After a long delay, the equity market finally realized that the Federal Reserve has much more work to do in the months ahead in order to combat inflation. It has become clear that the focus on the timing of a “peak fed funds rate” was premature. Last week the Fed raised the fed funds rate 75 basis points to a range of 3% to 3.25%, and the November meeting could see another 75-basis point increase which would carry this benchmark to 4%. The December meeting will be data-dependent, but it could also result in short-term rates moving higher. This combination of rate increases has had a dramatic impact on all interest rates and on the dollar, while keeping the government yield curve relatively inverted. See page 3.

However, the chart of government interest rates on page 3 shows another important detail which is how much interest rates have risen since the end of August. In particular, the two-year Treasury note yield has jumped 105 basis points in less than a month. To date, this is the largest monthly increase in the two-year Treasury note yield since the 1980 to 1981 era, which is an interesting era to compare to today’s situation, since inflation is also the highest in 40 years. In that inflationary period, inflation peaked at 14.8% YOY in March 1980, fell to 9.6% YOY in June 1981, but quickly rebounded to 11% YOY in September 1981. The Fed first raised rates dramatically until the effective fed funds rate hit 17.6% in April 1980. The Fed then cut rates due to a recession (January 1980 to July 1980) and the effective fed funds rate fell to 9% in July 1980. But when inflation reignited, the Fed boosted rates once again and the effective fed funds rate rose to 19.1% by June 1981. This hawkish policy triggered a second recession between July 1981 and November 1982.

We believe the current Fed hopes to avoid the erratic tightening policy of the 1980-1981 timeframe and will therefore continue to steadily raise rates until data shows prices are not simply decelerating, but in fact, the inflation cycle has been broken. This will take time and unfortunately, it is likely to result in a full-blown undeniable recession.

Canary in the Coal Mine

We have been watching the debt markets more carefully in recent days since the spike in the dollar can have consequences in areas least expected. The SPDR Bloomberg High Yield Bond ETF (JNK – $87.57) tracks the US high yield corporate bond market and it is spiraling downward, approaching the March 23, 2020 closing low of $84.57, which tested the March 2009 low of $77.55. However, while the bond market is displaying substantial concern about the future, the VIX is at $32.60, and remains well below its $82.69 close of March 16, 2020. See page 4. In our view, the equity market is too complacent about the current combination of rising interest rates, a higher dollar, and declining earnings.

Moreover, the bond market is more closely connected to the global environment where the mixture of rising debt loads (both sovereign and corporate), higher interest rates, and a strong dollar can be an explosive combination. In short, the decline in the high yield market concerns us and we fear the next unexpected event may materialize outside the US and be related to defaults.

Earnings Reality

Despite some comments by well-respected analysts, earnings estimates for 2022 and 2023 are falling. This week S&P Dow Jones consensus earnings estimates for 2022 and 2023 fell $0.78 and $1.33, respectively. Refinitiv IBES consensus earnings forecasts fell $1.50 and $1.24. The S&P consensus EPS estimate for 2022 is now $208.21 and the IBES estimate fell to $223.83, bringing EPS growth rates for 2022 to 0.3% and 7.5%, respectively. See pages 6 and 13.

We recently reduced our 2022 S&P 500 earnings estimate from $218 to $209 and for 2023 our estimate declines from $237 to $229. However, we must admit that we fear we may have to lower these estimates after third quarter earnings season. Nevertheless, our $209 estimate coupled with our valuation model which suggests that a 14 X multiple is appropriate for this environment creates a downside target of roughly SPX 2915. The yearend range is SPX 3452 to SPX 2380. This implies that there is more risk in the market. An alternative method would be to take an average PE of 15.8 X with our $209 estimate, and this equates to SPX 3302. See page 5. Either way, the market has not yet reached a level of table-pounding good value.

