DJIA: 34,823 From worst … to first. That was the pattern Monday and Tuesday. The 700 point Dow loss on Monday made the headlines, but as always we are more about the average stock than the stock averages. Monday’s bashing saw Advance-Declines 5-to-1 down, and up volume less than 15%. This, of course, cannot be called a complete surprise. The A/D numbers had flattened recently, negatively diverging from the averages like the Dow. The S&P was making new highs with fewer than 40% of components there above their own 50 day average. On the NASDAQ, a new high with more 12 month new lows was another warning. This deterioration simply caught up with the market on Monday. Monday did see a spike in Put/Call ratios and the S&P did hold its own 50 day average. Then pretty much out of the blue came Tuesday’s rally. It was not your dead cat bounce. The Advance-Declines cycled to 4.5-to-1up and up volume was greater than 85%. Since 1962, this kind of reversal has led to higher prices a month later every time, according to SentimenTrader.com. Covid seemed to catch the blame for Monday’s selloff, though we easily could have blamed China. Covid isn’t new, why was it important Monday? That’s just the way the market works – news follows price. The selloff was about the technical deterioration, specifically those A/D numbers. It’s important to look at them in conjunction with the averages. If the Dow is down 200 points the A/D’s will be negative, and they should be. If the Dow is up 200 points and the A/D’s are flat, let alone negative, that’s a problem – Thursday was that kind of negative day. As we pointed out last time, the performance of the “average stock” has been the best feature of the technical background, and now that seems to have changed. This also shows up in the Equal Weight S&P which has gone nowhere since early May, and the Russell 2000, a measure of small caps, which has gone nowhere since mid-March. Both are concerns, but alone are not uptrend killers. Rightly or wrongly, the Dow Theory doesn’t get much attention these days. Wrongly, because over time it has been quite often accurate. Rightly, because in recent years, not so much. The concept is sound enough – if you’re making the stuff you should be shipping the stuff. The transports should confirm the industrials. These days, of course, the Industrials are as much financials and the Transports have their airlines. And while the concept is simple enough, the nuances of the theory are a bit more complex. In any event, what seems important is that the transports peaked in early May, pretty much when the reflation trade peaked. If not a good indicator of market direction, they have seemed a good indicator of leadership, broadly speaking. Looking at the 20 component stocks, it’s a stretch to find a good chart. That’s even true of the truckers, which should come as a surprise if you have driven the Northeast Corridor lately. Breaking the downtrend here might suggest a move back to that reflation trade. The rotation, meanwhile, has become seemingly daily. Some of this, of course, is Covid related. The recent better action in Procter & Gamble (138) is a reminder of those bad old days. Most of the other staples aren’t on a par here, though Coke (56) and Pepsi (155) both have had upside breakouts. Seasonally it’s a good time for staples generally. Yet to get going are stocks like Zoom Video (361) and Teledoc (152) – guess they’re just not Domino’s (544). The industrials have had a tough go of it, but have come through so far more neutral than negative – see for example, XLI (103). It’s the metals and energy stocks that have taking the biggest hit. Together with bonds, a seeming telling commentary on inflation. Somewhat contradictory, economically sensitive real estate has done quite well. All hail the 50 day! Where would we be without it? That’s easy – lower. We are referring to the S&P and its 50 day moving average, though most apply it to individual stocks as well. Including a few minor dips below it, the S&P has bounced off its 50 day 13 times in the past year. It’s enough to make you wonder – could there be more chart guys than funnymental guys? You have to pay attention if only because most do. It’s with rare exception that we buy or hold a stock below its 50 day. Everyone likes to talk about the 200 day, but in an uptrend like this, by the time you get to the 200 day you have given up, or lost a lot of money. That said, the 200 day is important. It’s important in that it’s your last chance to remain solvent. The S&P remains some 11% above its 200 day, versus an average 13% in this year‘s first six months. Perhaps more importantly, the 50 day is some 8% above the 200 day. All the money is made against this backdrop – the 50 day above the 200 day. Frank D. Gretz
Author: Andrea
US Strategy Weekly: Volatility
The Dow Jones Industrial Average rose 549.95 points, or 1.62% on Tuesday after falling 725.81 points, or 2.1%, on Monday. This surge in volatility drove the VIX index (VIX – $19.73) over 25 earlier this week which was a concern to many investors, perhaps because many call the VIX the “fear index.” We are not surprised if the level of fear is increasing among investors given the spread of the Delta virus, the rich level of equity valuations and the potential of a change in monetary policy. However, the VIX is not a good short-term indicator in our opinion. It is actually most useful at the end of a bear market when fear is at its highest. VIX readings between 45 and 85 have marked recent bear market lows. This being true, a high VIX reading, particularly above 80, can denote a buying opportunity. See page 6. In comparison the recent readings of 25 are mild and are not a worry. Keep in mind that fear is emotional and often unpredictable, and this may be the message in the VIX’s rise – more volatility ahead. It has been our view that the second half of 2021 will be more volatile and is likely to include a correction of 10% or more.
In terms of technical indicators, we are more concerned about breadth data and specifically volume in advancing stocks. The last time the 25-day up/down volume oscillator showed strong and consistent buying pressure was when it recorded a single day in overbought territory on April 29. Prior to that there was a modest five consecutive trading days in overbought territory between February 4 and February 10. The February readings were a confirmation of the record highs made at that time. But since mid-February, there has not been any volume confirmation of recent highs. Currently, the 25-day up/down volume oscillator is at negative 2.19 after recording a negative 3.49 reading earlier this week. Monday’s drop to negative 3.49 was the first oversold reading since March-April 2020, or during the depths of the global pandemic.
In short, since early February, our 25-day up down volume oscillator has been showing us that as the indices were moving to new record highs, volume in advancing stocks was declining and volume in declining stocks was increasing. This is a sign of waning demand and/or investors selling into strength. The longer this non-confirmation of new highs continues, the greater the downside risk to the broader market. From this perspective, the recent selloff was expected and should be considered healthy.
