Late-Stage Bear

Equities are clearly in the throes of a bear market, and we do not believe the lows have yet been found. However, we do believe we are in a late stage of this bear cycle.

In recent weeks there have been four 90% down days — April 22: 90%; May 5: 93%; May 9: 92%; May 18: 93% — and history suggests that these extreme volume days tend to come in a series and reflect investor panic. More importantly, a series of 90% down days is a common characteristic of a later-stage bear market cycle. From a strategic perspective, the first sign of selling exhaustion appears when a 90% up day materializes. A 92% up day did appear on May 13, and while we believe this marked the beginning of the final phase of the current bear market, it does not necessarily define the final low.

Nevertheless, it did not surprise us that a 90% up day appeared immediately after the SPX slipped below the 4000 level. We have been using an average PE multiple of 17.5 coupled with our $220 earnings estimate for the S&P 500 in 2022 to define downside market risk. This combination equates to SPX 3850 and in our view, this is where “value” in the broader marketplace is found. However, a 17.5 PE multiple assumes that inflation will moderate by the end of this year, and it assumes that our $220 earnings forecast proves accurate. This PE estimate is at risk of revision due to inflation and our earnings forecast could be too high if the US economy weakens more than expected. Later this week, the Bureau of Economic Analysis will release an update on first quarter GDP. The initial estimate was a decline of 1.4% and if this number is revised lower it could weigh heavily on investor sentiment given the implications it would have on economic strength and earnings growth.

In the current environment, we believe the best strategy is to overweight sectors and stocks that benefit from, or are immune to, inflation. Areas such as energy, staples, defense stocks, and utilities. Most of these sectors also have excellent dividend yields which provide both income and downside support. Price declines have been intense in the technology sector due to the high PE multiples characteristic of this sector, but we believe good long-term buying opportunities will appear in this area later this year. However, we would not focus on the social media stocks that were the drivers of the past bull market, instead look for opportunities in technology with future growth such as defense, cybersecurity, robotics, and medical technology.      

The Long Cycle

In our work, we like to put the current cycle into an historical perspective. This helps us clarify whether equities are in a secular bull, secular bear, or a massive trading range market, and it can define the appropriate investment strategy. For example, secular bull markets often end as a result of an economic crisis. Over the past 150 years, the source of a major economic crisis has alternated between a debt/default/deflation cycle or an inflationary cycle. Either way, the crisis has typically created a multi-year ceiling for stock prices until the crisis is resolved. For example, in the last cycle, the S&P 500 peaked in March 2000 (1527.46) and again in October 2007 (1565.15). The 2000 peak was triggered by a surge in margin debt and margin calls and in 2008 sovereign debt defaults triggered a global banking crisis. It took years to resolve the global banking crisis and the S&P 500 did not better the 1565 level until 2014. See page 3.

The January 3, 2022 high of SPX 4796.56 materialized during a post-pandemic inflation cycle driven by an historic amount of monetary and fiscal stimulus. In the US, this generated the worst inflationary trend in 40 years. Unfortunately, we do not expect the equity market will be able to better its January 2022 peak until inflation is back under control. In short, both debt and inflation are debilitating to an economy, which is why the Fed’s job of fighting inflation and monitoring debt levels is critical to the economic health of the US. See page 4.

Earnings and Economic Concerns

There are many ways to define value in the equity market. As previously stated, we are using an average PE multiple of 17.5 times to define value in the marketplace, but we also have a valuation model that assigns a PE based upon current and forecasted inflation and interest rates. Unfortunately, even at the May 19 close of SPX 3900.79, the market remained 1.0% above the top of the forecasted year-end fair value range of SPX 2730-3860 and 18% above the mid-range of our valuation model. This is because even if inflation falls to 5% YOY, our model suggests a PE range this year of 14.5 times to 15.0 times. Again, this is an example of the debilitating impact of inflation. Again, investors can assume that value is found below the SPX 4000 level. See page 5.

