Economic data has been a tale of two cities in recent months. And after reviewing the latest survey releases, it is clear one could build a case for or against an economic recession in the coming months. However, those arguing that current data is much too strong for a recession should remember that recessions are rarely visible at their onset and are notoriously acknowledged only in hindsight by the National Bureau of Economic Research (NBER).

In terms of data, February’s ISM non-manufacturing index fell 0.1 to 55.1 but remained well above the 49.2 reading in December when it was signaling a decline in economic activity. Five of the nine components deteriorated in February, but business activity declined from 60.4 to 56.3 and accounted for most of the decline. The manufacturing survey was below the 50 benchmark for the fourth consecutive month, yet the components of the index were mixed. The main manufacturing index rose to 47.7, up a notch from January’s 47.4 reading, which was the lowest reading since May 2020. Manufacturing production fell from 48.0 to 47.3 and prices paid rose 6.8 points to 51.3. See page 3.

In the non-manufacturing survey, new orders rebounded from January’s 60.4 to 62.6. In the manufacturing survey, new orders also rose strongly from 42.5 to 47.9, however, the index remained below the 50 benchmark which is a sign of declining economic activity. Employment indices were also mixed. In the non-manufacturing survey, employment rose from 50.0 to 54.0 representing an expansion, while in the manufacturing survey employment fell from 50.6 to 49.1, representing a contraction. In general, both surveys displayed an erratic slowdown in employment during the October to December period. See page 4.

Inflation

Given the dramatic response of the equity and fixed income markets to Fed Chairman Jerome Powell’s testimony to Congress this week, it seems appropriate to repeat some of our historic charts on inflation and interest rates to see what history can disclose. In our view, a good deal of today’s statistics suggests a recession is ahead and possibly as soon as the second half of this year.

Over the last 80 years, whenever inflation has reached a standard deviation above the norm or greater — for the CPI this equates to a level of 6.5% or more – not one, but a series of recessions has followed. One could say it will be different this time, but we think that would be a high-risk judgment. From our perspective, the two negative quarters which appeared in early 2020 were the first, in what may become a series, of recessions. See page 5.

More importantly, monetary tightening cycles have rarely ended before the fed funds rate was at least 400 basis points above inflation, i.e., reaching a real fed funds yield of 4%. In other words, if inflation falls to 4% this year, a history of fed funds rate cycles suggests the fed funds rate should reach 8%. Clearly, this possibility has not been discounted by the market. But even if the current cycle is different and the economy is more interest rate sensitive than in prior cycles, we should still expect interest rates to move higher than 6% and stay high longer than expected. Unfortunately, this scenario is apt to end in a recession. See page 5.

On a happier note, debt levels in the financial, corporate, and household sectors are not as extreme as those seen in 2007 or at other economic peaks. From this standpoint, any future recession should be relatively mild.

Yield Curves

As already noted, Federal Reserve Chairman Powell’s hawkish testimony to Congress was a wake-up call for those believing interest rates were at or near a peak. And by the end of the trading session, as shorter-term yields soared, the closely watched inversion between yields in the two-year and 10-year Treasuries reached negative 103.1 basis points. It was the largest gap between short- and longer-term yields since September 1981. As a reminder, in September 1981 the economy was in the early months of a recession that would last until November 1982, becoming what was at that time the worst economic decline since the Great Depression. What history shows, and what is obvious in the charts on page 6, is that an inverted yield curve has always been followed by a recession. However, the lag time can be long. Equally important, recessions are always accompanied by an equity decline.

Valuation

Despite the fact that inflation has declined from the June 2022 peak of 9.1% YOY to January’s 6.4% YOY pace, inflation remains historically high. February data will be released on March 14, and it will be closely followed. In our opinion, investors are underestimating the impact inflation has on equity valuation. A simple way of defining the negative relationship between inflation and PE multiples is expressed by what we call the rule of 23, formerly known as the rule of 21. Historically, if the sum of the S&P’s PE multiple and inflation exceeds 23, the market is extremely overvalued. This typically results in lower stock prices and lower PE multiples. After this week’s sell-off, we estimate the trailing PE of the S&P 500 to be 20.2 and the forward PE to be 21.8. A more optimistic earnings estimate of $220 for this year could bring the 12-month forward PE to 18X, nevertheless, this combination of PE multiples and an optimistic assumption of 4% for the CPI, still places equities at the very top of the fair value range. See page 7. 

