With the Nasdaq Composite and Russell 2000 down 20% from their all-time highs and many individual stocks, including most of the FAANG stocks, down much more than 20% (for example, Netflix, Inc. [NFLX – $341.76] has had a 50% decline), we believe it is only proper to define the current sell-off as a bear market.
The fact that the S&P 500 and the Dow Jones Industrial Average have declined only 13% and 11.3%, respectively, is a mere technicality, in our opinion; and listening to financial news anchors talk about the S&P reaching “correction territory” makes us scratch our head. As history has shown us, the large-capitalization stocks are often the last to fall in a bear market, so the outperformance of the DJIA and the SPX is not unusual or consoling. And unfortunately, we do not believe the lows have yet been found. Neither technical nor fundamental guidelines give us comfort this week, and both sets of indicators suggest there is more downside risk in the market.
In our annual outlook forecasts for 2021 and 2022, we indicated that inflation would be the biggest hurdle facing equity investors in the months and years ahead and this finally became widely accepted late last year. Russia’s invasion of Ukraine is a new factor that could make inflation even more crippling than we anticipated. Although crude oil and energy stocks broke out of major base patterns prior to the Russian invasion, and the energy sector has been the best performing sector all year, WTI has soared an additional 38% on a closing price basis and 50% on an intra-day trading basis in recent days. It is well-known that Russia is a major oil exporter, but Ukraine and Russia are also major exporters of wheat and corn. Russia is a major producer of nickel, palladium, and fertilizer. And as the conflict continues into its second week without any hope of an easy or quick resolution, commodity prices have begun to soar. It now appears that shortages of commodities will be global and will continue well into the future. This is not good news for inflation or most of the world economies. As a result, the Russian invasion appears to be escalating the existing shift in the underlying market from growth to value. However, the conflict is also triggering a shift from technology to energy, commodities, and defense stocks. Last week we noted the shift to defense and aerospace and downgraded the financial sector from overweight to neutral and upgraded the industrial sector from neutral to overweight. We have an overweight recommendation of the staples sector where food-related stocks are found, but the S&P 500 does not include pure commodity plays where many of the breakouts in chart patterns exist. Nevertheless, this week we are upgrading the materials sector from underweight to neutral and downgrading the communication services sector from neutral to underweight. We would not be surprised if there is also a shift in leadership within the technology sector and would emphasize cybersecurity and cyber-defense-related stocks. See page 14.
Fundamentals are not encouraging
Fundamentals are important in a bearish market since they help define levels of value and identify potential lows in both stocks and the indices. With this in mind, we turn to our valuation model where we have a 2022 earnings estimate for the S&P 500 of $220, a 7% increase. Currently our forecast for inflation suggests prices will decelerate to a 4.4% pace, but recent developments suggest this may be too optimistic. Our interest rate forecasts indicate yields should rise to 0.8% in the 3-month Treasury and 2.2% in the 10-year Treasury note. This combination of inputs results in a forecasted “average” PE multiple of 15.8 times for 2022. Note that a 15.8 multiple is also equal to the average PE seen over the last 75 years. Our $220 earnings estimate coupled with a 15.8 multiple yields an SPX target of 3476. In short, our model predicts a decline of 27.5% in the SPX would be required to return the broad indices to “fair value.” This is an uncomfortable forecast but reasonable given the number of uncertainties that lie ahead for investors if the Russian/Ukrainian conflict is not resolved soon.
Prior to the Russian invasion, we believed the equity market had begun a correction that would bring prices and PE multiples back in line with traditional fundamental benchmarks. Unfortunately, the Russian invasion has upset the financial and economic landscape and puts even our modest forecasts for earnings, inflation, and interest rates at great risk. For example, higher commodity costs are likely to pressure profit margins and lower revenues for many companies and could make our $220 earnings estimate too optimistic.
This week both President Biden and several administration officials stated that US energy production is currently at record levels. However, we doubted this was true due to restrictions and regulations placed on the energy sector after the 2020 election. Data from the US Energy Information Administration (EIA) contradicts the administration’s statements. On page 3 we display an EIA chart with annual data that shows the US energy production peaked in 2019. A second chart shows weekly field production of crude oil in the US that confirms US oil production peaked in 2019. Industrial production data from the Federal Reserve Board of St. Louis also confirms that energy production peaked in 2019, fell during the pandemic, recovered, but is still well below 2019 production levels. In short, US production is not at peak levels and there is much more potential for energy production. If this were encouraged, Americans would not have to suffer the extreme prices currently seen at the pump and in energy bills.
The price of WTI crude oil jumped $20 this week and briefly touched $130 a barrel, exceeding the price target of $110 we noted last week. Some strategists are suggesting prices can move considerably higher, particularly after the Biden administration indicated the US will not buy Russian oil. Regrettably, there was not a simultaneous decision to increase US production. We expect the FOMC will decide to raise rates 25 basis points at the March meeting. And though the 10-year yield rose from 1.7% to 1.82% in the past week, the risk of an inverted yield curve in 2022, and a recession, continues to grow, in our view. See page 7.
Technical Death Crosses
We are not ardent followers of technical configurations called golden crosses or death crosses, but they are followed by many technicians and traders and are therefore worth noting. A golden cross occurs when a short-term moving average, such as the 50-day moving average, crosses above a long-term moving average like the 200-day moving average. A death cross is the opposite configuration. The first index to have experienced a death cross in the current bear market was the Russell 2000 index. This was followed by the Nasdaq Composite index, and this week, the Dow Jones Industrial Average is close to joining the group. Even the Wilshire 5000 index has formed a death cross. Interestingly, out of the five FAANG stocks, the only one that does not display a death cross is Apple, Inc. (AAPL – $157.44). The main reason we are not ardent followers of this technical pattern is that both the death cross and golden cross tend to appear late in a trend. Still, the importance of these death crosses is that the 200-day moving average becomes major long-term upside resistance in each stock and index. We continue to favor stocks over bonds and believe that stocks with a history of increasing dividends and yields in excess of 2.2% can best weather the volatility that is apt to continue in the first half of the year.
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