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

Gail Dudack

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

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

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

Fed Policy Is Pivotal

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

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

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

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

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

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

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

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

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

A Mix of Economics

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

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

Earnings and PE Multiples

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

Market Data

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

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

American Families Plan

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

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

Capital Gains Tax Hikes

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

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

Housing is On a Roll

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

Earnings on a Roll

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

Technical Indicator Review

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

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

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

Inflation Can Bite

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

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

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

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

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

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

New 2022 S&P Earnings Estimates

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

Technical Update

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

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

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

Similar but Different from 2000

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

Too Dangerous to Short

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

Consensus 2022 Hits $200

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

What Could Upset the Apple Cart?

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

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

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

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

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

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

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

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

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

Adjusting our Earnings Estimates for 2020 and 2021

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

Economic Reports

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

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

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

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

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One of the first warnings signs of the year was the rise in bullish sentiment reported by the Association of American Individual Investors (AAII) in their weekly survey. In the first week of 2021, bullish sentiment rose from 46.1% to 54.0% which means bullish sentiment has remained above the historical average of 38% for nine consecutive weeks. Bullish sentiment is also at its highest level since the November 11, 2020 reading of 55.8% which was a 12-month high. An early preview to current data suggests bullish sentiment may increase again in the current week. Nevertheless, the 8-week Bull Bear spread is negative for the second week in a row which is similar to the warning seen in early 2018. See page 18. As a reminder, 2018 was a roller coaster year of big price swings that ended with a loss of 5.6% in the Dow Jones Industrial Average and 6.2% in the S&P Composite.

It is important to keep in mind that sentiment indicators are not useful for timing market peaks or troughs, however they do provide good discipline for investors who may become too optimistic or pessimistic about equities. With bullish sentiment above 50%, investors should remain alert to other signs of risk in the markets. Nevertheless, most technical indicators are confirming the indices’ recent highs. The NYSE cumulative advance decline line made an all-time high on January 12, the 10-day average of daily new highs is robust at 433 and the 10-day average of daily new lows is 28, and well above the 10 or less per day that can appear at the end of a major advance. The one ambivalent technical indicator is the 25-day up/down volume oscillator which is currently neutral at 1.52. This oscillator was in overbought territory for 16 of 19 consecutive trading days between November 23 and December 18 and reached an extreme overbought reading of 5.52 on December 4. This combination was a solid confirmation of the new highs seen at year end. But if we see further gains in stock prices in 2021, we would also like to see an overbought reading to show that price gains are supported by solid buying pressure. See page 11, 12 and 13.

Last week we noted the favorable signal emanating from the Santa Claus rally given the gain during the last five trading days of the year and the first two trading days of the new year. The January Barometer, devised by Yale Hirsch of the Stock Trader’s Almanac in 1972, is another Wall Street adage that states “as goes January so goes the year.” This parable makes sense to us since liquidity, or cash, tends to at its best early in the year as a result of year-end tax-loss selling, year-end bonuses and annual funding of pension funds and IRA’s. History also suggests that the first five trading days of January predicts the month of January. On page 7 we show the performance history of the Dow Jones Industrial Average during the first five days of January, the month of January and the full year beginning in 1950. It indicates that the first five trading days of January has predicted the year’s action 79% of the time. However, the January Barometer has an even more impressive 95% accuracy in predicting the full year’s action if, and only if, January has a positive performance. The Barometer is less accurate when January ends with a loss. As the table shows, there have been 24 instances of losses in early January, 14 years with losses in the full month of January, and eleven years of negative performances for the full year. In short, January losses are far less predictive. But to date, the 1.6% gain in the first five days of January 2021 bodes well for the month and for the overall year. See page 9.

Anyone Focusing on Jobs?

The ISM manufacturing index increased from 57.5 to 60.7 in December, with most components, except for trade, also rising. Prices paid soared from 65.4 to 77.6. We remain nervous that inflation could be a big risk for equities this year. The nonmanufacturing index rose from 55.9 to 57.2 in December, but the employment index fell from 51.5 to 48.2. With the employment index below the 50 breakeven point, it suggests job growth in the service sector may weaken in coming months. See page 3.

