In last week’s Strategy Weekly, we wrote (“Neither Bear nor Bull” – August 24, 2022): “While technical indicators have their bright spots, we feel investors may have become too optimistic too soon. Re-emergence of meme stock investors is one sign that speculation has returned to the market too quickly. Expectations of a Fed pivot this year are quite likely to be wrong, or at least premature. Economic indicators are mixed but many are showing definitive signs of weakness and the possibility of a recession.”

Although we were skeptical of the recent rally, from a broad macro perspective, we still believe the equity market is in a bottoming phase. However, we should explain what this means. Toward the end of a classic bear market decline, equities often suffer an intense sell-off on heavy volume which is often accompanied by margin calls. June had many of these characteristics. In subsequent months, bear market lows are typically retested, and it is normal to see the popular averages hit a lower low which can trigger more selling panic. But the distinctive feature of a successful bottoming process in a bear market cycle is that breadth indicators show that the new lower low was made on less volume, accompanied by less selling pressure, with less extreme oversold readings, and with less extreme breadth statistics in general. These are all signs of a waning bear market and a successful test of the low. The rebound from this lower low should also contain a series of 90% up-volume days as further confirmation that the final low has been made.

With this as a historical backdrop, one should expect the June lows to be retested in the second half of the year. And keep in mind that the August-September months tend to be a seasonally weak period for equity prices. Actually, September ranks as the weakest of all twelve months averaging a 0.7% loss over the last 71 years. Although October has a bad reputation and is associated with bear markets, the truth is that October tends to be a “bear killer” or a turnaround month. Twelve of the last 48 declines of 10% or more in the S&P 500 were made in October, far more than any other month. Next in line is March with eight lows and June with seven.

September

Seasonality does not always work as planned, and it can be overridden by geopolitical or financial events. Still, it is wise to be aware of the seasonal tendencies of equity markets. A retest of the lows in the September/October timeframe makes sense to us for many reasons in addition to seasonality. First, it will be the start of another important earnings reporting season. Despite recent headlines suggesting that second quarter earnings results were “better than expected” the reality is that they were better than the very worst expectations. In truth, earnings for this year and next year came down substantially in recent weeks. The S&P Dow Jones consensus earnings estimate for 2022 fell $13.68 since the end of June. The IBES consensus estimate for 2022 fell $4.21 in the same period. As a result, our recently reduced forecast of $218 for the S&P 500 for this year is under review and may be in jeopardy.

Second, the next FOMC meeting is scheduled for September 20-21, and this will be followed by another meeting on November 1-2. The final Federal Reserve meeting of the year is set for December 13-14. However, the September meeting is the one we expect will set the tone for monetary policy for the rest of the year in terms of how much tightening the Federal Reserve expects it will do in the final months of 2022. More importantly, we believe the consensus will continue to be disappointed regarding monetary policy in 2023. For example, New York Federal Reserve Bank President John Williams recently stated that the Fed will “likely need to get its policy rate above 3.5% and is unlikely to cut interest rates at all next year as it wages a battle against far too high inflation.” That means no “Fed pivot” in the next sixteen months!

Third, September could be the month in which the energy crisis in Europe unravels and heating fuel is rationed. Unrest in Iraq could negatively impact energy supplies. China’s economy appears to be weakening despite several attempts to stimulate activity. Plus, as a result of a landmark audit deal between Beijing and US regulators, Alibaba Group Holdings (BABA – $93.84) will be the first Chinese company to be audited by US audit watchdog – Public Company Accounting Oversight Board (PCAOB) – in Hong Kong in mid-September. In sum, September has the potential of being a very important and eventful month.

Economic Review

The first revision for second quarter GDP indicated growth declined 0.6% versus the initial 0.9% decline. Nonetheless, economic activity weakened for two quarters in a row. Economists denying the first half of the year was a recession may be overlooking the debilitating impact of inflation. On page 3 we show the GDP deflator, which is currently at its highest level since December 1981. Note that similarly high inflation between 1970 and 1984 was a period marked by four separate recessions.

The most important data series, in our view, is real personal disposable income since this is the best measure of potential household demand. Fiscal stimulus bills boosted household income significantly in April 2020 and even more in March 2021, but these gains in personal income were one-time events and artificial. Real personal disposable income per capita was $45,464 in July, down noticeably from the pre-pandemic January 2020 level of $45,747 and down significantly from the stimulus-boosted level of $57,752 in March 2021. Government stimulus in 2021 simply added to inflationary pressures and households are now experiencing both higher prices and relatively lower income. It is a bad combination. Note that personal consumption has increased more than personal income in recent months and is a trend that is unsustainable. See page 5.

Technical Summary

All the popular indices tested their 200-day moving averages last week, but this resistance proved to be overwhelming. Unfortunately, neither the 100-day nor the 50-day moving averages provided support on the subsequent sell-off in the S&P 500, Dow Jones Industrial Average, or the Nasdaq Composite index which implies the June lows are apt to be tested. The 25-day up/down volume oscillator fell to 1.63 and is neutral this week after its mid-August overbought reading for seven of eight consecutive trading sessions. However, the August 26 session was a 91% down day coupled with a 1,008-point decline in the DJIA.

In sum, we expect there will be disappointments ahead in terms of monetary policy and earnings results, and in our view, these risks have not been fully priced into equities. We believe portfolios should be concentrated in sectors where earnings are most predictable and are both inflation and recession-resistant. These include areas such as energy, utilities, defense-related stocks, staples, and healthcare. 

Gail Dudack

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Market peaks and troughs are often confusing intervals because both are periods of transition, volatility, and mixed signals. And at risk of oversimplifying the current environment, we expect confusion will heighten among investors and market forecasters based upon the facts that the technical condition of the equity market has been improving while the economic condition of the economy has been deteriorating. This is not an unusual combination at a major low.

It has been our view that the first half of the year was a recession or a recessionary period. This is the good news and the bad news. History shows that stocks tend to bottom out midway or in the latter half of a recession. If we are right about the economy this precedent is positive for today’s investors. However, a recession is also destructive to earnings and while many stocks have discounted a significant decline in earnings growth, this is not true of all stocks. In short, risk remains, and optimism may be a bit premature, especially at recent elevated prices. Although short-term trading opportunities will continue to present themselves, we believe portfolio holdings should be concentrated in sectors and companies that are both inflation and recession resistant, such as energy, utilities, defense-related industrials, staples and healthcare.

Our strategic view has been that 1.) the stock market began a bottoming phase in June, 2.) the major indices have probably seen their bear market lows, but 3.) the lows will be retested in coming months. Our optimism is supported by the fact that some technical indicators are defining a likely shift in long-term momentum from bearish to, at a minimum, neutral.

Economics

While technical indicators have their bright spots, we feel investors may have become too optimistic too soon. Re-emergence of meme stock investors is one sign that speculation has returned to the market too quickly. Expectations of a Fed pivot this year are quite likely to be wrong, or at least premature. Economic indicators are mixed but many are showing definitive signs of weakness and the possibility of a recession. A good example of this is this week’s S&P Global Flash US Composite PMI Index which fell to 45.0 in August, down from 47.7 in July. This was the second successive monthly decrease in total business activity, below 50 (contractionary), and was at a 27-month low. Excluding the period between March and May 2020, the decline in total output was the steepest seen since the series began nearly 13 years ago.