On page 8 we show the inputs to the Rule of 23 to demonstrate that PE multiples are well above average despite the fact that inflation is also above average. Historically, double-digit inflation has resulted in single-digit PE multiples. And though the June inflation high of 9% did not reach double digits, it was high enough to put pressure on high PE stocks and in time this should result in PE multiples closer to the long-term average of 15.8 times. See page 8.

The relationship between the S&P price index and earnings is not perfect, but earnings cycles typically lead price cycles. This has been particularly true since 1990 and since 2008 the 5-year rate of change in earnings and the S&P price have been strongly correlated. At present both trends are decelerating, which explains why the next few quarterly earnings reports could be market-moving events. We do not see anything on the horizon that could trigger an acceleration in earnings growth, on the other hand, the persistent rise in interest rates could certainly be a headwind to earnings growth. Last, but far from least, higher inflation means higher interest rates, and at present, the yields on both Treasury bills and notes are close to or higher than the earnings yield on the S&P 500. This makes fixed income an attractive alternative to stocks for the first time since 2000. See page 9. In sum, we remain defensive and would emphasize stocks that are both inflation and recession resistant and/or have attractive dividend yields.

Gail Dudack

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Last week was a busy time for economic releases and unfortunately, the data was not favorable for those looking for a Fed pivot. The middle of the week was dominated by the release of minutes from February’s FOMC meeting, and it revealed that a few participants favored a 50-basis point increase. All board members were in favor of continuing rate increases in order to reach their target of inflation of 2% but some members wanted to get to a restrictive stance more quickly. The minutes also disclosed that Fed officials felt wage growth of 3.5% YOY would be compatible with a 2% inflation target.

But Friday’s economic releases showed that personal income rose 6.4% YOY in January and disposable income rose 8.4% YOY. The big surprise, however, was that real personal disposable income rose 2.8% YOY in the month — the first gain in real personal disposable income since March 2021! January’s CPI was already reported to be 6.4% YOY, so this gain in personal income closed a 21-month gap between inflation and income growth. See page 3. The savings rate also ratcheted up from 4.5% to 4.7% in the first month of the year. This data was better than expected.

While personal income rose 6.4% YOY, personal consumption expenditures rose 7.9% YOY, up nicely from the 7.5% reported in December but down considerably from the stimulus-driven peak rate of 30% YOY in April 2021. However, current household consumption is coming at a price. The Federal Reserve’s Z.1 report for the third quarter of 2022 showed that debt as a percentage of disposable income rose to nearly 103%, the highest level recorded since the end of 2017. See page 4.

Household Debt on the Rise

According to the Federal Reserve of NY’s latest Quarterly Report on Household Debt and Credit, total household debt rose $394 billion, or 2.4%, to $16.9 trillion in the final quarter of 2022. The $394 billion growth in the fourth quarter represented the largest nominal quarterly increase in twenty years according to the FRBNY. The $16.9 trillion total at the end of 4Q 2022 represented a year-over-year gain of 8.5%, the highest pace of debt accumulation since the first quarter of 2008.

Still, credit card balances were the most worrisome segment of debt. Credit card balances rose by $61 billion, the largest increase in FRBNY data going back to 1999. For all of 2022, credit card debt surged by $130 billion, also the largest annual growth in balances. After two years of historically low delinquency rates, the share of debt transitioning into delinquency increased for nearly all debt types. See charts on page 5. Unfortunately, credit card delinquencies are rising the fastest among 18 to 29-year-olds as compared to all age categories. This may become an even greater problem as interest rates rise.

Mortgages and auto loans grew at a relatively moderate pace in the fourth quarter. Mortgage balances rose to $11.92 trillion; auto loans rose to $1.55 trillion, and student loan balances rose to $1.60 trillion.

All in all, the increase in credit card debt and other revolving forms of credit will be unsustainable in a rising interest rate environment and consumption is apt to slow later in the year. But generally, most of January’s data releases pointed to a surge in economic activity. For example, January included an increase in new home sales to 670,000 (SAAR), an 8.1% rise in the pending home sale index to 82.5, and an increase in the University of Michigan consumer sentiment index from 64.0 to 67 in February. This sentiment index was offset a bit by the Conference Board consumer confidence index, also for February, which slipped from 106.0 to 102.9. Nevertheless, the present condition component of the Conference Board survey increased from 151.1 to 152.8.

