Did the Dow Jones Industrial Average actually plunge 1,920 points in the last four trading days without a catalyst? In our opinion, the decline was a long time in coming, but the most obvious answer to this question is that there were many catalysts, but the final straw was first quarter earnings results.

First Quarter Earnings Season

It has been our long-held view that first quarter earnings season could be a market-moving event. Earnings are always the underpinning of a stock market advance or decline, and as the first quarter of 2022 ended, it seemed like first quarter earnings results were the only hope investors had for good news. There was plenty of bad news. It has been clear for months that interest rates would be moving higher, and this would challenge equities and likely lower PE multiples. The Russia-Ukraine conflict which began in late February does not appear to be coming to a quick resolution. The longer the war persists, the more likely the world will see shortages of energy, grains, and metals, and as a result, more inflation. China is experiencing another COVID variant outbreak and by shutting down Shanghai and Beijing, fears of supply chain shortages are reappearing. The only real positive on the horizon for equities was that corporate America could overcome all these challenges and produce solid earnings results.

Unfortunately, to date, the results are mixed. Global banks reported profit challenges such as a decline in the investment banking business and loan-loss reserves against possible Russian debt defaults. A variety of companies like GE (GE – $80.59), Texas Instruments (TXN – $168.44), Mondelez International (MDLZ – $64.04), United Parcel (UPS – $183.05), and Raytheon Technologies (RTX -$99.19) reported profit challenges from rising inflation, supply chain snarls, and an increasingly cautious consumer. But adding to the market’s fears has been the sudden awakening that the Federal Reserve plans to raise rates significantly and quickly. Fed Chairman Jerome Powell has indicated that rates could increase 50 by basis points at each of the next two FOMC meetings. In real terms, this means short-term rates will jump 100 basis points in the next seven weeks! This would be one of the steepest increases in history. And it will take a toll on the economy, particularly on the housing and auto sectors.

Housing and Interest Rates

Home prices accelerated during the pandemic and newly released data for March showed that they reached all-time highs. The S&P/Shiller Case 10-city composite indicated a 19% YOY gain, and the 20-city composite index climbed over 20% YOY. One of the key underlying supports for home prices has been an extremely low level of supply. Inventory for existing single-family homes rose from 740,000 to 830,000 in March, and months of supply rose from 1.7 to 1.9; however, even with March’s increases, these levels remain among the lowest levels in history. See page 3.

And though both new home and existing home prices have been soaring for the last 18 months, the current cyclical peak in sales occurred months ago. In March, existing home sales were 14% below their October 2020 cyclical peak. New home sales in March were 23% below their January 2021 peak. These are significant declines however it is important to note that they appeared prior to the recent rise in mortgage rates. Lower sales imply a decrease in demand, something that could escalate as interest rates rise. See page 4.

The National Association of Realtors (NAR) housing affordability index fell from 143.1 in January to 135.4 in February. Although median family income rose in February, the falloff was due to rising home prices and higher mortgage rates. Note that the average 30-year fixed mortgage rate was 3.83% in February during the NAR survey, and it is currently 5.11%. Moreover, since the Fed plans to raise short-term rates 100 basis points in the next six to eight weeks, rates are apt to climb surprisingly quickly. In sum, due to tightening Fed policy, the housing sector is apt to suffer a meaningful slowdown in 2022. Although this should be expected after such a strong cycle, it will be a substantial hit on the US economy. According to the NAHB, housing contributes 15% to 19% to GDP. See page 5. The preliminary release of first quarter GDP is scheduled for April 28, and it will be an important benchmark for investors. Yet, regardless of how well or poorly the economy performed in the first quarter, economic momentum is apt to slow considerably in the next three quarters.

The angst in the housing sector is not new and has been evident in the NAHB home builder confidence survey all year. In fact, confidence peaked with the cyclical high in new home sales in late 2020 and has been falling somewhat erratically, ever since. See page 6.

Technical Breakdowns

Over the last twelve months, we have noted several technical patterns in the charts of the popular indices we thought had predictive significance. In the fourth quarter of 2021, we remarked on the severe underperformance of the Russell 2000 index and the warning that posed for the overall marketplace. Two weeks ago, we pointed to the convergence of the 50-day, 100-day, and 200-day moving averages in the Dow Jones Industrial Average at 35,000, and how this could be a pivotal level for the index and the broader market. Last week, the DJIA was unable to better the resistance at 35,000 and this foreshadowed the sell-off seen in recent days.

This week we are disturbed by the breaks of support seen in both the Nasdaq Composite Index and the Russell 2000. Both indices broke the lower end of trading ranges that have contained market sell-offs this year. These technical breaks imply a new downdraft in the popular indices should be expected. See page 9.

