If it’s a Low … Is it an Uptrend? 

DJIA:  34,099

If it’s a low … is it an uptrend?  They may seem the same, but they are not always so.  By historical standards a low should be close – bull market corrections typically fall in the 6% range.  The S&P has taken out its 50-day, as have most of the Averages, but this says little more than we are in a correction phase.  What does seem consequential is that the S&P had remained above its 50-day for close to 100 days. This sort of trend doesn’t happen in bear markets.  When the trend does end, on average the correction again tends to be about 6%.  We don’t really like data like this because often there’s “always something.”  Suffice it to say for now the weakness seems normal, if there is such a thing.  The rub comes in the new uptrend.  After breaking the 50-day sorting things out typically takes a month or so, new highs usually come a couple months later.  Even market lows can be a process.  

Banking may be a fine profession, it’s the bankers that give us trouble.  If not lending to Third World countries, or to see-through office buildings, they’re trying to rig LIBOR.  For now it’s the Regionals that are between a rock and a hard place.  They’re caught in the equivalent strategy of buying High, selling Low, and making it up on volume – a strategy we’ve tried with stocks from time to time.  Of course it’s not like rising rates were a big secret, and isn’t rate stuff what banks do?  What is done is done but not without some implications for the overall market.  There are a lot of banks and that has implications for market breadth, that is, the A/D Index.  It also helps explain why the Russell 2000, what we call love among the rejects, acts as badly as it does.  It’s 20% Regionals.

One non-reject in the Russell happens to be its largest holding, Super Micro Computer (263).  By our calculation, back in early August SMCI had outperformed Nvidia (472) year-to-date, then came the collapse – a 50-point downside gap, followed by an additional 50-point decline.  In Tech land, things sometimes change fast.  And things seem to be changing yet again. You can argue the overall uptrend was never threatened, and it was a much-needed correction, as they like to say.  What seems important in the here and now is the stock has re-taken the 50-day.  Buying stocks in overall or long-term uptrends is best.  When they correct, however, you never know.  Best to buy some if you must, and the rest when they retake the 50-day.

Tech gets all the attention, rightly so since they are what got us here, bull market-wise.  It is a bit ironic, however, that with the exception of Nvidia few Techs have been above their 50-day recently.  Meanwhile, the seemingly forgotten Oil shares have cycled from fewer than 15% above their 200-day to more than 90%.  This kind of momentum change has resulted in higher prices more than 80% of the time.  Then there are the unscathed, the stocks which have come through the correction with little or no damage.  Everyone likes to buy bargains, but often the stocks that give up little are those that lead in the next phase of rally.  We’re thinking here of stocks like Quanta (201), Eaton (221), Ingersoll (68) and Roper (489).  In Tech, Arista (179) has a pattern we particularly like – gap up and a high-level consolidation.

That Thursday was a “sell on the news day” was not completely surprising.  If more than just that it would be surprising, and not good.  We’ve been waiting for the market to ignore bad news, and there have been hopeful signs.  For sure, good markets don’t ignore good news.  Wednesday’s 3-to-1 up day, the first in more than a month, also was encouraging.  However, one day is just that, what is needed is a pattern of better A/Ds, especially on those days when the Averages are up.  Stocks aren’t cheap, rates are rising and Powell’s speech at this time last year took the market down some 19%.  A recovery is not guaranteed, but despite Thursday seems likely.  The S&P’s duration above the 50-day suggests this remains a bull market correction.

Frank D. Gretz

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US Strategy Weekly: Fed Minutes – Inflation is Unacceptably High

Fitch downgraded its credit rating for long-term US government securities from AAA to AA+ on August 1, 2023, citing an erosion of fiscal governance and rising general government deficits. Moody’s cut the ratings on 10 mid-sized lenders on August 8th. The Fitch Ratings service warned of a downgrade on more than a dozen banks on August 15th and S&P Global Rating downgraded five regional banks on August 21st, focusing on lenders with commercial real estate exposure. All these rating agencies indicated that some banks face a future risk to their balance sheets due to potential bad debts in the commercial real estate area, but all banks are dealing with liquidity pressure since many portfolios are drawing interest income of 2.5% to 4.5%, while needing to pay depositors 4.5% to 5.5% in savings and money market accounts. This may seem like an isolated problem within the banking sector, but it is not. Although there is no immediate crisis in the banking sector, there are strains in the system that are likely to continue longer than some expect. More importantly, the US economy cannot do well if the banking sector is not doing well. It never has. So, in our view, with this backdrop, it is not surprising that stock prices have been in a correction in August.

Trading Ranges Defined

The last year has produced a series of issues that have chastened both optimists and pessimists. From a longer-term perspective, the last 18 months have been frustrating for both the bulls and the bears. Our long-held view is that the stock market is in a broad sideways trading range, best defined by the Russell 2000 between support at 1650 and resistance at the 2000 level. The other indices have less obvious trading ranges, although it is clear that price action has been contained by resistance at the January 2022 peaks and support at the October 2022 lows.

