With a little more than two months left to the year, few would deny that 2020 has been an unusual year. The turning point was the historic, unpredictable, and relentless spread of the COVID-19 virus from China to most other countries around the world. It is not the virus, but its aftermath that will have major repercussions for people, companies, and economic trends for years to come. Yet in the face of this challenge, the S&P 500 and Nasdaq Composite Index reached new highs in September and the DJIA, SPX and Nasdaq Composite are currently 4.2%, 3.9% and 4.5%, respectively, from all-time highs.

Some believe the rally in equities reflects a disconnect between the stock market and reality. But as usual, investors face a mix of positive and negative factors. Today is no different, even when putting the political backdrop aside.

The current negatives are obvious. The spread of COVID-19 resulted in mandatory shutdowns of businesses around the world. In the US, some businesses learned to adapt, and this created a division between winners and losers. But the bottom line is that the shutdown put 22.2 million people out of work between February and April, and 10.7 million of those remained unemployed at the end of September. Another negative is a resurgence of the virus in Europe which is generating a new round of restrictions such as curfews and limits on gatherings. This resurgence places a European recovery in the second half of the year on hold. Together, these two events create a third negative which is an enormous pressure on corporate earnings and an increasing risk of small business bankruptcies. As a result, the S&P 500 index is close to peak valuations on a trailing earnings basis and even when based upon forecasted 2021 earnings valuation remains at nosebleed levels. Added to these problems is the fact that the government is challenging the power and influence of the biggest technology companies with concerted anti-trust action. This week the Justice Department sued Google (GOOG.O – $1555.93) for illegally using its market strength to fend off rivals with distribution agreements that gave its search engine prominent placement on phones and internet browsers. Anti-trust action may prove beneficial to consumers in the long run, but in the shorter run it could pressure the big cap technology stocks that represent a large percentage of the SPX’s market capitalization. In short, it could hurt market performance.

The artificial shutdown of most economies was quickly followed by a series of policy measures to keep economies afloat. In short, the positives must begin with the extraordinary stimulative fiscal and monetary policies put into place around the world. As we have noted in the past, the combination of fiscal and monetary ease announced by the US totaled $5.5 trillion ($2.55 trillion in three fiscal packages and a $2.99 trillion expansion in the Fed’s balance sheet). This $5.5 trillion represents 28% of nominal GDP ($19.53 trillion at the end of the second quarter), or 3.4 months of economic activity. This stimulus went directly to consumers and businesses and it provided a safety net for the broader economy. In addition, another fiscal stimulus package is on the horizon, it is simply a matter of time and politics.

Yet, the biggest positive for investors is how well the economy is doing, particularly the tremendous strength in housing and autos. As of September, the NAHB single-family housing environment survey has recorded three consecutive months of record readings. Homeownership rates are surging in all regions of the US and reached 67.9% in the third quarter. This represents the highest homeownership rate since the 69.2% seen in 2004. See page 3. Residential building permits recorded a 10-year high in September and existing home prices have been moving steadily upward all year. See page 4. September’s retail sales rose 5.2% YOY overall and 3.9% YOY excluding motor vehicles and parts. Autos have been the brightest part of retail sales rising 10.5% YOY in September. Plus, September’s retail sales data included many bright spots in the economy with the exception of clothing, electronics and food and beverage establishments. The best part of all these statistics is that it all bodes well for third quarter GDP. See page 5.

Benign inflation is another positive for the equity market since low inflation is favorable for monetary policy, PE multiples and consumers. In September, the CPI rose 1.4% YOY, PPI finished goods fell 1.2% YOY, final demand PPI rose 0.5% YOY, crude oil fell 26% YOY and the PCE deflator gained 1.4% YOY. The decline in energy prices and positive spread between CPI prices and PPI prices is a favorable one for corporate margins. See page 6.

And despite negative US headlines, there is good news regarding virus trends. On October 20th, The NEW YORK TIMES ran a story including charts that showed “new COVID cases” are trending higher in October, but due to the substantial increase in the number of tests taken and diagnosed since early September. Most importantly, US deaths per day have held steady since early September at around 700. See page 7. In general, this implies the spread of the virus and its deadliness is slowly fading. Moreover, therapies for the virus have advanced dramatically in the last six months and a vaccine is expected early in 2021. Overall, we believe all this good news outweighs the bad.

We have noticed that both consensus earnings estimates for 2020 have had unusually large increases in recent weeks. See page 10. IBES indicated that of the 66 companies that reported third quarter earnings to date, 86% beat expectations. Therefore, 2020 consensus forecasts are apt to move even higher. However, stock prices have ignored 2020 and for the last six months have been trading on 2021 earnings. Unfortunately, the 2021 outlook remains uncertain and this brings us to the biggest unknown of 2020 — the election.

With less than two weeks to go and with early voting taking place at a record pace, election results remain highly uncertain. The polls give former Vice President Biden a sizeable lead, but the race continues to narrow. Statista reports that 55% of Americans feel they are better off than they were four years ago and most Americans, particularly Democratic voters, feel this election matters more than previous years. This is an interesting, but inconclusive mix. See page 8. In terms of the election, the market’s 3-month performance is showing a gain in the SPX of 5.3% and a gain in the DJIA of 7.1% to date. In past election years gains have foretold of an incumbent victory. On the other hand, one cannot be sure that 2020 is a “typical” year. See page 9.

Last but far from least, the charts of the broad indices and technical indicators have turned increasingly bullish in the last two weeks. All the popular indices rallied from important support levels that equated to their 100-day or 200-day moving averages and in particular, the Russell 2000 index began to outperform large cap indices. The advance/decline line reached a record high on October 12 and the new high list continues to expand. Our 25-day up/down volume oscillator is yet to reach a fully overbought reading, but it did record its highest reading earlier this week since August 2020. These are all supporting the bullish case.

We continue to have a long-term bullish bias but would expect the market to be choppy and trendless prior to the election. If there is no clear winner on election night, the uncertainty is likely to create even more volatility. This implies investors should be somewhat cautious near term and focus on companies that will perform well despite the virus and despite an uncertain political backdrop.

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A new week brought new worries for the stock market. Moods were already downcast after the passing of Supreme Court icon Ruth Bader Ginsberg. Throughout her illustrious career Judge Ginsburg was a leader, a role model for working women and a staunch fighter for women’s rights. On Tuesday Prime Minister Boris Johnson told the British people to work from home if possible and ordered restaurants and bars to close early to counter a second wave of COVID-19. Johnson stopped short of imposing another full lockdown, as in March, but warned that more measures might be imposed if the virus were not contained. Newswire headlines announced US deaths from coronavirus surpassed 200,000 but failed to mention that the trend in new cases and deaths has decelerated dramatically. President Trump spoke (on video) to the 75th annual UN General Assembly and fueled fears of a geopolitical tiff by chiding China for unleashing COVID-19 on the world and stating that China needs to be held accountable for the destruction the plague has wrought by all members of the UN. The US Food and Drug Administration is expected to announce higher standards for an emergency authorization of any coronavirus vaccine, lowering the chances that a vaccine might be cleared before the November 3 election. And last but far from least, the first presidential debate scheduled for September 29th at 8:30 pm EST is merely one week away. This debate could become a pivotal factor for the stock market.

We believe last Friday’s Wall Street Journal’s article comparing Joe Biden’s and President Trump’s tax proposals may have been a contributing factor to the stock market’s recent decline. With Biden leading in the polls it is important for all investors to assess the impact a Democratic victory could have on the US economy. There are many factors to look at, but this week we will simplify it to tax policy.

President Donald J. Trump’s Tax Plan
President Trump’s tax policies are well known. He enacted tax breaks for individuals and corporations in 2017 and wants to extend these tax breaks past their current 2025 end date. Trump made it easier for corporations to bring home foreign profits and to deduct capital investment costs. Trump is currently proposing to cut the capital gain tax rate from the current 23.8% to 15% or 18.8%. And he wants to expand Opportunity Zones which offer capital gains tax breaks for investments in low income areas.

