A Bitcoin Quarter

Comments by Federal Reserve Chair Jerome Powell following the December 13, 2023 Fed meeting triggered a strong yearend rally that led to all four of the major US equity indices closing the year with impressive double-digit gains. The gist of Powell’s December comments was that while there would be no immediate change in Fed monetary policy, rate cuts could be coming in 2024.

Two subsequent FOMC meetings that ended on January 31, 2024 and March 20, 2024 followed a strikingly similar pattern, that is, no change in policy, a hint of rate cuts this year, followed by a strong stock market rally. Note that this sequence of events suggests that the equity market has been discounting the possibility of 2024 interest rate cuts multiple times. And since forecasts for 2024 corporate earnings have declined slightly in the interim, this means the price-earnings ratio for equities has been climbing. It is this rise in the price-earnings ratio that has led many to feel the market is or is becoming overvalued and it is also the reason the fear of an equity bubble is rising. To date, the 2024 equity market has been a momentum-driven market and not a value-driven market.

However, if the stock market is forming a bubble, and we think it is, it is in the early stages. PE multiples are exceedingly high at 24.2 times trailing 12-months and 21 times forward 12-months. Yet during the 1997-2000 bubble, the financial crisis of 2008, and even the post-COVID-19 peak, the trailing 12-month PE reached 26 to 30 times earnings.

The financial media has heralded the S&P 500’s 10.2% gain in the first three months of the year as the best first-quarter performance in five years, but this is a bit disingenuous since this only applied to the S&P 500 index and not to other indices. The Nasdaq Composite index had a solid gain of 9.1% in the first quarter, but this was less than the 16.8% gain seen in 2023. The Dow Jones Industrial Average rose 5.6% in the quarter which was the best first quarter since the 2021 gain of 7.8%. The Russell 2000 index rose 4.8%, the best first quarter since the 12.4% also seen in 2021. In short, it was a good first quarter performance for most stocks and most portfolios, but not the best first quarter in five years.


Still, the first quarter of 2024 may go down in history, not as the best equity performance in five years, but as the first time ETFs were introduced on spot bitcoin. After more than a decade of rejecting spot bitcoin ETFs in hopes of protecting investors from market manipulation, the Securities and Exchange Commission (SEC) was forced to approve them in January after an appeals court ruled that the SEC had not sufficiently detailed its reasoning for rejecting the products. The SEC approved 11 spot bitcoin ETFs in late January. And according to LSEG data, net flows into the ten largest spot bitcoin funds reached a stunning $2.2 billion in the week ended March 1. The cryptocurrency has soared nearly 162% since October, jumped 44% in February alone, reached a high of $73,157.00 on March 13, 2024, and generated a year-to-date gain of nearly 67%.

This surge in demand for Bitcoin (BTC= – $70,841.00) may be representative of today’s financial markets for several reasons. Bitcoin has the backing of a new generation of investors, ETFs are a form of leverage that attracts a larger audience of buyers, and there are no underlying fundamentals. Bitcoin has no assets, earnings, or revenues to analyze, yet it is surging based upon the belief that it will go higher. Likewise, momentum, liquidity, and leverage drive the typical equity bubble, not fundamentals. Bitcoin and the equity market are also similar in that they are both driven by an underlying expectation of lower inflation and lower interest rates. In sum, inflation and interest rates are the Achilles heel to both markets.

Leadership changes

Much like the popularity of spot bitcoin ETFs, many investors are using ETFs to participate in the equity market rather than buying individual stocks. And the performance of various ETFs reveals an interesting change in leadership in 2024.

In 2023 the best performing ETFs were linked to S&P sectors and industries related to technology, homebuilders, communication services, consumer discretionary, and semiconductors.

This year’s best performers have been found in oil, homebuilders, energy, communication services, financials, and industrials.

What we find most interesting about the shift in the first quarter of the year is the outperformance of oil and energy, which suggests there could be a risk of higher energy pricing and higher inflation. The good news about this shift is the outperformance of the financial sector implies a better economic environment in 2024.

Pivot or No Pivot

While the stock market is rallying in anticipation of a Fed pivot and lower interest rates, we believe a pivot is unnecessary. What many overlook is the fact that monetary policy is already very accommodative despite the rise in interest rates. Government yield curves may be inverted — and this has been the longest inversion without a recession in history – but as the Federal Reserve made a succession of interest rate hikes, underlying fiscal and monetary policies have remained surprisingly stimulative.

For example, the Federal Reserve has been shrinking its balance sheet down to $7.7 trillion as of March 20, 2024 from a peak of $9.0 trillion in April 2022. Yet this $7.7 trillion remains well above the $4 trillion seen in normal times before the pandemic. In short, the Fed’s balance sheet continues to provide considerable liquidity to the economy. Not surprisingly, this means there is plenty of liquidity in the banking system including a near-record level of total bank assets of $23.2 trillion and commercial bank deposits of $17.5 trillion (as of mid-March). These are down only modestly from the record $18.2 trillion seen in April 2022. In other words, government spending and a large Fed balance sheet have been providing liquidity and offsetting both the Fed’s interest rate hikes and the inversion of the yield curve. In our view, if the Fed should cut interest rates, we hope it is accompanied by substantial quantitative tightening. If not, it could open the door for another round of higher inflation.

*Stock prices are as of March 28, 2024 close

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Liquidity-driven Market

2023 ended with a flourish after Federal Reserve Chairman Jerome Powell indicated that interest rate cuts were likely in 2024. This surprising “Fed pivot” by Powell following the last FOMC meeting of the year, unleased a buying surge that generated one-month gains of 4.8% in the Dow Jones Industrial Average, 4.4% in the S&P 500, 5.5% in the Nasdaq Composite and a stunning 12% in the smaller cap Russell 2000 index. The December 2023 rally carried the Dow Jones Industrial Average to a new record high and the S&P 500 came within 1% of its all-time high.

Chairman Powell’s indication that rates would soon come down, unleashed a liquidity-driven advance fueled by the $7.5 trillion in cash seen in demand deposits, retail money market funds, and small-denomination time deposits. Yet, despite strong December performances, the Nasdaq Composite closed the year 6.5% from a record high and the Russell 2000 ended 17% below its November 8, 2021 high of 2442.74.

For the full year, the Dow Jones Industrial Average gained 13.7%, the S&P 500 gained 24.2%, the Nasdaq Composite inked a gain of 43%, and the Russell 2000 index rose 15%. Overall, it was an amazing yearend performance for a year that until then had been only modestly successful and a time most analysts expected to include a recession and a poor stock market.

Remembering 2023

The first half of 2023 was expected by many, including us, to be the final chapter of the post-pandemic hangover. There were many signs of an imminent recession, including a long and severely inverted Treasury yield curve, a slump in the real estate markets, recessionary levels in consumer and business sentiment surveys, historic weakness in the leading economic indicators, and negative year-over-year retail sales. Consumers were experiencing declining purchasing power due to rising prices, and corporations suffered profit margin squeezes from escalating costs for labor, transportation, and raw materials. Yet despite all these warnings, the economy continued to grow a bit each quarter, and in the third quarter of 2023, GDP reached 4.9% on a seasonally adjusted annualized basis.

