Inflation

S&P Global said its flash US Composite PMI Output Index, which tracks the manufacturing and services sectors, rose to 46.6 this month from a final reading of 45.0 in December. This was the first uptick since September; nevertheless, the index remains well below a key reading of 50 that is used to define contraction or growth in the private sector. Yet in a more worrisome sign in our view, the survey’s measures of input prices for both US services firms and goods producers rose month-over-month for the first time since last May. This bump in input prices may signal to the Federal Reserve that it needs to keep monetary policy tight and move interest rates higher if it is going to bring inflation back to its 2% target. And, inflation is a global problem as seen in Australian inflation, which shot to a 33-year high in the last quarter as the cost of travel and electricity jumped. Australia’s central bank is expected to raise interest rates again at a policy meeting next week. The Federal Reserve is expected to raise interest rates 25 basis points at its next meeting which ends on February 1.

The Debt Ceiling

Meanwhile, there are a few important issues brewing in the background. The current standoff in Washington over raising the $31.4 trillion federal debt ceiling is a significant risk to equity investors. Government shutdowns may seem like a routine part of governing since it has happened three times in the past 10 years. A partisan fight over healthcare spending led to a 16-day shutdown in October 2013. Disputes over immigration led to a three-day shutdown in January 2018 and a 35-day shutdown between December 2018 and January 2019. Last week Treasury Secretary Janet Yellen indicated that although the country has reached its current $31.4 trillion borrowing cap, the Treasury can continue to pay its bills until June by shuffling money between various accounts. But after that point, when the “normal” extraordinary measures are exhausted, the Treasury would run out of money from tax receipts to cover bond payments, workers’ salaries, Social Security checks and other bills. In short, the US Congress has a five-month window to find a solution, but a missed debt payment by the US government would send shockwaves through the global financial markets.

The FAANGS

This week the US Justice Department took a big step toward reducing big tech dominance when it accused Alphabet Inc.’s (GOOGL.O – $97.70) Google of abusing its dominance in digital advertising. The government said Google should be forced to sell its ad manager suite, which generated about 12% of Google’s revenues in 2021, however this suite also plays a vital role in the search engine and cloud company’s overall sales. Advertising is responsible for about 80% of Google’s revenue. The federal government also said its Big Tech investigations and lawsuits are aimed at a group of powerful companies that include Amazon.com, Inc. (AMZN.O – $96.32), Facebook owner Meta Platforms, Inc. (META.O – $143.14) and Apple Inc. (AAPL.O – $142.53) with a goal of leveling the playing field so smaller rivals can compete. In our opinion, these government lawsuits also mean that earnings for many of the stock market’s biggest players and largest earners are unsustainable and are likely to come down. And while many of these stocks have been beaten down in the last twelve months and have rallied smartly in the early part of this year, their leadership role in the equity market is most likely over.

It’s All About Earnings

The stock market has been driven wildly up and down in recent months based upon its changing view of inflation and Fed policy. However, the actual performance of the equity market will be ultimately based upon the pace of economic activity and the trend in earnings. The initial estimate for fourth quarter GDP will be released later this week, but the data for third quarter GDP showed that corporate profits at the end of September were basically unchanged year-over-year. According to S&P Dow Jones, S&P 500 profits are estimated to be negative on a year-over-year basis in the fourth quarter. Note that S&P earnings growth has turned negative only 15 times since 1946, and eleven of those times it was linked to an economic recession. See page 7.

Moreover, the relationship between GDP and S&P earnings is meaningful since the two are highly correlated. Therefore, it is also meaningful that S&P earnings have been outperforming GDP since June 2020, due in large part to post-pandemic stimulus that has now ended. In short, both monetary and fiscal stimulus gave a temporary and artificial boost to earnings growth for a time. However, whenever corporate earnings have been outperforming underlying economic activity, history shows that this outperformance in earnings is unsustainable. In other words, outperformance is typically followed by underperformance. See page 7. This combined with the government’s attack on the business models of many large technology companies implies a risk to S&P earnings in the quarters ahead. Again, we would emphasize sectors and companies with defensive and predictable earnings growth streams such as energy, staples, utilities, aerospace & defense, and companies where the PE multiple is in line with the company’s earnings growth rate.  