Long-term trading ranges are not unique in equity history, but they have not materialized in a while. Since the March 2009 low, equities have been in a relatively consistent uptrend. In short, for most of the last 14 years, stock prices have been “trending” and as result, new investors might be unfamiliar with rallies that have limited leadership and declines that lack follow through. However, trading ranges are not unusual, and in our view the current trading range is a substitute for a more dramatic bear market.

Classic bear markets are often triggered by an unexpected event that shakes investors’ confidence and this event becomes the catalyst for an unforeseen earnings decline. A dramatic bear market ensues and produces a relatively sudden but quick repricing of risk. A trading range is simply another way of repricing risk and can be a subtle substitute for a bear market.

In the current environment, a trading range is a way for earnings to catch up with prices. Earnings for the S&P 500 declined on a year-over-year basis during the second, third, and fourth quarters of last year. Earnings are now expected to grow modestly from these much-reduced levels; nevertheless, the outlook for earnings growth remains uncertain.

If we look at S&P Dow Jones operating earnings data, it shows that the four-quarter sum in earnings peaked in March 2022 at $210.16. The S&P Dow Jones consensus estimates show that four-quarter earnings could reach a new high by the end of the 2023 third-quarter earnings season, with earnings of $212.89. However, these are estimates and data shows essentially no earnings growth for most of 2022 and 2023. In sum, prices moved higher in 2023, but the fundamentals did not. The recent trading range is a way for earnings to eventually catch up with stock prices. In our view, the catalyst needed for stocks to break out of this trading range is for the Fed to successfully tame inflation and this will take more time. In the interim, we believe focusing on stocks with reliable earnings streams and reasonable PE multiples will be the best way of managing through this environment. 

FOMC September 20

One reason to believe the Federal Reserve will keep interest rates higher for longer is that they were so late to address the inflation problem. As seen on page 3, in previous cycles, the fed funds rate typically increased ahead of, or in line with, the level of inflation. In this cycle, the Fed was 12 to 18 months behind the inflationary trend, and this allowed inflation to become ingrained in the service sector. Since service sector inflation is less commodity driven and more salary driven, it is more difficult for the Fed to control. It also explains the Fed’s attention to service sector inflation. Meanwhile, it is important to note that the real fed funds rate usually reaches 400 basis points in a tightening cycle, and though the real rate has been rising, it is now only at 230 basis points. In short, we believe another rate hike is likely on September 20 and we do not believe this is discounted in stock prices.

The path of interest rates is important to the economy since it will impact both the auto industry (see page 4) and the residential housing market. The National Association of Home Builder Confidence index fell from 56 to 50 in August, which is not surprising, since the June NAR Housing Affordability index fell from 93.7 to 87.8, the lowest level since January 1984. This decline in affordability was before the Fed’s July rate hike! The June decline was attributed to a combination of median family income ratcheting down to $91,319, the median price of a single-family home rising to $416,000 and the NAR mortgage rate increasing 28 basis points to 6.79%. See page 5.

Although the housing market has been in a slump for almost two years, it is possible that housing is about to slow further as interest rates rise and remain high. This risk can be seen in the fact that both existing and new home prices have stopped increasing and in recent months have registered year-over-year declines. Also interesting is the fact that home prices and retail sales have been highly correlated over the last 60 years, and both appear to be on the cusp of a negative cycle. See page 7. Some may think that these are reasons for the Fed to pause, but underlying these risks are a tight labor market and wage growth that recently has exceeded the pace of inflation. We believe the Fed will remain higher for longer in order to be confident that inflation will reach its target of 2%. 

Technical Update

As a result of the recent weakness in the equity market, all the popular indices are currently trading below their 50-day moving averages and are about to test their 100-day moving averages. However, the Russell 2000, is about to test its 200-day moving average which is now at 1843. We would not be surprised if all these moving averages were broken in the near term since this would be typical of a long-term neutral trading range environment. See page 9. 

The 25-day up/down volume oscillator is at negative 2.05 this week, which is at the bottom of the neutral range. It is close to registering an oversold reading of negative 3.0 or less, which would neutralize the recent unsustained overbought readings. Meanwhile, the 10-day average of daily new highs is 54 and new lows are 111. This combination turned negative this week since new highs fell below 100 and new lows rose above 100. All of the above is normal for a trading range market.

Gail Dudack

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The Correction…

DJIA:  34,413

The correction has been more than expected – or perhaps just different than expected.  While just a few percent in the S&P, it has hit the seemingly unstoppable Tech the hardest.  Best to be wary when they start giving things a name – one-decision stocks, dot-com’s, Magnificent Seven.  What’s done is done – now a couple things need to change.  Good markets ignore bad news, this market has ignored some market friendly news – the Jobs number, and more recently the CPI.  The market has to start ignoring bad news.  More importantly, the spate of recent days with the Dow up and the A/D’s flat or down needs to not only change, it needs to reverse.  More than any level in the Averages, what’s needed is a sign of a buying interest, a couple of days with 3-to-1 up.