In the early and unsettled environment of 2023, some investors began to focus on the long-term growth prospects of artificial intelligence. This led to the popularity of a small group of stocks called the Magnificent Seven, which included Apple Inc. (AAPL – $192.53), Microsoft Corp. (MSFT – $376.04), Amazon.com (AMZN – $151.94), Nvidia Corp. (NVDA – $495.22), Alphabet Inc. (GOOG – $140.93), Tesla Inc. (TSLA – $248.48), and Meta Platforms Inc. (META – $353.96). These companies quickly became the investment darlings of 2023 driven in part by an analysis from PwC indicating that artificial intelligence was expected to improve productivity by 40% by 2035 and the global AI market was expected to grow 37% annually from 2023 to 2030. Not surprisingly, at a time when a recession appeared to be around the corner, these stocks became the most exciting investments to own. From our perspective, we felt it was also important to note that PwC’s surveys also showed that 73% of US companies have already adopted artificial intelligence in some areas of their business. This poses questions about the near-term potential of AI.

A Wall Street Journal article (“It’s the Magnificent Seven’s Market. The Other Stocks Are Just Living in It.” December 17, 2023) noted that these seven stocks soared 75% in 2023, while the remaining 493 stocks in the S&P 500 rose only 12% and the S&P 500 index gained 23%. But more importantly, these stocks represented 30% of S&P’s market value, which approaches the highest-ever share for seven stocks. Perhaps most surprisingly, the group represents more than the combined weighting of all stocks in Japan, France, China, and the UK, in the MSCI All Country World Index.

This outsized performance of a small group of stocks is reminiscent of the bubbly Nifty Fifty and the Dot-Com eras. In these earlier equity manias, a small group of stocks led dramatic advances that persisted for a year or two. But eventually, an extremely overvalued market later ended in tears. In our opinion, even though the current advance may not be over, there is risk in the overall market, and more importantly in these seven stocks. The Magnificent Seven stocks have discounted a substantial amount of future growth which means they would be vulnerable should anything challenge the expectations of AI-driven earnings growth. At the same time, these numbers suggest there is much better value found in the broader marketplace.

Our 2024 Forecasts

Our assumptions for 2024 include GDP growth of 0.8% YOY for the full year, which implies slowing economic activity and the possibility of a negative quarter of growth, but the year should escape a full recession of two consecutive falling quarters of GDP. In this environment we are assuming some weakness in topline revenues, but efficiencies developed during the economic shut down and a rocky economy in 2023 will help companies generate modest earnings growth of 10%. Given the Fed’s recent pivot we are expecting a possible 75 basis point decrease in the fed funds rate. To do this, we are assuming a modest decline in inflation to 2.75% which will allow the Fed to maintain a real yield of 220 basis points in the fed funds rate throughout the year. In line with this, our forecast expects Treasury bill yields to fall to 4.25% in line with an easier Fed policy, and for Treasury bond yields to be lower and stable at 3.6%.

There are many risks to these forecasts since external factors like the Houthi’s attacks in the Red Sea have the potential to interrupt trade and send oil prices higher. Other risks include the possibility that efficiencies from artificial intelligence may prove to be less than expected. The wars in Ukraine and Israel could increase past current borders and trigger fear of a widening escalation. Politics should be a major topic in 2024 since there will be nine parliamentary elections in Europe in 2024, as well as elections in the UK, Mexico, Taiwan, and the US.

Although the economy may manage to muddle through a year of sluggish growth in the economy and earnings, equity valuation remains a hurdle. Our forecasts for 2024 coupled with our valuation model, yield a mid-point predicted PE of 15.8 and a top-of-the-range PE of 18.4. This, combined with our 2024 S&P 500 earnings forecast of $230 creates a midpoint S&P 500 target of 3634 and a high of 4295 for 2024. Using a higher IBES 2024 earnings estimate of $245.21, these targets rise to 3875 and 4511, however, yearend prices have already exceeded these levels. And for those who think our model’s predicted PE multiples are too low, note that at the end of 2023, the S&P trailing PE was 22.3 and the 12-month forward PE was 19.6. These are at or above the top of the normal range for PE multiples. In sum, this implies that next year’s earnings growth has already been factored into current prices and this will leave the equity market vulnerable during every earnings season in 2024.

Sector changes

A shift in relative performance at the beginning of an advance is often a sign of new sector leadership and we are using December’s relative performance as a predictor of 2024 price action. As a result, we expect good performance from the consumer discretionary, financial, and materials sectors. Weak relative performance in December suggests underperformance in energy, staples, and utilities. December’s good performance in financials is a bullish factor since new bull market cycles require participation from this sector. However, the out-performance in the materials group may be a warning that inflation is not yet under control. Altogether, 2024 may be a year that requires nimbleness and attention to good fundamentals.

Closing prices are as of December 29, 2023

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October: The Turnaround Month

After a spectacular equity performance in the second quarter of 2023, the six-month surge of 16% in the S&P 500 index was the best first-half performance seen in this index in forty years. However, it did not last. The third quarter took much – or in the case of the Russell 2000 index, nearly all – of these gains away. Losses in the third quarter were 2.6% in the Dow Jones Industrial Average, 3.6% in the S&P Composite, 4.1% in the Nasdaq Composite index, and 5.5% in the Russell 2000. By the end of September, the popular indices closed with more modest year-to-date gains of just over 1% in both the Dow Jones Industrial Average and the Russell 2000 index, nearly 12% in the S&P Composite, and a still substantial 26% in the Nasdaq Composite index. In short, a narrow list of large-capitalization technology stocks that dominate the Nasdaq Composite continued to be the outperforming segment of the stock market in 2023. On the other hand, the average stock ended mostly unchanged after the first nine months of this year.

Higher and Longer

There was a multitude of reasons for the price weakness experienced in August and September, beginning with the fact that a government shutdown was at hand. Financial markets have weathered many government shutdowns in the past without much difficulty. But distinct from other recent shutdowns, such as the record 35-day government shutdown that began in December 2018, the Federal Reserve’s monetary policy is currently restrictive and expected to remain so. It was different in December 2018 when the Fed was signaling it was tilting dovish and about to wrap up its hiking cycle. In short, the overriding problem at the end of the third quarter was that the 10-year Treasury yield hit a 16-year high above 4.5% and may continue to climb upward. This could become a major hurdle for equities in the months ahead.

The concept of higher interest rates was also made clear by Fed Chairman Jerome Powell and his fellow Board members. Although the Federal Reserve chose to pause rate hikes in September, comments following the September FOMC meeting indicated that additional rate hikes were likely in the near future and interest rates were apt to remain high throughout most, if not all, of 2024. This crushed the consensus view that rate cuts would likely materialize by mid-2024. Adding to the view that interest rates would remain higher for longer were comments by Jamie Dimon, CEO of JPMorgan Chase & Co. (JPM – $145.02) who stated that many businesses and investors were not prepared for a worst-case scenario in which interest rates hit 7% and stagflation grips America. As a result, investors were forced to reassess equity risk and valuation at the end of the third quarter.

October Turnaround

From a historical perspective, September tends to be a seasonally weak month for equity performance. In fact, September ranks dead last in terms of performance and is the only one of all twelve months that averages a loss. Conversely, October, which tends to have a worse reputation than September, ranks seventh of all twelve months with an average gain of 1.0% in the S&P Composite. What is unique about October is that it tends to be a turnaround month and while its performance has often been dramatic it has also been a month that includes a number of bear market lows. This year October could be a particularly interesting time since so many risks are on the horizon and apt to be discounted.

The End of Goldilocks

In addition to the risk of the government shutting down, there is a United Auto Workers strike that is ongoing and negotiations do not seem to be close to an agreement. Whatever agreement passes, it will be scrutinized by economists for signs of future wage cost pressures and linkages to inflation. In terms of household finances, the reinstatement of student loan payments on October 1st and the October 15th due date for individual tax payments for Californians are likely to take a bite out of future spending. This could slow the economy.

