In a recent US Strategy Weekly (“Earnings Estimates and Inflation” August 25, 2021) we wrote that we thought the trend of the 2021 equity market could be simplified into two main positive components: 1.) a strong earnings rebound and 2.) historically easy monetary policy. Therefore, we are not surprised by this week’s sell-off since both of these underpinnings are currently coming under pressure.

Earnings

As we noted last week, consensus earnings forecasts may have made an important shift in late August. Very simply, after more than a year of steadily rising earnings estimates, forecasts are beginning to edge lower. And while estimates still reflect a positive growth rate for 2021 and 2022, these growth rates are falling, and this is noteworthy. Steadily rising earnings estimates have provided a continuous incentive to buy stocks while also providing good fundamental support in the event of any negative news shock. But now, with estimates drifting lower, downside support is less definable and reliable. This change could result in less demand for stocks and could make speculators more cautious in the final quarter of the year.

As an example of the current earnings shift, the S&P Dow Jones and IBES Refinitiv estimates for 2021 decreased $0.30 and $0.40, to $198.32 and $200.63, respectively, this week. Similarly, estimates for 2022 fell $0.35 and $0.42, bringing full year forecasts to $217.69 and $219.93, respectively. According to IBES estimates, with the SPX at 4360, the market is trading at 23.4 times trailing 12-month and 19.8 times next calendar year’s earnings forecasts. Neither multiple is cheap when compared to its respective long-term PE average of 15.8 times trailing or 17.7 times forward earnings. And unfortunately, estimates are being shaved just ahead of third quarter earnings season, which will make third quarter results and CEO comments on future earnings growth more important than ever. Also, analysts have theorized that the proposed Biden corporate tax rate changes could shave an additional 5% off earnings in 2022 which would make current 2022 estimates too high. In sum, investors may no longer be able to rely on rising earnings growth to boost stock prices in the months ahead.

Monetary Policy

In another turnaround, Federal Reserve Chairman Jerome Powell, in remarks delivered to the Senate Banking Committee on Tuesday, cautioned legislators that inflation is higher and lasting longer than he anticipated. In fact, Powell noted that as the economy continues to recover from the pandemic the increase in demand is putting more upward pressure on prices and supply bottlenecks in a number of sectors have not abated as expected. In our opinion, Powell’s comments should not have surprised investors since we saw few signs that inflation was indeed temporary. Yet it did seem to catch investors off guard, and the 10-year Treasury note yield jumped from 1.48% to 1.53%. Technology stocks swooned in response to the rise in interest rates which is a normal reaction for growth stocks. In most valuation models, the 3-month or 10-year Treasury yield is used as the risk-free rate to measure the relative attractiveness of equities to bonds. As interest rates rise, stocks with higher PE multiples and little or no dividend yield will look less attractive in these models. Along with Chairman Powell’s comments this week are comments from other Fed governors that monetary policy is about to change. At separate speaking engagements this week, Fed Governor Lael Brainard and regional presidents John Williams of New York and Charles Evans of Chicago all indicated that they are comfortable with a first phase of tapering and that a gradual pullback of monthly bond buying is appropriate. Quantitative easing has helped to support markets and the economy since March 2020. But comments from Chairman Powell and other Fed officials this week suggest investors may no longer be able to rely on monetary policy to support stock prices in the months ahead.

Geopolitical Backdrop

Neither a slowdown in earnings growth nor a shift in monetary policy are insurmountable hurdles for equities; however, both changes suggest the “easy” part of the bull market may be over. Meanwhile, a number of issues in the geopolitical/economic environment could become major problems. Perhaps the most worrisome is China’s power crunch which has been triggered by a shortage of coal supplies. At least 20 Chinese provinces and regions which make up more than 66% of the country’s gross domestic product, have announced some form of power cuts, mostly targeted at heavy industrial users. These power cuts have halted production at numerous factories including those that supply Apple (AAPL – $141.91), Tesla (TSLA – $777.56), and Toyota (TM -$184.85) and is expected to impact the production of steel, aluminum, and cement. It will reverberate through many global sectors including chemical producers, carmakers, building supplies and shipping companies. Overall, this could easily become a much bigger problem than the Evergrande crisis which continues to overhang the Chinese property market.

Plus, China’s energy shortage it is putting pressure on oil prices and lifted WTI (CLc1 – $74.26) over $75 a barrel this week which will put more pressure on global inflation. In short, China’s energy/property crises could easily slow global growth and increase inflation around the world. In the US, potential monetary policy changes are pushing interest rates higher at a time when Congress is threatening individuals and corporations with higher tax rates. Both will slow growth. Bull markets are known to “climb a wall of worry,” and it appears there will be many worries in the fourth quarter.

And there are more international concerns. In the UK, a combination of the pandemic and the county’s departure from the European Union are resulting in a shortage of tanker drivers to transport fuel across the country. Media reports of a handful of gas stations closing due to dwindling supplies triggered panic buying in Britain and created massive lines at gas stations. In Germany, a lack of clarity about the composition of the next government following Merkel’s departure, is creating a crisis for the European Union. Without a clear government in Germany a range of decisions from economic policy to defense are being delayed in the EU. In the background, many countries in East Asia and the Pacific continue to face major setbacks in their recovery from the coronavirus. There is no shortage of worries in the globe.

The debt ceiling will become a major financial topic in coming days. But keep in mind that the US government has been shut down several times due to a debt ceiling crisis, most notably in 1995 (one 5 day and one 21 day stretch), 2011 (when Treasury Secretary Timothy Geithner utilized “extraordinary measures” such as the sale of assets from the Civil Service Retirement and Disability Fund and the G Fund of the Thrift Savings Plan to acquire funds) and 2013 (which stretched on for months and also included “extraordinary measures” to pay obligations). Typically, a government shutdown includes the closure of national parks and any other nonessential personnel to save cash flow for social security payments and payments on debt. In general, the debt ceiling debate has been a political game of hot potato.

Technical Wrap Up There was little change in the technical condition of the equity market this week. However, the popular indices and their moving averages may be the most interesting of all technical indicators. The SPX and Nasdaq Composite are currently testing their 100-day moving averages which is normal in a bull market. The DJIA has broken its 50 and 100-day moving averages but still trades above its 200-day MA. The Russell 2000 is the most important index in our view having broken below its long-term 200-day moving average last week yet is holding slightly above this level (now 2213) currently. The RUT is the best representation of the broad-based market; therefore, holding above this 200-day moving average may be critical for the overall market. In general, the underpinnings of the equity market appear to be deteriorating and a defensive position including holding energy or financial and those stocks with good dividend yields and lower-than-average PE multiples may be the best strategy for the fourth quarter.     

Gail Dudack

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Raising S&P Earnings Estimates

In our opinion, the crux of the 2021 stock market can be defined by two components: 1.) a strong earnings rebound and 2.) historically easy monetary policy.

Securities markets are always complex and cannot really be explained by two simple factors. Clearly there have been other influences this year such as the positive support from fiscal stimulus and promises of more stimulus ahead or the negative drag from the spread of the Delta virus variant, China’s crackdown on technology companies and the threat of rising corporate and individual taxes and fees. But perhaps the most unique and interesting development of 2021 is the appearance of a new generation of investors and the growing influence of social media on stock market activity. As a result, market volatility has increased driven predominantly by enthusiastic day traders monitoring message boards such as WallStreetBets on Reddit. Plus, there are a slew of geopolitical issues this year such as the slowing of the Chinese economy, China’s tightening grip on Hong Kong and Taiwan, the geopolitics of climate change, reversals in US energy policies and rising prices of oil, disputes between Poland, Hungary and EU institutions, Japan’s struggle with the Delta variant, and more recently the unfortunate global threat that the US pullout from Afghanistan, the fall of Kabul and the rise of the Taliban poses for the world.