Technical Indicators may be weakening

Technical indicators have not been reassuring this week – quite the opposite. The charts of the popular indices look quite similar this week, unfortunately, all four of the popular indices appear to be in the midst of a capitulation-style decline. As we have indicated in recent weeks, the key to defining this bear market’s low will be whether breadth data is less negative on a new low in price. If so, it would be a positive sign of a bottoming formation. The alternative is not favorable for the intermediate term. See page 7.

At the moment, the jury is still out, but recent breadth data is not encouraging. The 25-day up/down volume oscillator is now at negative 4.35 and recording its sixth consecutive day in oversold territory, i.e., a reading of negative 3.0 or less. (On September 26, 2022, the 25-day indicator also hit a low of negative 4.95.) Since this oscillator was in oversold territory for six of eight consecutive sessions between July 6 and July 15 and hit an extreme oversold reading of negative 5.17 on July 14, 2022, a successful test of the June lows would require a shorter and/or less intense oversold reading on any new low in price in the S&P 500. Although the oscillator is slightly less oversold than it was in June, it is by a very narrow and tenuous margin. Another extreme sell-off day would take this indicator to a deeper oversold reading, turning this indicator negative, and indicate that lower lows may be ahead. In short, the market could be only a day or two away from an unsuccessful test of the June low.  See page 8.

In addition, the 10-day average of daily new highs is 32 and daily new lows are 896. This combination is negative with new highs below 100, and new lows above the 100 benchmark. More importantly, the 10-day moving average of new lows at 896 has now exceeded the previous peak of 604 made in early May. Again, the market is showing underlying weakness. The advance/decline line fell below the June low on September 22 just prior to the SPX breaking its June low. The NYSE cumulative advance/decline line is currently 53,150 net advancing issues from its 11/8/21 high – a large number and a negative sign for the near term. See page 9. On a more positive note, last week’s AAII readings showed a decrease of 8.4% in bulls to 17.7% and an increase of 14.9% in bears to 60.9%. The 17.7% reading is among the 20 lowest readings since the survey began in 1987. Optimism was at a similar level in May. Equity prices tend to be higher in the next six and/or twelve months following such extreme readings in sentiment. See page 10.  

Gail Dudack

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For the second time in six weeks, we are lowering our 2022 and 2023 earnings estimates for the S&P 500. For 2022, our forecast falls from $218 to $209, and for 2023 our estimate declines from $237 to $229. See pages 9 and 16. These estimates now translate into earnings growth rates of 0.4% this year and 9.6% next year. Both cuts in estimates were the result of disappointing earnings in the last two quarters. But more importantly, a weakening economy could put these reduced estimates in jeopardy.

It is worth pointing out that consensus estimates for 2022 have dropped precipitously as well. In particular, the S&P Dow Jones consensus estimate for 2022 was $227.51 in late April and fell to $209.66 last week, a 7.8% decline. The IBES Refinitiv consensus estimate hit a high of $229.57 in June and was $225.33 last week, a 1.8% decline. So, despite the misleading headlines suggesting that second quarter earnings season was better than analysts expected, earnings have disappointed in each reporting quarter this year. (Note that media headlines are never comparing earnings results on a year-over-year basis, but instead, compare results to the consensus estimate which may have been dramatically reduced just a few days earlier.) Moreover, most economists are now forecasting a recession for 2023, yet this does not seem to be reflected in current earnings estimates. Until this happens the door is open for more disappointments.

This earnings review of the first half of the year may explain why the market has been so weak as we approach the September FOMC meeting. Excluding the energy sector, earnings results for the S&P 500 are in the red for the first half of the year. Nevertheless, the Fed is expected to make the economic backdrop less friendly for corporate earnings in the coming months. It is likely that the Fed will raise interest rates 75 basis points this week, although it makes little difference if it is 75 basis points or 100 basis points, in our view. The bigger picture suggests that while the high of the fed funds range is currently at 2.5%, it is apt to reach 4% to 4.5% after the next few Fed meetings. In short, the Fed is undoubtedly going to trigger a recession, and this has not yet been fully factored into stock prices.