Nevertheless, after any brief oversold reading, a bull market should rise to new highs and have an accompanying overbought reading. This demonstrates solid buying pressure. If not, and if a rally fails to generate a new overbought reading, it would be a signal that the major trend is weakening or changing. If a subsequent decline in the indices generates a second oversold reading without an intervening overbought reading, it would indicate that the major cycle has shifted from bullish to bearish. In sum, these are the scenarios that concern us. These are the patterns we will be monitoring in coming weeks.
In June, major inflation benchmarks were rising at hefty year-over-year rates: CPI 5.3%, PPI 9.4%, GDP deflator 2.0% (March), import prices index 11.2%, and import prices excluding petroleum 6.8%. And core benchmarks were CPI 4.5%, PPI 3.6%, and core PCE deflator 3.4%. In short, inflation is widespread, and as high, or higher, than it was in 2008 and it is not apt to end soon. This pressures current monetary policy.
Plus, easy monetary policy tends to fuel inflation and the real fed funds rate is already at an all-time low. Most importantly, stock prices have not performed well during periods of high inflation. In fact, the chart on page 3 shows that high inflation and stocks prices tend to be inversely correlated. Also noticeable in this chart is that high inflation tends to precede recessions. All in all, it is not surprising that fear is rising.
Gail Dudack
All good things must end…the odds are
DJIA: 34,987
All good things must end … the odds are. The good thing in this case is the pattern in the S&P. The index has spent the entire first half above its 200 day, by an average of some 13%. This has happened only 34 times since 1929, according to Bank of America’s Steven Suttmeier. The problem is only 13 times did the pattern continue through the second half. The odds, of course, are often to be defied. It is a concern, though, that only about 60% of S&P stocks are above their 50 day average, indicating weakness short-term versus the longer-term strength. This becomes even more worrisome against the backdrop of new highs in the index itself. Another little divergence comes in the form of the Equal Weight S&P, which has gone nowhere since early to mid-May. None of this is reason to sell everything, but together it’s beginning to add up to an increased likelihood of a correction.
The divergence that most concerns us is one which has developed between the Dow and the Advance-Decline index. What’s going on in the “average stock” as measured by the A/D index, we consider of greater importance than what’s going on in the stock averages. The A/D index recently failed to match the highs in the averages. Granted this is very short term stuff, and last Friday’s 3-to-1 up day wasn’t exactly the feel of a divergence. Still, the divergence is there, and what seems important is the change. The A/D‘s had been outperforming the averages, now they’re lagging. It is relatively minor – a strong, broad rally would resolve the problem. Then, too, back in October 2000 it took only three days of this kind of action to lead to a 20% correction. There also are concerns about the NASDAQ, despite growth’s clear revival. Last week’s new high saw only 31% of stocks advance, and more twelve-month new lows than new highs. That’s a pretty thin new high, and worrisome.
Whatever happened to the rebounding post pandemic recovery? Since the beginning of last month bonds have rallied and the yield curve flattened, suggesting little inflation and a less robust economy. For stocks, value has outperformed growth for the year to date, but concerns about that trade have come to the fore. Clear examples are the airlines, hotels, resorts and cruise lines. All were hit by the pandemic and sold off sharply last year, but rebounded strongly in February. Since then they have seriously lagged the S&P. Meanwhile, growth stocks, bought when growth is thought to be scarce, have performed well compared to value. Whether correctly or not, concerns about the economy and, therefore, about the reopening trade now seem to dominate the thinking. Time will tell, to coin a phrase, but there’s reason not to give up on the value/reflation trade. Over the last month or so the ratio of value to growth stocks has plunged. The drop, however, is in the context of a long-term trend. Previous drops have tended to resolve in the direction of that trend.
The background worries seem obvious – the economy, inflation, cyber and Covid. These we all know. What always seems to cause the problems, we’ve noticed, are the worries we don’t know or we know but don’t consider worries. We’re thinking here of China. Recent headlines have been full of China’s latest clampdowns on companies and their listings, its growing attempt to eradicate bitcoin and the hassles for Tesla (651). The impact on stocks like BABA (215) and the others has been noticeable, not to mention the recently listed DiDi (12). To look at both manufacturing and services data, one could conclude China’s rebound is over. As the country that led the US, Europe and the rest of the world into the Covid-related slow down and out of it, and as the driver of much of the world’s growth, this is not good news. Technical patterns there, of course, have turned very weak.
It has been a good market, but not always good when it comes to making money. Many hedge funds, for example, have had a tough start to the year. From the Wall Street Journal, “Morgan Stanley and Goldman Sachs showed that fundamental stock-picking hedge funds posted negative alpha – trader talk for poor performance – in the first half of the year. Part of the challenge for professional stock-pickers is that markets have been heavily rotational, several hedge funds said. Markets this year have whipped back and forth between growth stocks and value stocks, making it difficult for managers to find winning trades.” For now growth seems to hold the upper hand – see, for example, the SPDR ETF (XLK – 152) where Apple (148) and Microsoft (281) dominate. And the recent breakouts in Amazon (3631) and Google (2540) are impressive. In market corrections, however, it’s rare they don’t get to everything. Meanwhile, bubbles are coming undone – the SPACS, Bitcoin, AMC (36).
Frank D. Gretz
Welcome the Bump in the Road
The S&P 500 and the Wilshire 5000 both rose to record highs at the end of June capping a wonderful first six months of 2021 for equity investors. Most broad market indices had year-to-date advances of 14%, which for most calendar years would be considered a terrific performance. One historical tidbit suggests that solid gains in the first half of the year tend to be followed by further advances in the second half, so there is reason to be optimistic for the intermediate term. But more importantly, the main characteristic of the 2021 stock market to date was the shift away from the perennial leadership of technology and growth stocks and to a range of stocks that can best be described as inflation driven. Sectors such as energy, REITs, materials, industrials, and financials outperformed the S&P Composite by a wide margin in the first six months of the year. And given the outlook for inflation, this performance may continue in the second half.