In addition, on April 22, 2022, when the DJIA fell 809 points, the NYSE volume data revealed the first extreme 90% down day since June 24, 2020. However, the June 2020 reading was actually the last in a series of 90% down days. The first one appeared in February 2020. In short, the April 22^nd 90% down day was the first sign of panic selling, but it is unlikely to be the last. History shows that 90% down days usually come in a series. Typically, after a series of 90% down days, a 90% up day will appear. This would be the first sign that the market may be stabilizing. We will keep you posted. On the positive side of the ledger, AAII bullish sentiment rose 3.0 points to 18.9% this week, but bullishness remained below 20% for the second consecutive week. These were the first two consecutively low bullish readings since May 2016. It is also only the 33rd time in history that bullishness fell below 20%. Extremely low bullishness is positive. Bearish sentiment decreased 4.5 points to 43.9% and has been above 40% for 12 of the last 14 weeks. It would be favorable if bearishness rose above 50% at the same time that bullishness is below 20%. We will see what next week brings. Overall, sentiment readings are favorable. Nonetheless, we would remain very cautious in the near term since the breaks in the Nasdaq and Russell suggest lower prices ahead.

Gail Dudack

Click to Download

Given the uncertainty of the current geopolitical environment, first-quarter earnings season will be very closely monitored and more important than usual. The atmosphere is rife with risk. Noting “seismic waves” from Russia’s invasion of Ukraine and warning that inflation was now a “clear and present danger,” The International Monetary Fund cut its forecast for global economic growth by nearly a full percentage point this week. The IMF also indicated that Ukraine’s GDP could collapse by 35% this year and Russia’s economy could shrink by 8.5%. Emerging and developing Europe (which includes both Russia and Ukraine) are forecasted to decline by 2.9%. The IMF also pointed out that these forecasts are in jeopardy for many reasons, including the likelihood of more sanctions on Russia, global food shortages, and tightening monetary policies. With this backdrop, investors will be riveted, not only on first-quarter results, but on corporate guidance for the rest of 2022.

To date, first-quarter earnings results are mixed. International Business Machine (IBM – $129.15) reported it expects to hit the top end of its revenue growth forecast for 2022 even though it expects a hit of a “few hundred million dollars” from the suspension of its business in Russia. Johnson & Johnson (JNJ -$183.08) cut both ends of its full-year profit forecast by 25 cents lowering expectations to $10.15 to $10.35 per share. JNJ cited currency fluctuations rather than fundamental business issues for the decline, and simultaneously raised its dividend by 6.6%. Meanwhile, Netflix Inc. (NFLX – $348.61) cratered 24% after the bell when it reported that subscriber numbers had declined for the first time in a decade. The streaming company lost 200,000 subscribers in the first quarter; but more disturbingly, it expects to lose an additional 2 million subscribers due to competition from Apple Inc. (AAPL – $167.40) and Walt Disney (DIS – $131.90). Account sharing and other challenges are also having a negative impact. Tesla (TSLA – $1028.15) reports earnings on Wednesday and investors will be watching and listening, not only for earnings results but to hear if Elon Musk discusses his bid for Twitter Inc. (TWTR -$46.16). On April 14, Musk offered to buy all Twitter shares for $54.20 per share and take the company private. This bid has been the most-followed story of the last week and the company responded by adopting a poison pill to thwart Musk. Twitter, which reports earnings on April 28, is listed by IBES Refinitiv as one of several companies likely to have a negative earnings surprise this quarter.

Stock Prices, Rising Interest Rates and Earnings

IBES Refinitiv is currently forecasting first-quarter earnings growth for the S&P 500 to be 6.3% YOY but excluding the energy sector – where profits are expected to rise 241.2% YOY — growth falls to 0.7% YOY. In short, 2022 is likely to be a difficult year for most companies and as we have been indicating in recent weeks, earnings growth needs to be substantial to counter the negative impact of rising inflation and interest rates.

There is much confusion about rising interest rates and stock market performance. Stocks can, and often have rallied in a rising interest rate environment. In fact, rising interests rates and a strong economy typically go hand-in-hand and as a result, good earnings growth offsets the negative impact of rising interest rates and PE compression. This explains why first-quarter results and corporate guidance will be important this season. If PE multiples cannot expand, the only driving force for equities will be rising earnings.

Meanwhile, it appears that the Fed is warning us that interest rates are about to rise quickly and substantially this year. St. Louis Federal Reserve Bank President James Bullard recently stated that he believes the fed funds rate needs to rise to 3.5% by the end of the year in order to slow the current 40-year-high inflation pace. He also said he would not rule out a 75-basis point rate hike in May, although his preferred rate path would be 50 basis-point hikes at each of the six remaining FOMC meetings this year. Separately, Chicago Federal Reserve Bank President Charles Evans said the Fed should raise its target range to 2.25%-2.5% by year end and then take stock of the state of the economy. If inflation remained high, the Fed could hike rates further. We have noted that most Fed policymakers estimate neutral to be somewhere between 2.25% and 2.5%.

All in all, these various comments by current Fed governors are tempering the markets for the Fed’s next move and to date, investors are responding well to the fact that rates will soon rise at least 50 basis points. We do not sense any panic, but we fear this could be temporary. In our opinion, the Fed is aware that it needs to slow the economy, and in order to tame inflation, they must tap the breaks on the housing market and auto sales. Unfortunately, steering the economy to a soft landing may be extremely difficult, particularly with the tenuous situation in Europe. We remain cautious and continue to emphasize areas of the market that benefit from inflation or can weather inflation such as energy, utilities, defense stocks, and staples. See page 12. Plus, stocks with solid dividends are good substitutes for bonds in a rising rate landscape.

