Breaking News

As we go to print there are a number of news headlines of significance. Unconfirmed reports suggest that a Russian-produced missile hit a Polish village near the border of Ukraine, killing two Polish citizens. This incident sparked a flurry of NATO leaders declaring that all NATO territories must be defended and as a result, fanned fears of an escalation and/or expansion in the Russia-Ukraine conflict. News of this explosion in Poland aborted an early-day rally that had been kindled by better-than-expected third quarter earnings from Walmart Inc. (WMT – $147.44).

Later this evening former President Trump is expected to announce his intention of running for re-election in 2024. This could split the Republican Party which is already showing signs of post-election fatigue and upheaval. The midterm elections did not produce a red or blue wave, but it is expected to create a shift in leadership in Congress. Rick Scott (R – FL) announced he will run against Senate Republican Leader Mitch McConnell (R – KY) for the role of minority leader in the Senate. And if the Republicans edge out the Democrats in the House of Representatives, Kevin McCarthy is expected to take the role of Speaker of the House from the indefatigable Democrat Nancy Pelosi. New leadership in Congress is unlikely to generate a meaningful difference in policy, but it is reassuring that a divided Congress is usually seen as a positive for the equity market.

These news events took the attention away from the collapsed crypto exchange FTX which has dominated financial news in recent days. The exchange, among the world’s largest, filed for bankruptcy protection on Friday after traders pulled $6 billion in three days from the platform and rival exchange Binance abandoned a possible rescue deal. FTX is the highest-profile crypto blowup to date and bankruptcy filings indicate the exchange faces a “severe liquidity crisis” and could have more than 1 million creditors. This is a warning of possible liquidity issues in unsuspected places in the upcoming weeks. Meanwhile, it is possible that FTX founder and former chief executive Sam Bankman-Fried will face felony charges due to what might be “unauthorized transactions” on its platform.     

The Rally

News of the wayward Russian missile threw a curve ball in what appeared to be an improving outlook for the Russia-Ukraine conflict. The retreat of Russian troops from Kherson left Russia with no forces on the right, or western, bank of Europe’s third largest river that bisects Ukraine and flows into the Black Sea. This is a vital conduit for Ukrainian grain exports. In fact, there were unsubstantiated reports that an agreement might be possible between Russia’s Putin and Ukrainian President Volodymyr Zelensky. We believe this possibility contributed to the massive rally in the euro and the decline in the dollar last week. This prospect, coupled with short covering, were catalysts for the rally in equities last week.

Yet stocks rose for a number of reasons including financial headlines like “US Fed could soon start easing rate policy.” We found this headline to be very misleading. Using the word “easing” in terms of monetary policy translates directly into the prospect of the Fed lowering interest rates. However, in this case, the media is actually referring to the possibility that interest rate increases could get smaller. However, these are two very distinct and different concepts. We question whether this headline was intentional and thereby playing with investor psychology or was it simply a symptom of naïve and inexperienced journalism. We do not know, but we do know that the market responded as if interest rates were about to decline. This makes us nervous about the rally.

Higher Interest Rates Ahead

As noted, investors celebrated better-than-expected CPI data for October with a massive rally, but as seen on page 5, the improvement was minor. Headline CPI was 7.8% YOY in October versus 8.2% YOY in September. Core CPI rose 6.3% YOY versus the 40-year high of 6.6% recorded in September. PPI data was somewhat better since it is coming down from cyclical highs recorded in June. In October, finished goods PPI rose 11.2%, core finished goods rose 8.1% and final demand PPI rose 8.0% YOY. Yet clearly, these rates remain well above the long-term average of 3% and remain at the highest pace in 40 years.

What is important to emphasize is that core CPI (6.3% YOY) and core PPI (8.1% YOY) remain well above the pace of wage growth (4.8% YOY) and this means household purchasing power continues to erode. This has been and will be a factor that will weigh on economic growth in the coming months. See page 6.

Another consideration that will slow economic activity is steady monetary tightening. Recent inflation data indicates that the fed funds rate continues to be negative and as a result, the Fed is not expected to stop raising rates in the foreseeable future. See page 7. All in all, we question the validity of the discussion around a Fed pivot. Even though the pace of interest rate increases may slow, this has very different implications from a reversal in interest rates. Sentiment on monetary policy is too optimistic, in our view. The Fed will continue to raise interest rates and depress economic activity in coming months making a recession likely in 2023.

Meanwhile, consumer and business confidence continue to erode. NFIB’s Small Business Optimism Index declined 0.8 points in October to 91.3, the 10th consecutive month below the 49-year average of 98. Of the 10 Index components, two increased, seven declined, and one was unchanged. Small business earnings and sales are at levels last seen during the 2020 recession and employment plans are declining. See page 3. Headline University of Michigan consumer sentiment hit a record low of 50.0 in June before rebounding. Nevertheless, it fell from October’s 59.9 to 54.7 in November. Economic expectations in the University of Michigan and Conference Board consumer sentiment indices, as well as the small business survey, have been falling nearly every month in the last two years. See page 4.

Technically Good News

The 25-day up/down volume oscillator is currently overbought for the third consecutive trading day with a preliminary reading of 3.83. This is significant because bear markets rarely reach overbought territory and if they do the reading tends to be modest and brief. In sum, this will be a key indicator to monitor in the coming days to assess the strength of any advance in prices. A long and extreme overbought reading would change our view of this rally merely being a strong bear market rebound. We will keep you posted.

In the interim, it is clear that this bear market has defined a transition of leadership. The FANG phenomenon is over. This new cycle is shifting from classic growth to value, from large capitalization to mid-to-small capitalization, and from global to domestic. We continue to favor recession-resistant areas such as energy, utilities, staples, aerospace and defense and recession-proof healthcare. 

Gail Dudack

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Politics and inflation are the features of this week; however, third-quarter earnings results continue to provide plenty of drama in the background.

Politics and Equities

In terms of this week’s elections, a number of strategists are noting that since WWII, the S&P 500 has had a perfect record of gains following the midterm elections. In addition, the S&P 500 has posted an increase in each of the 12-month periods after the midterm vote and these gains have averaged an impressive 15%. As we show on page 3, the fourth quarter of the midterm election year tends to be the best fourth quarter of any of the four years in the election year cycle. And more importantly, the first quarter of the pre-election year tends to be the best quarter in the entire election cycle for most of the popular indices. In short, the last quarter of 2022 and the first quarter of 2023 are periods that have a solid history of being strong periods for stock prices.  

To date, 2022 has been very volatile and has underperformed historical averages. This severe underperformance is best displayed by the chart on page 4. However, it is this underperformance that may have led to the strong rebound seen in October. Yet even apart from politics, November marks the start of the best 3-month and 6-month periods for equity prices. In short, the stock market should have the wind at its back in the coming months.

And we do not see anything in terms of election results that could hamper stock prices. History shows that equity investors tend to like a split Congress. According to Reuters, when a Democrat is president, the market performs best when Republicans hold either the House, Senate, or both. The average annual S&P 500 returns have been 14% with a split Congress, 13% with a Republican-held Congress, and a 10% gain when Democrats control both the White House and Congress. All in all, the midterm elections should have a positive effect on investor sentiment.

