanwhile most components of the CPI rose faster than the headline level. Fuel and utility prices rose 3.4% YOY while food and beverage prices rose 3.5% YOY. This means that prices of household necessities were increasing at a 3.5% YOY pace, well above the headline rate. In February, the PPI for finished goods rose 2.4% YOY and PPI for final demand rose 2.8% YOY. However, all inflation measures are impacted by the price of oil, which at the end of February was up 27% year-to-date and 37% YOY. In fact, at the current crude oil price of $64.97, oil prices are up 34% year-to-date and possibly up 220% YOY at the end of March. This will have a significant impact on March inflation data. In fact, even if the PPI for finished goods remains unchanged in March it will still be up 4.1% YOY. In our view, inflation comparisons will become very unfriendly as we approach the anniversary of the lows of March and April 2020.

Economists focus on core CPI due to the fact that food and energy prices can be erratic. Food prices are often impacted by droughts, storms, and other natural disasters but prices usually recover in a new planting season. Fuel prices can be influenced by politics and other temporary factors that change the short-term supply/demand balance. And as seen in the charts on page 4, energy prices have been extremely volatile since OPEC’s oil embargo of October 1973.

Energy prices dropped dramatically in response to the shutdown of the global economy last year, and this has kept Inflation subdued. However, that benefit is fading and could clearly reverse with vaccines becoming more plentiful and with an administration that is unfriendly to the energy sector. See page 5. Rising fuel costs will have many repercussions; and in 2021, the trend in crude oil may be a key driver of interest rates. We previously pointed out the strong connection oil and interest rates have had since 2015. At present both appear to be moving higher in tandem. See page 6. The consensus view is that a 10-year Treasury yield above 2.4% could negatively impact Fed policy and rates of 2.8% or more will hurt the economy. Rising inflation will also decrease the buying power of consumers and thereby lower corporate profits. Note that for most of the last eight years, average weekly earnings have grown well above the rate of inflation. But as inflation rises, this could shift and thereby restrain consumption. All in all, rising crude oil prices threaten monetary policy, interest rates, household consumption, the economy, and earnings. We see rising crude oil prices as the number one threat of the year.

The chart of the 10-year Treasury yield shows it has broken above resistance at 1.45% and technically this points to a new higher trend for interest rates. The first range of resistance is seen at the 1.75% to 1.85% level and secondarily at 2.1%. However, the more substantial resistance is noted at 2.4% which is the level that most economists believe would threaten the Fed’s current easy monetary policy. The chart suggests this is possible. See page 7.

Retail sales fell a disappointing 3.0% in February, but still rose 6.3% YOY. As seen on page 8, February’s 6.3% increase was down from a 9.5% gain in January. Declines were substantial and broadly based with only gas stations rising 3.6% and grocery store sales rising 0.1% for the month. Year-over-year changes were diverse, ranging from negative 17% at restaurants to positive 25.9% at nonstore retailers. These sales declines were the result of fading federal stimulus, but February should be a one-off statistic since another round of stimulus checks will begin to reach consumers in March.

The NFIB small business optimism index ticked up from 95.0 in January to 95.8 in February, but the report was fairly glum with sales expectations, the outlook for expansion, and inventory plans all falling two points apiece. Capital expenditure plans and hiring plans each rose one point. The outlook for business conditions rose from -23 to -19 and credit expectations fell from -3 to -6. In general, the NFIB survey report was uninspiring. See page 10.

New 2022 S&P Earnings Estimates

This week S&P Dow Jones initiated a 2022 S&P 500 earnings estimate of $199.50 which joins the Refinitiv IBES estimate of $201.64. We are also initiating a 2022 earnings estimate this week at of $200. This represents an 18.6% gain over our 2021 estimate of $168.60. Note that a 20 PE multiple to earnings of $200 equate to an SPX target of 4000. See page 12 and 19.

Technical Update

The 25-day up/down volume oscillator is currently 1.55 (preliminary) and neutral this week despite the March 15 highs in all the indices. However, if the indices continue to move into new high ground, we should see this indicator attain another overbought reading to demonstrate that volume is confirming price moves. This oscillator was last in overbought territory for five consecutive trading days between February 4 and February 10 when several momentum indicators peaked. Five days overbought is a minimum confirmation for any bull market advance. See page 14.

The 10-day average of daily new highs is 496, well above the bullish 100 which defines a bull market. The 10-day average of daily new lows (68) is below the 100 that defines a bear market, yet it is well above the 10 or less that signals an extreme in a bull market advance. The 10-day new high average reached 521 on February 17, exceeding the 489 recorded January 22, 2000. We view this as a potential yellow flag since the 2000 advance peaked in March. The A/D line made its last confirming record high on March 15, 2021, which is positive. AAII bullish sentiment for March 11 rose 9.1 points to 49.4%, a 16-week high, and has been above average for 15 of the last 17 weeks. Bearishness fell 1.8 points to 23.5% and is below its historical average of 30.5% for the fifth consecutive week. The 8-week spread remains neutral. In sum, the lack of extremes in all the technical indicators is positive for the bulls.

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US Strategy Weekly: Momentum and Mania

There is no doubt that the current equity market is displaying significant positive momentum. This is made clear by the fact that the Russell 2000 index has been core to price leadership in 2021. In fact, the iShares Russell 2000 Value ETF (IWN – $152.31), the iShares Russell 2000 ETF (IWM – $225.83) and the iShares Russell Growth ETF (IWO – $329.01) are all beating other indices with gains of 17.2%, 16.7%, and 16.5%, respectively. This compares to the 6.3% year-to-date gain in the SPY. See page 14.

Similar but Different from 2000

Several technical indicators are confirming the advance. The NYSE cumulative advance decline line is corroborating the advance with a record high as of February 12. Our favorite 25-day up/down volume oscillator is neutral this week but recorded five consecutive trading days in overbought territory last week. In this indicator, five to ten consecutive days in overbought territory is a sign that persistent buying pressure is supporting the move. See page 10. Even more impressive has been the 10-day average of daily NYSE new highs which hit 514 this week, exceeding both the 10-day average of 492 made on January 20, 2021, and the previous record of 489 made January 22, 2000. See page 11. This last point should also come as a warning flag to investors since the strong market breadth seen in January 2000 preceded the bull market peak made in March 2000 by less than two months. However, the 2000 market was driven by both momentum and more importantly a mania for stocks. Today’s market appears to be a bit different. First, the equity advance is much broader today than the narrow bull market of 2000. Second, valuations were far more stretched in March 2000 than they are at present. Third, the mania for stocks seen in 1999 and early 2000 is not apparent, at least not yet.

