How much potential or risk there is in stock prices is best explained by current and forecasted fundamentals, in our opinion. Momentum and sentiment can drive stock prices over the short-to-intermediate term, but over the longer term, earnings growth, or lack thereof, always underlies the trend of the equity market. For this reason, we sought to understand the underpinnings of the many S&P 500 forecasts of 5100 or 5700 for this year.

There are two simple components to any S&P forecast: the appropriate PE multiple and the earnings estimate. However, it is never that simple because both can be moving targets. As we noted in our 2024 outlook, our valuation model is a PE forecasting model derived from our expectations for inflation and interest rates. Our assumptions for 2024 are that inflation will ease to 2.75%, short-term interest rates will fall to 4.25%, and Treasury bond yields stay relatively stable at 3.6%. These are optimistic forecasts in our view; however, they fall well within the range of consensus forecasts. With these estimates, our valuation model indicates that the average PE for this year should be 18.5 times and the maximum PE multiple could be 21 times. A 21 PE multiple would be a possibility if inflation falls to 2% or less, since this would imply earnings growth is more “real.” In short, the model provides a broad range of possibilities.

When we take a multiple of 18.5 times and apply it to our 2024 earnings estimate of $234.00, a 10% increase from S&P Dow Jones 2023 estimate of $213.55, the result is an SPX target of 4330 for this year. If we use a maximum PE multiple of 21, we get an SPX target of 4914.

If we assume our earnings forecast is too pessimistic and use the IBES consensus estimate of $243.98 for this year, we get an SPX target of 4514 with an 18.5 multiple. To get to an SPX target of 5123, we need to use a maximum PE of 21 times and the IBES 2024 earnings estimate. This is a good explanation of why several strategists are using a 5000+ target for this year.

However, for those looking for even higher SPX targets, the forecaster must use not only a maximum PE of 21 times, but also the IBES 2025 earnings forecast of $274.59. This combination equates to a target of SPX 5766. In short, this exercise explains how one gets to an SPX target of 5100 or 5700, but it also reveals how much risk there is to these targets.

First, both targets assume stocks will reach and maintain a maximum PE which is likely only if inflation falls to 2% or less later this year. Second, an SPX 5100 forecast assumes that the IBES consensus earnings estimate for this year is correct. The risk here is that consensus earnings forecasts tend to peak early in the year, start to decline in March and then during each reporting season thereafter. This declining trend is rarely absent unless the economy is coming out of a recession. Analysts tend to be too pessimistic after a recession; and as a result, consensus earnings estimates are usually too low and increase during each quarterly earnings season.

Nonetheless, an SPX target of 5700 discounts not only a perfect year of low inflation but all the optimistic earnings growth expected over the next 24 months. There are many risks to these assumptions, the most obvious being that the economy may slow, revenues will decelerate, and earnings growth could disappoint. The first few days of 2024 have already been an adjustment to the overly optimistic view that there will be multiple interest rate cuts beginning in early 2024. And after analyzing the basis of the bullish targets for 2024 it becomes clear that every earnings season, every inflation report, and every FOMC meeting will be very important to substantiate the bullish forecasts for this year.

Employment Data

The 216,000 increase in payrolls in December was stronger than expected, but the unemployment rate was unchanged at 3.7%. Note that the unemployment rate for those with less than a high school degree has been rising and was 6% in December. Clearly, the lower-income worker was experiencing a more difficult job market at the end of the year. The household survey showed roughly a 1.5 million increase in people no longer counted in the labor force in December; meanwhile, there was a 460,000 increase in the number of people not included in the workforce but who indicated they want a job. Job growth was 1.75% in December, which is above the long-term average of 1.7%. However, job growth in the household survey was 1.18% and this was below the 1.5% long-term average for the first time since March 2021. In short, there were some signs of stress in the jobs data. See page 3.

Economic Data

The ISM manufacturing index improved slightly from 46.7 to 47.4 in December; however, the services index fell from 52.7 to 50.6. Since 50 is the breakeven level, the December services survey was indicating only modest economic activity. Perhaps more importantly, the services survey saw the employment index fall from 50.7 to 43.3 in December, the lowest reading since July 2020 and a sign that job growth has slowed or is declining in the service sector. The employment index in the manufacturing survey has been below 50 (neutral) since September. See page 4.

When we look at a variety of components in the ISM manufacturing index, it is obvious that most have been below 50 for most of 2023, a sign of weak economic activity. In the services survey, the overall trend was above 50 but slowly decelerating. The drop in the employment index may be a bad omen for 2024. See page 5.

The small business optimism index improved slightly in December, rising 1.3 points to 91.9. However, this reading was still the 24^th consecutive month below the long-term average of 98 and a sign of recession. In December, businesses indicated they were generally unhappy with the level of their inventories and indicated a reluctance to increase capital expenditure. Hiring plans also continued to decline. On a hopeful note, plans to raise prices appear to have peaked for most entrepreneurs. See page 6.

Technical Update The breakouts in all four of the popular indices were perpendicular and dramatic at the end of 2023, but only the Dow Jones Industrial Average managed to record an all-time high. The S&P 500 is most interesting since it has been fractionally away from recording a new high but is yet to better its January 3, 2022 high of 4796.56. The Russell 2000, after beating the key 2000 resistance, has now dropped below this level, which neutralizes the breakout seen at the end of the year. See page 9. The 25-day up/down volume oscillator is at 1.76 and neutral this week after being in overbought territory of 3.0 or higher for 22 of 25 consecutive trading days ending January 5. This indicator needed to remain in overbought territory for a minimum of five consecutive trading sessions to confirm the recent uptrend as “significant.” This is positive, however, weakness in the early part of a new year is often a warning sign of fading demand for equities. In sum, 2024 is apt to be a volatile and unpredictable year.

Gail Dudack

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A Bit of History

The media is filled with headlines stating that the S&P 500, the Dow Jones Industrial Average, and the Nasdaq Composite Index have booked nine consecutive weekly gains — the longest weekly winning streak for the S&P 500 since January 2004, and the longest stretch for the Dow Jones Industrial Average and the Nasdaq Composite Index since early 2019. Many in the media have then suggested that this strong run means more gains are ahead. Indeed, double-digit gains in the equity indices don’t suggest a bear market … unless there are three years in a row of double-digit gains. But as you can see from page 7, the full year 2004 had a fairly mediocre performance after its early advance. In 2019 an early advance in the first quarter stalled, then rallied, and in November, COVID-19 became a global pandemic, making comparisons difficult.

However, the parallel between 2004 and 2024 is not only due to the nine weekly gains, but that both are presidential election years. And they are years ending in “4.” Depending upon which market index one uses, the presidential election year has the third or fourth best performance of the four-year cycle. In short, election years tend to be mediocre. The pre-election year is the year with the biggest stock gains in the four-year cycle. This is probably due to fiscal stimulus done early in the year to help the economy and to help the incumbent president win votes due to a strong economy. This pattern seems to fit the current cycle, even though it is a most unusual economic cycle.

However, one of the most interesting things about an election year is that it has some ability to predict the outcome of the presidential election. When the incumbent is about to win, equities tend to be weakest in May in July. The May decline sets up a classic summer rally which is followed by a weak July. Typically, July is the fourth best performing month of the year, so this works against seasonality. In years when the incumbent loses, the weakest months of the year tend to appear in January, February, September, and October. January has a history of being the sixth best performing month, on the heels of good gains in November and December. So, this too, goes against seasonality and weakness early in the year is a bad omen for an incumbent president. In both cases, or most election years, the strongest months tend to be November and December. See page 8.