Earnings Revisions

While we do expect the election to be a positive for equities, we are less optimistic about the next six to twelve months due to the deterioration we see in corporate earnings. The steady decline in S&P 500 earnings for this year and next year has continued as the third-quarter earnings season passes its midpoint. This week the S&P Dow Jones consensus earnings estimates for 2022 and 2023 fell $0.57 and $2.76, respectively. Refinitiv IBES consensus earnings forecasts fell $0.36 and $3.28, respectively. What is notable about the last two weeks’ revisions is not just that they continue to fall but that estimates for 2023 are beginning to plummet. As a result, the 2022/2023 forecasts from S&P Dow Jones and IBES Refinitiv are now $204.17 and $230.11 for 2022 and $220.91 and $232.64 for 2023. Earnings growth rates for 2022 are (1.9%) according to S&P and 6.1% according to IBES.

We have been stating that our S&P 500 earnings estimates would be reviewed after third quarter results, however, results have been so poor that we believe our earnings estimates need addressing this week. Our 2022 and 2023 estimates are slashed this week from $209 to $202 and from $229 to $204, respectively. The decline in this year’s estimate reflects the weakness seen in 2022 earnings results to date. More importantly, and more dramatically, our revision for 2023 earnings is due to the negative impact we expect to see from current and future Fed rate hikes on economic activity. Although some economists are now placing odds on the ability of the Fed to maneuver a soft landing in 2023, we believe many parts of the economy are already in or will inevitably face a recession. As a result, this will continue to put pressure on consumers and therefore on top-line revenue growth. Plus, inflation will continue to pressure corporate profit margins. For these reasons, we continue to favor the more recession-resistant areas of the stock market such as energy, utilities, staples, and defense stocks. Healthcare is a DRG-neutral weighting (see page 13) but many health-related stocks are necessities and are therefore recession resistant. Note that this means one should emphasize value versus growth and growth at a reasonable price.

In terms of the economy, the ISM nonmanufacturing survey’s composite index fell from 56.7 to 54.4 in October and the details of the report were unfavorable. New orders and business activity declined, and employment slipped below the neutral 50 mark. Note that the service sector, which has been the relative outperforming sector of the US economy, now appears to be joining the manufacturing sector which has been in decline since early 2021. See page 5.

Valuation

The jump in short-term interest rates from nearly zero to 4.2% is currently having and will continue to have a dramatic impact on equity valuation. The current earnings yield of 5.4% and dividend yield of 1.8% still hold a slight edge over bonds, but this will continue to evaporate as interest rates rise and earnings forecasts fall. When we put our revised earnings forecasts of $202 and $204 into our valuation model, coupled with our estimates for headline CPI of 7.1% this year and 4.0% next year, and short-term interest rates of 4.75% this year and 5.0% for next year, equity valuations fall. The midpoints of our valuation model drop to SPX 2666 for 2022 and to SPX 3020 for 2023. In sum, equity risk due to inflation, rising interest rates, and falling earnings continues. See page 7.  

Technical Indicators Remain Interesting

The charts of the popular indices are as revealing as many of our technical indicators this week, and each tells a slightly different story about the equity market. On page 8 we have ordered the charts of the indices in terms of technical strength. The DJIA is the strongest index and has just exceeded its long-term 200-day moving average this week. It is less than 3% above the moving average that confirms a breakout, nevertheless, it is trading above all its moving averages. The Russell 2000 is approaching its 200-day moving average but remains below it. The S&P 500 continues to find resistance in the narrow range between its 50-and-100-day moving averages. And lastly, the Nasdaq Composite is the weakest of all the indices and is trading well below all its moving averages. This divergence in the indices is a demonstration of shifting leadership from growth to value. 

The 25-day up/down volume oscillator is currently neutral with a reading of 1.11. Last week we noted that the indicator was rising toward an overbought reading of 3.0 or greater, which could signal a turning point for the market. The significance of an overbought reading is that bear markets rarely reach overbought territory and if they do the reading is brief. However, in recent days this indicator retreated before reaching overbought territory – a sign of decelerating buying pressure on the rally. Nevertheless, this indicator will be important to monitor in the coming weeks since it could be a bellwether of the strength of future advances in prices. See page 9. With many indices at, or near resistance levels, it will be important to see if this week’s inflation data has a significant impact on investor sentiment.

Gail Dudack

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This week is significant since it marks the heaviest five days of the third quarter earnings reporting season. It also includes the November FOMC meeting and October’s employment report and precedes the midterm election on November 8. Each of these issues has ramifications for the equity market, but in our view, earnings reports should have the biggest short- and long-term impact on stocks.

The Importance of Earnings

To date, third quarter earnings results are coming in lower than much-reduced expectations. Last week the Refinitiv IBES estimates for this year and next fell $0.87 and $2.86, respectively. The S&P Dow Jones consensus estimates, which are important since S&P follows GAAP methodology, fell $2.00 and $2.52, respectively. As a result, the respective consensus estimates for this year are currently $221.27 and $204.70, which represent growth rates of 6.3% YOY for IBES and negative 1.7% YOY for S&P. See page 8. The steady decline in earnings estimates is a concern because we believe bear markets bottom out when the outlook for valuation is improving, or at least hopeful. Unfortunately, assuming the Federal Reserve will raise interest rates this week and again in December, and since rising interest rates suggest a weaker economy in 2023, the outlook for earnings is not optimistic. As a result, estimates for 2023 earnings are probably still too high and one can expect more negative surprises in the quarters ahead. Earnings disappointments erode investor confidence over time. In the short run, this week’s battery of earnings reports could set the tone for whether there is hope for 2023 earnings, or if estimates are still too high.

Nonetheless, our skepticism on S&P 500 earnings is not broadly based. In fact, we have been in favor of recession-resistant sectors and seek stocks where earnings growth is most predictable. In general, the current economic environment favors value stocks versus growth stocks, and we have been emphasizing necessities such as energy, staples, defense/aerospace, and utilities. The utility sector has shifted from being an outperformer to an underperformer in the last month, but keep in mind that “performance” in utilities should not be measured just by price, but by total return. We have a neutral weighting on healthcare, however, since healthcare is another household necessity with pricing power, it should not be overlooked in our view. See page 13. From a historical perspective, bear markets tend to be a transition period for a significant shift in leadership. We believe this is true of the current market. Notably, S&P sectors labeled as “growth” have varied over the decades, but they have had one thing in common and that is that they have represented the highest earnings growth rates of all 11 S&P sectors. In the next few years, or at least until inflation has come under control, we believe recession/inflation-resistant companies will provide the best earnings and price performance and will outperform the S&P 500 index. In truth, energy has been the growth sector of 2021 and 2022.

A Fed Pivot

The Federal Reserve is expected to raise the fed funds rate from its current range of 3% to 3.25% to 3.75% to 4.0% this week. This would be the fifth interest rate hike in a twelve-month period and the fourth consecutive 75 basis point increase this year. It would also constitute an increase of 375 basis points in the last 20 months. This will certainly have a major dampening effect on economic activity in the first half of next year and it has already put the residential real estate market in a recession. We would challenge market pundits who are focused on whether a 50-basis point increase at the December FOMC meeting would constitute a “Fed pivot” and a key buying opportunity, because we believe this misses a very important point — a 375-basis-point increase in the fed funds rate in a mere twelve months is likely to trigger a recession in 2023. Again, there are many reasons to focus on recession and/or inflation resistant companies at this juncture, even though we would note that the best three-month period for stocks (November, December and January) has just begun.

