Stay Nimble

We do not believe the lows of the current bear market cycle have been found; however, technical indicators suggest a rebound in prices is likely in the near term. Supporting a short-term rally scenario is the fact that both the Nasdaq Composite and the Russell 2000 traded more than 20% below their 200-day moving averages in mid-May. A 20% or greater spread between price and the 200-day moving average, is extreme, even in a bear market, and it is typically followed by a reflex rally. However, to date, we have not been impressed by recent rally attempts; volume has decelerated on rally days and while there have been positive breadth days, no 90% up days — a sign of buying conviction — have appeared. In sum, traders should remain nimble, and investors should remain cautious.

Economic Caution

There are many reasons to remain wary of equities at this juncture; but our biggest concerns are the resilience of the economy, the health of the consumer, and the risk this combination puts on earnings growth. First quarter GDP growth was revised from negative 1.4% to negative 1.5% last week. This reduction is significant since it indicates that the first quarter economic growth rate was not only negative, but it also fell below the low end of the standard deviation band – a level that has often indicated a recession is in place. See page 3. Weakness in the first quarter was concentrated in trade and inventories, but consumption was also weak.  

We believe it is wise to be on a “recession watch” and one tool we have found to be helpful in predicting GDP strength or weakness has been real retail sales. In the top chart on page 4, we overlay a 3-month moving average of the year-over-year rate of real retail sales with quarterly GDP. We have found that when the 3-month average of real retail sales turns negative, it has been an indication that a recession is in place. For the month of April, real retail sales were negative 1.55% YOY, but the 3-month average remained positive at 5.2% YOY. However, this means retail sales will be an important series to monitor in the months ahead. Two more months of negative real sales could point to a second quarter of negative GDP, i.e., a recession.

Another statistic that concerns us is the trend in personal income, or more precisely, real disposable personal income. This latter statistic reflects the true amount of money households have to spend. Personal income rose 2.6% YOY in April. Wage and salary disbursement rose a robust 11.7% YOY but government social benefits fell 17.8% YOY and personal current taxes increased 23.8% YOY. As a result, disposable personal income fell 0.27% YOY in April. However, after inflation, real disposable income fell 6.2% YOY in April, all of which is displayed in the bottom chart on page 4. In other words, the purchasing power of households is declining, and this does not bode well for our economy which is 70% consumer-driven.

These statistics explain the recent pressure on retailers and the disappointing first quarter earnings report from Walmart Inc. (WMT – $128.63). Walmart, the largest retailer, and the largest private employer in the US, reported earnings that fell well short of estimates due to rising costs for food, fuel and wages which weighed heavily on profit margins. The stock is currently down 25% from its recent high. And though Walmart reported solid sales in the first quarter, it now faces the choice of raising prices to consumers or continuing to face margin pressure. Moreover, price inflation for food and grains will only get worse due to Russia’s invasion of Ukraine. Since the start of the invasion on the 24th of February, Reuters reports that “Russia has blockaded all of Ukraine’s seaports and interrupted its grain exports. This in turn has impacted global food prices, caused food insecurity, and affected vulnerable populations.” In short, the summer months could be a time of more global shortages, inflation pressures and geopolitical unrest.

The Bureau of Economic Analysis data showed that even with this year’s steady decline in real personal disposable income, personal spending increased 0.7% in April versus March. However, this spending came at the expense of dipping into personal savings which fell from $922.3 billion to $815.3 billion. In April, the savings rate fell from 5% to 4.4%, its lowest level since the recession of 2008. See page 5.

With this as a backdrop, it is not surprising that consumer sentiment indices fell in May. In both surveys, it was clear that poor consumer sentiment was led by declines in expectations. May’s Conference Board consumer confidence results reversed the gains seen in April. However, the University of Michigan sentiment survey has been extremely weak all year and May’s confidence readings were the lowest reported in 11 years, or since 2011. See page 6. Both consumer surveys are sobering since they are painting a dismal picture for second quarter consumption and economic activity.

Keep in mind that the Federal Reserve will continue to raise interest rates this year. In April, headline CPI was 8.2% YOY, and even after two fed rate hikes, the real fed funds rate remains at an historically negative (and easy) level of negative 7.2%. The Fed has stated that it wants to get to a neutral fed funds rate as quickly as possible. Assuming year-end inflation moderates to 5%, the fed funds rate would have to increase another 400 basis points to simply match inflation and reach a zero cost of capital. If a 5% fed funds rate materializes, we expect the housing market – which we believe is slowing — would slow more dramatically and hurt economic activity meaningfully. See page 7.

With first quarter earnings season nearly complete, we notice that consensus earnings estimates are falling for this year and next year. The S&P Dow Jones and Refinitiv IBES consensus earnings estimates for 2022 fell $0.15 and $0.81, respectively, this week; however, the nominal earnings range is relatively unchanged at $224 to $228. Earnings growth rates for this year are 4.1% and 9.2%, respectively. Our DRG 2022 estimate remains at $220, a 5.7% YOY increase from $208.19 in 2021. As a reminder, we believe value begins with a PE multiple of 17.5 times which equates to SPX 3850 given our $220 earnings estimate. See page 9.

The Good News The best news of the week was found in investor sentiment. The AAII bullish sentiment index fell 6.2 points to 19.8% while bearish sentiment rose 3.1 points to 53.5%. We saw this combination of “less than 20% bulls and more than 50% bears” on April 27, 2022, and it repeated again last week. Prior to these two weekly readings, the combination was last seen on April 11, 2013. Also note, the April 27 bearish reading of 59.4% was the highest bearishness since the March 5, 2009, peak of 70.3%. Sentiment tends to be an inverse indicator and the spread between bullishness and bearishness is the widest since the 1990 low. See page 13. Equity prices tend to be higher in the next six and/or twelve months following these extreme readings. Again, we believe this is the beginning of the end of the bear market, but it is apt to be a multi-month process. We remain cautious, particularly on rallies above SPX 4000.

Gail Dudack

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PLEASE NOTE: Unless otherwise stated, the firm and any affiliated person or entity 1) either does not own any, or owns less than 1%, of the outstanding shares of any public company mentioned, 2) does not receive, and has not within the past 12 months received, investment banking compensation or other compensation from any public company mentioned, and 3) does not expect within the next three months to receive investment banking compensation or other compensation from any public company mentioned. The firm does not currently make markets in any public securities.

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