Although there are no signs that the US is in a recession, there are signs of an economic slowdown. April’s retail sales rose 4.7% YOY on a seasonally adjusted basis, and excluding autos, sales rose 6.1%. However, unadjusted retail sales fell 6.8% YOY and excluding autos, sales fell 4.5%. Moreover, seasonally adjusted sales of 4.7%, rose far less than April’s inflation rate of 8.2% YOY. This means real sales were negative in April, and it explains the negative EPS surprises reported by many retailers in the first quarter. See page 6.

New home sales were 591,000 (SAAR) in April, the slowest pace since April 2020, at the height of the shutdown. Existing homes sales were 5.61 million in April, the lowest since June 2020. See page 7. Note that April was the first time the Federal Reserve raised rates and mortgage rates are expected to move much higher in 2022. More importantly, even after two fed rate hikes, short-term interest rates remain at an historically negative (and easy) level of negative 7.2% given headline CPI of 8.2% YOY in April. The Fed has indicated that it wants to get to a neutral fed funds rate. But assuming inflation moderates to 5% by year end, the fed funds rate would need to increase 400 basis points in the coming months. See page 4. This could have a deleterious impact on the housing market.

The significance of a housing slowdown should not be overlooked since housing typically contributes 15% to 18.5% to GDP. Housing affordability declined sharply in April as a result of rising mortgage rates and soaring prices. This trend is expected to worsen, and we are concerned about the effect it will have on GDP and the broad economy. Not surprisingly, homebuilder confidence has been steadily slipping this year. Rising interest rates have not had a noticeable impact on the auto and truck sector, to date, but we believe it is only a matter of time before it does. For all these reasons, we believe portfolios should be insulated against the impact of inflation and rising interest rates to the best of one’s ability. We remain cautious.

Gail Dudack

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Last week we wrote that a series of 90% down days, also known as panic days, is a classic characteristic of a late-stage bear market cycle. This was significant since a string of 90% down days recently appeared on April 22 (90%); May 5 (93%); and May 9 (92%). More importantly, a 90% up day is typically the first sign that the panic and selling pressure that has been driving the bear trend is becoming exhausted. On May 13, 2022, the NYSE volume statistics reported a 92% up day, which we reported on May 16, 2022 (Direct from Dudack “A 92% Up Day”). This was excellent news.

Nevertheless, it is important to note that a single 90% up day does not define the ultimate low. What it does indicate is that downside risk is diminished. For example, the last time the market experienced a series of 90% down days was during the 2020 bear cycle. The series began on February 20, 2020, with a 91% down day when the SPX closed at 3373.23. In subsequent weeks there were six more 90% down days followed by a 92% up day on March 13, 2020, when the SPX closed at 2711.02, recording a 20% decline from the February peak of SPX 3386.15.

This 90% up day was not the end of the cycle; it was followed by two more 90% down days, but the ultimate low of SPX 2237.40 was recorded on March 23, 2020, six trading days later. Another 94% up day materialized on March 24, 2020. In short, while the first 90% up day did not indicate that the bear market was over, it did imply that a major low was on the horizon.

If we dissect the 2020 cycle, we find that the total bear decline in the SPX was 34%. A 90% up day materialized after a 20% decline. This was followed by a 17% decline in the following six trading sessions and the bear cycle ended on March 23, 2020. Overall, we believe the recent 92% up day is a favorable sign and we would also note that it appeared immediately after the SPX fell below the 4000 level. As a reminder, we have been using a 17.5 PE multiple with our $220 earnings forecast for the S&P 500 as a practical way of defining “value” in the broad market. This combination equates to SPX 3850. In sum, the market may not yet have recorded its final low, but we do think that the low of SPX 3930.08 on May 12, 2022, marked the beginning of a bottoming phase.