This is also a year ending in 4, and the decennial pattern suggests it will be a year with an average gain of 7.1%, leaving it tied for fifth place in the 10-year cycle. Still, “4” years have produced gains in nine of the last 14 cycles, so there is a bullish bias to years ending in 4. See page 6. All in all, history points to an up year, but more in line with a single-digit gain than a double-digit gain.

Liquidity

The dramatic gains seen at the end of 2023 were driven by the widely held belief that interest rates are coming down in 2024. Federal Reserve Chairman Jerome Powell attempted to dampen these expectations in subsequent days, however, his comments after the last FOMC meeting did indicate that rate cuts were likely in 2024. This suggestion triggered a swift decline in long-term interest rates and a rush out of cash and into equities. The momentum of the equity market is strong, and this is seen in our technical indicators. However, behind good momentum tends to be good liquidity. For this, we looked at Federal Reserve data on commercial banks. What we found was that banks hold nearly $19 trillion in customers’ liquid short-term assets. This number is the sum of $4.99 trillion in demand deposits, $1.7 trillion in retail money market funds, $1.0 trillion in small-denomination time deposits, and nearly $11 trillion in other liquid deposits. See page 4. In recent years, money flowed into short-term assets as interest rates rose and the threat of recession was looming. Powell’s “pivot” on interest rates created a “pivot” in investor sentiment and their opinion of cash. In a Cinderella world of falling interest rates, declining inflation, and no recession, $19 trillion is a substantial amount of potential demand for equities. Moreover, we know that the cash held at commercial banks is a majority, but not all inclusive, of household cash coffers.

Nevertheless, we have experienced liquidity-driven markets in the past and have learned that it is important to put any “liquidity cache” in perspective to the size of the overall market. If we compare current cash assets to total US market capitalization, we find that it represents 38% of total US market capitalization. This is a substantial, but not historic ratio, of cash. See page 4. Most secular bull cycles began when cash equals 50% or more of market capitalization. In short, cash levels support a strong momentum-driven market for a while, but do not suggest this is the start of a major secular bull market.

Valuation

If the equity market is on the verge of a bubble market, we will know fairly quickly since bubbles are driven by sentiment, liquidity, and leverage, not by earnings or fundamentals. At present, the fundamentals are not supportive of the bulls. There are many ways to measure valuation, but most show the market to be richly valued today. On page 9, we show the Rule of 23, which implies that when the sum of the trailing PE and inflation exceeds 23.8, the stock market is extended and overvalued. The current trailing PE is 22.3 times and the S&P PE based on 2024 earnings estimates is 19.6 times. With inflation at 3.2% and potentially easing, when coupled with the trailing PE of 22.3, the sum of 25.5 is well above the dangerous 23.8 level. Perhaps more importantly, if we add the estimated 2024 forward PE ratio of 19.6 times to inflation of 3.2%, the sum of 22.8 is only two points below the 23.8 danger level. In short, the stock market’s valuation has already discounted a substantial decline in inflation and all of this year’s potential earnings growth. This implies that every CPI report and every earnings reporting season has the potential to be a market-moving event.

Bullish Technicals

What keeps us from getting too negative about valuation too soon is the significant change in our technical indicators. The breakouts in all four charts of the popular indices are both perpendicular and dramatic, but to date, only the DJIA has managed to make a new all-time high. The SPX is most interesting at this juncture since it has been fractionally away from a new record high for several sessions but is yet to better its January 3, 2022 peak of 4796.56. The Russell 2000, after beating key resistance at the 2000 level, is now testing this level as support. If the Russell begins to trade below 2000 once again, it could neutralize what is now a very bullish technical pattern. See page 11. The 25-day up/down volume oscillator is at 3.45 this week and has been in overbought territory of 3.0 or higher for 19 of the last 22 consecutive trading days. To confirm the recent advance this indicator needed to remain in overbought territory for a minimum of five consecutive trading sessions, which means the oscillator has definitely confirmed the recent uptrend as “significant.” The current 19-day overbought reading is far better than the 11-day reading seen between January 25, 2022 and February 8, 2022. The only missing ingredient to the current strength of this indicator is an overbought reading in excess of 5.0. Extreme overbought readings of 5.0 or more are often seen at the start of a new bull market cycle. However, this is not a requirement for a significant advance. What will be important is that any pullback in the equity market ends once this indicator approaches an oversold reading. In a bull market oversold readings tend to be brief or nonexistent.  

Gail Dudack

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The yield on the 10-year Treasury note plummeted over 50 basis points during November and expectations for a fed funds rate cut shifted from late in 2024 to the first quarter of the new year. This sentiment shift supported a rally in US equities and in gold since gold tends to move inversely to interest rates. In other words, the market has been pricing in a Goldilocks scenario that consists of lower inflation, a soft landing or non-recession, Fed easing early in 2023, and a rebound in corporate earnings in 2024. However, as Mohamed El-Erian noted on CNBC this week, believing this scenario is possible in the current complicated environment is the equivalent of believing a pilot could land a jumbo jet without any passenger feeling any landing at all. The risks are therefore high, that the consensus will be proven wrong.

China/Debt/Gold

Perhaps if the US were functioning on its own, a soft landing might be possible. But there are risks on the horizon. The largest of these could be China. We have often written about the problems facing the Chinese economy in terms of its property crisis, but this week Moody’s lowered its rating on China’s A1 debt rating from stable to negative. This was the first rating shift on Chinese debt by Moody’s since 2017 and the company commented that the costs to bail out local governments and state firms while controlling its property crisis would weigh heavily on China’s massive economy. China’s total outstanding off-balance sheet debt is estimated to be somewhere between $7 trillion and $11 trillion, according to the International Monetary Fund. This figure would include corporate bonds issued by thousands of local government financing vehicles which borrowed money to build roads, bridges, and other infrastructure. According to a senior economist at UBS, most local government financing vehicles currently depend on capital injections from local governments, government subsidies, and external funding because they do not generate enough cash from their operations to cover the interest payments. The longer-term risk is that this massive debt problem becomes systemic to the Chinese banking system and becomes a global banking problem.

Meanwhile, China’s CSI 300 Index (000300.SS – 3,394.26 CNY) is trading at its lowest level in nearly five years. This backdrop of falling real estate prices, risk of debt defaults, falling stock market prices, and a weakening currency, explains why Chinese consumers are actively buying gold (GC=F $2038.30). According to the latest Chinese retail sales data, gold and silver jewelry have been among the best-performing consumer goods in China this year, with a 12% rise in value year-on-year in January-October and outpaced only by garments. A Chinese consumer survey released in late October found that 70% of consumers between the ages of 18 and 40 intend to purchase pure gold jewelry. Together, China and India, the world’s two biggest gold buyers, account for more than half of total global demand. And according to commodity analysts, China is the world’s top buyer of physical gold has been an increasingly important driver behind this year’s rally in global spot gold prices. Gold has clearly become the safe haven trade for Chinese investors. Perhaps the rally in bitcoin (BTC – $43,886.05) is also a result of Chinese investors looking to protect themselves from a weakening currency and falling stock and property prices.

