Stocks performed well in 2021, but while gains were widespread, it was not easy to outperform some of the indices. The best performing index in 2021 was the Dow Jones Transportation Average which rose 31.8% for the year. The SPX was second with a gain of 26.9%, followed by the Wilshire 5000 index which rallied 22.8%.

The Dow Jones Industrial Average had an 18.7% gain in 2021 and in most years, this would have been an exceptional performance, but for last year it made the index a laggard. The Russell 2000 index rose roughly half of the SPX at 13.7% for the year and performed just slightly better than the Dow Jones Utility Average which rose 13.4%. However, on a total return basis, the Dow Jones Utility Average clearly outperformed the Russell small cap index.

One might wonder about the amazing outperformance of the Dow Jones Transportation Average given the weak performance of the airlines during the pandemic, but airlines were offset by strong performances in some unexpected components like Avis Budget Group, Inc. (CAR – $202.53), and the various shipping and freight components such as, Expeditors International of Washington, Inc. (EXPD – $130.06), C. H. Robinson Worldwide, Inc. (CHRW – $110.38), J.B. Hunt Transport Services, Inc. (JBHT – $207.66), or the marine shipping company, Matson, Inc. (MATX – $91.15). Despite the angst about transportation logjams and the disaster at the Port of Los Angeles, many transportation stocks performed well last year.

However, for most individual investors and many money managers, 2021 proved to be a challenging time to outperform the SPX. The reason for this is the emergence of a few stocks that are beginning to dominate the cap-weighted benchmark indices like the S&P 500 and the Nasdaq 100. In our December 15, 2021 weekly (“Monetary Policy Shift Ahead”) we displayed a table of the eight stocks that represented 63% of the total market capitalization of the Nasdaq 100 at that time. These stocks are Apple, Inc. (AAPL – $179.70), Microsoft Corp. (MSFT – $329.01), Alphabet Inc. Class C (GOOG.0 – $2888.33), Alphabet Inc. Class A (GOOGL.O – $2887.99), Amazon.com, Inc. (AMZN – $3350.44), Tesla Inc. (TSLA – $1149.59), Meta Platforms, Inc. Class A (FB – $336.53) and Nvidia Corp. (NVDA – $292.90). This week, as Apple, Inc. approached an historic $3 trillion market capitalization, S&P wrote that a mere five stocks currently represent 26% of the market weight of the SPX (AAPL, MSFT, GOOG, AMZN and FB).

It is noteworthy that with a $3 trillion market capitalization, Apple would singularly represent 7.8% of the S&P 500 index. This market cap dominance easily exceeds the 6.4% weighting seen by International Business Machine (IBM – $138.02) in 1985. There are many theories about what happens to a stock when it becomes a dominant part of the index, and most theories suggest that dominance is not long-lived. However, there is another important aspect to the fact that a small group of stocks are driving the SPX. Particularly those money managers pegged to the SPX, the fact that AAPL is 7.8% of the SPX market capitalization, you risk underperforming your benchmark if you are not similarly weighted in AAPL. If you are not, this equates to a large bet against AAPL doing well. We expect there was a lot of portfolio adjustments going on at year end.

What we find disturbing about the dominance of a few stocks driving the major benchmark indices is that it reminds us of the Nifty Fifty era that preceded the top in 1970. The nifty fifty stocks included companies like Polaroid, Eastman Kodak, Digital Equipment and S.S. Kresge (Kmart), Sears and Roebuck, and Xerox (XRX – $23.76). Most of which do not exist in their previous form. It is also similar to the dot-com bubble that led to the 2000 peak. Global Crossing was part of the dot-com bubble. It was a telecommunications company founded in 1997 that reached a market capitalization of $47 billion in February 2000 before filing bankruptcy in January 2002. In both of these previous cases the momentum of the market was driven by a relatively small number of popular growth stocks that represented the future to most investors. They were the disruptors of their era. But over time, if a few stocks are driving market performance, fundamentals and valuation models are replaced by momentum models. Momentum models simply drive more investors into a small group of outperforming stocks. We do not believe we are currently in a bubble; but having lived through the aftermath of both the 1970 and 2000 tops, the seeds of a bubble do exist, in our view. If we are on the verge of a bubble, 2022 may be the decisive year. Many indicators point to a correction that is greater than 10% over the next twelve months. But if this does not materialize, it is quite possible that a new set of investors, who have never lived through the humbling experience of a bear market may continue to follow momentum and drive stock prices higher.

The last three years have been good to investors. The SPX has had consecutive annual gains of 28.9%, 16.3% and 26.9%. The Nasdaq Composite has been even stronger with gains of 35.2%, 43.6% and 21.4%. The DJIA has not quite kept up, yet in the last three years it has had gains of 22.3%, 7.2% and 18.7%. History has shown that three consecutive years of double-digit gains in the indices has been followed by a negative year. Since 1901 there has been only one exception to this pattern: the five double-digit up years that lead into the 2000 peak. See page 3. However, as we noted, 2000 was a bubble peak and March 2000 was followed by three consecutive years of losses.

In sum, 2022 is apt to be a pivotal and defining year. A down year should be expected and it would be stabilizing for the longer run. But if stocks continue to advance strongly, it would be a likely sign of an emerging bubble. Fundamentals do not work in a bubble, but technical indicators are helpful. The NYSE cumulative advance decline line peaked in late 1997, yet the indices continued to move higher for more than two years. This was a massive two-plus year divergence. We have found that the divergence between the advance decline line and the indices is a simple way of gauging future downside risk in the marketplace. At present, the NYSE cumulative advance decline line made its last record high on November 8. This 8-week divergence is not unusual, and it suggests a correction of 10% or more. But the longer the divergence persists, the more the downside risk in the market grows as seen in 2000.

One of the warning signs that a bubble is reaching its peak is a surge in leverage. Massive borrowing against stocks is what will produce an eventual selling surge as leverage is unwound. For this reason, we are keeping a watch on margin debt growth. But total margin debt fell $17.3 billion in November to $918.6 billion. See page 4. As a percentage of total market capitalization margin debt was unchanged at just under 1.8%. This is a high ratio but not a record. November’s 2-month rate-of-change in margin debt was a modest 1.7% and compares to a 1.4% gain in the Wilshire 5000. Prior to market peaks margin debt can rise to 15.3% or more, yet barely move equity prices higher. From this perspective, the equity market appears to be in good shape. Earnings are expected to increase 8% to 9% this year, but we fear inflation could erode this more than expected. The Santa Claus rally implies 2022 could be a good year and the first five trading days of January is off to a good start. The early January market has had an accuracy rate of 79% of predicting the annual trend. See page 5. We will follow up on this next week but overall, a diversified portfolio is the best way to manage through what may be a tumultuous year. Our favorite sectors for diversification are technology, financials, energy and staples — a mixture of growth, value, and yield.  

Gail Dudack

Click to Download

This week could be pivotal for equity investors since the December Federal Reserve Board meeting is expected to result in a well-telegraphed reversal in monetary policy. The details and timing of quantitative easing and interest rate changes will be most important. Quantitative easing is expected to slow, perhaps more quickly than previously thought, but reversing QE has rarely had a negative impact on equity trends. The crucial part of monetary policy is the raising or lowering of interest rates. History shows that three or more fed funds rate hikes within a 12-month period has been followed by equity declines. The faster the rate hikes are made, the bigger the negative affect on the stock market. Therefore, the real focus this week will be on Chairman Jerome Powell’s comments and the possible timing of interest rates increases.

