Quantitative Easing

Last week we wrote that the economic, political, and technical backdrop for the equity market was the best it had been in many months and that this combination would set the stage for a year-end rally. In our opinion, the inability of Congress to pass a large stimulus package – which could have included hefty business and personal tax rate increases — combined with the positive seasonality of November, December and January should not be ignored. Moreover, the monetary policy changes expected this week have been well telegraphed and discounted by investors and should make the slow elimination of quantitative easing a non-event. In sum, barring some unexpected negative mishap, we believe the stage is set for higher stock prices and a decent Santa Claus rally. Nonetheless, earnings growth is forecasted to slow in 2022, and though this may not have an impact until next quarter, we would still emphasize quality stocks. Companies with inflation resistant earnings growth are apt to be the best performers in the months ahead.

Earnings Backdrop

Third-quarter earnings are center stage again this week and as the economy bounces back from the coronavirus pandemic, most companies continue to report better-than-expected results. One should keep in mind that estimates were downsized in September when analysts were concerned about supply chain issues hurting third quarter estimates. Nonetheless, with 320 companies having reported, Refinitiv IBES indicates that S&P 500 earnings are anticipated to have climbed 40.2% in the third quarter from a year ago. This hefty earnings jump produces a nice cushion for the broad market as we move into the final months of the year.

Technical Challenges

But there are a few challenges in the technical backdrop this week. The 25-day up/down volume oscillator is at 1.96 and neutral after spending only two days in overbought territory last week. To confirm the string of new highs seen in the popular indices this week, this indicator should move to and remain in overbought range for a minimum of 5 consecutive trading days. However, the last time this indicator did this and confirmed new highs in the equity market was nine months ago, between February 4 and February 10 of this year.

In February, when the Russell 2000 previously recorded a record high, overbought readings in this indicator confirmed the equity market’s advance. Since then, there have been no validations of a succession of record highs. We should also point out that while the many indices made marginal new highs on November 2, breadth data was not convincing on the NYSE and data showed more declining issues than advancing issues for the session. Volume was also disappointing since it slipped below its 10- day average. In sum, November 2 was a great day for equities globally. The S&P 500, the DJIA, the Nasdaq Composite, the Russell 2000, the Wilshire 5000, France’s CAC 401, and the MSCI all-country world index all made record highs. However, it was not a convincing day from a breadth perspective. This could change over the course of the next week, but for example, the bullish breakout in the Russell 2000 index from a 9-month trading range needs to see confirming follow-through. In the interim we believe this is another reason to emphasize quality stocks.

Economic Data and the Fed

It has been a busy week in terms of economic releases and overall, we believe most results relieve the Fed of any pressure to raise interest rates. In general, we found economic data discouraging. The advance estimate for third quarter GDP indicated economic activity grew at a seasonally adjusted annualized rate of 2.0%. This was a big disappointment since 2.0% is well below the long-term average for GDP growth of 3.2%. In addition, third quarter activity was concentrated in a buildup of private inventories. This is a negative since the need to increase inventories is diminished and this could reduce economic activity in the fourth quarter. The main weaknesses in the third quarter estimate were found in personal consumption of goods, the negative drag from trade and a decline in residential investment. See pages 3 and 4.

The decline in the household’s consumption of goods can be explained by the recent data on personal income, consumption, and savings. Personal savings were $1.3 trillion in September down from $1.67 trillion in August and well below the April 2020 peak of $6.4 trillion. This is a sign that the “pent-up demand” economists expect from the pandemic’s buildup of household savings is quickly evaporating. September’s savings rate was 7.5% down from 9.2% in August and closing in on the 20-year average rate of 6.8%.

Personal income was $20.5 trillion in September, down from $20.7 trillion in August and well below the $24.1 trillion seen in March 2020. Personal disposable income was $17.9 trillion in September, down from $18.1 trillion in August, and also well below the $21.7 trillion seen in March. See page 5. However, wages rose to a record $10.38 trillion in September as people began to move back into the workforce. Keep in mind that wages represented a peak of 65% of personal income in July 1966 but have been steadily declining as a percentage of income and hit a low of 41% in March 2021. Wages rose to 51% of total personal income in September but much of this gain is statistical.

September’s headline personal income number declined as government social benefits fell from $4.2 trillion in August to $3.8 trillion in September. Total unemployment benefits fell from $352.3 billion in August to $97.7 billion in September. Note that unemployment benefits peaked at $1.4 trillion in June 2020. See page 6.

The decline in disposable personal income from $1.81 trillion in August to $1.79 trillion in September could reverse and improve dramatically if people return to work as unemployment insurance benefits are exhausted. But if employment does not increase and income stagnates, the outlook for the economy will dim. Historically, there has been a close, but lagging, relationship between the year-over-year growth in disposable personal income and the year-over-year growth retail sales. To date, retail sales have been the beneficiary of the massive 32% YOY growth in disposable income in March of this year. Retail sales grew nearly 12% YOY in September (14.2% on a 3-month average) and were easily beating inflation. See page 7. However, this may not continue. Disposable income growth slipped to 2.3% YOY in September, which is less than half September’s rate of inflation of 5.4%. This implies that retail sales will weaken in the months ahead. Companies have indicated that they have been able to pass on higher raw material and transportation costs to consumers. However, if household incomes do not grow faster than inflation in coming months, this cannot continue. Either corporate margins will contract, or top line growth will decline. This is not good news for 2022 profits. Therefore, we are not surprised that consumer and business confidence indices were weak in October. The University of Michigan consumer sentiment index fell from 72.8 in September to 71.4 in October and while the Conference Board Consumer Confidence index rose from September’s dreary 109.8 to 113.8 in October, it remains below previous highs. The NFIB confidence index continues to languish below 100. See page 7. In short, economic data suggests there is no reason for the Fed to raise rates in the foreseeable future. This is positive for equity investors.

Gail Dudack

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