Too Dangerous to Short

Normal sentiment indicators are surprisingly benign. The ISE Call/Put Volume ratio remains neutral. AAII bullish sentiment for February 11 jumped 8.1 points to 45.5% and bearish sentiment declined 9.3 points to 26.3% which puts it below its historical average of 30.5% for the first time this year; nevertheless, the 8-week bull/bear spread remains solidly neutral. On the other hand, February’s Bank of America survey of 225 global institutional, mutual and hedge fund managers did reveal a surprising level of bullishness. Cash levels in these investment portfolios dropped to 3.8%, the lowest level since May 2013. (This 2013 benchmark is significant since it coordinates with a Treasury bond sell-off triggered by Federal Reserve Chairman Ben Bernanke when he indicated his intention to taper bond purchases.) A net 91% of money managers indicated that they expect a stronger economy. This is the highest percentage reading in the history of the survey. One concerning fact is that only 13% of participants indicated they were worried about an equity market bubble. About 53% of all managers felt equity markets were in a late-stage bull market while 27% believe the bull market is still in its early stages. Equally notable, a net 25% of the investors surveyed said they were taking “higher-than-normal” risks at the present time. This was the highest percentage ever recorded. The most crowded trades were long technology and bitcoin and short the US dollar. Although this survey gives us concern, we believe it would be extremely dangerous to short this market at this time.

Consensus 2022 Hits $200

One reason it could be unwise to short the current market is that consensus S&P earnings for 2020 and 2021 continue to move upward. For this year and next, S&P Dow Jones consensus earnings estimates rose $0.08 and $0.22, respectively, and Refinitiv IBES consensus estimates rose $0.61 and $0.66, respectively. Full year 2021 earnings forecasts for S&P Dow Jones and IBES are now $170.77 and $173.70, respectively. But it is most important to note that the IBES consensus estimate for 2022 has exceeded $200 for the first time and is currently estimated at $200.41. Applying a 20 PE multiple to this estimate equates to a target for the SPX of 4000. In short, one could argue that the market is not wildly overvalued – just discounting future earnings.

What Could Upset the Apple Cart?

However, this last statement – just discounting future earnings — is dangerous since no investor can actually predict the economy, stock market or earnings two years in advance. With this in mind, it is prudent to think about what could go wrong with the two factors that underpin the bullishness of professional investors today — strong fiscal stimulus and easy monetary policy. In short, what could upset the apple cart?

The Democratic majority in Congress and the White House makes fiscal stimulus relatively predictable for 2021. But what about monetary policy? As we previously noted, low interest rates, high liquidity, and a benign Fed are the perfect recipe for speculators. Therefore, it is not surprising that a net 25% of the investors surveyed by Bank of America, the highest percentage ever recorded, said they were taking “higher-than-normal” risks today. However, keep in mind that as interest rates rise the risk/reward ratio for speculators will also change and at some point, potential risk will outweigh potential rewards. In a word, the risk for 2021 could be inflation.

The Biden administration has been quickly reversing the energy policies of the Trump administration and oil prices have been rising accordingly. This coupled with the freezing temperatures in Texas which are disrupting energy transportation while increasing demand for heating needs, have boosted the WTI future above $60 this week. This is a 35% YOY increase. It is likely to move higher and thereby be the driver of higher inflation in 2021. See page 3.

At the end of 2020, all inflation benchmarks were stable and hovering around 1.4%. This 1.4% level is good for both consumers and businesses as well as for Federal Reserve policy. However, history has shown that a sharp rise in crude oil pricing will not only negatively impact the CPI but will be the catalyst for higher long-term interest rates. This is already happening. The 10-year Treasury note yield is currently at 1.2% which is higher than any time since the pandemic struck in March 2020. See page 4.

On a not-seasonally-adjusted basis, January’s CPI rose 0.4% month-over-month and 1.4% year-over-year. Yet, January’s benign 1.4% inflation rate was contained by a seasonal 2.5% YOY decline in apparel and a 1.3% decline in transportation. The decline in transportation inflation is expected to be a temporary phenomenon. Fuel prices peaked in December 2019 at $61.06 and fell to $18.84 at the end of April 2020. In short, the easy year-over-year comparisons for fuel prices are behind us. See page 5. Charts of the crude oil future and the 10-year Treasury note yield index show the correlation between the two, but more importantly, the 10-year yield chart shows that there is resistance at the 1.4% yield level. If 1.4% is exceeded, it could indicate much higher levels for interest rates. Not only would inflation put pressure on interest rates and the Fed in terms of its easy monetary policy, but it could also force the FOMC to adjust its long-term outlook. A change in monetary policy is the opposite of what the consensus is expecting in 2021 and it could shock the equity market. In sum, do not fight the Fed, but beware of what could change the Fed’s outlook.

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US Strategy Weekly: Earnings Rising

Last week we outlined eight factors that typically identify a stock market bubble and discussed where we believe the current market stands in regard to each. One important and obvious characteristic of an equity bubble is that prices disconnect from valuation. Yet as we noted last week, while current valuation levels are rich, they are not at the inane levels often recorded at a bubble peak. We quote: “In short, fundamentals may be stretched today, but interest rates are low which means a 20 PE for 2021 is within our model’s fair value range. It will not be a surprise if valuations get even more stretched in coming months. All in all, equities are disconnecting from fundamentals, but this may continue for a time.” (US Strategy Weekly “And if it is a Bubble” January 27, 2021)

What is currently in the market’s favor is that this year’s consensus earnings estimate for the S&P 500 Composite is on the rise. According to Refinitiv IBES, to date, of the 203 companies in the S&P that reported fourth quarter earnings, 84% have beaten expectations. This is well above the long-term average of 60.5%. The blended earnings estimate for the fourth quarter now shows a decline of 1.2% YOY versus the decline of 10.3% YOY expected on January 1. Excluding the energy sector, IBES estimates fourth quarter earnings should actually rise 2.4% YOY, which would end three consecutive quarters of negative earnings comparisons for the S&P. In addition, energy sector earnings are expected to rebound sharply in 2021 and this should give an added boost to 2021 results.

At the end of last week IBES estimated 2020 consensus earnings were $138.71 and due to differences in accounting standards, S&P Dow Jones estimated earnings of $121.37. With only two more days of fourth quarter earnings results, IBES raised its 2020 estimate to $139.21. All told, fourth quarter earnings have been a pleasant surprise for investors.

Fourth quarter results are also a positive catalyst for 2021 earnings forecasts. At the end of last week, IBES estimated 2021 S&P earnings to be $171.55, but after two more days of earnings results, their estimate increased to $172.05 this week. S&P Dow Jones forecasted $169.39 for S&P 500 2021 earnings in their regular report at the end of last week. What is important about these various increases in earnings is that if one applies a 20 PE multiple to the current IBES estimate of $172.05 it equates to a price target of SPX 3441. Although this is 10% below current prices, the good news is that this does not represent an extreme overvaluation given the current low level of inflation and interest rates. Thus, any correction should find support around the SPX 3400 level. Conversely, stock market bubbles tend to end with ridiculously high PE multiples. In sum, if equities are forming a bubble market, it may continue for a time.