More Inflation Ahead
Some of this leadership shift was due to the belief that the global economy is conquering the spread of COVID-19 and the new Delta virus, which suggests that most trade and business activities will soon return to normal. To a large extent, this has encouraged investors to invest in economically sensitive, or cyclical stocks. However, a more significant driver of this leadership shift was a ubiquitous rise in prices. Soaring costs for energy, lumber, semiconductors, and a variety of raw materials are expected to be transient according to the Federal Reserve. But in our view, the dislocations from production and shipping that developed during the shutdown in 2020 will take quite a while to return to their typical standard. Energy prices are rising from a combination of green energy policies imposed by governments globally, a breakdown in OPEC discussions and a simultaneous rise in demand. Semiconductors are in short supply due to an increase in demand but more importantly, a concentration of manufacturing in one area of the world – Taiwan. This has exposed the semiconductor industry to a risk in terms of production and geopolitics. These are just some of the reasons why price increases are broadly based and may not be transient. General Mills’ (GIS – $59.99) recently announced that as a result of more expensive ingredients, packaging, trucking and labor costs, the company expects wholesale costs will be about 7% higher over the next year or so. These costs will be passed on to consumers. Therefore, it seems inevitable that households will be facing higher expenses throughout the second half of 2021, and this could alter consumption patterns. Investors should therefore focus on companies that will benefit from higher pricing.
Monetary Policy Risk
Counterbalancing higher expenses for households and businesses are the ongoing stimulative monetary and fiscal policies seen in the US. Since the pre-pandemic era, or the end of 2019, the Federal Reserve has increased its balance sheet by $3.85 trillion. Additionally, the Fed’s purchases of $120 billion of securities each month are open-ended. Unfortunately, much of this liquidity remains immobile within the banking system. Customer demand deposits at commercial banks increased $2.2 trillion in the same period and commercial bank reserves at the Federal Reserve have been on the rise. In other words, households are not consuming, and businesses are not investing, and cash continues to build within the banking system.
The injection of liquidity into the banking system is only one of the tools used by the Fed to stimulate the economy. The other tool is the fed funds rate. The effective fed funds rate was 0.06% at the end of June. The CPI closed June with a rise of 5% YOY. This combination means the real fed funds rate is negative 4.9% — the lowest, and the most stimulative, fed funds rate seen in 70 years. It is also the lowest rate ever experienced during an economic expansion. An extraordinarily low cost of capital should inspire substantial investment and it has been instrumental in supporting a booming residential housing sector. But low interest rates have done little to inspire strong business investment or commercial loan growth. According to the Bureau of Economic Analysis, there was a rebound in domestic investment in equipment and software in recent months and hopefully this will be a sign of a better trend. Yet while the Fed’s actions have not triggered significant business spending it has supported higher stock prices. And the combination of low interest rates, quantitative easing and fiscal stimulus should continue to support stock prices through the end of the year.
Speed bump
Nevertheless, we would not be surprised if the Fed and the stock market face a speed bump in the second half of the year. The longer the Fed continues its easy monetary policy in the face of an expanding economy, the more it risks fanning the flames of inflation and instigating a stock market bubble. Therefore, we expect the Fed to change its policy sometime in the second half. The Federal Reserve’s prestigious annual Jackson Hole policy symposium will be held on August 26 through August 28, and this may be the perfect opportunity for Fed governors to begin a discussion of lowering or ending quantitative easing and/or changing their forecast for higher interest rates. The significance of a Fed policy change cannot be underestimated. Since April 2020, Fed policies have been extraordinarily supportive of equities. Therefore, the Fed will face a challenge to convince investors that a change in monetary policy from easy to neutral is not the equivalent of a change from easy to tight policy or a hostile Fed.
All in all, an underlying prop for investors is apt to disappear later this year. While a shift in Fed policy could shake investor confidence in the next six months, underlying fundamentals should be able to soothe concerns. Equities are not wildly overvalued, and we do not expect the downside risks for stocks to be extreme if a correction materializes. In fact, earnings growth has been excellent this year. According to IBES data from Refinitiv, S&P 500 earnings grew nearly 53% YOY in the first quarter and in the quarter ending June 2021, earnings are expected to rise 65% from a pandemic-depressed second quarter of 2020. For the full year, IBES is estimating earnings will be $191.37, a gain of 37% YOY. For calendar 2022 the estimate rises to $213.76, a gain of 12% YOY. These are excellent numbers, and they currently translate into PE multiples of 23 times this year’s and 20 times next year’s earnings. PE’s of 20+ are above the long-term average but are in line with multiples seen in recent quarters. However, if inflation continues at or near its current pace of 5% YOY, PE multiples are at risk of contracting substantially. For this reason, a shift in Fed policy, which would help temper inflation going forward, should be viewed as a positive long-term event – even if it produces a bump in the road.
Gail Dudack, Chief Strategist
strategist@wellingtonshields.com
Disclosure: The information herein has been prepared by Dudack Research Group (“DRG”), a division of Wellington Shields & Co. The material is based on data from sources considered to be reliable; however, DRG does not guarantee or warrant the accuracy or completeness of the information. It is published for informational purposes only and should not be used as the primary basis of investment decisions. Neither the information nor any opinion expressed constitutes an offer, or the solicitation of an offer, to buy or sell any security. The opinions and estimates expressed reflect the current judgment of DRG and are subject to change without notice. Actual results may differ from any forward-looking statements. This letter is not intended to provide personal investment advice and it does not take into account the specific investment objectives, financial situation and the specific needs of any person or entity.
