Market peaks and troughs are often confusing intervals because both are periods of transition, volatility, and mixed signals. And at risk of oversimplifying the current environment, we expect confusion will heighten among investors and market forecasters based upon the facts that the technical condition of the equity market has been improving while the economic condition of the economy has been deteriorating. This is not an unusual combination at a major low.
It has been our view that the first half of the year was a recession or a recessionary period. This is the good news and the bad news. History shows that stocks tend to bottom out midway or in the latter half of a recession. If we are right about the economy this precedent is positive for today’s investors. However, a recession is also destructive to earnings and while many stocks have discounted a significant decline in earnings growth, this is not true of all stocks. In short, risk remains, and optimism may be a bit premature, especially at recent elevated prices. Although short-term trading opportunities will continue to present themselves, we believe portfolio holdings should be concentrated in sectors and companies that are both inflation and recession resistant, such as energy, utilities, defense-related industrials, staples and healthcare.
Our strategic view has been that 1.) the stock market began a bottoming phase in June, 2.) the major indices have probably seen their bear market lows, but 3.) the lows will be retested in coming months. Our optimism is supported by the fact that some technical indicators are defining a likely shift in long-term momentum from bearish to, at a minimum, neutral.
While technical indicators have their bright spots, we feel investors may have become too optimistic too soon. Re-emergence of meme stock investors is one sign that speculation has returned to the market too quickly. Expectations of a Fed pivot this year are quite likely to be wrong, or at least premature. Economic indicators are mixed but many are showing definitive signs of weakness and the possibility of a recession. A good example of this is this week’s S&P Global Flash US Composite PMI Index which fell to 45.0 in August, down from 47.7 in July. This was the second successive monthly decrease in total business activity, below 50 (contractionary), and was at a 27-month low. Excluding the period between March and May 2020, the decline in total output was the steepest seen since the series began nearly 13 years ago.
The S&P Global Flash US Services Business Activity Index was 44.1 in August, down from 47.3 in July, and the fastest decrease in business activity since May 2020. Service providers noted that hikes in interest rates and inflation dampened customer spending because disposable incomes were squeezed. This decline in spending was predictable in our view. As we have often noted, inflation destroys the purchasing power of consumers, higher fuel, transportation, and raw material costs pressure corporate margins, and while inflation has a negative impact on both consumption and earnings, it also lowers PE multiples. In sum, inflation is a triple threat to investors.
Some economic news was better than expected. Total retail & food service sales were $686.8 billion in July, a 10.3% YOY increase. Excluding motor vehicles and parts, sales were $557.9 billion, a 12.3% YOY gain. Sales of motor vehicles and parts dealers were $124.95 billion in July, a 2.1% YOY gain, and the first real year-over-year gain in autos since February 2022. See page 3. However, after adjusting for inflation, i.e., priced in 1982 dollars, real retail & food services sales were $231.25 billion in July, a much more modest 1.7% YOY gain. Nonetheless, this was the first positive year-over-year gain in real retail sales since February. But in terms of investments, it is important to note the changing composition of retail sales. There have been relative gains for gas stations, food services & drinking places, and nonstore retailers. But as a percentage of monthly retail sales, the losers have been autos, general merchandise, food & beverage, and clothing & clothing accessories stores. See page 4. These shifts in consumption are also reflected in sector performances with energy and utilities the only S&P 500 sectors to show year-to-date gains.
Meanwhile, the housing slump continues. Census data shows new home sales fell from 585,000 units in June to 511,000 units in July, the lowest level since October 2015 and 30% below a year earlier. Existing home sales fell from 5.1 million in June to 4.81 million in July, a 20% drop below the July 2021 level. Nonetheless, the median price of a new home rose from $414,900 to $439,400 in July, up 8% from a year earlier making homes less affordable in a rising interest rate environment. See page 5. And as home sales have been slowing, inventories have been rising. Existing home inventories have increased from the January 2022 low of 850,000 to 1.31 million units in July and the supply of single-family homes increased from 1.5 to 3.3 months in the same time period. Not surprisingly, building permits and starts have been falling in recent months. See page 6.
The S&P Dow Jones consensus EPS estimates for 2022 and 2023 rose $0.06 and fell $0.02, respectively, this week. Refinitiv IBES consensus EPS forecasts rose $0.16 and fell $0.03 respectively. However, the nominal earnings range for 2022 changed to $210.56 to $225.50 and earnings growth rates for this year were unchanged at 1.1% and 8.4%, respectively. But we want to point out that our DRG 2022 estimate was lowered from $220 to $218 in early August, and given the results of the second quarter, and the S&P estimate of $210.50 for this year, our estimate could still be too optimistic. See page 8.
The charts of the popular indices show that stocks had a convincing rally to their 200-day moving averages but have since retreated. See page 9. A test of the 200-day moving average is typical of a bear market rally and is not predictive; but other indicators suggest that the underlying momentum of the rally points to a weakening bear cycle and the possibility that the lows for many stocks may have been made in June.
The 25-day up/down volume oscillator fell to 2.19 this week but it was overbought for seven of eight consecutive days between August 10th and August 19th. It also reached a peak overbought reading of 5.26 on August 18th, the highest overbought reading since December 10, 2020. This is important since extreme and/or long overbought readings are rare in a bear market and if they appear, the readings tend to be brief, or less than six consecutive trading days recently seen. It is also important to note that the last two 90% days were up days on July 19, 2022 (92%) and August 10 (91%), an indication that momentum could be shifting from a bear cycle to, at worst, neutral. Still, the near-term market appears extended. In our view, investors are currently too optimistic that Fed tightening is nearly over, and this could change with Chairman Powell’s speech this week at Jackson Hole, WY. We would remain invested but concentrate on companies with predictable earnings streams and/or above average dividend yields.
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