Still, despite all these factors, investors can and will absorb a lot of bad news if earnings growth is strong – and to date, growth has definitely been strong. According to IBES Refinitiv’s report “This Week in Earnings”, with 476 of the 500 S&P companies reporting second quarter earnings, growth is expected to be nearly 95% YOY. Companies have been reporting quarterly earnings that are nearly 16% above estimates which compares to the long-term average surprise factor of 3.9%. This follows on the heels of IBES Refinitiv’s earnings growth estimate for the first quarter of 53% YOY. So as the second quarter earnings season ends, we are raising our 2021 SP 500 earnings estimates from $190 to $200, a 5% increase. However, this is a 19% increase from our December 2020 estimate of $168.60. We are also raising our 2022 estimate from $211 to $220, a 4% increase. In both cases we believe these estimates could prove to be conservative. See page 15.

This is good news for investors and this surge in earnings growth certainly supports equities. However, the easy comparisons from the pandemic-wreaked earnings quarters in the first half of 2020 are mostly behind us, and earnings growth is expected to slow to more typical levels of 30% in the third quarter and 21.6% in the fourth quarter. Despite the fact that strong gains in earnings have supported gains in the SPX, as seen in the charts on page 3, the run-up in the SPX relative to the gains seen in earnings has produced a significant valuation gap in both trailing and 12-month forward operating earnings. This valuation gap is similar to the one seen prior to the 2000 top. Another similarity between the 1997-2000 bull market and the current advance is the participation of a new generation of investors. A new generation of investors and a valuation disparity often go hand in hand and this characteristic of today’s market concerns us.   

Inflation is a tax on consumers and investors

While earnings have been strong in 2021, valuations still remain unusually high, and this is particularly true when inflation is taken into consideration. We often use the sum of inflation and the trailing PE as a benchmark to indicate when PE multiples are appropriate for the current level of inflation or as a warning when multiples get too high. In July with the CPI rising 5.4% YOY and the trailing PE at 24.5, the sum becomes 29.9, well above the standard deviation range. Since the top of the standard deviation range is 23.8, we call this The Rule of 23. See page 4. Note that the unusually high and sustained readings seen in this indicator recently are similar to those seen in 1999-2000 prior to the second worst bear market in history. Again, similarities to the 2000 market continue to grow.

Inflation will impact all investments. With 3-month and 10-year Treasury rates at 0.05% and 1.29%, respectively, equities remain competitive investments to fixed income. However, the chart on page 5 compares the history of interest rates and inflation and this chart suggests that unless inflation quickly drops below 1% YOY, interest rates on both the short and long end, are much too low and are likely to move higher. More ominously, a close inspection of the chart on page 5 also shows that a sharp rise in inflation, like that seen in 2021, has triggered eight of the eleven recessions seen over the last 75 years. This helps to explain the predicament the Federal Reserve faces this week as it meets in Jackson Hole WY. Interest rates are too low and accommodating given the level of inflation and the strength of the US economy. However, the pandemic-stricken economies of Europe and parts of Asia imply global growth may not be strong enough to withstand a change in Fed policy. Yet if the Fed allows inflation to continue to rise, it will inevitably end with even tighter and hawkish monetary policy in the years ahead which will almost guarantee an economic recession. It is not a simple problem. But it has been our view that the Fed needs to, and should have already, moved to neutralize its easy monetary policy in order to stifle inflation before it becomes ingrained in the system. This week we expect the Fed to steadily move the consensus view toward a reduction and possible elimination of quantitative easing. This is a necessary step to ensure the Fed is not stoking the flames of inflation. However, it will eliminate one of the two components that has underpinned the stock market’s advance.

Inflation is also having a negative impact on businesses. The NFIB Optimism Index decreased 2.8 points in July to 99.7, nearly reversing the 2.9-point gain in June’s report. Six of the 10 Index components declined, three improved, and one was unchanged. The NFIB Uncertainty Index decreased 7 points to 76, sales expectations decreased 11 points to a net negative 4 percent, owners expecting better business conditions over the next six months fell 8 points to a net negative 20, and earnings trends over the past three months declined 8 points to a net negative 13 percent. In sum, small businesses are becoming more concerned about their future given the current inflation and political environment. See page 6.

Technical Update

We are still focused on the Russell 2000 index (RUT – 2230.91) which has been trading in a sideways range for all of 2021. We believe it may give us clues about the stock market’s intermediate term direction. At present, the 200-day moving average (2160.82) is acting as support and the converging 50-day (2241.27) and 100-day (2247.88) moving averages — which are now decelerating — are acting as resistance. A breakout in the RUT from this narrowing range may define the broader market’s intermediate-term trend. There have been similar patterns in the RUT (trading between a rising 200-day moving average and decelerating 50- and 100-day moving averages) in the first half of 2011 and the second and third quarters of 2015. In both of these previous cases, the RUT broke below the 200-day moving average and this was the trigger for relatively sharp and fast corrections totaling 19.4% and 14%, respectively, in the SPX. Also worthy of note is the continued weakness in the 25-day up/down volume oscillator, which at 0.64 this week, is minimally above the lower half of neutral. This low reading implies that since early July volume has been as strong or stronger in declining issues as the volume seen in advancing stocks, i.e., investors have been selling into strength. And this week the 10-day average of new lows hit 101, before dipping to 99 on Tuesday. Nevertheless, this is close to the 100 new lows per day that defines a bear market. Daily new highs are still averaging 194, but the rise in daily new lows has shifted this indicator from positive to neutral. In short, we remain cautious and would focus on stocks with good value.  

Gail Dudack

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Not surprisingly, the second half of the year is proving to be more volatile than the first half and we believe this is due to several reasons. On the positive side is the strength seen in first and second quarter earnings results for the S&P 500 companies. This encouraging news on earnings is coupled with extremely easy monetary policy which includes low interest rates and $120 billion of monthly security purchases by the Fed, and child tax credits and a potential infrastructure bill in terms of fiscal stimulus.

On the negative side is the fact that earnings growth may be peaking. Although earnings growth should remain positive, the growth rates of 143% YOY in the first quarter and an estimated 65% YOY in the second quarter are unsustainable in the long term. In fact, consensus earnings forecasts suggest that earnings growth in the final quarters of the year will be less than half the pace seen in the second quarter. This decline in the growth rate is not a big negative; however, it does suggest that PE multiples may also have peaked. PE multiples tend to move higher when earnings growth is rising, but a decline in the earnings growth rate will not justify any further multiple expansion. PE multiples could also come under pressure in the second half given the extremely high levels of inflation recorded by all the inflation benchmarks.

Also on the negative side is the fact that monetary policy is apt to change in the second half. Although the Fed insists that inflation is temporary, it is unlikely to decrease soon, and this could force the Fed to alter its quantitative easing. There have already been some innuendos that the Fed may change its tone on inflation at this week’s post-meeting press conference. It has been our view that the Fed would initiate the discussion of reducing quantitative easing at its August symposium. The significance of this potential shift cannot be underestimated. The Fed has been flooding the US banking system with liquidity for more than 17 months. This historic level of liquidity has supported the economy, but it has also supported equities since March 2020. It has helped boost stock prices and investment in general. The absence of this support will not hurt stock prices per se, but investors will no longer have the wind at their backs.