A Critical Technical Juncture

Technical indicators are at an interesting and, in some cases, critical juncture just as important information from earnings, the Fed, economic data, and political elections loom on the horizon. The most important indicator this week is the 25-day up/down volume oscillator which is currently neutral with a reading of 2.61. However, this is surprisingly close to an overbought reading of 3.0 or greater. Since bear markets rarely reach overbought territory and if they do the reading is brief, there is the possibility of a turning point in this indicator. In sum, we will be watching the 25-day up/down volume oscillator very carefully in coming weeks.

And as the oscillator faces a potential turning point so does the S&P 500 index. A convergence of the  50- and 100-day moving averages at roughly SPX 3900 represents a key resistance level. If bettered, it would be a positive for the intermediate-term outlook and fall in line with the favorable seasonality that is typical of year end. If it proves to be resistance, it will confirm that the bear market cycle remains intact. See page 9. Nevertheless, the indices are not moving in unison, and it is worth noting that the DJIA is trading above its shorter-term moving averages and currently testing its 200-day moving average. The Russell 2000 is similarly close to its 200-day moving average. This divergence and relative outperformance of small capitalization stocks is favorable since the large capitalization stocks tend to be the last to fall in a bear market.

Economic Data

After contracting in the first two quarters of the year, GDP grew 2.6% (seasonally adjusted annualized rate – SAAR) in the third quarter. However, trade contributed 2.8% to the quarter as exports of oil & gas to Europe increased and a strong dollar translated into fewer dollars spent on imports. In short, these may be short-term influences and the domestic economy continued to struggle. See page 3.

Household consumption contributed less to third quarter activity than it did in the second quarter and consumer spending was disproportionately in services. Businesses slashed spending on structures and residential investment fell at a 26.4% annual rate. Residential fixed investment was the largest drag on third quarter GDP falling 1.4% (SAAR), followed by inventories which fell 0.7% (SAAR). Third quarter typically sees an inventory build ahead of the holiday season; however, real retail sales have been weak in recent months and retailers appear to be cautious. The one bright spot in the GDP report was a small decline in the GDP deflator from 7.6% to 7.0%. See pages 4 and 5.

In September, personal income grew 5.2% YOY and personal disposable income grew 3.2% YOY. But the true measure of household consumption is demonstrated by real personal income which declined 1.0% YOY and real disposable income which fell 2.9% YOY. See page 6. Yet despite a lack of purchasing power, personal consumption expenditures rose 8.2% YOY in September and grew 8.4% over the last three months. Not surprisingly, the savings rate fell from 3.4% to 3.1% in the same month. Overall, consumption may not be sustainable at this level.

Gail Dudack

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World News

It was a quiet week in terms of domestic economic news, but it was far from dull in terms of global news. In the UK, Rishi Sunak took over as Britain’s 57^th prime minister, replacing Liz Truss, whose 45 days in office was the shortest tenure in UK history. Sunak will be the first prime minister of South Asian descent, the first person of color, the first Hindu prime minister, and at 42 years old is the youngest person to hold the office in modern times. He has previously worked for Goldman Sachs, was a managing director of a hedge fund, and might be the richest person to ever hold the office. He formerly served as the Chancellor of the Exchequer (finance minister) in Boris Johnson’s cabinet. Sunak inherits a difficult economic environment, but the market’s first reactions were favorable and British sterling rallied on the news. Separately, the Bank of England is expected to raise interest rates 75 basis points on November 3, one day after the Federal Reserve is expected to raise the fed funds rate by another 75 basis points.

This week Russia took allegations to the UN Security Council implying that Ukraine is preparing to use a “dirty bomb” on its own territory. Western and Ukrainian officials dismissed these charges as misinformation, but many worry that this could be a pretext prior to Putin escalating the war. Simultaneously Putin notified the US of plans to carry out annual exercises of its nuclear forces.  

Over the weekend, the Chinese Communist Party unanimously chose Xi Jinping to be its leader for another term of five years, while also granting him a breadth of institutional power not seen since the days of Mao Zedong. In 2017 Xi removed term limits for the presidency. And in a blatant expression of power, Xi had China’s former president, Hu Jintao, forcibly removed from the final session of the 20^th National Congress, a sign that Xi is pushing all but his most loyal allies out of positions of power.

Saudi Arabia’s energy chief Prince Abdulaziz bin Salman blasted the use of emergency oil reserves to manipulate prices in a direct warning to President Biden who just released millions of barrels from strategic petroleum reserves. Saudi’s energy minister stated, “Losing emergency stocks may be painful in the months to come.” President Biden has signed off on historic use of the US Strategic Petroleum Reserve (SPR) this year, releasing 180 million barrels of oil since April, with another release of 14 million barrels this month. This supply has helped to keep a lid on energy inflation in the weeks before the midterm elections, but it is also putting oil markets under pressure with the SPR at its lowest level since 1984. 

Earnings

At the end of the week, slightly more than half of the S&P 500 component companies will have reported third quarter earnings. This week the S&P consensus EPS estimate for 2022 declined to $206.74 and IBES fell to $222.14 bringing EPS growth rates for 2022 to -0.7% and 6.7%, respectively. These estimates are down from $227.51 and $230, respectively, at the end of April. This means the S&P consensus estimate has declined nearly 10% in the last five months and it is still falling. This week forecasts for 2022 declined 59 cents and for 2023 fell 28 cents. And estimates are apt to fall again this week. Google parent Alphabet (GOOGL.O – $104.48) reported earnings of $1.06 per share versus $1.40 a year earlier, based upon disappointing ad sales. Last week Snap Inc. (SNAP – $9.60) reported its slowest ever revenue growth rate and the stock collapsed. Microsoft (MSFT – $250.66) reported earnings of $2.35 per share in its fiscal year ending in September, versus $2.71 a year earlier, and projected quarterly revenue below Wall Street targets across its business units. Microsoft suffered its worst quarterly net income decline in two years and the weakest revenue growth in more than five years. These results fanned fears of a slump in personal computer sales and slowing growth in its cloud computing business. General Electric Co. (GE – $73.00) trimmed its full-year forecast after reporting a decline in third quarter earnings due to higher raw material costs in its renewable energy business and demand uncertainty due to the expiration of renewable electricity production tax credits. In sum, we expect consensus earnings estimates for the S&P 500 will continue to decline. This fact puts our current 2022 estimate of $209 at risk. We will be reassessing our estimates at the end of third quarter earnings season.

A Bounce

There have already been two bear market rallies that tested the 200-day moving averages in the indices in this bear market cycle, and the recent oversold condition suggests we may be in the midst of a third test. This implies there is room at the top for this rally, but we would keep in mind where resistance could be expected. Key resistance levels are Dow Jones Industrial Average: 32,703; S&P 500 index: 4,126; Nasdaq Composite index: 12,458; and Russell 2000 index: 1891. We are monitoring the Russell 2000 index most closely since it is currently testing key resistance at 1,800. This could prove to be significant this week. Failure to better this level would be a sign that the broader rally is weakening. Remember, the Russell had been a lead indicator of the broad market in 2021 when it failed to move in step with the larger capitalization indices, warning of market weakness ahead. And more recently, October’s decline failed to slip significantly lower than the June low, a subtle sign of outperformance. As long as the Russell 2000 stays between resistance at 1,800 and support at 1,640 the technical trend is neutral. However, a break above 1,800 or below 1.640 could be a trigger for the next intermediate term move. See page 7.