Large-capitalization technology stocks have been at the core of positive price performance this year, but the Federal Trade Commission and 17 State Attorneys General are currently suing Amazon.com, Inc. (AMZN – $127.12) for monopolistic and unfair business practices with an aim to break up the company into smaller pieces. Simultaneously, the Department of Justice and eight states are also suing Alphabet Inc.’s Google (GOOG – $131.85), the second DOJ antitrust lawsuit against the company in just over two years. This suit focuses on Google’s monopolistic activities in the online advertising business and seeks to make Google divest parts of its business. Both suits could produce landmark changes in the internet space and could unsettle the market in October.

From a global perspective, it is important to monitor the crisis facing China’s property development sector. China Evergrande Group (3333.HK – 0.32), collapsed in 2021 and set off a panic in global markets. Now Country Garden Holdings Company (2007.HK – 0.91), the country’s largest real estate giant, is in default. The property sector represents roughly a quarter of China’s economy, is closely tied to China’s financial system, and many Chinese individuals who paid deposits on properties could lose all of their investment if the company fails. Experts feel these real estate troubles could spread into China’s broader financial markets and this could do significant damage to the world’s second largest economy. If so, it would be a major negative for global economic activity.

Oil prices surged at the end of September after government data showed that US crude stocks fell to the lowest level since July 2022. This announcement drove energy futures to their highest settlement in 2023 and compounded worries about tight energy supplies as we head into the winter heating season. This event coupled with the previously announced production cuts of 1.3 million barrels a day by Saudi Arabia and Russia have energy analysts forecasting crude oil prices of $100 a barrel in the near future. The technical charts for WTI energy futures also suggest higher prices. Higher energy prices will be a problem for future inflation benchmarks and will only add to the view that further Fed rate hikes may be necessary in the future. All in all, the Goldilocks view of a soft landing for the economy, lower inflation, and lower interest rates was debunked in September and this left equities vulnerable.

Trading Range Market

However, this has not changed our view that the equity market will be stuck in a broad trading range in 2023. This range is best defined by the chart of the Russell 2000 index which has been trading between support at 1650 and resistance found at 2000. Trading range markets are not unusual from a historical perspective, and they typically result from an overhanging issue in the economy such as high inflation or broad-based debt problems. We believe they can be a substitute for a more dramatic bear market cycle, and they allow equity valuations to normalize. Keep in mind that equity prices rose substantially in the first half of the year, but earnings did not. As a result, equity valuations became stretched.

However, trading range markets do require a change in strategy since there tends to be a rotation in leadership throughout this “flat” cycle and this experience can be frustrating for long-term investors. Yet in the long run, buying stocks which represent good value, a solid predictable earnings stream, and an above-average dividend yield tends to generate the best overall performance. Look for stocks where earnings growth is greater than that of the S&P Composite, but the PE multiple is lower than the S&P. This combination should outperform in the long term.

Meanwhile, we would not rule out a decline in early October that creates an excellent buying opportunity!

*Stock prices are as of September 29, 2023

Disclosure: The information herein has been prepared by Dudack Research Group (“DRG”), a division of Wellington Shields & Co. The material is based on data from sources considered to be reliable; however, DRG does not guarantee or warrant the accuracy or completeness of the information. It is published for informational purposes only and should not be used as the primary basis of investment decisions. Neither the information nor any opinion expressed constitutes an offer, or the solicitation of an offer, to buy or sell any security. The opinions and estimates expressed reflect the current judgment of DRG and are subject to change without notice. Actual results may differ from any forward-looking statements. This letter is not intended to provide personal investment advice and it does not take into account the specific investment objectives, financial situation and the specific needs of any person or entity.

This communication is intended solely for use by Wellington Shields clients. The recipient agrees not to forward or copy the information to any other person without the express written consent of DRG.

Copyright © Dudack Research Group, 2023.

Wellington Shields is a member of FINRA and SIPC

Gail Dudack, Chief Market Strategist

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FOMO: Fear of Missing Out

The increases seen in equity indices in the first six months of 2023 exceeded most forecasters’ projections and the first half ended with a gain of nearly 16% in the S&P 500 index. This was the best six-month performance in this index since 1983; however, the action of the S&P 500 index was not the experience of all equity investors. The tech-centric Nasdaq Composite index rose nearly 32%, or over twice the performance of the S&P 500. Conversely, the Dow Jones Industrial Average advanced a mere 3.8%, or less than one-fourth the performance of the S&P 500. The broader-based small capitalization index, the Russell 2000, rose 7.2%, and the Invesco S&P 500 equal weight ETF (RSP – $149.64) gained less than 6% year-to-date.

The disparity among the performances of the indices is best explained by the fact that the returns in the Nasdaq Composite and S&P 500 indices were due to gains in a relatively small group of large capitalization technology stocks, primarily those companies with exposure to generative artificial intelligence. It was a classic display of “FOMO: fear of missing out” that drove the momentum of AI-related stocks. As an example, Nvidia Corp. (NVDA – $423.02), which designs the chips and software used to power generative AI systems, soared nearly 190% in the first half of the year and Microsoft (MSFT – $340.54), which recently partnered with OpenAI, a company that debuted its ChatGPT generative AI-powered chatbot in November 2022, gained 42% year-to-date.

According to S&P Global Intelligence, in the first six months of the year, the top 10 performing companies in the index accounted for 37.4% of the total gains in the S&P 500 and several of these stocks hit major milestones at the end of the second quarter. Apple (AAPL – $193.97) breached the $3 trillion market capitalization mark and Microsoft was next in line with a market capitalization exceeding $2.5 trillion at the end of June.

What was most surprising was the market’s positive performance in spite of significant hurdles, in particular, the aggressive interest rate increases done by the Federal Reserve Bank and a series of US regional bank failures. Typically, either of these two scenarios would have triggered a decline in equity prices. However, in the month of June there were a number of developments that boosted investor optimism. The Federal Reserve Bank decided to pause its series of interest rate increases on June 14. CPI and PPI data for May showed inflation pressures were decelerating in most sectors of the economy. May housing statistics hinted at a possible turnaround in the residential housing recession. And finally, the last revision of first-quarter GDP growth showed economic activity increased at a 2% annualized rate, up from an earlier estimate of 1.3%. This latter point may be the good news/bad news story for the second half of the year since a strong 2% number gives the Federal Reserve more leeway to increase the fed funds rate in the months ahead without fear of pushing the economy into a recession.

Recession or no Recession?

Those looking for a recession in 2023 have been stymied to date, but according to historical precedents, there have been a number of reasons to expect a recession is on the horizon. First and foremost, the inversion of the government yield curve has been near historic levels and exceeded only by the inversions seen in January 1981 and September 1973. In both 1981 and 1973, a deeply inverted yield curve predicted severe recessions ahead. Economists have focused on the yield curve as a warning shot because in the last 70 years an inverted yield curve preceded each of the 9 recessions defined by the NBER.

Another economic caution signal is the Conference Board Leading Economic Index (LEI). This index is a composite of 10 variables that typically foresees turning points in the business cycle by about seven months. Over the last 60 years, a sustained decline in the LEI has preceded all but two US recessions. False signals in the LEI are rare, although a decline for several months in October 2019 did not result in a recession. Nevertheless, the LEI has been declining for 14 consecutive months and this is the first decline of this length without an economic slowdown.