This communication is intended solely for use by Wellington Shields clients. The recipient agrees not to forward or copy the information to any other person without the express written consent of DRG.
Copyright © Dudack Research Group, 2021.
Wellington Shields is a member of FINRA and SIPC
Either This or That pretty much is what the market has become
DJIA: 34,633 Either … or. That pretty much is what the market has become. The correlation between growth and value stocks has plunged to the lowest level since 1928, according to SentimenTrader.com. It is in fact reminiscent of the “old economy” versus “new economy” divergence of 1999 – 2000. Fortunately, not all divergences or non-correlations have had the same dire consequences as back then. An important distinction between now and then is the A/D index. We consider divergences there to be most important, and were present then but not now. Historically these low correlations have not meant much for the market as a whole. If anything, these non-correlations have been a warning sign for growth – the idea of too much of a good thing. Small-cap and large-cap stocks also are at their lowest correlation in 20 years. This hasn’t been a difficult year for the market, but it has been a difficult market because of the non-correlation and rotation.
There’s plenty of speculation in this market, but while speculation may tell you something about potential risk, it alone doesn’t kill uptrends. In terms of sentiment, what can kill uptrends is complacency, which usually comes when most are fully invested. It just seems a bit ironic that complacency should be so prevalent when there’s plenty out there to worry about. Inflation has been much discussed and for now the market is siding with Powell, it’s transitory. Some of the reopening bottlenecks may be transitory, but these labor shortages mean rising wages and inflation is always about wage inflation. Then, too, were inflation at hand we would expect precious metals to be acting well, and they’re not. Then there’s the problem of the Covid variants, a problem which seems very much here and now. The vac maker Moderna (235) has gotten renewed attention and has broken out. Another problem very much in the here and now is the potential for a cyber 9/11. ETFs like HACK (61) and CIBR (47) could help.
When it comes to seasonal patterns best known is “sell in May,” though it’s not particularly accurate. The inverse, ironically, is less emphasized and much more accurate – November–April – is up 80% of the time. Even without the distortions of the pandemic, seasonal patterns always seem of dubious usefulness. With this in mind, the period from July 10 to the end of August has produced some noteworthy weakness. Also of some concern is the recent pattern within the S&P itself. The index has reached new highs several times recently with less than half of its components above their 50 day average. Components above the 200 day remain close to 90%, so it’s a divergence between short term and medium term trends. In the past this also has produced some short term problems. It’s difficult to place too much emphasis here, however, when the A/D index is bumping up against new highs. That said, those numbers have flattened a bit as well.
In this past week’s Barron’s there was an article about Chart Industries (147). A colleague is very positive on the stock, so we are familiar with the story despite it being that funnymental stuff. Chart specializes in taking volatile gases and processing them so they can be contained and exported. The interesting part is this profitable business is combined with the opportunity to bet on hydrogen and carbon capture as well. The bad news, of all things, is the technical pattern. It’s not that the chart is bad, it’s that it is in a trading range, and has been since early this year – not the worst thing, but still. As we like to buy strength and sell weakness, this is the kind of pattern whose purpose is to take our money. You might have made a fortune trading the stock from 130 to 160, but that kind of mean reversion trading eventually doesn’t work. Those trades can be right 80% of the time, but eventually you lose 80% of your money, when finally there’s a big move up or down and you are on the wrong side. Patience doesn’t happen to be one of our virtues, but we are waiting for a move above 160 – 165. To see the potential here, look at a monthly chart, that is, a long term chart.
Kicking and screaming, the S&P managed another new high on the last day of June. It was lethargic and uneven, and again with more component stocks below their 50 day. Stocks haven’t exactly surged following their breakout/new high. Then, too, it’s summer. What has surged is the buying of speculative call options by the smallest option traders. Meanwhile, the SKEW (161) has surged, meaning hedge funds or someone is hedging against a decline. The SKEW tries to measure the price of far out of the money puts versus calls, with high readings suggesting a higher probability of a big decline within the next 30 days. You’ll be glad to know the SKEW isn’t taken too seriously by most, but like the upcoming seasonal pattern, we mention it so you are aware. More than the S&P, be aware the A/D index also made a new high, perhaps not so dynamically as in the past, but most days most stocks at least still go up. Not how markets get into important trouble.
Frank D. Gretz
It’s not the bad down days … it’s the bad up days
DJIA: 34,196
It’s not the bad down days … it’s the bad up days. For most of this year there have been few bad days either up or down. That changed a bit last week when there was what you might call real selling, both Thursday and, especially, Friday. The three day Dow loss of 1000 points is not the issue, it’s the one sided A/Ds, especially Friday’s 3-to-1 down day. Weakness happens, especially when amidst complacency the Fed comes along with a little surprise. Markets get over it, but it’s about how they get over it. A big Dow comeback without commensurate A/Ds, doesn’t do the trick. Indeed, that’s what we mean when we talk about a bad up day. As it happens, so far so good. Monday saw a near 600 point Dow up day with A/Ds near 3-to-1 – far from a bad up day. The A/Ds don’t stand alone. Analytically they need to be related to the market. It’s important that those numbers keep pace with the market averages.
It doesn’t seem the Fed has killed the market, but did they kill the inflation/reflation trade? While these shares did pull back, and in some cases more than we expected, we doubt they’re done. Most of that area has been stalled since early May, pretty much coinciding in the stall in the S&P itself. The Fed seems an excuse for the market to do another little rotation, something that he has been doing all year. In the process, Growth/Tech has reemerged, something that had begun just as the inflation trade was stalling. We will take rotation over everything going down any time. We don’t see this as something unhealthy, especially had you hedged those oil positions with a little Microsoft (266). To Look at XOP (98), the SPDR Oil and Gas Exploration ETF, oil seems to have come through this little correction in good shape, which should prove a positive going forward.