Weak Economic Signals

Signs of a slowing economy continue to grow, and this includes the third consecutive month of weakness in industrial production, and the tenth consecutive decline in the Conference Board Leading Economic Indicator. The LEI displayed widespread weakness in December, indicating deteriorating conditions for labor markets, manufacturing, housing, and financial markets. Conference Board economists have indicated that the persistent weakness in the LEI is signaling a recession in the near term. See page 3.

Historically, home prices and retail sales have been strongly correlated and both have been decelerating for all of 2022. Worrisome for us is the fact that real retail sales (adjusted for inflation) have been negative in five of the last ten months. Negative readings have been linked to recessions. Also note that as the Fed continues to raise rates, the affordability of homes is deteriorating and is apt to send the residential housing market into a deeper recession. See page 4. Although the NAHB Single-Family Index has been declining since its peak in November 2020, January’s survey experienced a small increase from recessionary levels. Meanwhile, December’s new residential permits and housing starts were down 29.9% YOY and 21.8% YOY, respectively. See page 5. New home sales in November were 15.3% lower than a year earlier, down to an annualized level of 640,000 units. Existing home sales were down 34% YOY in December to a new cyclical low of 4.02 million units on an annualized basis. As seen on page 6, similar declines have occurred in recession years. In sum, January’s rally has been impressive in many ways, and we particularly like the breakout in the Russell 2000 chart (see page 9) but there are storm clouds on the horizon. We fear prices are beginning to price in a Fed pivot and this would be premature. We remain cautious.

Gail Dudack

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Equities have demonstrated some impressive price momentum in recent weeks, and this inspired us to look at a range of markets to see what might either support or counter this advance. Unfortunately, what we found triggered more questions than answers.

Oil, the Dollar, Gold, and Treasury Bonds

We began by looking at the WTI crude oil future (CLc1 – $80.71) which peaked on June 8, 2022 at a price of $122.11. Much of the weakness in oil was attributed to the shutdowns being implemented in China due to a string of outbreaks of a Covid variant. This was logical since China’s actions implied factory shutdowns, less global economic activity, and less demand for oil. Plus, it was not only China that was a concern since there were growing fears of recessions in Europe and the US.

On September 27, 2022 the dollar (.DXY – $102.39) peaked at a price of $114.11. This was counter to the fact that the Fed was in tightening mode, but it was logical because most energy trades are done in dollars and a weakening global economy, and a lower price of oil would reduce global demand for dollars. However, we found it intriguing that the gold future (GCc1 – $1907.20) troughed on the very same day, September 27, 2022, at a price of $1626.70. This has different implications for the dollar. Gold, which had historically traded in line with inflation, was not an outperformer like most commodities and in fact, it continues to trade below its August 6, 2020 peak of $2051.50. The corresponding high in the dollar and the low in gold implies a possible switch by global investors from the dollar to gold as a safe-haven global currency. This suggests a lack of faith in the US dollar. But in fact, the underlying strength in gold and weakness in the dollar may be directly tied to China. Beijing rarely telegraphs its purchases of gold, yet it recently announced it had purchased 32 tons of gold in November and 30 tons in December. China’s stockpiling of gold resembles that of Russia before its invasion of Ukraine. Before invading Ukraine, Russia de-dollarized its economy and stockpiled gold and Chinese yuan. Some geopolitical analysts theorize that China may be building its gold coffers in preparation for an attack on Taiwan. Should this theory become reality, it would be a major negative for global stability and equities, in our view.