Monthly retail sales are an important indicator of economic activity since roughly 70% of US GDP is driven by personal consumption expenditures. When monthly retail sales are adjusted for inflation, it is easy to see if real sales are increasing or decreasing. Typically, if real retail sales are declining for more than three months it is either a symptom of a recession already in place or of one about to appear. As of May, real retail sales have been negative for six of the last seven months, yet GDP for the second quarter was revised upward to 2%. In short, a series of economic indicators have been waving warning flags of a recession and supporting a cautious view. Nonetheless, the economy has been resilient.

However, our favorite indicator for predicting a recession may hold the key to economic strength or weakness. Year-over-year changes in total employment have accurately predicted recessions in each of the last seven economic cycles. When the total number of people employed in the US turns negative on a year-over-year basis, it is a precursor of a recession. When this deceleration or decline in job growth reverses, it signals the end of a recession and the start of an economic recovery. By this simple measure, the US economy appears to be in fine shape because as of the end of May job growth was 2.7% YOY and well above the long-term average of 1.7%. The strength in the job market supports those economists who believe the Federal Reserve may be able to get inflation down to 2% without a major recession. Overall, this mix of indicators is likely suggesting that the second half of 2023 will be a mix of hot and cold sectors and of generally sluggish growth.

Student Loan Forgiveness

Several post-pandemic stimuli will end in the second half of the year, and this could negatively impact the consumer. The biggest of these is the end of student loan forgiveness. At the end of June 2023, the Supreme Court blocked President Biden’s bid to provide $430 billion of student loan forgiveness to borrowers. It was not a surprising development since according to the Constitution, the “power of the purse” resides in Congress, not the Executive branch of government. And though the White House responded with a string of new proposals to circumvent the Supreme Court ruling, it is very likely that a three-year moratorium of debt payment for student borrowers is coming to an end in October.

As a reminder, in March 2020, the CARES Act suspended payments for federally sponsored student loans, or roughly debt totaling $1.4 trillion. The Act also mandated a zero percent interest rate on outstanding balances and suspended collection activities on defaulted student loans. A Federal Reserve Board Study, “Implications of Student Loan COVID-19 Pandemic Relief Measures for Families with Children (May 2023), quoted an analysis which estimated that most student loan borrowers were able to improve their credit profiles during the pandemic and as of the Spring of 2022, grew their savings balances by $80 billion. This was a plus for economic activity. An analysis by Goss, Mangrum, and Scally (2022) estimated that approximately $200 billion in aggregate payments were waived for all borrowers that were eligible.

In other words, $100 billion per year in debt payments were frozen whether or not borrowers were current or in default on their loans, and this provided a substantial boost to consumer spending. However, in October, 44 million Americans will have to start paying back student loans with payments ranging from $210 to $320 per month and this will become a burden for many households. Moreover, many debtors will have had a change in their servicing companies in the last three years and this will add to the confusion in October and what is expected to be an increase in defaults and reductions in credit ratings for many borrowers.

All in all, economists expect that the resumption of student loan payments will generate a loss of roughly $70 billion in personal spending. While $70 billion may be a small number relative to nominal GDP of $26.5 trillion, it will be a major headwind for retail sales and some consumer-driven companies.

offense or defense?

In our view, the reason investors focused on stocks linked to generative artificial intelligence is that earnings growth for the overall market has been negative for three consecutive quarters and the outlook for 2023 corporate earnings remains uncertain. Although it has not received much attention, S&P Global data shows that in 2022 earnings for the S&P 500 declined by 5.4% and expectations for 2023 include an increase of 10% year-over-year. Overall, this does not support a robust bull market.

The June runup in equity prices was driven more by sentiment, and excitement in AI, than by earnings growth and as a result PE multiples have expanded. The S&P 500 index is now trading at 21.6 times earnings, which is 36% above the historical average of 15.9 times. This makes the equity market vulnerable to any unexpected surprises, particularly if the Federal Reserve continues to raise interest rates in the second half of the year.

However, since most of the recent gains have been concentrated in the AI favorite stocks which dominate the Nasdaq Composite index, this is where most of the risk is concentrated. The excitement in AI stocks is reminiscent of the Nifty Fifty era which led to the 1970 peak or the technology bubble of 2000. And the $1.44 trillion sitting in retail money market funds means there is plenty of dry tinder that could move these stock prices even higher. But we would not chase large capitalization stocks at this point. Instead, we would invest for the longer term and focus on companies with the most predictable earnings streams for 2023 and 2024 and where PE ratios are below the S&P 500 level of 21.6 times.

*Stock prices are as of June 30, 2023

Gail Dudack, Chief Strategist

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A Year of Volatility

The first quarter of the year closed with a gain of 7.0% in the S&P 500 index and a smaller 0.4% rise in the Dow Jones Industrial Average. Yet these numbers do not accurately reflect the market’s action in the first three months of 2023. The year started off with a bang as the S&P 500 soared 6.2% in January, but this quickly reversed to a swoon of 2.6% in February and this was followed by a 3.5% rebound in March. It was an extremely volatile quarter with nearly half the individual trading sessions generating gains or losses in the S&P 500 of 1% or more. January 6 posted outsized gains of over 2% in all three indices while the February 21 session posted a loss of 2% or more in all three indices.

But the quarter’s best price action was concentrated in stocks that had been the biggest losers in 2022. The worst sector performances last year were communications services (down 40%), consumer discretionary (down 38%), and technology (down 29%). However, it is important to note that the communications service sector includes not only companies like Verizon Communications Inc. (VZ – $38.89), but also familiar tech-like names such as Meta Platforms Inc. (META – $211.94), Alphabet Inc. Cl A (GOOGL – $103.73), Alphabet Inc. Cl C (GOOG – $104.00); and Netflix (NFLX – $345.48). The consumer discretionary sector includes large capitalization favorites like Amazon.com, Inc. (AMZN – $103.29) and Tesla, Inc. (TSLA – $207.46). The technology sector includes Microsoft Corp. (MSFT – $288.30); Apple Inc. (AAPL – $164.90), and Nvidia Corp. (NVDA – $277.77).

In other words, the early part of 2023 was a time of bottom fishing for investors. A trading strategy of buying the losers and selling the winners is what drove performance early in the year. As a result, the Nasdaq Composite index, home of many of the beaten down “large capitalization growth stocks” rose nearly 17% in the first quarter, outpacing all the other indices. However, we are not convinced that the first quarter represented the beginning of a new bull market move. First, it did not have the participation of the financial sector. Second, value usually outperforms growth during a period of rising interest rates because higher interest rates will limit speculative activity and goes hand in hand with lower PE multiples.

Making History

Financial stocks did not do well in the early part of the year. In fact, the first quarter of 2023 will go down in the history books because it contained two of the three largest bank failures in US history. Silicon Valley Bank, a regional bank in California, the second largest bank failure on record, was taken over by regulators on March 10, 2023, and Signature Bank, a New York-based regional bank, and the third largest bank failure in the US, closed on March 12, 2023. This led to ripples of uneasiness throughout the regional banking industry. Banking angst also increased on March 19, when Swiss regulators orchestrated a $3.25 billion takeover of Credit Suisse Group AG ADR(CS – $0.89), the second largest bank in Switzerland, by UBS Group AG (UBS – $21.34), the largest of Switzerland’s banks.