Unfortunately, we believe the Federal Reserve is already behind the curve. More importantly, one could opine that the current wave of inflation is man-made. A combination of historically large fiscal and monetary stimulus during an economic recovery is a perfect recipe for inflation — as any basic economic textbook would attest. Ironically, this was ignored by most economists, politicians and surprisingly by the Federal Reserve. And though equity investors have ignored soaring inflation numbers for months, recent data has made it more difficult to ignore. In our view, by ignoring inflation, the Fed has allowed it to become more embedded in the system. As a result, it could take more rate hikes to reverse than if it had been addressed earlier this year.

November’s inflation numbers were disconcerting. Headline CPI rose 6.8% YOY, the highest pace since the 7.1% YOY recorded in June 1982. Core CPI rose 4.9% YOY, the highest since the 5.0% pace in June 1991. See page 6. Headline PPI rose 13.3% YOY, the highest since October 1980. Core PPI, excluding food & energy, PPI jumped 5.9% YOY, the highest since March 1982 and final demand PPI rose 9.7% YOY, the highest on record. In other words, November’s inflation was the highest in thirty years which means many of today’s young investors have never dealt with inflation or understand its many repercussions.

Rising prices have spread throughout the economy and although fuel prices are no longer the main driver of US inflation, energy remains one of the most important triggers for future inflation. The good news is that WTI crude oil prices are down 16% from their October 26 peak of $84.65. The bad news is that WTI is still up 46% year-over-year. Gasoline prices are down a similar 16% from their high of $2.52 also made on October 26. See page 10.  

As we have discussed in previous reports, inflation of 4% or more tends to have a deleterious impact on price earnings multiples. For this reason, it is not surprising to see that many large capitalization technology stocks have encountered selling pressure this week. Technology stocks tend to have high multiples which become a high-risk asset as inflation rises. Also note that the following ten stocks in the Nasdaq 100 composite index represent 63% of the total market capitalization of the index and a significant percent of the S&P 500. During market weakness, or whenever selling pressure creates a liquidity crisis, large cap stocks become the most liquid and therefore bear the brunt of selling pressure.

We believe the best strategy for the next several months is avoid high PE stocks and tilt toward stocks with predictable earnings streams, modest PE multiples and dividend yields greater than the current 10-year Treasury bond yield of 1.4%. The recent gains in the consumer staples sector are an example of this transition. We expect a better buying opportunity for large cap technology stocks will appear in the first half of 2022.

Households Balance Sheet and Sentiment

US household net worth rose 1.7% in the third quarter to a record $144.7 trillion, which was an impressive 10.5% increase year-to-date. During the quarter, nonfinancial assets rose 3.7% and corporate equities fell slightly. Year-to-date, nonfinancial assets rose a sturdy 11.7% versus 15.7% for equities. Equity assets directly held by households, versus indirectly through pension funds for example, rose 18.6% in the first nine months of the year. However, household real estate gained 11.4% this year to date, and owners’ equity in real estate rose an impressive 14.7% in the first three quarters reaching 68.8%, the highest level since 1988! This suggests many households benefited from a rise in residential real estate values in 2021. See page 3. It may also explain why Christmas shopping appears to be setting a record this year.

However, Fed data on household balance sheets has also shown that when equity ownership exceeds real estate values, the equity market is at risk. This is true currently. Moreover, in June, equities represented 41.5% of total household financial assets and 29.4% of total assets. Both were new record levels that exceeded the previous peaks recorded in early 2000. In short, equity ownership may be reaching an over-owned condition, and this implies caution. See page 5.

Good news in net worth did not translate into an improvement in consumer sentiment. December’s preliminary consumer sentiment from the University of Michigan showed small gains in the index, yet the survey lingers only modestly above the 2021 lows. The NFIB small business index edged up 0.2 points to 98.4 in November, but most parts of the survey were little changed. On the other hand, the outlook for general business conditions worsened to negative 38, matching its worst level seen November 2012. All in all, soaring inflation appears to be taking a toll on businesses and consumers. There has been little change in technical indicators this week. The 10-day average of daily new highs fell to 82 this week and daily new lows are at 186. This combination — with new lows over 100 per day — was downgraded from neutral to negative last week. The NYSE advance/decline line’s last record high was on November 8, 2021, and it is trading well below this level currently. Volume has been rising on down days and slipping on rally days, which is a worrisome combination. See page 13. The 25-day up/down volume oscillator is at negative 2.5 and approaching an oversold reading which would be a negative omen. And finally, the Russell 2000 index continues to trade below all its moving averages which could be a sign of a trend reversal. All this points to the need to be cautious as 2022 approaches.  

Gail Dudack

Click to Download

Technical Indicators Revisited

Last week we focused on the technical condition of the US equity market since a number of macro indicators were at borderline negative readings and were exposing a rise in marketplace risk. This week we find little resolution in most of these indicators. For example, the 25-day up/down volume oscillator has ratcheted up to negative 1.23 after nearly falling into oversold range; but its rebound is minor and inconclusive. See page 12. On the other hand, the 10-day average of daily new highs fell to 68 this week and is well below the 100 mark that defines a bull market. Simultaneously, the 10-day average of daily new lows rose to 247 and well above the 100 level that defines a bearish market. Last week we downgraded the moving averages of new highs and lows to neutral and this week it is downgraded to negative. See page 13.

Less decisive is the NYSE cumulative advance decline line, which is well off its high made on November 8 even though the S&P 500 is only 0.4% away from its November 18 record high. Total NYSE volume continues to be slightly above average on down days and just below average on rally days which is also an ominous trend.

Not surprisingly, there is quite a bit of disparity in the performance of the popular indices. The S&P 500 and Nasdaq Composite index are the strongest benchmarks and appear to be successfully rebounding from tests of their 50-day moving averages. This looks positive. The Dow Jones Industrial Average is slightly less strong and appears to be rebounding from a test of its 200-day moving average. However, the Russell 2000 index continues to trade below all three of its moving averages, and even after its advance of 3% on December 7 remains in the middle of the trading range that contained prices for the first eight months of 2021. The Russell 2000 index had a false breakout in November and is now showing a surprising level of weakness. All in all, the action of the Russell 2000 is more in line with the trend seen in the NYSE advance decline line. See page 11.

The difference in the indices is easily explained. The S&P 500 and Nasdaq Composite are heavily weighted in the largest popular technology stocks which include Apple Inc. (AAPL – $171.18), Microsoft (MSFT – $334.92), Amazon (AMZN – $3523.29) and Alphabet Inc. (GOOG – $2960.73). Once the Omicron virus was discovered these stocks became increasingly volatile and have been driving the performance of the S&P 500 and Nasdaq Composite index.

The Dow Jones Industrial Average is only 30 stocks, but it is not market cap weighted and is more diversified in terms of sector representation. In general, it has been slightly weaker in terms of price performance. Since it includes 2000 stocks, the Russell 2000 is a far broader representation of the overall market, and it has been the worst performing index in recent weeks. In sum, the underlying tone of the equity market remains suspect, and we would recommend holding quality stocks that can weather the volatility that is apt to continue through year end.

Economic Data Shows Growth but Too Much Inflation

The unemployment rate fell to a 21-month low of 4.2% in November, but the headline jobs report was a disappointment with an increase of only 210,000 jobs. On the other hand, the household survey which includes many more categories of “workers” such as agricultural employees, unpaid household workers and entrepreneurs, increased by 1.1 million jobs. This was an unusually wide disparity between the two surveys, and it may signal an upward revision to job numbers next month.