The S&P Global Flash US Services Business Activity Index was 44.1 in August, down from 47.3 in July, and the fastest decrease in business activity since May 2020. Service providers noted that hikes in interest rates and inflation dampened customer spending because disposable incomes were squeezed. This decline in spending was predictable in our view. As we have often noted, inflation destroys the purchasing power of consumers, higher fuel, transportation, and raw material costs pressure corporate margins, and while inflation has a negative impact on both consumption and earnings, it also lowers PE multiples. In sum, inflation is a triple threat to investors.

Some economic news was better than expected. Total retail & food service sales were $686.8 billion in July, a 10.3% YOY increase. Excluding motor vehicles and parts, sales were $557.9 billion, a 12.3% YOY gain. Sales of motor vehicles and parts dealers were $124.95 billion in July, a 2.1% YOY gain, and the first real year-over-year gain in autos since February 2022. See page 3. However, after adjusting for inflation, i.e., priced in 1982 dollars, real retail & food services sales were $231.25 billion in July, a much more modest 1.7% YOY gain. Nonetheless, this was the first positive year-over-year gain in real retail sales since February. But in terms of investments, it is important to note the changing composition of retail sales. There have been relative gains for gas stations, food services & drinking places, and nonstore retailers. But as a percentage of monthly retail sales, the losers have been autos, general merchandise, food & beverage, and clothing & clothing accessories stores. See page 4. These shifts in consumption are also reflected in sector performances with energy and utilities the only S&P 500 sectors to show year-to-date gains.

Meanwhile, the housing slump continues. Census data shows new home sales fell from 585,000 units in June to 511,000 units in July, the lowest level since October 2015 and 30% below a year earlier. Existing home sales fell from 5.1 million in June to 4.81 million in July, a 20% drop below the July 2021 level. Nonetheless, the median price of a new home rose from $414,900 to $439,400 in July, up 8% from a year earlier making homes less affordable in a rising interest rate environment. See page 5. And as home sales have been slowing, inventories have been rising. Existing home inventories have increased from the January 2022 low of 850,000 to 1.31 million units in July and the supply of single-family homes increased from 1.5 to 3.3 months in the same time period. Not surprisingly, building permits and starts have been falling in recent months. See page 6.

Earnings

The S&P Dow Jones consensus EPS estimates for 2022 and 2023 rose $0.06 and fell $0.02, respectively, this week. Refinitiv IBES consensus EPS forecasts rose $0.16 and fell $0.03 respectively. However, the nominal earnings range for 2022 changed to $210.56 to $225.50 and earnings growth rates for this year were unchanged at 1.1% and 8.4%, respectively. But we want to point out that our DRG 2022 estimate was lowered from $220 to $218 in early August, and given the results of the second quarter, and the S&P estimate of $210.50 for this year, our estimate could still be too optimistic. See page 8.

Technicals

The charts of the popular indices show that stocks had a convincing rally to their 200-day moving averages but have since retreated. See page 9. A test of the 200-day moving average is typical of a bear market rally and is not predictive; but other indicators suggest that the underlying momentum of the rally points to a weakening bear cycle and the possibility that the lows for many stocks may have been made in June.

The 25-day up/down volume oscillator fell to 2.19 this week but it was overbought for seven of eight consecutive days between August 10th and August 19th. It also reached a peak overbought reading of 5.26 on August 18th, the highest overbought reading since December 10, 2020. This is important since extreme and/or long overbought readings are rare in a bear market and if they appear, the readings tend to be brief, or less than six consecutive trading days recently seen. It is also important to note that the last two 90% days were up days on July 19, 2022 (92%) and August 10 (91%), an indication that momentum could be shifting from a bear cycle to, at worst, neutral. Still, the near-term market appears extended. In our view, investors are currently too optimistic that Fed tightening is nearly over, and this could change with Chairman Powell’s speech this week at Jackson Hole, WY. We would remain invested but concentrate on companies with predictable earnings streams and/or above average dividend yields.

Gail Dudack

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The current rebound has carried the broad indices between 14% (Dow Jones Industrial Average) and 23% (Nasdaq Composite Index) above their June lows and the rally has created a number of positive technical changes in our indicators. These technical changes are encouraging for the intermediate-to-longer term. Still, we would not be chasing the rally at this juncture. Walmart’s (WMT – $139.37) better-than-feared earnings report for the second quarter, was a sign that some companies are beginning to adjust to the hurdles facing them in this difficult economic environment. But while WMT jumped more than 5% for the day, its earnings report did not suggest the economy and the consumer are about to return to normal. In fact, Walmart’s results suggest that higher income families have shifted to Walmart to buy groceries. This is not a sign of consumer strength, in fact, it appears to be the opposite.

Plus, there are numerous signs that speculation is returning to the equity market. In particular, the performance of meme stocks during the August 16^th trading session suggests that “risk” is back in vogue. Bed Bath and Beyond (BBBY – $20.65), halted at least twice for volatility during the day, rose 29%. GameStop (GME – $42.19), also halted for volatility, ended the day with a gain of 6.3%. Meme favorite AMC Entertainment Holdings (AMC – $24.81) rose 2.5%, fuboTV (FUBO – $6.35) jumped 45% and Vinco Ventures (BBIG – $1.13) soared 58.8%. Meme favorites tend to be beaten down stocks with high short interest levels that attract speculators looking for high risk and quick gains. In short, this activity does not represent true equity investors and it is a short-term negative.

We continue to have an overweight rating in stocks and sectors that have the most predictable earnings streams, and these areas also tend to be equities that are both inflation and recession resistant. Sectors such as energy, utilities, staples, and defense-related stocks in the industrial sector have these characteristics. Healthcare, where we have a neutral weighting, is also a “necessity” for most households and also tends to be inflation and recession resistant.  

Expectations

The return of the speculators suggests that some investors feel the worst is behind us and the economy is about to rebound after a weak and recessionary first half of the year. The University of Michigan consumer sentiment indicator for August suggests there is some truth to that thought. The August reading of 55.1, was up from July’s 51.5 reading and was a nice rebound from the record low of 50 recorded in June. Expectations also rose from a very weak reading of 47.3 in July to 54.9 in August. But strangely, the current conditions index fell from 58.1 in July to 55.5 in August. See page 7. In other words, consumers are not feeling great at the moment, but are hopeful that the future will get better. This may have a lot to do with the decline in gasoline prices in the last four weeks.

This optimism may be supported or upturned by the retails sales report coming out this week. We will be watching to see if real retail and food services sales can turn positive and show gains even after being adjusted for inflation. The last four consecutive months of negative growth in real retail sales is a classic sign of margin pressure on retailers, and a sign that consumers are actually consuming less in real terms. Moreover, it tends to be a sign of a recession. See page 7.

In our view, it is too early to celebrate, or to believe that the Federal Reserve has managed to steer the economy into a soft landing. Monetary policy is as tricky to predict this year as we have seen in many years. Inflation remains a hurdle. July’s CPI was up 8.5% YOY, down from June’s 9.0% YOY, but still extremely high. Core CPI was unchanged at 5.9% YOY last month. PPI for finished goods was 15.5% YOY in July versus 18.5% in June. Core PPI was 8.7% YOY in July versus 8.9% in June. In sum, by all price measures inflation remains well above the long-term average of 3.4% or the Fed’s target of 2%. And though inflation may have decelerated a bit, it remains dangerously high. See page 3. This poses a problem for the Fed. Although the high end of the fed funds target rate has increased from 25 basis points in February to 250 basis points in August, it is likely to go much higher. The reason for this is that the real fed funds rate is still negative 5.2% relative to the CPI and negative 4% relative to the PCE index. This is the equivalent of 520 or 400 basis points, which means it would not be surprising if the fed funds rate increases at least 200 basis points, or more, before it truly impacts inflation. See page 4. Unfortunately, these interest rate hikes will do damage to the economy and to corporate earnings.