Some Swiss financial leaders are already criticizing this shotgun deal for reasons including the fact that the total value of exotic securities – like options or futures contracts – held by the combined merged bank could be worth 40 times Switzerland’s total economic output. The Swiss Parliament indicated it will quickly organize a special session to discuss the takeover, including “too big to fail” legislation and possible penalties against Credit Suisse managers. All in all, the global banking system was on edge in the first quarter, and it remains under pressure. Still, none of this is surprising in view of the fact that the Federal Reserve had just increased interest rates by 450 basis points in less than 11 months. The rise in short-term interest rates puts pressure on the balance sheets of most banks, and also leads customers to shift money from checking accounts into money market funds and other higher interest rate paying investments. The second quarter will continue to be a tricky time for bankers.

Pause, Raise, or Pivot

Nevertheless, as expected, the Federal Reserve increased the fed funds interest rate by 25 basis points on March 22, lifting the range to 4.75% to 5.00%. Some forecasters thought the Fed might pause or reverse its tightening policy due to the instability in the global banking sector. And though we agree that recent bank failures will result in tougher credit conditions for households and businesses, and this will have an impact on the economy similar to higher interest rates, we do not think the Fed’s job in terms of fighting inflation is over. It will, however, make the central bank’s task trickier.

The banking crisis forced the Federal Reserve to reverse its quantitative tightening policy. It moved quickly to add reserves to the banking system in order to calm the markets; and to date, the Fed’s balance sheet has expanded by more than $366 billion dollars. The quick response from the Fed appears to have assuaged depositors and the crisis seems halted for the moment. However, it also neutralized the Fed’s tightening policy.

Nevertheless, history shows that there has been a strong relationship between the Fed increasing its balance sheet (adding liquidity to the banking system) and rising stock prices. In sum, equity prices could rise in the near term. But we would not be complacent about a near-term rally. In our opinion, the Federal Reserve will take every opportunity to raise rates again in the future.

Federal Reserve Chairman Jerome Powell has stated that fighting inflation is a key priority and to do this the real fed funds rate needs to shift to positive, i.e., the fed funds rate needs to be measurably above the rate of inflation. Yet even after February’s personal consumption expenditure deflator (the Fed’s preferred measure of inflation) declined from 5.3% to 5% in February and the March rate hike lifted the top of the fed funds range to 5%, the real fed funds rate only “improved” from negative 60 basis points to zero. This means the Fed needs to see more improvement in inflation data and even so, is likely to raise interest rates at every opportunity in the coming months.

We do not expect to see a Fed pivot in 2023 unless the economic or financial backdrop becomes extremely unstable and such an event would not be good for equities. In sum, the bullish camp looking for a pause or a pivot may be disappointed in upcoming months, and this means the volatility seen in the first quarter is likely to continue.


The March expansion in the Fed’s balance sheet is apt to be a positive for the equity market in the near term. However, history suggests that whenever inflation reaches more than one standard deviation above the norm, or above 6.5%, the US economy experiences a series of rolling recessions; therefore, we would not be in favor of chasing rising prices because we believe the market will be rangebound for most, if not all, of 2023. This range is best seen in the Russell 2000 index between support at 1650 and resistance near the 2000 level.

In terms of recessions, the first in a series could have been the two consecutive quarters of negative GDP recorded in the first half of 2022. It would not be surprising to see another mild recession in the next twelve months. If so, the current earnings estimates for the S&P 500 companies are far too optimistic. We remain defensive and would protect portfolios as much as possible early in 2023. This means emphasizing areas of the stock market with recession-proof revenue growth and predictable earnings streams such as that seen in many energy, staples, utilities, aerospace & defense stocks.

*Stock prices are as of March 31, 2023 close

Gail Dudack, Chief Strategist

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Cash is No Longer Trash

The last twelve months have been a difficult time for many investors. Full year declines in the major equity indices totaled 8.8% in the Dow Jones Industrial Average, 19.4% in the S&P 500 and a whopping 33.1% in the technology-heavy Nasdaq Composite Index. For each index, this was the worst annual decline since 2008. But as we noted a year ago, 2022 would be a year that followed three consecutive annual gains in all three indices – and history shows that three years of double-digit gains are typically followed by a down year. However, 2022 was also the year in which economists, investors, and the Federal Reserve Board finally acknowledged inflation was a long-term economic risk. As a result, investors learned, or in some cases relearned, that higher inflation is detrimental to equity investors since it means higher interest rates and lower price-to-earnings multiples. And unfortunately, tighter monetary policy and an inverted yield curve have historically been precursors of an economic recession. In our view, how to deal with a recession may be the lesson to learn in 2023. 

Remembering 2022

Despite the sharp declines seen in equities, it is difficult to judge how 2022 will be remembered. For some investors the collapse of FTX, the centralized crypto exchange, and the arrest of its founder and ex-CEO, Sam Bankman-Fried (aka SBF) for fraud, will be at the top of the list for the year. It clearly marked a turning point for the cryptocurrency phenomenon. But 2022 was also a turning point for “high growth” stocks and the popularity of the FAANG components. Facebook, now known as Meta Platforms, Inc. (META – $120.34) fell 64.2%, Amazon.com Inc. (AMZN – $84.00) lost 49.6%, Apple Inc. (AAPL – $129.93) was an outperformer with a 26.8% loss, Netflix (NFLX – $294.88) declined 51.1%, and Google, now known as Alphabet Inc. (GOOG – $88.73) dropped 38.7%. Also noteworthy was the 65.0% trouncing in the price of Tesla (TSLA – $123.18) which was a direct result of Elon Musk buying Twitter for $44 billion on October 27.

On the international scene, Russia’s invasion of Ukraine in February had a major impact on the world in terms of the price of oil, the global economy, and geopolitics. That country’s spirit and bravery in the face of deadly aggression catapulted Ukrainian President Volodymyr Zelensky to the cover of Time Magazine as the 2022 Person of the Year.

The year also marked the end of an era for Great Britain when Queen Elizabeth II, after 70 years on the throne, died at age 96 on September 8. Simultaneously, the UK was experiencing a revolving door in political leadership and had three prime ministers in a seven-week period between September 6 and October 25. These were in order: Boris Johnson, Liz Truss (50 days as prime minister), and Rishi Sunak. Domestically, the US Department of Energy announced a major breakthrough in nuclear fusion after researchers successfully produced more energy from fusion than the laser energy spent to drive it. Politically, New York FBI agents stormed Donald Trump’s Florida Mar-a-Lago home in August removing 20 boxes of materials, while in Washington DC, the Democratic House select committee probed the January 6 attack on the US Capitol. On December 22 the committee released its final report recommending that Trump should be barred from ever holding office again and on December 30, the House Ways and Means Committee released Donald Trump’s tax records. In the November mid-term elections, the control of the House of Representatives shifted to the GOP.

Plus, 2022 was a year of numerous natural disasters. These included a northeastern winter storm leaving 100,000 Americans without power in January, a series of wildfires in southern Europe, floods in South Africa, Nigeria, Brazil, India, Afghanistan, and Pakistan (where major flooding submerged a third of the country), earthquakes in Indonesia killing 334 people, in Afghanistan killing 1,036 people and in California killing two, droughts in East Africa, and back-to-back hurricanes in Florida. Mother Nature was unforgiving in 2022.