Another oddity in the household survey was that the number of people unemployed (see page 3) declined twice as much as the number of newly employed workers. This is a sign that people are leaving the workforce and it clarifies why the participation rate has been so slow to improve this year. The question is why are people leaving the workforce? Are more aging baby boomers retiring? Are working mom’s choosing to stay home? Has COVID inspired an increasing number of people to become independent entrepreneurs? Any or all of these possibilities may explain why fewer people are now included in the official workforce. However, the answer to these questions could point to when employment might finally fill the gap of 4 million workers lost between the February 2020 peak and November’s job report. See page 4.

Both the non-manufacturing and manufacturing ISM indices improved in November and the surveys showed solid increases in production and employment. We found it interesting that both surveys revealed a slowdown in the backlog of orders and in exports. See page 5. Some of this may be due to unresolved supply chain issues or it could be an offset to October’s record high exports. But it could also indicate that orders and business activity slow whenever COVID-19 cases begin to rise. For example, Europeans are currently protesting new strict regulations aimed to curb a rise in cases in many countries in Europe.

November’s Conference Board Consumer Confidence fell to its lowest level since February 2021. The main University of Michigan consumer sentiment index fell to its lowest level since November 2011, due in large part to the present conditions survey which at 73.6 is the lowest since the 68.7 recorded in August 2011. See page 6.

We believe the declines in consumer sentiment can be explained by the discovery of a new COVID-19 variant and the personal income report for October. Personal income rose nearly 6% YOY in October to $20.8 trillion and disposable income rose 4.1% YOY to $18.1 trillion. However, real personal disposable income fell 1.4% YOY to $15.4 trillion. This was a result of a 6.2% YOY rise in inflation and a 20% increase in personal current taxes. See page 7. In other words, purchasing power of households is declining. More importantly, in October, personal taxes equated to 12.9% of personal income, the highest percentage since late 2001. What concerns us is that sharp rises in taxes as a percentage of income have often been followed by recessions. See page 8. Monitoring taxes as a percentage of total personal income can help explain how fiscal policy impacts households and how, if not done wisely, policy can inadvertently trigger a recession. Another factor in terms of a weakening in consumer confidence is that the savings rate fell in October from 8.2% to 7.3%. This is notable since 7.3% is well below the long-term average rate of 8.9%. Crude oil prices fell 22% during the month of November but are still up 43% year-over-year. Hopefully the decline in crude oil prices will ease some of the pressure felt by the household sector as a result of rising gasoline and heating fuel prices. At the same time, this sell-off in oil raises the specter of weakening global economic activity. Stagflation could bring even more pain to investors in 2022.

Gail Dudack

Click to Download

We are not surprised that Federal Reserve Chairman Jerome Powell changed his view that inflation is transitory or that monetary policy would not change dramatically in the foreseeable future. However, we are surprised that he would make an abrupt about-face in his views less than two weeks after being reappointed as Chair of the Federal Reserve!

This week the Fed chief told members of the Senate Banking Committee that the word “transitory” should be retired when describing inflation. In terms of monetary policy, he added that the Federal Reserve “at our next meeting in a couple of weeks (is) going to have a discussion about accelerating that taper by a few months.” The fact that monetary policy may be changing more quickly than popularly expected spooked the market. But in our view, what is more disturbing is that the FOMC waited too long to address inflation and as a result, its delay in reducing monetary ease earlier this year means it will be forced to raise interest rates more often and higher in 2022 than if they had started a shift months ago. This is the crux of the issue, and it is what has investors worried.

Unfortunately, Powell’s comments came on the heels of another troubling event. On Thanksgiving Day, reports surfaced from South Africa indicating a new COVID strain known as Omicron had emerged in a number of southern African countries. The World Health Organization warned it was a “variant of concern” and European countries banned travelers from eight African countries. President Joseph Biden announced similar restrictions on Friday. The thought of another bout of restrictions compounded the list of unknowns facing the financial markets and this combination triggered a sell-off.

As we noted last week, we put little value on the market’s performance on the Friday after Thanksgiving Day. It is usually the lowest volume day of the year; many traders are on vacation and investors are also distracted. This combination can create a lot of volatility, but nothing meaningful in the longer run. In other words, the 905-point decline in the DJIA on November 26 was dramatic but did not carry great weight in our view, even though declining volume rose to 89% of total volume. But the rebound on November 29 which boosted the DJIA 236.6 points was indeed a concern. Volume rose in the session and was well above the previous 10-day average, yet despite the gain in the index, volume in advancing stocks was only 50% of the day’s volume while volume in declining shares represented 48% of the total. This was not impressive. However, volume on the 652-point decline in the DJIA on November 30 was more than twice the 10-day average. See page 12. In short, although the S&P 500 is less than 3% from its record high of 4704.54 made on November 19^th there are a number of changes in the landscape in the last three trading sessions. Several technical indicators are on the verge of turning negative.

One of the signs that the market is at risk in the intermediate term is seen in the chart of the Russell 2000 index. We have focused on this chart for months since it is broader than the SPX or DJIA and less influenced by the action of large cap technology stocks. The RUT underperformed for most of 2021 but broke out of an 8-month trading range in early November creating a very bullish chart pattern. However, in the last four trading sessions this breakout has reversed into what appears to be a breakdown. The RUT (2198.91) is now trading in the middle of its 8-month trading range, but it has dropped below its 200-day moving average of 2260.12. In short, it appears the early November rally in the RUT was a rare, but troubling, false breakout. See page 10.

Another technical indicator showing erratic behavior is the 10-day average of daily new highs and lows. The new high list has been consistently bullish in 2021 and the 10-day average reached a high of 368 in early November. Nonetheless, the average number of NYSE new highs in the last three trading sessions fell to 45 and the 10-day average dropped to 144. This is still above 100 and positive. But the number of new lows rose to 390 on November 30 and the 10-day average is now 206. This is well above 100. Since 100 new highs or lows defines the major trend, one can see that even with highs and lows currently averaging more than 100, the action of last few trading sessions is suggesting a major shift may be taking place. One should observe, not predict, the indicators, but the underlying trend is beginning to favor the pessimists.

Technical analysts take note of 90% volume days because these extremes tend to represent investor panic. Panic selling tends to start slowly, accelerate, trigger margin calls, and then turn into a short, but painful liquidity crisis. This multi-stage pattern often characterizes a major market trough. Panic buying has less predictive value, but 90% up days following a major sell-off frequently marks the end of a bear cycle. In recent days we have recorded an 89% down day on November 26 and an 88% down day on November 30. Neither quite met the criteria for a panic day; however, the combination did result in the 25-day up/down volume oscillator tumbling to negative 2.62 this week. It is close to recording an oversold reading of negative 3.0 or less. An oversold reading that follows a series of record highs in the indices that failed to record significant overbought readings, would be a sign of a major shift in trend. We will be monitoring this indicator closely in coming sessions. See page 11.

Given the weakness in the market this week we reviewed margin debt data, since sharp price declines can trigger margin calls and intensify selling pressure. Margin debt totaled $935.9 billion in October, up 4% for the month and up almost 42% YOY. As a percentage of total market capitalization, margin debt was 2.03% in September, matching the January 2014 level. It should be noted that the 2014 stock market did not have any major corrections but prices did fall nearly 10% from a September high to an October low. Yet with our estimate for October market capitalization, this ratio edged lower in October.