Vice President Joseph Biden’s Tax Plan
The Wall Street Journal article noted that Vice President Biden’s spending plans exceed his proposed tax revenue, but Biden explains this as stimulus for the economy. The Biden plan would raise taxes on individuals and entrepreneurs making more than $400,000 a year and would raise the corporate tax rate to 28%, impose a new minimum tax on companies and raise taxes on the foreign income of US based multinationals. His plan also includes reinstating the individual mandate to purchase health insurance, which is the proposal included in Obama care that the Supreme Court ruled was a tax on citizens. Mr. Biden proposes to raise the top individual tax rate of 37% to 39.6%, expand the 12.4% Social Security payroll tax which currently exempts wages above $137,700, but would restart the tax again on wages above $400,000. The plan also repeals a 20% deduction for income from pass-through businesses and impose new limits on itemized deductions. Most importantly, Biden would raise the capital gains tax rate from 23.8% to 39.6%, but reportedly only on households with income greater than $1 million. Nevertheless, this is likely to weaken the stock market prior to the election since many investors are apt to take profits on long-held stocks to avoid the possibility of this tax hike in 2021.

Millennials should take heed of structural changes to capital gains rules that Biden is proposing that could significantly impact their inheritances. At present, heirs only pay income taxes on gains in equity value that materializes after the original owner’s death and only when they sell the stock. Biden’s proposal would tax all unrealized gains as capital gains at the time of death. This is unsettling. Unless an heir has considerable liquidity at the time of inheritance this structural change would require an heir to sell much of the portfolio in order to pay taxes, incurring more capital gains taxes and potentially losing a significant amount of the inheritance. The very wealthy may have lawyers and accountants that can find a way around this tax, but Middle America will bear the brunt of this change.

All in all, we find the Biden proposals to be dicey for equities. Raising the capital gains tax rate has historically lowered stock prices in the short run as investors rush to avoid the tax hike and it lowers demand for equities over the longer-term since it raises the bar for speculators. All in all, a Republican sweep suggests more tax cuts while a Democratic sweep would bring increases.

Keep Some Powder Dry
Nonetheless, economic data has been strong. Housing data shows existing home sales rose to 6.0 million units in August, a 10.5% YOY increase. The median existing single-family home price rose 12% from a year earlier, while the average existing single-family home price gained 9% from a year ago. See page 3. August’s new home sales will be reported soon, but July’s data showed a 36.3% gain in units sold from a year earlier with median and average prices rising in the high single digits. See page 4. Homeownership also jumped from 65.3% in March to 67.9% in June, with the largest regional gain seen in the South where ownership rose from 67.6% to 71.1%. Black homeownership rose 3% to 47% and Hispanic ownership rose 2.5% to a record 51.4% in the second quarter of the year. See page 5. As a result, homebuilder confidence reached record heights in August. See page 6. In August, retail sales also reached a record level on a seasonally adjusted annualized basis and this tends to be a good forecaster of overall GDP. See page 7.

However, fundamental valuations remain stretched even as the Refinitiv/IBES consensus earnings estimate for the S&P 500 index continues to rise. This week’s estimate of $166.62 combined with a 20 PE multiple suggests a fair value level of SPX 3332, but as we show on pages 8-10 this still puts the equity market at the high end of fair value. It is possible that earnings estimates will continue to surprise on the upside, but the political climate is too uncertain to know. It is equally possible that higher corporate taxes would make current forecasts too high for 2021. In short, we remain cautious in the near term.

Technically, we see several important support levels that are worth monitoring. In the Dow Jones Industrial Average and in the Russell 2000 the 100-day and 200-day moving averages are converging. This makes the DJ 26,290 and the RUT 1457 levels crucial to the longer-term outlook. By holding at or near these levels the chart patterns improve. But breaks below these levels are highly likely to generate more selling. Breadth data is also showing some strain. The 10-day average of daily new lows fell to 76 this week and is below the 100 benchmark that characterizes a bull market cycle. The 25-day up/down volume oscillator is at minus 1.29 this week and at its lowest point since April 8, 2020. Corrections within a longer bull market cycle rarely reach a fully oversold reading on minus 3.0 or less; rather, corrections tend to reverse as this level nears. Overall, the risks in the market may only be political, but they are taking a toll on stock prices. We await the presidential debate next week. 

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Worldwide coronavirus cases reach 7.21 million and the death total moves above 400,000. The National Bureau of Economic Analysis (NBER) defines the US economy as being in a recession as of February 2020. Coronavirus wrecks demand and Germany’s exports and imports plunge in April, posting their biggest declines since data began in 1990. Canada and the US are about to extend their border closure and ban on non-essential travel through the end of July. Boeing (BA – $216.74) delivers four planes in May, down from six in April. And the NASDAQ Composite rises to an all-time high.

Even though bull markets are known to climb a wall of worry, these facts simply do not seem to fit together. Yet as we noted last week, history has taught us that equity prices are often better economic forecasters than economists. Recent market performance suggests investors are expecting a V-shaped recovery. This week the Federal Reserve will publish its first economic projections since the pandemic began and we doubt it will be optimistic. Economists are expecting the Fed to forecast a collapse in output this year and no change in interest rates for the foreseeable future. Still, investors are comforted by the fact that the Fed stands ready to support the economy; and in fact, the Fed eased the terms of its “Main Street” lending program this week by cutting loan size in half to $250,000 and lengthening the term by a year. These changes, along with zero required reserves, are in place to encourage businesses and banks to participate in making loans.

Perhaps investors are focused on what the 2020 fiscal and monetary stimulus packages can mean for future economic growth and earnings. First, we know that fiscal stimulus came in three packages (Phase 1 – $8.3 billion; Phase 2 – $171 billion; Phase Three – $2.3 trillion) totaling $2.5 trillion. The Fed’s balance sheet has expanded by nearly $3 trillion since the end of February. Together, this $5.3 trillion package of stimulus represents more than 25% of nominal GDP (March 2020 nominal GDP $21.5 trillion). In other words, the federal government has supported, or supplanted, the economy for an entire three months. And while businesses and consumption has slowed dramatically during the mandatory shutdown, this stimulus is still working its way into the broader economy. Or, in the case of taxpayers $1200 checks, it is sitting in checking or savings accounts. This may be why investors responded so joyously to the fact that there were only two months of job losses before a reversal in May. Jobs losses were 22 million in March and April and it will take time for all these people to get back to work. But as Americans move slowly back into the workforce and confidence builds, this liquidity should fairly quickly turn into consumption. There will be disruptions in the workforce; but we have faith in American ingenuity and the ability to rebuild.

Breakout or Bubble?
Despite our optimism about the economy, we still question whether the current surge in equity prices represents a significant bullish breakout or whether it is the beginning of a bubble. First, it is important to note that bubbles represent not only a complete disconnection from valuation but also a high degree of over ownership of equities, usually by the public. It is possible that this process is beginning today, but if so, the bubble will get very much bigger and prices will move much higher before the bubble bursts.

Our valuation model shows that the SPX is trading well above the fair value range today and is trading at a level forecasted for late 2021 based upon our 2021 SPX earnings estimate of $160.65 and the model’s predicted PE multiple of 19.6 times. However, we believe our earnings estimate could prove to be too conservative and this would support higher prices. Also note that while the SPX is trading above fair value range, it is still less extreme than what was seen late in 2009 when analysts caught up with the damage done by the financial crisis and cut earnings estimates dramatically. See page 13. Analysts proved too pessimistic in 2009 and the equity market rallied as earnings surprises turned positive later in the year. It is possible that a similar scenario will play out in 2020 as well.

Overall, we believe it is wise to remain vigilant to the risk that a bubble is forming; but investors who exit a bubble too early are often the same investors drawn into the market at the peak. Yes, bubbles are extremely dangerous but also enticing late in the cycle. In our view, we would rate the equity market as a strong hold. We are definitely concerned about the upside gaps we see in many of the popular indices which suggests market volatility will remain high in coming weeks. See page 14. But it is also likely that this rally could continue until economic news turns positive, in short, we would “sell on the news.” That day still lies ahead. In the near term we are watching for several of our technical indicators to make a clear confirmation of the breakout. To date, the cumulative advance decline line has done so, but we are waiting for further confirmation from our 25-day volume oscillator and the average of daily new highs. See pages 15 and 16.