Housing is very interest-rate sensitive, and the housing sector’s combined contribution to GDP generally averages a sizeable 15% to 18%. We believe housing is either already in a recession or about to slip into one. And though interest rates may be only halfway through their rise, housing affordability is already at its lowest level since late 1985. The NAHB confidence indices are also plummeting and looking quite bleak. See page 5. Housing prices continue to rise, due in large part to low inventories, but as a result, the median existing home price relative to income per capita at its highest point on record. This, coupled with rising mortgage rates account for the big decline in affordability. Not surprisingly, both building permits and housing starts are rolling over in July, with housing starts falling nearly 10% in the month and down 8% YOY. See page 6. With this as a backdrop, it will be difficult for the Fed to navigate the economy to a soft landing.

Lower crude oil prices will lower inflation in coming months, but this was not a result of monetary policy. Oil prices are down due to signs of progress on the Iran nuclear talks and the possibility that Iran could add a million barrels a day to global production. Also dampening oil prices were the surprisingly weak economic data coming from China (the world’s largest crude oil importer). This was coupled with worries of a global slowdown and signs of massive demand destruction after peak gasoline prices. However, all this could be temporary since the European Union’s embargo on Russian oil is set to take effect in December and could shift the supply/demand balance. In sum, investors may be too optimistic about inflation and a Fed pivot in rates.

We also feel investors are too optimistic about current and future earnings growth. The S&P Dow Jones consensus EPS estimates for 2022 and 2023 fell $6.38 and $1.01, respectively, this week. Refinitiv IBES consensus EPS forecasts rose $0.16 and fell $0.55, respectively, however, IBES does not adjust for actual earnings or adjust for GAAP accounting, which is why we prefer S&P data. Which means with the S&P estimate for 2022 now down to $210.50, a 1.1% YOY gain, we may have to lower our $218 estimate once again. In short, expectations for earnings may be too optimistic.

Technical Indicators Show Promise

The 25-day up/down volume oscillator rose to 4.93 this week, the highest since December 8, 2020, and has been in overbought territory for four of the last five consecutive trading sessions. This is an interesting juncture for this indicator because bear markets rarely record overbought readings and if they do the readings are brief. If this oscillator can remain overbought for five consecutive days this week, it would be a sign that most stocks have already seen their lows and the worst of the bear market is likely behind us. Nonetheless, the current reading of four overbought trading days already implies that the broad market may have seen its worst, and is likely to remain in a wide trading range for the rest of the year. The S&P 500 and Russell 2000 index are currently trading above their 200-day moving averages (MA) and the longer they trade above this key level, the more likely the rally will push higher. However, in all the indices, the 200-day moving average continues to fall, which remains a sign of a bear market trend. At a minimum, we would like to see the 50-day MA better the 100-day MA in each index, to suggest a bottoming trend is in place. In short, things have improved but expectations may be too high. We would not chase stocks here and continue to focus on earnings growth for stock selection.

Gail Dudack

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This week the BLS will release price data for August, and although we believe it is too little too late, inflation data is getting a lot of attention from market watchers. Investors are hoping that price data will begin to decelerate, and if so, it will ease the pressure on the Federal Reserve to be aggressive in terms of raising interest rates. However, they may be disappointed. A deceleration from the CPI’s 9% YOY pace in June would be nice; yet many are pinning their hopes on the fact that WTI oil futures are down more than 20% from their May close. But this ignores the fact that oil prices are up 33% YOY, a percentage that will continue to add to inflation pressures. Moreover, the geopolitics around energy is complex, volatile, and unpredictable, particularly since the leaders in many oil-producing countries like Brazil, Iraq, Iran, and Russia are facing a multitude of domestic issues, making any long-term forecast for oil prices nearly impossible.

Still, it is clear that inflation data for July and August will be important, and they will set the tone for the next FOMC meeting set for September 20-21. So too will employment data and that is one of our two main topics this week.

Employment Data

The July employment report showed a surprisingly strong monthly increase of 528,000 jobs and an equally surprising dip in the unemployment rate from 3.6% to 3.5%. Given the gloomy backdrop from other surveys such as the ISM manufacturing and nonmanufacturing surveys, this big jump in employment was clearly unexpected.

However, with July’s increase, the total number of people employed in the US rose to 152.54 million, beating the previous record of 152.50 million workers in February 2020 by 32,000. This was important in our view, since the fact that the total level of employment had not exceeded its February 2020 peak was one indication that the post-pandemic recovery was weak. It also helped explain the declines in GDP.

Also in July, the participation rate inched lower to 62.1% while the employment-population ratio rose 0.1 to 60% in July. However, both remained below their respective February 2020 peaks of 63.4% and 61.2%. These ratios show the relationship between the labor force and/or employment to the overall population. What July’s data indicated was that both remain below the 2020 peak levels. See page 3.

One reason for this weakness is that the labor force has been shrinking. In July, those no longer or “not in the labor force” rose to 100.15 million, the highest level seen since October 2021. There can be a variety of reasons for people to leave the labor force, but the percentage of those no longer in the labor force yet indicating they want a job increased to 6.3%, up from the February 2022 level of 5.3%. Separately, discouraged workers jumped from 386,000 to 471,000 in July. Keep in mind that the decline in the labor force is what contributed to the unemployment rate falling in July. See page 4.

Since employment data can have a major impact on monetary policy in coming months, we dug into the data in greater detail and we noticed several interesting things about July’s job report. The establishment survey showed seasonally adjusted employment rising 528,000 to a record 152.54 million, but not-seasonally-adjusted data showed a decrease of 385,000 jobs to 152.25 million. In short, unadjusted employment remained well below its peak of 153.1 million in November 2019. See page 5.

In addition to the establishment survey, the BLS conducts a broader household survey each month. This survey showed July employment at 158.29 million, a bit less than the 158.87 million recorded in February 2020. However, the not-seasonally-adjusted household series showed 159.1 million workers in July, matching the previous October 2019 record. All in all, a deep dive into job data left us questioning whether employment actually reached a record level in July.

And the BLS will add another complication to employment data. On August 24, 2022, the Bureau of Labor Statistics will release a preliminary estimate of the upcoming annual benchmark revision to the establishment survey. These benchmarks are derived from state unemployment insurance tax records that nearly all employers are required to file. A final benchmark revision will be issued with the publication of the January 2023 job report released in February 2023. Since benchmarks adjust data retroactively, it is nearly impossible at this moment to know if employment has really exceeded its February 2020 peak. We are skeptical particularly since seasonal adjustments are done on an active basis and pandemic layoffs have undoubtedly impacted normal seasonal patterns in employment. This may be too much information for some; but since the Fed is required to maintain full employment with moderate inflation, it is important to understand where US employment stands today. We think it could be weaker than the headlines imply.

Employment data is also a tale of the have’s and have not’s. The unemployment rate for workers with a bachelor’s degree or higher was 2% in July, well below the average, whereas the unemployment rate for workers without a high school degree rose to 5.9% in July, well above the headline 3.5%. The US workforce with a college degree has grown from 26% of all workers to 44% in July. It eclipsed all other groups in 2000. However, since the pandemic it is the only group that recovered to peak levels of employment. This means the other 56% of the workforce is yet to recover to pre-pandemic employment levels. See page 7.

