With the Nasdaq Composite and Russell 2000 down 20% from their all-time highs and many individual stocks, including most of the FAANG stocks, down much more than 20% (for example, Netflix, Inc. [NFLX – $341.76] has had a 50% decline), we believe it is only proper to define the current sell-off as a bear market.

The fact that the S&P 500 and the Dow Jones Industrial Average have declined only 13% and 11.3%, respectively, is a mere technicality, in our opinion; and listening to financial news anchors talk about the S&P reaching “correction territory” makes us scratch our head. As history has shown us, the large-capitalization stocks are often the last to fall in a bear market, so the outperformance of the DJIA and the SPX is not unusual or consoling. And unfortunately, we do not believe the lows have yet been found. Neither technical nor fundamental guidelines give us comfort this week, and both sets of indicators suggest there is more downside risk in the market.

In our annual outlook forecasts for 2021 and 2022, we indicated that inflation would be the biggest hurdle facing equity investors in the months and years ahead and this finally became widely accepted late last year. Russia’s invasion of Ukraine is a new factor that could make inflation even more crippling than we anticipated. Although crude oil and energy stocks broke out of major base patterns prior to the Russian invasion, and the energy sector has been the best performing sector all year, WTI has soared an additional 38% on a closing price basis and 50% on an intra-day trading basis in recent days. It is well-known that Russia is a major oil exporter, but Ukraine and Russia are also major exporters of wheat and corn. Russia is a major producer of nickel, palladium, and fertilizer. And as the conflict continues into its second week without any hope of an easy or quick resolution, commodity prices have begun to soar. It now appears that shortages of commodities will be global and will continue well into the future. This is not good news for inflation or most of the world economies. As a result, the Russian invasion appears to be escalating the existing shift in the underlying market from growth to value. However, the conflict is also triggering a shift from technology to energy, commodities, and defense stocks. Last week we noted the shift to defense and aerospace and downgraded the financial sector from overweight to neutral and upgraded the industrial sector from neutral to overweight. We have an overweight recommendation of the staples sector where food-related stocks are found, but the S&P 500 does not include pure commodity plays where many of the breakouts in chart patterns exist. Nevertheless, this week we are upgrading the materials sector from underweight to neutral and downgrading the communication services sector from neutral to underweight. We would not be surprised if there is also a shift in leadership within the technology sector and would emphasize cybersecurity and cyber-defense-related stocks. See page 14.    

Fundamentals are not encouraging

Fundamentals are important in a bearish market since they help define levels of value and identify potential lows in both stocks and the indices. With this in mind, we turn to our valuation model where we have a 2022 earnings estimate for the S&P 500 of $220, a 7% increase. Currently our forecast for inflation suggests prices will decelerate to a 4.4% pace, but recent developments suggest this may be too optimistic. Our interest rate forecasts indicate yields should rise to 0.8% in the 3-month Treasury and 2.2% in the 10-year Treasury note. This combination of inputs results in a forecasted “average” PE multiple of 15.8 times for 2022. Note that a 15.8 multiple is also equal to the average PE seen over the last 75 years. Our $220 earnings estimate coupled with a 15.8 multiple yields an SPX target of 3476. In short, our model predicts a decline of 27.5% in the SPX would be required to return the broad indices to “fair value.” This is an uncomfortable forecast but reasonable given the number of uncertainties that lie ahead for investors if the Russian/Ukrainian conflict is not resolved soon.

Prior to the Russian invasion, we believed the equity market had begun a correction that would bring prices and PE multiples back in line with traditional fundamental benchmarks. Unfortunately, the Russian invasion has upset the financial and economic landscape and puts even our modest forecasts for earnings, inflation, and interest rates at great risk. For example, higher commodity costs are likely to pressure profit margins and lower revenues for many companies and could make our $220 earnings estimate too optimistic.

Energy

This week both President Biden and several administration officials stated that US energy production is currently at record levels. However, we doubted this was true due to restrictions and regulations placed on the energy sector after the 2020 election. Data from the US Energy Information Administration (EIA) contradicts the administration’s statements. On page 3 we display an EIA chart with annual data that shows the US energy production peaked in 2019. A second chart shows weekly field production of crude oil in the US that confirms US oil production peaked in 2019. Industrial production data from the Federal Reserve Board of St. Louis also confirms that energy production peaked in 2019, fell during the pandemic, recovered, but is still well below 2019 production levels. In short, US production is not at peak levels and there is much more potential for energy production. If this were encouraged, Americans would not have to suffer the extreme prices currently seen at the pump and in energy bills.

The price of WTI crude oil jumped $20 this week and briefly touched $130 a barrel, exceeding the price target of $110 we noted last week. Some strategists are suggesting prices can move considerably higher, particularly after the Biden administration indicated the US will not buy Russian oil. Regrettably, there was not a simultaneous decision to increase US production. We expect the FOMC will decide to raise rates 25 basis points at the March meeting. And though the 10-year yield rose from 1.7% to 1.82% in the past week, the risk of an inverted yield curve in 2022, and a recession, continues to grow, in our view. See page 7.

Technical Death Crosses

We are not ardent followers of technical configurations called golden crosses or death crosses, but they are followed by many technicians and traders and are therefore worth noting. A golden cross occurs when a short-term moving average, such as the 50-day moving average, crosses above a long-term moving average like the 200-day moving average. A death cross is the opposite configuration. The first index to have experienced a death cross in the current bear market was the Russell 2000 index. This was followed by the Nasdaq Composite index, and this week, the Dow Jones Industrial Average is close to joining the group. Even the Wilshire 5000 index has formed a death cross. Interestingly, out of the five FAANG stocks, the only one that does not display a death cross is Apple, Inc. (AAPL – $157.44). The main reason we are not ardent followers of this technical pattern is that both the death cross and golden cross tend to appear late in a trend. Still, the importance of these death crosses is that the 200-day moving average becomes major long-term upside resistance in each stock and index. We continue to favor stocks over bonds and believe that stocks with a history of increasing dividends and yields in excess of 2.2% can best weather the volatility that is apt to continue in the first half of the year.

Gail Dudack

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As we go to print, we are also preparing for President Joseph Biden’s first State of the Union address to Congress. It could be a pivotal speech and a crucial time for Biden because at the same time, a massive Russian convoy is spotted outside Ukraine’s capital Kyiv and Russian aggression continues for the sixth consecutive day. Insights into President Putin’s actions were revealed in remarks made prior to his invasion when he claimed his actions were to achieve “demilitarization and denazification” of the neighboring nation. Clearly Putin expected an easy takeover of Ukraine since the Russian state-aligned media outlet RIA posted, but quickly deleted, an article on 8 AM February 26th that hailed Vladimir Putin for victory over Ukraine as Russia helps usher in a supposed “new world.” The RIA article can be found here: https://web.archive.org/web/20220226051154/https://ria.ru/were20220226/rossiya-1775162336.html.