Lastly, and on October 21, 2022, the 10-year Treasury yield index (.TNX – $35.35) peaked at $42.13 or the equivalent of a 4.2% yield in the 10-year bond. It has been declining ever since. A decline in long-duration Treasury bonds yields can have many explanations, but when investors are fearful of an economic slowdown, demand for Treasuries typically increases and yields fall. Global investors will shift to US Treasuries as a safe-haven investment in times of economic weakness or geopolitical uncertainty. This could explain the decline in long-term interest rates.

In sum, the weakness in oil, the dollar and long-term interest rates could make sense in times of impending economic weakness. The rise in gold and fall in the dollar could have ominous implications for Taiwan and geopolitics. In general, this threat could trigger an even greater shift toward gold for stability. Nevertheless, none of this explains or supports the advance in US equities from the October 12, 2022 S&P 500 low of 3577.03.    

Still Jumping the Gun

Headline CPI fell from 7.1% YOY to 6.5% YOY in December, which led to a rally in the equity market. However, this decline in inflation was concentrated in energy, the energy-derivative category, transportation, and apparel. All items less food and energy had a smaller decline from 6% to 5.7% YOY as prices continued to rise at a faster pace in housing, owners’ equivalent rent and services. See page 3. There were items to celebrate in the inflation report. Areas of the economy like new and used cars, transportation (public and private), lodging away from home and household furnishings and operations are experiencing major decelerations in price gains. On the other hand, food at home and all areas of the service sector continue to show stubbornly strong price rises. See page 4.

We remain concerned. Whenever inflation has exceeded a standard deviation above the norm (3.4%), a recession, or string of recessions, has ensued. We do not believe this time will be different. Plus, the Fed has indicated that its goal is to beat inflation and return to a real fed funds rate. Today the real fed funds rate is negative 210 basis points to CPI and negative 170 basis points to November’s PCE index. In short, all signals point to more Fed hikes in 2023. See page 5.

Consumer sentiment improves

Consumer sentiment has improved in recent months as seen by the headline Conference Board Consumer Confidence index rising nearly 7 points to 108.3. The University of Michigan released preliminary results for January which showed an increase from 59.7 to 64.6 in the overall survey, a jump from 59.4 to 68.6 in the present situations and an increase from 59.9 to 62.0 in the expectations survey. Both surveys are clearly improving and rebounding from recent recession levels. See page 6.

But we remain concerned about the consumer. The savings rate was 2.4% in November and has been below 3% for five of the last six months. Readings below 3% were last seen in April 2008 (2.9%), November 2007 (2.8%), and seven of nine consecutive months between February 2005 and October 2005. The record low savings rate of 2.1% was recorded in July 2005. Another indication that consumers are stretched is the rise in credit. As of November, total consumer credit grew 8% YOY, but since August 2022 revolving credit has been steadily expanding at a pace of 15% YOY or more. This is worrisome; however, one consolation is that revolving credit remains below levels seen prior to the 2008 recession. Nevertheless, real consumer credit is just modestly below its 2020 peak and is a sign that consumers are financially strained. See page 7. 

Technicals are Looking UP

The current rally has broadened to include most of the popular indices which are now trading above their 200-day moving averages. The one exception is the Nasdaq Composite. However, January’s advance is reminiscent of the August 2022 rally which also resulted in tests or breaks of the 200-day moving averages but became a failed rally. Nonetheless, the current rally could have staying power and it is significant that this rally is materializing in January, a month that can be predictive of the year’s performance. See page 9.

The 25-day up/down volume oscillator is currently neutral with a reading of 2.44 but is close to recording an overbought reading. An overbought reading that persists for at least five to ten consecutive trading sessions would be significant and a sign of a positive shift in the cycle. See page 10. Also interesting is that the 10-day average of daily new highs is 103 and new lows are 39. This combination is now positive since new highs are above the 100 benchmark and new lows are below 100. New highs have not consistently outnumbered new lows since April 2022. The advance/decline line is currently 33,545 net advancing issues from its 11/8/21 high – still negative yet a big improvement in the last two weeks. See page 11. We remain cautious but are carefully monitoring technical indicators, particularly the 25-day volume oscillator, for potential good news.