A Look at May’s Job Report
As dramatic and unexpected as May’s monthly increase of 2.5 million jobs was, this gain put barely a dent in the 22 million job losses seen in March and April. In May, the household survey’s employment level was 137,242, the lowest since October 2002. The establishment survey suggests May’s payrolls were 132,912, the lowest since December 2011. In short, while job gains should increase in the months ahead, it will take time to reach the peak levels seen earlier this year. However, the shorter the shutdown the easier the rebound, so we are encouraged to see many parts of the US getting back to normal. See page 3. The good news is that according to the BLS, 78.3% of those unemployed in April classified themselves as being on temporary layoff. Those classified as being on temporary layoff fell to 73% in May which likely accounted for the large job increase in May. However, the 73% level indicates that the vast majority of unemployed expect to return to their jobs in the near future. See page 5. It was also encouraging to see that the ten areas of the economy with the largest job losses in April were also the areas of largest job gains in May. These ten sectors were leisure and hospitality, accommodation and food services, food service and drinking places, trade, transportation and utilities, education and health services, goods producing, professional and business services, retail trade, healthcare and social assistance, and administrative and waste services. See page 6. When we look at 2020’s job creation year-to-date, we were surprised to find a gain in net jobs in most sectors. In fact, the only categories with year-to-date net job losses were leisure and hospitality, mining and logging and other services. Note that retail stores are included in BLS data for the trade, transportation, and utilities category. See page 7. The biggest loser during the shutdown was the leisure and hospitality sector which lost 7.5 million jobs in April; however, it recovered 16% of this, or 1.2 million jobs in May. This is a trend we hope will continue in coming months. See page 8.

Consumer confidence will only recover once the uncertainty of job losses ends and people can return to work. If there are no substantial spikes in coronavirus cases in the next two weeks following the massive and extensive protest marches seen in the last week, we believe businesses and consumers will become more confident about returning to a more normal lifestyle. This will help small business confidence as well. In May, the NFIB small business optimism index did recover from 90.9 to 94.4; but it remains well off its high of 105.0 in May 2019. Still, business confidence will be a key indicator in coming months since it will be the major source of jobs for the rest of 2020. See page 9. As dramatic and unexpected as May’s monthly increase of 2.5 million jobs was, this gain is barely visible in the chart below. In May, the household survey’s employment level was 137,242, the lowest since October 2002. The establishment survey suggests May payrolls were 132,912, the lowest since December 2011. In short, job gains should increase in the months ahead, but it is a long road to reach the peak levels seen earlier this year.

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May should be an important transition month in the fight against COVID-19 and all its repercussions. On this week’s earnings call, Disney’s CEO Bob Chapek (DIS – $101.06) announced that Shanghai Disneyland will open its doors on May 11 based on limited reservation-only attendance and Disney will employ temperature screenings and provide clear safety guidelines for guests. We expect this reopening will be watched carefully by many government and business leaders around the world since Shanghai could eventually become a blueprint for other theme parks, resorts, and businesses. The Ultimate Fighting Championship (UFC) has also announced plans to hold three Fight Night events in Florida between May 9 and May 16. All three lineups will take place at the VyStar Veterans Memorial Arena in Jacksonville without a live audience and with protections to safeguard athletes and staff. Most importantly, 32 states have announced individual plans to restart their economies based upon their own unique scientific data and circumstances. All of these announcements have received both praise and criticism by people and the media.

This is our take on the situation. COVID-19 is now part of the world’s long list of communicable diseases. It is far more contagious than normal flu and far more dangerous for those with underlying medical conditions. It will be impossible to ever totally eliminate the risk of contracting this virus and a vaccine is many months away, at best. But at this juncture, everyone has had the opportunity to learn how to reduce one’s risk of contracting the virus by washing their hands, keeping their hands away from their face, wearing a mask, social distancing and being sensible about activities outside the home. The underlying purpose of the nationwide shelter-in-place guidelines was not just to prevent deaths, but it was vital to slow the number of cases of COVID-19 so as not to overwhelm the capacity of hospitals and healthcare workers to care for patients. It was important in order to give the healthcare industry the time to gather necessary materials, drugs, and space to treat COVID-19 victims. It seems that this latter goal has been accomplished.

The Path to Resiliency
In the last two months the capacity for most hospitals and healthcare workers to address a possible second wave of COVID-19 has been markedly increased. New therapies for COVID-19 are being tested and multiple vaccines are moving closer to the testing phase. And therefore, we believe it is time to holistically take care of all Americans in terms of not only their physical, but also their mental and financial health. To do this, life needs to be restarted. And with the exception of a few COVID-19 hotspots, it seems appropriate for most Americans to start carefully down the path toward normalcy.

Still, the war against COVID-19 revealed disturbing weaknesses in our nursing home system, our drug and medical equipment manufacturing pipeline and other industrial areas that will require addressing in coming months. In short, two decades of globalism has not made American stronger nor more resilient against a variety of ominous threats. Perhaps this was the most important lesson learned from this plague.

Discounting Bad News
Meanwhile, the stock market has absorbed an amazing amount of bad news. From an economic perspective, first quarter GDP is estimated to have dropped 4.8% quarter-over-quarter and some economists are forecasting the second quarter to decline as much as 40%! See page 3. Real personal disposable income only grew 0.1% in March and is apt to see an actual decline in April. Personal consumption expenditures fell 3.8% in the first quarter led by a decline of 12.9% in durable goods. See page 4. All segments of personal income fell in the first quarter while unemployment insurance payments rose from an annualized rate of $26.2 billion in February to a $65.3 billion pace in March. We expect this to increase again in April. See page 5. The savings rate jumped from 8% to 13% in March, which was predictable since we noted that demand deposits at commercial banks jumped 26% YOY in the week ended April 13. They rose to 32% YOY in the week ended April 20. Likewise, money supply, as measured by M1, rose 24.1% YOY as of April 20, setting a new record. See page 6. Sentiment indicators for April were abysmal tumbling to levels last seen during the 2009 recession. These include the National Association of Home Builders housing market index, the University of Michigan consumer sentiment, Conference Board consumer and NFIB Small Business confidence indices. See page 7. Total retail sales for March fell 7% YOY and were down 2.3% YOY excluding vehicles. Auto and auto parts sales fell 24.3% in March, which was the worst since the recession. ISM indices for April were bleak with the manufacturing index falling to 41.5 and the nonmanufacturing index dropping to 41.8. Both indices were clearly below the base line of 50 which denotes recession. See page 8. The Refinitiv/IBES S&P 2020 earnings growth estimate fell from minus 17.2% to minus 20.9% this week and the S&P/Dow Jones consensus estimate fell from minus 13.4% to minus 20.1%. Both are now at the negative 20% level we expected. See page 12. Nevertheless, the good news is that the bad news is out, and it is being discounted in equity prices. Investors appear to be noticing and the market is demonstrating impressive resiliency.

Do not Fight the Fed or Fiscal Stimulus
This brings us to the important Wall Street adage “Don’t fight the Fed.” The Fed’s balance sheet grew by $2.5 trillion between the end of February and April 29 which is a record surge in liquidity in eight weeks. See page 9. We are monitoring excess reserves, which are liquid assets held on the balance sheets of banks beyond the level of required reserves. This represents monetary stimulus that is not entering the economy. Excess reserves are reported on a delayed basis, but in the month of March, excess reserves increased by $409 billion. In sum, Fed-driven liquidity still sits on the balance sheets of banks which means there is more potential stimulus from the monetary side. And we expect there is more stimulus coming from the fiscal side as well in terms of business loans, unemployment checks and $1200 payments. See page 10. To date, the total amount of monetary and fiscal stimulus put into effect by the government equates to more than 22% of nominal GDP. This liquidity not only supports stock prices, but we believe it points to great economic potential in the second half of the year. However, it requires businesses to open and people to get back to work. There is a counter side to the stimulus which is the growing deficit. The federal deficit grew by $387 billion in the first quarter and on a 12-month moving average basis this means the deficit as a percentage of GDP grew from 4.7% to 5.7% in the first three months of 2020. See page 11. However, the deficit is a problem for another day.

Watching Those Technicals
We have been impressed by the charts of all the popular indices. All indices were able to better the first level of upside resistance represented by their respective 50-day moving averages. They continue to trade above these levels and the longer this continues, the more the 50-day moving averages will become support and the more convincing the current rally becomes. The Russell 2000 index has been the laggard index for the last twelve months, but it too remains above its 50-day moving average. See page 13. Our 25-day up/down volume oscillator was in overbought territory for two consecutive trading sessions, before the 90% down day recorded on May 1 carried it back to neutral. This was not the long sustained overbought reading that would have implied a V-shaped bottom was materializing. Nonetheless, this indicator, along with all sentiment indicators, suggests that the March 23 was a major low. We remain long term bullish.

