US Strategy Weekly: Setting the Stage

Third Quarter Earnings

This is going to be a busy earnings week since 165, or one-third of the components of the S&P 500 companies will report third quarter earnings results in the five-day period. Thus far, results have generated an abundance of positive surprises. However, it is important to remember that the bar had been lowered by analysts in September when they dramatically cut estimates in response to supply chain hiccups and weaker than expected employment increases. To date, according to IBES Refinitiv, third quarter S&P earnings should show a gain of nearly 35% YOY, which is a healthy improvement in view of the disruptions from rising costs, supply issues, and hiring problems. In general, the quarter shows that corporate America is adept at maintaining margins despite rising costs and has been able to pass these costs on to consumers. Nonetheless, the S&P sectors that are accounting for the majority of the earnings gains in the third quarter are the areas that benefit from inflation.

Driven by Inflation

For example, in the third quarter, earnings are expected to rise 1538% YOY for energy, 96% YOY for materials, and 78% YOY for industrials. Technology ranks as the fourth best sector with IBES Refinitiv showing a gain of 33% YOY in the quarter. And the same trend holds true in the fourth quarter. IBES Refinitiv is forecasting S&P earnings growth of 22.8% YOY for the fourth quarter which includes an 8067% YOY gain for energy, a 66% YOY gain for materials, and a 57% YOY gain for industrials. The only minor difference in the fourth quarter is that the fourth best earnings growth rate of nearly 23% YOY is expected to be seen in the healthcare sector. See page 7. However, we would be amiss if we did not point out that, to date, the sector with the biggest surprise factor in the third quarter has been financials. Analysts were looking for earnings growth of 17% YOY at the start of the month and estimates are now showing a gain of 33% YOY. It is worth noting here that financials are fairly well insulated from the negative aspects of significant inflation and also benefit from a steepening in the yield curve.

Overriding Economic Worries

Positive earnings results contributed to the record highs in the popular indices this week, but we think investors were also encouraged by the fact that the proposed $3.4 trillion stimulus package was unraveling in Congress. This change also meant that the proposal to raise the corporate and individual tax rates was unlikely to materialize. This shift removed a dark cloud overhanging corporate earnings expectations for 2022 and it cannot be underrated. In our view, this “improvement” in earnings prospects for 2022 overcame signs of economic weakness in China and Germany.

Technical Changes

This news from earnings and the political environment not only drove several indices to record highs, but it was accompanied by significant changes in the technical status of the market. The 25-day up/down volume oscillator is at 3.09 this week and in overbought territory for the second consecutive trading day. Readers of our strategy weeklies know that to confirm any new high in the popular indices, this indicator needs to remain in overbought for a minimum of 5 consecutive trading days. Very simply, overbought readings demonstrate that the rally is accompanied by strong and consistent buying pressure.

The last time this indicator was in overbought territory for five consecutive days was February 4 through February 10 of this year, when the Russell 2000 also recorded its all-time high. Since then, there have been no validations of new highs by this indicator despite a succession of record highs in the SPX. The absence of overbought readings in this indicator, coupled with a one-day oversold reading on July 19 revealed that equity advances have not been accompanied by solid or consistent buying pressure. This has been true since February and it has been a sign of weakness. However, this week’s overbought reading could be a turning point. Two days is not yet sufficient for a confirmation which means the next week will be an important time for this indicator. See page 9.

The 10-day average of daily new highs had a significant jump to 275 this week and daily new lows fell to 65. This is also important since in recent weeks, the 10-day averages of daily new highs and lows had been converging and leaning toward a negative signal. Daily new lows actually exceeded 100 per day which is a sign of a bear market. However, this week’s data tilts positive. In addition, the A/D line made a confirming record high on October 25, 2021, beating its last record made on September 2. Volume has been slightly below average on this rally, which is a concern, but only a minor one. See page 10.

The Dow Jones Industrial Average, the S&P 500, and the Wilshire 5000 all reached record highs this week, while the Nasdaq Composite is trading fractionally below its September high. The Russell 2000 continues to be a major focus for us, and it is less than 3% from its February high. A breakout in the Russell 2000 index from what is now an 8-month trading range, would create a bullish chart pattern for the intermediate term. This would be true for both the index and the overall market. See page 8.

Setting the Stage

All in all, the economic, political, and technical backdrop for the equity market is the best it has been in many months. Given that we are moving into a seasonally strong time for the equity market, this shift in the political scene is timely. Monetary policy changes have been well telegraphed in recent months and have been discounted by investors, in our view. In short, barring some unexpected negative event in the next few weeks, we believe the stage is being set for a solid Santa Claus rally. Still, we continue to focus on quality stocks given that earnings are apt to be the major driver of stocks in the months ahead.

A Housing Bounce

The housing market experienced a nice rebound in September. Recent data shows new home sales rose 14% YOY to an annualized rate of 800,000 units and existing home sales increased 7% YOY to 6.29 million annualized units. Both of these rates were below the peaks seen at the end of 2020 however both reports were better than anticipated. See page 3. Housing permits and starts cooled a bit in September, but since the gap between new permits and housing starts was small, it suggests an improvement in starts is apt to appear in the fourth quarter. As of August, total residential construction reached a record annualized pace of $75.2 billion, a 25% YOY increase. See page 4. There was concern that this may have been a cyclical peak in residential construction. However, in August, the NAR housing affordability index ticked up as a result of a small decline in mortgage rates and a similarly small dip in home prices. These declines helped to offset the small drop in median household income. October’s National Association of Home Builders survey showed an encouraging rebound. The survey indicated an increase in pending sales, an uptick in home buyer traffic and an expectation that sales will increase in the next six months. See page 5. Since housing is a significant segment of the economy, this improvement in sentiment is a good sign for the fourth quarter.

Gail Dudack

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