Economic Releases

The NAHB single-family confidence survey for April revealed that homebuilders have had a slow, but steady decline in conviction for the first four months of the year. Housing starts and housing permits were higher in March, up 3.9% and 6.7% YOY, respectively; but unfortunately, the increase in both series was in multi-unit housing. Single-family permits and housing starts, which account for the biggest share of homebuilding, fell in March. See page 3.

Industrial production for March rose to a record high, edging above the August 2018 peak. March’s gain was driven by a rebound in auto and truck manufacturing where production had been weak for most of 2021 due to semiconductor supply problems. Electric & gas capacity utilization eased in March. Whereas electric & gas capacity utilization used to be a benchmark for defining activity in the manufacturing sector, the steady decline in utilization since May 1970 is a display of the energy efficiencies seen in the US over the last five decades. See page 4.

In March, total retail & food sales rose 6.9% YOY. Excluding autos, sales rose 9.1%, and excluding autos and gas, retail sales rose 6.2%. The volatility in retail sales in early 2021 makes year-over-year comparisons difficult and less meaningful. Still, with inflation up 8.6% YOY in the same time period that retail sales rose 6.9% YOY, this means real sales were negative in March. Equally important, gas station sales rose 17.1% YOY in the month as a result of soaring gas prices. See page 5.

Technical Updates

Stock prices appear to be in the midst of a rally, but due to a convergence of moving averages, important resistance levels are directly overhead in all the indices. This convergence/resistance is most apparent in the SPX at 4500 and in the DJIA at 35,000. The Nasdaq Composite Index and Russell 2000 have weaker charts and remain well below their 200-day moving averages. See page 8. Last week AAII bullish sentiment fell 8.9 points to 15.8%, the lowest since September 1992. Sentiment has been unusually volatile this year, but this low bullish sentiment is a positive for the longer term.

Gail Dudack

Click to Download

According to Reuters, as soon as Wednesday, President Joe Biden’s administration could announce it is extending another $750 million in military assistance for Ukraine’s fight against the Russian invasion. Separately, the Pentagon is hosting leaders from eight weapons and defense manufacturers to discuss the industry’s capacity to meet Ukraine’s needs in case the war with Russia lasts for years.

These announcements are just one indication of how the world, the financial markets, and potentially, our futures have changed in the last two months. There is no denying that energy prices were trending higher well before Russia invaded Ukraine in late February. However, energy, grains, metals, Russia, Ukraine, inflation, financial markets, and politics are now irrefutably intertwined in an inflationary quagmire. This war-induced combination is not really something the Fed has the tools to fix. And in our opinion, this is why the consensus has flipped from optimism to pessimism about the US economy and is worried about a Fed-induced recession. We are too.

Other headlines are also disconcerting: the possibility of Russia using chemical weapons in Ukraine, eurozone banks becoming risk averse and tightening corporate credit, and China shutting down Shanghai due to the spread of a COVID variant. It is a mixed collection of news, but individually and together, it points to substantially weaker growth or potentially a global recession.

Stay Defensive

We contemplated raising cash this week, however, we still believe select stocks can do well despite these challenges. In fact, some companies will benefit. Therefore, we remain overweight the energy sector, industrials (with an emphasis on defense stocks), consumer staples, and utilities. Each of these sectors is a direct, or indirect, beneficiary of the current world condition. Utilities are not a direct beneficiary, but they are defensive, can pass on costs to consumers and are preferable to bonds in an era of rising interest rates.

Inflation continues to Roar

The March CPI report was filled with bad news. Headline inflation exceeded expectations showing prices rising 8.5% YOY with core inflation up 6.5% YOY. Both series displayed the highest inflation in 40 years. Energy rose 32.2% YOY, up from 25.7% in February. Food prices rose 8.8% YOY, up from 7.9% in February. Services rose 4.7% YOY, up from 4.4% YOY. Goods inflation “moderated” to 11.7% YOY, down from 12.4% YOY in February. See page 3. The March CPI report indicates why the average household is struggling to keep up with normal expenses even though average weekly earnings rose 4.6% YOY in March. After inflation, the purchasing power of consumers fell nearly 4% YOY in March.

All the large segments of the CPI – housing, food & beverages, medical care, and transportation – have been experiencing escalating price increases over the last six months. See page 4. Many economists, like Larry Summers, are voicing concerns about the probability of a recession in the next two years; and not surprisingly, most strategists fear the Fed will trigger a recession by raising interest rates too much or too fast.

A History Lesson

However, history suggests that today’s inflation rate has reached a level that may make a recession inevitable. On page 4, we show a long-term chart of the S&P 500, various inflation benchmarks, and recessions. It shows that the last time inflation began to soar at this pace was during the oil embargo of 1973. That inflation was followed by three recessions in the subsequent ten years.

This era was called the “great inflation” and it began in late 1972 and did not end until the early 1980s. In his book “Stocks for the Long Run: A Guide for Long-Term Growth“ (1994), our friend Wharton Professor Jeremy Siegel, called it “the greatest failure of American macroeconomic policy in the postwar period.” This decade-long inflation era has been blamed on many things: oil prices, the end of the gold standard in 1973, funding of The Great Society legislation, greedy businessmen, food shortages due to bad weather, and avaricious union leaders. But, according to Professor Siegel, the root cause of the great inflation was monetary policies that financed massive budget deficits driven by political leaders and their legislation. This should sound familiar.