Adjusting our Earnings Estimates for 2020 and 2021

The S&P earnings results for the fourth quarter, and for 2020 generally, are much as we expected. So, with the annual earnings season nearly complete, we are adjusting our 2020 earnings estimate to match the S&P Dow Jones estimate of $121.87. This reflects a decline of 22.8% year-over-year versus our expectation of a decline of 20% to 25% in 2020. We are also raising our 2021 estimate from $166.60 to $168.60, representing a 39% increase this year. See page 19. But more importantly, we would not be surprised if this earnings estimate proves to be too conservative over time, particularly as the drag from the energy sector abates and the productivity improvements seen in 2020 help to drive the bottom lines for many companies in 2021.

Economic Reports

Real GDP grew in the fourth quarter at a seasonally adjusted annualized rate of 4%, which means that economic activity in the full year of 2020, contracted 3.5%. This 2020 contraction followed gains of 2.3% in 2017, 3.0% in 2018 and 2.2% in 2019. To our surprise, despite the 2020 recession, GDP grew at an average pace of 1.94% during Trump’s four years in office which was precisely the midpoint between the 1.89% rate for Obama’s eight years and 1.99% for GW Bush’s eight years. See page 3.

Economic growth in the fourth quarter was driven primarily by personal consumption of services and gross private investment. This shift in economic activity toward the service sector was a welcomed change since most of 2020’s economic activity was supported by personal consumption of durable goods, particularly housing and autos. The gains in gross domestic investment in the fourth quarter were primarily in residential structures. In fact, residential fixed investment hit a record $983.5 billion in the quarter which was an 18.3% gain year-over-year. This represented the strongest year-over-year rise in residential investment since the third quarter of 2013. See page 4. And as a percentage of real GDP, residential activity rose to 4.58%, the highest since the third quarter of 2007. This is strong but just slightly below its long-term average of 4.6% of GDP. See page 5. In sum, housing continued to be a major driver of economic activity at the end of 2020. But this may not continue in 2021. Ironically, as residential investment rose in the fourth quarter, homeownership levels declined rather markedly. See page 6. Total homeownership in the US fell from 67.4% of all households to 65.8%. The greatest decline was seen in the South where the homeownership rate fell from 70.8% at the end of September to 67.7% at the end of December. The Northeast was the only region in the US to experience a gain and rose from 62.0% to 62.6% in the fourth quarter. In terms of age groups, the 35 to 44 years old segment underwent the biggest decline in homeownership from 63.9% to 61.0%. Given the anecdotal evidence of households fleeing the Northeast and California to Texas, Florida and the Carolinas, this data seems illogical. However, the fourth quarter could be a transition phase as households move from states where restrictions have closed most institutions and establishments to states where schools and businesses have been open. Or it could be more ominous. The contraction of jobs in 2020 may have forced households to sell homes and move to apartments. Time will tell. However, we do believe economic growth in 2021 could disappoint investors if the federal government does not focus on stimulating job growth.

In December, personal income grew 4.1% YOY and real disposable income rose 3.2% YOY. However, a more revealing statistic is real personal income, which excluding current transfer payments fell 0.5% YOY in December. It also declined 0.45% in November. In short, government assistance, not economic activity, is propping up incomes and the economy. See page 9. And while personal income rose 4.1% in December, personal consumption declined 2.1%. Moreover, consumption has been negative in every consecutive month since March. This reveals the weak underbelly of the US economy and it is unlikely to change until the job market improves. See page 10.

Technical Indicators Little has changed in the technical arena. Our volume oscillator remains in neutral territory, the 10-day new high list has dropped from the record 492 hit on January 20th (breaking the previous record of 489 recorded in January 2000) to a more normal 259. Sentiment indicators are also surprisingly benign despite the headlines of individual traders driving volatile meme stocks. However, it is worth noting that at the end of the year stock market capitalization relative to nominal GDP was 2.1 and higher than the prior record of 1.82 set in March 2000. A similar Wilshire 5000 ratio was 1.83, exceeding its peak of 1.43 set in March 2000. These high ratios are signs that equity valuations may be outperforming the economy. See page 4. Expect 2021 to be a wild roller coaster ride and invest accordingly.   

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US Strategy Weekly: Sentiment and Inflation Warnings

One of the first warnings signs of the year was the rise in bullish sentiment reported by the Association of American Individual Investors (AAII) in their weekly survey. In the first week of 2021, bullish sentiment rose from 46.1% to 54.0% which means bullish sentiment has remained above the historical average of 38% for nine consecutive weeks. Bullish sentiment is also at its highest level since the November 11, 2020 reading of 55.8% which was a 12-month high. An early preview to current data suggests bullish sentiment may increase again in the current week. Nevertheless, the 8-week Bull Bear spread is negative for the second week in a row which is similar to the warning seen in early 2018. See page 18. As a reminder, 2018 was a roller coaster year of big price swings that ended with a loss of 5.6% in the Dow Jones Industrial Average and 6.2% in the S&P Composite.

It is important to keep in mind that sentiment indicators are not useful for timing market peaks or troughs, however they do provide good discipline for investors who may become too optimistic or pessimistic about equities. With bullish sentiment above 50%, investors should remain alert to other signs of risk in the markets. Nevertheless, most technical indicators are confirming the indices’ recent highs. The NYSE cumulative advance decline line made an all-time high on January 12, the 10-day average of daily new highs is robust at 433 and the 10-day average of daily new lows is 28, and well above the 10 or less per day that can appear at the end of a major advance. The one ambivalent technical indicator is the 25-day up/down volume oscillator which is currently neutral at 1.52. This oscillator was in overbought territory for 16 of 19 consecutive trading days between November 23 and December 18 and reached an extreme overbought reading of 5.52 on December 4. This combination was a solid confirmation of the new highs seen at year end. But if we see further gains in stock prices in 2021, we would also like to see an overbought reading to show that price gains are supported by solid buying pressure. See page 11, 12 and 13.

Last week we noted the favorable signal emanating from the Santa Claus rally given the gain during the last five trading days of the year and the first two trading days of the new year. The January Barometer, devised by Yale Hirsch of the Stock Trader’s Almanac in 1972, is another Wall Street adage that states “as goes January so goes the year.” This parable makes sense to us since liquidity, or cash, tends to at its best early in the year as a result of year-end tax-loss selling, year-end bonuses and annual funding of pension funds and IRA’s. History also suggests that the first five trading days of January predicts the month of January. On page 7 we show the performance history of the Dow Jones Industrial Average during the first five days of January, the month of January and the full year beginning in 1950. It indicates that the first five trading days of January has predicted the year’s action 79% of the time. However, the January Barometer has an even more impressive 95% accuracy in predicting the full year’s action if, and only if, January has a positive performance. The Barometer is less accurate when January ends with a loss. As the table shows, there have been 24 instances of losses in early January, 14 years with losses in the full month of January, and eleven years of negative performances for the full year. In short, January losses are far less predictive. But to date, the 1.6% gain in the first five days of January 2021 bodes well for the month and for the overall year. See page 9.

Anyone Focusing on Jobs?

The ISM manufacturing index increased from 57.5 to 60.7 in December, with most components, except for trade, also rising. Prices paid soared from 65.4 to 77.6. We remain nervous that inflation could be a big risk for equities this year. The nonmanufacturing index rose from 55.9 to 57.2 in December, but the employment index fell from 51.5 to 48.2. With the employment index below the 50 breakeven point, it suggests job growth in the service sector may weaken in coming months. See page 3.

