In last week’s US Strategy Weekly (Things to Ponder; August 8, 2023), we wrote “we do believe the recent rally is fragile since it has been driven by the new consensus view that the economy will have a soft landing or no landing. This view is coupled with the belief that there is no interest rate hike in September. We think the Fed will hike in September, unless economic data becomes very weak in the interim. What is clear is that this week’s CPI and PPI reports will be center stage and could be market moving.” In truth, there was not a big reaction to last week’s CPI report. See page 3. But the PPI report, which showed intermediate service sector inflation rose from June’s 4.4% YOY to 4.6% YOY, seemed to make investors anxious. And in a market priced for perfection, any unpleasant or unexpected news will make equities vulnerable.

There were a few other developments this week. Chinese economic reports for industrial production, retail sales, and property investment were weaker than expected. More importantly, the combination of this data reflected an economy that is potentially faltering. The PBOC responded by lowering key interest rates by 15 basis points. Yet the real concern is China’s real estate sector, which is estimated to represent as much as 30% of China’s GDP, and which has already weathered a string of defaults by residential property developers. This week the focus is on Country Garden Holdings Co. Ltd. (2007.HK: 0.81), a giant Chinese real estate developer that is expected to deliver nearly a million apartments in hundreds of cities throughout China. Unfortunately, Country Garden has not been paying its bills, indicated it would report a loss of as much as $7.6 billion in the first six months of the year, and in August skipped two interest payments on loans. A default is possible in September. The big concern is the exposure of China’s $3 trillion shadow banking sector to this potential real estate risk, as well as the risk to the broader Chinese economy.

Separately, Russia’s central bank raised its key interest rate from 8.5% to 12% to help stop the slide in its currency which has lost more than a third of its value since the beginning of the year. The ruble passed 101 to the US dollar earlier this week and continues to weaken due to capital outflows, big government spending on the Ukraine war, and a shrinking current account surplus as a result of Western sanctions on Russian oil and gas. Inflation reached 7.6% over the past three months, and according to Russia’s central bank, inflation is expected to keep rising, noting that the fall in the ruble is adding to the inflation risk.

Closer to home the Fitch Ratings service warned that the agency could downgrade more than a dozen banks, including some major Wall Street lenders. Fitch already lowered the score of the “operating environment” for banks to AA- from AA at the end of June – although this went largely unnoticed. And Fitch’s warning comes weeks after Moody’s cut the ratings of 10 mid-sized lenders, citing funding risks, weaker profitability, and increased risk from the commercial real estate sector.

Retail Sales

Advance estimates for July retail sales showed a month-to-month gain of 0.7% and the May and June estimates were revised from up 0.2% to up 0.3%. This acceleration in retail sales concerned investors who had been expecting a Fed pause, since economic momentum opens the door for a rate hike in September. On a seasonally adjusted basis, retail sales rose 3.2% YOY in July; on a non-seasonally adjusted basis, sales were up 2.5% YOY. However, when adjusting for inflation, real retail & food service sales, based on 1982 dollars, fell 0.1% YOY. See page 5. In other words, despite a month-to-month acceleration in sales, real YOY retail sales declined and have been negative for nine of the last 10 months. This pattern is a classic sign of an economic recession, not strength. See page 6.

Historically, a negative trend in retail sales is tied in with a decline in nominal GDP and that is true in this cycle as well. On page 7 we show a table that highlights, in red, all the months since January 1968 that have experienced below average retail sales. This table is important because a string of below average sales has always defined a recession and negative real retail sales in any year has also characterized recessions. The current string of “red” is the longest since 2008-2009, and to date, real retail sales are averaging negative 1.3% in 2023. Nonetheless, GDP continues to grow. It is uncanny. Still, we would not describe July’s retail sales report as strong.

However, one reason to believe the Fed will keep interest rates higher for longer is that they were so late to address the inflation problem. As seen on page 4, the fed funds rate typically increases ahead of, or in line with, the level of inflation. In this cycle, the Fed was 12 to 18 months behind the inflationary trend. This suggests more work needs to be done. Moreover, while the real fed funds rate has increased to 200+ basis points, it usually reaches 400 basis points in a tightening cycle.


The second quarter earnings season is close to ending and as is usual, retail stocks are the last to report. Home Depot Inc. (HD – $332.14) beat the consensus estimate for quarterly earnings per share, and though same-store sales fell 2% YOY this was less than the expected 3.5% decline. The company announced a $15 billion share repurchase program and it reiterated its muted forecast for the year. The company noted caution on the part of consumers towards big-ticket items. Walmart Inc. (WMT – $159.18) is expected to raise its full-year earnings forecast this week when it reports quarterly results. A research report by Stifel, Nicolaus & Company estimates more people plan to shop at Walmart compared to Costco and Target, even though they expect to spend 16% less on back-to-school purchases compared to a year ago. Retail is a sector of winners and losers in this environment.

All in all, earnings season has gone better than expected and the S&P Dow Jones consensus estimates for 2023 and 2024 are currently $219.41 and $244.06, up $2.31, and $1.00, respectively. Refinitiv IBES estimates for 2023 and 2024 are $219.09 and $245.55 up $0.41, and down $0.25, respectively. What is notable is that S&P Dow Jones and Refinitiv IBES are both showing a $219 estimate for this year. These two surveys tend to diverge in the second half of the year. Nevertheless, based on this year’s earnings estimate of $219.41, equities remain overvalued with a PE of 20.2 times. The 12-month forward operating earnings PE is 19.0 times, and the December 2024 PE is 18.1 times. When we add inflation of 3.2% to these PE multiples, we get 23.2, 22.2, and 21.2. All of these sums hover just under the 23.8 range that defines an extremely overvalued equity market. This is what explains the market’s nervousness.

Technicals are Slipping

The S&P 500, Nasdaq Composite, and Russell 2000 are all trading below their 50-day moving averages, a key level for some traders. However, the RUT, a useful benchmark for the last 18 months, failed to break above the 2000 resistance level in July, implying that the recent rally was simply part of a much larger neutral trading range. See page 9. The 25-day up/down volume oscillator is at a negative 0.51 reading this week and neutral. The oscillator generated overbought readings in 10 of 22 trading sessions ending August 1, but failed to remain overbought for the minimum of five consecutive trading days required to confirm the advance. This week the 10-day average of daily new highs fell to 88 and new lows rose to 75. This combination turned positive on June 8 when new highs rose above 100 and new lows fell below 100 but it turned neutral this week with both averages now below 100. In short, upside momentum appears broken.

Gail Dudack

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