US Strategy: Expectations

The current rebound has carried the broad indices between 14% (Dow Jones Industrial Average) and 23% (Nasdaq Composite Index) above their June lows and the rally has created a number of positive technical changes in our indicators. These technical changes are encouraging for the intermediate-to-longer term. Still, we would not be chasing the rally at this juncture. Walmart’s (WMT – $139.37) better-than-feared earnings report for the second quarter, was a sign that some companies are beginning to adjust to the hurdles facing them in this difficult economic environment. But while WMT jumped more than 5% for the day, its earnings report did not suggest the economy and the consumer are about to return to normal. In fact, Walmart’s results suggest that higher income families have shifted to Walmart to buy groceries. This is not a sign of consumer strength, in fact, it appears to be the opposite.

Plus, there are numerous signs that speculation is returning to the equity market. In particular, the performance of meme stocks during the August 16^th trading session suggests that “risk” is back in vogue. Bed Bath and Beyond (BBBY – $20.65), halted at least twice for volatility during the day, rose 29%. GameStop (GME – $42.19), also halted for volatility, ended the day with a gain of 6.3%. Meme favorite AMC Entertainment Holdings (AMC – $24.81) rose 2.5%, fuboTV (FUBO – $6.35) jumped 45% and Vinco Ventures (BBIG – $1.13) soared 58.8%. Meme favorites tend to be beaten down stocks with high short interest levels that attract speculators looking for high risk and quick gains. In short, this activity does not represent true equity investors and it is a short-term negative.

We continue to have an overweight rating in stocks and sectors that have the most predictable earnings streams, and these areas also tend to be equities that are both inflation and recession resistant. Sectors such as energy, utilities, staples, and defense-related stocks in the industrial sector have these characteristics. Healthcare, where we have a neutral weighting, is also a “necessity” for most households and also tends to be inflation and recession resistant.  

Expectations

The return of the speculators suggests that some investors feel the worst is behind us and the economy is about to rebound after a weak and recessionary first half of the year. The University of Michigan consumer sentiment indicator for August suggests there is some truth to that thought. The August reading of 55.1, was up from July’s 51.5 reading and was a nice rebound from the record low of 50 recorded in June. Expectations also rose from a very weak reading of 47.3 in July to 54.9 in August. But strangely, the current conditions index fell from 58.1 in July to 55.5 in August. See page 7. In other words, consumers are not feeling great at the moment, but are hopeful that the future will get better. This may have a lot to do with the decline in gasoline prices in the last four weeks.

This optimism may be supported or upturned by the retails sales report coming out this week. We will be watching to see if real retail and food services sales can turn positive and show gains even after being adjusted for inflation. The last four consecutive months of negative growth in real retail sales is a classic sign of margin pressure on retailers, and a sign that consumers are actually consuming less in real terms. Moreover, it tends to be a sign of a recession. See page 7.

In our view, it is too early to celebrate, or to believe that the Federal Reserve has managed to steer the economy into a soft landing. Monetary policy is as tricky to predict this year as we have seen in many years. Inflation remains a hurdle. July’s CPI was up 8.5% YOY, down from June’s 9.0% YOY, but still extremely high. Core CPI was unchanged at 5.9% YOY last month. PPI for finished goods was 15.5% YOY in July versus 18.5% in June. Core PPI was 8.7% YOY in July versus 8.9% in June. In sum, by all price measures inflation remains well above the long-term average of 3.4% or the Fed’s target of 2%. And though inflation may have decelerated a bit, it remains dangerously high. See page 3. This poses a problem for the Fed. Although the high end of the fed funds target rate has increased from 25 basis points in February to 250 basis points in August, it is likely to go much higher. The reason for this is that the real fed funds rate is still negative 5.2% relative to the CPI and negative 4% relative to the PCE index. This is the equivalent of 520 or 400 basis points, which means it would not be surprising if the fed funds rate increases at least 200 basis points, or more, before it truly impacts inflation. See page 4. Unfortunately, these interest rate hikes will do damage to the economy and to corporate earnings.

Housing is very interest-rate sensitive, and the housing sector’s combined contribution to GDP generally averages a sizeable 15% to 18%. We believe housing is either already in a recession or about to slip into one. And though interest rates may be only halfway through their rise, housing affordability is already at its lowest level since late 1985. The NAHB confidence indices are also plummeting and looking quite bleak. See page 5. Housing prices continue to rise, due in large part to low inventories, but as a result, the median existing home price relative to income per capita at its highest point on record. This, coupled with rising mortgage rates account for the big decline in affordability. Not surprisingly, both building permits and housing starts are rolling over in July, with housing starts falling nearly 10% in the month and down 8% YOY. See page 6. With this as a backdrop, it will be difficult for the Fed to navigate the economy to a soft landing.

Lower crude oil prices will lower inflation in coming months, but this was not a result of monetary policy. Oil prices are down due to signs of progress on the Iran nuclear talks and the possibility that Iran could add a million barrels a day to global production. Also dampening oil prices were the surprisingly weak economic data coming from China (the world’s largest crude oil importer). This was coupled with worries of a global slowdown and signs of massive demand destruction after peak gasoline prices. However, all this could be temporary since the European Union’s embargo on Russian oil is set to take effect in December and could shift the supply/demand balance. In sum, investors may be too optimistic about inflation and a Fed pivot in rates.

We also feel investors are too optimistic about current and future earnings growth. The S&P Dow Jones consensus EPS estimates for 2022 and 2023 fell $6.38 and $1.01, respectively, this week. Refinitiv IBES consensus EPS forecasts rose $0.16 and fell $0.55, respectively, however, IBES does not adjust for actual earnings or adjust for GAAP accounting, which is why we prefer S&P data. Which means with the S&P estimate for 2022 now down to $210.50, a 1.1% YOY gain, we may have to lower our $218 estimate once again. In short, expectations for earnings may be too optimistic.

Technical Indicators Show Promise

The 25-day up/down volume oscillator rose to 4.93 this week, the highest since December 8, 2020, and has been in overbought territory for four of the last five consecutive trading sessions. This is an interesting juncture for this indicator because bear markets rarely record overbought readings and if they do the readings are brief. If this oscillator can remain overbought for five consecutive days this week, it would be a sign that most stocks have already seen their lows and the worst of the bear market is likely behind us. Nonetheless, the current reading of four overbought trading days already implies that the broad market may have seen its worst, and is likely to remain in a wide trading range for the rest of the year. The S&P 500 and Russell 2000 index are currently trading above their 200-day moving averages (MA) and the longer they trade above this key level, the more likely the rally will push higher. However, in all the indices, the 200-day moving average continues to fall, which remains a sign of a bear market trend. At a minimum, we would like to see the 50-day MA better the 100-day MA in each index, to suggest a bottoming trend is in place. In short, things have improved but expectations may be too high. We would not chase stocks here and continue to focus on earnings growth for stock selection.

Gail Dudack

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