The Fed Problem

Last week’s final straw was the report on the Fed’s favorite inflation benchmark, the PCE deflator, which rose by 0.1% in January to 5.4%. This aligns with the CPI which had inflation picking up at the start of the year. The combination of good economic statistics and no significant slowdown in prices sent interest rates higher all along the yield curve. Conversely, stocks fell. The decline in equities is understandable. As we show on page 6, the gap between inflation and the fed funds rate has been narrowing, particularly versus the PCE deflator. But without a further slowdown in inflation, the prospects for higher interest rates will become open-ended. With an effective fed funds rate of 4.57% and the PCE deflator of 5.4%, this 100-basis point gap implies more than two 25-basis point hikes will be required in coming months. And if the Fed is serious about attaining a positive real fed funds rate, it could be even more.

The ISM manufacturing and service surveys will be released this week, but in general, there is little in terms of important economic reports until the February employment report scheduled for March 11. In the meantime, investors will continue to ponder earnings reports and the FOMC meeting on March 21-22, 2023.  

Technical Update

Last week we discussed the 2000 level in the Russell 2000 index and its importance. The RUT has been a leader in the recent advance and the 2000 level was the first significant level of resistance. In our view, the 2000 level would be an important test of the strength of the rally. Unfortunately, to date, this level has rebuffed the advance.

Now our attention shifts from the Russell 2000 to the S&P 500 and its confluence of moving averages, but in particular, the 200-day moving average at SPX 3940. This is an important level of support, and if broken, it could trigger further selling in our view. The SPX’s 200-day moving average currently sits between the 50-day moving average at 3,979.23 and the 100-day moving average at 3919.32, creating a significant range of support between SPX 3919 and 3979. If this range does not hold as support, we would expect the optimism that increased during the January rally will dissipate.

Summary As we noted a few weeks ago, the easy part of the rally may be behind us. Our view calls for a broad trading range until inflation is clearly under control. As seen by January’s data, this process could take another 12 to 18 months. Historically, the popular stock indices have spent 50% of the time in flat trends, so this is not unusual. We expect the broad indices will be contained between the January 3, 2022 SPX high of 4796.56 and the October 12, 2022 low of SPX 3577.03. If we are correct about a trading range market, leadership may rotate throughout the year. But note, while “flat” cycles are unable to sustain an advance above the previous market peak, they can include several bull and bear market moves of 20% or more. In short, the days of a “buy and hold” strategy may have ended for a while. Core holdings in portfolios should include inflation and recession resistant companies and stocks with attractive dividend yields and predictable earnings growth.

Gail Dudack

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Last week we pointed out that the 2000 resistance level in the Russell 2000 index (“Russell 2000 at 2000” February 15, 2023) could be pivotal for the near term. Similar to the less delineated DJIA 34,000 level, the RUT’s 2000 resistance level presented the first real challenge for the advance initiated from the October 2022 low.

The market also revealed signs of exhaustion with daily NYSE volume falling consistently below the 10-day average and sentiment indicators reaching short-term extremes. The AAII bull/bear sentiment indicator had a sizeable 7.6% jump in bullishness to 37.5%, the highest level in over a year. Bearishness fell 9.6% to 25%, its lowest level since November 2021. It was too much, too soon in terms of a sentiment switch. Not surprisingly, in this week’s first session, the Dow Jones Industrial Average fell 697.1 points, or 2.06%, to 33,129.59, and wiped out its year-to-date gains. The S&P 500 lost 81.75 points, or 2.00%, to 3,997.34; the Nasdaq Composite dropped 294.97 points, or 2.5%, to 11,492.30; and the Russell 2000 fell 58.14 points, or 2.99%, to 1888.21. These indices shaved previous gains but remained positive for the year.

There were numerous reasons for the market sell-off, but the main catalysts have not changed: concerns about earnings growth, the risk of more-than-expected Fed rate hikes and worries of an escalation of the Russia/Ukraine conflict. As the fourth quarter earnings season draws to a close, it is the results of retail companies that now come into focus. To date, these results have been less than stellar. More importantly, forward guidance has been sobering as corporate leaders warn of an earnings slowdown.

Earnings Growth

On page 15 we display our quarterly and annual forecasts for S&P 500 earnings as well as those from S&P Dow Jones and IBES. It is worth noting that the S&P Dow Jones 2022 earnings estimate for 2022 is currently $196.31 and for 2023 it is $220.16. As recently as July 22, 2022, the 2022 estimate was $220.70, or higher than the current 2023 estimate. IBES currently estimates this year’s earnings to be $222.85, but as recently as October 7, 2022, it showed a consensus estimate for last year’s earnings of $223.34. In sum, earnings estimates are coming down, but the question is how much further might they fall? This is a difficult question since economic signs are mixed and to a large degree, confusing.