The great inflation ended with Paul Volcker, Chair of the Federal Reserve from 1979 to 1987. Volker made financial history in March 1980 when he raised the fed funds rate from 14% to 20%, its highest level on record. It was tough love but needed in order to end years of crippling double-digit inflation. Volker also moved the fed funds rate back to 20% in May 1981 when inflation began to creep higher. Although widely criticized at the time, the March 1980 “Volker Shock” is now seen as a courageous and wise act. Both rate hikes to 20% were followed by recessions, but in the end, it finally broke the back of a dangerous inflationary cycle.

Perhaps this was the history lesson discussed at the March FOMC meeting. If so, it would explain why dovish Fed governors like Lael Brainard suddenly become monetary hawks. The current Fed seems determined to enforce tough love on the economy in 2022 by raising interest rates and contracting its balance sheet. We believe both are needed. Unfortunately, it also raises the risk of recession.

Earnings Season

This week kicks off first quarter earnings season, and while all earnings seasons are important, this time analysts will be listening carefully to hear what corporate leaders have to say about revenues and margins. As we show on page 6, inflation is apt to pressure margins this year and we already discussed how inflation will decrease the purchasing power of households. IBES currently is forecasting earnings growth in the first quarter of 6.1% YOY but excluding energy growth falls to 0.6%. Clearly, any disappointments this quarter could tip the balance to negative for the quarter. Again, we would emphasize companies that benefit from the current environment, have predictable earnings streams, and safe dividend yields.

Technical Events

In our view, the most meaningful technical event of the last week was the inability of the DJIA to better the resistance found at 35,000. A convergence of three key moving averages made this a critical point for the index, and the DJIA not only failed to break through but has been noticeably weak in recent sessions. All the popular indices have a similar pattern, but it was most clearly seen in the DJIA. In short, all major indices continue to trade below their 200-day moving averages in a classic bearish pattern. AAII sentiment has been unusually volatile. Last week, bullish sentiment fell 7.2 points to 24.7% while bearish sentiment jumped 13.9 points to 41.4%. Pessimism has been above 40% for nine of the last 12 weeks. Optimism has been below 27.9% for 10 of the last 13 weeks. Neutral has been above average for the third consecutive week. Overall, the AAII bull/bear spread remains positive.   

Gail Dudack

Click to Download

The Russian war on Ukraine continues and the news from the battlefronts are disturbing. Global sanctions on Russia, Russian companies, and their corporate leaders and oligarchs escalated this week as well with the hope that the financial pain inflicted by sanctions may deter President Putin from his aggressive path. In a lengthy statement this week, US Treasury Department listed companies and individual corporate leaders known to be used to evade recent sanctions, and imposed measures to close loopholes and prevent them from operating or procuring western technology. All property, interests in property, and assets in the US, including all financial assets in US banks, of individuals listed by the Treasury, are now frozen and cannot be used to pay interest on loans or perform any business transactions. Injunctions were expanded to include aerospace, marine, and electronics sectors.

In addition, the US and Germany jointly sanctioned the world’s largest and most prominent darknet market, Hydra Market, in a coordinated effort to disrupt malicious cybercrime services, sales of dangerous drugs, or other illegal offerings available on the Russian-based site. German Federal Criminal Police shut down Hydra servers in Germany and seized $25 million worth of bitcoin. Garantex, a ransomware-enabling virtual currency exchange founded in late 2019, was also sanctioned. All of these measures, and the sanctions ordered before this week, are meant to cripple Russia’s economy and provoke sovereign and corporate debt defaults.

Meanwhile, Britain ordered a report into shale gas fracking on Tuesday, less than three years after banning the practice, saying all options should be available in light of a Ukraine crisis-fueled surge in gas prices. We applaud this shift, but it also reveals the misjudgment of the UN-sponsored Paris Agreement on climate change. Western countries made major steps to decrease fossil fuel production, but these steps only opened the door for oil-rich countries like Russia to take control of the world’s energy markets. In our view, the path to renewable fuel should have been done in conjunction with the US remaining energy independent, not before.

Yield Curve Fears

However, none of these issues reversed the March rally. Instead, it was Federal Reserve Governor Lael Brainard, one of the Fed’s most dovish governors. She stated that a combination of interest rate hikes and balance sheet runoffs were needed to quickly move monetary policy to a more neutral position this year. The implication was that the Fed is clearly set on a hawkish path in 2022 to contain inflation. This week’s release of the March FOMC meeting minutes is expected to provide more details of the Fed’s plans.

However, as we just pointed out, today’s inflation is not simply a demand-driven cycle that the Fed can contain. It has materialized from a diminished supply of energy, particularly in fossil fuels. It came from a lack of investment. It is policy driven. It is man-made. In short, the Fed will have a difficult time trying to tame current price increases. Moreover, since Russia and Ukraine are the breadbasket of Europe food and meat prices will also rise this summer. This is a raw material inflation cycle, and the Fed does not have the tools to fix it, without perhaps triggering a recession.