Valuation Model Woes

We have been reporting on the repercussions of inflation for a long while – the reduction in purchasing power of households, the pressure on profit margins and the negative impact on PE multiples – and the market is finally beginning to confront these issues. However, the combination of lower earnings growth and lower PE multiples is a toxic mix for equity valuation. When we combine our new assumptions of $209 earnings in 2022, with short-term interest rates rising to 4% and inflation falling to 6.2% by year-end, we get some distressing results in our valuation model. See page 8. First, our model suggests that a PE multiple slightly below 14 times is appropriate for the 2022 environment and coupled with our earnings estimate of $209, it produces a target of SPX 2915. The year-end range shows a high of SPX 3452 and a low of SPX 2380. Keep in mind that periods of high inflation typically result in the SPX trading in the lower half of the range because earnings are worth less in an inflationary environment. This is one of the many miseries of high inflation.

Alternatively, we could use the long-term average PE multiple of 15.8 times to find value in the equity market. With our $209 earnings estimate this generates a downside target of SPX 3302, which is less disconcerting, but still 14% below current prices. Either way, we believe the market has further downside risk. See page 8.

History also shows us that periods of inflation tend to place a ceiling on stock prices until the inflationary cycle is under control. See page 7. We believe the Federal Reserve understands this. And though they were late to address the inflation problem, we believe they will be steadfast and aggressive in the near term to counter inflation as best they can. See page 6. Other countries face the same inflationary issues, and their central banks are following the Fed’s lead, as seen by Sweden’s central bank which raised interest rates 100 basis points this week.  

One can see the impact of inflation everywhere. Retail sales were up a robust 9.1% YOY in August, but up only 1.5% YOY after inflation is considered. Although August’s gain in real retail sales was not substantial, it was nonetheless a positive gain which is a favorable shift. Real retail sales were negative in three of the four months between March and June, which concerned us because months of negative real sales are a classic sign of an economic recession. And even though retail sales rose 0.3% in August on a month-over-month seasonally adjusted basis, nominal retail sales in US dollars in August were below the level reported in June. See page 3.

Average weekly earnings grew at a healthy 5.1% YOY pace in August, but inflation rose 8.2% YOY, which means purchasing power actually fell 3.1% on a year-over-year basis. And after nearly two years of rising prices, energy is no longer the driver of inflation. As seen in the chart on page 5 of core CPI, PPI and PCE, these indices rose 6.5%, 8.8%, and 4.6%, respectively in August. All core inflation measures were the highest is 40 years. This explains why a 75-basis point or a 100-basis point hike in interest rates is irrelevant. Interest rates must go much higher to curb the current inflationary problem.

Technical Update

The 25-day up/down volume oscillator fell to negative 3.02 this week which is the first oversold reading of negative 3.0 or less since July. Remember that this oscillator was in oversold territory for six of eight consecutive sessions between July 6 and July 15 and hit an extreme oversold reading of negative 5.17 on July 14, 2022. A successful test of the June lows would require a shorter and/or less intense oversold reading with or without a new low in price in the indices. This is an important juncture for this oscillator.

The key to a successful retest of a bear market low is whether or not a new low in price also generates a new low in breadth. A successful retest will show there is less selling pressure – a less severe oversold reading — despite a lower low in price. We think this is a possibility in the final months of the year, but it means that this indicator should not fall below negative 5.17 or remain oversold for more than six to eight consecutive days. If it does, it would be negative for the intermediate-term outlook. The charts of the popular indices are quite similar this week. All four of the popular indices appear to be on the verge of testing the June lows and we would not be surprised, or concerned if all four indices break these lows. The key will be whether or not breadth data is stronger on this new low than it was in June. Remember: in terms of seasonality, September tends to be the weakest month of the year and that seems to be proving true in 2022. However, October has the reputation of being a “bear killer” and a turnaround month. We will be monitoring our indicators for signs that this will also prove true in 2022.