The loss of 140,000 jobs in December did not surprise us given the extended shutdowns of businesses in states like New York and California; so, we are encouraged that Governor Cuomo appears to be ready to ease some restrictions. Still the risk of lengthy shutdowns is that businesses and entrepreneurs have been and will continue to face bankruptcy, which weakens the economy, and foreshadows more jobs losses. In December, the number of people employed was down 6.2% from a year earlier. Typically, any negative growth rate in employment suggests the economy is in the midst of a recession. The US economy has been buoyed by extraordinary fiscal and monetary stimulus for much of 2020, but stimulus cannot solve all problems. The unemployment rate in December was unchanged at 6.7%, but this is still well above the 3.6% seen in December 2019. Plus, when we look at the breakdown of unemployment, we find it is not evenly distributed. Those hurt the most in 2020 were workers with less than a high school degree which means households in the lower end of the job market remain under the greatest pressure. This dilemma is linked to the closure of food and drink establishments, hotels, and all employees tied to business and leisure travel. In our opinion, a weak job market will be another risk factor for the economy, earnings, and investors in 2021. Strangely, politicians seem focused on other matters and are ignoring this fact. See pages 4 and 5.

Small Business Confidence is Crumbling

Entrepreneurs and small businesses were feeling the impact of the pandemic at the end of 2020. The NFIB small business optimism index fell 5.5 points in December to 95.9 and all components with the exception of inventory satisfaction were lower. Owners expecting better business conditions over the next six months plummeted 24 points to a net negative 16. Sales expectations for the next three months fell 14 points to a net negative 4. Hiring plans fell 4 to 17, which was down but only to the lower end of the range seen over the last three years. This survey makes it clear that small businesses are concerned about their future in 2021.

The two areas of strength in the 2020 rebound have been housing and auto. Existing home sales were fairly robust at 6.69 million (SAAR) units in November, down slightly from October, yet up nearly 16% YOY. New home sales were 841,000 in November which was down from 945,000 units in October, but still up 21% YOY. The one warning sign we see for homebuilders is the pending home sales index which fell for the third consecutive month in November to 125.7. See page 7.

Earnings Forecasts are Stabilizing Consensus earnings estimates were revised significantly lower at year end but edged up slightly last week. S&P Dow Jones estimates rose $0.20 for 2020 and $0.17 for 2021 while IBES estimates rose $0.13 for 2020, $0.36 for 2021 and $0.37 for 2022. The S&P Dow Jones and IBES estimates for 2020 are $120.54 and $135.79 and for 2021 they are $164.57 and $167.61, respectively. Keep in mind that PE multiples have expanded dramatically in the last twelve months due in large part to low interest rates and indications from the Federal Reserve that monetary policy will not change before 2023. However, our valuation model indicates that the current low inflation/low interest rate environment translates into a 20 PE multiple. If we apply a 20 PE to the IBES $167.61 estimate for this year it implies a target for the SPX of 3352. In other words, the SPX has a 12% downside risk should optimism regarding earnings, the economy, interest rates or inflation change in the near term.

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US Strategy Weekly: Debt and Ownership

The 2020 gains in the popular indices are remarkable, yet surprisingly disparate. The Dow Jones Industrial Average is up 5.8% year-to-date. The S&P 500 has done somewhat better with a 14.4% gain. A sharp end of the year advance in small capitalization stocks drove the Russell 2000 to a year-to-date gain of 17.5%; however, it is the technology-laden Nasdaq Composite that is this year’s hard-to-beat champion with a 40.4% year-to-date gain. The Nasdaq’s performance has been extraordinary in 2020 and we would note that some bull market cycles do not experience a 40%+ gain and over the last 90 years the average gain in the S&P 500, prior to a 10% correction, has been 58%. Perhaps more significant is the fact that this 40.4% gain is nearly seven times the advance in the Dow Jones Industrial Average for the same time period. Since the March 2020 lows, the Dow Jones Industrial Average and S&P 500 have rebounded 62% and 65%, respectively. After recording fresh new highs this week, the Nasdaq Composite and the Russell 2000 have rallied 84% and 95.5%, respectively off those lows. It has been a spectacular year for investors, particularly since it also included the worst recession since the Great Depression and a bear market in earnings.

Investors have written off 2020 earnings and instead focused on the projected rebound in 2021 earnings. But even so, the stock market is not cheap. It is pretty clear that third quarter earnings estimates were better than expected but with third quarter earnings season practically complete, estimates are now stabilizing. In the week ended Friday, IBES consensus estimates rose $0.12 for 2020, $0.33 for 2021 and $0.43 for 2022. S&P Dow Jones consensus estimates were relatively unchanged and increased $0.05 for 2020 and $0.01 for 2021. Overall, the consensus estimates for 2021 are currently $169.18 for IBES and $166.20 for S&P Dow Jones. If one applies a 20 multiple to the IBES $169.18 forecast, it equates to an SPX target of 3384 for yearend 2021. The stock market is currently 8.5% above this target. While it is possible that earnings could outperform 2021 estimates, it seems the market has already factored positive earnings surprises in to current prices. More specifically, at SPX 3695, the 2021 year-end forecasted PE ratio for the S&P 500 is 22.2 X. The trailing operating PE ratio is 30.6 X which is higher than the June 1999 peak multiple of 29.3 X and the December 2001 peak multiple of 29.6 X.

Liquidity Wins
While we are worried about rich fundamentals, it is clear that the stock market is being driven by liquidity and as we have often noted it is not wise to “fight the Fed.” However, the market is priced for perfection, could be vulnerable to unexpected shocks and caution is warranted. As noted in previous weeks, some of our long-term indicators suggest that the market is apt to underperform over the next twelve-month period. However, this “underperformance” does not mean 2021 is destined to be a boring market. The new year could be an unusually volatile time including at least one big advance and a large decline. If so, investors should stay alert. It is wise to have stocks in one’s portfolio that can weather the volatility ahead and/or are good long-term holdings for good and bad times.

Assessing Debt and Ownership
Given our concerns about a liquidity driven market we are focused on factors that help define an equity bubble such as leverage, debt, and equity over-ownership. The Federal Reserve released financial data last week for the third quarter and it held few surprises.

Federal Debt Levels are Worrisome
Total outstanding US debt was a record $59 trillion in September, up from $53.9 trillion at the end of 2019. US debt represented 280% of nominal GDP in the third quarter, is up from 248% at the end of 2019 and is greater than the previous record of 273% of GDP recorded in 1933. See page 3.

Federal government debt grew at an annualized rate of 11.4% in the first quarter, 59% in the second quarter and 9.1% in the third quarter. It was a record $22.5 trillion in September and jumped from 87% of GDP in June to 106.3% in September. This compares to the record 110.3% of GDP recorded in 1944. Rising government debt is not a surprise given the fiscal stimulus provided during the shutdown; however, they are concerning when put into an historical perspective. See page 4.