Yet it is important to note that history has shown that the anticipation of a change in Fed policy can have a bigger and more immediate impact on stock prices and investor psychology. Therefore, any hint of a change in the Fed’s monthly purchases is apt to trigger a correction. In sum, expect more volatility ahead. Assuming this is true, some of the safest investments in the second half could be stocks with lower-than-average PE multiples and higher than average dividend yields.  

Another possible negative in the second half relates to China. There are already signs that China’s growth is beginning to slow and profit margins are being negatively impacted by higher raw material costs. But the larger risk regarding China may be its increasingly aggressive posture towards corporations inside of China and its posture with the US. Beijing has begun a sweeping crackdown on companies such as Tencent Holdings (0700.HK – $446.00) which it ordered to give up exclusive music licensing rights. China fined Alibaba Group Holdings (BABA.K – $186.07) for anti-monopoly violations. And it denied Huya Inc.’s (HUYA.K – $11.96) planned game streaming merger with DouYu International Holdings (DOYU.O – $3.77). Yet, most disturbing, is China’s increasingly aggressive stance with the US. This week’s meeting between US deputy Secretary of State Wendy Sherman and Chinese Foreign Minister Wang Yi ended with Chinese officials accusing the US of “coercive diplomacy,” and warned the US to stop meddling in Taiwan or Xinjiang issues. They also presented deputy Secretary Sherman with two lists of action. These included revoking sanctions on Communist Party officials, lifting visa bans for students, making life easier for state-affiliated journalists and reopening the door for Confucius Institutes. This meeting, which took place in the Chinese city of Tianjin, was not open to foreign press, although the Chinese press were allowed. All in all, this suggests that issues with Hong Kong and Taiwan may continue to escalate.

Economic News

New-home sales in June fell for a third month in a row as homebuilders contend with high construction costs and a burgeoning pipeline of single-family projects. New-home sales fell 6.6% to 676,000 annualized units in June, which was the lowest level since April 2020. We noticed that builders show that inventory for new homes for sale are currently low, but new homes under construction are up strongly. An even sharper uptrend can be seen in new home construction yet-to-be started.

Existing-home sales rose 1.4% in June to 5.86 million units annualized, fully reversing May’s losses, and breaking the four-month losing streak registered since the start of the year. The recent dip in mortgage rates along with a rebounding labor market contributed to the pickup in home sales. Single-family sales and condo/co-op-sales both rose 1.4% from the previous month. Sales were higher in all census regions except the South, where they were flat from the prior month.

Sentiment indicators are mixed with the Conference Board showing July gains in the broad index, present conditions and a flat reading in expectations. The University of Michigan sentiment reported losses in all indices and a particularly large drop from 83.5 to 78.4 in expectations. The difference may be due to timing of the surveys and the dispensing of stimulus checks. See page 3.

Technical Update

The 25-day up/down volume oscillator is at negative 1.27 and neutral this week after recording one day in oversold territory on July 19. This is an unusually low value for this oscillator particularly since there have been two 90% up volume days in the last 25 trading sessions. We do not remember ever seeing strong 90% up days with our oscillator remaining in the negative half of the neutral zone. This means that over the last 25 days there has been more volume in stocks declining than in those advancing.

The last time the 25-day up/down volume oscillator showed strong buying pressure was when it recorded one day in overbought territory on April 29. Prior to that there was a minimal five consecutive trading days in overbought territory between February 4 and February 10. In sum, the February readings confirmed the record highs in the broad indices at that time; but since then, there have been no confirmations of recent highs. The July 19 drop to negative 3.49 was the first oversold reading since the pandemic, or in March-April 2020.

Our 25-day up down volume oscillator is warning that demand is fading, and investors are selling into strength. The longer this volume non-confirmation of new highs continues the greater the downside risk to the broader market. In short, the recent erratic trend in the market has been expected and should be considered healthy. However, if a new rally fails to generate a new overbought reading, it would be a signal that the major trend is weakening. Should a future pullback in the equity market generate an oversold reading without an intervening overbought reading, it will confirm that the major cycle has shifted from bullish to bearish.

Gail Dudack

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The Dow Jones Industrial Average rose 549.95 points, or 1.62% on Tuesday after falling 725.81 points, or 2.1%, on Monday. This surge in volatility drove the VIX index (VIX – $19.73) over 25 earlier this week which was a concern to many investors, perhaps because many call the VIX the “fear index.” We are not surprised if the level of fear is increasing among investors given the spread of the Delta virus, the rich level of equity valuations and the potential of a change in monetary policy. However, the VIX is not a good short-term indicator in our opinion. It is actually most useful at the end of a bear market when fear is at its highest. VIX readings between 45 and 85 have marked recent bear market lows. This being true, a high VIX reading, particularly above 80, can denote a buying opportunity. See page 6. In comparison the recent readings of 25 are mild and are not a worry. Keep in mind that fear is emotional and often unpredictable, and this may be the message in the VIX’s rise – more volatility ahead. It has been our view that the second half of 2021 will be more volatile and is likely to include a correction of 10% or more.
In terms of technical indicators, we are more concerned about breadth data and specifically volume in advancing stocks. The last time the 25-day up/down volume oscillator showed strong and consistent buying pressure was when it recorded a single day in overbought territory on April 29. Prior to that there was a modest five consecutive trading days in overbought territory between February 4 and February 10. The February readings were a confirmation of the record highs made at that time. But since mid-February, there has not been any volume confirmation of recent highs. Currently, the 25-day up/down volume oscillator is at negative 2.19 after recording a negative 3.49 reading earlier this week. Monday’s drop to negative 3.49 was the first oversold reading since March-April 2020, or during the depths of the global pandemic.
In short, since early February, our 25-day up down volume oscillator has been showing us that as the indices were moving to new record highs, volume in advancing stocks was declining and volume in declining stocks was increasing. This is a sign of waning demand and/or investors selling into strength. The longer this non-confirmation of new highs continues, the greater the downside risk to the broader market. From this perspective, the recent selloff was expected and should be considered healthy.
Nevertheless, after any brief oversold reading, a bull market should rise to new highs and have an accompanying overbought reading. This demonstrates solid buying pressure. If not, and if a rally fails to generate a new overbought reading, it would be a signal that the major trend is weakening or changing. If a subsequent decline in the indices generates a second oversold reading without an intervening overbought reading, it would indicate that the major cycle has shifted from bullish to bearish. In sum, these are the scenarios that concern us. These are the patterns we will be monitoring in coming weeks.
In June, major inflation benchmarks were rising at hefty year-over-year rates: CPI 5.3%, PPI 9.4%, GDP deflator 2.0% (March), import prices index 11.2%, and import prices excluding petroleum 6.8%. And core benchmarks were CPI 4.5%, PPI 3.6%, and core PCE deflator 3.4%. In short, inflation is widespread, and as high, or higher, than it was in 2008 and it is not apt to end soon. This pressures current monetary policy.
Plus, easy monetary policy tends to fuel inflation and the real fed funds rate is already at an all-time low. Most importantly, stock prices have not performed well during periods of high inflation. In fact, the chart on page 3 shows that high inflation and stocks prices tend to be inversely correlated. Also noticeable in this chart is that high inflation tends to precede recessions. All in all, it is not surprising that fear is rising.