Valuation Remains a Concern

With first quarter earnings season 92% complete, there is a growing concern about the durability of earnings growth in 2022. According to Refinitiv IBES, results for S&P 500 earnings in the first quarter are pointing to a gain of 11% YOY, but after excluding the energy sector, this growth rate falls to less than 5%. Full-year growth forecasts, according to IBES, are expected to be 9% to 9.9%; whereas S&P Dow Jones shows earnings growth to be 5.8%. But estimates have been volatile. This week consensus earnings estimates for 2022 according to S&P Dow Jones fell $0.66 while Refinitiv IBES estimates rose $1.08. As a result, the nominal earnings range for 2022 widened to $224 to $228 and earnings growth rates for this year are 5.8% and 9.8%, respectively. (Note: consensus macro-EPS forecasts may differ from four quarter analysts’ forecast sums seen on page 16.)

Our DRG 2022 estimate remains at $220, a 5.7% YOY increase from $208.19 in 2021. We have noticed that strategists have been lowering their 2022 S&P earnings forecasts to $220 and most strategists are forecasting a 10% growth rate in 2023. Keep in mind that a 9% earnings growth rate coupled with inflation of 7.7%, equates to merely 2.3% real growth for this year. This is just one example of the destructive nature of inflation, and it helps to explain why PE multiples will fall during times of inflation.

Unfortunately, even at the May 12 close of SPX 3930.08, the stock market remained 1.8% above the top of our valuation model’s year-end fair value range of SPX 2730-3860 and 16% above the mid-point of the forecasted range, or SPX 3295. See page 5. Even if our $220 EPS estimate for 2021 proves to be too conservative, given current interest rates, our model implies that value is found below the SPX 4000 level. The good news is that the SPX recently dropped below 4000; the bad news is the SPX is currently back above the 4000 level. In sum, while the current oversold reading allows for a near-term rebound, we remain cautious for the intermediate term.

Economic Data

Despite high inflation, consumers keep spending. Retail sales rose a seasonally adjusted 0.9% in April, which was the fourth straight month of higher retail spending. However, the earnings results of retailers have been mixed with Walmart (WMT – $131.35) reporting that quarterly revenue was dented by rising food prices and supply-chain disruptions and Home Depot (HD – $300.95) reporting better than expected earnings, but noting that fewer customers are spending more per shopping trip.

The impact of inflation is found everywhere. From 2014 to 2020, wage growth exceeded inflation, and this helped households since it increased purchasing power. However, in 2021 and 2022 this changed dramatically, and real wage growth turned negative reducing purchasing power. More precisely, in April the year-over-year increase in weekly wages was 5.5% YOY, but CPI rose 7.7% YOY in the same period. As a result, real wages fell 2.2% YOY. This is a 2.2% decline in purchasing power and it is having a negative impact on all households, but most particularly on the poor and those on fixed incomes. See page 4. It is also worth noting that when inflation runs above the long-term average of 3.4% YOY, it has never been good for the stock market. To date, equities have held up better than one might expect but we believe the pressure on margins, earnings, and PE multiples will continue over the next twelve months. See page 4

The NFIB Small Business Optimism Index was unchanged in April at 93.2 and remained below the 48-year average of 98 for the fourth consecutive month. The preliminary University of Michigan consumer survey for May was lower in all categories, including headline and present conditions. Expectations fell from April’s 62.5 to 56.3. See page 3. April’s total industrial production report was a highlight this week, increasing 1.1%. This was the fourth consecutive month of gains of 0.8% or greater. All major market groups recorded gains in April, with most rising around 1%. Production of motor vehicles and parts contributed to increases of 1.5%, 3.3%, and 1.1% in the consumer durables, transit equipment, and durable materials categories, respectively. Business equipment and defense and space equipment each recorded gains of greater than 1%. Keep in mind that one of the contributing factors for the first quarter’s decline of 1.4% in GDP was a decline in inventories. April’s industrial production data suggests that inventories are being rebuilt and will therefore contribute to second quarter GDP in a positive way.

Gail Dudack

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On May 13, 2022, the NYSE volume statistics reported a 92% up day. As we have been reporting, a 90% up day is significant after a series of 90% down days in terms of defining downside market risk. Extreme volume readings with 90% of the day’s volume in declining stocks (90% down days) reflect panic and a 90% up day indicates that the worst of the panic selling may have occurred. It does not define the low, but it implies that the downside risk is diminished.