Frank D. Gretz

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US Strategy Weekly: Global Banking Sector Angst

In last week’s US Strategy Weekly (Things to Ponder; August 8, 2023), we wrote “we do believe the recent rally is fragile since it has been driven by the new consensus view that the economy will have a soft landing or no landing. This view is coupled with the belief that there is no interest rate hike in September. We think the Fed will hike in September, unless economic data becomes very weak in the interim. What is clear is that this week’s CPI and PPI reports will be center stage and could be market moving.” In truth, there was not a big reaction to last week’s CPI report. See page 3. But the PPI report, which showed intermediate service sector inflation rose from June’s 4.4% YOY to 4.6% YOY, seemed to make investors anxious. And in a market priced for perfection, any unpleasant or unexpected news will make equities vulnerable.

There were a few other developments this week. Chinese economic reports for industrial production, retail sales, and property investment were weaker than expected. More importantly, the combination of this data reflected an economy that is potentially faltering. The PBOC responded by lowering key interest rates by 15 basis points. Yet the real concern is China’s real estate sector, which is estimated to represent as much as 30% of China’s GDP, and which has already weathered a string of defaults by residential property developers. This week the focus is on Country Garden Holdings Co. Ltd. (2007.HK: 0.81), a giant Chinese real estate developer that is expected to deliver nearly a million apartments in hundreds of cities throughout China. Unfortunately, Country Garden has not been paying its bills, indicated it would report a loss of as much as $7.6 billion in the first six months of the year, and in August skipped two interest payments on loans. A default is possible in September. The big concern is the exposure of China’s $3 trillion shadow banking sector to this potential real estate risk, as well as the risk to the broader Chinese economy.

Separately, Russia’s central bank raised its key interest rate from 8.5% to 12% to help stop the slide in its currency which has lost more than a third of its value since the beginning of the year. The ruble passed 101 to the US dollar earlier this week and continues to weaken due to capital outflows, big government spending on the Ukraine war, and a shrinking current account surplus as a result of Western sanctions on Russian oil and gas. Inflation reached 7.6% over the past three months, and according to Russia’s central bank, inflation is expected to keep rising, noting that the fall in the ruble is adding to the inflation risk.

Closer to home the Fitch Ratings service warned that the agency could downgrade more than a dozen banks, including some major Wall Street lenders. Fitch already lowered the score of the “operating environment” for banks to AA- from AA at the end of June – although this went largely unnoticed. And Fitch’s warning comes weeks after Moody’s cut the ratings of 10 mid-sized lenders, citing funding risks, weaker profitability, and increased risk from the commercial real estate sector.

Retail Sales

Advance estimates for July retail sales showed a month-to-month gain of 0.7% and the May and June estimates were revised from up 0.2% to up 0.3%. This acceleration in retail sales concerned investors who had been expecting a Fed pause, since economic momentum opens the door for a rate hike in September. On a seasonally adjusted basis, retail sales rose 3.2% YOY in July; on a non-seasonally adjusted basis, sales were up 2.5% YOY. However, when adjusting for inflation, real retail & food service sales, based on 1982 dollars, fell 0.1% YOY. See page 5. In other words, despite a month-to-month acceleration in sales, real YOY retail sales declined and have been negative for nine of the last 10 months. This pattern is a classic sign of an economic recession, not strength. See page 6.

Historically, a negative trend in retail sales is tied in with a decline in nominal GDP and that is true in this cycle as well. On page 7 we show a table that highlights, in red, all the months since January 1968 that have experienced below average retail sales. This table is important because a string of below average sales has always defined a recession and negative real retail sales in any year has also characterized recessions. The current string of “red” is the longest since 2008-2009, and to date, real retail sales are averaging negative 1.3% in 2023. Nonetheless, GDP continues to grow. It is uncanny. Still, we would not describe July’s retail sales report as strong.

However, one reason to believe the Fed will keep interest rates higher for longer is that they were so late to address the inflation problem. As seen on page 4, the fed funds rate typically increases ahead of, or in line with, the level of inflation. In this cycle, the Fed was 12 to 18 months behind the inflationary trend. This suggests more work needs to be done. Moreover, while the real fed funds rate has increased to 200+ basis points, it usually reaches 400 basis points in a tightening cycle.

Earnings

The second quarter earnings season is close to ending and as is usual, retail stocks are the last to report. Home Depot Inc. (HD – $332.14) beat the consensus estimate for quarterly earnings per share, and though same-store sales fell 2% YOY this was less than the expected 3.5% decline. The company announced a $15 billion share repurchase program and it reiterated its muted forecast for the year. The company noted caution on the part of consumers towards big-ticket items. Walmart Inc. (WMT – $159.18) is expected to raise its full-year earnings forecast this week when it reports quarterly results. A research report by Stifel, Nicolaus & Company estimates more people plan to shop at Walmart compared to Costco and Target, even though they expect to spend 16% less on back-to-school purchases compared to a year ago. Retail is a sector of winners and losers in this environment.