Gail Dudack

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The price performance of the equity market during the first few days of the new year provided a nice respite for investors who weathered a very difficult 2022. But this year’s good start will face several hurdles in the upcoming days. Later this week the CPI report for December has the ability to reverse the current optimism on inflation. The consensus view is that inflation is steadily decelerating, but if that does not prove to be true, there will be disappointment. More importantly, fourth-quarter earnings reports begin at the end of the week, and these could set the tone – and the trend — for earnings over the next few quarters.

In our opinion, while some market commentators believe pessimism is currently too extreme and overdone, investors have not truly come to grips with the status of the current economy, the determination of the Fed to fight inflation and what that means, and the prospect for corporate earnings.  

The Economy

It is widely accepted that the real estate sector of the economy is in a slowdown or recession. But we see warnings in recent data releases that the downturn is broadening. For example, for the first time since April and May of 2020, both ISM indices ended below the 50-bench mark denoting a contraction in economic activity. Plus, in both surveys the “new orders” components slipped well below 50, signifying a weakness in future activity. In other words, both the manufacturing and the service segments of the economy appear to be declining. See page 3.

The one positive we found in the two ISM reports is that both the manufacturing and the non-manufacturing survey showed prices falling or decelerating. In the ISM manufacturing report, the price index fell from an already low of 43.0 to 39.4; while in the non-manufacturing report the price component fell from 70 to 67.6 – a sign of deceleration.

There were also encouraging inflation signs in the Small Business Optimism survey for December. The NFIB report indicated that fewer small businesses plan to raise prices in the coming months and the index fell from 34 to 24. However, fewer small businesses plan to increase employment and that component fell from 18 to 17. All in all, the NFIB Optimism index fell 2.1 points to 89.8, in December, recording its 12^th consecutive month below the 49-year average of 98. See page 4.

In December, payrolls increased by 223,000 and the unemployment rate edged down to 3.5%. These are actually robust numbers that could have worried investors, but the report was well received since average hourly earnings rose 5.0% YOY, down from November’s 5.5% YOY pace. This deceleration in wage gains was viewed by many as a positive thing, but we disagree. First, we do not think the deceleration is significant. Second, we do not believe the current economy is at risk of demand-pull inflation due to rising wages. In fact, the opposite is true. Inflation has had a very negative impact on real weekly earnings and in December real weekly earnings were actually down 2.6% YOY and were 4% lower than their May 2020 peak. In short, households have been losing purchasing power for nearly three years and are not a source of potential inflation. See page 5.

More signs that households are struggling are found in retail sales. In the nine months ended in November, total retail and food services sales grew at an average monthly pace of 8.4% YOY. This sounds healthy, but after adjusting for inflation, total real retail sales grew only 0.5% YOY. This lack of substantial revenue growth is a hurdle for many retailers and for future earnings. And though auto production has normalized, vehicle sales also declined in November. Weakness in the auto sector is also seen in used car prices which have been on the decline. See page 6. In sum, we have been anticipating a recession this year and recent economic data is falling in line with our theory.

Fed Policy – Too Soon for a Pivot

Many market commentators have suggested that the Fed will end rate hikes, or pivot once the economy shows signs of weakness. In our view, this is naïve thinking for several reasons. First, inflation does not materialize or end quickly. Prices were rising for several years before the CPI peaked at 9% last year. It is apt to take at least several years to get it back to the Fed’s target of 2%. Second, Fed tightening cycles have historically ended when the real fed funds rate reaches 300 basis points, or more. See page 7. It may not have to reach a full 300 basis points in this cycle, but the Fed has clearly indicated that a real fed funds rate is its objective. If this is true, the fed funds rate may need to move well above the 5% to 5.25% most economists are forecasting. For example, if inflation falls to 4% this year (our target) the fed funds rate could rise as high as 7% to break the inflationary cycle. There are other scenarios as well. Inflation could fall to 3% and the fed funds rate could peak at 6%. Nevertheless, this suggests the fed funds rate could move higher than most expect this year. In our opinion, nothing above a 5.25% fed funds rate has been discounted by recent equity prices.