Speaking of rotation, Cathie is back. Well, not completely back, but those ARK funds at least are back above their respective 50 day averages. The recovery hasn’t just been on the back of Tesla (680), though it, too, is above the 50 day. If anything it has been on the back of Roku (424), which figures prominently in many of her ETFs. That these are performing so much better seems testimony to the idea there’s little that’s still weak, a positive for the market overall. This is even more dramatically clear looking at solar stocks. As measured by TAN (85), the Invesco ETF, after a big run those stocks peaked back in January and fell more than 40%. Among the better component charts there are SolarEdge (267) and Sunrun (53). Both of which have broken their own steep downtrends. Those other Tech stocks, Biotechs, also seem much improved.
Sentiment is always difficult to measure, and even more difficult to act on. Investors are right in between, but wrong at the extremes. And how do you know an extreme, especially when you’re part of it? None of us are immune to good old greed and fear. Theoretically, there are some measures thought to be objective, like the Put/Call ratios and investment surveys. When it comes to market peaks, however, these can be over the top and stay that way until you just stop caring. Worse still, these measures often improve before the market peaks. When it comes to speculative markets like this one, the speculation often peaks before the market averages. That was the case in 2000 when the NAZ and dot.coms peaked before the S&P really started down, and it was true in 2007 when a little oil bubble peaked before the overall market. This time around we have seen a peak in the SPACs and likely Bitcoin. The MEME stocks should be next.
So the Fed may raise rates as soon as late next year. Granted we sometimes tend to be short term in our view of markets, but exactly how do “soon” and “late next year” go together? This week the market seemed to agree. If anything, after Powell’s diatribe, the market may have become reassured they are not off the reservation. A so-called taper is another matter, but taper does not mean stop. More importantly, there seems no tantrum. It also seems that if your particular stocks aren’t going up, just wait a week and they probably will – the rotation is such. The rotation they will tell you is the market trying to work out the implication of the Fed’s seeming shift in emphasis. Naturally, we have to listen to the Fed, but even recently it has paid to concentrate on the numbers. This week again, most days most stocks went up, not how markets get into important trouble.
Frank D. Gretz
US Strategy Weekly: We Were Not Surprised
At last week’s FOMC meeting, Fed officials implied they may raise interest rates as soon as 2023, perhaps a year earlier than anticipated. We were not surprised. And during a post-meeting news conference, Fed Chair Jerome Powell said that the central bank was starting talks about when to pare down its monthly $120 billion of purchases of government bonds and securities put in place last year to support the recovery. Again, we were not surprised. But in Tuesday’s appearance before Congress, Powell reaffirmed the central bank’s commitment to encourage a “broad and inclusive recovery” in the job market and indicated the Fed would avoid raising interest rates too early based only on the fear of future inflation. Subsequent trading in inflation-protected and other securities implied investors are betting the Fed will change its policies faster than projected and we would agree. And in our view, Powell’s commitment to a “broad and inclusive recovery” was simply pandering to a Democratic majority in Congress. We assume Powell understands the limits of Fed policy and what it can and cannot achieve. The Fed’s tools are both broad and blunt. It is unable to target areas of the economy to support job growth. It can only increase liquidity in the system and hope that this will lift all boats. It has not. It is the role of the administration and Congress, not the Fed, to target areas of the economy.
Only Congress can target economic areas of greatest need by encouraging business investment, by lowering the restrictions and taxes on small businesses and inspiring job growth. Unfortunately, they are not doing this. We are not surprised. However, related to President Biden’s $1.9 trillion American Rescue plan, on July 15, the IRS will begin sending out monthly payments to around 36 million families as part of an expanded child tax credit program. Families will get an $1,800 supplemental child tax credit divided into six payments that will be sent out through December. If you qualify, you will get $300 per month for each child under the age of six and $250 per month for every child between the ages of six and 17. To qualify you must be a single taxpayer with an income up to $75,000, a head of a household with an income up to $112,500, or a married couple filing jointly, a qualified widow, or widower, with an income of up to $150,000. Families with higher incomes will receive $50 less per $1,000 earned. Payments will be phased out for people who make roughly $20,000 more than the relevant threshold. However, we were surprised to read that a family of four making less than $150,000 could see more than $14,000 in pandemic relief this year from the expanded child tax credit and $1,400 stimulus checks to both adults and children. This means some households could receive government checks totaling as much as $16,800! For a family making $149,000 a year this is a potential 11.3% increase in income. For some families, it could actually double annual household income this year. It is significant for a large number of families in the US.
We applaud the effort to assist the millions of families with children that that have fallen below the poverty line as a result of last year’s government shutdowns. Nevertheless, this is a stop gap program. Households could be permanently lifted out of poverty if they had more opportunities for better paying jobs and if they did, they could also make plans and have hope for a better future. This could be accomplished by putting government money into job training, childcare, tax exempt small business loans, creating public/private opportunity zones in areas blighted by the pandemic, and removing restrictions and lowering taxes on new small business owners. This type of constructive fiscal policy would have a positive long-term impact on household financial and mental health. It is the role of our elected officials. It is not the role of the Federal Reserve. But it is not happening. We are not surprised.
Fed Policy Is Pivotal
There are a number of reasons why we believe the Fed will be forced to change its policy this year. And as seen by the market’s reaction after last week’s FOMC meeting, a change could have an immediate and negative impact on the securities markets. Since the end of 2019, or just prior to the pandemic, the Federal Reserve’s balance sheet has grown by $3.85 trillion, the equivalent of 17% of nominal GDP. In short, an amazing amount of liquidity has been pumped into the banking system and the pumping has not ended. The Fed plans to continue its $120 billion in asset purchases each month. See page 3. However, in our view, quantitative easing is apt to be the first change in monetary policy and it will not surprise us if the Fed slows or ends its asset purchases in the second half of the year.