All in all, earnings season has gone better than expected and the S&P Dow Jones consensus estimates for 2023 and 2024 are currently $219.41 and $244.06, up $2.31, and $1.00, respectively. Refinitiv IBES estimates for 2023 and 2024 are $219.09 and $245.55 up $0.41, and down $0.25, respectively. What is notable is that S&P Dow Jones and Refinitiv IBES are both showing a $219 estimate for this year. These two surveys tend to diverge in the second half of the year. Nevertheless, based on this year’s earnings estimate of $219.41, equities remain overvalued with a PE of 20.2 times. The 12-month forward operating earnings PE is 19.0 times, and the December 2024 PE is 18.1 times. When we add inflation of 3.2% to these PE multiples, we get 23.2, 22.2, and 21.2. All of these sums hover just under the 23.8 range that defines an extremely overvalued equity market. This is what explains the market’s nervousness.

Technicals are Slipping

The S&P 500, Nasdaq Composite, and Russell 2000 are all trading below their 50-day moving averages, a key level for some traders. However, the RUT, a useful benchmark for the last 18 months, failed to break above the 2000 resistance level in July, implying that the recent rally was simply part of a much larger neutral trading range. See page 9. The 25-day up/down volume oscillator is at a negative 0.51 reading this week and neutral. The oscillator generated overbought readings in 10 of 22 trading sessions ending August 1, but failed to remain overbought for the minimum of five consecutive trading days required to confirm the advance. This week the 10-day average of daily new highs fell to 88 and new lows rose to 75. This combination turned positive on June 8 when new highs rose above 100 and new lows fell below 100 but it turned neutral this week with both averages now below 100. In short, upside momentum appears broken.

Gail Dudack

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It’s Like Playing Russian Roulette with an Automatic Weapon

DJIA:  35,176

It’s like playing Russian Roulette with an automatic weapon.  That’s the look of these Tech stocks when they report.  If you believe, as we do, the market makes the news, this isn’t exactly what you’d like to see.  Then, too, it’s hard to be surprised they should be vulnerable.  Even Nvidia (424) broached it’s 50-day on Wednesday, a level perhaps too obvious.  For Tech overall, it has cycled from an oversold to overbought level in terms of its 200-day, but to a degree which suggests higher prices into year-end.  The caveat is first a pause like we’re seeing now. Meanwhile, stocks like Eaton (217) and Emerson (96) are consolidating after gapping higher.  United Rentals (482) looks particularly positive, and don’t forget Oil.

Frank D. Gretz

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US Strategy Weekly: Things to Ponder

More Credit Rating Risks

Last week Fitch stunned the financial sector with its downgrade of US Treasury debt. This week Moody’s surprised investors by cutting credit ratings on 10 small- to mid-sized US banks. In addition, Moody’s put six banking giants, including Bank of New York Mellon (BK – $45.72), U.S. Bancorp (USB – $40.23), State Street Corp. (STT – $72.73) and Truist Financial Corp. (TFC – $32.41), on review for potential downgrades. Moody’s indicated there is no immediate crisis, but “banks will find it harder to make money as interest rates remain high, funding costs climb, and a recession looms. Some lenders’ exposure to commercial real estate is a concern.”

Several financial analysts suggested these warnings were unwarranted, however, rating agencies are paid to point out risks and there is no doubt that an unbridled federal debt burden is a long-term hazard, particularly as interest rates rise. For most banks an inverted yield curve combined with the potential of commercial real estate defaults are real risks that should not be ignored.

Although stocks sold off on both credit rating warnings, the pushback from some analysts and even the Biden administration are more disturbing to us than the actual agency warnings. The gains in equity prices this year have been primarily multiple expansion, not earnings gains. According to IBES Refinitiv, earnings in the last two quarters of 2022 and first quarter of this year were 4.4%, negative 3.2%, and 0.1%, respectively, and estimates for calendar 2023 show an S&P 500 earnings growth rate of a measly 1.2%. According to S&P Dow Jones, the last three quarters of 2022 had year-over-year declines in earnings, and though a modest rebound in growth is forecasted for coming quarters, it is coming from a diminished earnings base. Perhaps this lack of earnings power is why investors are flocking into generative AI stocks and looking far into the future for earnings growth. But after massive price gains, these stocks now have extremely high PE multiples and even fans feel the stocks are richly valued.