Our 2023 Forecasts

Nonetheless, the global Covid pandemic had a major impact on fiscal and monetary policies around the world and its aftershocks will continue in 2023. Most developed countries employed historic amounts of stimulus to counter the economic shutdowns mandated in March 2020 to prevent the spread of the virus. Continuous stimulus packages led to booming stock markets and escalating inflation in 2020 and 2021 which were the upside of easy money. However, in May 2022 the Federal Reserve began to fight inflation by ending quantitative easing and increasing interest rates. This shift in monetary policy was late, but it was a predictable consequence of stimulus, and it had a debilitating impact on the equity market and PE multiples. In the first half of 2023 we believe there may be a final chapter to the post-pandemic hangover and Fed tightening, i.e., a recession. There are many signs of a pending recession, including the inverted Treasury yield curve, the slump in the real estate markets and weak retail sales. The downside of inflation is numerous, including a consumer with declining purchasing power, a profit margin squeeze, and declining corporate earnings.

With this backdrop we are forecasting GDP will grow 0.3% YOY, including negative growth in the first half of the year and a modest recovery in the second half. Much of this is based upon the fact that we expect the Fed to raise rates to at least 5% to 5.25% in the first quarter, and keep rates at that level for most, if not all, of the year. As a result, we forecast S&P 500 earnings will fall 10% to $180 in 2023. Unfortunately, applying an average PE multiple of 16.4 times earnings to $180 produces a low in the S&P 500 of 2952. In sum, we believe the S&P 500 will fall below the magic 3000 level in the first half of the year as the Fed fights to get inflation under control.

Recession Proofing

Given our forecasts, we believe a better buying opportunity will appear in the next six to eight months. Therefore, it would be advantageous to have above-average cash levels in portfolios. In our opinion, the US could be experiencing a series of rolling recessions, beginning with the two consecutive quarters of negative GDP recorded in the first half of 2022 and ending with a mild recession in 2023. The good news is that the balance sheets of households, corporations and banks are healthy, and this should temper the weakness expected in the economy. However, a recession will have a debilitating impact on earnings and stock prices. Therefore, we remain defensive and would protect portfolios as much as possible early in 2023. This means emphasizing areas of the stock market with recession-proof revenue growth and earnings such as energy, staples, utilities, aerospace, defense, and select areas in healthcare, such as health insurance.

Gail Dudack, Chief Strategist

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Staying Defensive

September has a long history of being a difficult time for the equity market and in 2022 this seasonal precedent held true once again. For the month, the S&P 500 fell 9.3%, notching its worst one-month decline since March 2020. The Nasdaq declined 10.5%, as soaring bond yields weighed heavily on high PE stocks and the Dow Jones Industrial Average tumbled 8.8%.

In terms of the third quarter, the S&P 500 fell 5.3%, the Nasdaq dropped 4.1%, and the Dow Jones Industrial Average lost 6.7%. Plus, for the first time since 2009 the S&P 500 and the Nasdaq suffered three consecutive quarterly losses. For the Dow Jones Industrial Average, it was the first time since 2015 that the index experienced three straight quarterly losses.

September’s poor performance was not a total surprise. As we noted in our July 2022 Quarterly Market Strategy Report, by the end of June, the S&P 500 had suffered its worst first-half performance since 1970. But more importantly, these two declines had something in common — they both took place during an economic recession. In general, it has been our view that economic activity was at risk for most, if not all of 2022, due primarily to the brunt of double-digit inflation and the negative impact this has on consumers’ purchasing power, profit margins, PE multiples, and monetary policy. Our opinion has not changed.

Earnings Recession

Although the two quarters of negative GDP growth seen in the first half of this year have not officially been declared a recession by the National Bureau of Economic Reseach, there is little doubt that it has been a difficult time for both consumers and businesses. One example is corporate earnings. Despite the headlines in the financial press indicating that most S&P 500 companies beat earnings expectations in the second quarter of the year, the back story is that these earnings estimates were substantially reduced ahead of reports. In reality, the S&P Dow Jones consensus earnings estimate declined more than 8% from its April high. The full year estimate for year-over-year earnings growth has now collapsed to breakeven according to recent S&P data. More importantly, full year earnings growth would be negative if earnings for the energy sector are excluded from the total.

In short, many companies are experiencing a deterioration in earnings in 2022, as is typical of a recession. We lowered our S&P 500 earnings forecast twice in the last eight weeks, but a further weakening of the economy could put even our reduced $209 per share estimate in jeopardy. It is this uncertainty surrounding earnings growth that has shaken investor confidence in recent weeks and taken stock prices lower.

Pivotal September

Plus, a number of global events helped trigger a negative shift in investor sentiment in September. Early in the month, the two-year advance in energy prices led to Finland announcing a 10-billion-euro credit package for the long-suffering Finnish power industry. The country also extended an additional 2.35-billion-euro package to its largest state-owned energy company which provides power to several countries in Europe. Some analysts estimate that the broader EU energy derivatives market may require as much as $1.2 trillion in government backing due to deteriorating debt in the sector.

Later in the month, the newly installed UK Prime Minister Liz Truss initiated a surprise tax cut intended to boost England’s struggling economy. However, concern about the new government’s fiscal responsibility and fear that this stimulus would inspire even more inflation led to turmoil in the financial markets. The British pound plummeted to an all-time low against the dollar, yields in 10-year British government gilts jumped above 4% for the first time in twelve years and the Bank of England hiked interest rates 50 basis points to its highest level in 14 years.

In addition, the Bank of England was forced to buy bonds after British pension funds struggled to meet margin calls on debt instruments, some of which lost a third of their value in four days. This chaos in the global debt market is a big concern, and we worry that rising interest rates can continue to have unexpected consequences in the months ahead.

All in all, the fear of recession in Europe and the US increased at the end of September and the feedback loop between stock and bonds became blatantly apparent.

Recession Proofing

In our opinion, the US is either in the midst of a recession or at risk of falling into a recession in coming months. Meanwhile, the Federal Reserve will continue to increase interest rates which will slow many sectors of the economy even more. Therefore, we continue to remain defensive and look to protect portfolios as much as possible for the likelihood of weak economic activity. This means emphasizing areas of the stock market that have predictable revenue growth and earnings streams. Many individual stocks can have these characteristics but in general, this suggests household necessities such as utilities, staples, and energy. The Russian invasion of Ukraine has stimulated demand for aerospace and defense, which is another recession-proof sector. In an environment of rising interest rates, we expect value stocks to continue to outperform growth stocks.

October: The Turnaround Month

The good news is that October has often been a time of reversing downtrends. In fact, twelve of the 48 declines of 10% or more seen since 1931 have taken place in October, which is why October has been called “the bear killer.” And though many technical indicators broke down at the end of September, investor sentiment hit historic extremes.

The AAII sentiment readings recently showed a decline in bullishness to 17.7% and an increase in bearishness to 60.9%. This 17.7% bullishness reading is among the 20 lowest readings since the AAII survey began in 1987. Optimism was at a similar level in May. This is favorable since equity prices tend to be higher in the next six and/or twelve months following such extreme readings in sentiment.

Disclosure: The information herein has been prepared by Dudack Research Group (“DRG”), a division of Wellington Shields & Co. The material is based on data from sources considered to be reliable; however, DRG does not guarantee or warrant the accuracy or completeness of the information. It is published for informational purposes only and should not be used as the primary basis of investment decisions. Neither the information nor any opinion expressed constitutes an offer, or the solicitation of an offer, to buy or sell any security. The opinions and estimates expressed reflect the current judgment of DRG and are subject to change without notice. Actual results may differ from any forward-looking statements. This letter is not intended to provide personal investment advice and it does not take into account the specific investment objectives, financial situation and the specific needs of any person or entity.

This communication is intended solely for use by Wellington Shields clients. The recipient agrees not to forward or copy the information to any other person without the express written consent of DRG.

Copyright © Dudack Research Group, 2022.