In our opinion, the obsession with the yield curve and a possible inversion is really based upon these underlying facts. Yes, the Fed was too slow to change policy to control inflation, but the cycle is now exacerbated by geopolitical events that are not under their control. This is a cause for concern.

Plus, the sanctions imposed on Russia are meant to create defaults on loans, and this too, will have repercussions. JPMorgan Chase CEO Jamie Dimon made two important comments recently. First, he indicated that the Fed could lift interest rates by more than 2.5% this year, more than most expect. Second, he indicated that the bank may need to take as much as a $1 billion of reserves against Russian debt.

Sector Weighting Shifts

Our main concern is that a combination of inflation-induced margin erosion, a rising cost of capital, and write-offs related to Russia, either from corporations exiting businesses in Russia or defaults from Russian debt, will weigh heavily on earnings performance this year. For these reasons, we remain cautious and believe investors should seek safety in areas that are insulated from these risks. These areas include energy, staples, cybersecurity, and aerospace and defense. We are upgrading utilities from underweight to overweight this week because we believe high dividend-paying stocks will be in demand as bond prices fall. Utilities are also able to pass on energy costs to consumers. We are also lowering our weighting on the technology sector from overweight to neutral. This is more in line with our view that technology stocks will be one of the most volatile areas of the market in 2022 and while trading opportunities arise, they may not provide the best intermediate-term strategy – with the exception of cybersecurity. Lastly, we are lowering the REIT sector from neutral to underweight due to the pressures we anticipate from higher interest rates and rising costs. See page 13.

Economic Releases

The final estimate for fourth quarter 2021 GDP growth was 6.9%, a nice improvement from the 2.3% pace seen in the third quarter. However, on page 3 we overlay the real 10-year Treasury note yield on real GDP growth. This shows that real yields are extremely negative, which historically has only been seen during a recession. Recent unnecessary stimulus explains the historic level of inflation we are currently experiencing and points out why interest rates must go much higher this year. The Fed’s task is now extremely difficult and the risk of too much tightening and an inverted yield curve is real.

The major contributor to growth in the fourth quarter was gross private investment, while personal consumption of goods was barely positive, and consumption of services rose modesty. Unfortunately, the largest contributor to private investment was a buildup of inventories, and this could dampen growth in the first quarter of this year.

Staying at home or traveling by car became the norm during the COVID pandemic and this contributed to strength in housing and autos. Auto sales have been a solid contributor to retail sales, but the pandemic boost appears to be over. Unit auto sales have been declining since mid-2021. In March, total unit sales of autos and light vehicles were 13.7 million, down 24% YOY. See page 5. The ISM manufacturing index slipped to 57.1 in March although employment, prices, and inventory rose. The main weakness in manufacturing was found in new orders and backlog of orders. The ISM non-manufacturing index rose slightly to 58.3 in March due primarily to strength in employment, new orders, and exports – all good signs. However, service business activity slipped a point to 55.5 in March. See page 6.

Gail Dudack

Click to Download

Rumors of improving discussions between Russia and Ukraine helped foster a rally in equities this week. The advance generated changes in our technical indicators as well as in the charts of the popular indices. However, to date, there is nothing to suggest that recent gains are anything more than a short-covering rally coupled with institutional accounts making portfolio adjustments at the end of the first quarter.

At present, both equities and commodities, particularly crude oil, are experiencing tremendous volatility and appear to be captive to ever-changing headlines, but the underlying economy is little changed. Inflation continues to be a major threat; monetary policy is destined to be unfriendly, and the combination is apt to be detrimental to the economy, the consumer, and corporate profits. The real question is how big a hurdle the combination of rising prices and rising interest rates will be for economic activity, particularly for the housing and auto sectors.

This week we will get data on personal income and personal expenditures for February, March employment, final fourth quarter GDP with corporate profits, plus vehicle sales and the ISM manufacturing report for March. These reports should give investors a better feel for how businesses and consumers are reacting to the Russian invasion, inflation, and rising interest rates. More importantly, in the coming weeks earnings reports for the first quarter will begin and as we have noted in the past, this could become a market-moving event. History has shown that stock markets can perform well in an environment of rising interest rates – the caveat is that earnings must be rising faster than before to compensate. This seems unlikely to us, but if earnings are better than expected, this could provide good downside support for stock prices.

Housing is Weakening

An index of pending home sales fell to 104.9 in February. This was the lowest reading since May 2020 and the fourth consecutive month of declines. Note that monthly new single-family home sales peaked in July 2020 at 85,000 and the year-over-year growth rate in units sold has been negative since June 2021. Unit sales dropped to 65,000 in February. We expect that rising rates will make housing less affordable and unit sales will continue to fall. See page 3.

New home unit sales, including multi-family, single-family and condominiums, were 772,000 in February, a 6% decline from a year earlier. However, while unit sales are slipping, prices are rising, and the average price of a new single-family home rose 25% YOY to $511,000. The median price of a single-family home rose 10.7% YOY to $400,600. These price gains are significant. When we index personal income and home prices to a baseline like 1973 it becomes clear that from 2008 to 2021 personal income was consistently rising faster than home prices. That made homeownership more affordable. Sadly, this changed in 2022 and prices are now rising faster than personal income, and this is one reason homeownership may become more challenging later this year. See page 4.