Things to Ponder

There are three things that we often wonder about although they are not part of our official forecast. The first is a risk that the stock market is on the verge of a bona fide bubble. This thought emanates from the excitement surrounding generative AI, estimates that the AI market will grow to $126.5 billion by 2031, and the massive runup that these stocks have had. AI has created a two-tiered market with the Nasdaq Composite up 33% year-to-date while the DJIA is up only 6.5%. This divergent price action is very reminiscent of the Nifty Fifty era that led to the January 11, 1973 peak and the Dot-com bubble era that ended on January 14, 2000. We have also thought about the fact that there were 27 years between those two market bubble peaks, and we are now 23 years past the 2000 peak. Since bubbles tend to be generational, we are in the right time frame to be on the lookout for a bubble. And the pattern we see of analysts ignoring fundamentals only adds to this worry.

Second, is the fact that bullishness is now consensus and the bears on Wall Street have been converted. Many sentiment indicators, particularly the AAII sentiment indices, are showing extremes last seen between February and May of 2021. The stock market did not peak until January of 2022; however, this is how sentiment indicators work. Sentiment are not timing indicators, rather they tend to be early warnings systems and only point out that risks are rising. See page 13.

Our last consideration is COVID, and the global pandemic it sparked. COVID resulted in an unprecedented manmade global recession in 2020 produced by many government leaders who decided to shut down their economies. It was not a normal economic recession. The subsequent recovery was also unusual, manmade, and manufactured with monetary and fiscal stimulus. This fiscal stimulus continues to drive many segments of the US economy to this day. History is often an excellent guide for economists and equity strategists, but there is no rule book for what has transpired over the last three years. Therefore, perhaps the typical signals of a recession such as an inverted yield curve, the 15-month decline in the Conference Board’s Leading Economic Index (the longest streak of decreases since 2007-2008), and the 7 months of negative real retail sales, are not applicable today. This seems strange to us. Nonetheless, the years of monetary and fiscal stimulus have kept the US economy afloat and it also provides the liquidity that could set off a stock market bubble. Thus, we ponder and worry. However, we do believe the recent rally is fragile since it has been driven by the new consensus view that the economy will have a soft landing or no landing. This view is coupled with the belief that there is no interest rate hike in September. We think the Fed will hike in September, unless economic data becomes very weak in the interim. What is clear is that this week’s CPI and PPI reports will be center stage and could be market moving.

Household Debt: the Good and the Bad

Total household debt rose by $16 billion in the three months ended in June and increased $909 billion in the prior 12 months. In short, household debt rose 5.6% YOY in June versus the 7.6% YOY increase seen in March. Of the $909 billion increase, $627 billion (or 69%) was in mortgages and $144 billion (or 16%) was in credit card debt. Credit card debt grew 16.2% YOY in June exceeding $1 trillion for the first time. As a result, credit card debt now represents 6.0% of total debt versus 5.5% a year earlier. See page 4.

A broader look at household debt shows that debt grew fairly rapidly in 2021 and 2022 but grew at a slower pace in 2023. A large part of the increase in household debt occurred in the under-40 age group and was likely linked with a period of significant increases in new credit card accounts. Note that the 2021-2022 period overlaps with the moratorium on student loan payments and a healthy trend in personal consumption. While the number of credit card accounts grew, the number of outstanding auto loans, mortgages and HELOC loans remained fairly stable in the same period. See page 5.

The good news in household debt data is that delinquencies have not had much of an increase from the low recorded last year. However, there are two big changes on the horizon. First is the massive increase in financing rates seen for revolving credit lines over the last year. This will make credit card debt less viable for many households. Second, the end of the moratorium on student loan payments which begins in October will also reduce liquidity for some households, particularly for middle class borrowers. See page 6.

Fundamentals The current S&P 500 trailing PE multiple is 21.5 times and above all historical averages; in short, the market is priced for perfection. The forward PE is 19.3 times, and when added to inflation of 3%, sums to 22.3, which is just below the standard deviation line of 23.8 denoting an overvalued equity market. In sum, earnings growth is pivotal to the market’s intermediate and longer-term trends. See page 8.

Gail Dudack

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Sometimes It’s Not About What the Market Does

DJIA:  35,215

Sometimes it’s not about what the market does … it’s about what the market doesn’t do.  These days most stocks go up, and that has been key to the uptrend’s longevity.  Last Thursday was an exception, when despite the Meta (313) news most stocks reversed to close lower by a margin of almost 3-to-1.  We would not have been surprised to see some follow-through the next day, despite the benign inflation number.  Instead, the market retraced most of the previous day’s loss, including in the A/D numbers.  After Thursday’s poor action, Friday easily could’ve seen what we call a weak rally – up in the Averages but poor breadth.  While this speaks to the market’s strength, we may be in for another health check this week.  Tuesday’s positive Dow against A/Ds that were 2-to-1 to the downside is not what you like to see.