The 25-day up/down volume oscillator is currently neutral with a reading of negative 1.21. However, back on September 30, the oscillator hit an oversold reading of negative 5.6 which was a deeper oversold reading than the negative 5.17 reading seen on July 14, 2022. It was also in oversold territory for 8 of 10 consecutive trading sessions in July and oversold for 18 of the 24 consecutive trading sessions in September/October. This was a longer oversold reading than at the previous low and a sign of intense selling pressure. In short, October’s test of the June lows was unsuccessful by several measures, and the bear market cycle continues. This is true despite the nearly 6% two-day gain seen in the market to open October, the 4% two-day gain seen last week and this week’s 1.6% up day. See page 8.

Our views on the stock market and economy are unchanged. With interest rates apt to move higher, the economy is likely to slow. This suggests a focus on recession resistant stocks and sectors, which means finding companies that can have the most predictable earnings streams in a difficult economic environment. In general, this favors value rather than growth as a strategy. We maintain an overweight status on energy, utilities, staples, and defense-related companies in the industrial sector. Our recommendation on healthcare is a neutral weighting, but we do appreciate its defensive qualities. See page 11.

Gail Dudack

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Technical Indicators

Our view of the recent rally is quite simple. The popular equity indices fell well below their moving averages in recent weeks and a rebound to at least the 50-day moving averages is likely in coming trading sessions. The levels to look for are 31,277 in the Dow Jones Industrial Average, 3,915 in the S&P 500, 11,637 in the Nasdaq Composite, and 1,822 in the Russell 2000 index. Note that a test of these levels equates to another 2.5%, 5.3%, 8.0%, and 3.7% upside, respectively, in the indices. See page 9.

The good news is that the current rebound has more potential; but unfortunately, the market’s action in recent weeks also suggests the bear market is ongoing. In short, the lows are yet to be found. Breadth data deteriorated in September, and in particular, the 25-day up/down volume oscillator hit an extreme oversold reading of negative 5.6 on September 30. This was a deeper oversold reading than the one seen at the June low. The 25-day oscillator was also in oversold territory for 10 consecutive trading sessions in September and to date, it has been oversold for a second time in six of the last seven trading sessions. This represents a much longer and persistent oversold condition than the six out of eight consecutive trading sessions seen at the June low. All in all, it indicates an escalation in selling pressure which means the test of the June lows was unsuccessful by several measures and the bear market continues. See page 10.

The current reading in the 25-day oscillator is oversold at negative 3.3, which is rather amazing given the nearly 6% two-day gain seen in the market to open October and the 4% two-day gain seen this week. This oversold reading reveals that despite these sharp rallies, selling pressure has overwhelmed buying pressure over the last 25 trading sessions, typical of a bearish trend. A successful test of a bear market low materializes when a new low in price is accompanied by less selling pressure and a less severe oversold reading. This indicates that selling pressure and downside risk is abating. In other words, a “non-confirmation” of a major low is a positive sign. Sadly, that is not what has been seen in October, to date.

Sentiment indicators have also been extreme recently, but this is favorable. Last week’s AAII readings showed bullishness at 20.4% and bearishness at 55.9%. Also noteworthy was the 17.7% bullish reading seen the week of September 17th since it was among the 20 lowest readings since the survey began in 1987. Bearish sentiment has been above 50% for seven of the last eight weeks which is also rare. Equity prices tend to be higher in the next six and/or twelve months following such extreme readings. Keep in mind that sentiment indicators are never good at timing market peaks or troughs, but they are good at indicating which way to lean. In this case, it suggests that investors should not be overly bearish on equities and should be looking for a buying opportunity ahead. See page 12.

Earnings Forecasts

We are happy to report that some anchors on CNBC are now pointing out that even though some companies are reporting third quarter earnings results that exceed consensus expectations, these earnings are nonetheless weaker than a year earlier. That is a step in the right direction, since the market had been ignoring the fact that earnings have been weakening in 2022.

This week the S&P Dow Jones consensus earnings estimates for 2022 and 2023 fell $0.79 and $2.62, respectively. Refinitiv IBES consensus earnings forecasts fell $0.76 and $1.17, respectively. To date third quarter results are triggering larger earnings cuts than what was seen in the second quarter. The S&P consensus EPS estimate for 2022 is now at $207.33 and the IBES estimate fell to $222.58 bringing EPS growth rates for 2022 to negative 0.4% and positive 7.7%, respectively. See page 8. Our 2022 and 2023 estimates are currently $209 and $229, respectively, but remain under review. Based on early releases, our S&P 500 earnings estimates could come down significantly before year end. Unfortunately, this means the fair value range for the SPX will also fall. The range in our valuation model currently shows a low of SPX 2354, a high of SPX 3430, and a midpoint of SPX 2890. It is the midpoint of the range that is the most likely to contain downside risk, in our view. However, this explains why lowering our earnings forecast poses even more downside risk in the marketplace.

Inflation

September’s inflation data disappointed many and this disappointment will continue in coming months unless analysts look deeper into CPI data. Forecasters were expecting lower inflation numbers because energy prices fell 6.2% month-over-month in September. Nevertheless, September’s CPI was unchanged year-over-year and core CPI rose. And note, this was not due entirely to owners’ equivalent rent, as some are saying. See page 3.

As we expected, healthcare prices are rising in the fourth quarter which tends to be a seasonal trend. Housing prices may be peaking in some regions of the country, but housing is still rising in the CPI index. More importantly, unnoticed by many is the fact that food and beverage prices rose 10.8% YOY in September. This should be a concern for all investors because food inflation is not impacted significantly by energy (except for transportation costs) but will be impacted by the conflict in Ukraine since Ukraine – the breadbasket of Europe — is a major grain producer. We expect grain shortages will drive prices higher for the foreseeable future. In addition, Hurricane Ian damaged large portions of agricultural land in central Florida which could have an impact on the supply of fruits, vegetables, and beef. In our view, food shortages are likely to add to inflation in the months ahead. See page 4.

Some economists are fixated on owners’ equivalent rent which has a 24% weighting in the CPI and rose 6.7% YOY in September. They are challenging the validity of homeowners’ equivalent rent as a measure of housing costs since it is measured not by transactions, but from a survey of home prices and rents in various neighborhoods. Some say the surveys are not reflecting the deceleration in home prices. This is true since rents always lag home prices, sometimes by quite a few months, but this has always been true. Still, when we compare the history of owners’ equivalent rent to the National Association of Realtors median single-family home price, we find the homeowners’ equivalent rent has been much more subdued than home prices and has been a slow and steady measure of costs over time. However, the 6.7% increase seen in September was above the normal range of zero to 6%. See page 6. Rents are likely to fall in time since housing is clearly in a down-cycle. Signs of a housing recession are numerous, including the year-long decline in NAHB confidence. See page 6. However, this is not the problem that we see. Food and beverages have a 14.5% weighting in the CPI and rose a greater 11% YOY. This combination concerns us. Moreover, inflation is rising 8.2% YOY and wages are rising 4.8%. This equates to a 3.4% loss of purchasing power. See page 5. We remain cautious and continue to favor recession resistant sectors and stocks.

Gail Dudack

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Earnings season will begin later this week as financial stocks begin to report third quarter results. And for the first time this year, investors seem to be taking a close look at the quality of earnings and earnings guidance. Expectations turned lower for the banking sector after several global banks indicated they plan to raise reserves in anticipation of a weakening economy. Friday will be our first look at how the financial sector managed in the third quarter.