GDP growth requires rising capital investment, and we fear housing may face a slowdown in the second half of this year. Residential construction spending was $50.3 billion (SAAR) in December, a solid 15.3% YOY increase, although a deceleration from the 31.8% YOY increase recorded at the May 2021 peak. At present, the residential construction market appears solid, but home builder confidence has been slipping in recent months. The National Association of Home Builders survey for single-family sales showed that “expectations for the next six months” fell to 70, the lowest level recorded since September 2019. In general, the survey shows that homebuilder confidence peaked in November 2020 and has been slowly declining since that time. Builders are indicating that pricing pressures and the knowledge that mortgage rates will be rising as factors that make them uncertain about the future. See page 5.

The Yield Curve

The 10-year note yield rose from 2.16% to 2.41% this week yet despite rates rising on the long end, fears of an inverted yield curve are escalating. In our view, an inverted yield curve requires inversion between the fed funds rate and the 10-year Treasury note yield to truly warn of a recession. Moreover, inverted yield curves have historically preceded recessions by six to twelve months, on average, and therefore the angst regarding an inversion today appears to be overdone and too early, in our opinion. However, given the expectations of seven to nine fed fund rate hikes this year, the risk of an inverted yield curve, and a recession in 2022, is a possibility. But keep in mind that the Fed has control over the short end of the curve, but not the long end of the curve. When investors believe the Fed has tightened too much, and a recession is at hand, this is when the long end of the curve collapses and the curve inverts. At present, interest rates are rising on the long end, and we find this a bit reassuring. See page 7.

Technical Indicators and Charts

The major head-and-shoulders top formation that we have been discussing in the S&P 500, that had downside targets of SPX 4000 and SPX 3800, was nullified this week by the advance seen in the SPX. The index rallied above all its moving averages, including the 200-day moving average, which is a positive for the overall market. See page 8.

In terms of technical strength, the SPX displayed the greatest price momentum in recent days. The DJIA also rallied and has edged above key resistance at the DJ 35,000 area. But we believe the DJIA needs to sustain this advance to demonstrate that this is not a false breakout. The Nasdaq Composite has moved up toward its resistance level defined by the combination of its 100-and 200-day moving averages, but it lags its counterparts and is yet to breach this resistance. See page 9.

The charts of the Russell 2000 index (RUT – $2133.10) and Amazon.com (AMZN – $3386.30) continue to look similar and since they were leaders at the top of the market it is also possible that they will be leaders at establishing a low in equities. AMZN is clearly outperforming the RUT; but the RUT is unfortunately the weakest of all the main market indices. It is about to test its 100-day moving average at 2143.85 and 200-day moving average at 2197.08 and we will be watching to see if this index can better resistance. Even so, while the SPX and DJIA have surpassed their respective resistance levels, further gains are required to confirm that these moves are indeed “breakouts” from resistance and not merely a short-covering rally and portfolio window dressing. See page 10. Our 25-day up/down volume oscillator is at 2.38 this week and close to an overbought reading above 3.0. An overbought reading would be surprising and suggest that the market is in a long-term trading range, not a bear market. The 10-day averages of new highs and lows are 133 and 177, respectively. Again, the combination implies a neutral market. Overall, we remain cautious for the near term.

Gail Dudack

Click to Download

Current Reuters headlines include: “Russian strikes turn Mariupol into ashes of a dead land,” “Russia trades barbs at the UN with the US and UK about chemical weapons in Ukraine,” “Traders warn of Russia-related diesel and gas shortages in Europe,” “Fed policymakers lean into bigger rate hikes to fight inflation,” “Biden’s Supreme Court pick Ketanji Jackson defends representing Guantanamo detainees,” “Hackers hit authentication firm Okta (customers include FedEx and Moody’s Corp.),” and “Biden approval rating drops to a new low of 40% – Reuters/Ipsos poll. ” These headlines include a wide range of topics, yet each is individually disturbing. Nevertheless, this is the backdrop for what has been a healthy rally from the March lows.

The rebound has been greatest in technology stocks as seen by the 12% gain in the Nasdaq Composite index, as compared to the gains of 6.7% or 8.1% seen in the Dow Jones Industrial Average or S&P Composite index, respectively. However, the “outperformance” of technology should be expected since it has been the high PE stocks within the technology sector that have declined the most from all-time peaks made over the last five months.

The question, therefore, arises whether the current rally indicates the lows have been found, or if it is simply a short-term rotation of leadership from value to growth, i.e., a bounce within a larger bear market decline. In our opinion, the bear market has not ended even though it is possible that many stocks may have found their lows. Nonetheless, the landscape ahead remains treacherous, and we remain wary. Not only does the future include a hawkish Fed, but the risk of war in Europe, defaults of Russian sovereign debt, a consumer burdened by rampant inflation leaving little discretionary spending after transportation and food expenses, and therefore, a downside risk for earnings.

