We give thanks to all our readers and wish you a safe and Happy Thanksgiving!

Oil prices hit a seven-year high in the US in late October. And as oil prices and inflation moved steadily higher this year, President Biden’s approval rating moved steadily lower. This, coupled with the razor thin majorities in both chambers of Congress and midterm elections on tap for next year, intimates the Democratic Party could lose seats in the 2022 elections. In short, this situation demanded action and is the catalyst for President Biden’s announcement this week. He authorized an historic 50 million barrel release from the US Strategic Petroleum Reserve and he also stated in his press conference that he will ask the Federal Trade Commission to investigate the gasoline industry for price gouging. This was his Thanksgiving gift to American households.

However, there was not much response from the financial markets or from energy prices. Simple logic explains why. China is the number one importer of energy in the world, and it currently imports more than 10 million barrels of oil a day. The United States ranks second in imports at about 6 million barrels per day. This total of 16 million barrels of imports and Biden’s 50-million-barrel release of strategic reserves equates to the import demand from just these two countries for three and one-eighth days. In short, the action is highly symbolic, but close to meaningless.

Biden did ask a broader group of countries to release oil from their reserves including India, Japan, and South Korea, which rank third, fourth and fifth, respectively, in terms of imports. Still, we do not believe it will have a significant impact on energy prices. Moreover, strategic reserves are “strategic” which means they are held aside for important emergencies. The current supply/demand imbalance of energy is not a true emergency, in our view. Like much of the current inflationary cycle, we believe it is man-made. The main culprit for soaring energy prices is the mismanagement of US energy as the administration attempts to force the country to green fuels. Inflation is driven by the historic fiscal and monetary policies implemented globally and maintained even throughout the global economic recovery. It is basic economics.

What would shift the energy supply/demand balance would be to restore the XL pipeline and to remove newly installed regulations on the US energy industry. This could immediately bring back the 2 million barrels per day of natural gas production that has been lost this year. And it would be long-lasting. This would be a sensible action, particularly since in terms of the environment, gas is one of the cleanest fuels available. We believe it is possible to support and incentivize renewable green fuel production and usage, while still allowing the US energy industry to produce shale and natural gas during the transition. But the right way in our opinion, is to find a joint public/private energy agreement that has a goal of a green renewable energy environment. The wrong way is to punish the oil and gas industry and the average American household.

And we doubt that an FTC investigation of the gasoline industry will find much, if any, price gouging or have a lasting impact on gasoline prices. On page 3 we show a NYMEX chart of the spread between gasoline futures and WTI futures. There is a natural lag between the price of oil and gasoline prices, yet they tend to ebb and flow within a predictable range. The current index of 17.19 is practically in the middle of the six-year range of 5 to 25. In short, price linkages look normal and an investigation is not apt to find anything untoward in the markets. But it does make for good political theater.

Markets and Technicals

The market is in the middle of its most favorable time of the year — November through January – and quantitative easing although slowing, still continues. This is a positive backdrop for equity investors. Third quarter earnings results have exceeded expectations and the recent round of earnings releases from retailers have been surprisingly strong. See page 6. These factors are supporting stock prices. However, we believe there will be many changes in the financial landscape as we move into 2022. We have written about all these issues in recent weeklies: 1.) energy-driven inflation, 2.) decelerating earnings growth, 3.) historically high ownership of equities, 4.) the risk of the Fed raising interest rates and 5.) the risk that China’s weakening property sector poses to the Chinese economy and perhaps the global banking system. All in all, December should be a time to prepare one’s portfolio for the changes ahead.

Technically, there has been little change in the indicators this week. The Dow Jones Industrial Average and the Russell 2000 hit record highs on November 8 and the S&P 500 and Nasdaq Composite index did so again on November 18 and 19, respectively. See page 7. The Russell 2000 index continues to be a focus for us since it is a broader-based index and driven less by the large cap technology stocks. And we would point out that the recent breakout by the RUT from an 8-month trading range is bullish for the intermediate term, but the index has weakened recently. This pattern of weakening is also seen in several breadth indicators.