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Stats and Treasuries
There will be a lot of news impacting the equity market in the coming months including economic data that could become quite ugly. But if we had to choose only two bits of data to watch in order to measure the risk/reward of the equity market, it would be the daily statistics on the virus in the US (looking for a peak in both new cases as well as deaths) and the 10-year Treasury bond yield. To a large extent we believe the debt market will be the best guide for equity investors in coming months. The 10-year US Treasury bond is valuable because it is a global market instrument, and as such, it incorporates information regarding global economies, politics, sentiment and liquidity. Since many investors view the US Treasury bond as a safe haven investment, it may be the best sentiment indicator to monitor in 2020. If this is true, it is possible that the March 9 record low of $4.99 in the 10-year Treasury yield index (TNX – $9.97) represented a peak in global panic; and if so, it is also possible that this panic low marked the beginning of a bottoming process for many financial markets.

Fundamentals are Fuzzy
Still, there are many things we are monitoring and perhaps the most challenging is assessing fundamentals. It will be months before we have data on first and second quarter GDP. But in mid-April first quarter earnings season will begin and the corporate guidance that accompanies these reports will give us our first clues as to how corporate America will be impacted by the COVID-19 crisis.

We can expect that it will generally be bad news and earnings estimates will come down. But keep in mind that many segments of the economy are doing well. Healthcare, pharmaceuticals, personal care products, communication services, utilities, e-commerce, delivery services, and videoconferencing will be among the industries that will be beneficiaries of the current situation. Yet many companies will be hurt, and one can expect shakeouts in some sectors such as energy and retail. In the interim, we can try to measure the risk in the overall market by assuming there will be an earnings recession in 2020. Therefore, it is reasonable and prudent to look at the risk in the equity market if earnings decline 10%.

Based upon the current level of inflation and the benign interest rate backdrop our valuation model suggests an average PE of 17.2 X is appropriate for both this year and 2021. S&P Dow Jones estimates earnings were $157.10 in 2019 which means a decline of 10% would suggest earnings of $141.39 in 2020. Applying a PE of 17.2 to $141.39 translates into a fair value target of SPX 2430 for 2020. As seen in our valuation model on page 3 and the charts on page 6, the SPX has already traded below that level. Yet, if we take this one step further and project a second 10% earnings decline in 2021, SPX earnings fall to $127.25 and the mid-point of our forecasted trading range drops to SPX 2340 in 2021. We believe this is very unlikely, but it is a valuable exercise and it shows that the March 16 close of SPX 2381 came close to discounting a two-year earnings recession, or a 20% decline in earnings.

Another way of looking at a worst-case scenario for the market would be to use $141.39 earnings in 2020 and a long-term average PE ratio of 15.5 times. This lower PE multiple could apply if there were uncertainty regarding the longer-term prospects for earnings growth. Earnings of $141.39 and a PE of 15.5 X translates into downside risk to SPX 2191. All in all, these exercises indicate that fundamental factors point to a wide range of possibilities, but the SPX 2400 and SPX 2200 levels tend to be areas of fundamental support.

Technicals Worth Noting
In the last 17 trading sessions, there have been seven trading sessions where volume in declining stocks represented 90% or more of the day’s total volume. These days are classic examples of panic selling and three of these seven down days were Mondays, representing classic Panic Monday selling sprees.

History suggests that the worst of the selling pressure tends to be over once buyers come back to the market in earnest and this shift is represented by a 90% up day. Indeed, after the March 12 close of SPX 2480.64, a 93% up day materialized on March 13 (Friday). Nevertheless, this 93% up day was followed by another disastrous Monday decline in which 93% of the volume was in declining stocks, the advance/decline ratio was 1 to 15 and the daily new high/low ratio was 1 to 65 and the market fell to a new low of SPX 2386.13. Volume was only slightly above the 10-day average since circuit breakers interrupted trading twice during this session. These circuit breakers are one of the ways the current market structure differs from historical precedent. They make it more difficult to find that high-volume big-decline capitulation day that washes out the market and often defines a significant low. Nonetheless, there is no doubt that volatility is at record levels and as we showed last week, to date, March 2020 has been more volatile than any month during the Crash of 1929. This is amazing since that crash preceded the Great Depression, a global trade war, a broken banking system, and the Dust Bowl that joined forces in 1930. Things are far less dire today.

But when we look at current breadth data, we do find similarities to the 2011 low. The 2011 decline was precipitated by a well-anticipated downgrade of US sovereign debt on August 8, 2011 and it was linked to a belief that a recession was at hand. The choppy August to October 2011 period was characterized by a confusing pattern of alternating 90% down and up days; yet when we look closely at that period we find that the first 90% up day occurred on August 9, 2011 (see arrow on page 7). This up day followed the August 8 low of SPX 1119.46. Although the ultimate low for 2011 did not materialize until October 3, 2011 at SPX 1099.23, this lower low in October was merely 1.8% below the August 9 close. In sum, the first 90% up day did indeed indicate that the worst of the selling was over, and the bottoming process had begun. We believe this may also be true of today’s environment. While we expect much volatility in the weeks ahead, the March 12 low of SPX 2480.64 and the March 16 low of SPX 2386.13 (4% lower), is hopefully the beginning of a bottoming phase for equities. Note that the December 2018 low of 2351.10 — a significant support level — was also tested on March 16. When we look at the chart of the SPX, it is clear that the uptrends from the 2009 and 2016 lows have been broken. But the SPX chart also shows important support levels are found around SPX 2400 and SPX 2200. See page 6. Both of these levels coordinate well with the valuation benchmarks discussed earlier.

No Comparison to 2008
To date, the 29.5% drop seen in the SPX is greater than the long-term average decline of 24% and is the largest decline since 2008. See page 5. Although there may be reasons to compare the current marketplace to the 2008-2009 period, keep in mind that this is a medical crisis and not a liquidity crisis. Therefore, the recovery from this crisis should be much easier to accomplish once the virus subsides and/or a therapy and vaccine are in place. In 2009 earnings for the S&P 500 index went negative for the first time in history. To have the S&P 500 report a deficit for the year is far different from earnings declining by 10% or more. The SPX’s deficit in 2009 was due to massive profit losses in the banking sector. Today, after the virus peaks, the prospect for a rebound in earnings is substantial due in large part to a low unemployment rate and a strong banking system. It will not be simple, but the federal government has made it clear it plans to support small and medium sized companies and their employees during this unusual period. In short, the 2020 equity market is apt to provide investors with an excellent buying opportunity, but we expect prices will remain unpredictable and volatile for a long while.

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Yesterday the World Health Organization declared the coronavirus to be a global pandemic. At 9 pm last night President Trump announced a 30-day travel ban with Europe. This combination suggests a recession might already be in place in Europe and this could easily hurt the US economy.

Last night I spoke to a doctor from the Mayo Clinic. She indicated that the hospital is expecting the spread of the virus to rise dramatically over the next two weeks. The reason for this is that coronavirus is a new virus, and no one has immunity. Statistically a normal person with the flu might infect 1.7 new people, but a coronavirus victim appears to infect 2.5 people. A coronavirus-infected person is symptom free for 3 to 5 days and is contagious during this time. While the normal flu virus can live on tabletops and other surfaces for two hours, the coronavirus can survive for two days or more. The reason some experts are suggesting staying six feet away from others (social distancing) is that the virus appears to infect an area three feet around someone with coronavirus. And finally, the fever that accompanies the coronavirus could reach 104 degrees and have symptoms of pneumonia in some cases. These are the factors that make it more deadly for the elderly and those with compromised immune systems.

She added that there is no need to panic and to a large extent this is much like a very bad flu; but in coming weeks and months it is important that everyone protect themselves by regularly washing their hands with plain soap and water for 20 seconds. The elderly and those with compromised immune systems should consider social distancing or perhaps self-quarantining.

Given what we know today, it is likely that the coronavirus epidemic will become much worse in the next two weeks. In the interim, we should expect the financial markets to remain under pressure.

The positive in the current situation is that this is a medical crisis and not a financial crisis. The 2008 crisis triggered systemic risk in the global banking systems. Had a liquidity crisis ensued it could have spiraled out of control. This is not true today; our financial system is well capitalized. In addition, President Trump has indicated that he will recommend to Congress that small and medium sized companies affected by the epidemic be offered credit during this period and employees suspended due to the crisis should continue to be paid. The US economy demonstrated good momentum up until the end of February and once this medical crisis is over it should spring back quickly. However, in the near term there are many unknowns. Financial markets handle bad news well, but they handle unknowns poorly.