Gail Dudack

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The past week has been filled with global events, although none as historic as the sudden passing of Queen Elizabeth II of Great Britain on September 8 at the age of 96. She was Britain’s longest-reigning monarch, who guided her country for decades with grace and diplomacy, held an audience with 15 British Prime Ministers and spanned a timeframe that included 14 US presidents, from Harry Truman to Joe Biden. Closer to home, Ken Starr, lead prosecutor in the Clinton-Lewinsky investigation which led to the impeachment of President Bill Clinton, died at age 76.  

Ukraine regained ground in the Russia/Ukraine conflict in what could be a pivotal shift in momentum in the war. The Ukrainian counteroffensive in the northeastern part of the country made impressive gains and, in some cases, pushed Russian soldiers back behind the Russian border. President Zelensky reported that his troops captured more territory in the last week than Russia did in the last five months. German Chancellor Olaf Scholz called on Russian President Vladimir Putin to find a diplomatic solution as soon as possible, based upon a ceasefire, complete withdrawal of Russian troops, and respect for the territorial integrity and sovereignty of Ukraine. This is a developing situation that could have significant implications for geopolitical and economic events in the months ahead.

Peiter “Mudge” Zatko, a famed hacker who served as Twitter’s (TWTR – $41.74) head of security until his firing in January, testified before the Senate Judiciary Committee this week in what could also be a turning point for both Twitter and Elon Musk. Zatko said that in the week before he was fired from Twitter, he learned the FBI told the company that an agent of China’s Ministry of State Security (MSS), the country’s main espionage agency, was on the payroll at Twitter. “This was a big internal conundrum,” according to Zatko since China is Twitter’s fastest growing overseas market for ad revenue. Musk and Twitter head to trial next month to determine whether the billionaire’s $44 billion takeover deal should be completed.

In an odd bit of timing, President Joe Biden celebrated his $430 billion climate change and drug pricing bill, mislabeled as, The Inflation Reduction Act, on the same day that the Bureau of Labor Statistics reported that inflation did not decline in August as expected but in fact rose 0.1%. This squashed burgeoning hopes that inflation was cooling. All three major stock indices turned sharply lower and notched their biggest one-day loss since the throes of the pandemic in June 2020. The Dow Jones Industrial Average fell 1,276.37 points, or 3.94%, to 31,104.97, the S&P 500 lost 177.72 points, or 4.32%, to 3,932.69 and the Nasdaq Composite dropped 632.84 points, or 5.16%, to 11,633.57. All 11 major sectors of the S&P 500 ended the session deep in red territory.

The Basics of Inflation

The stock market’s dramatic reaction to the inflation report was both startling and revealing, in our view. We were surprised at the market’s intense reaction to the fact that neither headline nor core CPI declined on a month-over-month basis. It reveals that neither economists nor investors understand the underpinnings of inflation or the composition of the consumer price index. It also reveals that much of the recent advance was based upon the expectations that inflation was moderating simply because gasoline prices had declined. Again, these were naïve or premature presumptions.

As we have been writing for the last 18 months, the combination of historic monetary and fiscal stimulus in 2021 during an economic recovery, coupled the with signing of The Paris Climate Agreement and reducing carbon fuel supplies, and the Russian invasion of Ukraine was a volatile mix for the world for the following reasons: 1.) Stimulus, monetary or fiscal, during a recovery is inflationary. 2.) Reducing carbon fuels without an immediate plan to replace these energy supplies is foolish and will immediately increase fuel prices. 3.) Russia, a major source of fuel for Europe, has weaponized oil and restricted energy supplies to Europe which is increasing fuel prices. 4.) Ukraine, the breadbasket of Europe, has been demolished and this will result in critical food shortages in the world and raise food prices in coming months.

None of the above are temporary, and only monetary policy is controllable by the Federal Reserve. Nevertheless, the Federal Reserve is responsible for reducing inflation and it will continue to do so by reducing money supply and increasing interest rates. Both will slow the economy and the combination will increase the risk of recession. In our opinion, the Fed will raise rates 75 basis points later this month, with the hopes that inflation will begin to slow, and rates will continue to decrease economic activity.