Global Woes

But the economic backdrop for earnings has come under review recently. This week The International Monetary Fund warned that “colliding pressures from inflation, war-driven energy and food crises and sharply higher interest rates were pushing the world to the brink of recession and threatening financial market stability.” Citing new 2023 global growth forecasts from its World Economic Outlook, the IMF said that countries representing a third of the world’s output could be in a recession next year. More disturbingly, the IMF highlighted that financial stability risks have increased, and it warned of disorderly repricing in markets.

Disorderly markets are not new news actually. Instability has already appeared in Britain. Last week the Bank of England expanded its program of daily bond purchases to include inflation-linked debt. It noted a “material risk” to British financial stability and “the prospect of self-reinforcing ‘fire sale’ dynamics” leading to chaos in its gilt market. The Bank pledged as much as 65 billion pounds of long-dated government bonds to allow for a more orderly disposal of assets in the pension fund sector. However, the risk continues, and investors are watching to see what happens when, or if, the Bank of England ends its purchasing program, perhaps as soon as later this week. History has shown how disorderly markets often reflect illiquidity and this instability can ripple through the global financial markets in unexpected ways. This is one of our main concerns for the latter part of the year.

It is important to note that these financial problems emanate partly from the US. The combination of inflation and rising interest rates in the US has driven the trade-weighted dollar to its highest level in 20 years. The Federal Reserve’s new nominal broad dollar index is currently at a 50-year high. See page 7. The strength in the dollar, coupled with rising interest rates, means that other central banks, like the Bank of England, will have to raise their interest rates to prevent their currencies from collapsing. In cases like England, where economic growth is already weak, rising interest rates compound the problem it already faces from higher energy costs, inflation, and a weakening economy. It can become a circular problem that is difficult to solve. Moreover, since crude oil is priced in dollars, energy becomes more expensive to non-US buyers, adding to inflation.  

Exacerbating these financial woes were reports from China that Shanghai and other cities have seen COVID-19 infections rise. Some local authorities began to close schools and entertainment venues, reigniting fears of more shutdowns, slower Chinese growth, and global supply shortages. Again, there are a number of issues outside the US that could have a significant impact on our financial markets in the remaining months of the year. This keeps us cautious.

Focus on Earnings

In terms of earnings, FedEx Corp. (FDX – $152.08) shocked investors last week when it revealed that it was preparing for a further decline in the number of e-commerce packages it would handle in the upcoming holiday season. The stock is down nearly 30% in the last month.

This week S&P Dow Jones consensus earnings estimates for 2022 and 2023 fell $0.63 and $0.25, respectively. Refinitiv IBES consensus earnings forecasts fell $0.38 and $0.86. But the most important news of the week was that the S&P consensus earnings estimate for 2022 declined to $208.12 and is now below 2021’s level of $208.17. This means that if economists are correct about a recession in 2023, investors could be facing two consecutive years of little or no earnings growth in equities. However, keep in mind that earnings in the energy sector continues to be strong, and when excluded from the S&P total, earnings growth in 2022 is already negative. We want to reinforce our view that investors should continue to focus on recession resistant stocks, such as energy, utilities, consumer staples, and special areas like defense-related companies.

Technical Indicator Update

The charts of the popular indices are quite similar this week with all four of the popular indices trading below all their moving averages. This is bearish. However, the one positive sign is the Russell 2000 index which is outperforming the other indices at the moment since the June lows have not been decisively broken. We focus on this small capitalization index since it was an early leader at the market top, and it could also be an early leader at the lows. Conversely, the Nasdaq Composite is the worst performing chart in a major decline. See page 10.

The 25-day up/down volume oscillator can be one of the best technical indicators at defining peaks and troughs. The oscillator fell to an oversold reading of negative 5.6 on September 30 which was a deeper oversold reading than the one seen at the June low, and it was in oversold territory for 10 consecutive trading sessions. This was longer than the oversold reading for six of eight consecutive trading sessions in June. In short, the test of the June lows was unsuccessful by this measure, and the bear market continues. The 25-day up/down oscillator is currently neutral with a reading of negative 2.93 but this is close to an oversold reading. A second oversold reading of greater than five consecutive days would confirm the market has not yet found its capitulation low. See page 11.

The 10-day average of daily new highs is 29 and daily new lows are 547. This combination is negative with new highs below 100, and new lows above the 100 benchmark. More importantly, the 10-day moving average of new lows was 1038 on September 26 and exceeded the previous peak of 604 made in early May. In addition, NYSE the advance/decline line fell below the June low on September 22 – is currently 56,191 net advancing issues from its 11/8/21 high – a negative sign. See page 12.

Jobs The increase of 263,000 jobs in September and a decline in the unemployment rate to the post-pandemic low of 3.5% was enough for investors to believe that the next Fed meeting will result in a 75-basis point increase. However, the number of people no longer counted in the labor force – 229,000 –increased nearly as much as job growth. This led to the participation rate falling 0.1 to 62.3% in September. Data also shows that 5.7% of those no longer counted in the labor force want a job. See page 5. And it is important to note that this is an economy of “haves” and “have-nots.” College educated workers are seeing growth in employment while those with less than a college degree struggle. But all workers are seeing a negative trend in real weekly earnings this year due to high inflation. See page 6.

Gail Dudack

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The S&P 500 index jumped nearly 6% in the first two days of October, as investors once again focused on the possibility that a Fed “pivot” is near. The incessant focus on a Fed pivot lacks an understanding of how difficult the Fed’s job is in terms of conquering an inflationary trend that has persisted for two years and reached double-digit levels. In our view, the Fed pivot mania is an attempt to simplify a global financial environment that is getting more complicated by the day. More importantly, it could be a misguided and potentially dangerous strategy for a number of reasons.

Forget the Pivot

First, it underestimates the Federal Reserve’s commitment to fight inflation. Most Fed governors have indicated that they are serious about lowering inflation and that they will remain vigilant and steadfast until it gets back to the Fed’s 2% goal. That will take a long time. Second, even if prices remain unchanged for the next several months, headline CPI will still be above the 6% level. This is far from nearing the Fed’s goal. The one piece of good news for inflation is that oil prices appear to be stabilizing at lower levels. But this will not be enough to get to lower levels of inflation. Even with WTI futures (CLc1 – $86.35) below $90 a barrel and down 25% from its May closing high, WTI is up 3.3% on a year-over-year basis. And in the background, OPEC+ is discussing cutting output. In short, the CPI is unlikely to come down substantially until 2023. Third, what could get the Fed to “pivot” on interest rates would be a financial crisis, or more specifically, a liquidity crisis in the banking system. However, such an event would be a disaster and rather than sparking an equity rally it would likely trigger a sizeable selloff. Unfortunately, this risk cannot be ruled out, particularly in an environment of rising rates and a strengthening dollar. There is instability in the global system as seen by the fact that the Bank of England had to employ emergency gilt purchases when British pension funds were swamped by margin calls. There are rumors of liquidity issues at Credit Suisse Group AG (CSGN.S – $4.29) and the government of Finland had to extend credit packages totaling 3.55 trillion euros to stabilize the power industry and the energy debt derivative sector, due to a deteriorating debt market. These events may seem unrelated, but we have seen lesser matters ripple through the global banking system and create chaos. It brings back memories of the financial crisis of 2008.