Divergences between the DJIA and the A/Ds lead to problems/corrections.  They can but don’t usually happen overnight.  In late 2018 The Dow saw three consecutive days of higher highs against three days of negative A/Ds, and the market quickly fell 20%.  For some reason they like to compare this market to 87, though technically they’re completely different. In 87 the A/Ds peaked in March, and there was a pattern of higher highs in the Dow against a pattern of lower highs in the A/Ds going into the October Crash.  Divergences mean markets have narrowed.  Markets narrow when there’s less sideline cash/buying power.  When that happens the large-cap stocks that dominate the Averages are the last to give it up, which offers hope for the laggards.  You know what they say about hope as an investment strategy.  While all of this is a sort of playbook for a market top, the market recently has broadened, and has too much momentum for important problems.

The upside momentum we have seen in this market brings to mind a trading system which has worked particularly well recently.  The system calls for being long or short at the start of each month, depending on whether the S&P the previous month was up or down, respectively.  Recently that would have meant going long at the end of March and capturing some 500 S&P points by the end of July.  While the system does work, it’s unusual to have the S&P up for five consecutive months.  And to the point of momentum, all streaks end but this kind of momentum doesn’t go away in a hurry.  Another way you might have captured this momentum run is through moving averages. The S&P crossed above its 50-day moving average in early April and has remained above it ever since.  A word of warning about “systems,” they all have their flaws, mainly whipsaws.  And then there’s human nature.  There are good trading systems, but few good systems traders.

Sentiment or investor psychology is often taken just as contrary thinking.  While there is a big part of that in these indicators, that’s very much an oversimplification.  A Wall Street Journal article recently cited an array of indicators suggesting sentiment is over the top.  Those include the AAII Survey, the University of Michigan Survey, P/C Ratios and a disappearing VIX.  How should we put it, investors aren’t stupid.  They would have to be to not be bullish/positive in a market like this.  Our favorite quip about this is that investors are wrong at extremes, but right in between.  So just what is an extreme?  It’s when you’re sitting there wishing you had more money to invest, but you don’t.  Chances are you’re not alone, and tops are about the money.   When it comes to surveys we prefer Investors Intelligence, which is a measure of those drop-dead smart market letter writers.  The record here is a jump often results in a temporary pullback, but then a higher market more than 90% of the time.  

So when you catch a Sovereign downgrade you’re supposed to sell all your Tech?  Or was Tech a bit over-loved and looking for an excuse to correct?  Before this spate of weakness, did you notice how the rally ran in the shorts?  The shorts in this case were not just stocks like TUP (4) and TDOC (26), the shorts included every negative Strategist.  That’s the market, doing what he does best – confounding the most number of people.  Things change, nowhere more than in Bonds and the Dollar – not a good thing.  While not exactly a scientific survey, our take is there have been more surprises down than up, including among the good charts.  That’s not good for job security – in this case our own.  The Market has dug itself into a bit of a hole in terms of the poor recent A/Ds, so we’re likely in this correction phase for a while.

Frank D. Gretz

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US Strategy Weekly: Charges and Changes

Oh Fitch!

As we go to print, the US has formally charged former President Donald Trump with conspiracy to defraud the US, witness tampering, and conspiracy against the rights of citizens. Separately, the ratings agency Fitch downgraded the US government’s top credit rating to AA+ from AAA, citing three years of fiscal deterioration and a high and growing government debt burden. Globally, Russia announced that a drone hit a residential building in Moscow placing responsibility at the feet of Ukraine. A coup against Niger’s elected president is triggering evacuations of US and European partners and a Ukrainian official is alleging that Russia is responsible.

Of these events, the most important for US consumers and investors will be the downgrade of US government bonds. Rating changes can impact the demand for US government bonds at a time that the debt burden is high and the need to issue more debt becomes important. Higher interest rates are good for bondholders, but they also could negatively impact economic activity and PE multiples.

Great Economic News

However, equity investors are ignoring such threats and it is not surprising given the recent string of economic releases. It begins with the report that in the second quarter GDP grew 2.4% (SAAR) which was an increase from the 2.0% seen in the first quarter. In short, economic activity accelerated in the second quarter and this was much better than we, and most economists, expected. It was a surprising development particularly since corporate profits, real retail sales, and residential investment continued to decline in the same period. Personal consumption of nondurable goods and services was the source of strength in the second quarter and inventories were less of a drag than they were in previous quarters. See page 3.

As we have often noted, high levels of inflation are typically a precursor to a recession, and this has been a major concern in recent years. For example, the June 2022 GDP price deflator hit a worrisome 7.6% which was the highest level of inflation since the 8.4% reported in December 1981. However, the second quarter GDP report showed that this deflator fell to 3.6% in June, well above the Fed target of 2% but good news, nonetheless. Similarly, the monthly personal consumption expenditure deflator fell from 3.8% in May to 3.0% in June, its lowest level in 2 years. See page 4.