In times of great uncertainty, we measure the worst-case scenario with trailing SPX operating earnings. Earlier this week we wrote: “If we measure downside risk using the average PE of 15.6 and SPX’s 2019 earnings of $158, we find a low-risk valuation target of SPX 2465. Note: this is 9.8% below this week’s intraday low of SPX 2734. Also supporting the equity market is the fact that the SPX dividend yield is now 152 basis points above the 10-year Treasury yield. This is the highest spread since March 1955.”

The bottom line is everyone should protect themselves and their families by being wise in terms of socializing and washing their hands frequently throughout the day with simple soap and water.

Regulation AC Analyst Certification
I, Gail Dudack, hereby certify that all of the views expressed in this report accurately reflect my personal views about the subject company or companies and its or their securities. I also certify that no part of my compensation was, is, or will be directly or indirectly related to the specific views contained in this report.

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IMPORTANT DISCLOSURES

RATINGS DEFINITIONS:

Sectors/Industries:
“Overweight”: Overweight relative to S&P Index weighting
“Neutral”: Neutral relative to S&P Index weighting
“Underweight”: Underweight relative to S&P Index weighting

Other Disclosures
This report has been written without regard for the specific investment objectives, financial situation or particular needs of any specific recipient, and should not be regarded by recipients as a substitute for the exercise of their own judgment. The report is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell securities or related financial instruments. The securities described herein may not be eligible for sale in all jurisdictions or to certain categories of investors. The report is based on information obtained from sources believed to be reliable, but is not guaranteed as being accurate, nor is it a complete statement or summary of the securities, markets or developments referred to in the report. Any opinions expressed in this report are subject to change without notice and Dudack Research Group division of Wellington Shields & Co. LLC. (DRG/Wellington) is under no obligation to update or keep current the information contained herein. Options, derivative products, and futures are not suitable for all investors, and trading in these instruments is considered risky. Past performance is not necessarily indicative of future results, and yield from securities, if any, may fluctuate as a security’s price or value changes. Accordingly, an investor may receive back less than originally invested. Foreign currency rates of exchange may adversely affect the value, price or income of any security or related instrument mentioned in this report.

DRG/Wellington relies on information barriers, such as “Chinese Walls,” to control the flow of information from one or more areas of DRG/Wellington into other areas, units, divisions, groups or affiliates. DRG/Wellington accepts no liability whatsoever for any loss or damage of any kind arising out of the use of all or any part of this report.

The content of this report is aimed solely at institutional investors and investment professionals. To the extent communicated in the U.K., this report is intended for distribution only to (and is directed only at) investment professionals and high net worth companies and other businesses of the type set out in Articles 19 and 49 of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001. This report is not directed at any other U.K. persons and should not be acted upon by any other U.K. person. Moreover, the content of this report has not been approved by an authorized person in accordance with the rules of the U.K. Financial Services Authority, approval of which is required (unless an exemption applies) by Section 21 of the Financial Services and Markets Act 2000.

Additional information will be made available upon request.

©2020. All rights reserved. No part of this report may be reproduced or distributed in any manner without the written permission of Dudack Research Group division of Wellington Shields & Co. LLC. The Company specifically prohibits the re-distribution of this report, via the internet or otherwise, and accepts no liability whatsoever for the actions of third parties in this respect.

The DJIA’s 1,031.61-point decline on Monday was followed by an 879.44-point decline on Tuesday, leaving the DJIA 8.4% below its recent all-time high of 29,551.42 made on February 12th. The SPX is currently 7.6% below its record high; while the Nasdaq Composite and Russell 2000 indices are 8.7% and 9.7%, respectively, below their recent peaks. In short, the sell-off has been sharp and severe, but it does not yet qualify as a “correction” which we define as a drop of 10% or more in the indices. And we remind readers that the intensity of this week’s decline is actually positive for the longer-term outlook since moves that are counter to the major trend tend to be the more dramatic.

Earlier this week we noted that Monday’s sell-off was a 91% down day and that these extreme readings are rare but tend to appear in a series. In Tuesday’s market, 89% of the day’s volume was in declining shares, which was not quite a 90% down day, but still extreme. In the next few days and weeks, we will be monitoring the market closely to see if a 90% up day appears. A 90% up day would be favorable since these readings have historically marked the reversal of selling pressure and suggest the worst of the decline is over.

It may surprise investors that our 25-day up/down volume oscillator closed at negative 2.81 on Tuesday, which is still above the negative 3.0 level that defines an oversold reading. This oscillator is apt to become oversold in coming sessions; and if it does it would be the first oversold reading since December 2018. We will be monitoring this indicator as well since oversold readings should be short in duration in a bull market cycle. For comparison, the December 2018 oversold reading lasted for nearly 13 consecutive trading sessions.

As a reminder, December 24, 2018 was a cyclical low that ended an 18.8% decline in the DJIA and a 19.8% decline in the SPX. The intense December 2018 selloff was the result of unknowns tied to fears of Fed tightening and rising US/China trade tensions. Economists were forecasting a US recession as a result of rising interest rates and a global trade war. The current environment is different. Although the sell-off is also due to unknowns, the coronavirus is not expected to trigger a US recession.

And finally, this week’s decline has carried the DJIA and the Russell 2000 index slightly below their respective 200-day moving averages. The SPX and Nasdaq Composite indices remain slightly above their 200-day MA’s. Most analysts view 200-day moving averages as good substitutes for long-term trendlines and we would point out that 200-day MA’s are normally tested and retested during a bull market cycle. Technicians often use a 2% rule for the 200-day moving average and consider a “successful” test one that does not fall more than 2% below this benchmark. In short, these moving averages are being tested this week. See page 2.

All in all, we believe the market should begin to stabilize at, or slightly below, current levels as it awaits more news about the spread of the epidemic and the possibility of a vaccine. If we are correct, this should be an opportune time to refine and upgrade portfolios and look for longer-term buying opportunities. We would still avoid travel-related sectors.

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A week ago, the world was on edge after the US took out Iranian Major General Soleimani in a drone strike at the Baghdad airport. Luckily Iran’s retaliation was minor and the political uproar that followed this bold and unforeseen event seems to have dissipated. Nevertheless, the first few weeks of 2020 have been an emotional roller coaster for investors, and we believe the year will continue to be marked by more unexpected political incidents. The predictable narratives are the Democratic primary election, the presidential election and Brexit; but these are only the obvious ones. Investors should stay on their toes while keeping a solid focus on fundamentals. 

Currently the financial press is dominated by more mundane economic stories such as the content of this week’s Chinese-US phase one trade deal and the positive earnings results reported by several large US banks. JPMorgan Chase (JPM – $138.80) reported a 9% increase in revenues in its fourth quarter. Citigroup (C – $81.91) reported a 7% increase. Chase reported their credit card, merchant services and auto revenue surged $6.3 billion or 9% at year end, with credit card loans up 8%. Citi beat profit estimates due to a jump in trading revenue and strong credit card sales. These revenue and earnings increases paint a favorable picture for fourth quarter GDP which will be released at the end of this month. Economists will get another clue to fourth quarter activity when December’s retail sales are released later this week. The consensus is looking for a 0.4% month-over-month gain in total sales versus the 0.2% recorded in November. Anything stronger would be an excellent sign that the consumer is doing better than expected. Wall Street is forecasting GDP growth of 1.6% in the fourth quarter, but it is worth noting that the consensus has been too pessimistic all year. The combination of a stronger-than-consensus fourth quarter and a signed phase one US-China trade deal could set the stage for a big positive surprise in the first quarter of 2020. 

TARGET TWEAKING 

In our OUTLOOK FOR 2020 (December 18, 2019) we noted that our SPX earnings forecast of $184 and our price target of SPX 3300 could prove too conservative. We are not surprised that equities are closing in on our SPX 3300 target this week. Yet since it is, we should remind readers that the top of our valuation model’s predicted range allows for a much higher target of SPX 3500 by December 2020. But SPX 3500 would require a perfect combination of strong earnings, low inflation, an accommodating Fed, and no upsetting political or geopolitical events. And while this is not impossible, we believe it is likely that the SPX 3300 level becomes upside resistance in the near term. Even so a signed trade deal, better than expected fourth quarter SPX earnings and a GDP report of 2% or more for 4Q19, could lead us to raise our target in coming weeks. 