Yet while the Fed has been stimulating the economy with a soaring balance sheet and low interest rates, households have been hoarding cash. Since the end of 2019 through to May 3, demand deposits at commercial banks have increased a stunning $2.22 trillion to $4.0 trillion. See page 4. This cash hoarding could become a liquidity trap for the Fed, since it means the Fed’s actions are not having the positive impact on the economy it had intended. More stimuli could simply become pushing on a string, i.e., a true liquidity trap, and investors will lose faith in the Fed. In our view, this would be due to poor fiscal policy that provides households with ever more cash but does not emphasize future job growth. Households may simply be boosting savings for the rainy day they see ahead. This could explain why both the small business and consumer confidence surveys recently saw significant declines in “future expectations” even though current conditions remained stable.
With the fed funds rate at 0.1% and May’s inflation as measured by the CPI at 5%, the real fed funds rate is negative 4.9%, or its lowest level in over 70 years. This is worrisome since it is an extremely dovish policy for a non-recessionary, and expanding environment. According to the Fed, the economy is recovering and if so, monetary policy should change. See page 5. Plus, the economic backdrop is not good for the Fed or households. Core CPI and PPI are up 3.8% YOY and 2.9%, respectively. The PCE index is up 3.6% YOY. Headline CPI and PPI are up 5% and 8.7%, respectively. Prices are rising in most areas of the economy, and we doubt this is transient inflation. In our view, a small change by the Fed now could prevent the need for huge interest rate hikes in the future. Moreover, inflation is the equivalent of a tax on consumers, and this too is adding to the anxiety households have about their financial future. See page 6.
Housing and autos were the center of the economic recovery in 2020. This year auto sales remain strong, and prices of old and new cars are rising. Housing, on the other hand, may be about to plateau for a variety of reasons. May’s median existing home price rose to $350,300, a 24% YOY increase and the biggest gain on record since 1999. Yet, mortgage applications fell 17% YOY and existing home sales fell to 5.8 million units, down 0.9% month-over-month, but still up 45% YOY. Rising prices and falling sales could be due to a lack of supply since months of supply remained low at 2.5. But we believe first home buyers are being priced out of the market since house prices are rising faster than incomes. This could be more than a short-term situation. Remember: there were 7.6 million fewer people employed in May than in February 2020. Little has changed in the market’s technical condition. The 25-day up/down volume oscillator is in neutral and falling – a sign of weakening demand for equities. The NYSE advance decline line made a new high June 11. The Nasdaq Composite index eked out a new high this week and this index bears watching. The IXIC has been trading in a range of 12,995 to 14,200 most of this year. If this week’s move to 14,253 is indeed a breakout it could propel equities higher. If it becomes another failed rally attempt, it may be a short-term warning sign for investors. Stay alert.
There go those bonds again … trying to tell stocks what to do
DJIA: 33,823
There go those bonds again … trying to tell stocks what to do. The economy is recovering, rates should go higher, bond prices lower. Recently, it hasn’t quite worked that way. The 10-year treasury yield had fallen to 1.5% from the 2021 peak around 1.75% in March, this amidst what seemed an inflation scare. Investors it seems had come to believe the Fed, of all people. As they say, the market isn’t always right, but when you go against it we’ve noticed they don’t give you your money back. The consequence of this rate perception had been twofold for equities. It means banks are between a rock and a hard place – the gap had narrowed between what they can charge for loans and what they pay on deposits or other short-term borrowings. Another consequence of the changed rate structure was a recent better performance by Tech. Tech is growth but who needs growth stocks when growth is everywhere. When growth is not there, then go to the companies that grow.
This is not to say the rally in cyclicals or commodities is over. They have performed well and are entitled to a little respite. While energy had lagged relative to spikes in copper and steel, it has performed well recently, suggesting the issue is not with the economic recovery. This just seems about more rotation and rotation seems the year’s defining characteristic. The market hasn’t had a 5% correction since last fall and, as we like to say, most days most stocks go up. It seems the often annoying rotation has in its own way kept the market technically healthy. Meanwhile, the option speculators of February are back, and “rumor” has it – to translate MEME to the Latin. The VIX has dwindled to a pandemic era low of 15.7, suggesting complacency more than speculation may be the worry. Then, too, the A/D index reached a new high just a few days ago, and momentum trumps sentiment.
To listen to the homebuilders, things could not be better. The only reason they can’t sell more homes is shortages. Somehow that doesn’t seem to fit with the recent collapse in lumber, but what do we know? Then, too, back in 2007 their story over and over was they didn’t see a bubble, so what do they know? Speaking of 2007, a ratio of home prices to rental prices is higher now than it was back then. This could reflect the pandemic induced city exodus but still, stretched prices don’t usually stay stretched. Meanwhile, the charts are looking a little the worse for wear, even including associated stocks as disparate as Home Depot (303) and Masco (59). Getting back to lumber, the price of lumber is crashing relative to gold. Lumber is considered a proxy for economic growth, while gold is considered a safe haven. Previous extremes did tend to precede further declines in lumber prices as well as home building stocks, according to SentimenTrader.com. Those homebuilding charts have begun to suggest the same could happen this time.
It wasn’t that long ago that $100 oil seemed almost laughable. After all, the world was in lockdown, the roads empty, and flights virtually nonexistent. Even now, $100 oil seems a stretch. Yet Brent already has moved to $73, its highest level in two years. It’s not that demand is that great, though it is growing, it’s more that new supplies have been slow in coming. We’ve gone from 15 years of reserves to 10, and capital expenditures have gone to $100 billion a year from $400 billion 5 years ago, according to FT. Jeremy Weir, executive chair of Trafigura, one of the world’s largest independent oil traders, told the FT Commodities Global Summit that the lack of spending on new supply was concerning, because the world is not ready to make the leap to clean energy and complete electrification. Oil stocks, of course, have been on to this for some time. Despite their performance this year they still seem underloved and, therefore, underowned. Since opinions typically follow price, this seems likely to change.