Earnings

The fourth quarter earnings season could become a disappointment for those looking for a rally, or at least a January rally. Some analysts believe investors will look past an anticipated trough in earnings and actually rally on bad earnings news. But in our view, it is nearly impossible to estimate how weak earnings might be in 2023. The combination of fed rate hikes and a weakened consumer is what led us to reduce our S&P 500 earnings estimate for this year to $180, reflecting a 10% decline from an estimated $200 in earnings in 2022. A 10% decline in corporate earnings is “average” during an economic recession.

It is important to point out that while S&P Dow Jones is currently estimating 2022 earnings to be $200.19, this is only a preliminary estimate. See page 8. Fourth quarter earnings have not yet been reported and this forecast is likely to move lower. This scenario may explain why the fourth quarter earnings season could become a market moving event. Weak fourth quarter earnings results would not only require analysts to bring their earnings estimates down for last year and this year; but corporate guidance may have a substantial negative impact on this year’s forecasts — which ironically continue to anticipate year-over-year gains, despite expectations of a recession.

Technical Update The DJIA is the only index that is currently trading above all its key moving averages and looking positive. Conversely, the Nasdaq Composite is trading below all its key averages and looking bearish. The SPX and Russell 2000 have somewhat mixed pictures in terms of their moving averages. This divergence in performance is a result of a market leadership shift from growth to value that took place in 2022 and which we believe will continue this year. To a large extent, it reflects our thoughts of “follow the earnings” which tend to be clustered in energy, staples, aerospace, utilities, and stocks that reflect other necessities.

Gail Dudack

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History may not repeat itself exactly, but there is always something to learn from past economic cycles. In 2022, inflation was the highest in 40 years and there is much to be learned from this. In fact, whenever inflation has been greater than one standard deviation above the norm, a recession has followed. In fact, very high inflation has usually been followed by a series of recessions over a period of years.

Looking for a Recession

We believe Chairman Jerome Powell knows this part of history very well and it explains why we believe he will keep interest rates higher for longer than most forecasters expect. In previous cycles the Fed lowered interest rates at the first sign of a recession, only to see inflation reappear 12 to 18 months later. Discussions today center on when investors believe the Fed will “pivot” and most expect weakness in the economy will be the catalyst for easier monetary policy. In our view, although the Fed may not speak of it publicly, it expects a recession and is unlikely to be frightened at the first signs of economic weakness. It will, however, keep its eye on its goal, which is to get inflation down to, or close to 2% YOY. Some believe a Fed pivot will begin with inflation at 4% YOY but we disagree. Inflation at that level is still above the long-term average of 3.4% and is debilitating to consumers and businesses.

Another reason we believe the economy will slip into a recession is the weakness we see in the consumer. The savings rate was 2.4% in November which ranks among the lowest rates in history. We are not surprised that savings are falling, because real purchasing power has been negative most of last year. Personal income rose 4.7% in November, but after taxes and inflation, real personal disposable income fell 2.5% YOY. And for many Americans, the numbers are even worse. Proprietors’ income rose 3.7% in November, well below the 4.7% headline level; and non-farm proprietors’ income rose a measly 1.3% YOY. This is just one example of how small businesses are struggling in the current inflationary environment. The CPI decreased to 7.1% YOY in November, but it continues to destroy purchasing power. This is just one example of why inflation of 4% is still too high.

Some parts of the economy are already in recession. The residential housing market is a prime example. Pending home sales decreased to 73.9 in November and have been falling steadily since the October 2021 peak of 122.4. November’s reading is just slightly above the historic low of 71.6 recorded in April 2020 during the pandemic shutdown. Most consumer and business confidence indices were lower in November, yet they remain above the cyclical lows reported in June. Confidence levels bear watching since they can be good lead indicators of recessions and recession lows.

