US Strategy Weekly: Staying Recession Resistant

Technical Indicators

Our view of the recent rally is quite simple. The popular equity indices fell well below their moving averages in recent weeks and a rebound to at least the 50-day moving averages is likely in coming trading sessions. The levels to look for are 31,277 in the Dow Jones Industrial Average, 3,915 in the S&P 500, 11,637 in the Nasdaq Composite, and 1,822 in the Russell 2000 index. Note that a test of these levels equates to another 2.5%, 5.3%, 8.0%, and 3.7% upside, respectively, in the indices. See page 9.

The good news is that the current rebound has more potential; but unfortunately, the market’s action in recent weeks also suggests the bear market is ongoing. In short, the lows are yet to be found. Breadth data deteriorated in September, and in particular, the 25-day up/down volume oscillator hit an extreme oversold reading of negative 5.6 on September 30. This was a deeper oversold reading than the one seen at the June low. The 25-day oscillator was also in oversold territory for 10 consecutive trading sessions in September and to date, it has been oversold for a second time in six of the last seven trading sessions. This represents a much longer and persistent oversold condition than the six out of eight consecutive trading sessions seen at the June low. All in all, it indicates an escalation in selling pressure which means the test of the June lows was unsuccessful by several measures and the bear market continues. See page 10.

The current reading in the 25-day oscillator is oversold at negative 3.3, which is rather amazing given the nearly 6% two-day gain seen in the market to open October and the 4% two-day gain seen this week. This oversold reading reveals that despite these sharp rallies, selling pressure has overwhelmed buying pressure over the last 25 trading sessions, typical of a bearish trend. A successful test of a bear market low materializes when a new low in price is accompanied by less selling pressure and a less severe oversold reading. This indicates that selling pressure and downside risk is abating. In other words, a “non-confirmation” of a major low is a positive sign. Sadly, that is not what has been seen in October, to date.

Sentiment indicators have also been extreme recently, but this is favorable. Last week’s AAII readings showed bullishness at 20.4% and bearishness at 55.9%. Also noteworthy was the 17.7% bullish reading seen the week of September 17th since it was among the 20 lowest readings since the survey began in 1987. Bearish sentiment has been above 50% for seven of the last eight weeks which is also rare. Equity prices tend to be higher in the next six and/or twelve months following such extreme readings. Keep in mind that sentiment indicators are never good at timing market peaks or troughs, but they are good at indicating which way to lean. In this case, it suggests that investors should not be overly bearish on equities and should be looking for a buying opportunity ahead. See page 12.

Earnings Forecasts

We are happy to report that some anchors on CNBC are now pointing out that even though some companies are reporting third quarter earnings results that exceed consensus expectations, these earnings are nonetheless weaker than a year earlier. That is a step in the right direction, since the market had been ignoring the fact that earnings have been weakening in 2022.

This week the S&P Dow Jones consensus earnings estimates for 2022 and 2023 fell $0.79 and $2.62, respectively. Refinitiv IBES consensus earnings forecasts fell $0.76 and $1.17, respectively. To date third quarter results are triggering larger earnings cuts than what was seen in the second quarter. The S&P consensus EPS estimate for 2022 is now at $207.33 and the IBES estimate fell to $222.58 bringing EPS growth rates for 2022 to negative 0.4% and positive 7.7%, respectively. See page 8. Our 2022 and 2023 estimates are currently $209 and $229, respectively, but remain under review. Based on early releases, our S&P 500 earnings estimates could come down significantly before year end. Unfortunately, this means the fair value range for the SPX will also fall. The range in our valuation model currently shows a low of SPX 2354, a high of SPX 3430, and a midpoint of SPX 2890. It is the midpoint of the range that is the most likely to contain downside risk, in our view. However, this explains why lowering our earnings forecast poses even more downside risk in the marketplace.

Inflation

September’s inflation data disappointed many and this disappointment will continue in coming months unless analysts look deeper into CPI data. Forecasters were expecting lower inflation numbers because energy prices fell 6.2% month-over-month in September. Nevertheless, September’s CPI was unchanged year-over-year and core CPI rose. And note, this was not due entirely to owners’ equivalent rent, as some are saying. See page 3.

As we expected, healthcare prices are rising in the fourth quarter which tends to be a seasonal trend. Housing prices may be peaking in some regions of the country, but housing is still rising in the CPI index. More importantly, unnoticed by many is the fact that food and beverage prices rose 10.8% YOY in September. This should be a concern for all investors because food inflation is not impacted significantly by energy (except for transportation costs) but will be impacted by the conflict in Ukraine since Ukraine – the breadbasket of Europe — is a major grain producer. We expect grain shortages will drive prices higher for the foreseeable future. In addition, Hurricane Ian damaged large portions of agricultural land in central Florida which could have an impact on the supply of fruits, vegetables, and beef. In our view, food shortages are likely to add to inflation in the months ahead. See page 4.

Some economists are fixated on owners’ equivalent rent which has a 24% weighting in the CPI and rose 6.7% YOY in September. They are challenging the validity of homeowners’ equivalent rent as a measure of housing costs since it is measured not by transactions, but from a survey of home prices and rents in various neighborhoods. Some say the surveys are not reflecting the deceleration in home prices. This is true since rents always lag home prices, sometimes by quite a few months, but this has always been true. Still, when we compare the history of owners’ equivalent rent to the National Association of Realtors median single-family home price, we find the homeowners’ equivalent rent has been much more subdued than home prices and has been a slow and steady measure of costs over time. However, the 6.7% increase seen in September was above the normal range of zero to 6%. See page 6. Rents are likely to fall in time since housing is clearly in a down-cycle. Signs of a housing recession are numerous, including the year-long decline in NAHB confidence. See page 6. However, this is not the problem that we see. Food and beverages have a 14.5% weighting in the CPI and rose a greater 11% YOY. This combination concerns us. Moreover, inflation is rising 8.2% YOY and wages are rising 4.8%. This equates to a 3.4% loss of purchasing power. See page 5. We remain cautious and continue to favor recession resistant sectors and stocks.

Gail Dudack

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