Pivotal Points in Technical Indicators

As we noted last week, the technical charts of the popular equity indices remain bullish with the first level of resistance encountered at the July highs and the second, and most important resistance, found at the all-time highs. Only the DJIA has exceeded its July high on the recent advance, touted by many to be the start of a new multi-year bull market. The July highs of 4600 in the SPX and 14,500 In the Nasdaq Composite have not been bettered and stock prices retreated as they tested those levels. The Russell 2000 index, which is our personal favorite for defining the broad marketplace, broke above its 100-day and 200-day moving averages last week, but the index remains neutral in its long-standing trading range between 1650 and 2000. In sum, the recent uptrend is unconfirmed. See page 8.

The 25-day up/down volume oscillator is at a positive 3.49 reading this week and has been in overbought territory of 3.0 or higher for four consecutive trading days. This is a positive development, but to confirm the recent advance this indicator should remain in overbought territory for a minimum of five consecutive trading sessions. In short, this indicator is close, but has not yet corroborated the recent uptrend as a significant trend. To date, both downtrends and uptrends have failed to sustain oversold or overbought readings for a minimum of five consecutive trading sessions. See page 9. However, this is in line with our long-held view that the stock market is in a broad trading range, which is a substitute for a bear market. We expect this range, best seen in the Russell 2000 index, to remain in force until inflation has been clearly brought under control.

The American Association of Individual Investors (AAII) survey showed a 3.5% increase in bullishness (48.8%), and a 4.0% decrease in bearishness (19.6%) last week. Bullish sentiment remains above average for the fourth consecutive week and bearishness is also below average for the fourth consecutive week. But more importantly, bearishness is at its lowest level since the January 3, 2018 reading of 15.6%. This extreme bearish reading in 2018 was followed by a 10% decline in the S&P 500 by February 8, a 13.6% advance by September 20, and a 19.8% decline by December 24. For the full year, the S&P 500 fell 6.2% in 2018. This too supports a view of a volatile trading range marketplace.

An Economic Mix

The headline ISM manufacturing index was unchanged in November, but six of the 10 components fell. The backlog of orders component declined to 39.3, its lowest reading since May 2020. The non-manufacturing index rose from 51.8 to 52.7, but the rise was mostly due to a buildup in inventories to 55.4. Order backlog also fell from 50.9 to 49.1. Readings below 50 indicate a contraction. See page 3.

The 5.2% GDP pace in the third quarter was the fastest rate recorded in nearly two years. Inventory build was a big contributor, consumption rebounded from a weak second quarter, and trade was a drag. However, this was the fourth consecutive quarter of negative real retail sales, which is typically associated with a recession. The key risk factor for the 2024 economy will be the strength of the consumer. See page 4.

Personal income rose 4.5% YOY in October, down from 4.8%. Disposable income rose nearly 7% YOY, down from 7.4%. Real disposable income increased 3.85% YOY, unchanged from September. Personal savings were $768.6 billion, up $19.6 billion, and the savings rate rose from 3.7% to 3.8%. But this remains well below the average long-term savings rate of 5.7%. See page 5.

Personal consumption expenditures rose 5.3% YOY in October and personal disposable income rose nearly 7% YOY. This marked the tenth consecutive month in which income exceeded consumption and it follows 21 consecutive months of consumption exceeding disposable income. Note that wage growth is decelerating for most employee sectors of the economy, except government, where wage growth was 8% YOY in October. See page 6.

Gail Dudack

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Media Hyperbole

It is widely known that there is political bias in the mass media, but we continually see signs of bias in the financial press as well. The bias tends to be bullish or optimistic, which may seem constructive and comforting, but it can also be dangerous if it is misleading to the public and/or investors. We have pointed out several situations in the past and there was more this week. In particular, we just read a headline from an international news source that shouted in bold letters “US consumer confidence rebounds, house prices maintain upward trend.” We had just finished writing the back pages of this report, so we knew what these economic releases contained, and this headline did not match what we learned from the data.

This headline sounded like the economy was on the verge of an economic rebound. However, within the article it did state that “the Conference Board said its consumer confidence index increased to 102.0 this month from a downwardly revised 99.1 in October. Economists polled by Reuters had forecast the index dipping to 101.0. The improvement in confidence was concentrated mostly among households aged 55 and up. Consumers in the 35-54 age group were less optimistic about their prospects.”

The fact that the 35-54 age group was less optimistic than those over 55 is noteworthy since this age group is of prime working age and has children in school, a combination that makes them core consumers and important drivers of the economy.

What was not made transparent in this article was that October’s index had initially been reported to be 102.6. This means the consensus estimate for November was 101.0 implying a decline in sentiment. And the only reason November’s index of 102.0 was better than forecasted was the large negative revision in October’s index, to 99.1. In our opinion, there is a bit of a sleight of hand to say that November’s confidence was a positive surprise and/or represented a rebound. Plus, the University of Michigan consumer sentiment index for November showed consumers were clearly worried, especially about higher inflation. The main index fell 2.5 to 61.3, present conditions were 2.3 lower to 68.3, and expectations fell 2.5 to 56.8. All in all, none of this supports a headline that says consumer confidence is rebounding, in our opinion. See page 6.

In terms of suggesting there is an upward trend in house prices, it is more of the same. The article was referencing housing data from the Federal Housing Finance Agency (FHFA) which does not measure home prices but calculates an index (1991=100) which is defined as a weighted repeat-sales index, meaning that it measures average price changes in repeat sales or refinancings on the same properties. It is a broad-based index but does not represent actual home prices. We doubt that the journalist understood this. Moreover, the FHFA index is released a month later than most other home price data, i.e., the article was referencing September data when data for October and surveys for November had already been released. See page 5.

As for the trend in new home sales and prices, according to data from the Census Bureau, sales were lower in October versus September, but up 17.7% YOY. New house inventories were at their highest level since January and the total months of supply of housing was 7.8, back to August’s level. But in terms of home prices, Census data showed that the average new single-family home price fell 10.4% YOY to $487,000 while the median price fell nearly 18% YOY to $409,300. This data does not support the international news article, but it does support the negative NAHB survey results reported for October and November. See page 4. In sum, do not believe everything you read.

Media Neglect

Not getting much attention by the media are the risks appearing in the Chinese economy. Most investors know about China’s property crisis and its impact across China is immense and ongoing. However, foreign investors have been souring on China for most of this year, and recent data shows strong evidence that the global trend of diversifying supply chains and other de-risking strategies are having a negative impact on the world’s second-largest economy. In the July-September period, China recorded its first-ever quarterly deficit in foreign direct investment, a sign of capital outflow pressure. See page 7. According to Rhodium Group (www.rhg.com), the value of announced US and European greenfield investment into China dropped to less than $20 billion last year, from a peak of $120 billion in 2018, while investment into India shot up by some $65 billion or 400% between 2021 and 2022.

Given this backdrop, it is not surprising that Chinese President Xi Jinping recently met with President Biden at the Asia-Pacific-Economic-Cooperation (APEC) Summit in San Francisco. Investment in China has dropped to historic lows, and President Xi attended the Summit in San Francisco to promote China’s economy. However, the data suggests that foreign firms are not only refusing to reinvest their earnings in China but are selling existing investments and repatriating funds. This trend could put further pressure on the yuan and dampen China’s economic growth in the long run. It also reduces China’s need to invest dollar inflows, which helps explain China’s decreasing demand for US Treasury bonds.