The 25-day up/down volume oscillator fell to negative 0.40 this week and has drifted into the lower half of the neutral range. This oscillator spent two days in overbought territory October 25 and 26; but to confirm new highs in the market it should have remained in overbought range for a minimum of five trading days. The last time this indicator did this and confirmed new highs in equities was between February 4 and February 10 of this year. What this means is that the new highs seen in the market since February were driven by less and less buying pressure. The fact that the oscillator is currently below the zero line means there has been more volume in declining stocks than in advancing stocks over the last 25 trading sessions. It is not a sign of underlying strength. See page 8.

The 10-day average of daily new highs dipped from 335 to 202 this week and on November 23, the new high list was less than 100. Meanwhile, the 10-day average of daily new lows rose to 132 this week from 85 last week. A 10-day average of 100 defines the market’s trend; therefore, the current combination of 202 new highs and 132 new lows is mixed. This indicator is downgraded from positive to neutral. The NYSE advance/decline line made a confirming record high on November 8 and has not confirmed the more recent highs seen in the S&P 500 and Nasdaq Composite. Volume has been declining and below the 10-day average for most sessions in November, but it was 25% above average on the down day of November 22. Bull markets should have volume rising on up days and falling on down days. Therefore, recent volume patterns are a bit of a concern. Still, the shortened Thanksgiving Day week has a long history of light trading volume and high price volatility and has not had any predictive value. Therefore, even though Wednesday is a heavy economic release day, we would not worry too much about price action this week. We expect many investors are finally traveling to see family after more than a year of restrictions. The action of the post-holiday week will be more important.

Gail Dudack

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Our 2021 outlook identified inflation as one of the major hurdles facing equities in 2021. We continue to believe this is true, but to date equity investors have ignored the threat of rising prices. President Biden, current Treasury Secretary and former Fed Chairwoman Janet Yellen and current Federal Reserve Chair Jerome Powell, have all given little credence to the relentless rise in price inflation.

The Federal Reserve is important since it plays a pivotal role in fighting inflation. Because its role is so important to the economy it is designed to be an independent non-political body. The seven members of the Board of Governors are nominated by the President and confirmed by the Senate for a term of fourteen years. Terms begin/end every two years, on February 1 of even-numbered years. The length and staggering of the terms of Board members hopefully result in a political balance on the Board while also removing political pressure on each governor since they can only serve for one term. Terms can only be extended if a Governor is appointed Chair or Vice Chair for four years.

However, the political climate is heated this year and by the end of this week, we should know whether Biden will reappoint Chairman Jerome Powell, a Republican and former private equity executive, for a second four-year term, or, as the media suggests he appoints another front runner, Lael Brainard, a Democrat and former Fed economist and political appointee in both Obama and Clinton administrations. Both Powell and Brainard have similar views on inflation and interest rates so it would appear that this decision could be rooted in politics. Either way, the Fed Chair will face some tough decisions in 2022.

The word “stagflation” has become part of the economic discussion in recent weeks and for good reason. GDP slowed to 2% in the third quarter down from a booming 6.7% in the second quarter. This means that the economy has been growing well below its long-term average of 3.4% in recent months. Meanwhile, inflation is on a tear. October’s CPI rose from 5.4% YOY to 6.2% YOY (NSA) and most underlying components saw significant increases during the month. At 6.2%, headline CPI now exceeds the level seen in 2008 and is rising at the fastest pace seen since November 1990. And inflation is unlikely to die out any time soon. In fact, if November’s monthly CPI increase is zero, the year-over-year headline rate will still be 6.1% YOY next month. However, we believe prices will move higher and therefore inflation could be the worst experienced since 1982. See page 3.

