The month of January ended with a gain of 2.8% in the Dow Jones Industrial Average and a 6.2% gain in the S&P 500 Composite. See pages 3 and 4. This was the 25th best January in the DJIA and the ninth best January for the SPX. January’s performance has been significant over the decades, and since 1950, a gain in the DJIA has correctly predicted an annual gain 89% of the time. In the SPX, a January gain has resulted in an annual gain slightly less than 79% of the time.

Technicals Improve

And at the same time, the January rally has generated several improvements in our technical indicators. The biggest change is the improvement in the 25-day up/down volume oscillator. It is currently showing an overbought reading of 4.49, and more importantly, has been overbought for five consecutive trading sessions. In addition, the month of January ended with a strong 90% up-volume day. This is an upgrade from the overbought reading recorded in November, off the October low. That reading was not sustained. The current reading needs to remain overbought for another week to be truly convincing, however, bear markets rarely reach overbought territory, and if they do, the reading is typically brief. An overbought reading that persists for at least five to ten consecutive trading days – and reaches a new overbought high reading — is significant and is an indication of a shift from bearish to positive, or at least from bearish to neutral. This week will be pivotal for this indicator. See page 14.

As a result of this broadening rally, all the popular indices are presently trading above their 200-day moving averages, including the Nasdaq Composite. This is another solid improvement in the technical arena. And as we noted last week, the Russell 2000 has an attractive technical chart, having bettered the 1900 resistance level, which is a good near-term sign for small cap stocks and the market overall. See page 13.

Flat versus Trending Markets

Given the strength of the January rally we believe this is a good time to review the long secular outlook for equities in order to put the current advance into a broader perspective. First, it is important to remember that a study of historical stock performance shows that equities spend only half their time in a persistent “trending market” i.e., a bull market with modest intervening corrections of 10% or more. When stocks are in a trending market a “buy and hold” strategy is beneficial and profitable. And in most trending cycles the economic backdrop is favorable for most industries and corporate profitability is good. In sum, it is an environment that “lifts all boats.”

However, the other 50% of the time the equity market and the economic backdrop are not as favorable. Usually this is due to the impact and/or aftermath of either inflation or deflation; as a result, the market vacillates in what we call “flat trends.” These flat trends can include several bull and bear markets that rise and fall of 20% or more, but the key distinction is that the benchmark indices usually fail to sustain an advance that moves higher than the previous peak. In short, the market tends to have a ceiling price near the peak of the previous bull market. We believe the inflationary cycle we are currently experiencing is the catalyst for such a market. What is important is that this means a “buy and hold” strategy will be less profitable and instead, investors should be alert to unique buying and selling opportunities when they arise. In most cases, the stock market is driven by a rotation of leadership among industries, value and/or growth at a reasonable price tend to be solid strategies, and taking profits and reinvestment becomes a preferable tactic over “buy and hold”. Also note that history shows that these flat trends tend to last for more than a decade. See page 5.

Another way to analyze the stock market’s “flat trend” phenomenon is to monitor the 10-year compound annual growth rate in the S&P 500. We do this on both a simple price basis and on a total-return basis. As we have pointed out in recent years, it is unusual for the S&P’s 10-year compound annual growth rate to exceed 13%; and when it has reached this level it typically presages a major decline is on the horizon. The 13% level was reached at the end of 2021. See page 6.

Conversely, whenever the 10-year compound annual growth rate approaches or falls below zero, it has been an good signal of an excellent long-term buying opportunity. The growth rate declined to 8.3% as of the end of January, but this is not a level that defines a major buying opportunity. Nevertheless, we do not expect “zero” to materialize for a long while, but we do expect there will be several bull and bear market cycles before the growth rate ever approaches zero.

In sum, we would not anticipate an equity rally will sustain an advance bettering the SPX high of 4796.56 made on January 3, 2022 for several years.

Fed and Economics

The preliminary estimate for fourth quarter GDP was 2.9% which was much better than the consensus view and it followed the 3.2% growth rate generated in the third quarter. Fixed residential investment declined 9.2% in the quarter and it is highly unusual for residential investment to decline this much without the overall economy being in a recession. We are not sure if this is good or bad news, but since we expect the Fed to raise rates at least two more times this year, housing will likely drag economic activity lower in coming months. See page 7.

In December, personal income rose 4.7% YOY, disposable personal income rose 3.2% YOY, yet real personal disposable income fell 1.7% YOY. Still, this was an improvement from July 2022 when real personal disposable income fell 5% YOY, and purchasing power was seriously eroding. However, inflation is taking a toll on consumption, which fell 0.2% in December after falling 0.1% in November. And though the pace of PCE has been decelerating in recent months, it was still rising 7.3% YOY in November and December. The question is how strong or weak will PCE be in 2023? See page 8.

There were clear signs that inflation was decelerating in December. The CPI fell from 7.1% YOY to 6.4% and core CPI declined from 6.0% YOY to 5.7%. Inputs to the CPI are also slowing. PPI for finished goods eased from 10.7% YOY to 9.0%, core PPI was modestly lower from 8.0% to 7.89%, and final demand PPI fell from 7.3% YOY to 6.2%. Equities appear to be celebrating this deceleration in inflation, but remember, these inflation rates remain multiples higher than the Fed’s target of 2% inflation. See page 9. The Federal Reserve’s preferred measure for inflation is the PCE deflator and that eased from 5.5% YOY to 5% YOY in December. Even so, this means the PCE deflator remains 70 basis points above the current fed funds rate. In short, there is plenty of incentive for the Fed to increase interest rates 25 basis points at this week’s meeting and another 25 basis points at the next meeting that ends on March 22. See page 10. We expect the Fed’s statement will be hawkish this week, as it should be. Inflation is not as easy to reverse as many investors appear to believe, and though the current rally could have further upside, we would remain focused on maintaining a portfolio tilted toward value.

Gail Dudack

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