Reducing Earnings Forecasts

Our other deep-dive topic is earnings. As we noted last week, financial headlines are full of reports of better-than-expected earnings results for the second quarter, but this too is misleading. Last week we discussed the difference between consensus estimates and whisper numbers. The whisper numbers, primarily among hedge fund managers, were far worse than the actual consensus earnings expectations and from this perspective, earnings were a positive surprise. Nevertheless, the S&P Dow Jones consensus earnings estimates for 2022 and 2023 fell $1.40 and $1.59, respectively, this week. Refinitiv IBES consensus earnings forecasts fell $1.52 and $1.97, respectively. Over the last seven weeks the S&P Dow Jones estimate for 2022 has dropped $7.36 and for 2023 has declined $6.26. IBES forecasts in the same seven weeks fell $4.07 for 2022 and $7.63 for 2023. As a result, the nominal earnings range for 2022 declined and is now $216.88 (S&P) to $225.50 (IBES). EPS growth rates for this year fell to 4.2% and 8.4%, respectively. To adjust for the weakness seen in second quarter earnings, we are lowering our DRG 2022 estimate from $220 to $218 and our 2023 estimate from $240 to $237, and fear that there may be more downside risk to these estimates. See page 10.   

Technicals Of all the indices the Russell 2000 has had one of the best performances from its June low. This is encouraging. We used the RUT as a leading indicator at the top and it may prove to be a good predictor of the low as well. Our 25-day volume oscillator is approaching an overbought reading. Bear markets rarely have overbought readings, and if they do, they are brief. Therefore, the current rally may be at a turning point. Without follow through in coming sessions and a solid overbought reading in this indicator, we would label the current advance as a bear market rally. We continue to focus on recession-resistant stocks and sectors. See page 15.

Gail Dudack

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Earnings, and earnings growth, are the bedrock of the equity market. And they can be especially important in an environment like the present where recession fears are plentiful. Therefore, we continue to focus on second quarter earnings results, yet we are having trouble reconciling perception versus reality in this department.

According to Reuters, “US companies are reporting mostly upbeat news this earnings season, surprising investors who had been bracing for a gloomier outlook on both businesses and the economy. More than halfway into the second-quarter reporting period, S&P 500 company earnings are estimated to have increased 8.1% over the year-ago quarter, compared with a 5.6% estimate at the start of July.” However, data from IBES Refinitiv shows that their S&P 500 earnings estimates for 2022 and 2023 fell $1.25 and $2.02, respectively last week, after rising only a penny for 2022 and falling $0.78 for 2023 a week earlier. Similarly, forecasts from S&P Dow Jones indicate earnings estimates fell $2.42 and $2.91, respectively, last week and fell $2.48 and $0.36, respectively, a week earlier. These sharp drops in estimates during peak earnings season hardly support the statement of “better than expected” earnings in the second quarter.

However, Howard Silverblatt, Senior Index Analyst at S&P Dow Jones Indices, may have said it best in the U.S. Equities Market Attributes July 2022 (August 2, 2022) report. He noted that: “while earnings for Q2 2022 were expected to increase 13% over Q1, the whisper numbers were much lower, as was the concern over the second-half guidance. However, actual earnings (72.1% reported) did not make the expected 13% gain and now indicate a 7% gain, which is a headline disappointment for some, but not if you were one of those money managers (or traders) who traded into the whisper numbers (and sold). For them, it was an unexpected beat and a time to reallocate…”

In other words, hedge funds were positioned for sharp earnings declines and were relieved at the actual numbers, even though they did not beat the consensus estimates. This is quite different in our opinion from an actual increase in earnings growth — which did not materialize. In fact, the nominal dollar earnings range for 2022 fell to $218 (S&P Dow Jones) and $227 (IBES). S&P Dow Jones and IBES earnings growth rates for this year sank to 4.8% and 9.1%, respectively. And while second quarter earnings season is less than 75% complete, we find that our DRG 2022 estimate of $220, a 5.7% YOY increase from $208.19 in 2021, is at risk and is currently under review. See pages 11 and 18.

Moreover, what the Reuters article failed to mention is that even though the IBES report shows an overall blended earnings growth estimate of 8.1% for the second quarter, if the energy sector is excluded the earnings growth rate falls to negative 2.5%. This was an important omission. And we would advise monitoring the much-discussed Senate’s Inflation Reduction Act since it would currently reinstate the Superfund tax on crude oil and imported petroleum at 16.4 cents per gallon (indexed to inflation) and increase other taxes and fees on the fossil fuel sector. Obviously, this would hurt S&P earnings since so much of the earnings growth in the last 18 months has come from the energy sector. More broadly, the bill would instate a minimum 15% tax rate on all corporations. This again, would negatively impact earnings. In sum, we are not finding comfort in second quarter earnings results or current fiscal policy.

Monitoring Economic Data

With first quarter GDP growth already inked at negative 1.6% and second quarter falling 0.9%, the US economy is technically in a recession. Many will be debating this issue in coming months, but the calculation for GDP makes it rather difficult to record a negative number after a negative quarter. In short, 2Q22 GDP implies economic activity continued to slide in the April through June period. The GDP price deflator also jumped to 7.5% YOY in the quarter, the highest pace seen in this indicator since the December 1981 report of 8.4%. Note that the December 1981 reading took place in between the 1980 and 1981-1982 recessions. These two recessions were also triggered by Fed rate hikes as monetary policy struggled with an inflationary cycle. See page 3.

The ISM manufacturing index fell to 52.8 in July, the third consecutive monthly decline, the fourth decline in the past six months, and remaining below a six-month average of 55.5. New orders declined from 49.2 in June to 48 which is the second consecutive month that new orders were below the neutral threshold of 50. All in all, this is a display of declining momentum in manufacturing. See page 4.

Homebuilder confidence fell from 67 in June to 55 in July and is at its lowest level since early 2020. The June pending home sales index fell from 99.6 in May to 91.0 in June, which was the lowest reading since the March/April 2020 recession readings and the third lowest since data began in 2018. Still, the homeownership rate edged up to 65.8% from the first quarter reading of 65.4%, with the strongest gains seen in the South and West sections of the country. The housing sector began to slow well before the Fed increased rates this year and we expect it will continue its slump throughout the second half as interest rates continue to rise. See page 5.

The personal savings rate fell from 5.5% to 5.1% in June and sits at its lowest level since the 2008 recession. Real personal disposable income, which was $15.10 trillion in June, remains below its pre-pandemic February 2020 level of $15.16 trillion and is one sign of potential weakness in consumption. And despite recent monthly job reports, this does not tell the whole story. Total employment remains more than half a million jobs below its February 2020 peak level. See page 6. Inflation has also changed household spending patterns. See page 7. In the 18 months ending in June, household spending for gasoline and other energy goods increased 106%, transportation services increased nearly 50% and food services and accommodations rose nearly 45%. These increases have reduced household consumption of things other than energy and food. See page 7.

With the yield curve nearly inverted, the debate about whether or not more rate hikes will be implemented this year will intensify. Nevertheless, June’s personal consumption expenditures index, the favorite inflation measure of the FOMC, indicated price trends were accelerating and the index rose 6.7% YOY, the highest rate since January 1982. Excluding food and energy, the PCE index is rising at a 5% YOY pace, the highest since records began in 1987. This report implies more rate hikes are required to tame inflation. See page 9.