This is important because inflation is a huge burden to the average household, and it increases the cost of non-negotiable necessities like food and shelter. As an example of what families faced in October data shows that food at home rose 5.4% YOY. Household furnishings and operations rose 6.25% YOY. Used car and truck prices rose 26%. Gasoline prices rose 50% YOY. All items less food, shelter and energy rose 5.3% which shows that price increases are not just tied to rising energy and transportation costs or supply chain issues but are broadly based. Anecdotally, our local nail spa just posted a sign indicating an arbitrary $5 increase on all services provided. This increase is not due to higher transportation costs, supply chain problems, or shrinking margins, but due to the fact that all families face a higher cost of living. But more importantly, this is a sign that inflation is becoming engrained in our economic system, and this is serious.

In our view, the Fed is losing the fight against inflation. We agree with Larry Summers, Treasury Secretary under Bill Clinton, director of the National Economic Council under Barack Obama, Chief Economist of the World Bank, and President of Harvard University who said “Biden’s American Rescue Bill made the mistake of pumping up demand too much without taking steps to increase supply. That had resulted in inflation.”

It is not possible to have historically easy monetary policy for an extended period of time, coupled with an historic level of fiscal spending — during an economic rebound — without suffering the consequences of inflation.

October’s PPI report suggests that the CPI will move even higher than 6.2% in coming months. The PPI for finished goods was up 12.5% YOY in October and final demand PPI rose 8.6% YOY. In short, big price increases are already in the manufacturing pipeline which we believe will push consumer prices higher in coming months.

The most unfortunate part of the current inflation trend is that it now exceeds the increase in weekly nonsupervisory earnings. This means buying power is declining this year which is the exact opposite of what happened between April 2020 and April 2021 when earnings increased much faster than inflation. See page 4. Personal income was also boosted by fiscal stimulus in 2020 and early 2021 and led to both higher savings and higher consumption.

It is also important for investors to take notice that “inflated earnings” are worth less than “real earnings.” For example, a 10% increase in earnings in a 6.3% inflationary environment means earnings growth was really 3.7%. However, the same 10% earnings growth coupled with 1% inflation translates into earnings growth of 9%. Overall, rising inflation will have a negative impact on PE ratios. The Rule of 23 is an easy tool for depicting the impact of inflation on the equity market since it is a simple sum of inflation and trailing earnings. At present, a combination of a trailing PE of 23.7 and inflation at 6.2% sums to 30, which is well above the 23-warning level. However, the market has been trading above 23 for a while, due in large part to the support of easy monetary policy. But sentiment could change if inflation begins to erode margins or if the Fed begins to fight inflation through higher interest rates. See page 5. This implies caution.

Inflation is at levels last seen in 1990, but at that time the 3-month Treasury and 10-year Treasury yields were much higher at 7% and 8.5%, respectively. The S&P earnings yield was 11% and still competitive with fixed income, yet the trailing PE was at 14 times and below the long-term average. Today the 3-month Treasury and 10-year Treasury yields are 0.05% and 1.4%, the earnings yield is 4.2% and the PE is 23.7 times. Stocks are competitive to bonds, but bonds are a wasting asset given the level of inflation. In sum, there is a big disconnect between inflation and the financial markets.

Moreover, the jump in crude oil prices is greater today than it was in 1990 and energy prices are apt to stay higher longer than expected due in large part to political and environmental policies around the world. All in all, it is a disturbing backdrop for the 2022 stock market and for the incoming Fed Chair. See page 6.

October’s retail sales beat expectations, rising 1.7% month-over-month and 16.3% YOY. Adjusted for inflation, retail sales growth drops to 11.3% YOY, but remains in double digits. Part of this rebound in sales was predictable due to October’s previously announced increase in unit motor vehicle sales. Census data shows that vehicle dollar sales rose from 8.8% in September to 11.5% in October. See page 7. In our view, the positive seasonality of November, December, and early January, coupled with the fact that quantitative easing is slowing, but still in place, is positive for equities. But we fear the environment for equities could change quickly in 2022 with inflation stubbornly high, earnings growth decelerating significantly and the boost from more fiscal stimulus dissipating. The technical backdrop of the market is little changed from a week ago and it suggests an aging bull market is in place.