A FEDERAL RESERVE ON HOLD 

Recent data releases suggest the Federal Reserve should be on hold for the foreseeable future. Employment in December was healthy, but not particularly strong. The 145,000 increase in payrolls was well below the 6-month average of 188,500 new jobs per month. And while the unemployment rate fell fractionally, it still rounded to 3.5%, or unchanged from November. Average weekly earnings for total private employees rose 2.3% YOY, down from 2.8% YOY in November. Average weekly earnings for production and nonsupervisory employees rose 2.4% YOY, down from 2.8% YOY in November. 2222 

Our favorite employment statistics are the annual growth rates in the number of people employed. In December, employment increased 1.4% YOY in the establishment survey and 1.3% YOY in the household survey. Both of these gains were slightly below their respective long-term average growth rates. Still, it is difficult to criticize these growth rates since the current expansion is now 10 ½ years old. Slow and steady is usually a better long-term trend than fast and extreme. Over 2.1 million jobs were created in 2019 and the number of unemployed workers receiving unemployment insurance fell by 533,000. These are all favorable numbers; but in our view, the most impressive statistics in December’s job report were not the headline data points. The percentage of those currently not in the labor force but wanting a job fell from 5.3% in December 2018 to 4.8% in December, after hitting a record low of 4.6% in October 2019. Discouraged workers, or those out of work who feel they will not be able to find work, fell to 277,000 in December, the lowest level since September 2007. These latter data points suggest the job market has definitely become healthier in 2019. See pages 3 and 4. 

The NFIB Small Business Optimism Index fell from 104.7 in November to 102.7 in December. This decline reversed some of the gains seen in the prior two months, yet the index remains generally strong. There were small declines in plans for capital expenditures, employment expansion, job openings, compensation increases, general expansion, and price increases. But there were small increases in the percentage of respondents that expect the economy and real sales to improve in the next twelve months. See page 5. 

December’s inflation data also supports the Federal Reserve’s neutral standing. December’s not-seasonally-adjusted CPI index showed a 2.3% YOY rise, which was just slightly higher than the 2.1% YOY gain seen in November. Meanwhile, core CPI was unchanged from November’s 2.3% YOY pace. Energy prices fell 0.8% for the month but rose 3.4% YOY. Food was up 0.1% for the month and up 1.8% YOY. See page 6. Of the largest components of the CPI, transportation, with a 16.4% weighting, tends to be the most volatile due to the erratic price of oil. For example, transportation prices rose 1.9% YOY in December after falling for three consecutive months. But medical care, with an 8.8% weighting, is the most concerning. Medical care had the largest year-over-year increase, up 4.6% YOY in December. The major driver of recent medical care inflation is health insurance, where prices have been increasing 20% YOY or more for three consecutive months. See page 7. 

Conversely, housing, which carries a 42.3% weight in the index, has been decelerating from a 3.0% pace to 2.6%. This has helped to dampen inflation trends. Prices for rent of primary residence, owners’ equivalent rent and household furnishings and operations are all slowing. This is favorable for consumers and should help keep headline and core inflation indices rising modestly between 2.0% and 2.3% for 2020. See page 8. 

TECHNICAL INDICATORS HOLD STRONG AND STEADY 

The 25-day up/down volume oscillator is 2.87 (preliminarily) and neutral after being in overbought territory for 11 of the last 15 consecutive trading sessions. This overbought reading, which began in December, represented the sixth consecutive overbought reading of 2019. Strong and repetitive overbought readings reveal solid and persistent buying pressure and are a classic characteristic of a bull market cycle. In short, this is a positive sequence for this indicator. See page 11. Breadth data continues to be strong and favorable. The 10-day average of new highs rose to an average of 343 this week, while the average number of daily new lows fell to 35. The NYSE cumulative advance decline line recorded a new high on January 14, which confirms the new highs recorded by most of the popular averages last week. See page 12. Equally important are the lack of extremes in sentiment. As of January 8, AAII bullish sentiment fell 4.1% to 33.1% and bearish sentiment rose 8.0% to 29.9%. The 8-week bull/bear spread remains neutral. The ISE Sentiment index which measures option sentiment is also neutral. In sum, sentiment indicators are not giving early warning signals of a peak in the market.

December’s payrolls increased by 145,000 workers, previous months were revised lower by 13,000 and the unemployment rate fell fractionally, but still rounded to 3.5%. See below. Employment grew 1.4% YOY in the establishment survey and 1.3% YOY in the household. Both of these paces were slightly below the long-term average employment growth rate; however, the job market remains robust considering the expansion is currently 10 ½ years old. 

Regulation AC Analyst Certification 

I, Gail Dudack, hereby certify that all the views expressed in this report accurately reflect my personal views about the subject company or companies and its or their securities. I also certify that no part of my compensation was, is, or will be, directly or indirectly related to the specific views contained in this report. 

IMPORTANT DISCLOSURES 

RATINGS DEFINITIONS: 

Sectors/Industries: 

“Overweight”: Overweight relative to S&P Index weighting 

“Neutral”: Neutral relative to S&P Index weighting 

“Underweight”: Underweight relative to S&P Index weighting 

Other Disclosures 

This report has been written without regard for the specific investment objectives, financial situation or particular needs of any specific recipient, and should not be regarded by recipients as a substitute for the exercise of their own judgment. The report is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell securities or related financial instruments. The securities described herein may not be eligible for sale in all jurisdictions or to certain categories of investors. The report is based on information obtained from sources believed to be reliable, but is not guaranteed as being accurate, nor is it a complete statement or summary of the securities, markets or developments referred to in the report. Any opinions expressed in this report are subject to change without notice and Dudack Research Group division of Wellington Shields & Co. LLC. (DRG/Wellington) is under no obligation to update or keep current the information contained herein. Options, derivative products, and futures are not suitable for all investors, and trading in these instruments is considered risky. Past performance is not necessarily indicative of future results, and yield from securities, if any, may fluctuate as a security’s price or value changes. Accordingly, an investor may receive back less than originally invested. Foreign currency rates of exchange may adversely affect the value, price or income of any security or related instrument mentioned in this report. 

DRG/Wellington relies on information barriers, such as “Chinese Walls,” to control the flow of information from one or more areas of DRG/Wellington into other areas, units, divisions, groups or affiliates. DRG/Wellington accepts no liability whatsoever for any loss or damage of any kind arising out of the use of all or any part of this report. 

The content of this report is aimed solely at institutional investors and investment professionals. To the extent communicated in the U.K., this report is intended for distribution only to (and is directed only at) investment professionals and high net worth companies and other businesses of the type set out in Articles 19 and 49 of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001. This report is not directed at any other U.K. persons and should not be acted upon by any other U.K. person. Moreover, the content of this report has not been approved by an authorized person in accordance with the rules of the U.K. Financial Services Authority, approval of which is required (unless an exemption applies) by Section 21 of the Financial Services and Markets Act 2000. 

Additional information will be made available upon request. 

©2020. All rights reserved. No part of this report may be reproduced or distributed in any manner without the written permission of Dudack Research Group division of Wellington Shields & Co. LLC. The Company specifically prohibits the re-distribution of this report, via the internet or otherwise, and accepts no liability whatsoever for the actions of third parties in this respect. 

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The new year began with a US drone strike at the Baghdad airport which killed Iranian Major General Qassem Soleimani and Iraqi militia leader, Abu Mahdi al-Muhandis, who had greeted him at the airport. To the extent that Iran retaliates and whether this is the start of an escalating conflict in the Middle East is a huge unknown. But it certainly could become the overriding issue of 2020. Still, it is important to note that history shows that stocks have performed surprisingly well during military conflicts. For example, equity prices rose in 1991 even though the US began a military operation – Operation Desert Storm – in January to expel Iraqi forces from Kuwait. (An interesting connection between 1991 and the current operation is that Muhandis had been labeled a terrorist and sentenced to death by a Kuwaiti court for the 1983 bombings of the American and French embassies in Kuwait.) 

Another significant factor to consider with regard to the Middle East is that the US has recently become the world’s largest energy producer. In 2018 the US delivered 18% of the world’s total oil production exceeding Saudi Arabia’s 12%. In November, the US had a petroleum trade surplus of $0.8 billion, the highest on record. This is an important difference between 1991 and 2020 since the US is now a greater force in global energy production, has become a more energy efficient economy and currently benefits economically from the rising price of oil. A rise in oil prices could also increase corporate earnings for energy companies and boost S&P 500 earnings. All of this could explain why the US equity market has performed better since the drone attack than many would have expected. 

WHAT HAS CHANGED? 