More Fed rate hikes

There are some worrisome signs for the economy. The Conference Board Leading Economic Index slipped 0.3% in January to 110.3 and represents the 11th consecutive monthly decline in the LEI. A long steady decline in the leading indicators has been a good predictor of a recession in previous cycles.

On the other hand, the latest S&P global flash PMI composites are telling a different story. The January US PMI Composite index rose from 46.8 to 50.2 to an 8-month high, led by strength in the service sector. The rise above 50 indicates an economic shift from contraction to modest expansion in the PMI indices. February’s Eurozone flash PMI rose for the fourth consecutive month to 52.3, indicating the strongest business activity since May 2022. The UK flash PMI for February also rose sharply from 48.5 to 53.0, registering the strongest expansion since June 2022. All in all, these flash economic surveys depict a rebound in economic activity in both the US and Europe.

An improvement in economic activity is usually good news, but when it is coupled with recent inflation data, it is a recipe for further Fed rate hikes, and this is upsetting for those who were expecting another “one and done” rate hike in March. It has been our view that the Fed would have to raise rates higher and keep them there longer than the consensus was expecting.

In January, the CPI rose 6.35% YOY, down fractionally from the 6.44% YOY rise in December, yet a major improvement from the 9.1% YOY seen in June 2022. Still, prices are not falling as quickly as some had hoped. The PPI for finished goods rose 8.7% in January, down only 0.2% from the 8.9% reported in December. Wages rose a healthy 5.4% YOY in January but after adjusting for inflation, household purchasing power declined 1% YOY in January. We have been concerned about the disparity between inflation and wage growth for the last year. The spread is narrowing but it has not closed, and the consumer remains under pressure. See page 3.

Nevertheless, households continue to spend. Total retail & food services sales rose 6.4% YOY in January, and sales excluding motor vehicles and parts, rose 7.3% YOY. However, when nominal retail sales are adjusted for inflation, real retail sales only grew 0.2%. This is down from 1.1% in December, but up from the 1% decline seen in November. See page 4. Total vehicle unit sales rebounded strongly from December’s 13.9 million (SAAR) to 16.2 million in January, and this makes the 7.3% YOY rise in January’s retail sales excluding autos, and 7.4% rise in sales excluding autos and gas stations, even more impressive. The 25.2% increase in food services and drinking places was noteworthy. See page 5.

However, this spending comes at a cost. The latest Quarterly Report on Household Debt and Credit from the New York Federal Reserve showed total debt balances grew by $394 billion in the fourth quarter of 2022, the largest nominal quarterly increase in twenty years. The increase in credit card balances between December of 2021 and December of 2022 was $130 billion, the largest annual growth in balances seen in the data history which began in 1999.

In terms of debt and mortgages, housing remains in a slump. December’s new home sales totaled 616,000 annualized units, down nearly 27% YOY. Existing home sales fell to 4 million units in January, a decline of nearly 37% from a year earlier. See page 6. The NAR housing affordability index improved from 94.3 in November to 101.2 in December, yet it remains at one of the lowest readings since 1986. This is not favorable. Nonetheless, in February, the NAHB housing index reflected a bit more optimism about the next six months and rebounded from the year-end 2022 cyclical lows. See page 7. 

Summary

Our view has not changed. We expect a trading range market until inflation is clearly under control, a process that is apt to take another 12 to 18 months. In terms of the indices, we anticipate a 12-to-18-month range as high as the January 3, 2022 peak of SPX 4796.56 and the October 12, 2022 low of SPX 3577.03. The February overbought reading in our 25-day up/down volume oscillator is in line with this forecast. To date, the rally has been led by large-cap technology stocks, but we do not believe technology as characterized by FAANG stocks, will be the leadership of the next bull market cycle. Typically, a long-term trading range market will see leadership rotate throughout the year.

Keep in mind that the popular stock indices have a history of spending 50% of the time in flat trends. These trends are not boring; they can include several bull and bear market moves of 20% or more. However, these cycles are defined as “flat” since market rallies are unable to sustain an advance above the previous market peak. In short, the days of “buy and hold” may have ended for a while.