Gail Dudack

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At last week’s FOMC meeting, Fed officials implied they may raise interest rates as soon as 2023, perhaps a year earlier than anticipated. We were not surprised. And during a post-meeting news conference, Fed Chair Jerome Powell said that the central bank was starting talks about when to pare down its monthly $120 billion of purchases of government bonds and securities put in place last year to support the recovery. Again, we were not surprised. But in Tuesday’s appearance before Congress, Powell reaffirmed the central bank’s commitment to encourage a “broad and inclusive recovery” in the job market and indicated the Fed would avoid raising interest rates too early based only on the fear of future inflation. Subsequent trading in inflation-protected and other securities implied investors are betting the Fed will change its policies faster than projected and we would agree. And in our view, Powell’s commitment to a “broad and inclusive recovery” was simply pandering to a Democratic majority in Congress. We assume Powell understands the limits of Fed policy and what it can and cannot achieve. The Fed’s tools are both broad and blunt. It is unable to target areas of the economy to support job growth. It can only increase liquidity in the system and hope that this will lift all boats. It has not. It is the role of the administration and Congress, not the Fed, to target areas of the economy.

Only Congress can target economic areas of greatest need by encouraging business investment, by lowering the restrictions and taxes on small businesses and inspiring job growth. Unfortunately, they are not doing this. We are not surprised. However, related to President Biden’s $1.9 trillion American Rescue plan, on July 15, the IRS will begin sending out monthly payments to around 36 million families as part of an expanded child tax credit program. Families will get an $1,800 supplemental child tax credit divided into six payments that will be sent out through December. If you qualify, you will get $300 per month for each child under the age of six and $250 per month for every child between the ages of six and 17. To qualify you must be a single taxpayer with an income up to $75,000, a head of a household with an income up to $112,500, or a married couple filing jointly, a qualified widow, or widower, with an income of up to $150,000. Families with higher incomes will receive $50 less per $1,000 earned. Payments will be phased out for people who make roughly $20,000 more than the relevant threshold. However, we were surprised to read that a family of four making less than $150,000 could see more than $14,000 in pandemic relief this year from the expanded child tax credit and $1,400 stimulus checks to both adults and children. This means some households could receive government checks totaling as much as $16,800! For a family making $149,000 a year this is a potential 11.3% increase in income. For some families, it could actually double annual household income this year. It is significant for a large number of families in the US.

We applaud the effort to assist the millions of families with children that that have fallen below the poverty line as a result of last year’s government shutdowns. Nevertheless, this is a stop gap program. Households could be permanently lifted out of poverty if they had more opportunities for better paying jobs and if they did, they could also make plans and have hope for a better future. This could be accomplished by putting government money into job training, childcare, tax exempt small business loans, creating public/private opportunity zones in areas blighted by the pandemic, and removing restrictions and lowering taxes on new small business owners. This type of constructive fiscal policy would have a positive long-term impact on household financial and mental health. It is the role of our elected officials. It is not the role of the Federal Reserve. But it is not happening. We are not surprised.

Fed Policy Is Pivotal

There are a number of reasons why we believe the Fed will be forced to change its policy this year. And as seen by the market’s reaction after last week’s FOMC meeting, a change could have an immediate and negative impact on the securities markets. Since the end of 2019, or just prior to the pandemic, the Federal Reserve’s balance sheet has grown by $3.85 trillion, the equivalent of 17% of nominal GDP. In short, an amazing amount of liquidity has been pumped into the banking system and the pumping has not ended. The Fed plans to continue its $120 billion in asset purchases each month. See page 3. However, in our view, quantitative easing is apt to be the first change in monetary policy and it will not surprise us if the Fed slows or ends its asset purchases in the second half of the year.

Yet while the Fed has been stimulating the economy with a soaring balance sheet and low interest rates, households have been hoarding cash. Since the end of 2019 through to May 3, demand deposits at commercial banks have increased a stunning $2.22 trillion to $4.0 trillion. See page 4. This cash hoarding could become a liquidity trap for the Fed, since it means the Fed’s actions are not having the positive impact on the economy it had intended. More stimuli could simply become pushing on a string, i.e., a true liquidity trap, and investors will lose faith in the Fed. In our view, this would be due to poor fiscal policy that provides households with ever more cash but does not emphasize future job growth. Households may simply be boosting savings for the rainy day they see ahead. This could explain why both the small business and consumer confidence surveys recently saw significant declines in “future expectations” even though current conditions remained stable.

With the fed funds rate at 0.1% and May’s inflation as measured by the CPI at 5%, the real fed funds rate is negative 4.9%, or its lowest level in over 70 years. This is worrisome since it is an extremely dovish policy for a non-recessionary, and expanding environment. According to the Fed, the economy is recovering and if so, monetary policy should change. See page 5. Plus, the economic backdrop is not good for the Fed or households. Core CPI and PPI are up 3.8% YOY and 2.9%, respectively. The PCE index is up 3.6% YOY. Headline CPI and PPI are up 5% and 8.7%, respectively. Prices are rising in most areas of the economy, and we doubt this is transient inflation. In our view, a small change by the Fed now could prevent the need for huge interest rate hikes in the future. Moreover, inflation is the equivalent of a tax on consumers, and this too is adding to the anxiety households have about their financial future. See page 6.

Housing and autos were the center of the economic recovery in 2020. This year auto sales remain strong, and prices of old and new cars are rising. Housing, on the other hand, may be about to plateau for a variety of reasons. May’s median existing home price rose to $350,300, a 24% YOY increase and the biggest gain on record since 1999. Yet, mortgage applications fell 17% YOY and existing home sales fell to 5.8 million units, down 0.9% month-over-month, but still up 45% YOY. Rising prices and falling sales could be due to a lack of supply since months of supply remained low at 2.5. But we believe first home buyers are being priced out of the market since house prices are rising faster than incomes. This could be more than a short-term situation. Remember: there were 7.6 million fewer people employed in May than in February 2020. Little has changed in the market’s technical condition. The 25-day up/down volume oscillator is in neutral and falling – a sign of weakening demand for equities. The NYSE advance decline line made a new high June 11. The Nasdaq Composite index eked out a new high this week and this index bears watching. The IXIC has been trading in a range of 12,995 to 14,200 most of this year. If this week’s move to 14,253 is indeed a breakout it could propel equities higher. If it becomes another failed rally attempt, it may be a short-term warning sign for investors. Stay alert.  

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Friday’s employment report will be important since it will set the stage for the Federal Reserve’s next FOMC meeting scheduled for June 15 and 16. The June meeting will be accompanied by a Summary of Economic Projections and economists will be checking this closely to see if estimates have changed and if so, might this mean that a pivot in monetary policy is on the horizon. In short, it could be a market moving event. April’s job report showed a disappointing increase of 266,000 new jobs, which was less that the average gain seen over the previous three or six months. May should see a nice recovery in the labor market since most states are now relaxing or eliminating pandemic restrictions. However, if the release shows an extraordinarily strong job market this could also spook investors who are worried that a strengthening economy, coupled with a high savings rate and pent-up demand, could fan the flames of inflation. We worry about this as well.

Federal Reserve officials continue to emphasize that any inflation will be transitory, but to some market observers this translates into the possibility, or likelihood, that the Fed is apt to fall behind the curve. If so, the Fed would need to raise rates even more aggressively sometime in the future in order to tame inflation. This is an important factor since most economic recessions in the US have been preceded by repeated Fed tightenings. In fact, this is the underlying principle in Edson Gould’s famous “three steps and a stumble rule.” Edson* was a well-respected market technician and stock market historian of the 1930-1980 era, yet some technicians do not believe his rule is valid today. We have found that to make this rule useful it is important to observe the number of Fed fund increases within a rolling twelve-month period. Three or more fed rate hikes, particularly if they are large, within a twelve-month period has always been followed by a weak stock market in the subsequent six and twelve months and it is usually in conjunction with a recession. For this reason, among others, it is important that the Fed not delay in addressing inflation and find itself running to catch up to control the cycle.