Gail Dudack

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China’s Property Sector

China’s property woes first rattled global markets in September and October, however, fears of systemic risk are resurfacing again. China Evergrande Group, the world’s most indebted developer, has been stumbling from deadline to deadline as it struggles with more than $300 billion in liabilities — $19 billion of which are in international bonds. A $148 million bond payment must be made on Wednesday, and this will be followed by coupon payments totaling more than $255 million on December 28. However new concerns appeared last week when Kaisa Group made a desperate plea to Beijing and creditors for help. Trading in shares of Kaisa and three of its units was suspended after an affiliate missed a payment to onshore investors. In response to Kaisa’s woes, China’s property sector has taken a pounding.

In terms of sales Kaisa Group is China’s 25th largest real estate developer but it ranks second to Evergrande Group in terms of bond repayment bills due next year. This makes Kaisa’s crisis meaningful. Also interesting is the fact that the US Federal Reserve just sent its first direct warning to China and investors about potential global damage from China’s property crisis. In its twice-yearly financial stability report released this week, the Fed wrote: “Financial stresses in China could strain global financial markets through a deterioration of risk sentiment, (and) pose risks to global economic growth.”

It is worth mentioning that economists estimate China’s property sector to be the largest contributor to China’s economy and if related industries are included, property accounts for more than 25% of GDP. Real estate has been a large and steady creator of jobs in the country and land sales account for a third of local governments revenues according to Nomura. Property also accounts for 40% of assets owned by Chinese households according to Macquarie Group Ltd. This suggests that if real estate continues to fall Chinese consumers could lose confidence and curtail consumption. And according to Reuters, the value of nationwide land sales fell 17.5% YOY in August. In short, there is a major risk to the Chinese economy as a result of the current property crisis.

Reuters also notes that due to a long, massive building boom and speculation, China has about 65 million empty homes, or the equivalent of all the households in France and the United Kingdom combined. As of June, Chinese developers owed 33.5 trillion yuan ($5 trillion), or a third of the country’s GDP, up more than two-fold from 2015, according to Nomura. This outstanding debt is roughly equivalent to the GDP of Japan, the world’s third-largest economy. The overriding question is whether or not China will be able to handle the risk that is growing in its property sector. All in all, these developments underscore why investors should not be myopic as the US equity indices make a series of record highs and instead be alert to global issues. Clearly factors outside the US could impact the global banking system, global liquidity and reverberate through the global financial markets. To sum up, China could easily become a major risk for the financial markets in the months ahead.

Assessing the Technical Backdrop

There are many good things happening in the technical backdrop of the market at present. This week the cumulative NYSE advance decline line reached an all-time high confirming the new highs seen in the indices. The Russell 2000 index made a bullish breakout from an 8-month trading/consolidation range which generates a positive outlook for the intermediate term. The daily new high list is averaging 350 new highs per day, and finally, sentiment indicators are oscillating in neutral ranges which means they are not indicating any excess optimism on the part of investors. See pages 9, 11 and 12. These are all positive. The only weakness is seen in volume.

Our first concern is that total volume on the NYSE has been decelerating and has been running below the 10-day average in many November sessions. Volume should increase during advances since rising volume reflects increasing demand. Second, the 25-day up/down volume oscillator has ticked higher but remains stuck in neutral. Currently, the oscillator is at 2.07 and neutral after spending only two days in overbought territory October 25 and 26. To confirm new highs in the popular indices, this indicator should remain in overbought range for a minimum of 5 consecutive trading sessions. The last time this indicator did this and confirmed new highs in the equity market was between February 4 and February 10 of this year. From a technical perspective, this is a sign of underlying weakness, and it is a warning that the bull market is aging.