Wellington Shields is a member of FINRA and SIPC

Gail Dudack, Chief Strategist

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Recession Proofing

Between March and June of this year, all three main market indices, the S&P 500 index, the Dow Jones Industrial Average, and the Nasdaq Composite index, recorded their worst 3-month declines since the first quarter of 2020. The S&P 500 suffered its worst first-half performance since 1970. But it is important to note that while these declines were steep, they had something else in common —  they took place during an economic recession. This is both the good news and the bad news for today’s investors.

Keep in mind that the Bureau of Economic Analysis (BEA) recently confirmed that the US economy, or GDP growth, declined 1.6% in the first quarter. And since the National Bureau of Economic Analysis defines an economic recession as two consecutive quarters of negative GDP growth, it is possible that the US economy is already in a recession. In line with this possibility is the fact that, aside from employment statistics, many economic data series have been in a decline all year.

On July 28, the BEA will release its initial estimate for second quarter GDP and with this release, economists will have a much clearer sense of the strength or weakness of the economy. But even if second quarter GDP growth is positive, the fact that the Federal Reserve plans to slow the economy by raising interest rates at each of this year’s upcoming FOMC meetings, means economic growth will remain at risk for most of 2022.  

Playing defense

Therefore, we should assume that the risk of recession will be high over the next twelve months. If so, it is important for investors to be defensive and insulate their portfolios against such weakness. This means emphasizing areas of the stock market that should have the most predictable consumer demand and reliable earnings. In short, we would focus on household necessities such as staples, utilities, and energy. Aerospace and defense are expected to see demand and earnings growth in the wake of Russia’s invasion of Ukraine. Ironically, these are the same areas of the stock market that we have been emphasizing in order to offset the impact of inflation. In short, these industries are both inflation and recession resistant.

We have been warning about the negative impact of inflation for over twelve months. High inflation is a destructive trend that acts like a massive tax increase on households, results in substantially higher interest rates, it pressures corporate margins, and it lowers the price-earnings multiples for stocks. Because of these factors, stock market leadership has made a massive shift from growth (including technology stocks where price-earnings multiples tend to be highest) to value (where price-earnings multiples tend to be low and dividend payouts high). We expect value stocks will continue to outperform growth stocks until inflation is under control, which may take a while. 

Recession Risk

There are a number of areas that suggest the economy is slowing, but the most important may be housing. The housing market represents 16% to 18% of GDP and it is showing signs of a weakness. The National Association of Realtors (NAR) publishes an affordability composite index and in April it fell to its lowest reading since the 2007 recession. The NAR housing market index has been falling all year, but in June the index measuring traffic of potential buyers fell to its lowest reading since June 2020. Unit sales of existing and new homes declined 8.6% YOY and 6% YOY, respectively. And new home sales are down 30% from its January 2021 peak. What is worrisome is that the median price of an existing home increased 15% YOY in May, but in the same period, personal income increased only 5.3% YOY. Moreover, disposable income rose 2.8% YOY and real disposable income fell 3.3% YOY. A combination of high prices, falling disposable income and soaring mortgage rates will have a negative impact on housing and the economy in coming months. The fact that on a year-over-year basis, real disposable income declined for twelve of the last thirteen months is not a good sign for the US economy which is 70% consumer-driven.

Consumer confidence levels are also giving warnings signs. Conference Board consumer confidence fell to 98.7 in June, its lowest level since February 2021 and expectations fell to its lowest point since October 2011. The University of Michigan consumer sentiment index fell to 50 in June, the lowest headline reading on record, and lower than any time during the recessions of 1980, 1982, 1990, 2001, 2008-2009, or 2020. Expectations fell to 47.5, the lowest reading since August 2011 (47.4) or May 1980 (45.3). In short, in both surveys, consumer confidence is at levels last seen during a recession.

The Good News

The good news is that while the stock market tends to be the best predictor of an economic recession, it usually bottoms halfway through a recession. This means that if second quarter GDP is negative, it suggests that the stock market would have been at, or close to, a bottom at its June 16th low in the S&P 500 index of 3666.77.

In addition, a recent poll by the American Association of Individual Investors’ showed only 18.2% of small investors are bullish and 59.3% are bearish. This was the fourth weekly poll with less than 20% bulls and more than 50% bears since end of April. The 8-week bearish reading of 50.9% on May 18 was the highest bearish percentage since the March 12, 2009 peak. According to the AAII, equity prices tend to be higher in the next six and/or twelve months following such extreme readings.

In sum, while the first half of the year has been a challenging period, it is clearly not the time to be bearish. In fact, several factors suggest that the slowdown the Fed has set as its goal may be materializing faster than expected. Ironically, this would be the good news. The one concern we have is that earnings forecasts are still too high in many cases, and this could make second quarter earnings season in late July a time of weakness. Volatility is likely to continue but investors should maintain a long-term view and adjust portfolios accordingly. The third quarter could produce opportunities to buy equities at attractive prices.

Disclosure: The information herein has been prepared by Dudack Research Group (“DRG”), a division of Wellington Shields & Co. The material is based on data from sources considered to be reliable; however, DRG does not guarantee or warrant the accuracy or completeness of the information. It is published for informational purposes only and should not be used as the primary basis of investment decisions. Neither the information nor any opinion expressed constitutes an offer, or the solicitation of an offer, to buy or sell any security. The opinions and estimates expressed reflect the current judgement of DRG and are subject to change without notice. Actual results may differ from any forward-looking statements. This letter is not intended to provide personal investment advice and it does not consider the specific investment objectives, financial situation and the specific needs of any person or entity.

Gail Dudack, Chief Strategist

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Stagflation or Recession?

To date, 2022 has been a rough year for equity investors. After seven consecutive quarters of solid price gains, the first quarter of the year ended with a loss of 4.9% in the S&P 500 index, a fall of 4.6% in the Dow Jones Industrial Average and a larger 9.1% decline in the Nasdaq Composite index. These were the first 3-month declines in the indices in exactly two years, or since early 2020, when the COVID-19 global shutdown triggered a global recession.

Still, considering the alarming invasion and bombing of Ukraine by Russia in late February, we believe the decline in stocks has been remarkably orderly. Particularly since this attack has catapulted the world economic and geopolitical environments into turmoil. In addition, February’s inflation benchmarks revealed that consumer prices were soaring 7.9% year-over-year – a forty year high — and Russia’s conflict with Ukraine is expected to exacerbate prices in fuel, grain, and fertilizer for the foreseeable future.

Last, but far from least, in mid-March the long awaited, yet decisive shift from a monetary policy of extreme ease to tightening began. This shift by the Fed reverses the historic liquidity boost that has been supporting stock prices for the last 24 months. In addition, following the FOMC meeting, Chairman Jerome Powell indicated there will be many more interest rate increased before year-end and the consensus is now forecasting rate hikes in each of the next six FOMC meetings this year. There is no doubt that a shift in monetary policy will impact the US economy. The only question is how much. Will the Federal Reserve be able to manage a soft landing for the economy? Or will the shift trigger stagflation or a recession? The next few months should be telling.

Changing Landscape for Investors

In short, the environment for equities has changed and the Fed’s shift to a tightening policy will be pivotal. Expectations of multiple rate hikes have triggered fears of an inverted yield curve and a recession. While we believe this fear is real, we also believe it is premature. First, inverted yield curves can be measured in many ways, but in our opinion, a truly inverted yield curve requires the 3-month

A truly inverted yield curve requires the 3-month Treasury bill yield to exceed the yield on the 10-year Treasury note yield. This is not in place and is unlikely to appear in coming months.  