In our view, inflation has always been the main risk for equity investors in 2021 since it means both a change from easy monetary policy, a rise in interest rates and a decline in average PE multiples.

Inflation does not have to be a disaster for equities, however. Stock prices can rise along with interest rates as long as earnings increase enough to compensate for the rise in the risk-free rate. Good earnings growth appears to be a strong possibility for this year and next; therefore, the greater risk over the next twelve months is more likely to be the Fed. If the Fed delays a shift in monetary policy too long, it could find itself having to tighten more aggressively to stem off inflation; thereby triggering a recession. The Fed’s favorite benchmark for inflation is the personal consumption expenditures (PCE) price index and this revealed a 3.6% YOY rise in April after being up 2.4% YOY in March. We were not surprised by this big jump in the PCE deflator since it puts it in line with all other inflation measures which now uniformly exceed 3% YOY. The implications for monetary policy are potentially huge. To demonstrate the pressure that this places on the Fed we have a chart of the real fed funds rate as compared to the PCE deflator. See page 7. The real fed funds rate is currently negative 3.5% and reflecting the “easiest” policy seen since February 1975, during the 1974-1975 recession. This negative real fed funds rate will prove to be far too stimulative as people go back to work and the economy recovers. It will force the FOMC to change its verbiage and actions.

Only time will tell if inflation is transitory or not. Meanwhile, we believe the healthiest scenario for the equity market would be either a 10% correction or a sideways market over the next few months. If not, the inevitable shift in Fed policy will trigger a correction that could exceed 10% in the SPX. Seasonality also suggests the stock market may be about to take a pause. June tends to be an underperforming month in the annual calendar and ranks 9th or 10th in terms of performance in most indices. See page 9.

A Mix of Economics

Housing has been a main pillar of the economic recovery during the pandemic. However, the pending homes sales index for April fell from 111.1 to 106.2, which was its lowest level since May 2020. April’s survey leaves the index below its long-term average of 108.7. This decline in housing sales is likely to continue, particularly if home prices continue to rise. Buyers are apt to be priced out of the market. In April, the median home price for a single-family home rose 20% YOY, the largest twelve-month increase in National Association of Realtors records going back to 1999. Mortgage rates remain historically low but have also been rising, which will become another handicap for first time buyers. See page 3.

Stimulus checks boosted personal income 30% YOY in March; but in April personal income fell 13.1% month-over-month, which translated into a small 0.5% YOY increase. Disposable personal income rose 33.3% YOY in March but fell 1% YOY in April. The savings rate remains high but erratic at 14.7% in February, 27.7% in March and 14.9% in April. See page 4. The most interesting part of personal income is pre-pandemic total compensation which does not include transfer payments. Total compensation peaked in February 2020 at a seasonally adjusted annualized rate of $11.82 billion; however, despite the drop in employment, we were surprised to find that total compensation achieved a new record of $11.88 billion in November 2020. In April, total compensation rose to an all-time high of $12.3 billion. The same pattern is true if we look solely at wages or supplements for employees in the private sector. This underlying momentum in wages seen since November 2020 challenges the need for further fiscal stimulus in 2021. It also indicates that further stimulus could over-stimulate the economy. See page 5.

Earnings and PE Multiples

Both Refinitiv IBES and S&P Dow Jones consensus EPS estimates for the SPX for 2021 and 2022 continue to rise which is favorable and provides support for the equity market. The current IBES and S&P estimates are $189.61 and $186.59 for 2021 and $212.12 and $209.50 for 2022, respectively. This means the market is rich, but not overvalued, in a low inflation environment where a 20 PE multiple is justifiable. However, if inflation is 3.5% or higher PE multiples are likely to fall back to average or lower. The long-term average PE multiple for the SPX based upon forward earnings has been 18.2 times and on trailing 12-month earnings the average PE is lower at 15.8 times. This points to why inflation is a dilemma.

Market Data

To date, 2021 has been most notable for its leadership shift, away from the technology-laden Nasdaq Composite Index and small capitalization Russell 2000 index and toward cyclically driven inflation sectors such as energy, materials, financials, and REITs. See page 16 for sector performances year-to-date. This shift is producing new highs in the SPX and DJIA and sideways patterns in the IXIC and RUT. See page 12. There are also disparities in macro technical indicators. The NYSE cumulative advance decline line made a record high on June 1 confirming a bull market, whereas the 25-day up/down volume oscillator continues to languish in neutral. At present this indicator is suggesting the indices are moving to new highs but on lower volume and less robust buying pressure. This is a sign of waning investor demand and therefore is a warning. Again, a sideways or correcting market would be the healthiest scenario near term. *https://www.ofeed.com/Star%20Traders/1135

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Monetary and fiscal policy will be in the spotlight this week. The FOMC meets Tuesday and Wednesday but no significant changes in monetary policy are expected. Federal Reserve Chairman Jerome Powell’s Wednesday afternoon statement will be followed by President Joe Biden’s first major address later that evening. Biden’s first appearance to a joint Congress takes place on the eve of his 100^th day in office. Although newly inaugurated presidents typically address a joint Congress a month after they are inaugurated in January, this administration delayed the address to April due to “complications with the ongoing coronavirus pandemic.”

American Families Plan

Biden’s address will be widely covered, not only because it is his first major speech, but because it will highlight the administration’s American Families Plan, which the financial media expects will detail a $1.8 trillion spending and tax plan. President Biden may focus more on the hundreds of billions of dollars itemized for national childcare, prekindergarten, paid family leave, tuition-free community colleges, subsidies for the Affordable Care Act and other domestic programs. But Wall Street will be listening to hear how this plan will be funded. Most expect about a half-dozen tax hikes on high-income Americans and investors and many of the proposed changes are already eliciting fierce opposition in Congress and on Wall Street.

Keep in mind that this proposal represents the second part of Biden’s “Build Back Better” agenda, and it follows the $2.3 trillion jobs and manufacturing proposal the White House released a few weeks ago. If one includes Biden’s American Rescue Plan Act of 2021, a $1.9 trillion stimulus package which was passed in early March, the three plans total approximately $6 trillion in new spending and would be one of the most ambitious government overhauls of the economy since the Johnson administration.

Capital Gains Tax Hikes

Gathering the most attention and controversy about how the American Families Plan will be financed is the proposed capital gains tax. To finance the proposed spending, the administration hopes to raise the capital gains tax rate for people making more than $1 million from 20% to 39.6%. Note that the Affordable Care Act includes a 3.8% surtax on all capital gains. This would still be in force and would push the real capital gains tax rate to 43.4%. If passed, it would translate into the highest maximum capital gains tax rate in history. See page 3. Unfortunately, what some politicians fail to grasp is that raising the capital gains tax rate rarely, if ever, generates the tax revenue that is predicted. The reason is that tax laws change people’s behavior. Raising the capital gains tax rate may prove to be a boon for tax lawyers and accountants since they will find ways for clients to avoid taxes. Investors will invariably change their investment strategy, shift assets to trusts or move assets out of the US. As a reminder, when the tax laws changed and only made mortgage interest payments tax deductible, investors borrowed against their home to fund colleges, autos, home improvement and other personal loans. Government officials fail to understand this change in behavior. Projected revenue from a tax policy change will rarely be a straight line.

Moreover, a hike in the capital gains tax rate is always bad for stockholders. The reason is that a higher capital gains tax changes the risk-reward ratio for investors, in a negative way. The 39.6% would be the highest rate on capital gains in any global country and this would have a negative impact on foreign investment in the US. This means those who do not make $1 million or more will still be hurt by this potential tax hike. However, most strategists do not believe the bill will pass as proposed. We hope this proves correct.