However, the Fed has been late, and inflation has become systemic, in our view. As we show on page 3, prices are rising in all areas of the economy particularly in housing, food, and medical care. Owners’ equivalent rent has a hefty 23.65% weighting in the CPI, and it rose 6.3% YOY in August. This series tends to move in line with housing prices, but with a multi-month lag, which means rents are likely to continue to rise along with housing and add to inflation even as gasoline prices fall. Auto and lodging prices rose less dramatically in August, but medical prices are seasonal which means they will now switch from tempering inflation to adding to inflation. Note that medical insurance prices tend to rise annually in the fourth quarter when corporate and Medicare contracts are finalized. See page 4. A broadening of inflation can be seen by the fact that while headline inflation fell from July’s 8.5% YOY to August’s 8.3% YOY, core inflation rose from July’s 5.9% YOY to August’s 6.3% YOY.

All of this was predictable for anyone who understands the concept of supply and demand and the composition of CPI. Note that all but one component of CPI is currently growing at multiples of the Fed’s target rate of 2%. See page 5. This indicates the difficulty facing the FOMC in coming months. The US Treasury yield curve is not fully inverted, but it is inverted between the 1-year Treasury and the 10-year Treasury note. And even after a 75-basis point increase in the fed funds rate later this month, the effective fed funds rate would be 3.08% and would still be lower than the current 10-year Treasury yield of roughly 3.42%. Yet what concerns us is the historically large spread between the inflation rate and the 10-year Treasury yield. In the inflationary cycle of 1968 to 1982, inflation exceeded the Treasury yield, but was not broken until the Treasury yield matched the inflation rate – with a lag. Hopefully, it will be different this time and inflation will ease as interest rates rise. But the risk of recession remains high in most any scenario. See page 6.  

There was some good news in sentiment indicators this week. AAII readings showed a decrease of 3.8% in bulls to 18.1% and an increase of 2.9% in bears to 53.3%. These results are in line with the five weeks of less than 20% bulls and more than 50% bears between April 27, 2022 and July 7, 2022. Equity prices tend to be higher in the next six and/or twelve months following such a reading. See page 14. In sum, we remain cautious, particularly in September, and remain focused on sectors and stocks with recession resistant earnings such as energy, utilities, staples, and defense stocks.

Gail Dudack

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Right after the G-7 agreed to implement a price cap on Russian oil, Russia indicated it would halt gas supplies through Gazprom’s Nord Stream 1 pipeline, Europe’s major supply route, for an indefinite period of time. This was done under the ruse that Siemens Energy (ENR.TI – $14.14), needed to repair faulty equipment. Siemens Energy, which is headquartered in Munich, Germany, said it did not understand Gazprom’s presentation of the situation because it was not currently commissioned by Gazprom to do maintenance work on the turbine with the reported leak, nevertheless, the company would be on standby. This is just one example of how Russia is using energy as a weapon against Europe.

And the Nord Stream pipeline is important because all of Europe is facing a deepening energy crisis which could also become a financial and humanitarian disaster. The humanitarian element of this crisis will hopefully be avoided, but it will play out as cold weather hits Europe and fuel becomes both scarce and expensive.

Canary in the Coal Mine

On the financial side, we see a number of worrisome developments for Europe which are linked to energy. Finland’s Fortum Oyj (FORTUM.HE – 9.2 euro) recently signed a bridge financing arrangement with the Finnish government for 2.35 billion euros ($2.34 billion). Fortum Oyj is a Finnish state-owned energy company that operates power plants and generates and sells electricity and heat throughout Europe. The loan, which carries a steep 14.2% interest rate, was made to cover soaring collateral needs in the Nordic power derivatives market. Over the weekend, the Finnish government had already announced a 10-billion-euro package of credit for the Finnish power industry. CNBC recently discussed the fact that eurozone may require as much as $1.2 trillion in backing for the EU energy derivatives markets as the energy industry faces immense challenges. In short, it is possible that the energy derivatives market may be the canary in the coal mine for a financial crisis in the next twelve months. It is worth monitoring. Meanwhile, it is very clear that European countries are creating major programs that will increase sovereign debt.

