The new year arrived, and with it came a new and revised perspective on the equity market. This is understandable. In 2021, the financial markets were insulated from downside risk given the extremely friendly posture of the Federal Reserve and the potential of more fiscal stimulus. Monetary policy would keep interest rates low and safeguard speculators while fiscal stimulus would support economic activity. With these two safety nets as backing, one could ignore inflation without consequences. But the Fed, many economists, and bankers are now addressing the strain that rising prices has had on consumers in 2021 and many are suddenly, although belatedly, calling for quick action. At the same time, more fiscal stimulus is looking less likely. Thus, both safety nets are disappearing in 2022.
In terms of fiscal policy, the logjam in Congress is no surprise. However, the shift in monetary policy came about amazingly quickly. At the June FOMC meeting, Fed officials — or the dot plot — forecasted no fed funds rate increases until 2023. In September, the dot plot changed to include one possible rate hike at the end of 2022. December’s dot plot implied three possible rate hikes in 2022. This week the consensus expectation has changed once again to include four or five fed funds rate hikes this year, or at least one increase per quarter. This is a startling turnaround, albeit a necessary one. We believed inflation would be a big hurdle for equities last year. It proved not to be. But this year as the Fed addresses the existence of inflation, the significance of price increases is apt to become quite apparent. Keep in mind that four fed fund rate hikes within a twelve-month period tends to produce a down market in the subsequent six months. We will discuss Fed rate hikes in future weeklies.
Independent of monetary and fiscal policy, the new year begins under a dark cloud. As we have often noted, three consecutive years of double-digit gains in the indices are often followed by a year of losses. The one exception to this precedent was the five double-digit up years that led into the 2000 peak. However, this historic rise was a stock market bubble, and it was followed by three consecutive years of losses. See page 3. Therefore, if history is any guide, 2022 may a defining year – either it is a down year or it is the beginning of an equity bubble. We think the first quarter will be revealing and may provide the answer.
January and Liquidity
Wall Street adages are typically built upon some fundamental or economic premise and the January Barometer is one of these. The concept of the first five days of the year and/or the first month of the year having predictive value for the overall year is based upon liquidity. The end of the year and the beginning of any year is a unique time for liquidity. A grouping of pension funding, IRA funding, tax loss selling proceeds, bonus payments and salary increases tends to cluster in the December/January period and makes this time unique in terms of providing potential demand for equities. If equities fail to rise during this time, it may be a signal of trouble ahead. Overall, it is a warning.
January is off to a weak start this year, with a 1.9% decline in the S&P 500 index and a 0.3% decline in the Dow Jones Industrial Average. And as shown on page 5, ten of the last 17 post-election-year markets were flat to down years. However, it is important to point out that the early January Barometer has a poor record of predicting annual declines. Early January losses have only been followed by annual declines 42% of the time in the S&P 500 and 46% of the time in the DJIA. A decline in the month of January has been more accurate. January declines have been followed by annual declines 69% and 66% of the time in the S&P 500 and DJIA, respectively. All in all, the January Barometer has been a better guide in predicting up years after January gains. See pages 4 and 5. Still, we do think it would be a bad omen for January to be weak in face of the obstacles we see for equities.
One of the issues facing equities is the potential slowdown in earnings growth. After what we expect will be a high double-digit earnings growth rate in 2021, the pace is expected to slow to a single digit level this year. Currently, IBES Refinitiv and S&P/Dow Jones have 2022 earnings growth rates of 8.5% YOY and 9.0% YOY, respectively. Our estimate is for a 10% YOY growth rate, but only because our 2021 earnings estimate is below the consensus view. See page 7 and 16. Nevertheless, earnings are facing tough comparisons in 2022 and earnings will not provide the fundamental support it did over the last twelve months.
Higher inflation also pressures price-earnings multiples. Unless inflation falls well below the 4% level this year, we expect multiples to fall from the current level of 20+ to the average of 17.5 times. But inflation dropping to less than 4% seems unlikely in the near term, particularly with crude oil futures rising once again. The charts of both WTI and gasoline futures point to higher prices this year. See page 8. This implies inflation and multiple risk in coming months.
Plus, it is easy to become too insular and forget about the geopolitical problems that could upset the financial markets. Political hotspots include North Korea which launched two ballistic missiles off its East Coast in the last week, US forces in Iraq and Syria suffering three separate rocket attacks in recent days, Russian troops hovering ominously on the Ukrainian border and China becoming increasingly assertive in controlling both Hong Kong and Taiwan. All of these have the potential of upending the financial applecart.
High PE stocks face the biggest threat in an environment of soaring inflation and rising interest rates. And we expect technology stocks could bear the brunt of any correction in 2022. With this in mind we looked at the charts of the FANG stocks this week and found some patterns that deserve monitoring. We have comments on Amazon (AMZN – $3307.24), Meta Platform (FB – $334.37) and Alphabet (GOOG – $2800.35) on page 9. Each of these stocks have critical support levels that if broken, could trigger further selling. In sum, we would be defensive in the short run; but a sell-off in 2022 could produce an excellent long-term buying opportunity. Meanwhile, there are pockets of safety in the market in areas such as energy, banks, and staples, which all have modest multiples and good dividend yields.
Technical Indicators The Russell 2000 index also has a pattern similar to the aforementioned FANG stocks in that the 2100 support level is important to the index. If this level is broken it would be extremely bearish for the RUT and a negative omen for the market. See page 10. Most other technical indicators are neutral or indecisive this week. The 25-day up/down volume oscillator is at 2.06 this week and above the midpoint of the neutral range, but still has not confirmed any market highs since February 2021. This implies that investors have been selling into rallies. Both the 10-day averages of new highs and new lows are above 100, leaving the “trend” of the market ambiguous. The NYSE cumulative advance/decline line made its last record high on November 8. Sentiment indicators like the AAII bull bear survey and the ISE call/put volume index are neutral. All in all, we remain cautious for the near term.
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