Housing is On a Roll

March housing data was strong. Although still below the peaks recorded in November 2020, the National Association of Homebuilders’ single-family housing sentiment was generally higher in March. Traffic was the most improved segment of the survey at 75 versus 72 in February. Both new residential permits and housing starts rose in March on a month-over-month and year-over-year basis. Permits hit a record high in January; housing starts reached a record high in March 2021. See page 4. Housing received a big boost in 2020 from fiscal stimulus and stay-at-home restrictions. The massive fiscal stimulus seen in early in 2020 had a direct impact on median existing home prices. See page 5. Housing inventory is currently low, and this lack of supply will continue to support prices in the coming months. New home sales rose 66.8% YOY from a depressed March 2020 level and prices increased 6% YOY. Single-family existing home sales grew 12.3% YOY and prices jumped 11.8% YOY in March. See page 6. However, homeownership hit a cyclical peak of 67.9% in June 2020 and fell to 65.6% at the end of March. And despite the much-touted mass exodus from the Northeast to Florida, the South had the sharpest decline in homeownership, which fell from 71.1% in June 2020 to 67.4% in March. In the same time frame, Northeast homeownership fell merely 0.2%. See page 7. This decline in US homeownership rates is favorable since it implies there is more future demand for housing.

Earnings on a Roll

The best part of the last week has been first quarter earnings season. Early in the year, Refinitiv IBES consensus estimates were forecasting a 14.5% YOY growth rate for the first quarter, but as earnings season progresses, we have seen estimates rising sharply. IBES now assesses earnings will increase over 35% in the first quarter. To date, 85% of companies reporting first quarter results beat expectations. To date, all energy, healthcare, technology, and communications services companies have beaten their forecasts and have had positive surprise factors of 434%, 15%, 12%, and 8.6%, respectively. In aggregate, companies are reporting earnings that are 23% above estimates, which compares to the long-term average surprise factor of 3.7%. This display of earnings power is providing an excellent foundation to the current rally. 

Technical Indicator Review

There are good points to the market’s technical backdrop, and this includes the new highs in the NYSE cumulative advance-decline line on April 26 and the new high list which is averaging a strong 477 new highs per day. But higher prices do not impress us if volume is not supporting the advance. The 25-day up/down volume oscillator is currently 1.99 (preliminary) and neutral this week despite the new highs in the popular indices in recent sessions. This indicator was last overbought for five consecutive trading days between February 4 and February 10 which is when many momentum indicators peaked. At present, our indicator is revealing that the indices are moving to new highs on lower volume – a sign of diminishing demand. The longer this persists, the more worrisome it becomes. However, we should point out that prior to the March 2000 peak, this oscillator had not generated an overbought reading since November 1998 (17 consecutive days in overbought). This 16-month period of price advances without confirmation from advancing volume predicted a significant decline. At present, we have a 10-week non-confirmation, which is concerning, but not a sign of a bear market. Sentiment is also problematic. The AAII bullish sentiment for April 21 fell 1.1 points to 52.7% and has been above average for 21 weeks. Bearishness fell 4.1 points to 20.5% and is below average for the 11th time this year. Historically, periods of above-average bullishness and below-average bearishness have been followed by below-average 6- and 12-month equity performances. In sum, there is good news in the earnings backdrop, potentially negative news in the political scenario, and a mixed bag in the technical condition of the stock market. In our view, equities are apt to see a 5% to 10% correction in the second quarter – and this would be the healthiest development for investors.

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The financial media is asking whether the stock market believes the Fed in terms of its future plans for monetary policy, and we feel the only answer to this question is yes. In fact, the answer is obvious since the indices would not have made all-time highs earlier this week if investors did not believe Chairman Jerome Powell and the Fed. Based upon the unprecedented fiscal and monetary stimulus promised by the federal government and the Federal Reserve, we believe investors should maintain a bullish bias. But at the same time, we remain very alert to anything that could jeopardize the consensus view that the economy will remain strong, interest rates will remain low, and earnings growth will continue to be solid in 2021 and 2022. In our opinion, there are risks to this view and they include the 9.5 million people unemployed, rising crude oil prices and margin pressure threats. So, the better question would be should the market believe the Fed?  

The Fed will be meeting this week and reporting on Wednesday when it will release both economic and interest rate forecasts as well as its statement. These will be closely analyzed by economists. Most expect the Fed’s statement will imply that interest rates are not likely to be raised until 2023. However, the consensus view regarding the end of quantitative easing has shifted to this November from November 2022. We do not expect the Fed will upset the consensus this week, particularly with a new administration in office for barely two months. But recent data shows there could be a growing inflation scare materializing in coming months. In sum, be bullish, but stay on high alert.

Inflation Can Bite

February’s inflation data was comfortably benign on the surface with headline CPI rising 1.7% YOY and core CPI rising a subdued 1.3% YOY. However, as seen in the table on page 3, February’s inflation was restrained by the 3.6% decline in apparel. Meanwhile most components of the CPI rose faster than the headline level. Fuel and utility prices rose 3.4% YOY while food and beverage prices rose 3.5% YOY. This means that prices of household necessities were increasing at a 3.5% YOY pace, well above the headline rate. In February, the PPI for finished goods rose 2.4% YOY and PPI for final demand rose 2.8% YOY. However, all inflation measures are impacted by the price of oil, which at the end of February was up 27% year-to-date and 37% YOY. In fact, at the current crude oil price of $64.97, oil prices are up 34% year-to-date and possibly up 220% YOY at the end of March. This will have a significant impact on March inflation data. In fact, even if the PPI for finished goods remains unchanged in March it will still be up 4.1% YOY. In our view, inflation comparisons will become very unfriendly as we approach the anniversary of the lows of March and April 2020.

Economists focus on core CPI due to the fact that food and energy prices can be erratic. Food prices are often impacted by droughts, storms, and other natural disasters but prices usually recover in a new planting season. Fuel prices can be influenced by politics and other temporary factors that change the short-term supply/demand balance. And as seen in the charts on page 4, energy prices have been extremely volatile since OPEC’s oil embargo of October 1973.

Energy prices dropped dramatically in response to the shutdown of the global economy last year, and this has kept Inflation subdued. However, that benefit is fading and could clearly reverse with vaccines becoming more plentiful and with an administration that is unfriendly to the energy sector. See page 5. Rising fuel costs will have many repercussions; and in 2021, the trend in crude oil may be a key driver of interest rates. We previously pointed out the strong connection oil and interest rates have had since 2015. At present both appear to be moving higher in tandem. See page 6. The consensus view is that a 10-year Treasury yield above 2.4% could negatively impact Fed policy and rates of 2.8% or more will hurt the economy. Rising inflation will also decrease the buying power of consumers and thereby lower corporate profits. Note that for most of the last eight years, average weekly earnings have grown well above the rate of inflation. But as inflation rises, this could shift and thereby restrain consumption. All in all, rising crude oil prices threaten monetary policy, interest rates, household consumption, the economy, and earnings. We see rising crude oil prices as the number one threat of the year.

The chart of the 10-year Treasury yield shows it has broken above resistance at 1.45% and technically this points to a new higher trend for interest rates. The first range of resistance is seen at the 1.75% to 1.85% level and secondarily at 2.1%. However, the more substantial resistance is noted at 2.4% which is the level that most economists believe would threaten the Fed’s current easy monetary policy. The chart suggests this is possible. See page 7.