As a percentage of GDP, margin debt hit a record 3.93% in September. This ratio is a less meaningful measure than margin debt to market cap, but it does suggest that the level of leverage in the system is high. Our favorite indicator uses margin debt to help identify when a leveraged price bubble is about to burst. We have found that when margin debt is increasing at an unusually fast pace and this leverage is not moving the market indices in equal measure, it is a sign of exhaustion. This is the 2-month rate-of-change (ROC) index. A reading of margin debt growing at 2 standard deviations (15.3%) or more, without a similar reading in the Wilshire has marked significant market tops in March 1972, March and June 1976, June 1983, December 1999, June 2003, and May 2007. The good news is that this indicator is now neutral. See page 7. Last, but far from least, the chart of WTI crude oil (CLc1 – $66.18) has declined 20% along with stock prices but is still up 48% YOY. WTI has now dropped below its 200-day moving average and although there is substantial support in the low $60 area, the uptrend from the 2020 low is at risk. This sell-off will ease some of the pressure the household sector has experienced from increases in gasoline and heating fuel prices. Nevertheless, this sharp fall in energy prices does raise the specter of stagflation which is a scenario that could bring even more pain to investors in 2022. In sum, there are signs that the major trend in the market could be shifting, and this emphasizes the need for quality stocks that can overcome the forces of either inflation or a weakening economy.

Gail Dudack

Click to Download

We give thanks to all our readers and wish you a safe and Happy Thanksgiving!

Oil prices hit a seven-year high in the US in late October. And as oil prices and inflation moved steadily higher this year, President Biden’s approval rating moved steadily lower. This, coupled with the razor thin majorities in both chambers of Congress and midterm elections on tap for next year, intimates the Democratic Party could lose seats in the 2022 elections. In short, this situation demanded action and is the catalyst for President Biden’s announcement this week. He authorized an historic 50 million barrel release from the US Strategic Petroleum Reserve and he also stated in his press conference that he will ask the Federal Trade Commission to investigate the gasoline industry for price gouging. This was his Thanksgiving gift to American households.

However, there was not much response from the financial markets or from energy prices. Simple logic explains why. China is the number one importer of energy in the world, and it currently imports more than 10 million barrels of oil a day. The United States ranks second in imports at about 6 million barrels per day. This total of 16 million barrels of imports and Biden’s 50-million-barrel release of strategic reserves equates to the import demand from just these two countries for three and one-eighth days. In short, the action is highly symbolic, but close to meaningless.

Biden did ask a broader group of countries to release oil from their reserves including India, Japan, and South Korea, which rank third, fourth and fifth, respectively, in terms of imports. Still, we do not believe it will have a significant impact on energy prices. Moreover, strategic reserves are “strategic” which means they are held aside for important emergencies. The current supply/demand imbalance of energy is not a true emergency, in our view. Like much of the current inflationary cycle, we believe it is man-made. The main culprit for soaring energy prices is the mismanagement of US energy as the administration attempts to force the country to green fuels. Inflation is driven by the historic fiscal and monetary policies implemented globally and maintained even throughout the global economic recovery. It is basic economics.

What would shift the energy supply/demand balance would be to restore the XL pipeline and to remove newly installed regulations on the US energy industry. This could immediately bring back the 2 million barrels per day of natural gas production that has been lost this year. And it would be long-lasting. This would be a sensible action, particularly since in terms of the environment, gas is one of the cleanest fuels available. We believe it is possible to support and incentivize renewable green fuel production and usage, while still allowing the US energy industry to produce shale and natural gas during the transition. But the right way in our opinion, is to find a joint public/private energy agreement that has a goal of a green renewable energy environment. The wrong way is to punish the oil and gas industry and the average American household.

And we doubt that an FTC investigation of the gasoline industry will find much, if any, price gouging or have a lasting impact on gasoline prices. On page 3 we show a NYMEX chart of the spread between gasoline futures and WTI futures. There is a natural lag between the price of oil and gasoline prices, yet they tend to ebb and flow within a predictable range. The current index of 17.19 is practically in the middle of the six-year range of 5 to 25. In short, price linkages look normal and an investigation is not apt to find anything untoward in the markets. But it does make for good political theater.

Markets and Technicals

The market is in the middle of its most favorable time of the year — November through January – and quantitative easing although slowing, still continues. This is a positive backdrop for equity investors. Third quarter earnings results have exceeded expectations and the recent round of earnings releases from retailers have been surprisingly strong. See page 6. These factors are supporting stock prices. However, we believe there will be many changes in the financial landscape as we move into 2022. We have written about all these issues in recent weeklies: 1.) energy-driven inflation, 2.) decelerating earnings growth, 3.) historically high ownership of equities, 4.) the risk of the Fed raising interest rates and 5.) the risk that China’s weakening property sector poses to the Chinese economy and perhaps the global banking system. All in all, December should be a time to prepare one’s portfolio for the changes ahead.

Technically, there has been little change in the indicators this week. The Dow Jones Industrial Average and the Russell 2000 hit record highs on November 8 and the S&P 500 and Nasdaq Composite index did so again on November 18 and 19, respectively. See page 7. The Russell 2000 index continues to be a focus for us since it is a broader-based index and driven less by the large cap technology stocks. And we would point out that the recent breakout by the RUT from an 8-month trading range is bullish for the intermediate term, but the index has weakened recently. This pattern of weakening is also seen in several breadth indicators.

The 25-day up/down volume oscillator fell to negative 0.40 this week and has drifted into the lower half of the neutral range. This oscillator spent two days in overbought territory October 25 and 26; but to confirm new highs in the market it should have remained in overbought range for a minimum of five trading days. The last time this indicator did this and confirmed new highs in equities was between February 4 and February 10 of this year. What this means is that the new highs seen in the market since February were driven by less and less buying pressure. The fact that the oscillator is currently below the zero line means there has been more volume in declining stocks than in advancing stocks over the last 25 trading sessions. It is not a sign of underlying strength. See page 8.

The 10-day average of daily new highs dipped from 335 to 202 this week and on November 23, the new high list was less than 100. Meanwhile, the 10-day average of daily new lows rose to 132 this week from 85 last week. A 10-day average of 100 defines the market’s trend; therefore, the current combination of 202 new highs and 132 new lows is mixed. This indicator is downgraded from positive to neutral. The NYSE advance/decline line made a confirming record high on November 8 and has not confirmed the more recent highs seen in the S&P 500 and Nasdaq Composite. Volume has been declining and below the 10-day average for most sessions in November, but it was 25% above average on the down day of November 22. Bull markets should have volume rising on up days and falling on down days. Therefore, recent volume patterns are a bit of a concern. Still, the shortened Thanksgiving Day week has a long history of light trading volume and high price volatility and has not had any predictive value. Therefore, even though Wednesday is a heavy economic release day, we would not worry too much about price action this week. We expect many investors are finally traveling to see family after more than a year of restrictions. The action of the post-holiday week will be more important.

Gail Dudack

Click to Download

Our 2021 outlook identified inflation as one of the major hurdles facing equities in 2021. We continue to believe this is true, but to date equity investors have ignored the threat of rising prices. President Biden, current Treasury Secretary and former Fed Chairwoman Janet Yellen and current Federal Reserve Chair Jerome Powell, have all given little credence to the relentless rise in price inflation.