Although the geopolitical landscape is quite different today from when we published our 2020 outlook in December, there is little that we would change in our forecasts. The SPX is trading at 20 times trailing operating earnings this week, the same multiple as seen in mid-December. Our earnings forecast of $184 is likely to be too conservative, particularly if energy sector earnings rebound more than expected in 2020. And in turn, we believe our SPX price target of 3300 (PE multiple of 17.9 times) could prove to be too conservative. However, given the uncertainty that the Middle East now poses, it is possible that the SPX 3300 level will be a hurdle in the intermediate-term, or at least until the risk of conflict subsides. Conversely, sell offs related to the Middle East should be viewed as longer-term buying opportunities. As we go to print there are reports that there are rocket attacks on multiple US facilities in Iraq and US equity futures are down 1%. 

ASSESSING ECONOMIC STRENGTH 

The majority of recent data releases indicate that economic activity is improving. November’s trade data pointed to a goods-only trade deficit that declined 5.8% to $63.9 billion and a total trade deficit that fell 8.2% to $43.1 billion. Both of these monthly figures are the lowest deficits recorded since October 2016. The petroleum surplus mentioned earlier, contributed to the declines in deficits. Most importantly, the trade deficit as a percentage of GDP is ratcheting lower which means it could be less of a drag on GDP in future quarters. Last but far from least, trade with China continues to decline and Mexico and Canada remain our number one and two trading partners. See page 3. 

One of the most promising segments of the US economy is housing. Pending home sales – a leading indicator of single-family home, condo and co-op sales – rebounded in November despite a shrinking 2222 

level of available inventory. This report was accompanied by large jumps in building permits and housing starts, which are now at their highest levels in twelve years. See page 4. Since pending home sales are based upon signed real estate contracts, November’s report suggests that existing home sales and prices should rise in the first quarter of 2020. See page 5. 

Given this housing backdrop it is not surprising that home builder confidence is also rising. In November, the NAHB housing market index was approaching levels last seen in 1999. This is good news for the stock market. Housing is an important part of the US economy and the trickle-down effect from new and existing home sales is influential to many other parts of the economy. Therefore, it is not surprising that the NAHB housing market index and the SPX are strongly correlated. As seen on page 6, with the exception of 2006 and 2007, homebuilder confidence has moved in close step with stock prices. In fact, the weakness in the NAHM index in 2006-2007 was an excellent, although early, predictor of the mortgage crisis that led to the financial crisis in 2008. 

In our OUTLOOK FOR 2020 (December 18, 2019) we outlined the strengths we see in the household sector which included a healthy job market, solid gains in real wages, record household net worth, homeowners’ equity of 64% (the best since 1991), and debt service ratios that remain at or near 40 year lows. Recent data on personal income and personal expenditures also point to a strong consumer base. In November, personal income grew 4.85% year-over-year and personal disposable income rose 4.6% year-over-year. And despite the increase in the CPI from 1.8% to 2.1% in November, our calculation for real personal disposable income showed an increase from 2.4% to 2.5%. In short, purchasing power continues to improve. The cyclicality in personal consumption is another encouraging factor for the US economy. As seen on page 7, PCE tends to decline and hit a low every two to four years. There were cyclical slumps in personal consumption in 2009, 2013, 2015 and in 2019. However, the slump in 2019 is now a good omen for 2020 since it implies there should be a rebound ahead. 

Not everything is bright for the US economy. The ISM manufacturing index fell from 48.1 in November to 47.2 in December, recording its third consecutive decline and its fifth consecutive reading below 50. The manufacturing sector continues to be in the doldrums. Conversely, the ISM nonmanufacturing index rose from 53.9 to 55.0 in November. The employment survey in each ISM series edged lower in December but since the unemployment rate is low, we are less concerned about these employment indices than we were. More importantly, the nonmanufacturing employment index was 55.2 in November, a level that indicates expansion. Keep in mind that nonmanufacturing represents 80% of the US workforce. See page 8. 

TECHNICAL INDICATORS REMAIN BULLISH 

One of the most bullish indicators we monitor is the 25-day up/down volume oscillator. This indicator is an excellent barometer of underlying buying and selling pressure and it helps us determine if a bull or bear market is strong, getting stronger or running out of steam. The oscillator is currently 2.84 and neutral this week but it was in overbought territory for 7 of 8 consecutive trading sessions at year end. This represented the sixth consecutive overbought reading (without an intervening oversold condition) in 2019 and is distinctly bullish. The cumulative advance decline line made an all-time high on January 6, which confirmed the new highs seen in the indices on January 2. And since the equity market has been setting a series of record highs, we plan to monitor sentiment indicators more closely. Sentiment indicators tend to be an early warning system for extended bull market cycles since extreme bullishness usually accompanies bull market peaks. The good news today is that sentiment indicators are not recording high levels of optimism. The AAII bullish sentiment reading for January 1 was 37.2%, down 4.7% from the previous week. Bearish sentiment rose 0.3% to 21.9% in the same week. The ISE Sentiment index edged toward positive territory but was also in neutral territory this week. In sum, there are no extremes in the technical arena that would suggest that the bull market advance is over. All in all, this suggests that future market weakness should provide investors with a favorable buying opportunity. 

Regulation AC Analyst Certification 

I, Gail Dudack, hereby certify that all the views expressed in this report accurately reflect my personal views about the subject company or companies and its or their securities. I also certify that no part of my compensation was, is, or will be, directly or indirectly related to the specific views contained in this report. 

IMPORTANT DISCLOSURES 

RATINGS DEFINITIONS: 

Sectors/Industries: 

“Overweight”: Overweight relative to S&P Index weighting 

“Neutral”: Neutral relative to S&P Index weighting 

“Underweight”: Underweight relative to S&P Index weighting 

Other Disclosures 

This report has been written without regard for the specific investment objectives, financial situation or particular needs of any specific recipient, and should not be regarded by recipients as a substitute for the exercise of their own judgment. The report is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell securities or related financial instruments. The securities described herein may not be eligible for sale in all jurisdictions or to certain categories of investors. The report is based on information obtained from sources believed to be reliable, but is not guaranteed as being accurate, nor is it a complete statement or summary of the securities, markets or developments referred to in the report. Any opinions expressed in this report are subject to change without notice and Dudack Research Group division of Wellington Shields & Co. LLC. (DRG/Wellington) is under no obligation to update or keep current the information contained herein. Options, derivative products, and futures are not suitable for all investors, and trading in these instruments is considered risky. Past performance is not necessarily indicative of future results, and yield from securities, if any, may fluctuate as a security’s price or value changes. Accordingly, an investor may receive back less than originally invested. Foreign currency rates of exchange may adversely affect the value, price or income of any security or related instrument mentioned in this report. 

DRG/Wellington relies on information barriers, such as “Chinese Walls,” to control the flow of information from one or more areas of DRG/Wellington into other areas, units, divisions, groups or affiliates. DRG/Wellington accepts no liability whatsoever for any loss or damage of any kind arising out of the use of all or any part of this report. 

The content of this report is aimed solely at institutional investors and investment professionals. To the extent communicated in the U.K., this report is intended for distribution only to (and is directed only at) investment professionals and high net worth companies and other businesses of the type set out in Articles 19 and 49 of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001. This report is not directed at any other U.K. persons and should not be acted upon by any other U.K. person. Moreover, the content of this report has not been approved by an authorized person in accordance with the rules of the U.K. Financial Services Authority, approval of which is required (unless an exemption applies) by Section 21 of the Financial Services and Markets Act 2000. 

Additional information will be made available upon request. 

©2020. All rights reserved. No part of this report may be reproduced or distributed in any manner without the written permission of Dudack Research Group division of Wellington Shields & Co. LLC. The Company specifically prohibits the re-distribution of this report, via the internet or otherwise, and accepts no liability whatsoever for the actions of third parties in this respect. 

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Historic Events

This week can be marked as historic with Democrats from the House of Representatives, led by House Leader Nancy Pelosi, announcing two articles of impeachment, abuse of power and obstruction of Congress, against President Trump. This was long anticipated. But in an odd act of timing, Leader Pelosi followed one hour later with a press conference indicating the House is likely to pass an amended and long-delayed USMCA trade deal. Earlier this week, The Washington Post exposed a confidential trove of government documents showing that, throughout an 18-year campaign, senior US officials failed to tell the truth about the war in Afghanistan, made pronouncements they knew were false and hid evidence from the press and the American public that the war had become unwinnable. In short, Washington DC is all abuzz.