The geopolitical and financial backdrop could quickly evolve this week, but to a large extent, there is no change from the “Direct from Dudack” (Downside Risk Guidance) sent on February 24, 2022, in which we reviewed the downside potential of the equity market from both a technical and fundamental perspective. To date, the declines from recent peaks have been 9.97%, 11.9%, 18.8%, 20.4%, and 13.2% in the Dow Jones Industrial Average, S&P 500, Nasdaq Composite, Russell 2000, and Wilshire 5000 composite, respectively.

Fundamental Perspective

Although technical indicators tend to be best at forecasting market peaks, fundamentals become increasingly important in a bearish decline, in our view. They are tools that can help define levels of value, project best long-term buying opportunities and identify potential lows in both stocks and indices. For a fundamental perspective, we first turn to our valuation model. Models can only be as good as their inputs and for transparency, our estimates for 2022 begin with a forecast of $220 for S&P 500 earnings which equates to a 7% increase. We also expect inflation to abate in 2022, but only to a 4.4% pace. Our interest rate forecasts expect yields to rise to 0.8% for the 3-month Treasury and 2.2% for the 10-year Treasury note. Our model indicates that with this financial backdrop, the appropriate “average” PE multiple should be 15.8 times. Surprisingly, a 15.8 multiple is also equal to the average PE seen over the last 75 years. Applying our $220 earnings estimate to a 15.8 multiple yields an SPX target of 3476. In short, our model predicts a decline of 27.5% in the SPX is required to return to “fair value.” See page 4. Since our $220 earnings estimate is in line with the consensus, this also means that every earnings reporting season will be critical for the market. Positive or negative earnings surprises during earnings season could become market-moving events which could shift the perception of where “value” is found in the market. See page 5.

Technical Perspective

Many of our volume/breadth indicators revealed weakness in the latter half of 2021 and most of these indicators continue to point to a bearish trend. However, the chart of the S&P is of particular interest in the near term since a head and shoulders top formation has developed over the last three quarters. A head and shoulders top only becomes important once the “neckline” of the formation has been broken. The neckline in the SPX’s head and shoulders is irregular and can be drawn at several different levels, but we show the neckline at SPX 4300. See page 7. A break below the neckline of a head and shoulders formation triggers two separate downside targets – the difference between the height of the shoulder to the neckline and the difference between the head and the neckline. The first of these downside targets implies SPX 4000, which was nearly tested on an intra-day basis, in recent sessions. The second downside target is SPX 3800 which equates to a 20% correction. Note that a 20% correction in the SPX appears quite possible, and perhaps reasonable, given that the Russell 2000 index has already experienced a 20% decline from its record high.

The charts of Amazon.com (AMZN – $3022.84) and the Russell 2000 index (RUT – $2008.51) continue to intrigue us since they are ironically similar. See page 9. Both charts experienced sharp declines within days of each other and led the overall market weakness. Both are currently trading below all key moving averages. The recent rebound in AMZN after the company reported good earnings, failed to better the first level of resistance at $3223; however, this remains a key level to watch on rally days. However, the charts continue to parallel each other and after initial precipitous declines, both show that these lows were retested. To date, these tests have been successful. This is a favorable development and the longer the initial lows hold in both charts, it is a sign that the overall market is beginning to test and define significant lows. The support levels to monitor are $2700 in Amazon and $1900 in the RUT.

Federal Reserve Policy

Although we are only two weeks away from the important FOMC March meeting, it is being overshadowed by geopolitical events. In the current environment it is unlikely that the Fed will raise interest rates 50 basis points to fight inflation, but we do believe a 25-basis point hike is prudent. Still, the Fed has a very difficult job ahead of them. The fallout from Russia’s invasion of Ukraine is impacting them in two ways. First, commodity prices are spiking. The bullish crude oil chart has fulfilled upside targets of $90 and $100 and appears headed for a third target and key level of resistance at $110. See page 6. Rising energy and commodity prices make the Fed’s job of controlling inflation extremely difficult. Second, a flight to safety is taking 10-year Treasury note yields lower. The 10-year note yield is currently at 1.7%, down from a recent high of 2%, which makes the risk of an inverted yield curve in 2022 more likely as the Fed increases short-term rates. An inverted yield curve has been the best forecaster of economic recessions, and therefore the risk of recession appears to be growing.

Sector Shifts

The invasion of Ukraine impacts the US in a variety of ways but primarily it will raise inflation and thereby reduce household spending power. This could impact corporate earnings in 2022 which is why we continue to recommend an overweight rating in energy and staples. The sanctions imposed on Russia are necessary, but they do have the risk of impacting the global banking system, including US banks. For this reason, we are downgrading the financial sector from a recommended overweight to a neutral weight. Meanwhile, Russia has awakened the Western world to the risks of war and Germany responded by indicating they will spend 2% of their GDP on military defense. As a result, defense stocks are viewed as an area of the market that should have increasing revenues and better than expected earnings. The charts of many of the US defense corporations display bullish breakouts from long-term sideways patterns. We are upgrading the industrials from a neutral weighting to an overweight. In these uncertain times we still believe equities are the best holdings. We continue to also overweight energy and staples, but a balanced portfolio is emphasized. Companies with a history of increasing dividends and with yields in excess of 2.2% can best weather the volatility that is apt to dominate the first half of the year.

Gail Dudack

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Summary

From both a technical and fundamental perspective there are two areas of downside risk/support for the equity market. The first of these is roughly the SPX 4000 area which is being challenged this week. However, all lows tend to be retested and are often broken temporarily. The second area of support identified by fundamental and technical measures falls within a range of SPX 3470-3700. This implies a fall below SPX 3700 would be a favorable/low risk entry point. The fallout of the Russian invasion of Ukraine could be known within a matter of days, however there is also the possibility that China may take advantage of the geopolitical scene to make moves on Taiwan. Therefore, identifying these short and longer-term entry points in advance is prudent. In the near term the energy, financial, and staples sectors are favored. Defense stocks are also apt to do well given the risk of war in Europe. Longer-term we see this sell-off as a great opportunity to buy technology at “value” levels.

Valuation

When inflation is above its long-term average of 3.5%, it is normal for PE multiples to fall to their long-term average of 15.8 times or lower. Applying a 15.8 multiple to our $220 earnings estimate for 2022 equates to a downside of SPX 3476, or the SPX 3500 area.

Our valuation model suggests an average PE of 15.8 for 2022 and a range of 13.2 to 18.3 times, assuming inflation falls to 4.4% this year. Inflation is questionable with crude oil at $100 a barrel. However, these PE multiples couple with our $220 earnings forecast equate to an SPX low, mid, and high range of 2905, 3470, and 4035.

The head and shoulders top has broken the neckline support and now generates downside targets of roughly SPX 4000 and 3700. More specifically, the neckline at SPX 4222, less the 574 points to the record high of SPX 4796.56 yields a full downside count of SPX 3648 and a midpoint count of SPX 3844.