The Federal Reserve is important since it plays a pivotal role in fighting inflation. Because its role is so important to the economy it is designed to be an independent non-political body. The seven members of the Board of Governors are nominated by the President and confirmed by the Senate for a term of fourteen years. Terms begin/end every two years, on February 1 of even-numbered years. The length and staggering of the terms of Board members hopefully result in a political balance on the Board while also removing political pressure on each governor since they can only serve for one term. Terms can only be extended if a Governor is appointed Chair or Vice Chair for four years.

However, the political climate is heated this year and by the end of this week, we should know whether Biden will reappoint Chairman Jerome Powell, a Republican and former private equity executive, for a second four-year term, or, as the media suggests he appoints another front runner, Lael Brainard, a Democrat and former Fed economist and political appointee in both Obama and Clinton administrations. Both Powell and Brainard have similar views on inflation and interest rates so it would appear that this decision could be rooted in politics. Either way, the Fed Chair will face some tough decisions in 2022.

The word “stagflation” has become part of the economic discussion in recent weeks and for good reason. GDP slowed to 2% in the third quarter down from a booming 6.7% in the second quarter. This means that the economy has been growing well below its long-term average of 3.4% in recent months. Meanwhile, inflation is on a tear. October’s CPI rose from 5.4% YOY to 6.2% YOY (NSA) and most underlying components saw significant increases during the month. At 6.2%, headline CPI now exceeds the level seen in 2008 and is rising at the fastest pace seen since November 1990. And inflation is unlikely to die out any time soon. In fact, if November’s monthly CPI increase is zero, the year-over-year headline rate will still be 6.1% YOY next month. However, we believe prices will move higher and therefore inflation could be the worst experienced since 1982. See page 3.

This is important because inflation is a huge burden to the average household, and it increases the cost of non-negotiable necessities like food and shelter. As an example of what families faced in October data shows that food at home rose 5.4% YOY. Household furnishings and operations rose 6.25% YOY. Used car and truck prices rose 26%. Gasoline prices rose 50% YOY. All items less food, shelter and energy rose 5.3% which shows that price increases are not just tied to rising energy and transportation costs or supply chain issues but are broadly based. Anecdotally, our local nail spa just posted a sign indicating an arbitrary $5 increase on all services provided. This increase is not due to higher transportation costs, supply chain problems, or shrinking margins, but due to the fact that all families face a higher cost of living. But more importantly, this is a sign that inflation is becoming engrained in our economic system, and this is serious.

In our view, the Fed is losing the fight against inflation. We agree with Larry Summers, Treasury Secretary under Bill Clinton, director of the National Economic Council under Barack Obama, Chief Economist of the World Bank, and President of Harvard University who said “Biden’s American Rescue Bill made the mistake of pumping up demand too much without taking steps to increase supply. That had resulted in inflation.”

It is not possible to have historically easy monetary policy for an extended period of time, coupled with an historic level of fiscal spending — during an economic rebound — without suffering the consequences of inflation.

October’s PPI report suggests that the CPI will move even higher than 6.2% in coming months. The PPI for finished goods was up 12.5% YOY in October and final demand PPI rose 8.6% YOY. In short, big price increases are already in the manufacturing pipeline which we believe will push consumer prices higher in coming months.

The most unfortunate part of the current inflation trend is that it now exceeds the increase in weekly nonsupervisory earnings. This means buying power is declining this year which is the exact opposite of what happened between April 2020 and April 2021 when earnings increased much faster than inflation. See page 4. Personal income was also boosted by fiscal stimulus in 2020 and early 2021 and led to both higher savings and higher consumption.

It is also important for investors to take notice that “inflated earnings” are worth less than “real earnings.” For example, a 10% increase in earnings in a 6.3% inflationary environment means earnings growth was really 3.7%. However, the same 10% earnings growth coupled with 1% inflation translates into earnings growth of 9%. Overall, rising inflation will have a negative impact on PE ratios. The Rule of 23 is an easy tool for depicting the impact of inflation on the equity market since it is a simple sum of inflation and trailing earnings. At present, a combination of a trailing PE of 23.7 and inflation at 6.2% sums to 30, which is well above the 23-warning level. However, the market has been trading above 23 for a while, due in large part to the support of easy monetary policy. But sentiment could change if inflation begins to erode margins or if the Fed begins to fight inflation through higher interest rates. See page 5. This implies caution.

Inflation is at levels last seen in 1990, but at that time the 3-month Treasury and 10-year Treasury yields were much higher at 7% and 8.5%, respectively. The S&P earnings yield was 11% and still competitive with fixed income, yet the trailing PE was at 14 times and below the long-term average. Today the 3-month Treasury and 10-year Treasury yields are 0.05% and 1.4%, the earnings yield is 4.2% and the PE is 23.7 times. Stocks are competitive to bonds, but bonds are a wasting asset given the level of inflation. In sum, there is a big disconnect between inflation and the financial markets.

Moreover, the jump in crude oil prices is greater today than it was in 1990 and energy prices are apt to stay higher longer than expected due in large part to political and environmental policies around the world. All in all, it is a disturbing backdrop for the 2022 stock market and for the incoming Fed Chair. See page 6.

October’s retail sales beat expectations, rising 1.7% month-over-month and 16.3% YOY. Adjusted for inflation, retail sales growth drops to 11.3% YOY, but remains in double digits. Part of this rebound in sales was predictable due to October’s previously announced increase in unit motor vehicle sales. Census data shows that vehicle dollar sales rose from 8.8% in September to 11.5% in October. See page 7. In our view, the positive seasonality of November, December, and early January, coupled with the fact that quantitative easing is slowing, but still in place, is positive for equities. But we fear the environment for equities could change quickly in 2022 with inflation stubbornly high, earnings growth decelerating significantly and the boost from more fiscal stimulus dissipating. The technical backdrop of the market is little changed from a week ago and it suggests an aging bull market is in place.

Gail Dudack

Click to Download

China’s Property Sector

China’s property woes first rattled global markets in September and October, however, fears of systemic risk are resurfacing again. China Evergrande Group, the world’s most indebted developer, has been stumbling from deadline to deadline as it struggles with more than $300 billion in liabilities — $19 billion of which are in international bonds. A $148 million bond payment must be made on Wednesday, and this will be followed by coupon payments totaling more than $255 million on December 28. However new concerns appeared last week when Kaisa Group made a desperate plea to Beijing and creditors for help. Trading in shares of Kaisa and three of its units was suspended after an affiliate missed a payment to onshore investors. In response to Kaisa’s woes, China’s property sector has taken a pounding.

In terms of sales Kaisa Group is China’s 25th largest real estate developer but it ranks second to Evergrande Group in terms of bond repayment bills due next year. This makes Kaisa’s crisis meaningful. Also interesting is the fact that the US Federal Reserve just sent its first direct warning to China and investors about potential global damage from China’s property crisis. In its twice-yearly financial stability report released this week, the Fed wrote: “Financial stresses in China could strain global financial markets through a deterioration of risk sentiment, (and) pose risks to global economic growth.”

It is worth mentioning that economists estimate China’s property sector to be the largest contributor to China’s economy and if related industries are included, property accounts for more than 25% of GDP. Real estate has been a large and steady creator of jobs in the country and land sales account for a third of local governments revenues according to Nomura. Property also accounts for 40% of assets owned by Chinese households according to Macquarie Group Ltd. This suggests that if real estate continues to fall Chinese consumers could lose confidence and curtail consumption. And according to Reuters, the value of nationwide land sales fell 17.5% YOY in August. In short, there is a major risk to the Chinese economy as a result of the current property crisis.