In terms of China’s economic activity, a survey released by The Conference Board showed that more than two-thirds of responding CEOs indicated that China’s demand has not returned to pre-COVID levels. Forty percent of respondents are expecting a decrease in capital investments in China and a similar proportion are expecting to cut jobs. In sum, corporations will become more dependent upon US consumers for top-line growth in the future.

Market Update

Not much has changed this week. The charts of the popular equity indices remain bullish with the first level of resistance seen at the July highs and the most important resistance found at the all-time highs. The near-term levels to monitor are 4600 in the SPX (July high) and the 1820-1827 area of the Russell 2000 index where the 100-day and 200-day moving averages merge. These short-term challenges are yet to be tested. However, while moves above these levels would be favorable for a year-end rally, the all-time highs are the real source of resistance. In our view, the longer-term trading ranges remain intact. See page 10.

Beware What You Wish For The consensus believes rate hikes are over and rate cuts, accompanied by a soft landing are in store for 2024. Yet, today’s rapid Fed tightening cycle would be most comparable to the early 1950s or the early 1980s. In both cases, Fed tightening led to multiple recessions. And while the stock market is currently rallying based upon the view that rates have peaked and will soon decline, the decline in interest rates following a tightening cycle has usually appeared in tandem with a recession. In short, the current stock market rally appears to be celebrating the onset of a recession, whether it is aware of it or not.

Gail Dudack

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Happy Thanksgiving to all! We are grateful for many things, but most of all the friendship and loyalty of our clients. Wishing you the best that Thanksgiving represents gratitude, family, friendship, and great food!!

Momentum Shift

After a strong four-week advance off the October lows, US equities retreated this week. Part of the retreat was due to a string of weak earnings reports from retail companies, but stocks also stalled from a lack of news that could move stocks higher. Even a positive earnings report from chip designer, Nvidia Corp. (NVDA – $499.44), failed to impress, and the stock traded lower in after-market trading. Nvidia noted in its earnings report that it faces challenges in both Israel, where employees are being called up for active duty, and in China, where sales will be affected by US export controls. The release of FOMC minutes confirmed the consensus view that the Fed is apt to be on hold, barring any bad news on the inflation front. This is a positive factor, but it has already been discounted by rising stock prices.

However, the technical condition of the market did improve in the last week. Trading on November 14 recorded a 91% up day, i.e., volume in advancing stocks represented 91% of total NYSE volume. In addition, the NYSE total volume for the day rose above the 10-day average. This combination displayed a positive shift in conviction. (Note that our indicators use NYSE volume versus composite volume to separate day trading and professional hedging from actual buyers and sellers.) The 10-day average of daily new highs rose to 122, above the 100 benchmark that helps define an uptrend, while the 10-day average of daily new lows fell to 79, below the 100 benchmark. This combination also reversed a negative trend that had been in place since mid-September. See page 12.

Nevertheless, our 25-day up/down volume oscillator is at a negative 0.40 reading this week and neutral. See page 11. This lackluster response, despite several strong days of upward momentum, does not surprise us since it is in line with our view that the market is long-term trendless. Our view that the equity market will remain in a wide trading range, a substitute for a bear market, has not changed.

The charts of the popular equity indices continue to be bullish with the first level of resistance seen at the July highs and the second level of resistance found at the all-time highs. The key levels to watch in coming days are 4600 in the S&P 500, which is roughly the July high and the 1830 area of the Russell 2000 index where the 100-day and 200-day moving averages merge. These levels pose near-term challenges for these equity indices and will help define the strength of the current advance. The favorable seasonality of the November, December, and January months are in the stock market’s favor, but it was disappointing that the Russell 2000 index was the worst performing index in this week’s pullback. We do not expect year-end strength to carry the indices to new highs and this suggests that the long-term trading ranges will remain intact.

The Economy is a Tale of Two Cities

Strategists can be broken down into two distinct groups of those looking for a recession and those looking for a soft landing. However, the underlying data drives this division.

The positive factors include October’s headline CPI showing a 3.2% YOY rise, the PPI for finished goods falling 0.4% YOY, and the price of crude oil down 3.8% YOY. This combination makes a lower inflation outlook seem probable. Some inflation benchmarks are still higher with core CPI at 4% and core PPI at 3.2%, but overall, most inflation benchmarks are now below the long-term CPI average of 3.4% YOY. In short, inflation is lower, and if not yet at 2%, it is still below average. See page 3. This coupled with a job environment that is neither robust, nor weak, makes a soft landing credible.

However, this would be the first time in history that inflation at or approaching a double-digit pace, was not followed by a series of recessions. And it would be the first time that the real fed funds rate did not have to rise to 400 basis points before an inflationary trend was reversed. See page 4. We believe the jury is still out whether the current 200 basis points in the real fed funds rate will cure inflation. See page 4.

Neither the last recession nor economic recovery were normal business cycles. The recession was the result of a mandated shutdown of the economy and the recovery was the result of historic stimulus policies by both the administration and the Fed. Does this mean it will be different this time? It is difficult to tell. Inflation is a cruel tax on the lower end of the income spectrum, and this is what sparks a recession. We can see this in the current economy, which is a tale of two cities, i.e., the wealthy and the poor.

Retail sales were down slightly in October, but up 2.5% YOY. However, if adjusted for inflation, real retail sales fell 0.7% YOY in October and were negative for 10 of the last twelve months. Negative real retail sales is typical of a recessionary economy. See page 6.

Consumer credit growth has been decelerating all year, which is not a surprise given the rise in interest rates and interest costs. However, the most disturbing development is the increase in the number of people taking hardship withdrawals from their 401k plans. Wells Fargo & Co. (WFC – $42.60) reported a rise in such withdrawals last week and Fidelity National Information Services Inc. (FIS – $53.90) reported a similar trend this week. These withdrawals are a sign that many households are in very poor financial shape. Moreover, it suggests that future consumption trends will likely slow in the US. This is in line with weak reports from retailers in the third quarter. See page 7.

The housing market had been a boost to the economy in the first half of the year, but that has changed in recent months. Existing home sales were 3.79 million in October, the slowest pace in 13 years. Housing affordability is at its lowest level since 1985 and the NAHB survey is at its lowest levels since the start of the year. It is clear that rising rates are taking a toll on housing. See page 8. The 2023 economy has been a division of the haves and the have-nots, and the question is will higher income families keep the economy afloat in 2024, or not? It is an important question since the recent rally has carried the averages back to a relatively rich level. S&P Dow Jones consensus estimates for 2023 and 2024 are $214.65 and $242.73, respectively, down $0.53, and $0.60, respectively, this week. LSEG IBES estimates for 2023 and 2024 are $220.38 and $244.98, down $0.24, and $0.33, respectively. Based upon the IBES EPS estimate of $220.38 for this year, equities remain overvalued with a PE of 20.6 times and inflation of 3.24%. This sum of 23.84 is fractionally above the 23.8 level that defines an overvalued equity market. Note: based upon the S&P estimate of $214.65, the 2023 PE is even higher at 21.1 times.  