Another example is the newly installed UK Prime Minister Liz Truss, who ran on a program to cap energy costs in Great Britain at a cost of $116 billion to the government. Closer to home and totally separate from Europe’s energy predicament, President Joe Biden signed a $1.2 trillion Infrastructure Investment and Jobs Act bill on November 15, 2021 and combined with his $1.85 trillion Build Back Better Act, which became the Inflation Reduction Act of 2022, requires Congress to invest over $3 trillion in national infrastructure and social programs. The impact of these bills on the US deficit is debatable and unknown. Nonetheless, it is no surprise that interest rates are on the rise.

The US Treasury yield curve is not yet fully inverted, but it has been inverted between the 1-year Treasury and the 10-year Treasury note for a few months and this is a warning of an impending recession. But in the last week interest rates have been rising as much as 30 basis points along the curve. This is apt to continue as the Fed increases rates and sovereigns continue to increase debt. See page 3.

Economic Roundup

The ISM manufacturing index was unchanged in August at 52.8 and the non-manufacturing index rose 0.2 to 56.9. Both indices are well below their 2021 peaks. The best component in both surveys was new orders, which rose from 48.0 to 51.3 in manufacturing and from 59.9 to 61.8 in the non-manufacturing survey. Employment was 54.2 in manufacturing and 50.2 in non-manufacturing, and both above 50 for the first time since March. In sum, these were slight improvements. See page 4.

Many feel that the August payroll report was the perfect combination for the Federal Reserve of “not too hot, not too cold” with a job gain of 315,000 and an unemployment rate that ratcheted up to 3.7%. But in our opinion, job growth has been subpar for a while. For the first time in this economic “expansion,” the seasonally adjusted level of employment in the establishment survey exceeded the peak employment level reached in February 2020, but only by a modest level of 240,000. Still, as seen on page 5, the not-seasonally-adjusted level of employment was 152.57 million in August and remained below the November 2019 peak level of 153.1 million.

In short, the monthly numbers do not tell the whole story. There has not been job “growth” in this expansion, in reality, there has barely been a job catch-up to pre-COVID levels. We see this as a critical weakness of the post-pandemic expansion. A normal economic expansion will see new peaks in employment and an accompanying increase in household income and consumption; but in fact, there are fewer people employed today than prior to the COVID shutdown. See page 5. We also noticed that there is a declining trend in the number of people who are “not in the labor force and do not want a job” and a corresponding rising trend in those “not in the labor force but want a job.” See page 6. This desire to return to work may be a sign of financial pressure in many households as the combination of inflation and rising taxes erodes purchasing power.

September

September is a great month in many ways, but it has a long history of poor stock market performance. Since 1950, the month is the weakest of all 12 months averaging a loss of 0.4%. Data going back to 1931, shows September to be the weakest month with an average loss of 0.9%. Either way, seasonality suggests September is a time to be cautious, particularly since it will include another Fed funds rate hike, earnings warning season, and dollar strength increases the cost of energy for all non-US entities and intensifies the pressure on the European economy.    

Technicals

Once the rally encountered resistance at the 200-day moving averages, the indices all plunged below all other shorter moving averages. It is a sign that the lows are apt to be tested in the near term. And keep in mind that it is not unusual for a test of bear market lows to generate a new low in price. In our opinion, it is the FANG-type stocks and the stay-at-home stocks that look the weakest currently. This is in line with the fact that the key to a successful retest of a bear market low is whether or not a new low in price also generates a new low in breadth. A successful retest will show there is less selling pressure – a less severe oversold reading — despite a lower low in price. We think this is a possibility in the final months of the year. See page 13. Since we believe there could be disappointments in September in terms of monetary policy, earnings, and a festering energy crisis/recession in Europe, and these risks have not been fully priced into equities, portfolios should be concentrated in sectors where earnings are most predictable and are both inflation and recession resistant. These include areas such as energy, utilities, defense-related stocks, staples, and select healthcare. 

Gail Dudack

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