Reuters also notes that due to a long, massive building boom and speculation, China has about 65 million empty homes, or the equivalent of all the households in France and the United Kingdom combined. As of June, Chinese developers owed 33.5 trillion yuan ($5 trillion), or a third of the country’s GDP, up more than two-fold from 2015, according to Nomura. This outstanding debt is roughly equivalent to the GDP of Japan, the world’s third-largest economy. The overriding question is whether or not China will be able to handle the risk that is growing in its property sector. All in all, these developments underscore why investors should not be myopic as the US equity indices make a series of record highs and instead be alert to global issues. Clearly factors outside the US could impact the global banking system, global liquidity and reverberate through the global financial markets. To sum up, China could easily become a major risk for the financial markets in the months ahead.

Assessing the Technical Backdrop

There are many good things happening in the technical backdrop of the market at present. This week the cumulative NYSE advance decline line reached an all-time high confirming the new highs seen in the indices. The Russell 2000 index made a bullish breakout from an 8-month trading/consolidation range which generates a positive outlook for the intermediate term. The daily new high list is averaging 350 new highs per day, and finally, sentiment indicators are oscillating in neutral ranges which means they are not indicating any excess optimism on the part of investors. See pages 9, 11 and 12. These are all positive. The only weakness is seen in volume.

Our first concern is that total volume on the NYSE has been decelerating and has been running below the 10-day average in many November sessions. Volume should increase during advances since rising volume reflects increasing demand. Second, the 25-day up/down volume oscillator has ticked higher but remains stuck in neutral. Currently, the oscillator is at 2.07 and neutral after spending only two days in overbought territory October 25 and 26. To confirm new highs in the popular indices, this indicator should remain in overbought range for a minimum of 5 consecutive trading sessions. The last time this indicator did this and confirmed new highs in the equity market was between February 4 and February 10 of this year. From a technical perspective, this is a sign of underlying weakness, and it is a warning that the bull market is aging.

Still, this is a seasonally strong time for equities. November ranks as the best performing month for the S&P 500 and ranks number two for the DJ Industrial Average. December ranks third in terms of performance for both indices. The other contender is April which currently ranks second for the S&P 500 and first for the DJ Industrial Average. Note that the seasonally strong months tend to coincide with pension funding cycles or tax strategies and IRA funding for individuals. Liquidity is an important ingredient in terms of stock performance; and this good seasonality coupled with a decent technical backdrop makes us optimistic about the next few months. But we see the potential of storm clouds ahead. Not only is China a threat to the global economy and to global liquidity, but earnings growth in the US will fall into single-digit territory in 2022. The great support found in earnings growth this year will not be repeated in the next twelve months. Therefore, a balanced portfolio with companies that are inflation resistant, have strong balance sheets and below average PE multiples remain our preferences.

Economic Roundup

Economic data is mixed. October’s employment report was encouraging not only because it showed a gain of 531,000 jobs in the month, but because the increase in private industry jobs was significantly higher at 604,000 new jobs. Revisions to two prior months were also positive. In the household survey, the number of people employed grew in excess of the increase in the labor force, which resulted in the unemployment rate falling from 4.8% to 4.6%. Nonetheless, there are 4.2 million fewer people employed currently than in February 2020. See page 3.

October’s ISM manufacturing survey showed that global supply-chain issues are not abating. Most areas were slightly lower but there was an uptick in hiring plans. Conversely, the ISM nonmanufacturing survey was strong, setting a record for the fourth time in 2021. The only blemish in the services report was the decline in the employment index. See page 5.

Vehicles sales increased to 13 million units (SAAR) in October and was below 14 million for the fourth straight month. October’s sales were 21% below a year ago and the lowest October in 11 years. However, sales did rebound from September’s low, and this should help next week’s October retail sales report. See page 6. The NFIB small business survey slipped 0.9 points in October to 98.2, but the real story is that the outlook for business fell 4 more points to negative 37. This was just above the record low of negative 38 set in November 2012. The survey shows both sales and earnings have been sliding since mid-2020. Plans to raise prices jumped from 46 to 51 in October. See page 7.

Gail Dudack

Click to Download

Quantitative Easing

Last week we wrote that the economic, political, and technical backdrop for the equity market was the best it had been in many months and that this combination would set the stage for a year-end rally. In our opinion, the inability of Congress to pass a large stimulus package – which could have included hefty business and personal tax rate increases — combined with the positive seasonality of November, December and January should not be ignored. Moreover, the monetary policy changes expected this week have been well telegraphed and discounted by investors and should make the slow elimination of quantitative easing a non-event. In sum, barring some unexpected negative mishap, we believe the stage is set for higher stock prices and a decent Santa Claus rally. Nonetheless, earnings growth is forecasted to slow in 2022, and though this may not have an impact until next quarter, we would still emphasize quality stocks. Companies with inflation resistant earnings growth are apt to be the best performers in the months ahead.

Earnings Backdrop

Third-quarter earnings are center stage again this week and as the economy bounces back from the coronavirus pandemic, most companies continue to report better-than-expected results. One should keep in mind that estimates were downsized in September when analysts were concerned about supply chain issues hurting third quarter estimates. Nonetheless, with 320 companies having reported, Refinitiv IBES indicates that S&P 500 earnings are anticipated to have climbed 40.2% in the third quarter from a year ago. This hefty earnings jump produces a nice cushion for the broad market as we move into the final months of the year.

Technical Challenges

But there are a few challenges in the technical backdrop this week. The 25-day up/down volume oscillator is at 1.96 and neutral after spending only two days in overbought territory last week. To confirm the string of new highs seen in the popular indices this week, this indicator should move to and remain in overbought range for a minimum of 5 consecutive trading days. However, the last time this indicator did this and confirmed new highs in the equity market was nine months ago, between February 4 and February 10 of this year.

In February, when the Russell 2000 previously recorded a record high, overbought readings in this indicator confirmed the equity market’s advance. Since then, there have been no validations of a succession of record highs. We should also point out that while the many indices made marginal new highs on November 2, breadth data was not convincing on the NYSE and data showed more declining issues than advancing issues for the session. Volume was also disappointing since it slipped below its 10- day average. In sum, November 2 was a great day for equities globally. The S&P 500, the DJIA, the Nasdaq Composite, the Russell 2000, the Wilshire 5000, France’s CAC 401, and the MSCI all-country world index all made record highs. However, it was not a convincing day from a breadth perspective. This could change over the course of the next week, but for example, the bullish breakout in the Russell 2000 index from a 9-month trading range needs to see confirming follow-through. In the interim we believe this is another reason to emphasize quality stocks.

Economic Data and the Fed

It has been a busy week in terms of economic releases and overall, we believe most results relieve the Fed of any pressure to raise interest rates. In general, we found economic data discouraging. The advance estimate for third quarter GDP indicated economic activity grew at a seasonally adjusted annualized rate of 2.0%. This was a big disappointment since 2.0% is well below the long-term average for GDP growth of 3.2%. In addition, third quarter activity was concentrated in a buildup of private inventories. This is a negative since the need to increase inventories is diminished and this could reduce economic activity in the fourth quarter. The main weaknesses in the third quarter estimate were found in personal consumption of goods, the negative drag from trade and a decline in residential investment. See pages 3 and 4.