Gail Dudack

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Kicking the Can Down the Road

A stopgap spending bill that would extend government funding at current levels into mid-January was passed hours ago. This gives House lawmakers time to craft several detailed spending bills that will cover everything from the military and defense allotments to scientific research. Some Republicans on the party’s right fringe were frustrated that the bill did not include the steep spending cuts and border security measures they sought; nonetheless, the bill was passed with help from the Democratic side of the House, and it pushed the potential of a government shutdown into the New Year.

However, the partisan gridlock seen in Congress is not over and this is what led Moody’s to lower its credit rating on US debt from “stable” to “negative” last week. Moody’s pointed to economic risks including high interest rates, the government’s steadily-growing debt pile, and political polarization in Washington as reasons for the downgrade. Treasury Secretary Janet Yellen voiced disagreement with Moody’s shift, nevertheless, this implies she is blind to the ballooning deficits that now point to long-term fiscal risks. Burgeoning federal debt has recently provoked fresh warnings from economists, politicians, and credit-rating agencies.

Monthly fiscal deficits surged during the COVID shutdown and then fell on a year-over-year basis as stimulus payments began to fade and people went back to work and started paying taxes. However, a 12-month sum of monthly deficits began growing again this year and showed a 135% gain as of July 2023. This declined to a 29% YOY gain in October once Californian individual tax payments came due. Nevertheless, deficit spending is on an ominous trend, and particularly worrisome since the debt ceiling has been suspended until 2025. Not surprisingly, last week’s $24 billion sale of 30-year Treasury bonds (part of the government’s $112 billion debt sale) drew weaker-than-expected demand. This resulted in a yield of 4.769%, or 0.051% higher than the yield in the pre-auction trading in order to entice buyers. Primary dealers, who buy up the supply not taken by investors, had to accept 24.7% of the offering, more than double the 12% average for the past year. All in all, it was considered a bad performance, and it shows how rising debt levels will eventually push interest rates higher.

Moody’s had been the only one of the three main assessors with a top rating for the US. Fitch Ratings downgraded the US government credit rating in August following the latest debt-ceiling battle. S&P Global Ratings stripped the US of its top score in 2011 amid that year’s debt-limit crisis.

Here Comes Goldilocks

The equity market had a muted response to these debt risks, probably due to the fact that the economy has been surprisingly resilient. Yet it had a wildly bullish response to October’s CPI release. October’s headline CPI was unchanged for the month and up 3.2% YOY. This was down from 3.7% YOY in September and better than the consensus expected. However, if you look at the major components of CPI the only segments showing weaker than headline inflation were fuels & utilities, transportation, education & communications, and apparel. See page 3. There is still work to be done to get inflation down to the Fed’s target of 2%.

More importantly, core CPI rose 0.2% in October and was up 4% YOY, down slightly from September’s 4.1% YOY. Service sector inflation was still high at 5.1% YOY in October, down from 5.2% YOY in September. See page 4. What is clear from the history of inflation cycles is that it takes years for inflation to fall back to average or less after a sharp spike in rising prices. Inflation has been decelerating for 13 months and the consensus is declaring victory. This week equity traders began to discount an expectation that the Federal Reserve has not only ended its tightening cycle, but that rate cuts are on the horizon in the first half of 2024.

Some optimists suggest that inflation is already at 2% if housing, which lags home prices, is eliminated from the CPI equation. We doubt this is true and we doubt that consumers would agree or that renters are seeing only a mere 2% rise in rents. What is in fact helping to dampen service inflation is the recent decline in medical care services. But note that most medical services, including medical insurance, are repriced in the fourth quarter, so this favorable trend could shift in coming months and push core CPI higher at year end. See page 5. In short, this week’s rally is ushering in a Goldilocks scenario which we believe is unlikely.

Warning Signs

There are warning signs of economic weakening. The NFIB small business optimism index fell 0.1 point in October recording its 22^nd month below the long-term average. A long below-average reading is typically a sign of a recession. What we noticed in the last NFIB survey was that sales fell to their lowest level since July 2020, i.e., during the COVID recession, and earnings fell to their second lowest reading since June 2020. See page 6.

In recent weeks we reported that credit card balances increased to more than $1 trillion and newly delinquent rates on credit cards are at the highest level in over a dozen years. In addition, a Bank of America report indicates that a growing number of “cash-strapped Americans” are using their retirement nest eggs for emergency funds. The number of Bank of America 401(k) plan participants taking hardship distributions in the third quarter was 18,040, an increase of 13% between the second and third quarters and the highest level in the past five quarters since Bank of America began tracking this data. This ominous trend shows that while many financial commentators emphasize the “resiliency of the US economy” there is a growing segment of the population experiencing financial stress. The economy may be weaker than some suspect.

Big Technicals

The charts of the popular equity indices are surprisingly bullish after this week’s big price rise. The first upside resistance in most indices is found at the July highs, and the next resistance would be the all-time highs. This week the Russell 2000 index had it best performance since November 2020, rising 4.5% after October’s inflation report, but the index will encounter important resistance around the 1830 area where the 100-day and 200-day moving averages merge.

We remain cautious. Seasonal factors are usually bullish in November, December, and January, and this dramatic surge in prices could be hedge funds jumping ahead of what is seen as a seasonally strong equity market in order to lock in gains prior to yearend portfolio pricing. It does not appear to be a broad-based demand for equities. Either way, our view of the market is unchanged. The trend is neither bullish, nor bearish, but stuck in a broad trading range which is a substitute for a bear market decline. We have been expecting this trading range to persist until inflation is under control. In short, traders may be jumping the gun.

Gail Dudack

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As we near the end of the calendar year, we know that seasonal factors favor a stronger stock market. However, we also recognize that the outlook for 2024 is clouded by the Ukraine/Russia and Israel/Gaza wars, the uncertainties surrounding the presidential election in November 2024, questions about monetary policy, nagging inflation, rising credit card balances, rising credit card delinquencies, questions about the health of the US consumer, the ability of the US Treasury to fund ever-growing levels of debt, and most importantly, the prospect for corporate earnings.

Yet, what may soon jump to the top of the list of concerns will be the possibility of a government shutdown. This will not be a debt ceiling debate. On June 3, 2023 President Biden signed a bill that suspended the government’s $31.4 trillion debt ceiling until January 2025, in other words, until after the presidential election. Nevertheless, while there is currently no limit to how much the US government can borrow, Congress is required to approve government spending. Historically this has been in the form of a budget proposal originating from the President for the fiscal year (October 1 through September 30). Typically, this budget then goes to the House Ways and Means Committee which creates its own budget, details are debated and negotiated by both houses of Congress and passed. However, Congress has only completed this process in a timely manner three times in the last 47 years. The last time was the budget for the fiscal year ending in 1997.

Continuing Resolutions

The alternative to this process is a continuing resolution (CR). Continuing resolutions are temporary spending bills that allow federal government operations to continue when final appropriations have not been approved by Congress and signed by the President. Without final appropriations or a continuing resolution, there could be a lapse in funding that results in a government shutdown. This is the situation Congress will soon be facing, again. On September 30, House and Senate lawmakers passed a short-term budget extension to avoid a shutdown at the start of the new fiscal year which began on October 1 but that deal will expire on November 17. In short, lawmakers will be back in the same legislative predicaments they faced in mid-September in less than 10 days.