In other words, the focus on a Fed pivot is not a practical exercise in our opinion. Even if the Fed were to pause rate increases, it would not necessarily reflect a change in monetary policy and bring back the easy money policies that had encouraged speculators to the markets. All in all, it is a very short-term view. But it did spark an impressive two-day rally, to date.

A Focus on Earnings

We think a more appropriate focus for investors would be on corporate earnings. Although the financial press places its emphasis on whether or not a company has beaten its quarterly consensus earnings forecast, we think it would be more insightful to focus on whether quarterly earnings growth is positive or negative on a year-over-year basis. Companies have been beating consensus earnings, but that is a bit of a charade since corporations have lowered guidance and analysts have reduced estimates as earnings season approaches. Therefore, the charts from Refinitiv on page 10 are important. They show that the earnings estimate revision trend has been negative for most weeks at least since the middle of July. For the week ending September 30, the earnings revisions for S&P 500 companies were 67% negative and 33% positive. For all US companies, revisions for the week were 62% negative and 38% positive. And it is important to note that since April, according to S&P Dow Jones consensus estimates, the 2022 forecast has declined 8.2% and the 2023 forecast has decreased 4.4%. At present, the S&P Dow Jones earnings growth rates for this year and next are 0.3% and 14.3%. Both of these numbers include earnings for the energy sector which is providing most of the growth.

However, if the Fed continues its tightening policy the risk of recession increases and earnings forecasts for 2023 are apt to fall from positive to negative. In our opinion, this is where the financial press, analysts, and investors should concentrate. And this is what keeps us cautious.

Technical Breakdown

The two-day October rally has been impressive and included a 91% and 95% up day in volume. The advance was triggered from a deeply oversold condition and gained momentum on softer economic news and a smaller than expected increase of 25 basis points by the Reserve Bank of Australia. This combination refueled predictions of a Fed pivot. However, despite the strength of the two-day rally, breadth statistics remain negative. Sadly, the 25-day up/down volume oscillator hit an oversold reading of negative 5.6 on September 30 and was in oversold territory for a string of 10 consecutive trading sessions. The current reading is neutral at negative 2.66. Nevertheless, the 10-day oversold reading was more extreme than the oversold reading at the June low. This means September’s test of the June lows was unsuccessful and the bear market continues. See page 12.

This was not the only indicator that broke down at the end of September. The 10-day average of daily new lows reached 1,038, exceeding the previous peak of 604 made in May. The NYSE cumulative advance/decline line fell below its July 2022 low and is now 47,465 net advancing issues away from its all-time high. See page 13. The charts of the indices show prices are well below their 200-day moving averages and could rally back to test their 100-day moving averages. However, the long-term trend would still remain bearish.

The one positive is sentiment. Last week’s AAII bull/bear readings showed a 2.3% increase in bullishness to 20.0% and a 0.1% decrease in bearishness to 60.8%. Last week’s 17.7% bullish reading was among the 20 lowest readings since the survey began in 1987. Sentiment indicators are not good timing indicators, but they do suggest that this is not the time to become too bearish. Equity prices tend to be higher in the next six and/or twelve months following such extreme readings.

Economic Review

Many housing statistics were released in the last week, and they paint a picture of a housing sector experiencing an accelerating slowdown. Pending home sales have been declining since October 2021. Affordability is at its lowest level since 2006. Median home prices reached a record level relative to income in June 2022, and when coupled with rising mortgage rates, make this a difficult time to buy a home. The NAHB confidence index has been falling all year and in the September survey, dropped to levels last seen in 2014. Census Bureau data indicated that building permits fell in August to its lowest level in two years. But in a surprise, housing starts picked up from 1.404 million to 1.575 million in August. The ISM manufacturing index fell from 52.8 in August to 50.9 in September. New orders dropped from 51.3 in August to 47.1 in September and have been below 50 (neutral) for three of the past four months. Employment fell from 54.2 to 48.7 and has been below 50 for four of the last five months. These weak statistics may increase the hope of a Fed pivot, but they will not be good for earnings growth in coming quarters. Stay cautious.

Gail Dudack

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After a long delay, the equity market finally realized that the Federal Reserve has much more work to do in the months ahead in order to combat inflation. It has become clear that the focus on the timing of a “peak fed funds rate” was premature. Last week the Fed raised the fed funds rate 75 basis points to a range of 3% to 3.25%, and the November meeting could see another 75-basis point increase which would carry this benchmark to 4%. The December meeting will be data-dependent, but it could also result in short-term rates moving higher. This combination of rate increases has had a dramatic impact on all interest rates and on the dollar, while keeping the government yield curve relatively inverted. See page 3.

However, the chart of government interest rates on page 3 shows another important detail which is how much interest rates have risen since the end of August. In particular, the two-year Treasury note yield has jumped 105 basis points in less than a month. To date, this is the largest monthly increase in the two-year Treasury note yield since the 1980 to 1981 era, which is an interesting era to compare to today’s situation, since inflation is also the highest in 40 years. In that inflationary period, inflation peaked at 14.8% YOY in March 1980, fell to 9.6% YOY in June 1981, but quickly rebounded to 11% YOY in September 1981. The Fed first raised rates dramatically until the effective fed funds rate hit 17.6% in April 1980. The Fed then cut rates due to a recession (January 1980 to July 1980) and the effective fed funds rate fell to 9% in July 1980. But when inflation reignited, the Fed boosted rates once again and the effective fed funds rate rose to 19.1% by June 1981. This hawkish policy triggered a second recession between July 1981 and November 1982.

We believe the current Fed hopes to avoid the erratic tightening policy of the 1980-1981 timeframe and will therefore continue to steadily raise rates until data shows prices are not simply decelerating, but in fact, the inflation cycle has been broken. This will take time and unfortunately, it is likely to result in a full-blown undeniable recession.

Canary in the Coal Mine

We have been watching the debt markets more carefully in recent days since the spike in the dollar can have consequences in areas least expected. The SPDR Bloomberg High Yield Bond ETF (JNK – $87.57) tracks the US high yield corporate bond market and it is spiraling downward, approaching the March 23, 2020 closing low of $84.57, which tested the March 2009 low of $77.55. However, while the bond market is displaying substantial concern about the future, the VIX is at $32.60, and remains well below its $82.69 close of March 16, 2020. See page 4. In our view, the equity market is too complacent about the current combination of rising interest rates, a higher dollar, and declining earnings.

Moreover, the bond market is more closely connected to the global environment where the mixture of rising debt loads (both sovereign and corporate), higher interest rates, and a strong dollar can be an explosive combination. In short, the decline in the high yield market concerns us and we fear the next unexpected event may materialize outside the US and be related to defaults.

Earnings Reality

Despite some comments by well-respected analysts, earnings estimates for 2022 and 2023 are falling. This week S&P Dow Jones consensus earnings estimates for 2022 and 2023 fell $0.78 and $1.33, respectively. Refinitiv IBES consensus earnings forecasts fell $1.50 and $1.24. The S&P consensus EPS estimate for 2022 is now $208.21 and the IBES estimate fell to $223.83, bringing EPS growth rates for 2022 to 0.3% and 7.5%, respectively. See pages 6 and 13.