The decline in the household’s consumption of goods can be explained by the recent data on personal income, consumption, and savings. Personal savings were $1.3 trillion in September down from $1.67 trillion in August and well below the April 2020 peak of $6.4 trillion. This is a sign that the “pent-up demand” economists expect from the pandemic’s buildup of household savings is quickly evaporating. September’s savings rate was 7.5% down from 9.2% in August and closing in on the 20-year average rate of 6.8%.

Personal income was $20.5 trillion in September, down from $20.7 trillion in August and well below the $24.1 trillion seen in March 2020. Personal disposable income was $17.9 trillion in September, down from $18.1 trillion in August, and also well below the $21.7 trillion seen in March. See page 5. However, wages rose to a record $10.38 trillion in September as people began to move back into the workforce. Keep in mind that wages represented a peak of 65% of personal income in July 1966 but have been steadily declining as a percentage of income and hit a low of 41% in March 2021. Wages rose to 51% of total personal income in September but much of this gain is statistical.

September’s headline personal income number declined as government social benefits fell from $4.2 trillion in August to $3.8 trillion in September. Total unemployment benefits fell from $352.3 billion in August to $97.7 billion in September. Note that unemployment benefits peaked at $1.4 trillion in June 2020. See page 6.

The decline in disposable personal income from $1.81 trillion in August to $1.79 trillion in September could reverse and improve dramatically if people return to work as unemployment insurance benefits are exhausted. But if employment does not increase and income stagnates, the outlook for the economy will dim. Historically, there has been a close, but lagging, relationship between the year-over-year growth in disposable personal income and the year-over-year growth retail sales. To date, retail sales have been the beneficiary of the massive 32% YOY growth in disposable income in March of this year. Retail sales grew nearly 12% YOY in September (14.2% on a 3-month average) and were easily beating inflation. See page 7. However, this may not continue. Disposable income growth slipped to 2.3% YOY in September, which is less than half September’s rate of inflation of 5.4%. This implies that retail sales will weaken in the months ahead. Companies have indicated that they have been able to pass on higher raw material and transportation costs to consumers. However, if household incomes do not grow faster than inflation in coming months, this cannot continue. Either corporate margins will contract, or top line growth will decline. This is not good news for 2022 profits. Therefore, we are not surprised that consumer and business confidence indices were weak in October. The University of Michigan consumer sentiment index fell from 72.8 in September to 71.4 in October and while the Conference Board Consumer Confidence index rose from September’s dreary 109.8 to 113.8 in October, it remains below previous highs. The NFIB confidence index continues to languish below 100. See page 7. In short, economic data suggests there is no reason for the Fed to raise rates in the foreseeable future. This is positive for equity investors.

Gail Dudack

Click to Download

Third Quarter Earnings

This is going to be a busy earnings week since 165, or one-third of the components of the S&P 500 companies will report third quarter earnings results in the five-day period. Thus far, results have generated an abundance of positive surprises. However, it is important to remember that the bar had been lowered by analysts in September when they dramatically cut estimates in response to supply chain hiccups and weaker than expected employment increases. To date, according to IBES Refinitiv, third quarter S&P earnings should show a gain of nearly 35% YOY, which is a healthy improvement in view of the disruptions from rising costs, supply issues, and hiring problems. In general, the quarter shows that corporate America is adept at maintaining margins despite rising costs and has been able to pass these costs on to consumers. Nonetheless, the S&P sectors that are accounting for the majority of the earnings gains in the third quarter are the areas that benefit from inflation.

Driven by Inflation

For example, in the third quarter, earnings are expected to rise 1538% YOY for energy, 96% YOY for materials, and 78% YOY for industrials. Technology ranks as the fourth best sector with IBES Refinitiv showing a gain of 33% YOY in the quarter. And the same trend holds true in the fourth quarter. IBES Refinitiv is forecasting S&P earnings growth of 22.8% YOY for the fourth quarter which includes an 8067% YOY gain for energy, a 66% YOY gain for materials, and a 57% YOY gain for industrials. The only minor difference in the fourth quarter is that the fourth best earnings growth rate of nearly 23% YOY is expected to be seen in the healthcare sector. See page 7. However, we would be amiss if we did not point out that, to date, the sector with the biggest surprise factor in the third quarter has been financials. Analysts were looking for earnings growth of 17% YOY at the start of the month and estimates are now showing a gain of 33% YOY. It is worth noting here that financials are fairly well insulated from the negative aspects of significant inflation and also benefit from a steepening in the yield curve.

Overriding Economic Worries

Positive earnings results contributed to the record highs in the popular indices this week, but we think investors were also encouraged by the fact that the proposed $3.4 trillion stimulus package was unraveling in Congress. This change also meant that the proposal to raise the corporate and individual tax rates was unlikely to materialize. This shift removed a dark cloud overhanging corporate earnings expectations for 2022 and it cannot be underrated. In our view, this “improvement” in earnings prospects for 2022 overcame signs of economic weakness in China and Germany.

Technical Changes

This news from earnings and the political environment not only drove several indices to record highs, but it was accompanied by significant changes in the technical status of the market. The 25-day up/down volume oscillator is at 3.09 this week and in overbought territory for the second consecutive trading day. Readers of our strategy weeklies know that to confirm any new high in the popular indices, this indicator needs to remain in overbought for a minimum of 5 consecutive trading days. Very simply, overbought readings demonstrate that the rally is accompanied by strong and consistent buying pressure.

The last time this indicator was in overbought territory for five consecutive days was February 4 through February 10 of this year, when the Russell 2000 also recorded its all-time high. Since then, there have been no validations of new highs by this indicator despite a succession of record highs in the SPX. The absence of overbought readings in this indicator, coupled with a one-day oversold reading on July 19 revealed that equity advances have not been accompanied by solid or consistent buying pressure. This has been true since February and it has been a sign of weakness. However, this week’s overbought reading could be a turning point. Two days is not yet sufficient for a confirmation which means the next week will be an important time for this indicator. See page 9.

The 10-day average of daily new highs had a significant jump to 275 this week and daily new lows fell to 65. This is also important since in recent weeks, the 10-day averages of daily new highs and lows had been converging and leaning toward a negative signal. Daily new lows actually exceeded 100 per day which is a sign of a bear market. However, this week’s data tilts positive. In addition, the A/D line made a confirming record high on October 25, 2021, beating its last record made on September 2. Volume has been slightly below average on this rally, which is a concern, but only a minor one. See page 10.

The Dow Jones Industrial Average, the S&P 500, and the Wilshire 5000 all reached record highs this week, while the Nasdaq Composite is trading fractionally below its September high. The Russell 2000 continues to be a major focus for us, and it is less than 3% from its February high. A breakout in the Russell 2000 index from what is now an 8-month trading range, would create a bullish chart pattern for the intermediate term. This would be true for both the index and the overall market. See page 8.

Setting the Stage

All in all, the economic, political, and technical backdrop for the equity market is the best it has been in many months. Given that we are moving into a seasonally strong time for the equity market, this shift in the political scene is timely. Monetary policy changes have been well telegraphed in recent months and have been discounted by investors, in our view. In short, barring some unexpected negative event in the next few weeks, we believe the stage is being set for a solid Santa Claus rally. Still, we continue to focus on quality stocks given that earnings are apt to be the major driver of stocks in the months ahead.