Household debt is the second largest sector after the federal government, and it grew 5.6% in the third quarter due to an escalation in mortgages. The household’s total debt was nearly $16.2 trillion in September and represented 76.5% of GDP. However, this percentage is well below the 98.2% of GDP seen at the end of 2008 prior to the financial crisis in mortgages. In general, household debt has been fairly contained in 2020. The financial sector is also in good shape and its $17.3 trillion in debt represents 81.9% of GDP and is well below the 2008 peak of 123.7%. A healthy banking system is important for the overall economy and so is a financially stable household sector. Corporate debt actually declined in the third quarter after double digit growth in the first two quarters of the year. See pages 5 and 6. All in all, there were few surprises in this year’s debt accumulation, most of which has been due to fiscal spending. Our main concern for federal deficits would be sharply higher interest rates which would compound federal deficits going forward.

Stock Ownership Helps Net Worth but Needs Monitoring
The Federal Reserve also released household net worth and equity ownership data last week. After increasing a solid 12% in 2019, household net worth increased 4.4% in the first three quarters of 2020 to $123.5 trillion. In 2019, the increase in household net worth was due primarily to a 27.5% increase in equity holdings. In 2020 the increases in household net worth were a combination of a 16.6% increase in cash, due in large part to fiscal stimulus, and a 5.5% increase in tangible assets, primarily real estate. Equity holdings only increased 3.3% in the nine months ended September. This may be surprising to some, but remember, in the first nine months of the year the SPX gained 4.1% and the DJIA lost 2.7%. In short, it was a dull first three quarters. But we expect stock market gains will boost household net worth in the fourth quarter.

We are closely watching the relationship between equity and real estate ownership within the household sector. It is normal for residential real estate, or a home, to be a family’s main asset and thus represent the main pillar of net worth. But in the third quarter, the household sector showed equity holdings of $35.6 trillion, an amount that easily exceeded real estate holdings of $31.2 trillion. Since 1952, there have only been four other quarters in which equity ownership was greater than real estate ownership. These were the fourth quarter of 2019, the third quarter of 2018, the first quarter of 2000 and the fourth quarter of 1999. Each of these previous quarters were followed by sharp stock market corrections. More important, the two back-to-back quarters of high equity ownership in late 1999 and early 2000 represented the end of the 1997-2000 stock market bubble. See page 8. This is a worrisome precedent. We are also watching for extreme levels of equity ownership relative to total assets which could represent a saturation of demand. This can be measured as equities as a percentage of total assets and/or as a percentage of financial assets. In the third quarter, equities were 25.4% of total assets versus the 2000 peak of 26.4%. Equities were 22.6% of financial assets versus the March 2000 peak of 24.2%. Given the rally seen in equities in recent months, these percentages are apt to increase in the fourth quarter. In short, it is possible that equities are approaching an over-ownership situation. See page 9. In sum, the current advance has excellent momentum, but be alert to any and all pitfalls.

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US Strategy Weekly: Liquidity Wins

We focus on three issues this week. The first is that technical indicators have finally and whole-heartedly confirmed the current advance. The second is that even though third quarter earnings estimates are beating expectations, it has little relevance to a market that has been focused on 2021 forecasts since March. Based on 2021 earnings estimates, equities are priced for perfection and this is certainly a cause for concern. And third, recent data releases are defining a pattern of economic deceleration. This is also worrisome. This combination of deteriorating economics/fundamentals and strengthening price action can only be explained by the fact that liquidity is driving the equity market.

Several indicators that we monitor suggest the market is likely to underperform over the next twelve to eighteen months. But bear in mind that this does not mean 2021 is destined to be a boring market. It is more likely that 2021 could contain several bull and bear market cycles that result in little gain in the end. Investors should prepare for an unusual environment and adjust portfolios so that they can weather extreme volatility.

Economic data for November was generally disappointing. The unemployment rate declined in November to 6.7% from 6.9%, but this was due in large part to the decline in the civilian labor force. The addition of 245,000 new jobs was less than expectations and perhaps the biggest letdown was the decline in the employment population ratio from 57.4 to 57.3. The participation rate also fell from 61.7 to 61.5. In short, the percentage of the population that is employed and working is declining. See page 3.

Jobs are key to the economy. They are the most critical component of household income, personal consumption, corporate revenues, and earnings. Therefore, the steady shift of workers from temporary layoff to being permanently unemployed is disturbing. See page 4. In our opinion, the absence of CDC guidelines that would allow businesses to safely open coupled with the lack of urgency seen in Congress to pass fiscal stimulus that would support small businesses is unconscionable.

In our view, the best way to assess the job market is to monitor the growth rate of “employment” over a 12-month period. A decelerating rate that approaches zero will predict a pending recession and a recession begins when this growth rate turns negative. But a pivot in the growth rate often defines a recovery. From this perspective, the job market was arbitrarily shut down so there was little warning for this unusual recession. However, the employment low was made in April with a negative 13.5% growth rate and has been improving ever since. But November’s growth rate was still poor at negative 6%. Meanwhile, the pace of those unemployed 27 weeks or longer continues to rise and currently resembles the pattern seen in early 2009! See page 5. These statistics suggest household consumption is apt to decline in the first quarter. If so, earnings could also disappoint.

The ISM indices are good benchmarks for assessing the strength of both the manufacturing and service sectors of the US economy. However, both ISM indices declined in November and both surveys pointed to weakness in new orders and general business activity. See page 6. The NFIB Small Business Optimism Index fell from 104.0 in October to 101.4 in November which was worse than expectations. The most revealing part of the survey was that the net share of respondents expecting the economy to improve dropped from 27% to 8%. This was a perfect example of how the current number of COVID-19 cases and the accompanying restrictions are hurting small businesses and dampening sentiment.

Autos and housing have been the core of the 2020 rebound, yet both weakened in November. Total vehicle unit sales fell from 16.74 million to 15.97 million units in November and all segments of the industry showed a decline. For the second month in a row the pending home sales index fell. October’s index fell to 128.9, down from the August peak of 132.9. See page 7.

Under normal circumstances, third quarter earnings results for the S&P 500 would make us bullish, but these are far from normal times. As of December 4, 496 companies in the S&P 500 Index had reported third quarter 2020 earnings. And of these, 84.5% reported earnings that were above analysts’ expectations and 12.3% reported earnings below expectations. In a typical quarter, 65% of companies beat and 20% miss estimates. Even more impressively, companies have reported earnings that are 19.7% above estimates. This is dramatically better than the 26-year average surprise factor of 3.5% and the last four quarter average of 8.7%. In addition, more than 78% of reporting companies exceeded revenue expectations and beat forecasts by 3.6%. This compares to the long-term average surprise factor of 1.5%. Not surprisingly, the estimated earnings growth rate for the S&P 500 in the third quarter is now negative 6.1% and much improved from the July 1 consensus forecast of a 25% decline. If the energy sector is excluded, the third quarter growth rate improves to negative 1.9%. Earnings growth forecasts improved for all sectors in the third quarter, but the greatest improvement was in consumer discretionary which flipped from an expectation of a 50% decline in year-over-year earnings growth to positive 0.8% currently. However, despite all this good news for the quarter, IBES consensus estimates for 2021 are relatively unchanged at $168.85. A PE multiple of 20 times next year’s earnings equates to an SPX target of 3377, or 9% below recent closing prices. See page 10.