Multiple Signs of Recession

The WTI crude oil future is at $94.42 and below its 200-day moving average now at $94.70. The longer the future trades below the 200-day MA, the more likely oil prices will fall further to the $80-$85 range. This decline in oil would bring relief to future inflation, but it is not a result of Fed rate hikes. More exactly, energy is falling due to fears of weakness in China’s economy, as a result of shutdowns, weakness in manufacturing and troubles in the real estate sector. Meanwhile, the 10-year Treasury note yield at 2.74%, having recently reached an intra-day low of 2.52%, has become very volatile and is signaling economic weakness. With the fed funds future at 2.5%, a falling 10-year Treasury yield increases the likelihood that the entire Treasury yield curve will invert resulting in a classic sign of a recession.

And lastly, Technicals The recent equity rebound carried all the indices up to their 100-day moving averages which are now at roughly DJIA: 32,719; SPX: 4,119; NAZ: 12,335; and RUT 1,873. However, only the Nasdaq Composite is currently trading above its moving average. These moving averages are only first-level resistance points, yet they could prove to be pivotal for the intermediate term. At present, the market appears to be wobbling at this resistance level. In sum, we continue to maintain a relatively cautious stance focusing on stocks where earnings are most predictable, even in a recession. In general, this equates to energy, staples, utilities, and defense stocks.

Gail Dudack

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This is a week filled with potential market-moving events that include the July FOMC meeting, the first look at second quarter economic activity and 172 earnings results for companies in the S&P 500 index. Each of these events will have important implications for equity investors, but in our view, second quarter earnings results will be the most significant since these will help define where value is found in the equity market.

75-basis points and the Treasury Curve

In terms of monetary policy, the consensus is expecting a 75-basis point increase in the fed funds rate this week and we think this should prove accurate. In recent months the Fed has had a pattern of either matching consensus expectations for monetary policy changes or signaling its intentions well in advance of changes. In short, the Fed displays no desire to surprise, or stress, the financial markets and as a result, the expectation of a 75-basis point hike is probably discounted in current stock prices. However, we are less certain that the longer-term ramifications of a 75-basis point increase has been fully priced into equities, particularly if the economy slips into a recession.

The Treasury yield curve is currently flat, although it is technically inverted between the 6-month and 10-year Treasury note benchmarks. This makes a 75-basis point increase on the short end of the curve important since it is possible that the entire yield curve could invert shortly after the July Fed meeting. Keep in mind that a 75-basis point increase this week and the 75- or 50-basis point increase expected in September could raise the short end of the curve as much as 150 basis points. See page 3.

What makes the Treasury yield curve important at this juncture is that it has been better than most economists in terms of predicting a recession. A long history of the Treasury yield curve, focusing on the 1-year to 10-year curve, shows that in nine of the eleven inversions since 1956, an inverted yield curve has been followed by an economic recession, typically within eight months. (The range has been zero months (1957) to fourteen months (1978).) The only exceptions to this were in September 1966 — when a five-month inversion was not followed by a recession — and in September 1998 — when a four-month inversion did not result in a recession. Yet more recently, as in 2000, 2006 and 2019, inverted yield curves were followed by a recession within six to eight months. See page 4.

Quantitative Tightening and Money Supply

Yet as we focus on the fed funds rate and the yield curve, it is important to point out that rates are not the only tool in the Fed’s arsenal. While the Fed is expected to raise rates at each meeting this year, it also has indicated its intention to shrink its balance sheet. The $1.6 trillion increase in the Fed’s balance sheet between January 2021 and March 2022 was implemented during an expanding economy and it was a contributing factor to the stock market’s advance and current inflation. However, as of June 1, 2022, the Fed began reducing the reinvestment of principal payments in Treasury securities by $30 billion per month and will increase this amount to $60 billion per month beginning September 1^st. For agency debt and agency mortgage-backed securities, the reinvestment reductions are $17.5 billion and $35 billion per month. In short, the liquidity balloon that has been propelling stock prices higher since early 2020 is slowly deflating. But this is important in terms of reducing money in circulation, or money supply.

Another part of the Fed’s stimulus program was the elimination of required reserves for banks. The removal of this requirement in March 2020 resulted in a huge jump in excess reserves in the banking system and a massive increase in money supply. See page 5. This was an unusual tool for the Fed since there are laws that require banks and other depository institutions to hold a certain fraction of their deposits in reserve, in very safe, secure assets. This has been a part of our nation’s banking history for many years and “required” reserves are designed to ensure the liquidity of bank notes and deposits, particularly during times of financial strains.*

Nevertheless, in March 2020 the banking system was suddenly awash in liquidity. The 6-month rate-of-change in M2 (i.e., M2 money stock – a measure of the amount of currency in circulation) jumped to 19.5% in July 2020, an all-time record. The linkage between money supply and inflation is well-known by economists and was surely known by Fed officials. Yet this was the quandary of 2020 and 2021 for economists, strategists, and investors. Money supply fuels inflation but it also fuels stock prices. It was a double-edged sword. However, as liquidity is now being withdrawn to temper inflation, the underlying booster for equities is gone. Unfortunately, the longer-term problem of inflation remains.

GDP and Housing

Second quarter GDP will be released this week and it may answer the question of whether the US is currently in a recession, or on the brink of one. We continue to focus on the housing sector since it represents 17% to 19% of GDP in any given quarter. Unfortunately, recent news releases have not been encouraging. New home sales were 590,000 in June, down 17.4% YOY and down from 642,000 units in May. The average price of a single-family home fell to $456,800 in June, the lowest price in 12 months, but still up 5.8% YOY. The NAR affordability index dropped to 105.2 in May, which was its worst level since August 2006. However, the June, July and August readings are apt to move lower as the impact of rising mortgage rates negatively impacts potential buyers. See page 7.

Earnings and Valuations

To date, second quarter earnings season has been mixed, but a clearer picture may be available by the end of the week, or once we pass the midpoint of earnings season. We are noticing that many companies are making or exceeding revenue forecasts but are missing estimates on the bottom line. This was to be expected due to the rising cost of labor, transportation, and raw materials, but it is not good for earnings overall. Last week, the S&P Dow Jones consensus earnings estimates for 2022 and 2023 fell $2.48 and $0.36, respectively. Refinitiv IBES consensus earnings forecasts rose $0.01 and fell $0.76, respectively. This disparity between S&P Dow Jones and IBES is typical in the second half of the year since S&P adjusts earnings for GAAP accounting while IBES simply aggregates estimates. We measure “value” in the equity market by the S&P Dow Jones data.

Following S&P’s cut in its 2022 forecast to $220.21 this estimate is now in line with our forecast of $220, a 5.7% YOY increase from $208.19 in 2021. This earnings quarter will be important, and we will be looking closely at margins and the impact margin pressure may have on our $220 forecast.

All in all, none of this changes our view that the equity market is bottoming but may not have found its ultimate low. We continue to emphasize that recession/inflation proof segments of the market like energy, staples, defense-related stocks, and utilities where earnings are most predictable in this difficult environment. *https://www.federalreserve.gov/monetarypolicy/0693lead.pdf

Gail Dudack

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The July 19, 2022 trading session was notable, not just for the 754-point gain in the Dow Jones Industrial Average, but because preliminary NYSE data shows that 92% of the day’s total volume was in advancing stocks. We have been waiting for a 90% up day to appear in breadth data which would show that downside risk is minimized. Yet while we are pleased for the near term, we are not impressed for the longer term.