Retail sales fell a disappointing 3.0% in February, but still rose 6.3% YOY. As seen on page 8, February’s 6.3% increase was down from a 9.5% gain in January. Declines were substantial and broadly based with only gas stations rising 3.6% and grocery store sales rising 0.1% for the month. Year-over-year changes were diverse, ranging from negative 17% at restaurants to positive 25.9% at nonstore retailers. These sales declines were the result of fading federal stimulus, but February should be a one-off statistic since another round of stimulus checks will begin to reach consumers in March.

The NFIB small business optimism index ticked up from 95.0 in January to 95.8 in February, but the report was fairly glum with sales expectations, the outlook for expansion, and inventory plans all falling two points apiece. Capital expenditure plans and hiring plans each rose one point. The outlook for business conditions rose from -23 to -19 and credit expectations fell from -3 to -6. In general, the NFIB survey report was uninspiring. See page 10.

New 2022 S&P Earnings Estimates

This week S&P Dow Jones initiated a 2022 S&P 500 earnings estimate of $199.50 which joins the Refinitiv IBES estimate of $201.64. We are also initiating a 2022 earnings estimate this week at of $200. This represents an 18.6% gain over our 2021 estimate of $168.60. Note that a 20 PE multiple to earnings of $200 equate to an SPX target of 4000. See page 12 and 19.

Technical Update

The 25-day up/down volume oscillator is currently 1.55 (preliminary) and neutral this week despite the March 15 highs in all the indices. However, if the indices continue to move into new high ground, we should see this indicator attain another overbought reading to demonstrate that volume is confirming price moves. This oscillator was last in overbought territory for five consecutive trading days between February 4 and February 10 when several momentum indicators peaked. Five days overbought is a minimum confirmation for any bull market advance. See page 14.

The 10-day average of daily new highs is 496, well above the bullish 100 which defines a bull market. The 10-day average of daily new lows (68) is below the 100 that defines a bear market, yet it is well above the 10 or less that signals an extreme in a bull market advance. The 10-day new high average reached 521 on February 17, exceeding the 489 recorded January 22, 2000. We view this as a potential yellow flag since the 2000 advance peaked in March. The A/D line made its last confirming record high on March 15, 2021, which is positive. AAII bullish sentiment for March 11 rose 9.1 points to 49.4%, a 16-week high, and has been above average for 15 of the last 17 weeks. Bearishness fell 1.8 points to 23.5% and is below its historical average of 30.5% for the fifth consecutive week. The 8-week spread remains neutral. In sum, the lack of extremes in all the technical indicators is positive for the bulls.

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There is no doubt that the current equity market is displaying significant positive momentum. This is made clear by the fact that the Russell 2000 index has been core to price leadership in 2021. In fact, the iShares Russell 2000 Value ETF (IWN – $152.31), the iShares Russell 2000 ETF (IWM – $225.83) and the iShares Russell Growth ETF (IWO – $329.01) are all beating other indices with gains of 17.2%, 16.7%, and 16.5%, respectively. This compares to the 6.3% year-to-date gain in the SPY. See page 14.

Similar but Different from 2000

Several technical indicators are confirming the advance. The NYSE cumulative advance decline line is corroborating the advance with a record high as of February 12. Our favorite 25-day up/down volume oscillator is neutral this week but recorded five consecutive trading days in overbought territory last week. In this indicator, five to ten consecutive days in overbought territory is a sign that persistent buying pressure is supporting the move. See page 10. Even more impressive has been the 10-day average of daily NYSE new highs which hit 514 this week, exceeding both the 10-day average of 492 made on January 20, 2021, and the previous record of 489 made January 22, 2000. See page 11. This last point should also come as a warning flag to investors since the strong market breadth seen in January 2000 preceded the bull market peak made in March 2000 by less than two months. However, the 2000 market was driven by both momentum and more importantly a mania for stocks. Today’s market appears to be a bit different. First, the equity advance is much broader today than the narrow bull market of 2000. Second, valuations were far more stretched in March 2000 than they are at present. Third, the mania for stocks seen in 1999 and early 2000 is not apparent, at least not yet.

Too Dangerous to Short

Normal sentiment indicators are surprisingly benign. The ISE Call/Put Volume ratio remains neutral. AAII bullish sentiment for February 11 jumped 8.1 points to 45.5% and bearish sentiment declined 9.3 points to 26.3% which puts it below its historical average of 30.5% for the first time this year; nevertheless, the 8-week bull/bear spread remains solidly neutral. On the other hand, February’s Bank of America survey of 225 global institutional, mutual and hedge fund managers did reveal a surprising level of bullishness. Cash levels in these investment portfolios dropped to 3.8%, the lowest level since May 2013. (This 2013 benchmark is significant since it coordinates with a Treasury bond sell-off triggered by Federal Reserve Chairman Ben Bernanke when he indicated his intention to taper bond purchases.) A net 91% of money managers indicated that they expect a stronger economy. This is the highest percentage reading in the history of the survey. One concerning fact is that only 13% of participants indicated they were worried about an equity market bubble. About 53% of all managers felt equity markets were in a late-stage bull market while 27% believe the bull market is still in its early stages. Equally notable, a net 25% of the investors surveyed said they were taking “higher-than-normal” risks at the present time. This was the highest percentage ever recorded. The most crowded trades were long technology and bitcoin and short the US dollar. Although this survey gives us concern, we believe it would be extremely dangerous to short this market at this time.

Consensus 2022 Hits $200

One reason it could be unwise to short the current market is that consensus S&P earnings for 2020 and 2021 continue to move upward. For this year and next, S&P Dow Jones consensus earnings estimates rose $0.08 and $0.22, respectively, and Refinitiv IBES consensus estimates rose $0.61 and $0.66, respectively. Full year 2021 earnings forecasts for S&P Dow Jones and IBES are now $170.77 and $173.70, respectively. But it is most important to note that the IBES consensus estimate for 2022 has exceeded $200 for the first time and is currently estimated at $200.41. Applying a 20 PE multiple to this estimate equates to a target for the SPX of 4000. In short, one could argue that the market is not wildly overvalued – just discounting future earnings.

What Could Upset the Apple Cart?

However, this last statement – just discounting future earnings — is dangerous since no investor can actually predict the economy, stock market or earnings two years in advance. With this in mind, it is prudent to think about what could go wrong with the two factors that underpin the bullishness of professional investors today — strong fiscal stimulus and easy monetary policy. In short, what could upset the apple cart?

The Democratic majority in Congress and the White House makes fiscal stimulus relatively predictable for 2021. But what about monetary policy? As we previously noted, low interest rates, high liquidity, and a benign Fed are the perfect recipe for speculators. Therefore, it is not surprising that a net 25% of the investors surveyed by Bank of America, the highest percentage ever recorded, said they were taking “higher-than-normal” risks today. However, keep in mind that as interest rates rise the risk/reward ratio for speculators will also change and at some point, potential risk will outweigh potential rewards. In a word, the risk for 2021 could be inflation.

The Biden administration has been quickly reversing the energy policies of the Trump administration and oil prices have been rising accordingly. This coupled with the freezing temperatures in Texas which are disrupting energy transportation while increasing demand for heating needs, have boosted the WTI future above $60 this week. This is a 35% YOY increase. It is likely to move higher and thereby be the driver of higher inflation in 2021. See page 3.

At the end of 2020, all inflation benchmarks were stable and hovering around 1.4%. This 1.4% level is good for both consumers and businesses as well as for Federal Reserve policy. However, history has shown that a sharp rise in crude oil pricing will not only negatively impact the CPI but will be the catalyst for higher long-term interest rates. This is already happening. The 10-year Treasury note yield is currently at 1.2% which is higher than any time since the pandemic struck in March 2020. See page 4.