This week will continue to be busy since it includes the December FOMC meeting, a December 12^th UK parliamentary vote, the results of which could determine the fate of Brexit, EU monetary policy and the debut press conference of the new head of the European Central Bank, Christine Lagarde. Key economic reports on the CPI, PPI, import and export prices and retail sales will also be released. We do not expect any change to monetary policy in December, so the key report of the week is apt to be November’s retail sales report. This release should have preliminary data for Black Friday sales, but it will not include Cyber Monday online sales which are reported to have totaled $9.4 billion, up nearly 19% YOY according to Adobe Analytics. Estimates for Black Friday sales are currently $7.4 billion. All in all, these retail sales numbers point to the start of a healthy holiday selling season and it bodes well for the fourth quarter economy.

Employment is Better than Expected

November’s payroll numbers also suggest the economy is doing better than many economists have been predicting. Job gains for the month surged to 266,000, their best performance since January, while revisions to the two prior months added 41, 000 more jobs. Although the reversal of October’s auto strike losses was expected to add 54,000 jobs to the month, payroll gains still exceeded 200,000 in November. This was an impressive increase since the usual holiday lift in retail payrolls failed to materialize. Employment gains in November were strongest in healthcare and professional and technical services. See page 3.

Our favorite job statistic is measuring year-over-year growth in both employment surveys. The establishment survey had a 1.47% YOY increase in jobs in November, slightly below its long-term average of 1.77%. The household survey had a 1.14% YOY increase in jobs, just under its long-term average of 1.5%. In fact, both surveys have exhibited below average growth for most of 2019, even though the pace of employment gains have been positive and steady. Yet slow and steady is much different from a sharp deceleration in the rate of job growth; deceleration is a typical precursor of a pending recession. But this is not a concern today. In the 12-months ended in November there have been 2.2 million new jobs created and this contributed to a 3.5% unemployment rate which matches September 2019. These are the lowest unemployment rates since the 3.4% reported in June 1969. See page 4.

November’s participation rate of 63.2% is only slightly above the September 2015 low of 62.4% and this lackluster performance is due to Baby Boomers leaving the labor force. Baby Boomer retirements mean this ratio is unlikely to improve in the years ahead. Conversely, the employment population ratio was 61% in November and has moved steadily higher since its July 2011 low of 58.2%. This is an indication of a strengthening labor market. The fact that the percentage of people who are not in the labor force but want a job was 4.7% in November, close to previous month’s all-time low of 4.6%, is another sign of a strong market. See page 5. Historically, a 3-month average of job gains or losses has had a strong correlation with consumer confidence. In November the 3-month average job gain rose from 189,330 to 205,000; confidence is also rising. This relationship has been stronger than that of the unemployment rate and GDP. See page 6. November’s average hourly earnings grew 3.7% YOY, an acceleration over the 3.4% YOY rate seen a year ago. Average weekly earnings rose 3.0% YOY in November which is down from the 3.4% YOY pace seen in November 2018. In sum, November marked a deceleration in the pace of weekly earnings growth, but the rate still well above the 2.2% YOY pace seen between 2011 and 2016. See page 7. Based upon this, it is no surprise that consumer confidence is on the rise.

Trade is Better than Expected

Trade data also points to fourth quarter strength. The trade deficit narrowed from $51.1 billion in September to $47.2 billion in October, the second consecutive monthly decline and the fourth decline in the past five months. On an annualized basis, the trade deficit is running at 4% of GDP versus the 4.25% of GDP recorded in 2018. See page 8. Most of this improvement in the deficit is the result of declining trade with China. The US trade deficit with China is running at 1.6% of GDP this year versus 2.04% in 2018. Some of this falloff with China is becoming a boon for other countries. Trade is expanding with countries in the European Union, Japan and Canada; but Mexico has been the biggest beneficiary of the trade war. Imports from Mexico are up 4.5% and exports have declined 2%, year-to-date. As a result, the trade deficit with Mexico is running at 0.48% of GDP versus the 0.39% seen in 2018. Another factor improving US trade is energy. This can be seen by the fact that in the first 10 months of 2019, the US is experiencing a $7.7 billion surplus with OPEC nations. See pages 9-11.

Technical Indicators Continue to be Strong

After strong advances from the mid-October lows to December’s record highs, the popular indices are consolidating this week. But trends remain favorable and indices are trading above all moving averages. The Russell 2000 index has been our biggest concern in 2019 since it has lagged the larger capitalization indices most of the year. However, the RUT has broken above the 1600 resistance level and it continues to hold above this level which is bullish. See page 13. The 25-day up/down volume oscillator is at 0.83 and is neutral this week. But the last reading in this indicator was a five-day overbought reading, the fifth such reading in 2019, which represents a bullish pattern of solid buying pressure. See page 14. Average daily new highs remain above 100 per day and average daily new lows remain below 100 per day, which is classically bullish. The NYSE cumulative advance decline line made an all-time high on November 27^th confirming the new highs in the indices. And last, we are encouraged that sentiment indicators remain in neutral territory even as the market continues to climb to new heights. In short, there are no signs of excessive optimism that tends to mark major bull market peaks.

Summary

Economic data including reports on jobs, trade, sentiment, housing, and GDP continue to show a stellar US economy led by a consumer supported by the best job market in years. This bodes well for the fourth quarter economy and for earnings. We continue to believe that our 2020 SPX target of 3300 could prove to be conservative.

Next week we will publish our Outlook for 2020 on Wednesday December 18^th.

November’s payroll gain of 266,000 jobs was strikingly strong even after adjusting for the 54,000 job increase attributed to the UAW settlement. Moreover, revisions added 41,000 jobs to the prior two months. The 6-month averages rose to 196,330 in the establishment survey and to 305,830 in the household survey.

Regulation AC Analyst Certification 

I, Gail Dudack, hereby certify that all the views expressed in this report accurately reflect my personal views about the subject company or companies and its or their securities. I also certify that no part of my compensation was, is, or will be, directly or indirectly related to the specific views contained in this report. 

IMPORTANT DISCLOSURES 

RATINGS DEFINITIONS: 

Sectors/Industries: 

“Overweight”: Overweight relative to S&P Index weighting 

“Neutral”: Neutral relative to S&P Index weighting 

“Underweight”: Underweight relative to S&P Index weighting 

Other Disclosures 

This report has been written without regard for the specific investment objectives, financial situation or particular needs of any specific recipient, and should not be regarded by recipients as a substitute for the exercise of their own judgment. The report is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell securities or related financial instruments. The securities described herein may not be eligible for sale in all jurisdictions or to certain categories of investors. The report is based on information obtained from sources believed to be reliable, but is not guaranteed as being accurate, nor is it a complete statement or summary of the securities, markets or developments referred to in the report. Any opinions expressed in this report are subject to change without notice and Dudack Research Group division of Wellington Shields & Co. LLC. (DRG/Wellington) is under no obligation to update or keep current the information contained herein. Options, derivative products, and futures are not suitable for all investors, and trading in these instruments is considered risky. Past performance is not necessarily indicative of future results, and yield from securities, if any, may fluctuate as a security’s price or value changes. Accordingly, an investor may receive back less than originally invested. Foreign currency rates of exchange may adversely affect the value, price or income of any security or related instrument mentioned in this report. 

DRG/Wellington relies on information barriers, such as “Chinese Walls,” to control the flow of information from one or more areas of DRG/Wellington into other areas, units, divisions, groups or affiliates. DRG/Wellington accepts no liability whatsoever for any loss or damage of any kind arising out of the use of all or any part of this report. 

The content of this report is aimed solely at institutional investors and investment professionals. To the extent communicated in the U.K., this report is intended for distribution only to (and is directed only at) investment professionals and high net worth companies and other businesses of the type set out in Articles 19 and 49 of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001. This report is not directed at any other U.K. persons and should not be acted upon by any other U.K. person. Moreover, the content of this report has not been approved by an authorized person in accordance with the rules of the U.K. Financial Services Authority, approval of which is required (unless an exemption applies) by Section 21 of the Financial Services and Markets Act 2000. 

Additional information will be made available upon request. 

©2019. All rights reserved. No part of this report may be reproduced or distributed in any manner without the written permission of Dudack Research Group division of Wellington Shields & Co. LLC. The Company specifically prohibits the re-distribution of this report, via the internet or otherwise, and accepts no liability whatsoever for the actions of third parties in this respect. 

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