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Bear Markets and Transitions

Bear markets have a multitude of catalysts, but history shows that the most significant bear markets are triggered by one of two factors. A bear cycle often begins after an immense accumulation of debt and leverage that leads to massive defaults, a sharp decline in demand, a period of deflation, and falling profits. Or conversely, a bear cycle is triggered by a huge supply/demand imbalance that leads to an inflationary cycle, a loss of purchasing power, profit margin pressure, declining earnings, and lower PE multiples. The inflationary cycles of 1970-1974 and the current bear market were clearly linked to inflation driven by a lack of supply of oil. However, inflation preceded Russia’s invasion of Ukraine and most of today’s price cycle is due to the historic monetary and fiscal stimulus undertaken around the world to combat the worldwide economic shutdowns. In short, political decisions played a large part in today’s inflationary cycle.

But perhaps the most important characteristic of any bear market is that it almost always results in a major shift, or transition, in market leadership. It is this transition in leadership that is the key to outperforming, not only during the bear market, but in the bull market that follows.

Follow the money” is a phrase that solves many financial and political mysteries, but “follow the earnings” is the simplest way to understand the leadership emerging in the current cycle. In 2020 our favorite sectors were those we described as “inflation-resistant” segments of the economy. In 2021 and 2022 we emphasized “recession-resistant” sectors and stocks for outperformance. Not surprisingly, inflation-resistant also tended to be recession-resistant and included sectors such as energy, utilities, staples, defense, and aerospace. These sectors can also be called defensive, household necessities, value, and total return, but they are most importantly the areas that have pricing power and profits in an era of rising costs and shrinking margins. Segments of healthcare can also be defensive and weather both inflation and recession. Technology has defensive segments such as security technologies. But in every case, it is a stock or sector with a predictable earnings stream in what is a difficult and unpredictable economic time.

Earnings Insecurity

The third quarter earnings season seems to have sounded the alarm that earnings are at risk for this year and next. In the last five weeks, the S&P Dow Jones consensus earnings estimate for 2022 has declined 3% — an unusually large decline in a short period of time. However, the erosion in forecasts actually began in April when estimates were 12% higher than they are today. We lowered our 2022 and 2023 earnings estimates two weeks ago to adjust for the weakness seen in the third quarter results. Unfortunately, the S&P Dow Jones estimate has dropped so quickly (it is now $201.58) that it is already below our $202 estimate for the S&P for this year. Although seasonality for the next three and six-month periods tends to be positive, the underlying erosion in earnings could prove to be quicksand for the overall market. Again, safety is equal to finding companies with solid earnings streams. See page 6. Unfortunately, the increase in interest rates and decrease in earnings estimates seen this year has lowered the midpoints of our valuation model to SPX 2625 for 2022 and to SPX 3020 for 2023. See page 7. In short, risk continues in the first half of 2023.

Real Estate Recession

There is little doubt that residential real estate and the homebuilding sector is in a recession. In September, new home sales fell 18%, the median new single-family home price fell 14% YOY, and the average home price fell 10% YOY. Existing home sales fell 28.4% YOY in October and the median existing single-family home price rose 6% YOY. See page 4.

A lack of inventory has been supporting existing home prices this year, however, that too is beginning to change. According to the National Association of Realtors, the months of supply of inventory have increased from the cyclical low of 1.5 in January of this year to 3.3 months in October. Housing starts were down 8.8% YOY in October and new home permits were off 10% from a year earlier. See page 5. And the outlook for the housing sector in 2023 continues to be dim, particularly since the Federal Reserve is expected to continue to raise rates in coming months. Affordability is already at its worst level in 37 years and the NAHB builder confidence survey has been declining for 11 consecutive months. November’s survey fell 5 points to 33, which is well below the neutral benchmark of 50. Both current traffic and the outlook for sales in the next six months are at recessionary levels. See page 6. Keep in mind that these dismal numbers are likely to get worse due to the Fed’s tightening policy in coming months. But, to a large extent this is the Fed’s goal – an economic slowdown.

October’s retail sales were stronger than expected, with total retail and foods service sales increasing 8.3% YOY and total sales excluding autos and gas stations rising 8% YOY. However, retail sales priced in 1982 dollars (adjusted for inflation) rose a mere 0.5%. Still, this small increase was better than the real retail sales data for April and June which were negative on a year-over-year basis. These declines were worrisome since negative YOY retail sales have been characteristic of all previous recessions. See page 3. However, investors should focus on where retail sales have actually been growing. In the post-COVID era. Sales have increased for six segments: gas stations, food service, building materials, sporting goods, miscellaneous and non-store retailers. This is in line with what we are seeing in terms of stock performance. See page 14.

Technical Watch

What we are seeing in terms of earnings performance is playing out in the popular indices. On page 9 we have ordered the indices in terms of their technical strength. The DJIA is by far the best-performing index, seen by the fact that it is now trading above its long-term 200-day moving average and has broken above a downtrend line off the January 4, 2022 peak of 36,799.65. The Russell 2000 index is the second-best performing index and is threatening to break above its 200-day moving average but is yet to do so. The S&P 500 is third best, and while trading above both its 50 and 100-day moving averages, it is trading 60 points below its 200-day moving average. The Nasdaq Composite index is by far the worst-performing index. It has barely exceeded its 50-day moving average and trades well below its 100 and 200-day moving averages. These differences are a display of the shifting leadership we noted earlier. Value has widely outperformed growth year-to-date and during the recent rally. See page 9. The 25-day up/down volume oscillator is neutral at 2.28 but was overbought for five of the last eight trading days. This is significant since bear markets rarely reach overbought territory and if they do the reading is brief. A true overbought reading should persist for at least five to ten consecutive trading days to be significant, therefore, the recent reading is ambiguous. Nevertheless, this will be a key indicator to monitor in the coming weeks to assess the strength of any advance in prices.

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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