The loss of 140,000 jobs in December did not surprise us given the extended shutdowns of businesses in states like New York and California; so, we are encouraged that Governor Cuomo appears to be ready to ease some restrictions. Still the risk of lengthy shutdowns is that businesses and entrepreneurs have been and will continue to face bankruptcy, which weakens the economy, and foreshadows more jobs losses. In December, the number of people employed was down 6.2% from a year earlier. Typically, any negative growth rate in employment suggests the economy is in the midst of a recession. The US economy has been buoyed by extraordinary fiscal and monetary stimulus for much of 2020, but stimulus cannot solve all problems. The unemployment rate in December was unchanged at 6.7%, but this is still well above the 3.6% seen in December 2019. Plus, when we look at the breakdown of unemployment, we find it is not evenly distributed. Those hurt the most in 2020 were workers with less than a high school degree which means households in the lower end of the job market remain under the greatest pressure. This dilemma is linked to the closure of food and drink establishments, hotels, and all employees tied to business and leisure travel. In our opinion, a weak job market will be another risk factor for the economy, earnings, and investors in 2021. Strangely, politicians seem focused on other matters and are ignoring this fact. See pages 4 and 5.

Small Business Confidence is Crumbling

Entrepreneurs and small businesses were feeling the impact of the pandemic at the end of 2020. The NFIB small business optimism index fell 5.5 points in December to 95.9 and all components with the exception of inventory satisfaction were lower. Owners expecting better business conditions over the next six months plummeted 24 points to a net negative 16. Sales expectations for the next three months fell 14 points to a net negative 4. Hiring plans fell 4 to 17, which was down but only to the lower end of the range seen over the last three years. This survey makes it clear that small businesses are concerned about their future in 2021.

The two areas of strength in the 2020 rebound have been housing and auto. Existing home sales were fairly robust at 6.69 million (SAAR) units in November, down slightly from October, yet up nearly 16% YOY. New home sales were 841,000 in November which was down from 945,000 units in October, but still up 21% YOY. The one warning sign we see for homebuilders is the pending home sales index which fell for the third consecutive month in November to 125.7. See page 7.

Earnings Forecasts are Stabilizing Consensus earnings estimates were revised significantly lower at year end but edged up slightly last week. S&P Dow Jones estimates rose $0.20 for 2020 and $0.17 for 2021 while IBES estimates rose $0.13 for 2020, $0.36 for 2021 and $0.37 for 2022. The S&P Dow Jones and IBES estimates for 2020 are $120.54 and $135.79 and for 2021 they are $164.57 and $167.61, respectively. Keep in mind that PE multiples have expanded dramatically in the last twelve months due in large part to low interest rates and indications from the Federal Reserve that monetary policy will not change before 2023. However, our valuation model indicates that the current low inflation/low interest rate environment translates into a 20 PE multiple. If we apply a 20 PE to the IBES $167.61 estimate for this year it implies a target for the SPX of 3352. In other words, the SPX has a 12% downside risk should optimism regarding earnings, the economy, interest rates or inflation change in the near term.

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The 2020 gains in the popular indices are remarkable, yet surprisingly disparate. The Dow Jones Industrial Average is up 5.8% year-to-date. The S&P 500 has done somewhat better with a 14.4% gain. A sharp end of the year advance in small capitalization stocks drove the Russell 2000 to a year-to-date gain of 17.5%; however, it is the technology-laden Nasdaq Composite that is this year’s hard-to-beat champion with a 40.4% year-to-date gain. The Nasdaq’s performance has been extraordinary in 2020 and we would note that some bull market cycles do not experience a 40%+ gain and over the last 90 years the average gain in the S&P 500, prior to a 10% correction, has been 58%. Perhaps more significant is the fact that this 40.4% gain is nearly seven times the advance in the Dow Jones Industrial Average for the same time period. Since the March 2020 lows, the Dow Jones Industrial Average and S&P 500 have rebounded 62% and 65%, respectively. After recording fresh new highs this week, the Nasdaq Composite and the Russell 2000 have rallied 84% and 95.5%, respectively off those lows. It has been a spectacular year for investors, particularly since it also included the worst recession since the Great Depression and a bear market in earnings.