Gail Dudack

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Nearly a year ago the US economy was recovering well from the pandemic shutdown. The Fed continued to stimulate an expanding economy and Congress worked on passing more pandemic stimulus. Crude oil prices began to escalate in response to the post-pandemic recovery and the amplified regulations on fossil fuels following the US reentering The Paris Agreement in February 2021. Rising inflation was inevitable, and unlikely to be transitory due to global standards put in place for the reduction of fossil fuels. Earnings were booming in 2021 but estimates for 2022 showed single-digit growth versus difficult comparisons. All in all, it was clear one year ago that inflation would rise but earnings growth would slow in 2022. This combination is a hostile environment for equities and one we expected would translate into both margin compression and lower PE multiples.

In addition, in November 2021, newspapers and new casts displayed satellite photos of Russia mustering troops on the Ukraine border, but NATO said and did nothing. Therefore, the current crisis on the Ukrainian border is also not a revelation. In short, the sell-off that shaved 1392 points off the DJIA in the last four trading sessions should not have come as a surprise to investors.

Black Swan or Inevitable

Investopedia defines a black swan as “an unpredictable event that is beyond what is normally expected of a situation and has potentially severe consequences. Black swan events are characterized by their extreme rarity, severe impact, and the widespread insistence they were obvious in hindsight.”

Given this definition, we do not believe one could call the Russia/Ukraine border crisis a Black Swan. It was predictable and, in our opinion, the Russia/Ukraine crisis has merely been a catalyst for investors to reassess the inevitable — that the equity landscape has become increasingly risky, and areas of the market had become quite overvalued. Nevertheless, it does have a negative impact on the global economy. For the US it will mean higher energy costs which will make the job of the Federal Reserve more difficult than ever.

Assessing Downside Risk

To date, the declines in the Dow Jones Industrial Average, the S&P 500, the Nasdaq Composite, the Russell 2000, and the Wilshire 5000 have been 8.7%, 10.25%, 16.7%, 18.9%, and 11.4%, respectively. The SPX is therefore in correction territory with a 10.25% decline, while the RUT with its 18.9% sell-off is close to bear market territory. Many individual stocks have already had declines of 20% or more. Given the extent of recent price declines we believe we should now start looking for signs of a bottom.

A classic sign of a major low is a high-volume sell-off day, where 90% or more of the volume is in declining stocks and volume may rise to twice the normal daily pace. A major low may have a string of such days, followed by a rebound, and a retest. Typically, this high volume sell-off is due to a sharp rise in margin debt that then triggers margin calls once stock prices begin to decline. However, it is not likely that a margin call washout will occur in the current cycle. We have been monitoring monthly margin debt numbers and they have been declining, not rising as prices peaked in recent months. Combined margin debt in January was $798.6 billion, down 12.2% from December’s $910.0 billion and unchanged from a year earlier. The 2-month rate of change in margin debt was negative 13.1% in January and as a percentage of total market cap it was 1.4%, down from 1.53% in December and down from 1.7% from a year earlier. In short, the leverage that is usually unwound at the end of bear cycle is simply not as substantial as that seen in previous cycles. See page 7. This being true, the end of the correction may not be as dramatic.

We are monitoring a number of technical charts to assess overall market risk. One of these is the SPX which may be in the process of forming a substantial head and shoulders top pattern. Some technical analysts have already noted this pattern. The important level to watch is the neckline support that is found at the SPX 4300 level on a closing basis and at SPX 4222 on an intra-day basis. The SPX 4300 level is currently being tested. From a technical perspective, a break of the SPX 4300 area creates downside targets of SPX 4000 and SPX 3800. See page 9. Since algo traders use support and resistance levels for intra-day trading, we would expect a drop in the SPX below 4300 would likely trigger more selling.

It intrigues us that a small-capitalization stock index and one of the largest capitalization companies in the S&P 500 have similar chart patterns. And we have already written about the parallels in the charts of Amazon (AMZN – $3003.95) and the Russell 2000 index. In both charts, the breakdowns from lengthy trading ranges, materialized within days of each other and preceded the decline in the overall market. Since both were leaders in terms of market weakness, we are now monitoring them for signs of stabilization in hope that this would imply a low has been found. To date, there is no confirmation from these charts. See page 10.

The economy and the equity market face uncertainty as long as inflation continues to trend higher. Therefore, the chart of WTI futures is another risk factor. Unfortunately, once the crude oil future bettered the $77 level, the technical chart indicated potential targets of $90, $100, and $110. With crude futures now at $91.91 the risk of inflation continues and will make the Federal Reserve’s job more difficult. This implies multiple interest rate hikes in the months ahead. Stabilization in the WTI futures chart would relieve the current certainty of higher inflation, reduce the burden on the Fed, and lower the risk that the yield curve may invert later this year. These are the risks that the Russia/Ukraine border crisis poses to the world – more inflation and its consequences. See page 8.

Valuation Benchmarks

Technical indicators are often the best tools for defining a market top, but valuation tools can best determine where downside risk is minimized. Our model is forecasting an average PE of 15.8 for year-end 2022 and a PE range of 13.2 times to 18.3 times. These low, mid, and high PEs coupled with our earnings forecast of $220 (a 7% YOY growth rate) equates to SPX valuation targets of 2904, 3469, and 4026. These are fairly frightening downside SPX targets. We prefer to use the long-term average PE of 16.5 X as the appropriate multiple given the current level of inflation which creates a worst-case scenario of SPX 3630. Another approach would be the 2000-2022 average PE of 19.5 times to define fair value and probably downside risk. This equates to an SPX target of 4290. In our view, this combination implies that “value” is found directly below the SPX 4000 level. In the interim, energy, financial and staples remain our favorite sectors for the current environment, along with individual stocks that can weather the inflationary environment and have dividends in excess of 2%. Nonetheless, the 2022 sell-off is apt to provide an excellent long-term buying opportunity in the technology stocks so this is a time to have a list of favorite buys on hand if the SPX should fall below the 4000 level. Be cautious but be alert for opportunities.

Gail Dudack

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Stocks plunged, then surged. Oil surged, then slipped. It was all a reaction to Russia assembling more than 100,000 troops on the border of Ukraine, threatening to invade and then as a token of appeasement, pulling back some soldiers on Tuesday. However, Western leaders remained skeptical of Putin’s de-escalation move since Russian military equipment was left behind. After the pullback, Ukraine was hit by a cyber-attack and blamed it on Russia. From a global perspective, airlines, and the leasing companies, controlling billions of dollars worth of passenger jets, are by necessity, drawing up contingency plans for a freeze in business with Russia if the standoff on Ukraine’s border boils over into a military conflict. Flight paths will also have to be changed if war breaks out. It all is reminiscent of the Cold War we thought was left behind.