Gail Dudack

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Technical Indicators in the Spotlight

The easy part of the 2023 rally may now be behind us. We are concerned that daily volume on the NYSE has been consistently lower than the 10-day average for seven consecutive trading sessions. It is a sign of fading demand. More importantly, the Russell 2000 index, which was an excellent leading indicator at the 2021 peak and has been a decent leader at the October low, is now facing stiff resistance at the 2,000 level. The Russell index has the most attractive technical pattern of all the major indices and if it can better the 2000 level, the Russell could rally another 10%. However, in our view, it is more likely that the equity market is extended, a consolidation process has begun, and part of this process could include a retest of the lows. See page 10.

Another warning sign is found in the American Association of Individual Investors (AAII) survey which had some surprising shifts last week. The AAII readings showed a 7.6% increase in bullishness to 37.5%, its highest bullish reading in over a year. It is also the first time in 58 weeks that bullish sentiment is at or above its historical average of 37.5%.

Investors who indicated they were neutral, neither bullish nor bearish, rose 2% to 37.5%, and were also at the highest level in over a year. Conversely, a huge 9.6% decrease in bearishness took the bullish ratio to 25.0%, its lowest reading since November 11, 2021, or 15 months ago. Bearishness is now below its long-term average of 31.0%. The Bull/Bear Spread remains positive but it is moving toward neutral for the first time since January 2022. Sentiment readings were most extreme on September 21, 2022, and equity prices tend to be higher in the next six and/or twelve months following such extreme readings. Nevertheless, last week’s readings are a display of too much optimism appearing too quickly and it is a negative omen for the near term. See page 13.

Some technical indicators continue to be positive. The 10-day average of daily new highs is 130 and new lows are 26. This combination remains positive since new highs are above the 100 benchmark that defines the trend, and new lows are well below 100. The NYSE advance/decline line is currently 28,517 net advancing issues from its November 8, 2021 high, which is further away than it was a week ago. In general, the AD line is negative, but it has been improving since the end of the year. See page 12.

Inflation, the Fed, and PE multiples

January’s CPI data, on a non-seasonally adjusted basis, showed prices rising 6.4% YOY versus the 6.5% YOY reported for December. Core CPI rose 5.6% versus 5.7% a month earlier. This was slightly worse than the consensus expected, but not bad enough to change the outlook for Fed policy. Inflation is slowing, but at a slower pace than some had expected. The energy component of CPI rose 8.7% YOY in January versus 7.3% YOY in December, which was a surprise because the price of the WTI future fell 10.5% YOY in January versus a 6.7% YOY gain in December. The good news is that the energy component of the CPI remains well below the peak of 41.6% YOY seen in June 2022. See page 3.

Many inflation watchers like to exclude the owner’s equivalent rent component from the CPI to moderate inflation, however, the OER has been a part of the CPI for decades and without controversy prior to this cycle. What is interesting to us is that when we compare the OER and the fed funds rate, it is clear that the Fed had been far more aggressive in terms of fighting inflation in the past. The Fed typically increased rates ahead of any significant rise in the OER, or at the first sign of inflation. Today, the Fed remains well behind the curve and behind the rise in the OER. More importantly, housing is not the problem for the Fed since interest rates have had, and will continue to have, a significant impact on mortgage rates, housing demand and housing inflation. The problem has switched to the service sector where inflation is rising broadly. In January, service sector inflation rose from 7.5% to 7.6%. See page 4. All told, inflation may be more entrenched than previously thought and the Fed will need to keep interest rates higher for longer than many expect.

Lowering inflation is critical for many reasons, but in terms of equity valuation, high inflation usually translates into lower PE multiples. The current trailing PE for the S&P 500 of 20.9 times and the forward PE is 22.3 times based upon our 2023 estimate of $180, or 18.8 times based upon the current S&P Dow Jones estimate of $220.31. All of these PE multiples are extremely high with inflation over 6% YOY. The risk in the market is that equity valuations can only be supported if inflation is 2%. Unfortunately, that is unlikely to materialize this year. In other words, breadth has improved on this rally, but valuation has not.

Sentiment

There was a small increase in the University of Michigan consumer sentiment survey for February and it was due entirely to the present conditions component, which rose 4.2 points to 72.6. Ironically, the present conditions index is now more than 10 points above the expectations index. More confusing is the fact that this is in complete contrast to December’s detailed survey on personal finances, where personal finances were falling throughout 2022, but expectations rose in the final months of the year. The University of Michigan consumer sentiment is a timelier survey, so hopefully, this improvement in present conditions will be sustained.  See page 5.