But the best news was found in reports on personal income and consumption. In June, personal income rose 5.3% YOY, disposable income rose a stunning 7.9% YOY, and our favorite benchmark, real personal disposable income, rose 4.75% YOY, up from 4.1% YOY in May. Personal consumption expenditures have been in a downward trend after hitting an unsustainable peak of 30% YOY in April 2021, but in June, PCE remained at a healthy 5.4% YOY pace. More importantly, the June acceleration in real personal disposable income is a positive sign for steady household consumption as we begin the third quarter. See page 5.

All the good news on the inflation front, combined with the 25-basis point hike in the fed funds rate in July, results in the real Fed funds rate increasing from 211 basis points to 236 basis points relative to the CPI. The real fed funds rate is similar when compared to the PCE deflator. What is important is that the combination is getting closer to the 300-400 basis points we believe the Fed is targeting for its monetary policy. But keep in mind that the strength seen in the economy also opens the door for the Fed to raise rates again on September 20 and perhaps even at the November 1 meeting. We believe the Fed will continue to raise rates until the real fed funds rate is at least 300 basis points and we do not believe the consensus agrees. This is a risk.

Politics Plays a Major Role

Equally important is the fact that 2023 is a pre-election year, and as is typical of a pre-election year, the incumbent party tends to pass stimulus bills to boost the economy. In this cycle, it comes in the form of the Inflation Reduction Act (IRA) which is actually a stimulus bill focused on supporting the green economy and technology sectors.

In addition, President Biden has circumvented the Supreme Court’s rejection of his sweeping student loan forgiveness plan and has launched its SAVE plan (Saving on a Valuable Education). This is a revision of a previous income-driven repayment plan, and the revisions include factors that base monthly payments on income. For many borrowers’ previous monthly payments will be cut in half and for some borrowers there will be no monthly bill. It is in fact a loan forgiveness plan of sorts. The Department of Education has stated that borrowers who sign up for the plan this summer will have their application processed before student loan repayments are expected to resume in October. In other words, the negative impact the end of the student loan moratorium might have had in the fourth quarter of 2023 has been eliminated to a large extent.

Given these developments we are raising our S&P 500 earnings estimates for this year from $200 to $212 and for 2024 from $220 to $230. These estimates remain slightly below consensus but are more in line with the fact that a recession in 2023 is less unlikely today than it was a month ago. See page 16.

However, even if we use S&P Dow Jones earnings estimates, which are higher than our forecasts, the current S&P 500 trailing PE multiple is 22 times and sits above all historical averages. We fear this means the equity market is priced for perfection. The 12-month forward estimated PE is 19.7 times, and when added to inflation of 3%, sums to 22.7. This 22.7 level is just below the standard deviation line of 23.8 which denotes an extremely overvalued equity market. See page 8. In other words, a lot of good news has been discounted in current prices. Also,  keep in mind that the earnings season currently being reported took place during the 2.4% GDP economy, which was an improvement over the first quarter’s economic activity. If earnings do not show an improvement, it could dampen investor sentiment.

Technical Tests

The charts of the S&P 500, DJIA, and Nasdaq Composite index are bullish and suggest the indices may, or should, be about to test their all-time highs. However, the Russell 2000 index has failed to break above the 2000 resistance despite numerous attempts in recent sessions. This is not conclusive, and the RUT may still break out, but it does leave the overall look of the market somewhat pivotal and uncertain at the moment. See page 10.

Similarly, the 25-day up/down volume oscillator is at a 4.03 reading this week and overbought for the third consecutive trading session. The good news is that the oscillator has had overbought readings for 10 of the last 21 trading sessions; however, to date, none of these overbought readings have lasted the minimum of five consecutive days needed to confirm the advance in the averages. Strong rallies should also include at least one extremely overbought day. Nonetheless, these requirements are what should be seen at a new market high and none of the indices have recorded new record highs. The rally has only produced new “cyclical” highs in most indices. See page 11.

Gail Dudack

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Two Months … But Who’s Counting

DJIA:  35,282

Two months … but who’s counting.  The market hasn’t suffered a 1% down day in two months. That’s quite a streak though by no means the longest.  It’s the kind of streak that doesn’t happen in bear markets.  Still, when the streak ends you have to wonder if the abyss awaits.  Despite what you might think or fear, history suggests otherwise.  It’s that momentum thing again – big uptrends don’t turn on a dime.  At play here, too, is what they call the market’s broadening.  And it’s not just semantics, it is broadening rather than rotation – we’ve expanded without leaving a lot behind.  The improvement in Staples and Financials are the prime examples here, both broad areas.  It’s a tough call to be negative on Tech, not one we are brave enough to make, or believe should be made.  That said, Tech stocks have come a long way and now there are opportunities elsewhere.