For example, the last series of 90% down days began on February 20, 2020, with a 91% down day and the SPX closed at 3373.23. There were six more 90% down days followed by a 92% up day on March 13, 2020, when the SPX closed at 2711.02.

This was followed by two more 90% down days. The ultimate low of SPX 2237.40 was recorded on March 23, 2020, with a 94% up day on March 24, 2020. Note that the total 2020 decline in the SPX was 34%, and there was a 17% decline in the six trading sessions between the first 90% up day and the final low.

In sum, the market may not yet have recorded its final low, but we do think that the low of SPX 3930.08 on May 12, 2022, is the beginning of a bottoming phase. As a reminder, we have been using a 17.5 multiple and our $220 earnings forecast for the S&P 500 as defining “value” in the broad market. That equates to SPX 3850.  

Gail Dudack

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The Good News

According to NYSE volume statistics, recent trading sessions have included three significant 90% down days: April 22: 90%; May 5: 93%; and May 9: 92%. History suggests that these extreme downside volume readings usually come in a series and reflect underlying investor panic. The good news is that a series of 90% down days is also a characteristic of a late-stage bear market cycle. Unfortunately, there is no consistent pattern to how many extreme down days may occur; however, the first indication that selling pressure and panic is becoming exhausted is seen when a 90% up day appears. Hopefully, a 90% up day will be on the horizon.

As a result of recent extreme breadth days, the 25-day up/down volume oscillator dropped to negative 3.80 this week, its most oversold reading since April 1, 2020. But to put this into context, in March and April of 2020, the market was in oversold territory for 25 of 28 consecutive trading sessions and reached an oversold reading of negative 7.32 on March 23, 2020, the same day the stock market bottomed at SPX 2237.40. See page 8. In short, there is no telling how long selling pressure may last.

The other bit of good news has been sentiment indicators. The American Association of Individual Investors (AAII) sentiment survey was revealing two weeks ago when the survey showed 16.5% bullishness and 59.4% bearishness. This bearish reading was the highest percentage since the March 5, 2009, reading of 70.3%. This week’s survey results of 26.9% bullishness and 52.9% bearishness are also relatively extreme, and the AAII Bull/Bear Spread remains in positive territory. See page 10. Low bullish sentiment is typical of the end of a decline; therefore, investors should be wary of becoming too negative at this juncture.

Over the last twelve months, we have pointed out a pattern of sequential weakness in the popular indices. This trend can be seen in charts of the DJIA, SPX, IXIC, and RUT, in that order, where the declines from their recent peaks has been 12.6%, 16.6%, 26.9%, and 27.9%, respectively. What has been notable during this time, is that the Russell 2000 index has been the best forecaster for the overall market. It was an early leader at the top and it may lead at the low as well. We will continue to monitor these charts, but at present the RUT shows no signs of bottoming. See page 7.

Many investors are focused on the CBOE Volatility index (.VIX – $32.99) which has moved up from a recent low of $18.50 to a high of $35. The VIX is a measure of volatility, and it often spikes at the end of a bear market cycle, just like volatility does. But overall, we find the VIX to be an unreliable indicator since there is no level that actually defines a peak in volatility, and conversely, a low in prices. For example, at the end of corrections in 2010, 2011, 2015 and 2018, the VIX rose to levels in excess of 45. But it reached 85 at the 2020 low and 82 at the 2008 low. In short, the VIX would have to more than double from current readings to suggest the bear market cycle is over.

The Bad News

The bad news is that first quarter earnings season is not going well. Last week S&P Dow Jones lowered its 2022 S&P 500 earnings forecast by $2.45 to $225.06 and IBES Refinitiv lowered its consensus forecast by $1.14 to $227.60. Yet as bad as these reductions appear, consensus estimates are merely returning to where they were a few months ago. Nonetheless, we have noticed that several strategists are lowering their 2022 earnings estimates as first quarter earnings season is ending. As a result, my 2022 earnings forecast of $220 is no longer a downside outlier. This is important to keep in mind because valuation is an important factor at the end of a bear market cycle.

