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

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

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

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

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

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

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

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

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

Gail Dudack

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

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

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

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

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

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

Markets and Technicals

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

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

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

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

Gail Dudack

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

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

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

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

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

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

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

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

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

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

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

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

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

Gail Dudack

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China’s Property Sector

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

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

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

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

Assessing the Technical Backdrop

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

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

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

Economic Roundup

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

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

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

Gail Dudack

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Quantitative Easing

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

Earnings Backdrop

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

Technical Challenges

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

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

Economic Data and the Fed

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

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

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

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

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

Gail Dudack

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Third Quarter Earnings

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

Driven by Inflation

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

Overriding Economic Worries

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

Technical Changes

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

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

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

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

Setting the Stage

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

A Housing Bounce

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

Gail Dudack

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

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

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

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

Not All Records are Good

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

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

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

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

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

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

Gail Dudack

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

Earnings

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

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

Monetary Policy

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

Geopolitical Backdrop

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

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

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

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

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

Gail Dudack

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Raising S&P Earnings Estimates

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

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

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

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

Inflation is a tax on consumers and investors

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

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

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

Technical Update

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

Gail Dudack

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

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

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

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

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

Economic News

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

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

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

Technical Update

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

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

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

Gail Dudack

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