The NFIB small business optimism index rose 0.5 points to 90.3 in January but remained below the long-term average of 98 for the 13th consecutive month. Eight subcategories improved this month and five deteriorated. However, even though the outlook for business conditions rose from -51 to -45, it lingers well below the zero line, although 16 points above its June 2022 low of -61. See page 6. Plans to increase capital expenditures or inventories declined in January while plans to increase employment and expand rose modestly. Small businesses were gloomier about the prospect of real sales increasing even though plans to raise prices also rose in January. See page 7. There were small increases in actual sales and earnings in January which may have contributed to the rise in the uncertainty index to 76, up 5 points for the month and up from the June 2022 low of 55. See page 8.

Summary We expect the equity market will remain in a broad trading range until inflation is clearly under control, a process that is apt to take another 12 to 18 months. In the interim, we expect the broad indices will be contained between the January 3, 2022 SPX high of 4796.56 and the October 12, 2022 low of SPX 3577.03. The improvement in our 25-day up/down volume oscillator is in line with this forecast. To date, the rally has been led by large-cap technology stocks which we do not believe will be the leadership of the next bull market cycle. Technology stocks had been at the center of heavy short selling, and it is likely that short covering contributed to the current advance. If we are correct about a trading range market, leadership may rotate throughout the year. Keep in mind that historically, the popular stock indices have spent 50% of the time in flat trends. Flat trends can include several bull and bear market moves of 20% or more, but we define them as “flat” since rallies are unable to sustain an advance above the previous market peak. In short, the days of “buy and hold” may have ended for a while.

Gail Dudack

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There were a number of developments in economic, fundamental, and technical data over the last week, but the most significant change was technical and the performance of our 25-day up/down volume oscillator. In our last strategy report, we indicated that it would be important to monitor this indicator because it could be close to making a positive shift. That is what it did this week. The oscillator has now been in overbought territory for ten consecutive trading sessions. Ten is an important number because bear markets rarely have rallies that can sustain an overbought reading for five to ten days. The initial advance in a bull market will have an extended overbought reading and it usually includes an extreme reading of 5.0 or greater. Currently, the oscillator has been as high as 4.81 but it has not exceeded the 5.0 reading generally seen at the start of a new bull cycle. Nonetheless, this long overbought reading is a positive change in this indicator. See page 12.

And there are other positives in the technical arena. The 10-day average of daily new highs has been over 100 for the last week and the 10-day average of daily new lows has been below 30. This combination is bullish since 100 or more defines the trend. The current rally also carried the popular indices above their 200-day moving averages, including the lagging Nasdaq Composite Index. And as we noted recently, the Russell 2000 has an attractive technical chart after bettering the 1900 resistance level. The move above this resistance price is a good near-term sign for small cap stocks and the market overall. However, the 2200 level in the RUT represents significant resistance for the advance which means, the current advance may be a good trading opportunity, but investors should be cautious. 

Our longer-term view is that the market is apt to remain in a broad trading range until inflation is clearly under control. We believe this will take another 12 to 18 months. But in the interim, we expect a broad trading range to contain stock prices with the January 3, 2022 SPX high of 4796.56 as a ceiling and the October 12, 2022 low of SPX 3577.03 as a probable floor. This signal from our 25-day up/down volume oscillator is in line with this forecast. And even though this is a better outcome than we expected earlier this year, we would not chase the current rally. Much of the shift is taking place in large capitalization technology stocks which we do not believe will be the leadership of the next bull market cycle. Technology stocks have been at the center of heavy short selling, and it is likely that short covering is contributing to the current advance.

Nonetheless, the technical improvement seen in recent sessions implies that the underlying bear cycle is diminished, and a neutral range is ahead. We reviewed our concept of a flat market trend last week (“Reviewing Flat Trends” February 1, 2023) and showed that historically, the popular stock indices have spent 50% of the time in flat trends. Flat trends can include several bull and bear market moves of 20% or more, but we define them as “flat” since rallies are unable to sustain an advance above the previous market peak. Note that flat cycles tend to be linked to periods of inflation or deflation. In our opinion, this is why it is critical that the Fed deal firmly with the current inflation cycle. History shows that inflation is difficult to control once it exceeds 7% YOY and it has only been resolved with a series of recessions. We believe the Fed understands this issue and is attempting to be a slow and steady force to undermine inflation without igniting a recession. It will not be easy.