This was the first “90% up-volume day” since the 92% up-volume day recorded on May 13. The May 13 session materialized right after the S&P 500 dropped below the 4000 level, which in our view, was a sign that value was returning once prices fell below the SPX 4000 mark. However, on both May 13 and July 19, total NYSE volume was average, or in the case of July 19, below the 10-day average. This is unfortunate since below-average volume weakens the signal in terms of defining a major bear market low. Nevertheless, the July 19 trading session is important since it denotes a return of buying pressure and it represents another step in the market’s bottoming process. We expect more follow-through to this rebound in prices.

In concert with the 90% up day, all the broad equity indices moved above their 50-day moving averages for the first time since April. It is quite normal for a bear market rebound to retest the 100-day or 200-day moving average. However, the 50-day moving averages have been a ceiling for prices in all the indices since early April. At this juncture, it would be normal for momentum to carry stock prices to at least the 100-day moving average lines. These averages equate to Dow Jones Industrial Average 32,840; S&P 500 4,148; Nasdaq Composite 12,470 and Russell 2000 1,890. See page 9.

Another technical indicator we will focus on in coming weeks is our 25-day up/down volume oscillator. It has amazed us that despite the substantial declines in prices this year, there have been few oversold readings in this indicator. But in the last two weeks the oscillator was oversold in six of eight consecutive trading sessions. The deepest oversold reading was on July 14 at negative 5.17, the most extreme oversold reading since March 27, 2020. At a classic bear market trough pattern, stock prices may fall to a new low in price, but this oscillator will have a less extreme oversold condition. This would be a sign of waning selling pressure and be favorable. So, in coming weeks, a new low, but a less severe oversold reading would be a positive sign.

The Week Ahead

The equity market is way overdue for a rebound; however, there are several land mines in the immediate future. Next week is the July FOMC meeting and there is a vigorous debate about whether the Fed will raise the fed funds rate 75 basis points or 100 basis points. Fed Chair Powell will be announcing the decision on July 27. A rate hike is widely expected; yet history has shown that when the Fed raises interest rates substantially, it increases the value of the dollar. Rising interest rates coupled with a strong dollar can have repercussions on global finances, particularly in subprime credit markets, in ways that are unexpected.

On July 28, the Bureau of Economic Analysis will release its preliminary estimate for second quarter GDP. As we have previously stated, we would not be surprised if it is a weak number, or a negative reading. A negative GDP number could ironically be a major plus for investors since it would confirm a recession — and stock markets tend to bottom in the second half of a recession. In short, the next few days should be interesting.

Inflation, the Fed, and the Consumer

Barring signs of an immediate recession, recent economic releases show the Fed is way behind the curve and has a lot of work ahead of it.

Inflation accelerated in June. Headline CPI rose 9.1% YOY, up from 8.5% in May and core CPI increased 5.9% YOY, in line with the 6% recorded a month earlier. Although the administration and many economists are highlighting the small decline seen in gasoline prices recently, the outlook for inflation is not good for the rest of the year. For example, homeowners’ equivalent rent increased 5.5% in June, up from 5.1% in May. Rent prices are apt to rise further since rents tend to lag the trend in home prices, and home prices are still rising at a double-digit rate. The median price of an existing single-family home rose 15% in June. See page 3.

Plus, there is plenty of inflation in the pipeline. The PPI for finished goods rose 18.6% YOY in June. Core PPI increased 8.8%. The PPI for final demand rose 11.2% in June, up from 10.8% in May. These price gains in the PPI indicate consumers face more price increases ahead or businesses face more margin pressure. One or both of these trends are likely in coming months. See page 4.

The persuasive argument for a recession is directly linked to inflation because inflation has increased more than wages. See page 4. As a result, real wages are declining and so is purchasing power. The way to stall or reverse inflation is to raise interest rates, but that too, will hurt consumers through higher mortgage and loan rates. It will impact small businesses by weakening profit margins, making credit more expensive and in some cases unavailable. Unfortunately, the Fed allowed inflation to get too high before responding. The gap between inflation, now at 9.1% YOY, and fed funds, now at 1.75%, means the fed funds rate is 863 basis points below inflation, or the “neutral” level. The Fed’s forecasts show that they expect inflation to slowly decline in 2022 which would make this gap a bit smaller. But that may be wishful thinking.

While a weaker economy and therefore lower inflation is a possibility, it also means a recession is already here. We think there are signs of an imminent recession in recent retail sales data. Total retail and food service sales increased 8.4% YOY in June, which may sound like the consumer is strong and vibrant. However, once sales are adjusted for inflation, year-over-year real retail sales (measured in $1982-1984) have been negative for four consecutive months. See page 5. Negative year-over-year real retail sales have been highly correlated with recessions in the past.

Auto sales are a major part of retail sales, and though there was a pickup in June; the longer-term trend remains negative. Moreover, as interest rates and prices rise, we expect auto sales to remain sluggish in the second half of the year. Gas station sales have been a boost to retail sales, but these gains are due only to the high price of fuel and it is shutting out other areas of consumption. Housing is also weak. The National Association of Home Builders survey for July dropped from 67 to 55. Traffic of potential buyers fell from a weak reading of 48 in June to an even weaker reading of 37 in July. In sum, many areas of the economy are showing weakness and it may not all be factored into equities as yet.

Gail Dudack

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Downside Volume

We believe it is likely that equities are on the verge of establishing a new low. The good news is this may be an important part of a defining low in this bear market. The main reason for our near-term concern is the action of our NYSE 25-day up/down volume oscillator. The 25-day up/down volume oscillator declined to negative 3.7 this week, recording its third oversold day in the last five trading sessions. The decline was sudden and the pattern in the oscillator suggests downside volume is gaining momentum. In fact, the July 6 reading of minus 4.09 was the most oversold reading recorded since April 1, 2020. And though some might think that an oversold reading is positive, we would point out that in March and April of 2020, the market dropped to oversold and remained in oversold territory for 25 of 28 consecutive trading sessions. See page 12. Sometimes negative momentum begets more negative momentum.

Inflation

This acceleration in downside volume is coming just ahead of the releases of June CPI and PPI data. And it may reflect the concern investors now have regarding inflation. Unfortunately, we believe the consensus may be disappointed in the results. To be specific, the May headline CPI release showed prices rising 8.5% YOY, the highest pace in 40 years. See page 9. What we believe is important is that if the CPI were to remain unchanged in June, the pace of inflation would still remain high at 7.6% YOY. However, an unchanged CPI seems unlikely since even at the lower prices for WTI crude oil (CLc1 – $95.84) seen currently, WTI is up 29% YOY.

And as previously noted, housing represents 42% of the CPI’s weighting and housing rose 6.9% YOY in May. The median price of an existing single-family home rose nearly 15% YOY in May, and while 15% YOY is down from a peak rate of 26% YOY a year earlier, housing will still add to inflationary pressure. Meanwhile, rents, which represent nearly 24% of the CPI weighting, tend to follow the trend in home prices, but with a sizable lag. Given this backdrop, it is difficult to see inflation falling much in June. We have also pointed out that medical care prices have been offsetting some of the larger increases seen in transportation costs. Medical care rose a “modest” 3.7% in May, but health insurance pricing is seasonal, and we expect medical insurance, and the medical care segment of the CPI, will add to inflation in coming months.