At present, House and Senate leaders have not made meaningful progress on a full-year budget deal or short-term compromise plan. The new Speaker of the House, Mike Johnson (Republican – Louisiana), has said that budget cuts or other policy riders will be included in upcoming proposals from his chamber but Senate Majority Leader Chuck Schumer (Democrat – New York), has called those ideas a dead end. Political analysts suggest there are three choices for Speaker Johnson. He could push for a simple funding bill that would move the November 17 deadline into next year without any strings attached. He could pair government funding with GOP priorities linked to immigration or other policies like cutting federal spending. Or Johnson could propose a “laddered CR” that would extend government funding for different agencies for different periods of time. This would allow lawmakers to favor certain parts of the government over others. For example, defense and homeland security spending would be placed ahead of other agencies. Still, without a continuing resolution, active-duty troops will not be paid any salary and hundreds of thousands of federal employees will be furloughed.

We suggested this once before, but we think Congressional salaries should be sacrificed for every day of a government shutdown. It might improve productivity in Washington DC.

Credit Card Woes

Recent data from the New York Federal Reserve revealed distinct pockets of weakness in the consumer sector and this could impact future economic activity. Total household debt balances grew $228 billion in the third quarter across all types of borrowing, particularly for credit cards and student loans. Credit card balances increased $48 billion in the quarter and $154 billion on a year-over-year basis. It was the eighth consecutive quarter of year-over-year increases and the largest increase since the NY Fed began collecting data in 1999.

This expansion in consumer debt helps to explain the surprisingly high GDP growth seen in the quarter, but it is coming at a cost. Credit card delinquencies increased from the historical lows experienced during the pandemic and topped pre-pandemic levels by the end of the quarter. Mortgages, which comprise the largest share of household debt, have delinquency transition rates that are below their pre-pandemic levels; nevertheless, auto loan and credit card delinquencies have surpassed their pre-pandemic levels. The rise in credit card delinquencies is being led by Millennials, whereas Baby Boomers, Generation X, and Generation Z have delinquency rates closer to 2019 levels. Delinquency rates have been increasing in each income quartile but are rising fastest for lower-income credit card holders. Those with combined balances over $20,000 have the highest delinquency transition rate, but fortunately these balances represent only 6% of credit card holders. Not surprisingly, delinquencies are rising most quickly for consumers with auto and student loans.

Haves and Have-Nots

In the second half of the year, the winding down of fiscal stimulus, the rise in interest rates, and the resumption of student loan payments, began to impact households, particularly the lower-income category. Still, the post-pandemic expansion has been an unusual one and continues to be a story of the haves and the have-nots. Seen from one point of view, higher income households have been going to Taylor Swift concerts, enjoying expensive cruises, and traveling the world for fun. Lower-income households have been battered by high inflation and are having trouble paying their mortgage, paying rent, putting gas in their car, and paying for their children’s education. The third quarter GDP of 4.9% did not feel all that special from their perspective.

This week we also review vehicle sales, Conference Board consumer sentiment (seven out of 10 consumers expect a recession in the next 12 months), ISM indices, the employment cost index, and S&P earnings. See pages 3-7.

Technical Update

The Russell 2000 index spent only two trading days below the key 1650 support level, which was too brief to confirm that the breakdown in the index was significant. This is good news since a breakdown would have meant much lower prices for the overall market. In upcoming weeks, the most important index could be the SPX as it trades between its 100- and 200-day moving averages, which represent resistance at 4400 and support at 4251. See page 8. The 25-day up/down volume oscillator is at a positive 0.90 reading this week and neutral, after recording an 89% up day on November 2, on volume that exceeded the 10-day average. See page 9. However, this indicator did not confirm the advance in August nor the weakness in October. This is in line with our long-held view that the equity market remains in a broad neutral trading range.

Gail Dudack

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Federal Debt Distress

There are many things to worry about this week. At the top of the list are the wars in the Middle East and in Europe, which are proxy wars for any and all democratic societies, and which could have an impact on the price of crude oil. Earnings season has been a mixed bag and results have not been confidence-building. The Federal Reserve meets this week, but we doubt there will be any change in the fed funds rate given the uncertainty of the world’s geopolitical situation. However, one of our main concerns is the rising level of government debt, the lack of political will to change current trends, and what this will mean for the future of interest rates. Total outstanding US debt has grown from $31.5 trillion in June to $33.17 trillion recently. And this level is up from $23.2 trillion in pre-pandemic 2020, which equates to a shocking 43% increase in 3 ½ years. Meanwhile, Congress seems willing to put this issue on the back burner.

This year the Treasury sold roughly $1.56 trillion of new Treasury bills through the end of September and the bulk of this materialized after Congress suspended the debt ceiling in June. This week the Department of the Treasury announced its estimates of privately held net marketable borrowing for this year’s fourth quarter and next year’s first quarter. The Treasury indicated it expects to borrow $776 billion in privately held net marketable debt in the current quarter, down $76 billion from its July estimate, due in large part to projections of higher receipts. Since this new estimate is lower than what was previously announced, the bond market responded favorably to the news.

But borrowing will increase. The Treasury also indicated it plans to borrow $816 billion in privately held net marketable debt in the first quarter of 2023, assuming their projections of cash on hand are correct for December 2023. Treasury yields, especially on longer-dated securities, have risen in step with growing bond supply and supply is expected to continue to grow. By the end of fiscal 2028, White House forecasts show gross debt rising to $42 trillion, a 28% increase from current levels, and debt held by the public rising to $34.5 trillion, a 33% increase. See page 3.

There are many problems related to growing deficits. The first risk is that supply drives interest rates higher, but eventually, high levels of debt become a Catch-22. Interest payments on the debt increase deficits and raise interest rates which increase the interest payments on the debt, and so on. As we noted last week, while defense spending grew 7%, to $774 billion in FY 2023, interest payments on the debt increased 33%, to $711 billion. At this pace, interest on the debt will overtake defense spending in fiscal 2024.

Another warning sign is the high level of short-term government debt. The TBAC, or Treasury Borrowing Advisory Committee recommends keeping Treasury bills at 20% or less of total outstanding marketable US government debt. However, the current level of short-term debt already exceeds 20% which increases the rollover risk as interest rates rise. See page 4. In sum, the market may be too complacent about interest rates, particularly as the Fed leaves rates unchanged after two consecutive meetings, but we see the potential for the bond market to upset the stock market in the months ahead.

Economics: A Strong September

The advance estimate for GDP in the third quarter was a surprisingly strong 4.9% and this follows a 2.1% gain in the second quarter. Consumer spending was an important source of growth as well as inventories. Residential investment made its first positive contribution to growth since early 2021. See page 5. In line with this was good news about September’s personal income. It rose 4.7% YOY, disposable income rose 7.1% YOY, and real disposable income rose 3.5% YOY. Real personal disposable income has now been positive for nine consecutive months. However, personal consumption expenditures rose 5.9% YOY, which explains why the savings rate fell from 4.0% in August to 3.7% in September. See page 6.

It is worth noting that September’s 3.7% saving rate is well below the 2000-2023 average of 5.7% and this suggests that the current rate of consumption is unsustainable. In addition, rising interest rates continue to pressure consumption. Personal interest payments were up 48% YOY in September and currently represent 2.8% of personal consumption. See page 7.