Closer to home, Canadian Prime Minister Justin Trudeau employed emergency powers in an attempt to control the trucker-led Freedom Convoy movement that is now in its third week. The convoy, protesting vaccine mandates and other Covid measures, has blocked downtown Ottawa and major bridges and crossings into the US. On day 19 of the protest, the Chief of Police of Ottawa resigned. The convoy has paralyzed Canada’s capital city and is having an economic impact on both Canada and the US.

On US soil, Senate action on President Joe Biden’s five nominees to the Federal Reserve became stalled after Republicans boycotted a key vote over objections to Sarah Bloom Raskin, the White House’s pick to be the central bank’s Wall Street regulator. Raskin has been criticized over her past statements expressing support for using financial rules to support and police climate change. Failure to advance these nominations will further delay regulatory changes that have been in limbo since October.

All of this is background noise as the US economy struggles with inflation and the likelihood of higher interest rates. And it is taking a toll on consumers. The preview for February’s University of Michigan consumer sentiment readings revealed a series of cyclical lows. The headline index fell 5.5 points to 61.7. The survey on present conditions fell 3.5 to 68.5. The expectations index fell 6.7 points to 57.4, the lowest level since 2011.

Inflation Woes

Inflation data showed that price increases accelerated in January and the CPI jumped from December’s 7.0% YOY to 7.5% YOY. This headline rate was the highest inflation pace in 40 years. And inflation was broadly based, with most CPI sub-indices showing gains well above the Fed’s 2% target rate. The only exception was education and communication which rose 1.6% YOY. The greatest price gains were the transportation sector, up 20.8% YOY. Fuels and utilities rose 12%. Prices for food at home rose 7.4% and apparel rose 5.3%. See page 3.

All the heavyweight components of the CPI are trending sharply higher although the transportation segment has been hovering around the 20% YOY level for several months. Housing – which is a significant 42.4% of the CPI weighting — saw prices rising 5.7% YOY in January. Household furnishings rose 9% and operations increased 4%. See page 4.

At $91.99 a barrel, WTI futures are up over 50% YOY which denotes future inflation numbers will remain high and worrisome. January’s PPI numbers were also higher than predicted with headline rising 12.2% YOY and PPI final demand prices rising 8.5%. December’s import prices excluding oil fell but were still up 6.8% YOY. See page 5. Clearly, inflation has become widespread and embedded in the economy.

Monitoring Yield Curves

With inflation trends escalating, there is great anticipation for the Federal Reserve’s March meeting. We have been expecting a 50-basis point rate hike at this meeting and this is becoming a consensus view. However, it could be that the March meeting will be a lose/lose situation for Chairman Jerome Powell. A 25-basis point hike might be regarded as too little too late, but a 50-basis point rate hike may make the FOMC appear desperate. Already, economists are indicating that they fear the Fed is about to make a mistake that will trigger a recession. For this reason, we have been monitoring the Treasury yield curve to measure financial sentiment. An inverted yield curve has been an accurate precursor of a recession. Although it is worth pointing out that while yield curve inversions have preceded each recession in the last 50 years, the timing is inconsistent and not every inversion has been followed by a recession. Nonetheless, the yield curve is currently normal and that is a godsend.  See page 6.

Technical Indicators

At the top of our inflation concerns is the technical chart of WTI futures. After a major breakout at $77, WTI hit its first upside target of $90. However, this bullish chart pattern also suggests targets of $100 and $110. In our view the Fed’s job of controlling inflation is difficult since domestic and global politics are driving fuel prices. This may contribute to the view that the Fed is at risk of triggering a recession. To date, Treasury note yields have lagged the trend in WTI. But the 10-year Treasury note yield recently exceeded the psychological 2.0% level and is apt to move higher. See page 9. In sum, both inflation and higher interest rates are formidable hurdles for equities this year; but investors can insulate portfolios with stocks that have dividend yields of 2% or more and good earnings prospects.

Despite the recent rally, all the popular indices are trading below all important moving averages. The sole exception is the SPX which is trading above its 200-day moving average this week. The Nasdaq Composite, which has had the deepest correction, is the most oversold; but this is not an unusual pattern in a correction. Large cap stocks are often the last to fall. Therefore, the DJIA and SPX are potentially the most vulnerable indices in coming weeks or months. See page 10.

Amazon (AMZN – $3130.21) which has a chart pattern that resembles the Russell 2000 index, rebounded nicely after in recent swoon, however, it is still trading below all its key moving averages. The first level of resistance is found at $3223 which is a key level to watch. The rebound in AMZN has created a difference between its pattern and the RUT, nevertheless, these chart patterns remain amazingly similar. We will continue to monitor these charts, watching for a bottoming formation that may show that the worst of the correction is behind us. To date, it appears the market’s lows may not have been found. We remain cautious in the near term given the unstable situation with Russia/Ukraine and with the upcoming FOMC meeting. But we continue to favor the energy, financial, and staples sectors and stocks with reliable earnings and dividends.

Gail Dudack

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January’s job growth was well above the consensus estimate and the 467,000 increase was a welcomed event. But this number was in sharp contrast to other economic series also released in the last week. Both of January’s ISM indices are indicating that the recovery is slowing. The ISM manufacturing index fell from 58.8 to 57.6. The manufacturing employment component rose modestly from 53.9 to 54.5, but this and imports, were the only parts of the survey to show any improvement. The ISM service index had consistently been the stronger of the two surveys, but it also fell in January from 62.3 to 59.9. All components in the service group fell with the exception of inventory. In general, both ISM surveys have been deteriorating for the last two months. Not surprisingly, the small business survey, the NFIB Optimism Index, had a large slump in January as small business owners pointed to rising inflation as the number one challenge for their companies and profits. See page 7.

The jobs report also had a counterpoint to the nice job increase in that the unemployment rate ratcheted up from 3.9% to 4.0%. The unemployment rate is part of the BLS household survey which showed that while employment grew strongly in January, so did the number of unemployed. This accounted for the rise in the unemployment rate. The civilian noninstitutional population grew less than the growth in employed and for this reason there was fractional improvement in the participation rate and the employment population ratio. See page 3.

In our opinion, the only employment data point that is important is that there are 2.9 million fewer people employed today than at the peak in February 2020. Typically, total employment will exceed its previous peak level twelve months after a recession ends. Yet, despite all the stimulus and fiscal programs initiated in the last two years, employment remains well below peak levels. There are many reasons for this; but the most significant one may be that the administration has not focused on job growth much at all. Perhaps distracted by COVID-19, the Delta and Omicron variants, vaccines, inflation, North Korean missiles, and the Russia/Ukraine problem, it has not been a focal point.

Inflation is the domestic threat

Inflation is the major threat facing the US economy and its ramifications are clear. One of these is also found in January’s employment report. Average hourly earnings were $26.92 in January, up 6.9% YOY and average weekly earnings rose to $912.59, a 5.4% YOY. These gains are impressive at first glance; however, adjusting for inflation, real weekly earnings were down 1.2% YOY in January. This is the unfortunate part of inflation — it destroys buying power. On page 4 we have a chart of average weekly earnings that are inflation-adjusted to represent 1964 dollars. The chart shows how average real earnings steadily declined throughout the high inflationary period of 1968 to 1990. See page 4. For this and many other reasons, the administration and the Federal Reserve should make fighting inflation their number one domestic priority.