We have long been of the opinion that equities needed a valuation adjustment due to high inflation spurred on by too much monetary ease. And while equity prices were peaking before Russia invaded Ukraine, the war only exacerbates the existing problems. It translates into tremendous geopolitical uncertainty in the months ahead, and also means that diminished supplies of energy and grain will make the inflationary problem more severe. In short, if equities were facing a bear market in 2022; it is now worsened by the Russian invasion. This is a complex situation for a Federal Reserve, particularly since they were already slow to curb inflation. Strategists are now forecasting several 50 basis point rate hikes by the Fed and the Fed’s own dot-plot implies the fed funds rate will reach 2.8% by 2023. The sum of all this points to the risk of stagflation, the possibility of an inverted yield curve, and/or recession by the end of the year.

Valuation

In our view, the earnings results for the first quarter and the comments made by companies about earnings prospects for the full year could become a market-moving event. If companies are optimistic about earnings, it will provide fundamental support for equities. If not, pessimism could generate another selling wave. Keep in mind that our valuation model for 2022 indicates that the appropriate PE multiple is 15.8 times earnings, which also happens to be the average trailing PE over the last 75 years. In our view, this is where value is found in the broad equity market. A 15.8 multiple with our $220 earnings estimate for this year equates to a downside risk to SPX 3475. The S&P 500 may not have to fall this far, but to date, we do not believe the lows have been made.

Technically Speaking

From a technical perspective, all the indices have rebounded above their 50-day moving averages, which is well within the characteristics of a bear market rally. More importantly, the 100- and 200-day moving averages are trending on a path that suggests they may soon converge in the indices. If so, this converging will define important resistance points in the near term. In the Dow Jones Industrial Average, the 100-day moving average is 35,145 and the 200-day moving average is at 34,975, implying that the DJIA 35,000 area will be a critical level for the intermediate-term. See page 9. One hopeful sign is found in the S&P 500 index where the move above the 200-day moving average has the potential to negate the major head-and-shoulders top formation we have discussed in recent weeks. If the index betters the 100-day moving average, which is now at SPX 4550, this will help to neutralize this bearish pattern. See page 8.  

Economic Trends

Recent economic releases should be analyzed with the knowledge that the numbers preceded the Russian invasion of Ukraine, the Fed’s first rate hike, and statements by board governors that the FOMC may become more hawkish in coming months.

On a seasonally adjusted basis, retail sales for February rose 0.3% month-over-month and 17.6% YOY. It should be noted that gas station sales rose 5.3% for the month and 34.6% YOY, which is the impact of higher gasoline prices. When auto and gasoline sales are excluded, retail sales fell 0.4% in the month, but still rose 15.8% YOY. The more interesting tidbit in retail sales data showed that February’s unadjusted retail sales fell 1.55% YOY; however, February or March tend to be the seasonal low point for retail sales. This means that March and April releases should be more revealing about the current status of household spending. See page 3.

The National Association of Home Builder confidence index fell from 81 in February to 79 in March, which marked the third consecutive month of declines. The sharpest decline in sentiment was seen in “sales expectations for the next six months” which fell from 80 to 70, the lowest reading since June 2020 during the pandemic. The pending home sales index is reported with a lag, but the January index fell to 109.5, its third consecutive decline and the lowest level seen since April 2021. Given the NAHB readings, we expect pending home sales will continue to fall. See page 4. Existing home sales for February were an annualized rate of 6.02 million, which was a 7.2% decline for the month and decline of 2.4% YOY. The weakest segment of the market was the northeast where sales were down 11.5% for the month and down 12.7% YOY. Nevertheless, the median sales price of a single-family existing home was $363,800, a gain of 15.5% from a year earlier. See page 5. The housing market will be one of the most important areas of the economy to monitor in the months ahead. Interest rates are clearly headed higher, but inventories remain low, and prices are steady. Wages are increasing, and this could offset some of the increase in housing costs. Still, there have been anecdotal stories of millennials who recently purchased homes but underestimated the cost of maintenance, taxes, and heating. In our opinion, all signals point to a slower housing market in the second half of 2022. And if rates rise quickly, the housing market could come to a quick halt. This will be a drag on GDP and will again, make the Fed’s job of taming inflation without throwing the economy into a recession all the more difficult. We remain cautious.   

Gail Dudack

Click to Download

The big event of the week will be the Federal Reserve meeting and Chairman Jerome Powell’s commentary since monetary policy is expected to change for the first time in two years. The fed funds rate is expected to rise 25 basis points to a range of 25 to 50 basis points on Wednesday, and this will be the Fed’s first interest rate increase since December 2018. The shift is meaningful, but widely expected and fully priced into stock prices, in our opinion.

But while the Fed may be the media focus on Wednesday, the day is also notable for the fact that Russia has a $117 million payment due on US dollar-denominated Eurobond coupons. This will be the first of several key payments due on Russia’s sovereign debt in coming months and the first since the Fitch rating system downgraded Russian debt to a “C” rating, indicating that a sovereign default is imminent. Most economists now expect Russia to default since it has become the pariah of the Western banking world. Following Russia’s invasion of Ukraine many countries froze Russian reserves of dollars and euros held at banks and this crippled Russian liquidity and will make payment difficult. However, a nonpayment usually initiates a notice of a 30-day grace period to the issuer before defaults are officially triggered. Still, it will be interesting to see how Russia responds to this week’s likely default since it is apt to be the first of many. Several more payments will be coming due in the weeks ahead and we will be watching to see if these defaults have unexpected consequences. Russia’s debt is not large enough to worry about a major banking crisis, but it could result in some unexpected private losses.