At SPX 3702, the trailing operating PE is 30.6 X and remains higher than the June 1999 (29.3 X) and December 2001 (29.6 X) peaks. The 12-month forward PE ratio for the SPX is 22.3 X. Both benchmarks are well above their standard deviation lines and the SPX is now trading more than 13% above the top of our valuation model’s year end 2021 fair value range. See page 11. High valuation suggests the market is vulnerable to unexpected shocks and this suggests caution is warranted.

But in direct contrast to this the popular indices continue to set a series of record highs and our technical indicators are finally confirming the advance. In particular, the 25-day up/down volume oscillator is currently 5.02 (preliminary), above 3.0 and has been in overbought territory for six consecutive trading days and for nine of the last eleven trading days. The oscillator reached a reading of 5.52 late last week which was the strongest reading since February 2019. It is our contention that new price highs in the indices should be accompanied by long and often extreme overbought readings which represent solid buying pressure. After a lengthy delay, this oscillator has finally confirmed the new highs. See page 13. And most other breadth indicators followed suit. The 10-day average daily new high indicator is robust at 380 per day and the NYSE cumulative advance decline line made a simultaneous record on December 8 with the indices. See page 14. The AAII bullish sentiment index rose to 49.1% and the last 4 weekly readings are the highest since January 2020. But while the AAII bull/bear 8-week spread is quickly rising it still remains in neutral territory. See page 15.

There is one simple way to explain the discrepancy between the underlying fundamental and technical factors of the market and it is liquidity. Historically, there has been a strong correlation between easy monetary policy and stock market gains. M2 growth peaked at 19.6% in July but in late November it was still growing at a 6.6% pace. Demand deposits at commercial banks jumped in late November from $2.5 billion to $2.97 billion. In sum, remember the wise Wall Street adage “Don’t fight the Fed.”

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US Strategy Weekly: Counting Positives and Negatives

With a little more than two months left to the year, few would deny that 2020 has been an unusual year. The turning point was the historic, unpredictable, and relentless spread of the COVID-19 virus from China to most other countries around the world. It is not the virus, but its aftermath that will have major repercussions for people, companies, and economic trends for years to come. Yet in the face of this challenge, the S&P 500 and Nasdaq Composite Index reached new highs in September and the DJIA, SPX and Nasdaq Composite are currently 4.2%, 3.9% and 4.5%, respectively, from all-time highs.

Some believe the rally in equities reflects a disconnect between the stock market and reality. But as usual, investors face a mix of positive and negative factors. Today is no different, even when putting the political backdrop aside.

The current negatives are obvious. The spread of COVID-19 resulted in mandatory shutdowns of businesses around the world. In the US, some businesses learned to adapt, and this created a division between winners and losers. But the bottom line is that the shutdown put 22.2 million people out of work between February and April, and 10.7 million of those remained unemployed at the end of September. Another negative is a resurgence of the virus in Europe which is generating a new round of restrictions such as curfews and limits on gatherings. This resurgence places a European recovery in the second half of the year on hold. Together, these two events create a third negative which is an enormous pressure on corporate earnings and an increasing risk of small business bankruptcies. As a result, the S&P 500 index is close to peak valuations on a trailing earnings basis and even when based upon forecasted 2021 earnings valuation remains at nosebleed levels. Added to these problems is the fact that the government is challenging the power and influence of the biggest technology companies with concerted anti-trust action. This week the Justice Department sued Google (GOOG.O – $1555.93) for illegally using its market strength to fend off rivals with distribution agreements that gave its search engine prominent placement on phones and internet browsers. Anti-trust action may prove beneficial to consumers in the long run, but in the shorter run it could pressure the big cap technology stocks that represent a large percentage of the SPX’s market capitalization. In short, it could hurt market performance.

The artificial shutdown of most economies was quickly followed by a series of policy measures to keep economies afloat. In short, the positives must begin with the extraordinary stimulative fiscal and monetary policies put into place around the world. As we have noted in the past, the combination of fiscal and monetary ease announced by the US totaled $5.5 trillion ($2.55 trillion in three fiscal packages and a $2.99 trillion expansion in the Fed’s balance sheet). This $5.5 trillion represents 28% of nominal GDP ($19.53 trillion at the end of the second quarter), or 3.4 months of economic activity. This stimulus went directly to consumers and businesses and it provided a safety net for the broader economy. In addition, another fiscal stimulus package is on the horizon, it is simply a matter of time and politics.

Yet, the biggest positive for investors is how well the economy is doing, particularly the tremendous strength in housing and autos. As of September, the NAHB single-family housing environment survey has recorded three consecutive months of record readings. Homeownership rates are surging in all regions of the US and reached 67.9% in the third quarter. This represents the highest homeownership rate since the 69.2% seen in 2004. See page 3. Residential building permits recorded a 10-year high in September and existing home prices have been moving steadily upward all year. See page 4. September’s retail sales rose 5.2% YOY overall and 3.9% YOY excluding motor vehicles and parts. Autos have been the brightest part of retail sales rising 10.5% YOY in September. Plus, September’s retail sales data included many bright spots in the economy with the exception of clothing, electronics and food and beverage establishments. The best part of all these statistics is that it all bodes well for third quarter GDP. See page 5.

Benign inflation is another positive for the equity market since low inflation is favorable for monetary policy, PE multiples and consumers. In September, the CPI rose 1.4% YOY, PPI finished goods fell 1.2% YOY, final demand PPI rose 0.5% YOY, crude oil fell 26% YOY and the PCE deflator gained 1.4% YOY. The decline in energy prices and positive spread between CPI prices and PPI prices is a favorable one for corporate margins. See page 6.

And despite negative US headlines, there is good news regarding virus trends. On October 20th, The NEW YORK TIMES ran a story including charts that showed “new COVID cases” are trending higher in October, but due to the substantial increase in the number of tests taken and diagnosed since early September. Most importantly, US deaths per day have held steady since early September at around 700. See page 7. In general, this implies the spread of the virus and its deadliness is slowly fading. Moreover, therapies for the virus have advanced dramatically in the last six months and a vaccine is expected early in 2021. Overall, we believe all this good news outweighs the bad.

We have noticed that both consensus earnings estimates for 2020 have had unusually large increases in recent weeks. See page 10. IBES indicated that of the 66 companies that reported third quarter earnings to date, 86% beat expectations. Therefore, 2020 consensus forecasts are apt to move even higher. However, stock prices have ignored 2020 and for the last six months have been trading on 2021 earnings. Unfortunately, the 2021 outlook remains uncertain and this brings us to the biggest unknown of 2020 — the election.