On a positive note, we present the misery index this week. This index is the sum of inflation and unemployment which are the two variables that can impose great hardship on households. The misery index jumped to 15.1% in April 2020 when the unemployment rate jumped to 14.7% and was well above the standard deviation level of 12.7%. However, this was a man-made unemployment level triggered by the pandemic and fiscal stimulus offset much of this “misery” with checks to households and augmented unemployment benefits. Currently, the rise in inflation is wreaking havoc with households but the misery index is at 10.6%. This is well within the long-term “normal” range. See page 6.

Still, we do not see inflation coming under control very soon. The WTI crude oil future moved above $90 a barrel this week. The $90 level was one of the technical targets we wrote about once crude broke out of an 8-year base pattern in the fourth quarter of 2021. The chart pattern also suggests targets of $100 and $110 are possible in the coming months. This will keep inflation high, put more pressure on households and make the Fed’s job of controlling inflation more difficult. Interest rates are also rising this week and the 10-year Treasury note yield is challenging the psychological 2% level. See page 9. Keep in mind that stocks with dividend yields of 2% or more that also have a predictable earnings stream remain very competitive to bonds.

Valuation readjustment

The combination of rising inflation and rising interest rates is a big hurdle for equities, and it explains why value stocks are outperforming growth stocks in 2022. This shift could continue for most of the year and in simple terms, it is a valuation readjustment. We remain cautious in the near term, primarily for stocks with high multiples. Overall, we believe stocks that benefit from, or are immune to, inflation are the best holdings in the near term. These include sectors such as energy, financials, and staples. Nonetheless, we would not ignore the technology sector since 2022 is likely to provide an excellent long-term buying opportunity.   

As part of the current valuation readjustment, we believe the market’s PE could return to normal levels. As an example of what this means, a PE multiple of 18 coupled with our 2022 earnings forecast of $220 equates to an SPX target of 3960. Applying the long-term average PE multiple of 17.5 to $220 equates to SPX 3850. In both cases, it implies that good long-term value is found at levels directly below SPX 4000.

It would not surprise us if PEG ratios, or a comparison of a stock’s PE to its 5-year earnings growth estimate, came back into style. Historically, a PEG ratio of 1.5 in a growth stock represented table-pounding “value.” Value stocks were typically viewed as excellent buys with PEG ratios of 1.0 or less. Again, these are good benchmarks for uncertain times.

Technical update

We remain intrigued by the similarity in the charts of the Russell 2000 index and Amazon (AMZN – $3228.27). After AMZN reported solid earnings last week, the stock rebounded sharply, generating a small difference in the charts. However, the patterns remain largely similar and AMZN is yet to move above its first level of resistance which is the 50-day moving average now at $3255.86. This will be an interesting level to watch. There are no other major changes in technical indicators. The new high/low averages and cumulative advance/decline line are bearish. Our 25-day up/down volume oscillator remains neutral, which means the market is not washed out on an intermediate-term basis. The AAII bull/bear sentiment indices have shown extreme bearish readings for the last three weeks and as a result, the AAII Bull/Bear Spread index is favorable. The good news is that this AAII survey suggests the market is undergoing a normal correction. The survey never showed the extreme optimism that is typical of a bubble peak. Nonetheless, we believe the current rebound is simply a rebound and we do not believe the lows have been found. It would not surprise us if the Fed increased rates 50 basis points in March and this could trigger a sell-off that could characterize the end of the correction.

Gail Dudack

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Last week’s FOMC meeting resulted in no major surprises, in our view. The Fed used its January meeting to prepare the global financial markets for quantitative easing that would end by March and for its balance sheet to probably shrink later in 2022. But most importantly, Chairman Jerome Powell was quite clear in his statements that interest rates would begin to rise in March and likely do so for most of the year.

In the wake of this meeting, pundits began to speculate about the number of rate increases investors should expect in 2022. In our opinion, these guesstimates are not useful because we agree with the Fed’s comment that tightening policy going forward will be data dependent. Yet, since the Fed is behind the curve, we would not be surprised if the first fed funds rate hike is 50 basis points. This double-hike would help jumpstart the Fed’s inflation-fighting cycle. It might startle the markets, but it will also dampen the expectations of inflation that has become embedded in the economy.

Unfortunately, we would not be surprised if the Fed’s tightening strategy becomes more complicated later in the year with a combination of inflation that remains stubbornly high, coupled with an economy that shows signs of deceleration. We have often discussed the problems that inflation poses to equities — rising interest rates, multiple compression, profit margin weakness — another risk is that it weakens broad-based consumption. For 2022, we are recommending sectors that are relatively insulated from these risks, such as energy, financials, and staples. Part of this reason is that as the cost of necessities such as heating fuel, gasoline, and food continue to rise, consumers will have less and less money to spend on luxuries such as vacations, new clothes, and entertainment. The net result will be declining revenues for a variety of companies. We expect to hear debates about stagflation in the coming months, but there is no reason to expect this to materialize in 2022. The actual definition of stagflation is an economy characterized by rising inflation and rising unemployment. This was last seen in the 1970s during the oil embargo. We do not see unemployment rising; we simply see a challenging time ahead for corporate earnings.

There are some similarities between the 1970s and the current situation, but they are curable. Instead of an oil embargo that created an energy crisis in the 1970s, The Paris Agreement on global climate change signed in 2021, triggered a sharp rise in fossil fuel regulation and a subsequent decline in energy supply. In short, the current situation is different because it is self-imposed, but we are not sure if this matters. The decline in the supply of fossil fuels is a bigger driver of global inflation than supply disruptions, in our judgment. Yet we doubt this will change the minds of our global leaders.

Furthermore, the price of oil is exacerbated by geopolitics and the fear that Russia is planning to invade Ukraine. As a result, the WTI crude oil future, at $88.36 a barrel currently, is up 17.5% since the end of 2021 and up 44% YOY. See page 10. It should also be noted that Russia is a major beneficiary of the rise in oil prices.

This means inflation will be very difficult to control, at least in the first half of this year, and the Fed has a challenging task ahead of it.

The Good News

January closed the month with declines of 3.3%, 5.3%, 9.0%, and 9.7%, in the Dow Jones Industrials, S&P 500, Nasdaq Composite, and Russell 2000 index, respectively. Moreover, the Nasdaq Composite has experienced an 11.3% decline from its all-time high and the Russell 2000 has dropped 17% from its record high. In short, the broad market is clearly in a correction. We expect the large cap stocks will be the last to fall at the end of the decline; but in the near term, a bounce is likely.  