Treasury bill yield to exceed the yield on the 10-year Treasury note yield. Given the present level of short-term rates, all things being equal, it would take eight 25 basis point rate hikes by the Fed to invert the yield curve. This is unlikely to materialize in coming months.

Second, history shows that markets usually rally following early rate hikes and begin to weaken only after four consecutive rate hikes take place within a twelve-month period. This implies the actual risk associated with inverted yield curve will appear later in the year.

In our view, the 10-year Treasury note market is a huge global market, is not under the Fed’s control, and due to its global reach, can be an excellent predictor of future economic strength. Yields often fall, sometimes precipitously once investors expect rising interest rates will significantly damage economic activity. We would remain alert to this possibility, but do not expect it soon. And remember, the curve usually inverts six to twelve months prior to the start of a recession.

Earnings will be the key to investments

Balanced portfolios should include stocks with a predictable earnings stream shielded from inflation, price earnings multiples at or below the S&P 500 average and dividend yields greater than 1.5%.  

Whether the Russia-Ukraine conflict increases or diminishes, whether inflation grows or weakens, earnings growth, or the lack thereof, is the true foundation of any market trend. With this in mind, the upcoming first quarter earnings season will be important since it will indicate how well, or how poorly, companies have weathered the various difficulties of supply constraints, inflation, and rising interest rates, of the first quarter. First quarter earnings season begins this month, and it could become a market moving event.

Beneficiaries of inflation such as energy, food, and staples are expected to do best and outperform this year. The Russian invasion has been the catalyst for many Western countries to increase their defense budgets and this increase in spending will benefit defense stocks and the industrial sector. Cybersecurity is another sector that is likely to see more capital investment and rising demand from consumers. Conversely, we will be watching company statements from housing and auto companies to see how corporate leaders respond to the prospect of rising interest rates and waning demand.

Investing in a new environment

In an era of rising inflation and higher interest rates, equites can still perform well but portfolios need to adjust. The best insulation today would a balanced portfolio that include stocks with earnings shielded from the pressures of inflation, price earnings multiples at or below the S&P 500 average, and stocks with dividend yields greater than 1.5%.

However, given the geopolitical and policy uncertainties in the current environment; we would not be surprised if equity indices trade within a broad trading range for most of 2022. If so, holding a core portfolio tilted toward value stocks is still advised. But for those willing to be nimble, we expect a trading opportunity may appear in the technology sector in coming months.

Gail Dudack, Chief Strategist

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A Year of Reckoning

A year ago, we stated that despite denials from the Federal Reserve Board and the administration, inflation would become a big problem for consumers and the securities markets in 2021. We did not believe that rising prices would be transient or mild because monetary and fiscal policy had remained too stimulative for too long. Investors managed to ignore inflation for most of 2021, but at the December 2021 FOMC meeting, with consumer prices rising 6.9% year-over-year and producer prices for finished goods rising more than 13% year-over-year, Chairman Jerome Powell did accept the existence of inflation. He stated quite clearly that monetary policy needed to change in 2022 and that quantitative easing would end by March and interest rates could increase two or three times this year. This is a pivotal switch.

Fed Policy in the Crosshairs

However, the Federal Reserve appears to be behind the curve in terms of fighting inflation since big price hikes are now widely accepted and widespread. As a result, the shift from easy to tightening monetary policy might need to be longer and more frequent than if it had begun sooner. And though this policy adjustment will be the big challenge for investors in 2022, it is a necessary move. The asset inflation seen in housing, commodities, securities, energy, and all forms of collectibles has been the result of too much money chasing too few goods and this is due to the Fed feeding the banking system with too much cash. The alternative would fuel an asset bubble environment.

Quantitative easing and/or falling interest rates have usually been a positive for equities and this is the source of the Wall Street adage “Don’t Fight the Fed.” The end of quantitative easing (QE) has no predictive value for equities. However, one could say that without quantitative easing equities no longer have the wind at their back and would need a new catalyst to move higher. What is more likely to pose a problem for equities is the Fed’s transition from historically low to higher interest rates. Bonds and stocks compete as investments, therefore as interest rates rise, the pendulum of risk shifts from bonds to equities. Higher interest rates raise the bar for equities in valuation models.

Investing in a Changing Environment

In an era of rising inflation and higher interest rates, equites can still perform well but portfolios may need some adjustments. It is important to note that inflation and interest rates pressure high PE stocks since they represent the highest-risk segment of the market. This explains the recent selling pressure in high-flying tech stocks. In 2022, investors should look to protect portfolios from these risks. The best insulation would be balanced portfolios that include stocks with earnings shielded from the pressures of inflation, price earnings multiples at or below the S&P 500 average, and stocks with dividend yields greater than 1.5%.

A number of sectors should do well in 2022 despite rising prices and interest rates. For example, energy stocks have been the beneficiaries of inflation. The sector recorded a gain of 47.7% before dividends in 2021 which made them the best performing sector in the S&P 500. However, gasoline demand should continue to increase as the pandemic fades and the United States Energy Information Administration (EIA) expects global consumption of petroleum and liquid fuels to increase by 3.5 million barrels per day in 2022 to average 100.5 million barrels per day. It follows that energy sector earnings should be strong in 2022. Moreover, energy stocks tend to have low PE multiples and many stocks have dividend yields that are double the current rate in the 10-year Treasury note.

Financial stocks are another sector that can not only weather inflation but do well as interest rates rise. Banks, in particular, can benefit from a steepening yield curve. Assuming COVID-19 and its variants fade into history in 2022, global economic activity will expand, and financial stocks will benefit from this increased activity. In addition, the sector tends to have modest valuation multiples and solid dividend yields. But note that as the world of finance continues to change, so does the composition of the S&P financials sector. Many fin-tech stocks were added to the S&P financial sector in December, such as PayPal (PYPL – $187.60), Fiserv Inc. (FISV – $108.83), and Jack Henry & Associates (JKHY – $169.75). Although bank stocks tend to have healthy PE multiples and yields, these new additions will have higher earnings growth potential but higher PE multiples. This will raise the average PE and lower the yield of the overall sector.

Consumer staples should also fare well in a volatile and changing environment. Staples are a defensive play that should demonstrate growth as the global economy recovers. Valuations for staples are modest, and the yields are above average. Note that in December S&P added Target Corp. (TGT – $230.78), Dollar General (DG – $238.37), and Dollar Tree Inc. (DLTR – $140.96) to its staples sector. We find these interesting additions. In an environment of rising inflation, when households are acutely price sensitive, these three retailers are known for providing quality products at low prices. They are attracting consumers from all income brackets. Again, investors should be looking for companies that can not only survive, but thrive, in an inflationary environment.

The Technology Sector

Technology stocks may come under pressure in 2022 as interest rates rise. But, in our view a correction in the technology sector would provide a long-term buying opportunity. In other words, be patient when adding technology stocks to portfolios.

As a final note, history has shown that three consecutive years of double-digit gains – as seen in the S&P 500 and Nasdaq Composite index — have been followed by a down year. This implies the S&P 500 and Nasdaq Composite index, which are heavily influenced by the largest market capitalization stocks, may come under pressure in coming months. But declines are a normal part of any equity cycle. The S&P 500 has more than doubled since the March 2020 low without as much as a 10% correction. A correction in the next twelve months should be viewed as a healthy and stabilizing event for the longer term.

*Closing prices as of 1/7/2022

Gail Dudack, Chief Strategist

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