With less than two weeks to go and with early voting taking place at a record pace, election results remain highly uncertain. The polls give former Vice President Biden a sizeable lead, but the race continues to narrow. Statista reports that 55% of Americans feel they are better off than they were four years ago and most Americans, particularly Democratic voters, feel this election matters more than previous years. This is an interesting, but inconclusive mix. See page 8. In terms of the election, the market’s 3-month performance is showing a gain in the SPX of 5.3% and a gain in the DJIA of 7.1% to date. In past election years gains have foretold of an incumbent victory. On the other hand, one cannot be sure that 2020 is a “typical” year. See page 9.

Last but far from least, the charts of the broad indices and technical indicators have turned increasingly bullish in the last two weeks. All the popular indices rallied from important support levels that equated to their 100-day or 200-day moving averages and in particular, the Russell 2000 index began to outperform large cap indices. The advance/decline line reached a record high on October 12 and the new high list continues to expand. Our 25-day up/down volume oscillator is yet to reach a fully overbought reading, but it did record its highest reading earlier this week since August 2020. These are all supporting the bullish case.

We continue to have a long-term bullish bias but would expect the market to be choppy and trendless prior to the election. If there is no clear winner on election night, the uncertainty is likely to create even more volatility. This implies investors should be somewhat cautious near term and focus on companies that will perform well despite the virus and despite an uncertain political backdrop.

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US Strategy Weekly: Trump Biden Tax Proposals

A new week brought new worries for the stock market. Moods were already downcast after the passing of Supreme Court icon Ruth Bader Ginsberg. Throughout her illustrious career Judge Ginsburg was a leader, a role model for working women and a staunch fighter for women’s rights. On Tuesday Prime Minister Boris Johnson told the British people to work from home if possible and ordered restaurants and bars to close early to counter a second wave of COVID-19. Johnson stopped short of imposing another full lockdown, as in March, but warned that more measures might be imposed if the virus were not contained. Newswire headlines announced US deaths from coronavirus surpassed 200,000 but failed to mention that the trend in new cases and deaths has decelerated dramatically. President Trump spoke (on video) to the 75th annual UN General Assembly and fueled fears of a geopolitical tiff by chiding China for unleashing COVID-19 on the world and stating that China needs to be held accountable for the destruction the plague has wrought by all members of the UN. The US Food and Drug Administration is expected to announce higher standards for an emergency authorization of any coronavirus vaccine, lowering the chances that a vaccine might be cleared before the November 3 election. And last but far from least, the first presidential debate scheduled for September 29th at 8:30 pm EST is merely one week away. This debate could become a pivotal factor for the stock market.

We believe last Friday’s Wall Street Journal’s article comparing Joe Biden’s and President Trump’s tax proposals may have been a contributing factor to the stock market’s recent decline. With Biden leading in the polls it is important for all investors to assess the impact a Democratic victory could have on the US economy. There are many factors to look at, but this week we will simplify it to tax policy.

President Donald J. Trump’s Tax Plan
President Trump’s tax policies are well known. He enacted tax breaks for individuals and corporations in 2017 and wants to extend these tax breaks past their current 2025 end date. Trump made it easier for corporations to bring home foreign profits and to deduct capital investment costs. Trump is currently proposing to cut the capital gain tax rate from the current 23.8% to 15% or 18.8%. And he wants to expand Opportunity Zones which offer capital gains tax breaks for investments in low income areas.

Vice President Joseph Biden’s Tax Plan
The Wall Street Journal article noted that Vice President Biden’s spending plans exceed his proposed tax revenue, but Biden explains this as stimulus for the economy. The Biden plan would raise taxes on individuals and entrepreneurs making more than $400,000 a year and would raise the corporate tax rate to 28%, impose a new minimum tax on companies and raise taxes on the foreign income of US based multinationals. His plan also includes reinstating the individual mandate to purchase health insurance, which is the proposal included in Obama care that the Supreme Court ruled was a tax on citizens. Mr. Biden proposes to raise the top individual tax rate of 37% to 39.6%, expand the 12.4% Social Security payroll tax which currently exempts wages above $137,700, but would restart the tax again on wages above $400,000. The plan also repeals a 20% deduction for income from pass-through businesses and impose new limits on itemized deductions. Most importantly, Biden would raise the capital gains tax rate from 23.8% to 39.6%, but reportedly only on households with income greater than $1 million. Nevertheless, this is likely to weaken the stock market prior to the election since many investors are apt to take profits on long-held stocks to avoid the possibility of this tax hike in 2021.

Millennials should take heed of structural changes to capital gains rules that Biden is proposing that could significantly impact their inheritances. At present, heirs only pay income taxes on gains in equity value that materializes after the original owner’s death and only when they sell the stock. Biden’s proposal would tax all unrealized gains as capital gains at the time of death. This is unsettling. Unless an heir has considerable liquidity at the time of inheritance this structural change would require an heir to sell much of the portfolio in order to pay taxes, incurring more capital gains taxes and potentially losing a significant amount of the inheritance. The very wealthy may have lawyers and accountants that can find a way around this tax, but Middle America will bear the brunt of this change.

All in all, we find the Biden proposals to be dicey for equities. Raising the capital gains tax rate has historically lowered stock prices in the short run as investors rush to avoid the tax hike and it lowers demand for equities over the longer-term since it raises the bar for speculators. All in all, a Republican sweep suggests more tax cuts while a Democratic sweep would bring increases.

Keep Some Powder Dry
Nonetheless, economic data has been strong. Housing data shows existing home sales rose to 6.0 million units in August, a 10.5% YOY increase. The median existing single-family home price rose 12% from a year earlier, while the average existing single-family home price gained 9% from a year ago. See page 3. August’s new home sales will be reported soon, but July’s data showed a 36.3% gain in units sold from a year earlier with median and average prices rising in the high single digits. See page 4. Homeownership also jumped from 65.3% in March to 67.9% in June, with the largest regional gain seen in the South where ownership rose from 67.6% to 71.1%. Black homeownership rose 3% to 47% and Hispanic ownership rose 2.5% to a record 51.4% in the second quarter of the year. See page 5. As a result, homebuilder confidence reached record heights in August. See page 6. In August, retail sales also reached a record level on a seasonally adjusted annualized basis and this tends to be a good forecaster of overall GDP. See page 7.

However, fundamental valuations remain stretched even as the Refinitiv/IBES consensus earnings estimate for the S&P 500 index continues to rise. This week’s estimate of $166.62 combined with a 20 PE multiple suggests a fair value level of SPX 3332, but as we show on pages 8-10 this still puts the equity market at the high end of fair value. It is possible that earnings estimates will continue to surprise on the upside, but the political climate is too uncertain to know. It is equally possible that higher corporate taxes would make current forecasts too high for 2021. In short, we remain cautious in the near term.

Technically, we see several important support levels that are worth monitoring. In the Dow Jones Industrial Average and in the Russell 2000 the 100-day and 200-day moving averages are converging. This makes the DJ 26,290 and the RUT 1457 levels crucial to the longer-term outlook. By holding at or near these levels the chart patterns improve. But breaks below these levels are highly likely to generate more selling. Breadth data is also showing some strain. The 10-day average of daily new lows fell to 76 this week and is below the 100 benchmark that characterizes a bull market cycle. The 25-day up/down volume oscillator is at minus 1.29 this week and at its lowest point since April 8, 2020. Corrections within a longer bull market cycle rarely reach a fully oversold reading on minus 3.0 or less; rather, corrections tend to reverse as this level nears. Overall, the risks in the market may only be political, but they are taking a toll on stock prices. We await the presidential debate next week.