We recently reduced our 2022 S&P 500 earnings estimate from $218 to $209 and for 2023 our estimate declines from $237 to $229. However, we must admit that we fear we may have to lower these estimates after third quarter earnings season. Nevertheless, our $209 estimate coupled with our valuation model which suggests that a 14 X multiple is appropriate for this environment creates a downside target of roughly SPX 2915. The yearend range is SPX 3452 to SPX 2380. This implies that there is more risk in the market. An alternative method would be to take an average PE of 15.8 X with our $209 estimate, and this equates to SPX 3302. See page 5. Either way, the market has not yet reached a level of table-pounding good value.

Technical Indicators may be weakening

Technical indicators have not been reassuring this week – quite the opposite. The charts of the popular indices look quite similar this week, unfortunately, all four of the popular indices appear to be in the midst of a capitulation-style decline. As we have indicated in recent weeks, the key to defining this bear market’s low will be whether breadth data is less negative on a new low in price. If so, it would be a positive sign of a bottoming formation. The alternative is not favorable for the intermediate term. See page 7.

At the moment, the jury is still out, but recent breadth data is not encouraging. The 25-day up/down volume oscillator is now at negative 4.35 and recording its sixth consecutive day in oversold territory, i.e., a reading of negative 3.0 or less. (On September 26, 2022, the 25-day indicator also hit a low of negative 4.95.) Since this oscillator was in oversold territory for six of eight consecutive sessions between July 6 and July 15 and hit an extreme oversold reading of negative 5.17 on July 14, 2022, a successful test of the June lows would require a shorter and/or less intense oversold reading on any new low in price in the S&P 500. Although the oscillator is slightly less oversold than it was in June, it is by a very narrow and tenuous margin. Another extreme sell-off day would take this indicator to a deeper oversold reading, turning this indicator negative, and indicate that lower lows may be ahead. In short, the market could be only a day or two away from an unsuccessful test of the June low.  See page 8.

In addition, the 10-day average of daily new highs is 32 and daily new lows are 896. This combination is negative with new highs below 100, and new lows above the 100 benchmark. More importantly, the 10-day moving average of new lows at 896 has now exceeded the previous peak of 604 made in early May. Again, the market is showing underlying weakness. The advance/decline line fell below the June low on September 22 just prior to the SPX breaking its June low. The NYSE cumulative advance/decline line is currently 53,150 net advancing issues from its 11/8/21 high – a large number and a negative sign for the near term. See page 9. On a more positive note, last week’s AAII readings showed a decrease of 8.4% in bulls to 17.7% and an increase of 14.9% in bears to 60.9%. The 17.7% reading is among the 20 lowest readings since the survey began in 1987. Optimism was at a similar level in May. Equity prices tend to be higher in the next six and/or twelve months following such extreme readings in sentiment. See page 10.  

Gail Dudack

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For the second time in six weeks, we are lowering our 2022 and 2023 earnings estimates for the S&P 500. For 2022, our forecast falls from $218 to $209, and for 2023 our estimate declines from $237 to $229. See pages 9 and 16. These estimates now translate into earnings growth rates of 0.4% this year and 9.6% next year. Both cuts in estimates were the result of disappointing earnings in the last two quarters. But more importantly, a weakening economy could put these reduced estimates in jeopardy.

It is worth pointing out that consensus estimates for 2022 have dropped precipitously as well. In particular, the S&P Dow Jones consensus estimate for 2022 was $227.51 in late April and fell to $209.66 last week, a 7.8% decline. The IBES Refinitiv consensus estimate hit a high of $229.57 in June and was $225.33 last week, a 1.8% decline. So, despite the misleading headlines suggesting that second quarter earnings season was better than analysts expected, earnings have disappointed in each reporting quarter this year. (Note that media headlines are never comparing earnings results on a year-over-year basis, but instead, compare results to the consensus estimate which may have been dramatically reduced just a few days earlier.) Moreover, most economists are now forecasting a recession for 2023, yet this does not seem to be reflected in current earnings estimates. Until this happens the door is open for more disappointments.

This earnings review of the first half of the year may explain why the market has been so weak as we approach the September FOMC meeting. Excluding the energy sector, earnings results for the S&P 500 are in the red for the first half of the year. Nevertheless, the Fed is expected to make the economic backdrop less friendly for corporate earnings in the coming months. It is likely that the Fed will raise interest rates 75 basis points this week, although it makes little difference if it is 75 basis points or 100 basis points, in our view. The bigger picture suggests that while the high of the fed funds range is currently at 2.5%, it is apt to reach 4% to 4.5% after the next few Fed meetings. In short, the Fed is undoubtedly going to trigger a recession, and this has not yet been fully factored into stock prices.

Valuation Model Woes

We have been reporting on the repercussions of inflation for a long while – the reduction in purchasing power of households, the pressure on profit margins and the negative impact on PE multiples – and the market is finally beginning to confront these issues. However, the combination of lower earnings growth and lower PE multiples is a toxic mix for equity valuation. When we combine our new assumptions of $209 earnings in 2022, with short-term interest rates rising to 4% and inflation falling to 6.2% by year-end, we get some distressing results in our valuation model. See page 8. First, our model suggests that a PE multiple slightly below 14 times is appropriate for the 2022 environment and coupled with our earnings estimate of $209, it produces a target of SPX 2915. The year-end range shows a high of SPX 3452 and a low of SPX 2380. Keep in mind that periods of high inflation typically result in the SPX trading in the lower half of the range because earnings are worth less in an inflationary environment. This is one of the many miseries of high inflation.

Alternatively, we could use the long-term average PE multiple of 15.8 times to find value in the equity market. With our $209 earnings estimate this generates a downside target of SPX 3302, which is less disconcerting, but still 14% below current prices. Either way, we believe the market has further downside risk. See page 8.

History also shows us that periods of inflation tend to place a ceiling on stock prices until the inflationary cycle is under control. See page 7. We believe the Federal Reserve understands this. And though they were late to address the inflation problem, we believe they will be steadfast and aggressive in the near term to counter inflation as best they can. See page 6. Other countries face the same inflationary issues, and their central banks are following the Fed’s lead, as seen by Sweden’s central bank which raised interest rates 100 basis points this week.  

One can see the impact of inflation everywhere. Retail sales were up a robust 9.1% YOY in August, but up only 1.5% YOY after inflation is considered. Although August’s gain in real retail sales was not substantial, it was nonetheless a positive gain which is a favorable shift. Real retail sales were negative in three of the four months between March and June, which concerned us because months of negative real sales are a classic sign of an economic recession. And even though retail sales rose 0.3% in August on a month-over-month seasonally adjusted basis, nominal retail sales in US dollars in August were below the level reported in June. See page 3.

Average weekly earnings grew at a healthy 5.1% YOY pace in August, but inflation rose 8.2% YOY, which means purchasing power actually fell 3.1% on a year-over-year basis. And after nearly two years of rising prices, energy is no longer the driver of inflation. As seen in the chart on page 5 of core CPI, PPI and PCE, these indices rose 6.5%, 8.8%, and 4.6%, respectively in August. All core inflation measures were the highest is 40 years. This explains why a 75-basis point or a 100-basis point hike in interest rates is irrelevant. Interest rates must go much higher to curb the current inflationary problem.

Technical Update

The 25-day up/down volume oscillator fell to negative 3.02 this week which is the first oversold reading of negative 3.0 or less since July. Remember that this oscillator was in oversold territory for six of eight consecutive sessions between July 6 and July 15 and hit an extreme oversold reading of negative 5.17 on July 14, 2022. A successful test of the June lows would require a shorter and/or less intense oversold reading with or without a new low in price in the indices. This is an important juncture for this oscillator.