We show the results of the January Barometer for the Dow Jones Industrials on page 3 and for the S&P 500 on page 4. We have faith in this Wall Street adage that states “As goes January, so goes the year” because we believe the liquidity available to the equity market tends to be at its best in January. However, we must admit that the barometer has a far better track record when January posts a gain than when it posts a loss. A January gain in the Dow Jones Industrials has been followed by a full year gain 89% of the time. In the S&P 500, a January gain has produced an annual gain 88% of the time. But declines in January are much less predictive. In the Dow Jones Industrials, a loss in the first month of the year is followed by an annual loss 54% of the time and in the S&P 500, 47% of the time. In sum, one should not be bearish based upon the January Barometer.  

It is also good news that the stock market has not displayed the characteristics of a classic bubble top. The key to a true bubble is leverage and most importantly, an escalation in leverage. While margin debt has grown markedly in the last 24 months, it has not grown at the pace seen at most major tops. See page 5. The 2-month rate of change in margin debt grew more than 15% in December 2020, as we reported at that time, but margin debt actually contracted in November and December of last year. This is positive since it limits the leverage, and risk of margin calls in the current environment.

Economic Releases

In our view, subtle signs of decelerating economic growth are already appearing. For the third consecutive month, January’s ISM manufacturing index fell, declining from 58.8 in December to 57.6. However, it does remain comfortably above the neutral 50 level. Vehicle sales fell more than 4% in December to an annualized rate of 12.45 million and are down a disturbing 32% from the April 2021 pace of 18.78 million units. See page 6. January’s consumer sentiment indices were glum with the Conference Board Confidence index slipping from 115.2 to 113.8 and the University of Michigan headline reading falling from 70.6 to 68.8. The only uptick in sentiment was found in the Conference Board’s present conditions index which moved up from 144.8 to 148.2. See page 7. New home sales came in stronger than expected in December, increasing nearly 12% to 811,000 units. However, this rebound followed a sharp decline in new single-family home sales in 2021. Existing home sales were more resilient than new home sales last year, but there are signs in both data series that prices are rolling over. See page 8. This should not be a surprise given the recent gains in home prices and the fact that interest rates will be moving higher.

Technical Review

There were not a lot of changes in the technical indicators this week, but the 10-day average of daily new highs fell to 54 which is notable. Daily new lows rose to a 10-day average of 505. This indicator is now clearly negative, after tilting negative for several weeks. The NYSE cumulative advance/decline line’s last record high was on November 8, 2021, and it is trading well below this level currently. Volume has not been rising on declines, which is a worrisome trend. On the plus side, AAII bearish sentiment rose 6.2 points to 52.9%, this week and is above the historical average of 30.5% for the tenth consecutive week. This was the highest reading since April 2013. As a result, the AAII bull/bear spread index is positive for the second consecutive week. Note, AAII never displayed the extreme bullishness that is typical of a major, or bubble, peak. This is a good sign for the longer term.

Gail Dudack

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In our January 5, 2022, weekly “On the Verge of a Bubble?” we stated that we thought 2022 would be a decisive year for the equity market. In our view, stocks would either see a significant correction this year, or if a rally continued, it meant an equity bubble, driven purely by liquidity and momentum, was in place. Fortunately, the first few weeks of the year have been decisive. We say fortunately because we believe a correction is a much healthier option for investors. But this means our focus shifts from technical divergences and the risk of an impending top to measuring the potential downside based upon a variety of fundamental benchmarks. We do not believe equities have made their final lows and fundamentals can provide guidance on measuring downside risk.

Valuation Model: The inputs

Most valuation models rely on similar inputs. The inputs to our model are our earnings estimates, the rate of inflation and forecasts for short- and long-term rates. For 2022, we estimate SPX earnings will be $220, inflation will fall to 4.4%, short-term interest rates rise to 0.8% and the 10-year Treasury note yield increases to 2.2%. These inputs give us a projected range as well as a midpoint of the range for the SPX.

In 2015 the SPX shot to the top of our model’s projected fair value range and continued to trade there until 2020. However, trading at the top of the fair value range is acceptable with inflation at, or below, 2% YOY, which it was at that time. Low inflation supports a higher PE multiple. However, in early 2020 the index began to trade well above the fair value range and by the end of the year the disparity between the actual SPX price and the top of the projected range grew to a level last seen during the 2000 bubble. See page 5. Still, with inflation relatively low one might see this as the equity market discounting the economic rebound that was widely expected to materialize in 2021.

Indeed, earnings rebounded strongly after the earnings trough of December 2020, but inflation also began to rise. Earnings growth is worth less in an inflationary environment and as a result, PE multiples slowly began to fall in 2021. However, inflation did not just increase in 2021, it soared to 40- year highs and this is the crux of the market’s problem this year. Inflation of 7% YOY implies much lower multiples and at the same time, monetary policy is apt to be aggressively tight in 2022 to control inflation. This combination makes it a hostile environment for equities.

Valuation Model: Inflation

Our model demonstrates the pressure inflation places on equities. For example, in 2020 when inflation was 1.4%, our model indicated that the average PE should be 17.7 times. However, at the end of 2021, with inflation at 7%, the model forecasted an average multiple of 14.5 times. In 2022, we estimate inflation will fall to 4.4% — which is still above the long-term average inflation rate of 3.6% — and our valuation model suggests the average PE multiple should rise to 15.8 times. The high end of the PE range lifts to 18.4 times by December. Nonetheless, the current trailing SPX PE multiple is 21.4 times.

The impact of inflation on PE multiples can be seen in the chart on page 8. Although the trailing PE multiple has been declining toward 20 times in recent months, the rise in inflation has lowered the forecast for the high-end PE from roughly 20 times to 18 times. In short, more multiple compression lies ahead.

Calculating Downside Risk

One way of measuring downside market risk is to see what the trailing PE has been at previous market troughs. Although the PE at the end of a major decline is also impacted by inflation, we noticed that the last two market troughs occurred with a trailing PE multiple of 16.5 times. Applying this to our $220 earnings estimate for this year yields a downside market risk to SPX 3630. Similarly, if we applied an 18 multiple to our earnings estimate, the downside risk for the SPX is 3960. These two scenarios imply that the market begins to find “value” below SPX 4000. Note that a drop to SPX 3960 is the equivalent of a 17% decline from the record high of 4796.56 made on January 3, 2022. See page 4. This does not appear unreasonable, particularly since the Russell 2000 index has already declined 18.6% from its record high.

In our view, the worst-case scenario would be a decline to the midpoint of our model’s projected range. This means a PE of 15.8 with our $220 earnings estimate or the equivalent of SPX 3475. This midpoint would be a bear market decline of 28%. We cannot rule this out, but we would also point out that the pandemic decline in 2020 produced an even greater 34% decline in the SPX. Yet earnings and stocks rebounded smartly after the pandemic-driven recession of 2020. To insulate portfolios from risk, we continue to focus on stocks and sectors that can weather the inflationary environment of 2022. This includes energy, staples, and financials. Nevertheless, as we have been indicating, technology stocks are expected to bear the brunt of the correction, but this decline will also create an excellent opportunity for growth stocks. A break below SPX 4000 may create such an opportunity.