To a large extent, the only response to Russia’s invasion of Ukraine have been economic sanctions by the US and other NATO nations. Therefore, a sovereign debt default may be the first of many tests of how well Russia and its economy can weather the sanctions from the West and still continue to wage a costly war in Ukraine.

Oil and Interest Rates

The stock market rose ahead of this week’s FOMC meeting but this rally could have been due to a variety of factors. First, the price of WTI crude oil ($95.15) dropped $28.50 this week after jumping $20 last week. This decline was a welcomed event however, the technical chart of the WTI future shows it still remains above all its key moving averages and remains in an uptrend. Keep in mind that crude oil ended the year at $75 which means it is up 27% year-to-date, despite this pullback. See page 8.

We think the most interesting chart of the week is the 10-year Treasury note yield, which rose from 1.82% to 2.16%. This 34 basis-point jump, ahead of the Fed meeting is somewhat consoling since it reduces the immediate risk of an inverted yield curve, but we are curious about the move since it did not appear to be linked to “economic strength.” The risk of an inverted yield curve in 2022, and of a recession, continues to be significant in our opinion. In short, we believe this week’s equity rally is best for traders. Unfortunately, the problem that inflation brings, its impact on consumers, investors, profit margins, the Fed and PE multiples will not go away any time soon.

There will be a number of key economic releases this week including retail sales as well as industrial production, housing data, and construction spending. However, all this data will be for the month of February and will not include the impact the Russian invasion may have had on the American public. History suggests that wars tend to be good for the economy, but this is mainly true for the industrial sector. The US is a consumer-led economy and wars can have a negative impact on consumer psyche and consumer spending, particularly when the price of gasoline and food is rising rapidly.

Inflation

Headline inflation rose from 7.5% to 7.9% in February and core CPI rose from 6.0% to 6.5%. These numbers indicate that inflation continues to be a plague on the economy. Energy sector prices are the biggest issue, up 25.6% YOY in February. Nevertheless, inflation has become well-ingrained in the economy and all but 6.4% of the CPI weighting is rising well above the Fed’s target of 2%. See page 3. Transportation costs were up 21% YOY in February, the highest since early 1980.

As we anticipated, housing, which is 42.4% of the weighting of the CPI are now rising. Housing costs did not begin to rise until recently and had been a nice offset to rising fuel cost. But the housing sector saw prices up 5.95% YOY in February, the highest since early 1982. The worrisome issue is that housing costs are now accelerating dramatically and are adding to the inflation problem facing households. See page 4.

Producer price indices were also released this week and they show little signs of decelerating. The PPI for finished goods rose 13.8% YOY in February versus 12.5% YOY a month earlier. The core PPI for finished goods rose 7.7% YOY versus 7.0% in January. Only PPI final demand displayed any sign of stabilizing and was unchanged at a disturbingly high rate of 10.1% YOY. See page 5. The pace of inflation is a big concern, and it is now the steepest jump in prices since the OPEC oil embargo imposed on the US in 1973. The embargo in 1973 was related to the Arab-Israeli War and was imposed by OPEC when the US supplied Israel with military support. Note the US dependence on foreign oil and the impact this has on geopolitics. We find this to be a disturbing parallel in many ways.

The rise in inflation has now created a spread between the fed funds rate and inflation that is even larger than that seen in 1973. As we have often noted, the Fed’s failure to reduce monetary ease early last year to stem the growing tide of inflation, has now created a major problem. Our view of the number of fed funds rate hikes this year is evolving. It is likely that inflation will dampen consumption, weaken profit margins, and slow the US economy in 2022. The Fed must now balance between inflation and the risk of sparking a recession. It is a difficult decision.  

This risk is visible in sentiment indicators. The University of Michigan consumer sentiment index fell to 59.7 in March, a new cyclical low. The NFIB Small Business Optimism Index decreased by 1.4 points to 95.7 in March, the second consecutive month below the 48-year average of 98. Twenty-six percent of owners surveyed reported that inflation was their single most important problem in operating their business. This was a four-point increase since December and the highest reading since the third quarter of 1981. Not surprisingly, hiring plans fell from 26 to 19 in March. See page 6.

Little has changed in the technical area although the S&P 500 index has joined all the other indices in confirming a “death cross.” A death cross occurs when the 50-day moving average falls below the 200-day moving average and it is a negative configuration. But since a death cross tends to happen midway or late into a bear cycle, we do not find that meaningful. Still, we do not believe the lows have yet been found. Neither technical nor fundamental guidelines give us comfort this week, and both sets of indicators suggest there is more downside risk in the market. The safest equity sectors in the current environment are energy, staples, defense-related and companies that are insulated from inflation and have dividends greater than 2%. But we do believe a long-term opportunity to buy technology stocks is on the horizon.

Gail Dudack

Click to Download

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

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

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

Fundamentals are not encouraging

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

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

Energy

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

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

Technical Death Crosses

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

Gail Dudack

Click to Download

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

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

Fundamental Perspective

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

Technical Perspective

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

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

Federal Reserve Policy

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

Sector Shifts

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

Gail Dudack

Click to Download

Summary

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

Valuation

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

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

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

Gail Dudack

Click to Download Charts