In most bear market cycles, earnings growth, or lack thereof, is usually an issue. We have expected this to be true in the current cycle as well. Regrettably, the fundamental factors that are most predictable today are inflation and short-term interest rates, both of which are rising. Rising inflation and interest rates are a drag on earnings, and we fear that analysts may have underestimated the impact.

April’s inflation data will be released this week and it could take a toll on the market. Some economists are calling for a deceleration in the pace of inflation, but we checked our files and found that if headline CPI were unchanged in the month of April, the year-over-year pace would still be 7.7%, down from 8.5%. Similarly, core inflation would be 5.6%, down from 6.5%. PPI would be 14.5%, down from 15.2% and PPI final demand would be 10.1%, down from 11.2%. In other words, we expect inflation will remain high and continue to be a problem for the Federal Reserve. Unless data suggests inflation is under control the Fed has been extremely clear on its intentions of raising the fed funds rate 50 basis points at each of the next five meetings. In sum, the fed funds rate could rise as high at 3.5% by the end of this year. If it does, it could be a huge drag on the economy and earnings or it could trigger a recession. As we noted last week, given that first quarter GDP was already negative, is it possible we are already halfway through a recession of two consecutive quarters of negative growth? Either way, earnings growth is at risk in 2022.

Because earnings are usually in danger in a major correction of a bear market, we use trailing operating earnings to help us define “value” and the potential downside risk for equities. In short, we are defining value, absent any earnings growth. Analysts typically measure value for the S&P 500 based upon a price-earnings multiple. But PE multiples can vary depending upon perspective. For example, when the SPX closed at 3991.24 on May 9, the 12-month trailing PE fell to 18.7. This was clearly below the 5, 10, and 30-year average PE multiples, but just barely below the 20-year average of 18.9 times. Yet 18.7 times is still above the 50-year or 74-year averages of 16.6 and 15.8 times, respectively. See page 3. In short, valuation is a matter of perspective. We have been using a PE of 17.5 with our $220 earnings estimate to define “value” in the market. This equates to a level at, or below, SPX 3850. This view is unchanged. The sum of the trailing PE and inflation is called the Rule of 23, and the current sum of 25.53 remains well above the normal range of 14.8 to 23.8. To return to the normal range, the SPX would need to fall to a 17.5 multiple while inflation declines to 5.5%. We believe this combination is possible in the coming months. Sadly, there is a more bearish case for equities, and it is best displayed by our valuation model. Even at the May 9 close of SPX 3991.24, the market remained 8.5% above our model’s predicted fair value range of SPX 2575-3676. This range rises to SPX 2734-3865 by year end which is closer to our target of SPX 3850. Nevertheless, most benchmarks point to value appearing 5% to 10% below the SPX 4000 level.

Gail Dudack

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The Federal Reserve is expected to raise the fed funds rate 50 basis points this week, but this move is widely expected and unlikely to impact stock prices, in our view. What was not expected was last week’s GDP report that showed first quarter economic activity fell 1.4% SAAR.

First, it is important to remember how real GDP is calculated. Economic activity is measured on a quarter-over-quarter basis, adjusted for inflation, and annualized. Since real GDP in the fourth quarter of 2021 grew at a robust 6.9% rate, it is not surprising that the first quarter of 2022 slowed from that level. Nevertheless, an actual decline in growth was not expected.

We were surprised by this negative number, and we will remind you that last week we wrote that whatever the GDP report revealed for the first quarter’s economy, the second quarter was apt to be slower. Our thought process was that the Fed is expected to raise short-term interest rates by 100 to 150 basis points during the second quarter and more in the second half of the year. These rate hikes will weigh heavily on economic activity, particularly in the housing and auto sectors. We also reported that there were indications that residential real estate and vehicle sales were already decelerating in March. Higher financing costs would lower demand for housing and autos even further and the deceleration in these key sectors would continue.