Fundamentals/Earnings

As we expected, fourth quarter earnings season is tempering expectations for 2023 earnings. Last week the S&P Dow Jones earnings forecast for 2023 fell $2.62 and the Refinitiv IBES consensus earnings forecast fell $1.70. This brought the consensus 2023 full year estimates to $219.29 and $224.31, respectively. What is interesting in our view is that these 2023 estimates now match the estimates analysts had for last year’s earnings back in May 2022. See page 10.

Economics

Some economic data releases also suggest corporate margins may be under severe pressure this year. Labor productivity fell 1.3% in 2022. This followed a 2.4% increase in 2021 and a 4.4% rise in 2020. Keep in mind that falling productivity often means a rising cost of labor. Total labor compensation costs rose by 5.1% YOY in June 2022, the highest pace since June 1990. And the compensation cost index remained consistently high at 5.1% YOY at year end. Labor costs increased across the board, for both wages and benefits. See page 6. What may keep the Fed awake at night is the fact that while inflation peaked at 9.1% in June of 2022, the employment cost indices have not declined, and they remain high for both private and government workers. This will have two negative impacts: it will encourage the Fed to keep interest rates high long enough to reduce this trend and, in the interim, it will erode corporate profits. See page 7.

Total nonfarm payroll employment rose a surprisingly large 517,000 in January, and the unemployment rate was slightly lower at 3.4%. Job growth was widespread, but it was led by gains in leisure and hospitality, professional and business services, and health care. However, there were a number of reasons to not place too much emphasis on this report.

As seen on page 3, the seasonally adjusted payroll employment rose to a new cyclical high, whereas the not-seasonally-adjusted employment number fell well below the high recorded in November 2022. Nevertheless, there were underlying reasons for the inconsistencies in January’s release. The BLS introduced its annual revision of the establishment survey in January. This is a once-a-year re-anchoring, based on March 2022 data, of employment estimates from the unemployment insurance (UI) tax records filed by nearly all employers with State Workforce Agencies. As a result of the adjusted estimate for March 2022, total nonfarm employment had an upward revision of 568,000 or 0.4%. The not-seasonally adjusted total nonfarm employment estimate was revised by 506,000, or 0.3%. Over the prior 10 years, these benchmark revisions have averaged 0.1%, with a range from −0.3% to 0.3%. In short, this was a very large revision that “technically” erased January’s outsized job gain.

The household survey also had an annual update to total civil noninstitutional population based upon revised Census data. This impacted the participation rate and the employment population ratio modestly. Lastly, there were changes to the North American Industry Classification System (NAICS) which resulted in some work categories being delisted and others added. These changes are typical of most January reports, but this year the revisions were larger than normal. See page 4.   The ISM surveys will be important to monitor in coming months. In the December reports, the weakness seen in the manufacturing sector appeared to be spreading and the service sector fell below 50, reflecting a contraction. But in January, a rebound in the ISM nonmanufacturing index reversed most of December’s weakness. The recovery in the service sector could be significant and has the potential of boosting economic activity, perhaps even in manufacturing. In sum, it is worth monitoring the ISM indices in the months ahead. The rate of change in the manufacturing index has been highly correlated with the rate of change in the S&P Composite. It could be pivotal. See page 9.  

Gail Dudack

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The month of January ended with a gain of 2.8% in the Dow Jones Industrial Average and a 6.2% gain in the S&P 500 Composite. See pages 3 and 4. This was the 25^th best January in the DJIA and the ninth best January for the SPX. January’s performance has been significant over the decades, and since 1950, a gain in the DJIA has correctly predicted an annual gain 89% of the time. In the SPX, a January gain has resulted in an annual gain slightly less than 79% of the time.

Technicals Improve

And at the same time, the January rally has generated several improvements in our technical indicators. The biggest change is the improvement in the 25-day up/down volume oscillator. It is currently showing an overbought reading of 4.49, and more importantly, has been overbought for five consecutive trading sessions. In addition, the month of January ended with a strong 90% up-volume day. This is an upgrade from the overbought reading recorded in November, off the October low. That reading was not sustained. The current reading needs to remain overbought for another week to be truly convincing, however, bear markets rarely reach overbought territory, and if they do, the reading is typically brief. An overbought reading that persists for at least five to ten consecutive trading days – and reaches a new overbought high reading — is significant and is an indication of a shift from bearish to positive, or at least from bearish to neutral. This week will be pivotal for this indicator. See page 14.

As a result of this broadening rally, all the popular indices are presently trading above their 200-day moving averages, including the Nasdaq Composite. This is another solid improvement in the technical arena. And as we noted last week, the Russell 2000 has an attractive technical chart, having bettered the 1900 resistance level, which is a good near-term sign for small cap stocks and the market overall. See page 13.