So they’re talking about talking about. Wednesday’s Fed meeting has resulted in a change in expectations, like everyone expected rates to stay low forever. What it didn’t do was signal any real retreat from pandemic crisis measures, for now and for some time. As seems his intention, Powell has plenty of justification to stay the course – employment is yet to improve that much and much of the inflation does seem about bottlenecks that should prove transitory. That yields had fallen in the last three months, and did so again even on Thursday indicates what seems a prevailing belief the Fed won’t be panicked into tightening. Similar market reactions – 0.5% declines in stocks, bonds and gold – followed other FOMC announcements in the past. After some short term consolidation, what followed was higher prices. Keep in mind, too, we came into this with a better than good pattern in the A/D’s, a pattern of higher lows versus the pattern of lower lows in the averages. If you want to see a market with real credit restrictions, take a look at China.
Frank D. Gretz
Hedge fund, or … hedge fun
DJIA: 34,466
Hedge fund, or … hedge fun. Back when we frequented the Hamptons, we were impressed by those hedges surrounding, though not quite completely hiding, the Estates. We also were impressed to learn the price of a trim, so to speak. So much so, we came up with a name for our new, though theoretical business, something to do with fun. The two things that worry us are not about technical analysis. We worry about a cyber 9/11 and a variant the vaccines don’t overcome. Both, of course, would do significant damage to share prices. It’s a bull market, making hedging very difficult. The cyber security stocks and ETF’s seem to make sense when it comes to hedging the likely ongoing threat there. HACK, the Prime Cyber Security ETF (HACK-61) and CIBR (46), the First Trust Security ETF should be useful there. As for a Covid problem, the VAC makers BioNTech (240) and Moderna (217) should be useful.
If be bearish you must, Goldman Sachs has a model which predicts the probability of a bear market. The model is cleverly named the Bear Market Probability Model, and consists of unemployment, ISM manufacturing, the yield curve, inflation rate and P/E‘s. As the model cycles from below 40% to above 65% the odds of a bear market are said to increase. When above 65% the S&P has returned an annualized +3.4%, according to SentimenTrader.com, which hardly sounds like a bear market to us. Then, too, that’s only a sixth of the return when the probability is below 40%. Currently around 67%, the model is not high enough to be a major concern, but the model has cycled from below 40% to above 65% in just 11 months, the fastest turnaround ever. The model, obviously, is based on those funnymentals. As we mentioned last time, were we one of those types we likely would be more concerned about the Cyclically Adjusted P/E. Instead, with the Advance-Decline index making new highs and 80% of stocks above the 200 day, that is, in uptrends, we think any bear market is yet some time away.
Energy is the best performing sector this year. Like anything up, especially anything at 45%, most aren’t interested when you are positive. This proved true in a recent discussion when the retort was just that – they’re up too much. When we asked how many oil stocks this person owned, the answer was none. And there it is. When it comes to the oil stocks most own little or none. They’re under-owned and that’s why they’ll keep going. Add to that, as is always the case, now the news is getting better. Activists are leaning on big oil to drill less, the rig count is down 35% from pre-Covid levels, oil inventories are below their five-year average – all this as demand continues to climb. The news is better but the stocks are up too much to buy, most think. When the stocks keep going the news will become almost compelling, to the point that you have to buy. It’s just the way the market works. XOP (97), the SPDR Oil and Gas ETF is a good start.
Sentiment or market psychology is an important part of technical analysis. Simply put, traders and even investors tend to be wrong at the extremes. Sentiment, of course, isn’t easy to measure or to follow. When bullishness is extreme we are all likely to be part of it, and hesitant to give up that lovin’ feeling that comes with making money. And at such times, it’s nice to be around those who share a similar sentiment, so to speak. This might explain the enthusiasm for last weekend’s Crypto conference. Attendance was 12,000 versus 2,000 the prior year, and the $600 ticket price was selling for $1200 before the conference started – a better investment than Bitcoin recently. The real concern here is the price action. Using the Grayscale Bitcoin Trust as a proxy, it’s a look that can’t be described in polite company. As for the market overall, it’s easy to say sentiment is over the top, but it’s difficult to measure. Mechanical measures didn’t capture the dot.com’s back then, and now don’t capture Crypto, SPACS, and Memes. Fortunately, momentum trumps sentiment.
We tend to fixate on the A/D‘s rather than the market averages. The A/D index is at new highs, and the daily numbers have been positive nine of the last 11 days. What’s not to like? That said, even we are surprised at the lack of movement in the S&P – stocks go up most days but not enough to break out the average? Of course, when they do break out the concern will be about a false breakout, one which quickly reverses. Ever notice, there’s always something. What has come to be of a bit more concern than the S&P is the Transports. They peaked the middle of May and are now teetering on their 50 day average. This doesn’t seem a concern for the market overall, but it is from a leadership standpoint. We still believe leadership lies in Cyclicals and Commodities, but we would like a little reassurance from the Transports. Meanwhile, annoying as the incessant rotation may be, it is at least intriguing. One of the best acting Tech stocks these days is a little company that makes “business machines.” And, by the way, war may be nigh to look at the defense stocks.
Frank D. Gretz
US Strategy Weekly: Tighten Now or Later
Friday’s employment report will be important since it will set the stage for the Federal Reserve’s next FOMC meeting scheduled for June 15 and 16. The June meeting will be accompanied by a Summary of Economic Projections and economists will be checking this closely to see if estimates have changed and if so, might this mean that a pivot in monetary policy is on the horizon. In short, it could be a market moving event. April’s job report showed a disappointing increase of 266,000 new jobs, which was less that the average gain seen over the previous three or six months. May should see a nice recovery in the labor market since most states are now relaxing or eliminating pandemic restrictions. However, if the release shows an extraordinarily strong job market this could also spook investors who are worried that a strengthening economy, coupled with a high savings rate and pent-up demand, could fan the flames of inflation. We worry about this as well.