Investors have written off 2020 earnings and instead focused on the projected rebound in 2021 earnings. But even so, the stock market is not cheap. It is pretty clear that third quarter earnings estimates were better than expected but with third quarter earnings season practically complete, estimates are now stabilizing. In the week ended Friday, IBES consensus estimates rose $0.12 for 2020, $0.33 for 2021 and $0.43 for 2022. S&P Dow Jones consensus estimates were relatively unchanged and increased $0.05 for 2020 and $0.01 for 2021. Overall, the consensus estimates for 2021 are currently $169.18 for IBES and $166.20 for S&P Dow Jones. If one applies a 20 multiple to the IBES $169.18 forecast, it equates to an SPX target of 3384 for yearend 2021. The stock market is currently 8.5% above this target. While it is possible that earnings could outperform 2021 estimates, it seems the market has already factored positive earnings surprises in to current prices. More specifically, at SPX 3695, the 2021 year-end forecasted PE ratio for the S&P 500 is 22.2 X. The trailing operating PE ratio is 30.6 X which is higher than the June 1999 peak multiple of 29.3 X and the December 2001 peak multiple of 29.6 X.

Liquidity Wins
While we are worried about rich fundamentals, it is clear that the stock market is being driven by liquidity and as we have often noted it is not wise to “fight the Fed.” However, the market is priced for perfection, could be vulnerable to unexpected shocks and caution is warranted. As noted in previous weeks, some of our long-term indicators suggest that the market is apt to underperform over the next twelve-month period. However, this “underperformance” does not mean 2021 is destined to be a boring market. The new year could be an unusually volatile time including at least one big advance and a large decline. If so, investors should stay alert. It is wise to have stocks in one’s portfolio that can weather the volatility ahead and/or are good long-term holdings for good and bad times.

Assessing Debt and Ownership
Given our concerns about a liquidity driven market we are focused on factors that help define an equity bubble such as leverage, debt, and equity over-ownership. The Federal Reserve released financial data last week for the third quarter and it held few surprises.

Federal Debt Levels are Worrisome
Total outstanding US debt was a record $59 trillion in September, up from $53.9 trillion at the end of 2019. US debt represented 280% of nominal GDP in the third quarter, is up from 248% at the end of 2019 and is greater than the previous record of 273% of GDP recorded in 1933. See page 3.

Federal government debt grew at an annualized rate of 11.4% in the first quarter, 59% in the second quarter and 9.1% in the third quarter. It was a record $22.5 trillion in September and jumped from 87% of GDP in June to 106.3% in September. This compares to the record 110.3% of GDP recorded in 1944. Rising government debt is not a surprise given the fiscal stimulus provided during the shutdown; however, they are concerning when put into an historical perspective. See page 4.

Household debt is the second largest sector after the federal government, and it grew 5.6% in the third quarter due to an escalation in mortgages. The household’s total debt was nearly $16.2 trillion in September and represented 76.5% of GDP. However, this percentage is well below the 98.2% of GDP seen at the end of 2008 prior to the financial crisis in mortgages. In general, household debt has been fairly contained in 2020. The financial sector is also in good shape and its $17.3 trillion in debt represents 81.9% of GDP and is well below the 2008 peak of 123.7%. A healthy banking system is important for the overall economy and so is a financially stable household sector. Corporate debt actually declined in the third quarter after double digit growth in the first two quarters of the year. See pages 5 and 6. All in all, there were few surprises in this year’s debt accumulation, most of which has been due to fiscal spending. Our main concern for federal deficits would be sharply higher interest rates which would compound federal deficits going forward.