Therefore, we were not surprised that consumer sentiment indices were uniformly weak in October. The Conference Board confidence index fell from 104.3 to 102.6, with present conditions weakening from 146.2 to 143.1. The expectations index fell from 76.4 to 75.6. The University of Michigan sentiment index declined from 67.9 to 63.8, while present conditions fell from 71.1 to 70.6. The expectations component was much weaker, falling from 65.8 to 59.3. All in all, October has not been a good month for many households. See page 8.

Technical Breakdown

The deterioration in the technical charts of all the popular indices was obvious this week. However, the most significant development was the sell-off in the Russell 2000 index below the 1650 support level. This breakdown has not yet been confirmed since the index rebounded to 1662 on October 31, nonetheless, the pattern is worrisome. A confirmed breakdown will be a sign of lower prices for the overall market and the likelihood of another 5% to 10% downside risk. See page 10.

The 25-day up/down volume oscillator is at a negative 0.81 reading this week and neutral, after being in oversold territory for two consecutive trading days on October 20 and October 23 and for three out of four consecutive days on October 5 to October 9. It may surprise some readers that this oscillator did not reach an extreme oversold reading after last week’s decline; however, the lack of a consistent oversold reading continues to suggest that the equity market is in an extended trading range. Keep in mind that broad trading ranges are often substitutes for bear markets and are simply another way for prices to come in line with valuation. See page 11.  

The 10-day average of daily new highs is currently 34 and the 10-day average of new lows is at 454. This combination is negative with new highs well below 100 and new lows well above 100 since we assume 100 is the benchmark for defining the market’s trend. The NYSE advance/decline line fell below the June low on September 22 and is now 40,491 net advancing issues from its 11/8/21 high. July was the first time in two years that the disparity between the AD line’s peak and current levels was consistently less than 30,000 net advancing issues. However, in recent weeks this disparity has increased well above 30,000 issues once again. See page 12.

Last week’s AAII readings showed a 4.8% decline in bullishness to 29.3%, and an 8.6% increase in bearishness to 43.2%. Bullish sentiment is below its historical average of 37.5% for the 9th time in 11 weeks. Pessimism is above its historical average of 31.0% for the 8th time in 10 weeks. After hitting a negative one-week reading the week of August 2, the 8-week bull/bear spread is now neutral and closing in on a positive reading. We remain near-term cautious but sense a good intermediate-term buying opportunity is approaching.  

Gail Dudack

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Halloween is quickly approaching, but the financial markets are spooked for other reasons. It is already an unsettling time with Iran and Russia sparking wars in Israel and Ukraine and many of the world’s major cities experiencing disturbingly large demonstrations in support of the Hamas terrorist group. The breadth of antisemitism seen both domestically and abroad has been a frightening revelation for many. A small consolation is found in the growing number of industry leaders stating they want the names of pro-terrorist demonstrators seen on Ivy League campuses because they will not hire them. University donors are also pulling money from universities that are supporting Hamas, or do not differentiate between Hamas or other terrorist organizations and Palestine. These are small steps in the right direction in very troubling times.

However, here at home, there is another potential crisis. It began with the historic ousting of House Speaker Kevin McCarthy on October 3 which exposed the large schisms in the Republican party and how a small number of Republicans could wield control over the election of the Speaker of the House. Without a speaker, the House is unable to conduct government business, to continue its subcommittee investigations, or to push through bills, including vital spending bills that would prevent a government shutdown on November 18. As we go to print, a third candidate, Tom Emmer, Minnesota Congressman, who was nominated by fellow Republicans as Speaker candidate earlier this week, abandoned his bid due to party infighting. The House has now gone 22 days without a leader and a US government shutdown looms on the horizon. Government paralysis in the face of massive global disruptions and significant fiscal hurdles will not be good for the securities markets.

Crosscurrents

It is not surprising to us that the 10-year Treasury yield broke above the 5% resistance level in recent sessions. Treasury bonds are facing two strong and opposing crosscurrents. On the one hand, deficit spending has continued to increase. Year-end data from the September 2023 Monthly Treasury Statement of Receipts and Outlays of the United States Government show that the deficit for FY 2023 was $1.7 trillion, $320 billion higher than the prior year’s deficit. As a percentage of GDP, this was 6.3%, an increase from 5.4% in FY 2022. The Office of Management and Budget estimates that the FY 2024 deficit will be 6.9% of GDP. See page 3.

With both deficits and interest rates rising, interest payments on the debt have increased 33% from $534 billion in FY 2022 to $711 billion in FY 2023. In comparison, defense spending grew 7% from $727 billion to $774 billion in the same period. If this pace continues, interest on the debt will overtake defense spending next year. See page 4. In the near term, the anticipated record issuance of debt in the next few quarters has worried bond investors. But in the longer term, interest payments on this debt and its impact on deficits will soon become a Catch-22 problem for debt markets.

The other crosscurrent that is now helping the bond market is the war in the Middle East. Not only is the US bond market seen as a safe haven in a time of war, but this flight to safety is also having a positive impact on the price of gold and bitcoin. In sum, the cross currents in the bond market are as powerful as we have seen in a long time.

Higher interest rates seem likely over the intermediate term, although we doubt the Federal Reserve will raise rates in November, ahead of a possible escalation of the Israel-Gaza conflict. It will only raise rates once it has prepared the market for higher rates. Yet, the impact of rising interest rates is being felt throughout the economy. Mortgage rates have increased 425 basis points in the 24 months ended August 2023, and this is impacting the residential housing market. The August NAR housing affordability index dropped to its lowest level since June 1985, and mortgage rates have increased in the interim. The September report will be released November 9. The October NAHB confidence survey fell to 40, dropping 16 points since July and is now at its lowest level since January. See page 5. In short, the housing market is slowing, and we expect higher rates will impact auto affordability as well in the coming months.

Earnings

This is one of the busiest weeks in terms of third quarter earnings releases and as we noted last week, it includes a number of the large cap technology darlings. To date, the results are mixed. Microsoft Corp. (MSFT – $330.53) beat estimates for fiscal first quarter results in all segments, but Google-parent Alphabet Inc. (GOOG – $140.12) missed its cloud business revenue estimates and the stock was pummeled. The S&P Dow Jones consensus estimates for 2023 and 2024 are $218.71 and $244.97, respectively, down $0.84, and up $0.18, respectively as of October 20. LSEG IBES estimates for 2023 and 2024 are $219.74 and $246.91, down $0.72, and $0.05, respectively. This is the first time that the IBES estimate has dropped below $220. And based upon the IBES EPS estimate of $219.74 for this year, we believe equities remain overvalued. A PE multiple of 19.3 times is high given that inflation remains above average at 3.7%. The sum of inflation (3.7) and the market’s PE (19.3) equals 23.3 and this is barely under the 23.8 level that defines an overvalued equity market. See page 6.