Federal Reserve officials continue to emphasize that any inflation will be transitory, but to some market observers this translates into the possibility, or likelihood, that the Fed is apt to fall behind the curve. If so, the Fed would need to raise rates even more aggressively sometime in the future in order to tame inflation. This is an important factor since most economic recessions in the US have been preceded by repeated Fed tightenings. In fact, this is the underlying principle in Edson Gould’s famous “three steps and a stumble rule.” Edson* was a well-respected market technician and stock market historian of the 1930-1980 era, yet some technicians do not believe his rule is valid today. We have found that to make this rule useful it is important to observe the number of Fed fund increases within a rolling twelve-month period. Three or more fed rate hikes, particularly if they are large, within a twelve-month period has always been followed by a weak stock market in the subsequent six and twelve months and it is usually in conjunction with a recession. For this reason, among others, it is important that the Fed not delay in addressing inflation and find itself running to catch up to control the cycle.
In our view, inflation has always been the main risk for equity investors in 2021 since it means both a change from easy monetary policy, a rise in interest rates and a decline in average PE multiples.
Inflation does not have to be a disaster for equities, however. Stock prices can rise along with interest rates as long as earnings increase enough to compensate for the rise in the risk-free rate. Good earnings growth appears to be a strong possibility for this year and next; therefore, the greater risk over the next twelve months is more likely to be the Fed. If the Fed delays a shift in monetary policy too long, it could find itself having to tighten more aggressively to stem off inflation; thereby triggering a recession. The Fed’s favorite benchmark for inflation is the personal consumption expenditures (PCE) price index and this revealed a 3.6% YOY rise in April after being up 2.4% YOY in March. We were not surprised by this big jump in the PCE deflator since it puts it in line with all other inflation measures which now uniformly exceed 3% YOY. The implications for monetary policy are potentially huge. To demonstrate the pressure that this places on the Fed we have a chart of the real fed funds rate as compared to the PCE deflator. See page 7. The real fed funds rate is currently negative 3.5% and reflecting the “easiest” policy seen since February 1975, during the 1974-1975 recession. This negative real fed funds rate will prove to be far too stimulative as people go back to work and the economy recovers. It will force the FOMC to change its verbiage and actions.
Only time will tell if inflation is transitory or not. Meanwhile, we believe the healthiest scenario for the equity market would be either a 10% correction or a sideways market over the next few months. If not, the inevitable shift in Fed policy will trigger a correction that could exceed 10% in the SPX. Seasonality also suggests the stock market may be about to take a pause. June tends to be an underperforming month in the annual calendar and ranks 9th or 10th in terms of performance in most indices. See page 9.
A Mix of Economics
Housing has been a main pillar of the economic recovery during the pandemic. However, the pending homes sales index for April fell from 111.1 to 106.2, which was its lowest level since May 2020. April’s survey leaves the index below its long-term average of 108.7. This decline in housing sales is likely to continue, particularly if home prices continue to rise. Buyers are apt to be priced out of the market. In April, the median home price for a single-family home rose 20% YOY, the largest twelve-month increase in National Association of Realtors records going back to 1999. Mortgage rates remain historically low but have also been rising, which will become another handicap for first time buyers. See page 3.
Stimulus checks boosted personal income 30% YOY in March; but in April personal income fell 13.1% month-over-month, which translated into a small 0.5% YOY increase. Disposable personal income rose 33.3% YOY in March but fell 1% YOY in April. The savings rate remains high but erratic at 14.7% in February, 27.7% in March and 14.9% in April. See page 4. The most interesting part of personal income is pre-pandemic total compensation which does not include transfer payments. Total compensation peaked in February 2020 at a seasonally adjusted annualized rate of $11.82 billion; however, despite the drop in employment, we were surprised to find that total compensation achieved a new record of $11.88 billion in November 2020. In April, total compensation rose to an all-time high of $12.3 billion. The same pattern is true if we look solely at wages or supplements for employees in the private sector. This underlying momentum in wages seen since November 2020 challenges the need for further fiscal stimulus in 2021. It also indicates that further stimulus could over-stimulate the economy. See page 5.
Earnings and PE Multiples
Both Refinitiv IBES and S&P Dow Jones consensus EPS estimates for the SPX for 2021 and 2022 continue to rise which is favorable and provides support for the equity market. The current IBES and S&P estimates are $189.61 and $186.59 for 2021 and $212.12 and $209.50 for 2022, respectively. This means the market is rich, but not overvalued, in a low inflation environment where a 20 PE multiple is justifiable. However, if inflation is 3.5% or higher PE multiples are likely to fall back to average or lower. The long-term average PE multiple for the SPX based upon forward earnings has been 18.2 times and on trailing 12-month earnings the average PE is lower at 15.8 times. This points to why inflation is a dilemma.
Market Data
To date, 2021 has been most notable for its leadership shift, away from the technology-laden Nasdaq Composite Index and small capitalization Russell 2000 index and toward cyclically driven inflation sectors such as energy, materials, financials, and REITs. See page 16 for sector performances year-to-date. This shift is producing new highs in the SPX and DJIA and sideways patterns in the IXIC and RUT. See page 12. There are also disparities in macro technical indicators. The NYSE cumulative advance decline line made a record high on June 1 confirming a bull market, whereas the 25-day up/down volume oscillator continues to languish in neutral. At present this indicator is suggesting the indices are moving to new highs but on lower volume and less robust buying pressure. This is a sign of waning investor demand and therefore is a warning. Again, a sideways or correcting market would be the healthiest scenario near term. *https://www.ofeed.com/Star%20Traders/1135