Still, this is a seasonally strong time for equities. November ranks as the best performing month for the S&P 500 and ranks number two for the DJ Industrial Average. December ranks third in terms of performance for both indices. The other contender is April which currently ranks second for the S&P 500 and first for the DJ Industrial Average. Note that the seasonally strong months tend to coincide with pension funding cycles or tax strategies and IRA funding for individuals. Liquidity is an important ingredient in terms of stock performance; and this good seasonality coupled with a decent technical backdrop makes us optimistic about the next few months. But we see the potential of storm clouds ahead. Not only is China a threat to the global economy and to global liquidity, but earnings growth in the US will fall into single-digit territory in 2022. The great support found in earnings growth this year will not be repeated in the next twelve months. Therefore, a balanced portfolio with companies that are inflation resistant, have strong balance sheets and below average PE multiples remain our preferences.

Economic Roundup

Economic data is mixed. October’s employment report was encouraging not only because it showed a gain of 531,000 jobs in the month, but because the increase in private industry jobs was significantly higher at 604,000 new jobs. Revisions to two prior months were also positive. In the household survey, the number of people employed grew in excess of the increase in the labor force, which resulted in the unemployment rate falling from 4.8% to 4.6%. Nonetheless, there are 4.2 million fewer people employed currently than in February 2020. See page 3.

October’s ISM manufacturing survey showed that global supply-chain issues are not abating. Most areas were slightly lower but there was an uptick in hiring plans. Conversely, the ISM nonmanufacturing survey was strong, setting a record for the fourth time in 2021. The only blemish in the services report was the decline in the employment index. See page 5.

Vehicles sales increased to 13 million units (SAAR) in October and was below 14 million for the fourth straight month. October’s sales were 21% below a year ago and the lowest October in 11 years. However, sales did rebound from September’s low, and this should help next week’s October retail sales report. See page 6. The NFIB small business survey slipped 0.9 points in October to 98.2, but the real story is that the outlook for business fell 4 more points to negative 37. This was just above the record low of negative 38 set in November 2012. The survey shows both sales and earnings have been sliding since mid-2020. Plans to raise prices jumped from 46 to 51 in October. See page 7.

Gail Dudack

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Quantitative Easing

Last week we wrote that the economic, political, and technical backdrop for the equity market was the best it had been in many months and that this combination would set the stage for a year-end rally. In our opinion, the inability of Congress to pass a large stimulus package – which could have included hefty business and personal tax rate increases — combined with the positive seasonality of November, December and January should not be ignored. Moreover, the monetary policy changes expected this week have been well telegraphed and discounted by investors and should make the slow elimination of quantitative easing a non-event. In sum, barring some unexpected negative mishap, we believe the stage is set for higher stock prices and a decent Santa Claus rally. Nonetheless, earnings growth is forecasted to slow in 2022, and though this may not have an impact until next quarter, we would still emphasize quality stocks. Companies with inflation resistant earnings growth are apt to be the best performers in the months ahead.

Earnings Backdrop

Third-quarter earnings are center stage again this week and as the economy bounces back from the coronavirus pandemic, most companies continue to report better-than-expected results. One should keep in mind that estimates were downsized in September when analysts were concerned about supply chain issues hurting third quarter estimates. Nonetheless, with 320 companies having reported, Refinitiv IBES indicates that S&P 500 earnings are anticipated to have climbed 40.2% in the third quarter from a year ago. This hefty earnings jump produces a nice cushion for the broad market as we move into the final months of the year.

Technical Challenges

But there are a few challenges in the technical backdrop this week. The 25-day up/down volume oscillator is at 1.96 and neutral after spending only two days in overbought territory last week. To confirm the string of new highs seen in the popular indices this week, this indicator should move to and remain in overbought range for a minimum of 5 consecutive trading days. However, the last time this indicator did this and confirmed new highs in the equity market was nine months ago, between February 4 and February 10 of this year.