Flat versus Trending Markets

Given the strength of the January rally we believe this is a good time to review the long secular outlook for equities in order to put the current advance into a broader perspective. First, it is important to remember that a study of historical stock performance shows that equities spend only half their time in a persistent “trending market” i.e., a bull market with modest intervening corrections of 10% or more. When stocks are in a trending market a “buy and hold” strategy is beneficial and profitable. And in most trending cycles the economic backdrop is favorable for most industries and corporate profitability is good. In sum, it is an environment that “lifts all boats.”

However, the other 50% of the time the equity market and the economic backdrop are not as favorable. Usually this is due to the impact and/or aftermath of either inflation or deflation; as a result, the market vacillates in what we call “flat trends.” These flat trends can include several bull and bear markets that rise and fall of 20% or more, but the key distinction is that the benchmark indices usually fail to sustain an advance that moves higher than the previous peak. In short, the market tends to have a ceiling price near the peak of the previous bull market. We believe the inflationary cycle we are currently experiencing is the catalyst for such a market. What is important is that this means a “buy and hold” strategy will be less profitable and instead, investors should be alert to unique buying and selling opportunities when they arise. In most cases, the stock market is driven by a rotation of leadership among industries, value and/or growth at a reasonable price tend to be solid strategies, and taking profits and reinvestment becomes a preferable tactic over “buy and hold”. Also note that history shows that these flat trends tend to last for more than a decade. See page 5.

Another way to analyze the stock market’s “flat trend” phenomenon is to monitor the 10-year compound annual growth rate in the S&P 500. We do this on both a simple price basis and on a total-return basis. As we have pointed out in recent years, it is unusual for the S&P’s 10-year compound annual growth rate to exceed 13%; and when it has reached this level it typically presages a major decline is on the horizon. The 13% level was reached at the end of 2021. See page 6.

Conversely, whenever the 10-year compound annual growth rate approaches or falls below zero, it has been an good signal of an excellent long-term buying opportunity. The growth rate declined to 8.3% as of the end of January, but this is not a level that defines a major buying opportunity. Nevertheless, we do not expect “zero” to materialize for a long while, but we do expect there will be several bull and bear market cycles before the growth rate ever approaches zero.

In sum, we would not anticipate an equity rally will sustain an advance bettering the SPX high of 4796.56 made on January 3, 2022 for several years.

Fed and Economics

The preliminary estimate for fourth quarter GDP was 2.9% which was much better than the consensus view and it followed the 3.2% growth rate generated in the third quarter. Fixed residential investment declined 9.2% in the quarter and it is highly unusual for residential investment to decline this much without the overall economy being in a recession. We are not sure if this is good or bad news, but since we expect the Fed to raise rates at least two more times this year, housing will likely drag economic activity lower in coming months. See page 7.

In December, personal income rose 4.7% YOY, disposable personal income rose 3.2% YOY, yet real personal disposable income fell 1.7% YOY. Still, this was an improvement from July 2022 when real personal disposable income fell 5% YOY, and purchasing power was seriously eroding. However, inflation is taking a toll on consumption, which fell 0.2% in December after falling 0.1% in November. And though the pace of PCE has been decelerating in recent months, it was still rising 7.3% YOY in November and December. The question is how strong or weak will PCE be in 2023? See page 8.

There were clear signs that inflation was decelerating in December. The CPI fell from 7.1% YOY to 6.4% and core CPI declined from 6.0% YOY to 5.7%. Inputs to the CPI are also slowing. PPI for finished goods eased from 10.7% YOY to 9.0%, core PPI was modestly lower from 8.0% to 7.89%, and final demand PPI fell from 7.3% YOY to 6.2%. Equities appear to be celebrating this deceleration in inflation, but remember, these inflation rates remain multiples higher than the Fed’s target of 2% inflation. See page 9. The Federal Reserve’s preferred measure for inflation is the PCE deflator and that eased from 5.5% YOY to 5% YOY in December. Even so, this means the PCE deflator remains 70 basis points above the current fed funds rate. In short, there is plenty of incentive for the Fed to increase interest rates 25 basis points at this week’s meeting and another 25 basis points at the next meeting that ends on March 22. See page 10. We expect the Fed’s statement will be hawkish this week, as it should be. Inflation is not as easy to reverse as many investors appear to believe, and though the current rally could have further upside, we would remain focused on maintaining a portfolio tilted toward value.

Gail Dudack

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