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US Strategy Weekly: Breakout or Bubble?

Worldwide coronavirus cases reach 7.21 million and the death total moves above 400,000. The National Bureau of Economic Analysis (NBER) defines the US economy as being in a recession as of February 2020. Coronavirus wrecks demand and Germany’s exports and imports plunge in April, posting their biggest declines since data began in 1990. Canada and the US are about to extend their border closure and ban on non-essential travel through the end of July. Boeing (BA – $216.74) delivers four planes in May, down from six in April. And the NASDAQ Composite rises to an all-time high.

Even though bull markets are known to climb a wall of worry, these facts simply do not seem to fit together. Yet as we noted last week, history has taught us that equity prices are often better economic forecasters than economists. Recent market performance suggests investors are expecting a V-shaped recovery. This week the Federal Reserve will publish its first economic projections since the pandemic began and we doubt it will be optimistic. Economists are expecting the Fed to forecast a collapse in output this year and no change in interest rates for the foreseeable future. Still, investors are comforted by the fact that the Fed stands ready to support the economy; and in fact, the Fed eased the terms of its “Main Street” lending program this week by cutting loan size in half to $250,000 and lengthening the term by a year. These changes, along with zero required reserves, are in place to encourage businesses and banks to participate in making loans.

Perhaps investors are focused on what the 2020 fiscal and monetary stimulus packages can mean for future economic growth and earnings. First, we know that fiscal stimulus came in three packages (Phase 1 – $8.3 billion; Phase 2 – $171 billion; Phase Three – $2.3 trillion) totaling $2.5 trillion. The Fed’s balance sheet has expanded by nearly $3 trillion since the end of February. Together, this $5.3 trillion package of stimulus represents more than 25% of nominal GDP (March 2020 nominal GDP $21.5 trillion). In other words, the federal government has supported, or supplanted, the economy for an entire three months. And while businesses and consumption has slowed dramatically during the mandatory shutdown, this stimulus is still working its way into the broader economy. Or, in the case of taxpayers $1200 checks, it is sitting in checking or savings accounts. This may be why investors responded so joyously to the fact that there were only two months of job losses before a reversal in May. Jobs losses were 22 million in March and April and it will take time for all these people to get back to work. But as Americans move slowly back into the workforce and confidence builds, this liquidity should fairly quickly turn into consumption. There will be disruptions in the workforce; but we have faith in American ingenuity and the ability to rebuild.

Breakout or Bubble?
Despite our optimism about the economy, we still question whether the current surge in equity prices represents a significant bullish breakout or whether it is the beginning of a bubble. First, it is important to note that bubbles represent not only a complete disconnection from valuation but also a high degree of over ownership of equities, usually by the public. It is possible that this process is beginning today, but if so, the bubble will get very much bigger and prices will move much higher before the bubble bursts.

Our valuation model shows that the SPX is trading well above the fair value range today and is trading at a level forecasted for late 2021 based upon our 2021 SPX earnings estimate of $160.65 and the model’s predicted PE multiple of 19.6 times. However, we believe our earnings estimate could prove to be too conservative and this would support higher prices. Also note that while the SPX is trading above fair value range, it is still less extreme than what was seen late in 2009 when analysts caught up with the damage done by the financial crisis and cut earnings estimates dramatically. See page 13. Analysts proved too pessimistic in 2009 and the equity market rallied as earnings surprises turned positive later in the year. It is possible that a similar scenario will play out in 2020 as well.

Overall, we believe it is wise to remain vigilant to the risk that a bubble is forming; but investors who exit a bubble too early are often the same investors drawn into the market at the peak. Yes, bubbles are extremely dangerous but also enticing late in the cycle. In our view, we would rate the equity market as a strong hold. We are definitely concerned about the upside gaps we see in many of the popular indices which suggests market volatility will remain high in coming weeks. See page 14. But it is also likely that this rally could continue until economic news turns positive, in short, we would “sell on the news.” That day still lies ahead. In the near term we are watching for several of our technical indicators to make a clear confirmation of the breakout. To date, the cumulative advance decline line has done so, but we are waiting for further confirmation from our 25-day volume oscillator and the average of daily new highs. See pages 15 and 16.

A Look at May’s Job Report
As dramatic and unexpected as May’s monthly increase of 2.5 million jobs was, this gain put barely a dent in the 22 million job losses seen in March and April. In May, the household survey’s employment level was 137,242, the lowest since October 2002. The establishment survey suggests May’s payrolls were 132,912, the lowest since December 2011. In short, while job gains should increase in the months ahead, it will take time to reach the peak levels seen earlier this year. However, the shorter the shutdown the easier the rebound, so we are encouraged to see many parts of the US getting back to normal. See page 3. The good news is that according to the BLS, 78.3% of those unemployed in April classified themselves as being on temporary layoff. Those classified as being on temporary layoff fell to 73% in May which likely accounted for the large job increase in May. However, the 73% level indicates that the vast majority of unemployed expect to return to their jobs in the near future. See page 5. It was also encouraging to see that the ten areas of the economy with the largest job losses in April were also the areas of largest job gains in May. These ten sectors were leisure and hospitality, accommodation and food services, food service and drinking places, trade, transportation and utilities, education and health services, goods producing, professional and business services, retail trade, healthcare and social assistance, and administrative and waste services. See page 6. When we look at 2020’s job creation year-to-date, we were surprised to find a gain in net jobs in most sectors. In fact, the only categories with year-to-date net job losses were leisure and hospitality, mining and logging and other services. Note that retail stores are included in BLS data for the trade, transportation, and utilities category. See page 7. The biggest loser during the shutdown was the leisure and hospitality sector which lost 7.5 million jobs in April; however, it recovered 16% of this, or 1.2 million jobs in May. This is a trend we hope will continue in coming months. See page 8.

Consumer confidence will only recover once the uncertainty of job losses ends and people can return to work. If there are no substantial spikes in coronavirus cases in the next two weeks following the massive and extensive protest marches seen in the last week, we believe businesses and consumers will become more confident about returning to a more normal lifestyle. This will help small business confidence as well. In May, the NFIB small business optimism index did recover from 90.9 to 94.4; but it remains well off its high of 105.0 in May 2019. Still, business confidence will be a key indicator in coming months since it will be the major source of jobs for the rest of 2020. See page 9. As dramatic and unexpected as May’s monthly increase of 2.5 million jobs was, this gain is barely visible in the chart below. In May, the household survey’s employment level was 137,242, the lowest since October 2002. The establishment survey suggests May payrolls were 132,912, the lowest since December 2011. In short, job gains should increase in the months ahead, but it is a long road to reach the peak levels seen earlier this year.

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