In February, when the Russell 2000 previously recorded a record high, overbought readings in this indicator confirmed the equity market’s advance. Since then, there have been no validations of a succession of record highs. We should also point out that while the many indices made marginal new highs on November 2, breadth data was not convincing on the NYSE and data showed more declining issues than advancing issues for the session. Volume was also disappointing since it slipped below its 10- day average. In sum, November 2 was a great day for equities globally. The S&P 500, the DJIA, the Nasdaq Composite, the Russell 2000, the Wilshire 5000, France’s CAC 401, and the MSCI all-country world index all made record highs. However, it was not a convincing day from a breadth perspective. This could change over the course of the next week, but for example, the bullish breakout in the Russell 2000 index from a 9-month trading range needs to see confirming follow-through. In the interim we believe this is another reason to emphasize quality stocks.

Economic Data and the Fed

It has been a busy week in terms of economic releases and overall, we believe most results relieve the Fed of any pressure to raise interest rates. In general, we found economic data discouraging. The advance estimate for third quarter GDP indicated economic activity grew at a seasonally adjusted annualized rate of 2.0%. This was a big disappointment since 2.0% is well below the long-term average for GDP growth of 3.2%. In addition, third quarter activity was concentrated in a buildup of private inventories. This is a negative since the need to increase inventories is diminished and this could reduce economic activity in the fourth quarter. The main weaknesses in the third quarter estimate were found in personal consumption of goods, the negative drag from trade and a decline in residential investment. See pages 3 and 4.

The decline in the household’s consumption of goods can be explained by the recent data on personal income, consumption, and savings. Personal savings were $1.3 trillion in September down from $1.67 trillion in August and well below the April 2020 peak of $6.4 trillion. This is a sign that the “pent-up demand” economists expect from the pandemic’s buildup of household savings is quickly evaporating. September’s savings rate was 7.5% down from 9.2% in August and closing in on the 20-year average rate of 6.8%.

Personal income was $20.5 trillion in September, down from $20.7 trillion in August and well below the $24.1 trillion seen in March 2020. Personal disposable income was $17.9 trillion in September, down from $18.1 trillion in August, and also well below the $21.7 trillion seen in March. See page 5. However, wages rose to a record $10.38 trillion in September as people began to move back into the workforce. Keep in mind that wages represented a peak of 65% of personal income in July 1966 but have been steadily declining as a percentage of income and hit a low of 41% in March 2021. Wages rose to 51% of total personal income in September but much of this gain is statistical.

September’s headline personal income number declined as government social benefits fell from $4.2 trillion in August to $3.8 trillion in September. Total unemployment benefits fell from $352.3 billion in August to $97.7 billion in September. Note that unemployment benefits peaked at $1.4 trillion in June 2020. See page 6.

The decline in disposable personal income from $1.81 trillion in August to $1.79 trillion in September could reverse and improve dramatically if people return to work as unemployment insurance benefits are exhausted. But if employment does not increase and income stagnates, the outlook for the economy will dim. Historically, there has been a close, but lagging, relationship between the year-over-year growth in disposable personal income and the year-over-year growth retail sales. To date, retail sales have been the beneficiary of the massive 32% YOY growth in disposable income in March of this year. Retail sales grew nearly 12% YOY in September (14.2% on a 3-month average) and were easily beating inflation. See page 7. However, this may not continue. Disposable income growth slipped to 2.3% YOY in September, which is less than half September’s rate of inflation of 5.4%. This implies that retail sales will weaken in the months ahead. Companies have indicated that they have been able to pass on higher raw material and transportation costs to consumers. However, if household incomes do not grow faster than inflation in coming months, this cannot continue. Either corporate margins will contract, or top line growth will decline. This is not good news for 2022 profits. Therefore, we are not surprised that consumer and business confidence indices were weak in October. The University of Michigan consumer sentiment index fell from 72.8 in September to 71.4 in October and while the Conference Board Consumer Confidence index rose from September’s dreary 109.8 to 113.8 in October, it remains below previous highs. The NFIB confidence index continues to languish below 100. See page 7. In short, economic data suggests there is no reason for the Fed to raise rates in the foreseeable future. This is positive for equity investors.

Gail Dudack

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