There were a number of developments in economic, fundamental, and technical data over the last week, but the most significant change was technical and the performance of our 25-day up/down volume oscillator. In our last strategy report, we indicated that it would be important to monitor this indicator because it could be close to making a positive shift. That is what it did this week. The oscillator has now been in overbought territory for ten consecutive trading sessions. Ten is an important number because bear markets rarely have rallies that can sustain an overbought reading for five to ten days. The initial advance in a bull market will have an extended overbought reading and it usually includes an extreme reading of 5.0 or greater. Currently, the oscillator has been as high as 4.81 but it has not exceeded the 5.0 reading generally seen at the start of a new bull cycle. Nonetheless, this long overbought reading is a positive change in this indicator. See page 12.
And there are other positives in the technical arena. The 10-day average of daily new highs has been over 100 for the last week and the 10-day average of daily new lows has been below 30. This combination is bullish since 100 or more defines the trend. The current rally also carried the popular indices above their 200-day moving averages, including the lagging Nasdaq Composite Index. And as we noted recently, the Russell 2000 has an attractive technical chart after bettering the 1900 resistance level. The move above this resistance price is a good near-term sign for small cap stocks and the market overall. However, the 2200 level in the RUT represents significant resistance for the advance which means, the current advance may be a good trading opportunity, but investors should be cautious.
Our longer-term view is that the market is apt to remain in a broad trading range until inflation is clearly under control. We believe this will take another 12 to 18 months. But in the interim, we expect a broad trading range to contain stock prices with the January 3, 2022 SPX high of 4796.56 as a ceiling and the October 12, 2022 low of SPX 3577.03 as a probable floor. This signal from our 25-day up/down volume oscillator is in line with this forecast. And even though this is a better outcome than we expected earlier this year, we would not chase the current rally. Much of the shift is taking place in large capitalization technology stocks which we do not believe will be the leadership of the next bull market cycle. Technology stocks have been at the center of heavy short selling, and it is likely that short covering is contributing to the current advance.
Nonetheless, the technical improvement seen in recent sessions implies that the underlying bear cycle is diminished, and a neutral range is ahead. We reviewed our concept of a flat market trend last week (“Reviewing Flat Trends” February 1, 2023) and showed that historically, the popular stock indices have spent 50% of the time in flat trends. Flat trends can include several bull and bear market moves of 20% or more, but we define them as “flat” since rallies are unable to sustain an advance above the previous market peak. Note that flat cycles tend to be linked to periods of inflation or deflation. In our opinion, this is why it is critical that the Fed deal firmly with the current inflation cycle. History shows that inflation is difficult to control once it exceeds 7% YOY and it has only been resolved with a series of recessions. We believe the Fed understands this issue and is attempting to be a slow and steady force to undermine inflation without igniting a recession. It will not be easy.
As we expected, fourth quarter earnings season is tempering expectations for 2023 earnings. Last week the S&P Dow Jones earnings forecast for 2023 fell $2.62 and the Refinitiv IBES consensus earnings forecast fell $1.70. This brought the consensus 2023 full year estimates to $219.29 and $224.31, respectively. What is interesting in our view is that these 2023 estimates now match the estimates analysts had for last year’s earnings back in May 2022. See page 10.
Some economic data releases also suggest corporate margins may be under severe pressure this year. Labor productivity fell 1.3% in 2022. This followed a 2.4% increase in 2021 and a 4.4% rise in 2020. Keep in mind that falling productivity often means a rising cost of labor. Total labor compensation costs rose by 5.1% YOY in June 2022, the highest pace since June 1990. And the compensation cost index remained consistently high at 5.1% YOY at year end. Labor costs increased across the board, for both wages and benefits. See page 6. What may keep the Fed awake at night is the fact that while inflation peaked at 9.1% in June of 2022, the employment cost indices have not declined, and they remain high for both private and government workers. This will have two negative impacts: it will encourage the Fed to keep interest rates high long enough to reduce this trend and, in the interim, it will erode corporate profits. See page 7.
Total nonfarm payroll employment rose a surprisingly large 517,000 in January, and the unemployment rate was slightly lower at 3.4%. Job growth was widespread, but it was led by gains in leisure and hospitality, professional and business services, and health care. However, there were a number of reasons to not place too much emphasis on this report.
As seen on page 3, the seasonally adjusted payroll employment rose to a new cyclical high, whereas the not-seasonally-adjusted employment number fell well below the high recorded in November 2022. Nevertheless, there were underlying reasons for the inconsistencies in January’s release. The BLS introduced its annual revision of the establishment survey in January. This is a once-a-year re-anchoring, based on March 2022 data, of employment estimates from the unemployment insurance (UI) tax records filed by nearly all employers with State Workforce Agencies. As a result of the adjusted estimate for March 2022, total nonfarm employment had an upward revision of 568,000 or 0.4%. The not-seasonally adjusted total nonfarm employment estimate was revised by 506,000, or 0.3%. Over the prior 10 years, these benchmark revisions have averaged 0.1%, with a range from −0.3% to 0.3%. In short, this was a very large revision that “technically” erased January’s outsized job gain.
The household survey also had an annual update to total civil noninstitutional population based upon revised Census data. This impacted the participation rate and the employment population ratio modestly. Lastly, there were changes to the North American Industry Classification System (NAICS) which resulted in some work categories being delisted and others added. These changes are typical of most January reports, but this year the revisions were larger than normal. See page 4. The ISM surveys will be important to monitor in coming months. In the December reports, the weakness seen in the manufacturing sector appeared to be spreading and the service sector fell below 50, reflecting a contraction. But in January, a rebound in the ISM nonmanufacturing index reversed most of December’s weakness. The recovery in the service sector could be significant and has the potential of boosting economic activity, perhaps even in manufacturing. In sum, it is worth monitoring the ISM indices in the months ahead. The rate of change in the manufacturing index has been highly correlated with the rate of change in the S&P Composite. It could be pivotal. See page 9.
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