US Strategy Weekly: Pray for Ukraine

As we go to print, we are also preparing for President Joseph Biden’s first State of the Union address to Congress. It could be a pivotal speech and a crucial time for Biden because at the same time, a massive Russian convoy is spotted outside Ukraine’s capital Kyiv and Russian aggression continues for the sixth consecutive day. Insights into President Putin’s actions were revealed in remarks made prior to his invasion when he claimed his actions were to achieve “demilitarization and denazification” of the neighboring nation. Clearly Putin expected an easy takeover of Ukraine since the Russian state-aligned media outlet RIA posted, but quickly deleted, an article on 8 AM February 26th that hailed Vladimir Putin for victory over Ukraine as Russia helps usher in a supposed “new world.” The RIA article can be found here: https://web.archive.org/web/20220226051154/https://ria.ru/were20220226/rossiya-1775162336.html.

The geopolitical and financial backdrop could quickly evolve this week, but to a large extent, there is no change from the “Direct from Dudack” (Downside Risk Guidance) sent on February 24, 2022, in which we reviewed the downside potential of the equity market from both a technical and fundamental perspective. To date, the declines from recent peaks have been 9.97%, 11.9%, 18.8%, 20.4%, and 13.2% in the Dow Jones Industrial Average, S&P 500, Nasdaq Composite, Russell 2000, and Wilshire 5000 composite, respectively.

Fundamental Perspective

Although technical indicators tend to be best at forecasting market peaks, fundamentals become increasingly important in a bearish decline, in our view. They are tools that can help define levels of value, project best long-term buying opportunities and identify potential lows in both stocks and indices. For a fundamental perspective, we first turn to our valuation model. Models can only be as good as their inputs and for transparency, our estimates for 2022 begin with a forecast of $220 for S&P 500 earnings which equates to a 7% increase. We also expect inflation to abate in 2022, but only to a 4.4% pace. Our interest rate forecasts expect yields to rise to 0.8% for the 3-month Treasury and 2.2% for the 10-year Treasury note. Our model indicates that with this financial backdrop, the appropriate “average” PE multiple should be 15.8 times. Surprisingly, a 15.8 multiple is also equal to the average PE seen over the last 75 years. Applying our $220 earnings estimate to a 15.8 multiple yields an SPX target of 3476. In short, our model predicts a decline of 27.5% in the SPX is required to return to “fair value.” See page 4. Since our $220 earnings estimate is in line with the consensus, this also means that every earnings reporting season will be critical for the market. Positive or negative earnings surprises during earnings season could become market-moving events which could shift the perception of where “value” is found in the market. See page 5.

Technical Perspective

Many of our volume/breadth indicators revealed weakness in the latter half of 2021 and most of these indicators continue to point to a bearish trend. However, the chart of the S&P is of particular interest in the near term since a head and shoulders top formation has developed over the last three quarters. A head and shoulders top only becomes important once the “neckline” of the formation has been broken. The neckline in the SPX’s head and shoulders is irregular and can be drawn at several different levels, but we show the neckline at SPX 4300. See page 7. A break below the neckline of a head and shoulders formation triggers two separate downside targets – the difference between the height of the shoulder to the neckline and the difference between the head and the neckline. The first of these downside targets implies SPX 4000, which was nearly tested on an intra-day basis, in recent sessions. The second downside target is SPX 3800 which equates to a 20% correction. Note that a 20% correction in the SPX appears quite possible, and perhaps reasonable, given that the Russell 2000 index has already experienced a 20% decline from its record high.

The charts of Amazon.com (AMZN – $3022.84) and the Russell 2000 index (RUT – $2008.51) continue to intrigue us since they are ironically similar. See page 9. Both charts experienced sharp declines within days of each other and led the overall market weakness. Both are currently trading below all key moving averages. The recent rebound in AMZN after the company reported good earnings, failed to better the first level of resistance at $3223; however, this remains a key level to watch on rally days. However, the charts continue to parallel each other and after initial precipitous declines, both show that these lows were retested. To date, these tests have been successful. This is a favorable development and the longer the initial lows hold in both charts, it is a sign that the overall market is beginning to test and define significant lows. The support levels to monitor are $2700 in Amazon and $1900 in the RUT.

Federal Reserve Policy

Although we are only two weeks away from the important FOMC March meeting, it is being overshadowed by geopolitical events. In the current environment it is unlikely that the Fed will raise interest rates 50 basis points to fight inflation, but we do believe a 25-basis point hike is prudent. Still, the Fed has a very difficult job ahead of them. The fallout from Russia’s invasion of Ukraine is impacting them in two ways. First, commodity prices are spiking. The bullish crude oil chart has fulfilled upside targets of $90 and $100 and appears headed for a third target and key level of resistance at $110. See page 6. Rising energy and commodity prices make the Fed’s job of controlling inflation extremely difficult. Second, a flight to safety is taking 10-year Treasury note yields lower. The 10-year note yield is currently at 1.7%, down from a recent high of 2%, which makes the risk of an inverted yield curve in 2022 more likely as the Fed increases short-term rates. An inverted yield curve has been the best forecaster of economic recessions, and therefore the risk of recession appears to be growing.

Sector Shifts

The invasion of Ukraine impacts the US in a variety of ways but primarily it will raise inflation and thereby reduce household spending power. This could impact corporate earnings in 2022 which is why we continue to recommend an overweight rating in energy and staples. The sanctions imposed on Russia are necessary, but they do have the risk of impacting the global banking system, including US banks. For this reason, we are downgrading the financial sector from a recommended overweight to a neutral weight. Meanwhile, Russia has awakened the Western world to the risks of war and Germany responded by indicating they will spend 2% of their GDP on military defense. As a result, defense stocks are viewed as an area of the market that should have increasing revenues and better than expected earnings. The charts of many of the US defense corporations display bullish breakouts from long-term sideways patterns. We are upgrading the industrials from a neutral weighting to an overweight. In these uncertain times we still believe equities are the best holdings. We continue to also overweight energy and staples, but a balanced portfolio is emphasized. Companies with a history of increasing dividends and with yields in excess of 2.2% can best weather the volatility that is apt to dominate the first half of the year.

Gail Dudack

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