History of Negative Performances

Several market commentators have noted that it is rare to get broad-based back-to-back price declines in the equity averages. This is true, but it is possible. Annual losses were seen in the periods inclusive of 1929-1932, 1939-1941, 1973-1974, and 2000-2002. What each of these bear market periods have in common is that they were either the aftermath and unwinding of a stock market bubble, or in the case of 1939-1941 it was the prelude to the US being drawn into a major world war. See page 4.

This may explain why we are seeing major declines in the FAANG components, meme stocks, cryptocurrencies and the “Covid-shutdown” beneficiaries, where speculation was most extreme in the previous advance. In short, the bubbles in these areas are unwinding.

The good news is that the declines in 2022, particularly in high PE stocks, appear to be a major step in terms of wringing out excess and moving toward value in the US equity market. Still, we are not convinced that investors have discounted an actual decline in earnings in 2023. Many analysts are talking about a recession but have not factored it into earnings forecasts. In fact, we have heard some strategists suggest it is time to look across the valley of earnings and focus on an earnings rebound. This would have been true if we had already seen earnings forecasts turn negative, but they have not. At this juncture we do not know how deep, or how long, the valley in earnings may be.

Last year the S&P 500 Composite index fell 19.4%, and according to S&P Dow Jones consensus, earnings are expected to have declined 3.8% for the year. See page 3. But there are two caveats to this earnings decline. First, the fourth quarter earnings season will begin in several weeks, and in the last three reporting seasons estimates have declined significantly as quarterly earnings reports were released. In short, the estimate for 2022 may still be too high. Second, the S&P Dow Jones consensus earnings forecast for 2022 may be negative, but 2023 shows a growth rate of 13%. It is very likely that earnings will decline again in 2023, so this implies earnings disappointments are ahead. And do not forget that the S&P’s earnings decline in 2022 was muted by the outsized earnings gains seen in the energy sector. Most corporations had difficult comparisons in 2022 due to stimulus-boosted gains in 2020 and corporate margin pressure from higher raw material prices, soaring transportation costs and wage increases. The challenge in 2023 in our view, will be a lack of revenue growth. For this reason, we would focus on necessities and companies with reliable earnings streams such as energy, utilities, staples, aerospace & defense, and health insurance companies.  

Santa Baby

There has been much discussion about a Santa Claus rally this year, including controversy about its timing and effectiveness. For the record, Yale Hirsch of the Stock Trader’s Almanac monitored this phenomenon over the years and the Santa Claus rally is composed of the last five trading sessions of the year and the first two trading days of the new year; however, some analysts have added an extra day at either end of this period. Either way, a Santa Claus rally has materialized in seven of the last nine years. See page 5.

But that is not the real significance of the Santa Claus rally. The adage is: If Santa Claus should fail to call, bears may come to Broad and Wall. In short, it is not simply that a year-end rally tends to materialize, but that a rally, or the lack thereof, has some predictive value. We believe the tendency for a year-end rally arises from the fact that the last few days of the year often have a positive tilt from waning tax-loss selling, free cash as a result of tax-loss selling, rebalancing of mutual funds, pension fund inflows at the end of the year, and employee bonuses and Christmas money. In short, liquidity should be better than average at the very end of each year and should produce positive results in stocks. If not, it could be that either investor pessimism is high, or liquidity is below average. Neither would be a positive sign. As noted, rallies have appeared in seven of the last nine years and in each of the last six years. Four of these six years ended with double-digit gains in the S&P (66% accuracy) and two years ended with losses, including 2022. We do not put a lot of credence into year-end performances, but to date, the 2022-2023 Santa Claus rally has a 0.07% gain. It will be interesting to see if the market can hold on to this gain. See page 5. What has more predictive value in our view, is the January Barometer. See page 6.

Gail Dudack

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