Given this backdrop and the negative GDP seen in the first quarter, the obvious question becomes – are we already in the midst of a recession? The Bureau of Economic Research states we have already had one quarter of negative growth, yet surprisingly, we do not hear economists questioning whether or not we are IN a recession right now. The silence is deafening. And this is a concern.

There are two reasons why negative growth in the current second quarter is not totally predictable. The first is that GDP was already negative in the first quarter. It is easier to “calculate” a slowdown from a strong GDP quarter than it is from a weak GDP quarter. Simple math indicates that economic activity would have to decelerate even more in the current quarter for GDP to remain negative. This may not be probable, but it is possible, and we certainly would not rule it out. A second point is that weakness in the first quarter was centered in poor trade data, inventory depletion, and lower government spending. Notably, the strength seen in the fourth quarter of 2021 was due to an inventory build. See page 4. The March ISM manufacturing survey also pointed to low inventories which gives us hope that manufacturing and trade may return to positive in the second quarter and add to GDP. Yet, all in all, we remain cautious on the outlook for the economy and the stock market in the coming months.

Rebound

The Dow Jones Industrial Average lost more than 2000 points in the last nine trading sessions. As a result, our technical breadth indicators are as oversold as they were in March of this year. From this perspective, we would not be surprised if stock prices rebounded from current levels. However, it is clear from the charts and from statistics, that equities are in a bear market. In short, we would consider any near-term rally to be a rebound within a bear market cycle.

From a technical perspective, the 90% down day recorded on April 22^nd was the first extreme breadth day recorded since June 24, 2020. The good news is that this is a sign of panic and panic is characteristic of a late-stage bear market. The bad news is that 90% panic days tend to come in a series.

To date, we have not seen another 90% down day, although there was an 88% down day on April 26^th and an 89% down day on April 29^th. Still, historically, 90% down days tend to appear in clusters and it is likely that there will be more. Panic days also tend to be high volume days, and while the 90%, 89%, and 88% down days we experienced recently were accompanied by higher volume, it was not a significant increase in volume. One could not say the current market is “washed out.”

Lastly, the first telltale sign that selling pressure is becoming exhausted is when a 90% up day appears. A 90% up day may not appear at the exact low, but it tends to appear near the tail end of a bear market. It is usually a sign that downside risk is minimal. Unfortunately, that is yet to be found.

Technical update

There are some technical indicators that are more favorable, particularly the AAII sentiment survey. AAII bullish sentiment fell 2.5 points to 16.4% last week and has been below 20% for three consecutive weeks. This was only the 34th time in AAII history that bullishness fell below 20%. Bearish sentiment jumped 15.5 points to 59.4% and is at its highest level since a March 5, 2009, reading of 70.3%. This combination of extreme sentiment readings is favorable. Unfortunately, sentiment indicators have rarely been good timing tools, but they do tend to keep investors from becoming too bullish or too bearish. In the current case, sentiment indicators are warning us not to become too bearish for the longer term.

Still, the charts of the major indices are worrisome. With the exception of the DJIA, all the popular indices broke to new cyclical lows this week. And while the steepness of recent declines suggest a rebound from current levels, the chart patterns are uniformly negative. See page 7.

Valuation Benchmarks Technical indicators can be especially useful at market tops, but we find fundamental tools to be best at defining “potential” bottoms. Earlier this year we wrote that the current level of inflation was a warning that PE multiples could fall to their long-term average or lower. The long-term average PE multiple is 17.5 times. Our S&P 500 earnings estimate is $220, which is conservative and below the general consensus. But applying a PE multiple of 17.5 to our $220 earnings estimate suggests that value in the broad equity market is found near the SPX 3850 level. This is important to keep in mind if we get a series of 90% down days and the market becomes emotional. SPX 3850 sounded extremely bearish earlier this year, but it is less than 8% below current prices. With many of the technology darlings, like Apple (AAPL – $159.48) also coming under selling pressure in recent days we believe it is time to start looking for a possible turnaround. In a classic bear market cycle, the large capitalization darlings of the previous bull market cycle tend to be the last to fall.

Gail Dudack

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