Oh, my Russell

The popular indices exhibit surprisingly different chart characteristics this week. The SPX looks best since it is trading modestly below its 200-day moving average, but all of its moving averages are rising. The DJIA appears second best. It is trading below its 200-day moving average and the moving averages have not crossed below each other. The Nasdaq Composite index is the weakest of this grouping, trading below all its moving averages and the 50-day moving average is at risk of falling below the 100-day moving average. See page 11.

The Russell 2000 index has been our bellwether index for the market since early 2021 and as we noted last week, this chart is very bearish. The 50-day moving average has broken below all other moving averages and this “death cross” configuration is attracting attention. More importantly, the Russell 2000 broke below the 8-month trading range last week that contained most of 2021’s trading action. This consolidation range has become a large top and there is no support in the chart prior to 1700. What is also surprising is how much the chart of Amazon (AMZN – $2799.72) looks like the Russell 2000 index. Note, AMZN is not in the Russell 2000 index yet ironically the chart patterns are very similar, and worrisome. Despite all the media buzz about the market being oversold, we find our 25-day up/down volume oscillator at a modest negative 0.21 reading this week. Typically, major market troughs are characterized by panic, and this is measured by extreme levels of breadth, for example, days with 90% or more of the daily volume in declining stocks. The huge intra-day swings this week and the rebounds from early session lows have kept breadth data fairly moderate at the end of each session. We do not see this as a good thing. It implies that the panic may still lie ahead; therefore, we would be cautious in the coming weeks. But danger equates to opportunity, so we are also looking to acquire technology stocks at lower levels.

Gail Dudack

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In this week’s title, “the chickens” refers to inflation. After ignoring inflation for much of 2021, in early 2022, the actual toll of rising prices is finally becoming headline news. In our mind, this was inevitable. But the saddest part of the current inflation cycle is that it could have been avoided. Inflation was a predictable outcome of keeping monetary policy extremely easy despite the fact that the economy was already recovering from COVID. Inflation was also stoked by a too liberal fiscal policy that flooded the system with money even after stores and businesses were getting back to work. It is never good policy to add fuel to an economic rebound. In short, too much money chasing too few goods is always inflationary – yet Washington DC ignored rising prices for the first three quarters of 2021. Now inflation is coming home to roost.

And this is seen in many ways. Goldman Sachs Group (GS – $354.40) missed its earnings target this week and it triggered a wide-ranging sell-off in the marketplace. The company noted that its profit miss was due to weaker trading revenues and rising expenses. In our opinion, Goldman may be a bellwether for the broader economy. After pumping historic sums of liquidity into the capital markets for 18 months to offset the impact of the pandemic, the Fed has just begun to slow its purchases and indicates it will end quantitative easing by March. The Fed’s quantitative easing fueled trading activity in stocks and bonds and Goldman was a big beneficiary of the market’s rise since March 2020. But trading has already begun to slow. Goldman’s quarterly profits were also hurt by a 23% rise in operating expenses, mainly reflecting higher compensation and benefits costs. This combination of slower top line growth and profit margin contraction will be true of many companies this year and it is a concern to us.

Reverberations

Headline CPI jumped more than 7% YOY in December and this represented a 40-year high in inflation. Core CPI rose 5.5%, the highest pace in 30 years. The fact that we have not seen prices rise at this magnitude for so many decades means that many of today’s investors have had little or no experience with inflation and its various implications. Economists and analysts ignored the dark side of inflation in 2021 but we doubt that this complacency will continue in 2022. The most obvious reason is that a shift in Fed policy changes the environment for investors and inflation will now determine what the Fed must do in the coming months.

Unfortunately, we expect inflation will get worse before it gets better later this year. This is obvious to us in several ways. First, the producer price index for finished goods, which feeds into the consumer price index, rose 12.2% YOY in December and unfortunately there are still no signs of it peaking. Second, homeowners’ equivalent rent (HER) has a weighting of 23.5% in the CPI. Since prices for single-family homes were up 15% YOY in December, it is very likely that homeowners’ equivalent rent will move much higher than the 3.8% YOY seen in December. Rental fees tend to follow home prices in every neighborhood. See pages 3 and 4. Plus, WTI futures have already risen 15.5% year-to-date and this will keep gasoline and transportation prices rising in the early months of 2022. Moreover, this week’s move to $86.50 in the WTI future is a breakout from an 8-year base pattern and from a technical perspective, the chart shows the potential of moving higher. See page 9.

With headline inflation at 7% and the fed funds rate at zero to 0.25%, the real fed funds rate is nearly negative 7%. This is due to “easy” monetary policy. Reducing the disparity between the fed funds rate and the CPI is necessary to tame inflation. Unfortunately, it means the FOMC would have to raise rates significantly in 2022. Rising interest rates will be a difficult hurdle for equities since stocks and bonds compete in terms of valuation. Rising interest rates also raises the bar for speculators who are likely to leave the marketplace.

Corporations and all businesses will be facing an uphill battle with raw material, and intermediate good prices rising much faster than prices to consumers. Rising prices is also putting pressure on wages, as seen by Goldman Sachs report, and this adds to expenses. The net result of this is a major erosion in profit margins. All in all, it puts earnings at risk. See page 5.

In addition, profits are less valuable in an inflationary environment, and this puts pressure on PE multiples. In the low inflationary environment of 2008-2020, our valuation model indicated that PE’s could remain as high as 20 times. But as inflation moves above 4% this changes. Given our assumption that inflation decelerates to 5.5% YOY and 10-year Treasury note yields rise to 2.2%, the high-end of the PE range should drop to 18 times. See page 6. In short, 2022 could be a challenging year. There will be pressure on households from inflation and consumption patterns will change. Corporations may suffer from top line growth. Businesses will also be pressured by higher raw material and wage costs, crimping profit margins. And rising interest rates and inflation could also produce a decline in PE multiples.

Again, this means investors should try to insulate themselves from these risks by focusing on areas of the market that can weather this changing environment. We believe that suggests sectors such as energy, financials, and staples. It may also be wise to hold some cash in order to look to buy some high growth technology stocks later in the year.