Stock Ownership Helps Net Worth but Needs Monitoring
The Federal Reserve also released household net worth and equity ownership data last week. After increasing a solid 12% in 2019, household net worth increased 4.4% in the first three quarters of 2020 to $123.5 trillion. In 2019, the increase in household net worth was due primarily to a 27.5% increase in equity holdings. In 2020 the increases in household net worth were a combination of a 16.6% increase in cash, due in large part to fiscal stimulus, and a 5.5% increase in tangible assets, primarily real estate. Equity holdings only increased 3.3% in the nine months ended September. This may be surprising to some, but remember, in the first nine months of the year the SPX gained 4.1% and the DJIA lost 2.7%. In short, it was a dull first three quarters. But we expect stock market gains will boost household net worth in the fourth quarter.

We are closely watching the relationship between equity and real estate ownership within the household sector. It is normal for residential real estate, or a home, to be a family’s main asset and thus represent the main pillar of net worth. But in the third quarter, the household sector showed equity holdings of $35.6 trillion, an amount that easily exceeded real estate holdings of $31.2 trillion. Since 1952, there have only been four other quarters in which equity ownership was greater than real estate ownership. These were the fourth quarter of 2019, the third quarter of 2018, the first quarter of 2000 and the fourth quarter of 1999. Each of these previous quarters were followed by sharp stock market corrections. More important, the two back-to-back quarters of high equity ownership in late 1999 and early 2000 represented the end of the 1997-2000 stock market bubble. See page 8. This is a worrisome precedent. We are also watching for extreme levels of equity ownership relative to total assets which could represent a saturation of demand. This can be measured as equities as a percentage of total assets and/or as a percentage of financial assets. In the third quarter, equities were 25.4% of total assets versus the 2000 peak of 26.4%. Equities were 22.6% of financial assets versus the March 2000 peak of 24.2%. Given the rally seen in equities in recent months, these percentages are apt to increase in the fourth quarter. In short, it is possible that equities are approaching an over-ownership situation. See page 9. In sum, the current advance has excellent momentum, but be alert to any and all pitfalls.

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We focus on three issues this week. The first is that technical indicators have finally and whole-heartedly confirmed the current advance. The second is that even though third quarter earnings estimates are beating expectations, it has little relevance to a market that has been focused on 2021 forecasts since March. Based on 2021 earnings estimates, equities are priced for perfection and this is certainly a cause for concern. And third, recent data releases are defining a pattern of economic deceleration. This is also worrisome. This combination of deteriorating economics/fundamentals and strengthening price action can only be explained by the fact that liquidity is driving the equity market.

Several indicators that we monitor suggest the market is likely to underperform over the next twelve to eighteen months. But bear in mind that this does not mean 2021 is destined to be a boring market. It is more likely that 2021 could contain several bull and bear market cycles that result in little gain in the end. Investors should prepare for an unusual environment and adjust portfolios so that they can weather extreme volatility.

Economic data for November was generally disappointing. The unemployment rate declined in November to 6.7% from 6.9%, but this was due in large part to the decline in the civilian labor force. The addition of 245,000 new jobs was less than expectations and perhaps the biggest letdown was the decline in the employment population ratio from 57.4 to 57.3. The participation rate also fell from 61.7 to 61.5. In short, the percentage of the population that is employed and working is declining. See page 3.

Jobs are key to the economy. They are the most critical component of household income, personal consumption, corporate revenues, and earnings. Therefore, the steady shift of workers from temporary layoff to being permanently unemployed is disturbing. See page 4. In our opinion, the absence of CDC guidelines that would allow businesses to safely open coupled with the lack of urgency seen in Congress to pass fiscal stimulus that would support small businesses is unconscionable.

In our view, the best way to assess the job market is to monitor the growth rate of “employment” over a 12-month period. A decelerating rate that approaches zero will predict a pending recession and a recession begins when this growth rate turns negative. But a pivot in the growth rate often defines a recovery. From this perspective, the job market was arbitrarily shut down so there was little warning for this unusual recession. However, the employment low was made in April with a negative 13.5% growth rate and has been improving ever since. But November’s growth rate was still poor at negative 6%. Meanwhile, the pace of those unemployed 27 weeks or longer continues to rise and currently resembles the pattern seen in early 2009! See page 5. These statistics suggest household consumption is apt to decline in the first quarter. If so, earnings could also disappoint.