The PPI represents the pricing pressure in the pipeline that will eventually shift to consumer prices. The PPI for final demand rose 10.7% YOY in May. If prices were unchanged in June, the year-over-year pace only falls to 9.8%. In short, there is some simple math behind the CPI and PPI data that suggests the June inflation data will not soothe investors’ nerves.

Earnings Season

Moreover, second quarter earnings season begins in earnest this week, and this could be a market moving event. A number of brokerage houses are bringing their 2022 earnings estimate for the S&P 500 index down to our $220 forecast and that is a plus. But as we noted in our March 9, 2022 (“A Bear is a Bear is a Bear”) “higher commodity costs are likely to pressure profit margins and lower revenues for many companies and could make our $220 earnings estimate too optimistic.” We still believe this is true. Our $220 estimate represents a 5.7% YOY increase from 2021, and we feel it is conservative considering that earnings for the energy sector are expected to increase between 120% YOY (IBES) and 137% YOY (S&P Dow Jones) this year. Excluding the energy and perhaps the materials sectors, we expect earnings will decline in 2022. In a week or so, investors will have a better idea of second quarter earnings results.

PepsiCo, Inc. (PEP – $169.50) released earnings results this week and its second quarter core earnings rose 8.1% YOY, but reported earnings fell 39.4% YOY due to a write-off related to the Russia-Ukraine conflict. A key takeaway from the company’s earnings call was that it planned price increases and cost management. A main part of our strategy for 2022 is to focus on companies and sectors that will be most immune to both inflation and recession. This includes necessities like food, staples, energy, utilities, and we also include the defense-related industrial stocks given the increase in funding of national defense by Western countries as a result of the Russian invasion of Ukraine.

Worrisome Economic Data

The June jobs report indicated an increase of 372,000 jobs and an unchanged unemployment rate of 3.6%. However, total employment in the US is yet to exceed its previous peak which is unusual for an expansion that is now over two years old. We think this is a weakness in the employment data that most economists have overlooked. See page 3. And employment gains have been a story of the haves and have-nots. Unemployment for those with less than a high school degree has risen in the last four months from 4.3% to 5.8%. Economists may be disregarding this factor since this segment represents only 6.4% of the workforce. However, the only group that has made significant gains in employment in the last two years has been those with a bachelor’s degree or higher, which represents 43% of the working public. The remaining 47% have not seen the same gains. See page 4.

Both the manufacturing and nonmanufacturing ISM indices fell in June, and were down 13% YOY and 9% YOY, respectively. However, take note that both surveys show their employment indices falling below the 50 neutral level, indicating a decline in employment. This could be a leading indicator for the BLS employment data. See page 5.

In June, the NFIB small business optimism index fell to 89.5, its lowest reading since the 88.8 seen in January 2013. The outlook for the next six months fell to negative 61, the lowest reading on record. All ten components fell in June, including plans to expand business, to increase capital expenditures, to increase employment, or to add to inventories. The only positive seen in June’s survey was that 50% of owners indicated they had unfilled job openings. See page 6.

A number of markets are trading as if a recession is approaching. As previously mentioned, the price of crude oil has collapsed from a high of $122.11 in early June to $95.84, this week. This appears to be due to a fear of a global recession. Nevertheless, oil is still up 29% from July 2021. Also falling is the 10-year Treasury note yield which had reached a high of 3.48% in June, before dropping to 2.95% this week. This decline is not a good sign since the Treasury yield curve is now inverted from the one-year note yield to the 10-year note yield. Keep in mind that the Fed expects to raise the fed funds rate to 3.5% or higher which would invert the entire yield curve in a classic sign of a recession. See page 7. Valuation can be deceiving when not put into perspective. The current trailing PE of 17.7 X looks low, relative to the 50-year and post-1947 averages, but the PE will rise if EPS forecasts are too high. Plus, the impact of inflation is best seen in the charts on page 9. When inflation moved above average (3.5% YOY) in the 1972-1982 period, PE multiples fell to single-digits and below the standard deviation range. Another way of measuring inflation is the Rule of 23, which sums inflation and PE multiples. The market has traded above 23 for the last two years and the sum is currently 24.8. Unfortunately, based on this historical benchmark, the market remains expensive. See page 9.

Gail Dudack

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The Right Environment for a Low

Second quarter earnings season will begin in earnest in mid-July, and it could be a market-moving event. First quarter earnings results disappointed the consensus in April, and this setback contributed to a sharp decline in the averages. However, GDP was negative in the first quarter, therefore, poor earnings results for the S&P 500 stocks should not have been a surprise to investors.

This month, the start of second quarter earnings season will be quickly followed by the Bureau of Economic Analysis’s report of its first estimate for second quarter GDP growth, scheduled for release on July 28. This crucial combination of earnings and economic activity should be a meaningful time for investors.

Last week we noted that despite the perpendicular selloffs in the broad averages, to date, the equity market has been unable to sustain a significant or normal rebound. Unfortunately, this is a sign of weakness. Plus, our biggest concern is that analysts have not yet significantly lowered earnings forecasts for this year. And despite multiple signs of deteriorating economic activity, economists are yet to worry about a recession in 2022. It is possible that second quarter earnings results and the BEA’s estimate for second quarter GDP growth could be the catalyst that shifts attitudes and forecasts. If so, it would create the right environment for the stock market to establish a meaningful low.

As we noted last week, the bear market finale is likely to include the realization that earnings will be lower than expected for both 2022 and 2023, and this could happen in late July. From a simple technical perspective, it would be wise to wait for an impressive high-volume 90% up day before committing to equities in a major way. A 90% up day would confirm that buyers have returned to the equity market in earnest.

Hints of Recession

US economists may not be forecasting a recession, but global markets are indicating that recession fears are rising. This week the euro sank to its lowest level against the dollar in over 20 years. The global benchmark for Brent crude collapsed 9.5% in one day. Similarly, the WTI future fell 8.2%. The 10-year Treasury bond index lost nearly 400 basis points in the last four trading sessions. In the Euro zone, purchasing managers’ surveys for June show the manufacturing sector is in a decline and the service sector has suffered a major loss in momentum. China’s growth is becoming questionable after Shanghai said it would begin new rounds of mass testing of its 25 million residents over a three-day period. This is an effort to trace infections linked to an outbreak at a karaoke bar and it stokes fears of another potential lockdown of China’s largest city of 24.5 million people. In sum, we continue to believe the US economy may already be in a recession. The good news is that the equity market tends to find its low midway through a recession.

Real Disposable Income Tells the Story

For most of the last 60 years, personal income has been in a slow steady uptrend, dipping only slightly during recessionary periods. However, in the past two years, even though personal income has inched higher, disposable income has been flat as a result of increases in both personal taxes and government social insurance taxes. This creates financial pressure on many households, and as a result, the personal savings rate fell from a high of 10.5% in July 2021, to 5.4% in May. In April, the savings rate hit a cyclical low of 5.2%, matching its November 2009 level. The savings rates for March and April were revised fairly dramatically in the last release, from 5% to 5.3% and from 4.4% to 5.2%, respectively. Nevertheless, the newly revised savings rates remain the lowest since the 2008-2009 recession. See page 3.

There was a boost in personal income in 2020 and in 2021 due to two pandemic stimulus packages passed by Congress. The 2020 package was done during the pandemic shutdown and recession, but the second stimulus package was larger and implemented during the post-pandemic recovery in 2021. See page 4. This later package in our view, coupled with massive monetary stimulus, was the recipe for the historic inflationary cycle now impacting our economy.

