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

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

Black Swan or Inevitable

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

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

Assessing Downside Risk

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

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

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

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

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

Valuation Benchmarks

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

Gail Dudack

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

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

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

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

Inflation Woes

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

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

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

Monitoring Yield Curves

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

Technical Indicators

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

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

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

Gail Dudack

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

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

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

Inflation is the domestic threat

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

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

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

Valuation readjustment

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

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

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

Technical update

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

Gail Dudack

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

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

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

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

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

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

The Good News

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

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

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

Economic Releases

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

Technical Review

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

Gail Dudack

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

Valuation Model: The inputs

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

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

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

Valuation Model: Inflation

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

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

Calculating Downside Risk

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

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

Oh, my Russell

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

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

Gail Dudack

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

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

Reverberations

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

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

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

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

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

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

Technical Charts and Indicators

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

Gail Dudack

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

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

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

January and Liquidity

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

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

Obstacles

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

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

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

FANG stocks

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

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

Gail Dudack

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

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

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

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

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

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

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

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

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

Gail Dudack

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

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

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

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

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

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

Households Balance Sheet and Sentiment

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

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

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

Gail Dudack

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Technical Indicators Revisited

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

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

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

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

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

Economic Data Shows Growth but Too Much Inflation

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

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

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

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

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

Gail Dudack

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