To make clear our thinking on Tech, there’s momentum here that won’t easily go away.  We’re thinking of a stall more than real weakness.  More than 90% of Tech shares are above their 50 and 200-day averages, having cycled from less than 7%.  This kind of change has produced good returns over the next six and 12 months for both Tech and the S&P, according to SentimenTrader.com.  The recent action here has become a bit more ragged, including Wednesday’s surprising weakness in Microsoft (331).  Meanwhile, while most may not realize it, stocks like Walmart (159) and Costco (562) are in their own long-term uptrends and arguably are acting better than most of Tech recently.  These are among the top 10 holdings in the Staples ETF (XLP-75), together with Coke (62) and Pepsi (189) which also are acting well and similarly have long-term uptrends.  As we suggested above, a problem for Tech might be it’s no longer Tech and Tech only acting well, you now have options.

So you say you always believed in the Meta-verse, or was it Facebook?  Left for dead late last year, Meta Platforms (312) as it’s now known, has tripled.  If Meta was on the giveth side, Microsoft was a bit on the taketh this week, but in the case of the latter, you have to wonder for how long.  The stock is dabbling with its 50-day, as it did a couple of weeks ago, and again back in April.  Were it to break, which seems unlikely, it would be a change of some concern.  Meanwhile, Google (129) had its own upside gap – guess FANG isn’t going away this week.  On the other side of Tech, both Costco and Walmart are bumping up against all-time highs, together with the likes of Cintas (505), Grainger (725) and Parker Hannifin (397) – strange bedfellows you might say.  And these days there’s the much improved commodity complex – Steel, Copper, and of course, Oil.  The China news may have helped, but these have been improving for some time.

Volume is important, both for the overall market and for individual stocks.  For the latter volume often precedes price, while a rally without volume is suspect.  Stock volume is pretty straightforward, what you see on the screen usually will do.  It’s a different story when it comes to the overall market where one might ask whose volume or what volume?  We use SPY volume which seems a reasonably straightforward and consistent gauge.  Most important is what side is volume on, so to speak.  We look at an A/D Index calculated only on those days when volume is higher than the prior day.  In theory volume should rise on up days and fall on down days, and over the years this Index has been helpful.   This measure turned decisively higher at the end of May.  Meanwhile, have you noticed stocks rarely split anymore?  If every $200+ stock were to split, think what that would do for volume overall.

While the Fed meeting was a snooze, we are always interested in what Powell has to say.  In this case he repeated numerous times that any further raises in rates will depend on incoming data.  We find it fascinating that even we know monetary policy acts with a considerable lag, yet policy depends on the whimsy of some number du jour?  Still the market hangs on this stuff. Fortunately Fed speak doesn’t usually matter for more than a day, and “don’t fight the Fed” has been about as useful as “sell in May.”  The market tells the story and the average stock tells the market story.  Talk has centered on the Dow’s winning streak going into Thursday, but the streak in the A/D numbers has been just as good.  Tops occur when markets lose participation as the money runs out – little sign of that so far.  Despite the performance by Meta, many stocks reversed early on Thursday, including Microsoft.  With Thursday the market may be in need of a little more correction.

Frank D. Gretz

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DO EARNINGS AND INTEREST RATES STILL MATTER?

Contrary to many predictions at the beginning of the year, stocks have advanced nicely for the first half of 2023. While gains in the second quarter were still concentrated in large technology companies, market breadth broadened. On an equally weighted basis, the S&P 500 total return was 7% for the first half of the year.

Financial markets react not only to the level of economic data, but also to the direction and rate of change—and a lot has improved in the U.S. this year. To date, the percentage of people employed increased by 1% to an all-time high of 156 million, while unemployment hovers near the multi-decade low of 3.5%. With inflation falling, real disposable income increased 2.5% through May. Contributing to the current robust employment situation are many areas of the economy that are thriving, including fossil fuel production, new homes under construction, reshoring of manufacturing, and the beneficiaries of the $280B CHIPS Act and the $437B Inflation  Reduction Act.

There are risks this current economic strength could diminish. The U.S. Bureau of Labor Statistics reported 209,000 jobs were created in June, which fell short of estimates. More importantly, the rate of growth in private sector job creation continues to slow, reaching 159,000 in June. This figure has consistently slowed for the past 12 months. The U.S. labor market does not appear to have rolled over enough to remove concerns about wage inflation yet, and the Federal Reserve has forecast additional interest rate increases.  Price inflation likely peaked in mid-2022, however core inflation was still 4.8% on a year-over-year basis in June.

For these and other reasons, aggregate earnings expectations for both fiscal year 2023 and 2024 have been revised significantly lower since early 2022. The U.S. Treasury yield curve remains inverted, and the Conference Board’s Leading Economic Index has been in decline for 14 consecutive months, all while interest rates have been rising.

We believe the stock market is trading at one-year highs based upon the assumptions that there will only be a mild economic slowdown, a consistent drop in inflation, and the Fed will not hike rates more than expected. To extend the gains meaningfully from here, however, we think we will have to see interest rates falling, economic growth re-accelerating, or an increase in S&P 500 earnings estimates.  As to earnings and interest rates—both continue to matter.

July 2023

                                                                                                                                                

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