The ISM indices are good benchmarks for assessing the strength of both the manufacturing and service sectors of the US economy. However, both ISM indices declined in November and both surveys pointed to weakness in new orders and general business activity. See page 6. The NFIB Small Business Optimism Index fell from 104.0 in October to 101.4 in November which was worse than expectations. The most revealing part of the survey was that the net share of respondents expecting the economy to improve dropped from 27% to 8%. This was a perfect example of how the current number of COVID-19 cases and the accompanying restrictions are hurting small businesses and dampening sentiment.

Autos and housing have been the core of the 2020 rebound, yet both weakened in November. Total vehicle unit sales fell from 16.74 million to 15.97 million units in November and all segments of the industry showed a decline. For the second month in a row the pending home sales index fell. October’s index fell to 128.9, down from the August peak of 132.9. See page 7.

Under normal circumstances, third quarter earnings results for the S&P 500 would make us bullish, but these are far from normal times. As of December 4, 496 companies in the S&P 500 Index had reported third quarter 2020 earnings. And of these, 84.5% reported earnings that were above analysts’ expectations and 12.3% reported earnings below expectations. In a typical quarter, 65% of companies beat and 20% miss estimates. Even more impressively, companies have reported earnings that are 19.7% above estimates. This is dramatically better than the 26-year average surprise factor of 3.5% and the last four quarter average of 8.7%. In addition, more than 78% of reporting companies exceeded revenue expectations and beat forecasts by 3.6%. This compares to the long-term average surprise factor of 1.5%. Not surprisingly, the estimated earnings growth rate for the S&P 500 in the third quarter is now negative 6.1% and much improved from the July 1 consensus forecast of a 25% decline. If the energy sector is excluded, the third quarter growth rate improves to negative 1.9%. Earnings growth forecasts improved for all sectors in the third quarter, but the greatest improvement was in consumer discretionary which flipped from an expectation of a 50% decline in year-over-year earnings growth to positive 0.8% currently. However, despite all this good news for the quarter, IBES consensus estimates for 2021 are relatively unchanged at $168.85. A PE multiple of 20 times next year’s earnings equates to an SPX target of 3377, or 9% below recent closing prices. See page 10.

At SPX 3702, the trailing operating PE is 30.6 X and remains higher than the June 1999 (29.3 X) and December 2001 (29.6 X) peaks. The 12-month forward PE ratio for the SPX is 22.3 X. Both benchmarks are well above their standard deviation lines and the SPX is now trading more than 13% above the top of our valuation model’s year end 2021 fair value range. See page 11. High valuation suggests the market is vulnerable to unexpected shocks and this suggests caution is warranted.

But in direct contrast to this the popular indices continue to set a series of record highs and our technical indicators are finally confirming the advance. In particular, the 25-day up/down volume oscillator is currently 5.02 (preliminary), above 3.0 and has been in overbought territory for six consecutive trading days and for nine of the last eleven trading days. The oscillator reached a reading of 5.52 late last week which was the strongest reading since February 2019. It is our contention that new price highs in the indices should be accompanied by long and often extreme overbought readings which represent solid buying pressure. After a lengthy delay, this oscillator has finally confirmed the new highs. See page 13. And most other breadth indicators followed suit. The 10-day average daily new high indicator is robust at 380 per day and the NYSE cumulative advance decline line made a simultaneous record on December 8 with the indices. See page 14. The AAII bullish sentiment index rose to 49.1% and the last 4 weekly readings are the highest since January 2020. But while the AAII bull/bear 8-week spread is quickly rising it still remains in neutral territory. See page 15.

There is one simple way to explain the discrepancy between the underlying fundamental and technical factors of the market and it is liquidity. Historically, there has been a strong correlation between easy monetary policy and stock market gains. M2 growth peaked at 19.6% in July but in late November it was still growing at a 6.6% pace. Demand deposits at commercial banks jumped in late November from $2.5 billion to $2.97 billion. In sum, remember the wise Wall Street adage “Don’t fight the Fed.”

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