A Housing Bounce

The housing market experienced a nice rebound in September. Recent data shows new home sales rose 14% YOY to an annualized rate of 800,000 units and existing home sales increased 7% YOY to 6.29 million annualized units. Both of these rates were below the peaks seen at the end of 2020 however both reports were better than anticipated. See page 3. Housing permits and starts cooled a bit in September, but since the gap between new permits and housing starts was small, it suggests an improvement in starts is apt to appear in the fourth quarter. As of August, total residential construction reached a record annualized pace of $75.2 billion, a 25% YOY increase. See page 4. There was concern that this may have been a cyclical peak in residential construction. However, in August, the NAR housing affordability index ticked up as a result of a small decline in mortgage rates and a similarly small dip in home prices. These declines helped to offset the small drop in median household income. October’s National Association of Home Builders survey showed an encouraging rebound. The survey indicated an increase in pending sales, an uptick in home buyer traffic and an expectation that sales will increase in the next six months. See page 5. Since housing is a significant segment of the economy, this improvement in sentiment is a good sign for the fourth quarter.

Gail Dudack

Click to Download

Stock prices moved higher this week on the back of good earnings results for the third quarter. However, the 10-year bond yield (TNX – 16.35) and the WTI crude oil future (CLc1 – $83.00) also moved up which implies that higher interest rates and higher inflation are in our future. Most companies reporting third quarter earnings indicated that rising raw material and transportation costs are becoming a margin problem, but in nearly all cases, corporate leaders state they plan to pass these costs on to consumers via higher prices. As we have been suggesting, inflation is not a temporary phenomenon, but is becoming engrained in the system. In the months ahead the risk of margin pressure and/or higher consumer prices increases. The former will hurt earnings, but the latter could negatively impact consumption and top line growth. In sum, earnings risks are compounding.

We believe the fourth quarter of 2021 will be a time of shifting trends, but right now little has changed. Monetary policy remains extremely accommodative, and the Fed continues to buy $120 billion of securities per month flooding the banking system with liquidity. But this week Federal Reserve Governor Christopher Waller, in a speech to Stanford Institute for Economic Policy Research, stated that tapering of asset purchases should commence following the next Federal Open Market Committee meeting set for November 2-3. This implies a change is on the horizon, but remember, monetary policy will remain stimulative, just slightly less so. Putting recent Fed actions into perspective, the central bank has purchased $4.3 trillion assets since the end of 2019, a number that represents 19% of nominal GDP. Fiscal stimulus has added $6 trillion of liquidity to the economy and together this stimulus is the equivalent of more than 45% of GDP, a historic level! However, this is unlikely to continue. Easy monetary policy will slowly shift and could end by mid-2022. Fiscal stimulus is unknown. To a substantial extent, the stimulus package working its way through Congress is not apt to have a major impact on the economy. Most of the proposed spending in the bill will go to federal agencies and programs — not directly to households. Government bureaucracy tends to mute the impact of money spent by Congress. Again, stimulus support will be waning in 2022.

But this is not likely to be true for inflation. Even if supply chain issues get resolved quickly, the rising price of energy will keep inflation elevated in 2022. With WTI futures at $83 a barrel, crude oil prices are up 130% year-over-year. These prices will be trickling down into producer and consumer price indices over the next three to six months. Auto sales have been weak recently due to a shortage of semiconductors; however, auto makers indicate that once production resumes, auto prices will move significantly higher. Raw material costs are also raising the price of new homes, remodeling, and home furnishings. The two segments of the economy that have not experienced big price increases have been homeowners’ equivalent rent and healthcare. But last month’s CPI data showed that housing costs are now on the rise and although rent increases tend to lag house prices, they are now beginning to trend higher. Healthcare costs tend to be seasonal and health insurance prices tend to rise in the fourth quarter. For all these reasons, we see inflation remaining higher than expected for the near future.

Keep in mind that inflation is similar to raising taxes on households. Inflation changes and lowers consumption patterns. Historically, inflation tends to lower PE multiples and for this reason higher inflation has made high-growth high-PE sectors like technology more volatile. We expect this will continue. Nonetheless, inflation will benefit the energy sector. Higher interest rates are a positive for the financial sector, particularly banks. To the extent that corporations are able to pass on higher costs to consumers without hurting demand, these stocks should do well. But we favor companies with strong balance sheets, moderate PE multiples and dividend yields in excess of 1.5% in order to insulate portfolios in the fourth quarter.

Not All Records are Good

Recent data on market capitalization, GDP, margin debt and the household’s balance sheet revealed interesting patterns. Market capitalization hit a record 2.23 times nominal GDP in December 2020 and has been hovering around 2.2 times in the first half of 2021. Margin debt reached an all-time high of 3.9% of GDP in June 2021. Both of these ratios imply that the stock market may be running ahead of the economy and that leverage has been an integral part of the market’s advance. See page 4.

The sum of NYSE and NASD margin debt was $903 billion in September, just slightly below the record $911.5 billion seen in August. Margin debt as a percentage of market capitalization was 2.03% in September, slightly below the record 2.07% of March 2013. More importantly, on a year-over-year basis, margin debt has grown 38%, far more than the 20% YOY gain in market capitalization. This disparity in growth can be a long-term risk factor. However, a major warning appears whenever the 2-month rate-of-change in margin debt is 15% or greater and widely exceeds the margin debt in total market capitalization (or the Wilshire 5000). Luckily, this comparison is currently neutral, but we will be monitoring margin debt for signs of excessive speculation. See page 5.

Household net worth increased 7.8% in the first half of 2021 to a record $159.3 trillion. The greatest driver of net worth came from equities (directly and indirectly owned), up 77% in the six-month period. Nonfinancial assets rose 6.5% and financial assets gained 8.3%. For the first time since March 2000, the household’s ownership of equities exceeds its holdings in real estate. Typically, a home is the household’s largest asset, not stocks. Therefore, this significant increase in equity ownership may be a sign of excessive exuberance. See page 6.

Equity ownership as a percentage of total assets was 29.5% in June and as a percentage of financial assets equities was 41.5%. Both of these percentages now exceed the previous records made in March 2000 at that major market peak. The counterbalance to equities was the record low in debt securities, now at 3% of financial assets. This is a result of historically low interest rates, the Fed’s dovish monetary policy, and it helps to explain how monetary policy can inflate asset prices and runs the risk of generating a stock market bubble.

We do not believe the equity market is a bubble, but valuations are high and equity ownership is at record levels; therefore, it is wise to be on the alert for signs of extreme optimism or excessive leverage. To date, these are not apparent. However, as Mark Twain famously wrote “history does not repeat itself, but it often rhymes.” The current cycle includes the introduction of meme stocks, bitcoin, and other digital currencies. Therefore, we should be aware that the signs of speculation used to identify equity tops in previous cycles may not work as well this time.

Technical Update Market gains have lifted all the popular indices above their key moving averages this week, including the Russell 2000 index, which continues to lag but is now above the critical 200-day moving average. However, volume on rally days has been well below average and this makes the advance suspicious. The 10-day average of daily new lows increased to more than 100 per day this week, erasing the looming negative seen a week ago. The 25-day up/down volume oscillator is at 1.82, its highest and best level since June, but it still remains in neutral territory and has not confirmed any new high since February. Keep in mind that the Russell 2000 index made its all-time high back on March 15, 2021. Overall, broad-based upward momentum may have peaked in the first quarter of 2021.  

Gail Dudack

Click to Download