The key to a successful retest of a bear market low is whether or not a new low in price also generates a new low in breadth. A successful retest will show there is less selling pressure – a less severe oversold reading — despite a lower low in price. We think this is a possibility in the final months of the year, but it means that this indicator should not fall below negative 5.17 or remain oversold for more than six to eight consecutive days. If it does, it would be negative for the intermediate-term outlook. The charts of the popular indices are quite similar this week. All four of the popular indices appear to be on the verge of testing the June lows and we would not be surprised, or concerned if all four indices break these lows. The key will be whether or not breadth data is stronger on this new low than it was in June. Remember: in terms of seasonality, September tends to be the weakest month of the year and that seems to be proving true in 2022. However, October has the reputation of being a “bear killer” and a turnaround month. We will be monitoring our indicators for signs that this will also prove true in 2022.

Gail Dudack

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The past week has been filled with global events, although none as historic as the sudden passing of Queen Elizabeth II of Great Britain on September 8 at the age of 96. She was Britain’s longest-reigning monarch, who guided her country for decades with grace and diplomacy, held an audience with 15 British Prime Ministers and spanned a timeframe that included 14 US presidents, from Harry Truman to Joe Biden. Closer to home, Ken Starr, lead prosecutor in the Clinton-Lewinsky investigation which led to the impeachment of President Bill Clinton, died at age 76.  

Ukraine regained ground in the Russia/Ukraine conflict in what could be a pivotal shift in momentum in the war. The Ukrainian counteroffensive in the northeastern part of the country made impressive gains and, in some cases, pushed Russian soldiers back behind the Russian border. President Zelensky reported that his troops captured more territory in the last week than Russia did in the last five months. German Chancellor Olaf Scholz called on Russian President Vladimir Putin to find a diplomatic solution as soon as possible, based upon a ceasefire, complete withdrawal of Russian troops, and respect for the territorial integrity and sovereignty of Ukraine. This is a developing situation that could have significant implications for geopolitical and economic events in the months ahead.

Peiter “Mudge” Zatko, a famed hacker who served as Twitter’s (TWTR – $41.74) head of security until his firing in January, testified before the Senate Judiciary Committee this week in what could also be a turning point for both Twitter and Elon Musk. Zatko said that in the week before he was fired from Twitter, he learned the FBI told the company that an agent of China’s Ministry of State Security (MSS), the country’s main espionage agency, was on the payroll at Twitter. “This was a big internal conundrum,” according to Zatko since China is Twitter’s fastest growing overseas market for ad revenue. Musk and Twitter head to trial next month to determine whether the billionaire’s $44 billion takeover deal should be completed.

In an odd bit of timing, President Joe Biden celebrated his $430 billion climate change and drug pricing bill, mislabeled as, The Inflation Reduction Act, on the same day that the Bureau of Labor Statistics reported that inflation did not decline in August as expected but in fact rose 0.1%. This squashed burgeoning hopes that inflation was cooling. All three major stock indices turned sharply lower and notched their biggest one-day loss since the throes of the pandemic in June 2020. The Dow Jones Industrial Average fell 1,276.37 points, or 3.94%, to 31,104.97, the S&P 500 lost 177.72 points, or 4.32%, to 3,932.69 and the Nasdaq Composite dropped 632.84 points, or 5.16%, to 11,633.57. All 11 major sectors of the S&P 500 ended the session deep in red territory.

The Basics of Inflation

The stock market’s dramatic reaction to the inflation report was both startling and revealing, in our view. We were surprised at the market’s intense reaction to the fact that neither headline nor core CPI declined on a month-over-month basis. It reveals that neither economists nor investors understand the underpinnings of inflation or the composition of the consumer price index. It also reveals that much of the recent advance was based upon the expectations that inflation was moderating simply because gasoline prices had declined. Again, these were naïve or premature presumptions.

As we have been writing for the last 18 months, the combination of historic monetary and fiscal stimulus in 2021 during an economic recovery, coupled the with signing of The Paris Climate Agreement and reducing carbon fuel supplies, and the Russian invasion of Ukraine was a volatile mix for the world for the following reasons: 1.) Stimulus, monetary or fiscal, during a recovery is inflationary. 2.) Reducing carbon fuels without an immediate plan to replace these energy supplies is foolish and will immediately increase fuel prices. 3.) Russia, a major source of fuel for Europe, has weaponized oil and restricted energy supplies to Europe which is increasing fuel prices. 4.) Ukraine, the breadbasket of Europe, has been demolished and this will result in critical food shortages in the world and raise food prices in coming months.

None of the above are temporary, and only monetary policy is controllable by the Federal Reserve. Nevertheless, the Federal Reserve is responsible for reducing inflation and it will continue to do so by reducing money supply and increasing interest rates. Both will slow the economy and the combination will increase the risk of recession. In our opinion, the Fed will raise rates 75 basis points later this month, with the hopes that inflation will begin to slow, and rates will continue to decrease economic activity.

However, the Fed has been late, and inflation has become systemic, in our view. As we show on page 3, prices are rising in all areas of the economy particularly in housing, food, and medical care. Owners’ equivalent rent has a hefty 23.65% weighting in the CPI, and it rose 6.3% YOY in August. This series tends to move in line with housing prices, but with a multi-month lag, which means rents are likely to continue to rise along with housing and add to inflation even as gasoline prices fall. Auto and lodging prices rose less dramatically in August, but medical prices are seasonal which means they will now switch from tempering inflation to adding to inflation. Note that medical insurance prices tend to rise annually in the fourth quarter when corporate and Medicare contracts are finalized. See page 4. A broadening of inflation can be seen by the fact that while headline inflation fell from July’s 8.5% YOY to August’s 8.3% YOY, core inflation rose from July’s 5.9% YOY to August’s 6.3% YOY.

All of this was predictable for anyone who understands the concept of supply and demand and the composition of CPI. Note that all but one component of CPI is currently growing at multiples of the Fed’s target rate of 2%. See page 5. This indicates the difficulty facing the FOMC in coming months. The US Treasury yield curve is not fully inverted, but it is inverted between the 1-year Treasury and the 10-year Treasury note. And even after a 75-basis point increase in the fed funds rate later this month, the effective fed funds rate would be 3.08% and would still be lower than the current 10-year Treasury yield of roughly 3.42%. Yet what concerns us is the historically large spread between the inflation rate and the 10-year Treasury yield. In the inflationary cycle of 1968 to 1982, inflation exceeded the Treasury yield, but was not broken until the Treasury yield matched the inflation rate – with a lag. Hopefully, it will be different this time and inflation will ease as interest rates rise. But the risk of recession remains high in most any scenario. See page 6.  

There was some good news in sentiment indicators this week. AAII readings showed a decrease of 3.8% in bulls to 18.1% and an increase of 2.9% in bears to 53.3%. These results are in line with the five weeks of less than 20% bulls and more than 50% bears between April 27, 2022 and July 7, 2022. Equity prices tend to be higher in the next six and/or twelve months following such a reading. See page 14. In sum, we remain cautious, particularly in September, and remain focused on sectors and stocks with recession resistant earnings such as energy, utilities, staples, and defense stocks.

Gail Dudack

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