And for the first time in 40 years, consumers and households are seeing inflation rise faster than their income. This results in a decline in purchasing power. To date, personal consumption expenditures remain positive on a year-over-year basis, but the trend is unsustainable and is declining. See page 5. Since the US economy is 70% consumption-driven, this decline in household purchasing power is not a good sign for economic activity in the second half of the year.

The ISM manufacturing index fell from 56.1 to 53.0 in June. Although this index has been steadily declining all year, it still remains slightly above the neutral 50 level. However, the ISM manufacturing employment index was 47.3 in June, its second monthly report below 50, and a sign that employment in manufacturing is shrinking. New orders also fell from 55.1 to 49.2. This fall below 50 indicates a slump in new orders and demonstrates weakness within the manufacturing sector. See page 6.  

Watching the Russell 2000 Again

The Russell 2000 index has dropped to a key support level that is the equivalent of the price peaks made in 2018 and 2020 at the 1700 area. The charts of the other broad indices are different from the Russell, and all the other indices are well above their 2020 peaks. However, for reference the levels equivalent to the 2020 peaks are 29,500 in the Dow Jones Industrial Average, 3,380 in the S&P 500, and 9,800 in the Nasdaq Composite index. See page 8. It will be important for the Russell 2000 to stabilize at the 1700 level and begin to build support. The 25-day up/down volume oscillator declined to negative 2.96 this week and is close to an oversold reading for the first time since mid-May. The lack of a deeply oversold reading in this indicator, like the ones seen in August 2015, February 2016, December 2018, or March 2020, is somewhat bewildering given the seven 90% down days recorded in recent months. However, it implies that the equities market may not yet have found its trough. See page 9. While we believe many stocks may have found their 2022 lows, as in most bear markets, the lows will get retested. For this reason, we remain cautious.

Gail Dudack

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We believe a significant low could materialize in the next few months; however, we would not be too hasty to fully re-enter the equity market at this juncture. The first reason for our caution is that despite the market’s oversold condition and the perpendicular declines in the charts of the major indices, equities seem unable to find any upside traction this week. This is a sign of weakness, and it displays a lack of underlying demand for equities at current prices.

The second reason is, while there are many open discussions regarding a recession and the possibility that the economy is already in a recession, we have not yet seen any economist actually forecast a recession for 2022 or 2023. Most economists are fiddling with GDP targets depicting slowing “growth.” This is an important distinction because, in our experience, Wall Street’s industry analysts and strategists rarely, and are sometimes unable, to factor a recession into their industry or macro earnings estimates until their economist has forecasted a recession.

And it may not surprise readers that most economists fail to recognize a recession until it is almost, or completely, over. Therefore, this implies that earnings forecasts may be too high for 2022 and 2023 and are apt to come down in time. Ironically, we would be more confident that the lows have been found if earnings forecasts were incorporating the possibility of a recession; but to date, this has not happened. Our earnings forecast for 2022 S&P 500 earnings has been a negative outlier at $220; nevertheless, we are fearful that this too may still prove to be too optimistic.

Third, July could be the month of changes. The Bureau of Economic Analysis releases its final estimate for first quarter GDP this week. Growth is currently estimated to be negative 1.5% in the first quarter of the year, indicating a decline in economic activity. On July 28, the BEA is expected to release its advance estimate for second quarter GDP. This single data point could be pivotal since a recession is defined as two consecutive quarters of negative GDP. Another negative number would confirm that the US economy is currently in a recession. Yet even if second quarter GDP displays very weak growth it could be enough to prompt economists to dramatically lower their economic forecasts for the year.

July is also important since second quarter earnings season will begin mid-month. Most earnings quarters begin in earnest with the release of money center bank earnings, which are scheduled to start on July 13. Keep in mind that retailers have fiscal years and quarters that end a month later than most companies, so these results will not be available until August. But it was not just a coincidence that the equity market broke below the SPX 4000 level shortly after Walmart Inc. (WMT – $122.37), reported earnings below expectations on May 17, 2022. Its next earnings report is scheduled for August 16, 2022.

In sum, the bear market finale is likely to include a realization that earnings will be lower than expected for 2022 and 2023. This could happen in late July. And from a technical perspective, it would be wise to wait for an impressive high-volume 90% up day to confirm that buyers have returned to the equity market in earnest.

Housing – the Canary in the Coal Mine

It is clear that the housing market is slowing. Existing home sales, which represent the bulk of the overall housing market, were 5.41 million units in May, down 8.6% YOY. This pace was also down 20% from the October 2020 peak and the slowest pace since June 2020. New home sales were 696,000 in May up from April but down nearly 6% YOY, and down 30% from the January 2021 peak. See page 3.

Homeownership has been relatively stable at 65.4% for the last four quarters and has been hovering just slightly above the long-term average of 62.9%. This implies there is neither pent-up demand nor excessive ownership in the housing market. However, the median price of an existing home reached a record $414,200 in May, up nearly 15% YOY. These high house prices are the result of many things such as an emphasis on the home and homeownership during the 2020 pandemic shutdown, historically high household liquidity in 2020 due to a series of fiscal stimulus packages, historically low interest rates due to monetary stimulus, and a booming stock market. All of this made housing attractive and affordable. However, this is all changing. Moreover, while the median price of an existing single-family home rose 15% YOY, personal income increased only up 2.6% YOY in April, and real disposable income fell 6.2% YOY. This is a bad combination. See page 4.

The National Association of Realtors (NAR) housing affordability composite index fell from 124.2 in March to 109.2 in April. This was the lowest reading since the 106.9 recorded in July 2007. More importantly, this index is likely to decline further as the fed raises interest rates and mortgage rates move up in unison. The headline NAR housing market index has been falling all year, but in June the traffic of potential buyers index, fell to 48, its lowest reading since June 2020. It is a sign of dwindling demand. See page 5.

Pending home sales inched up to 99.9 in May, from 99.2 in April; however, both April and May’s readings were the lowest since the 70 recorded in April 2020 during the recession. These cumulative signs of deterioration in the housing market are extremely important since the housing market represented 16.8% of GDP in 2021. Residential fixed investment contributed 4.7% and housing services represented 12.1% of GDP. However, there are other “non-housing” factors such as furniture, carpeting, appliances, etc. that also help to boost economic activity during a housing boom. We expect all of these industries to slow in the second half of the year. See page 6.

Consumer confidence can be a critical component of an economic cycle, and it can also be the canary in the coal mine that predicts a recession – even when economists fail to see it. Conference Board consumer confidence fell to 98.7 in June, its lowest level since February 2021. The survey showed that expectations fell to 66.4, the lowest point since October 2011. The University of Michigan consumer sentiment index fell to 50 in June, the lowest headline reading on record, and lower than any time during the recessions of 1980, 1982, 1990, 2001, 2008-2009, or 2020. Expectations fell to 47.5, the lowest reading since August 2011 (47.4) or May 1980 (45.3). In short, in both surveys, consumer confidence is at levels last seen during a recession. And we would remind readers that last week we pointed out that whenever inflation has reached 5% or more, it has been followed not by one recession, but by a series of tightening cycles and recessions. See “Liquidity Crisis” June 22, 2022; page 6. The market lows in June were the beginning of the discounting of a recession, in our view. But it may not be over.

Gail Dudack

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