Technical Indicators in Focus

The Nasdaq Composite index is the only index that has not broken below its 200-day moving average in the last week, although it did have an intra-day test of this long-term average recently. To date, it is unclear if this test will prove successful. The S&P 500 index rebounded after breaking below its 200-day moving average, but it is now trading only marginally above this long-term average. The Dow Jones Industrial Average and Russell 2000 are both trading below their 200-day moving averages as noted last week. Nonetheless, a break below the 200-day moving average is not unusual for a market that is in a long-term sideways trend. However, at 1679.50, the Russell 2000 is perilously close to key support at the 1650 level. This support has contained selling sprees in the past and it would be a major negative if this support level were broken. If it breaks, we believe it would be a precursor to further price weakness. See page 7

The 25-day up/down volume oscillator is at a negative 2.54 reading this week and neutral, but only after being in oversold territory for two consecutive trading days on October 20 and October 23. This follows oversold readings for three out of four trading sessions in early October. These oversold readings could be mirror images of the overbought readings seen in August, when no overbought readings lasted the minimum of five consecutive trading days. In short, August’s rally was unconfirmed. Now that this indicator has had oversold readings of minus 3.0 or less, the same is true – five consecutive trading days in oversold are needed to confirm that recent weakness is a confirmed downtrend. To date, there have not been five consecutive trading days in oversold, which means the decline is not confirmed and the longer-term trend remains vulnerable, but neutral. See page 8. We remain cautious but believe a buying opportunity could materialize before year end.

Gail Dudack

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There has been a lot of volatility in recent days, yet there was very little progress in the popular indices. This is not surprising to us. There are almost too many variables and risks to monitor at the moment and so the indices are whipsawed by the ever-changing news of the day. Aside from the economic backdrop, the Israeli-Gaza war creates a frightening and unpredictable global environment, and the sad state of affairs in the US House of Representatives — which seems incapable of electing a new Speaker — has put a dangerous halt to US fiscal and foreign policy. (Shouldn’t we stop paying their salaries until they do their jobs?) US border officials have released thousands of migrants onto the streets of the San Diego area and Russia states that it no longer needs to obey the UN Security Council restrictions on giving missile technology to Iran since the restrictions will soon expire. It does make your head spin.

The Magnificent 7

In times like these, it is always important to monitor earnings and valuation. In this regard, Refinitiv IBES, in conjunction with Lipper Alpha Insight, released an interesting study on third quarter earnings season. It included information reminding investors that the S&P Dow Jones earnings estimates are share weighted, not market capitalization weighted. It then looked at what they called the “Magnificent-7”. These are Apple Inc. (AAPL – $177.15), Amazon.com, Inc. (AMZN – $131.47), Alphabet Inc. (GOOG – $140.99), Meta Platforms, Inc. (META – $324.00), Microsoft Corp. (MSFT – $332.06), Nvidia Corp. (NVDA – $439.38), and Tesla, Inc. (TSLA – $254.85).

IBES noted that these seven stocks have a market cap weighting in the S&P 500 index of 29.9% — an all-time high — but have earnings and revenue weights of 15.6% and 9.7%, respectively. The Magnificent-7 also has an aggregate forward PE of 27.6 times, which represents a 55% premium to the overall index. A table from this report is presented on page 11 with the 11 sectors of the S&P 500, their market cap weighting, earnings share weighting, revenue share weighting, and forward PE multiples. It basically shows that the technology sector is by far the most expensive segment of the S&P 500, while financials and energy are the least expensive. It is an interesting macro view of valuation.

Given their excessive weighting in the S&P index, the earnings reports from these seven stocks will be important to monitor. Tesla, Inc. will be the first to report on October 18, followed by Microsoft Corp. and Alphabet Inc. on October 24, Meta Platforms, Inc. on October 25, Amazon.com, Inc. on October 26. Apple Inc. and Nvidia Inc. report on November 2 and November 21, respectively.

Economics in Focus

There were many economic releases in the last week which we would summarize as showing weakness in business and consumer sentiment, stickiness in inflation, resiliency in retail sales, and better-than-expected industrial production led by autos. All in all, these reports would probably lead to another fed funds rate hike in November, if all things were equal. But all things are not equal in the Middle East or in the US and as a result,  we do not expect the Federal Reserve to raise rates. Keep in mind that another debt ceiling crisis will materialize before the end of the year.

The NFIB small business optimism index fell slightly in September, from 91.3 to 90.8; however, the business outlook fell from -37 to -43 and “expected credit conditions” dropped from -6 to -10. See page 3. Preliminary data for October’s University of Michigan sentiment survey showed a decline in consumer sentiment even though gasoline prices had declined. The main index fell from 68.1 to 63.0; present conditions fell from 71.4 to 66.7; expectations fell from 66.0 to 60.7. Conference Board indices fell in September and October data will be released at the end of the month. See page 5.

Industrial production rose a better-than-expected 0.3% in September. Nonetheless, total IP was barely above the level seen a year ago, nondurable production was down 0.3%, but durables, led by auto production, rose 1.7% YOY. However, auto and truck production appears to be rolling over after its May-June peaks. See page 4.

Advance estimates for September’s retail and food services sales were $704.9 billion, up 0.7% for the month, and up 3.8% YOY. This was much better than the consensus expected; yet, after inflation, real retail sales in September were up only 0.1% YOY. At the end of August, real retail sales had been negative on a year-over-year basis for nine out of ten consecutive months. We believe this is an important point since year-over-year declines are typically seen only during recessions. See page 6.

The key reports last week were related to inflation. The PPI is usually a leading indicator of the CPI, and the good news was that core PPI, while still high at 3.4% YOY, appears to be decelerating. On the other hand, headline PPI, after being negative for months, has begun to uptick again and reached 2.5% in September. Similarly, core CPI, still high at 4.1%, appears to be decelerating, but headline CPI rose slightly in September to 3.7%. See page 7. Most of the major components of the CPI rose more than headline, both on a monthly and a yearly basis, and all items less food and energy rose 4.1% YOY. Stemming an even bigger jump in inflation in September were the declines seen in fuels & utilities and medical care. Still, since transportation costs typically lag the price of oil which has been rising, there is an upward risk to future inflation numbers. See page 8.

The Federal Reserve is most concerned about service sector inflation which eased only slightly from 5.39% to 5.16% in September. Owners’ equivalent rent inched down from 7.3% to 7.1% and rents of primary residences eased from 7.8% to 7.4%. Medical care pricing was negative for the third consecutive month falling 1.4% YOY. However, other services, with a 9.4% weighting in the CPI, are trending higher and were up 4.4% in September. See page 9.

The biggest risk to future inflation could be higher crude oil prices. This is likely given the chaos in the Middle East. After months of YOY declines, WTI rose 14.2% YOY in September and to date, is up 1% YOY in October. Equally important, the chart of WTI turned bullish once the price broke above the $80 resistance level. See page 10. Again, if it were not for all the domestic and global political risks, the Federal Reserve would likely be raising rates in November.

Technical Guides The Russell 2000 continues to trade below its 200-day moving average, the Dow Jones Industrial Average broke below its long-term average before recovering in recent sessions. The S&P 500 rebounded after an intra-day test of its 200-day average, which was technically impressive. The Nasdaq Composite, led by the Magnificent-7, continues to trade well above its long-term average. But overall, the patterns of the major indices remain characteristic of a long-term neutral trading range. This is best represented by the 1650-2000 range in the Russell 2000. If the Russell were to break below the 1650 support, it would be bad news for the broader market, in our view, but this is not our expectation. Our 25-day up/down volume oscillator was oversold for three of five trading sessions in early October but is now neutral. In short, it too suggests the market remains in a long-term trading range.  

Gail Dudack

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