Technical Charts and Indicators

The charts of the main indices are worrisome this week since there are signs of weakening trends. The SPX is the best-looking chart of all the main indices since it has only broken its 50-day moving average and is currently testing its 100-day moving average. Its uptrend appears intact. The DJIA looks less positive. The price trend is decelerating, and the index is below its 50-day and 100-day moving averages, but it is still above its 200-day moving average. The Nasdaq Composite index fell below all its moving averages this week and needs to rebound sharply in coming sessions to maintain a positive long-term trend. The Russell 2000 index is the weakest chart of all, having broken below all moving averages, but more importantly falling below the bottom of the 8-month trading range seen for much of 2021. This breakdown has very negative implications for the index and the overall marketplace. See page 10. The 10-day average of daily new highs fell to 174 this week and daily new lows rose to 244. This combination of both averages being above 100 per day is neutral, but the indicator tilts negative since new lows are exceeding new highs. The NYSE cumulative advance/decline line’s last record high was on November 8, 2021, and it is trading well below this level currently. The current disparity between the AD line and the SPX totals to 8-weeks, which is not uncommon, but typically indicates a correction of 10% to 15% lies ahead. Note that the longer this disparity persists, the deeper the eventual correction might be. Volume has not been rising on rally days, which is a worrisome trend. All in all, we are not surprised by this week’s weakness and would point out that the Nasdaq Composite and Russell 2000 are already trading 9.7% and 14.2%, respectively, from the record highs.    

Gail Dudack

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The new year arrived, and with it came a new and revised perspective on the equity market. This is understandable. In 2021, the financial markets were insulated from downside risk given the extremely friendly posture of the Federal Reserve and the potential of more fiscal stimulus. Monetary policy would keep interest rates low and safeguard speculators while fiscal stimulus would support economic activity. With these two safety nets as backing, one could ignore inflation without consequences. But the Fed, many economists, and bankers are now addressing the strain that rising prices has had on consumers in 2021 and many are suddenly, although belatedly, calling for quick action. At the same time, more fiscal stimulus is looking less likely. Thus, both safety nets are disappearing in 2022.

In terms of fiscal policy, the logjam in Congress is no surprise. However, the shift in monetary policy came about amazingly quickly. At the June FOMC meeting, Fed officials — or the dot plot — forecasted no fed funds rate increases until 2023. In September, the dot plot changed to include one possible rate hike at the end of 2022. December’s dot plot implied three possible rate hikes in 2022. This week the consensus expectation has changed once again to include four or five fed funds rate hikes this year, or at least one increase per quarter. This is a startling turnaround, albeit a necessary one. We believed inflation would be a big hurdle for equities last year. It proved not to be. But this year as the Fed addresses the existence of inflation, the significance of price increases is apt to become quite apparent. Keep in mind that four fed fund rate hikes within a twelve-month period tends to produce a down market in the subsequent six months. We will discuss Fed rate hikes in future weeklies.

Independent of monetary and fiscal policy, the new year begins under a dark cloud. As we have often noted, three consecutive years of double-digit gains in the indices are often followed by a year of losses. The one exception to this precedent was the five double-digit up years that led into the 2000 peak. However, this historic rise was a stock market bubble, and it was followed by three consecutive years of losses. See page 3. Therefore, if history is any guide, 2022 may a defining year – either it is a down year or it is the beginning of an equity bubble. We think the first quarter will be revealing and may provide the answer.

January and Liquidity

Wall Street adages are typically built upon some fundamental or economic premise and the January Barometer is one of these. The concept of the first five days of the year and/or the first month of the year having predictive value for the overall year is based upon liquidity. The end of the year and the beginning of any year is a unique time for liquidity. A grouping of pension funding, IRA funding, tax loss selling proceeds, bonus payments and salary increases tends to cluster in the December/January period and makes this time unique in terms of providing potential demand for equities. If equities fail to rise during this time, it may be a signal of trouble ahead. Overall, it is a warning.

January is off to a weak start this year, with a 1.9% decline in the S&P 500 index and a 0.3% decline in the Dow Jones Industrial Average. And as shown on page 5, ten of the last 17 post-election-year markets were flat to down years. However, it is important to point out that the early January Barometer has a poor record of predicting annual declines. Early January losses have only been followed by annual declines 42% of the time in the S&P 500 and 46% of the time in the DJIA. A decline in the month of January has been more accurate. January declines have been followed by annual declines 69% and 66% of the time in the S&P 500 and DJIA, respectively. All in all, the January Barometer has been a better guide in predicting up years after January gains. See pages 4 and 5. Still, we do think it would be a bad omen for January to be weak in face of the obstacles we see for equities.      

Obstacles

One of the issues facing equities is the potential slowdown in earnings growth. After what we expect will be a high double-digit earnings growth rate in 2021, the pace is expected to slow to a single digit level this year. Currently, IBES Refinitiv and S&P/Dow Jones have 2022 earnings growth rates of 8.5% YOY and 9.0% YOY, respectively. Our estimate is for a 10% YOY growth rate, but only because our 2021 earnings estimate is below the consensus view. See page 7 and 16. Nevertheless, earnings are facing tough comparisons in 2022 and earnings will not provide the fundamental support it did over the last twelve months.

Higher inflation also pressures price-earnings multiples. Unless inflation falls well below the 4% level this year, we expect multiples to fall from the current level of 20+ to the average of 17.5 times. But inflation dropping to less than 4% seems unlikely in the near term, particularly with crude oil futures rising once again. The charts of both WTI and gasoline futures point to higher prices this year. See page 8. This implies inflation and multiple risk in coming months.

Plus, it is easy to become too insular and forget about the geopolitical problems that could upset the financial markets. Political hotspots include North Korea which launched two ballistic missiles off its East Coast in the last week, US forces in Iraq and Syria suffering three separate rocket attacks in recent days, Russian troops hovering ominously on the Ukrainian border and China becoming increasingly assertive in controlling both Hong Kong and Taiwan. All of these have the potential of upending the financial applecart.

FANG stocks

High PE stocks face the biggest threat in an environment of soaring inflation and rising interest rates. And we expect technology stocks could bear the brunt of any correction in 2022. With this in mind we looked at the charts of the FANG stocks this week and found some patterns that deserve monitoring. We have comments on Amazon (AMZN – $3307.24), Meta Platform (FB – $334.37) and Alphabet (GOOG – $2800.35) on page 9. Each of these stocks have critical support levels that if broken, could trigger further selling. In sum, we would be defensive in the short run; but a sell-off in 2022 could produce an excellent long-term buying opportunity. Meanwhile, there are pockets of safety in the market in areas such as energy, banks, and staples, which all have modest multiples and good dividend yields.

Technical Indicators The Russell 2000 index also has a pattern similar to the aforementioned FANG stocks in that the 2100 support level is important to the index. If this level is broken it would be extremely bearish for the RUT and a negative omen for the market. See page 10. Most other technical indicators are neutral or indecisive this week. The 25-day up/down volume oscillator is at 2.06 this week and above the midpoint of the neutral range, but still has not confirmed any market highs since February 2021. This implies that investors have been selling into rallies. Both the 10-day averages of new highs and new lows are above 100, leaving the “trend” of the market ambiguous. The NYSE cumulative advance/decline line made its last record high on November 8. Sentiment indicators like the AAII bull bear survey and the ISE call/put volume index are neutral. All in all, we remain cautious for the near term.  

Gail Dudack

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