US Strategy Weekly: Liquidity Wins

We focus on three issues this week. The first is that technical indicators have finally and whole-heartedly confirmed the current advance. The second is that even though third quarter earnings estimates are beating expectations, it has little relevance to a market that has been focused on 2021 forecasts since March. Based on 2021 earnings estimates, equities are priced for perfection and this is certainly a cause for concern. And third, recent data releases are defining a pattern of economic deceleration. This is also worrisome. This combination of deteriorating economics/fundamentals and strengthening price action can only be explained by the fact that liquidity is driving the equity market.

Several indicators that we monitor suggest the market is likely to underperform over the next twelve to eighteen months. But bear in mind that this does not mean 2021 is destined to be a boring market. It is more likely that 2021 could contain several bull and bear market cycles that result in little gain in the end. Investors should prepare for an unusual environment and adjust portfolios so that they can weather extreme volatility.

Economic data for November was generally disappointing. The unemployment rate declined in November to 6.7% from 6.9%, but this was due in large part to the decline in the civilian labor force. The addition of 245,000 new jobs was less than expectations and perhaps the biggest letdown was the decline in the employment population ratio from 57.4 to 57.3. The participation rate also fell from 61.7 to 61.5. In short, the percentage of the population that is employed and working is declining. See page 3.

Jobs are key to the economy. They are the most critical component of household income, personal consumption, corporate revenues, and earnings. Therefore, the steady shift of workers from temporary layoff to being permanently unemployed is disturbing. See page 4. In our opinion, the absence of CDC guidelines that would allow businesses to safely open coupled with the lack of urgency seen in Congress to pass fiscal stimulus that would support small businesses is unconscionable.

In our view, the best way to assess the job market is to monitor the growth rate of “employment” over a 12-month period. A decelerating rate that approaches zero will predict a pending recession and a recession begins when this growth rate turns negative. But a pivot in the growth rate often defines a recovery. From this perspective, the job market was arbitrarily shut down so there was little warning for this unusual recession. However, the employment low was made in April with a negative 13.5% growth rate and has been improving ever since. But November’s growth rate was still poor at negative 6%. Meanwhile, the pace of those unemployed 27 weeks or longer continues to rise and currently resembles the pattern seen in early 2009! See page 5. These statistics suggest household consumption is apt to decline in the first quarter. If so, earnings could also disappoint.

The ISM indices are good benchmarks for assessing the strength of both the manufacturing and service sectors of the US economy. However, both ISM indices declined in November and both surveys pointed to weakness in new orders and general business activity. See page 6. The NFIB Small Business Optimism Index fell from 104.0 in October to 101.4 in November which was worse than expectations. The most revealing part of the survey was that the net share of respondents expecting the economy to improve dropped from 27% to 8%. This was a perfect example of how the current number of COVID-19 cases and the accompanying restrictions are hurting small businesses and dampening sentiment.

Autos and housing have been the core of the 2020 rebound, yet both weakened in November. Total vehicle unit sales fell from 16.74 million to 15.97 million units in November and all segments of the industry showed a decline. For the second month in a row the pending home sales index fell. October’s index fell to 128.9, down from the August peak of 132.9. See page 7.

Under normal circumstances, third quarter earnings results for the S&P 500 would make us bullish, but these are far from normal times. As of December 4, 496 companies in the S&P 500 Index had reported third quarter 2020 earnings. And of these, 84.5% reported earnings that were above analysts’ expectations and 12.3% reported earnings below expectations. In a typical quarter, 65% of companies beat and 20% miss estimates. Even more impressively, companies have reported earnings that are 19.7% above estimates. This is dramatically better than the 26-year average surprise factor of 3.5% and the last four quarter average of 8.7%. In addition, more than 78% of reporting companies exceeded revenue expectations and beat forecasts by 3.6%. This compares to the long-term average surprise factor of 1.5%. Not surprisingly, the estimated earnings growth rate for the S&P 500 in the third quarter is now negative 6.1% and much improved from the July 1 consensus forecast of a 25% decline. If the energy sector is excluded, the third quarter growth rate improves to negative 1.9%. Earnings growth forecasts improved for all sectors in the third quarter, but the greatest improvement was in consumer discretionary which flipped from an expectation of a 50% decline in year-over-year earnings growth to positive 0.8% currently. However, despite all this good news for the quarter, IBES consensus estimates for 2021 are relatively unchanged at $168.85. A PE multiple of 20 times next year’s earnings equates to an SPX target of 3377, or 9% below recent closing prices. See page 10.

At SPX 3702, the trailing operating PE is 30.6 X and remains higher than the June 1999 (29.3 X) and December 2001 (29.6 X) peaks. The 12-month forward PE ratio for the SPX is 22.3 X. Both benchmarks are well above their standard deviation lines and the SPX is now trading more than 13% above the top of our valuation model’s year end 2021 fair value range. See page 11. High valuation suggests the market is vulnerable to unexpected shocks and this suggests caution is warranted.

But in direct contrast to this the popular indices continue to set a series of record highs and our technical indicators are finally confirming the advance. In particular, the 25-day up/down volume oscillator is currently 5.02 (preliminary), above 3.0 and has been in overbought territory for six consecutive trading days and for nine of the last eleven trading days. The oscillator reached a reading of 5.52 late last week which was the strongest reading since February 2019. It is our contention that new price highs in the indices should be accompanied by long and often extreme overbought readings which represent solid buying pressure. After a lengthy delay, this oscillator has finally confirmed the new highs. See page 13. And most other breadth indicators followed suit. The 10-day average daily new high indicator is robust at 380 per day and the NYSE cumulative advance decline line made a simultaneous record on December 8 with the indices. See page 14. The AAII bullish sentiment index rose to 49.1% and the last 4 weekly readings are the highest since January 2020. But while the AAII bull/bear 8-week spread is quickly rising it still remains in neutral territory. See page 15.

There is one simple way to explain the discrepancy between the underlying fundamental and technical factors of the market and it is liquidity. Historically, there has been a strong correlation between easy monetary policy and stock market gains. M2 growth peaked at 19.6% in July but in late November it was still growing at a 6.6% pace. Demand deposits at commercial banks jumped in late November from $2.5 billion to $2.97 billion. In sum, remember the wise Wall Street adage “Don’t fight the Fed.”

Click to download