Last week we pointed out that the 2000 resistance level in the Russell 2000 index (“Russell 2000 at 2000” February 15, 2023) could be pivotal for the near term. Similar to the less delineated DJIA 34,000 level, the RUT’s 2000 resistance level presented the first real challenge for the advance initiated from the October 2022 low.

The market also revealed signs of exhaustion with daily NYSE volume falling consistently below the 10-day average and sentiment indicators reaching short-term extremes. The AAII bull/bear sentiment indicator had a sizeable 7.6% jump in bullishness to 37.5%, the highest level in over a year. Bearishness fell 9.6% to 25%, its lowest level since November 2021. It was too much, too soon in terms of a sentiment switch. Not surprisingly, in this week’s first session, the Dow Jones Industrial Average fell 697.1 points, or 2.06%, to 33,129.59, and wiped out its year-to-date gains. The S&P 500 lost 81.75 points, or 2.00%, to 3,997.34; the Nasdaq Composite dropped 294.97 points, or 2.5%, to 11,492.30; and the Russell 2000 fell 58.14 points, or 2.99%, to 1888.21. These indices shaved previous gains but remained positive for the year.

There were numerous reasons for the market sell-off, but the main catalysts have not changed: concerns about earnings growth, the risk of more-than-expected Fed rate hikes and worries of an escalation of the Russia/Ukraine conflict. As the fourth quarter earnings season draws to a close, it is the results of retail companies that now come into focus. To date, these results have been less than stellar. More importantly, forward guidance has been sobering as corporate leaders warn of an earnings slowdown.

Earnings Growth

On page 15 we display our quarterly and annual forecasts for S&P 500 earnings as well as those from S&P Dow Jones and IBES. It is worth noting that the S&P Dow Jones 2022 earnings estimate for 2022 is currently $196.31 and for 2023 it is $220.16. As recently as July 22, 2022, the 2022 estimate was $220.70, or higher than the current 2023 estimate. IBES currently estimates this year’s earnings to be $222.85, but as recently as October 7, 2022, it showed a consensus estimate for last year’s earnings of $223.34. In sum, earnings estimates are coming down, but the question is how much further might they fall? This is a difficult question since economic signs are mixed and to a large degree, confusing.

More Fed rate hikes

There are some worrisome signs for the economy. The Conference Board Leading Economic Index slipped 0.3% in January to 110.3 and represents the 11th consecutive monthly decline in the LEI. A long steady decline in the leading indicators has been a good predictor of a recession in previous cycles.

On the other hand, the latest S&P global flash PMI composites are telling a different story. The January US PMI Composite index rose from 46.8 to 50.2 to an 8-month high, led by strength in the service sector. The rise above 50 indicates an economic shift from contraction to modest expansion in the PMI indices. February’s Eurozone flash PMI rose for the fourth consecutive month to 52.3, indicating the strongest business activity since May 2022. The UK flash PMI for February also rose sharply from 48.5 to 53.0, registering the strongest expansion since June 2022. All in all, these flash economic surveys depict a rebound in economic activity in both the US and Europe.

An improvement in economic activity is usually good news, but when it is coupled with recent inflation data, it is a recipe for further Fed rate hikes, and this is upsetting for those who were expecting another “one and done” rate hike in March. It has been our view that the Fed would have to raise rates higher and keep them there longer than the consensus was expecting.

In January, the CPI rose 6.35% YOY, down fractionally from the 6.44% YOY rise in December, yet a major improvement from the 9.1% YOY seen in June 2022. Still, prices are not falling as quickly as some had hoped. The PPI for finished goods rose 8.7% in January, down only 0.2% from the 8.9% reported in December. Wages rose a healthy 5.4% YOY in January but after adjusting for inflation, household purchasing power declined 1% YOY in January. We have been concerned about the disparity between inflation and wage growth for the last year. The spread is narrowing but it has not closed, and the consumer remains under pressure. See page 3.

Nevertheless, households continue to spend. Total retail & food services sales rose 6.4% YOY in January, and sales excluding motor vehicles and parts, rose 7.3% YOY. However, when nominal retail sales are adjusted for inflation, real retail sales only grew 0.2%. This is down from 1.1% in December, but up from the 1% decline seen in November. See page 4. Total vehicle unit sales rebounded strongly from December’s 13.9 million (SAAR) to 16.2 million in January, and this makes the 7.3% YOY rise in January’s retail sales excluding autos, and 7.4% rise in sales excluding autos and gas stations, even more impressive. The 25.2% increase in food services and drinking places was noteworthy. See page 5.

However, this spending comes at a cost. The latest Quarterly Report on Household Debt and Credit from the New York Federal Reserve showed total debt balances grew by $394 billion in the fourth quarter of 2022, the largest nominal quarterly increase in twenty years. The increase in credit card balances between December of 2021 and December of 2022 was $130 billion, the largest annual growth in balances seen in the data history which began in 1999.

In terms of debt and mortgages, housing remains in a slump. December’s new home sales totaled 616,000 annualized units, down nearly 27% YOY. Existing home sales fell to 4 million units in January, a decline of nearly 37% from a year earlier. See page 6. The NAR housing affordability index improved from 94.3 in November to 101.2 in December, yet it remains at one of the lowest readings since 1986. This is not favorable. Nonetheless, in February, the NAHB housing index reflected a bit more optimism about the next six months and rebounded from the year-end 2022 cyclical lows. See page 7. 

Summary

Our view has not changed. We expect a trading range market until inflation is clearly under control, a process that is apt to take another 12 to 18 months. In terms of the indices, we anticipate a 12-to-18-month range as high as the January 3, 2022 peak of SPX 4796.56 and the October 12, 2022 low of SPX 3577.03. The February overbought reading in our 25-day up/down volume oscillator is in line with this forecast. To date, the rally has been led by large-cap technology stocks, but we do not believe technology as characterized by FAANG stocks, will be the leadership of the next bull market cycle. Typically, a long-term trading range market will see leadership rotate throughout the year.

Keep in mind that the popular stock indices have a history of spending 50% of the time in flat trends. These trends are not boring; they can include several bull and bear market moves of 20% or more. However, these cycles are defined as “flat” since market rallies are unable to sustain an advance above the previous market peak. In short, the days of “buy and hold” may have ended for a while.

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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