On a not-seasonally-adjusted basis, January’s CPI rose 0.4% month-over-month and 1.4% year-over-year. Yet, January’s benign 1.4% inflation rate was contained by a seasonal 2.5% YOY decline in apparel and a 1.3% decline in transportation. The decline in transportation inflation is expected to be a temporary phenomenon. Fuel prices peaked in December 2019 at $61.06 and fell to $18.84 at the end of April 2020. In short, the easy year-over-year comparisons for fuel prices are behind us. See page 5. Charts of the crude oil future and the 10-year Treasury note yield index show the correlation between the two, but more importantly, the 10-year yield chart shows that there is resistance at the 1.4% yield level. If 1.4% is exceeded, it could indicate much higher levels for interest rates. Not only would inflation put pressure on interest rates and the Fed in terms of its easy monetary policy, but it could also force the FOMC to adjust its long-term outlook. A change in monetary policy is the opposite of what the consensus is expecting in 2021 and it could shock the equity market. In sum, do not fight the Fed, but beware of what could change the Fed’s outlook.

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Last week we outlined eight factors that typically identify a stock market bubble and discussed where we believe the current market stands in regard to each. One important and obvious characteristic of an equity bubble is that prices disconnect from valuation. Yet as we noted last week, while current valuation levels are rich, they are not at the inane levels often recorded at a bubble peak. We quote: “In short, fundamentals may be stretched today, but interest rates are low which means a 20 PE for 2021 is within our model’s fair value range. It will not be a surprise if valuations get even more stretched in coming months. All in all, equities are disconnecting from fundamentals, but this may continue for a time.” (US Strategy Weekly “And if it is a Bubble” January 27, 2021)

What is currently in the market’s favor is that this year’s consensus earnings estimate for the S&P 500 Composite is on the rise. According to Refinitiv IBES, to date, of the 203 companies in the S&P that reported fourth quarter earnings, 84% have beaten expectations. This is well above the long-term average of 60.5%. The blended earnings estimate for the fourth quarter now shows a decline of 1.2% YOY versus the decline of 10.3% YOY expected on January 1. Excluding the energy sector, IBES estimates fourth quarter earnings should actually rise 2.4% YOY, which would end three consecutive quarters of negative earnings comparisons for the S&P. In addition, energy sector earnings are expected to rebound sharply in 2021 and this should give an added boost to 2021 results.

At the end of last week IBES estimated 2020 consensus earnings were $138.71 and due to differences in accounting standards, S&P Dow Jones estimated earnings of $121.37. With only two more days of fourth quarter earnings results, IBES raised its 2020 estimate to $139.21. All told, fourth quarter earnings have been a pleasant surprise for investors.

Fourth quarter results are also a positive catalyst for 2021 earnings forecasts. At the end of last week, IBES estimated 2021 S&P earnings to be $171.55, but after two more days of earnings results, their estimate increased to $172.05 this week. S&P Dow Jones forecasted $169.39 for S&P 500 2021 earnings in their regular report at the end of last week. What is important about these various increases in earnings is that if one applies a 20 PE multiple to the current IBES estimate of $172.05 it equates to a price target of SPX 3441. Although this is 10% below current prices, the good news is that this does not represent an extreme overvaluation given the current low level of inflation and interest rates. Thus, any correction should find support around the SPX 3400 level. Conversely, stock market bubbles tend to end with ridiculously high PE multiples. In sum, if equities are forming a bubble market, it may continue for a time.

Adjusting our Earnings Estimates for 2020 and 2021

The S&P earnings results for the fourth quarter, and for 2020 generally, are much as we expected. So, with the annual earnings season nearly complete, we are adjusting our 2020 earnings estimate to match the S&P Dow Jones estimate of $121.87. This reflects a decline of 22.8% year-over-year versus our expectation of a decline of 20% to 25% in 2020. We are also raising our 2021 estimate from $166.60 to $168.60, representing a 39% increase this year. See page 19. But more importantly, we would not be surprised if this earnings estimate proves to be too conservative over time, particularly as the drag from the energy sector abates and the productivity improvements seen in 2020 help to drive the bottom lines for many companies in 2021.

Economic Reports

Real GDP grew in the fourth quarter at a seasonally adjusted annualized rate of 4%, which means that economic activity in the full year of 2020, contracted 3.5%. This 2020 contraction followed gains of 2.3% in 2017, 3.0% in 2018 and 2.2% in 2019. To our surprise, despite the 2020 recession, GDP grew at an average pace of 1.94% during Trump’s four years in office which was precisely the midpoint between the 1.89% rate for Obama’s eight years and 1.99% for GW Bush’s eight years. See page 3.

Economic growth in the fourth quarter was driven primarily by personal consumption of services and gross private investment. This shift in economic activity toward the service sector was a welcomed change since most of 2020’s economic activity was supported by personal consumption of durable goods, particularly housing and autos. The gains in gross domestic investment in the fourth quarter were primarily in residential structures. In fact, residential fixed investment hit a record $983.5 billion in the quarter which was an 18.3% gain year-over-year. This represented the strongest year-over-year rise in residential investment since the third quarter of 2013. See page 4. And as a percentage of real GDP, residential activity rose to 4.58%, the highest since the third quarter of 2007. This is strong but just slightly below its long-term average of 4.6% of GDP. See page 5. In sum, housing continued to be a major driver of economic activity at the end of 2020. But this may not continue in 2021. Ironically, as residential investment rose in the fourth quarter, homeownership levels declined rather markedly. See page 6. Total homeownership in the US fell from 67.4% of all households to 65.8%. The greatest decline was seen in the South where the homeownership rate fell from 70.8% at the end of September to 67.7% at the end of December. The Northeast was the only region in the US to experience a gain and rose from 62.0% to 62.6% in the fourth quarter. In terms of age groups, the 35 to 44 years old segment underwent the biggest decline in homeownership from 63.9% to 61.0%. Given the anecdotal evidence of households fleeing the Northeast and California to Texas, Florida and the Carolinas, this data seems illogical. However, the fourth quarter could be a transition phase as households move from states where restrictions have closed most institutions and establishments to states where schools and businesses have been open. Or it could be more ominous. The contraction of jobs in 2020 may have forced households to sell homes and move to apartments. Time will tell. However, we do believe economic growth in 2021 could disappoint investors if the federal government does not focus on stimulating job growth.

In December, personal income grew 4.1% YOY and real disposable income rose 3.2% YOY. However, a more revealing statistic is real personal income, which excluding current transfer payments fell 0.5% YOY in December. It also declined 0.45% in November. In short, government assistance, not economic activity, is propping up incomes and the economy. See page 9. And while personal income rose 4.1% in December, personal consumption declined 2.1%. Moreover, consumption has been negative in every consecutive month since March. This reveals the weak underbelly of the US economy and it is unlikely to change until the job market improves. See page 10.

Technical Indicators Little has changed in the technical arena. Our volume oscillator remains in neutral territory, the 10-day new high list has dropped from the record 492 hit on January 20^th (breaking the previous record of 489 recorded in January 2000) to a more normal 259. Sentiment indicators are also surprisingly benign despite the headlines of individual traders driving volatile meme stocks. However, it is worth noting that at the end of the year stock market capitalization relative to nominal GDP was 2.1 and higher than the prior record of 1.82 set in March 2000. A similar Wilshire 5000 ratio was 1.83, exceeding its peak of 1.43 set in March 2000. These high ratios are signs that equity valuations may be outperforming the economy. See page 4. Expect 2021 to be a wild roller coaster ride and invest accordingly.   

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