Last week was a busy time for economic releases and unfortunately, the data was not favorable for those looking for a Fed pivot. The middle of the week was dominated by the release of minutes from February’s FOMC meeting, and it revealed that a few participants favored a 50-basis point increase. All board members were in favor of continuing rate increases in order to reach their target of inflation of 2% but some members wanted to get to a restrictive stance more quickly. The minutes also disclosed that Fed officials felt wage growth of 3.5% YOY would be compatible with a 2% inflation target.

But Friday’s economic releases showed that personal income rose 6.4% YOY in January and disposable income rose 8.4% YOY. The big surprise, however, was that real personal disposable income rose 2.8% YOY in the month — the first gain in real personal disposable income since March 2021! January’s CPI was already reported to be 6.4% YOY, so this gain in personal income closed a 21-month gap between inflation and income growth. See page 3. The savings rate also ratcheted up from 4.5% to 4.7% in the first month of the year. This data was better than expected.

While personal income rose 6.4% YOY, personal consumption expenditures rose 7.9% YOY, up nicely from the 7.5% reported in December but down considerably from the stimulus-driven peak rate of 30% YOY in April 2021. However, current household consumption is coming at a price. The Federal Reserve’s Z.1 report for the third quarter of 2022 showed that debt as a percentage of disposable income rose to nearly 103%, the highest level recorded since the end of 2017. See page 4.

Household Debt on the Rise

According to the Federal Reserve of NY’s latest Quarterly Report on Household Debt and Credit, total household debt rose $394 billion, or 2.4%, to $16.9 trillion in the final quarter of 2022. The $394 billion growth in the fourth quarter represented the largest nominal quarterly increase in twenty years according to the FRBNY. The $16.9 trillion total at the end of 4Q 2022 represented a year-over-year gain of 8.5%, the highest pace of debt accumulation since the first quarter of 2008.

Still, credit card balances were the most worrisome segment of debt. Credit card balances rose by $61 billion, the largest increase in FRBNY data going back to 1999. For all of 2022, credit card debt surged by $130 billion, also the largest annual growth in balances. After two years of historically low delinquency rates, the share of debt transitioning into delinquency increased for nearly all debt types. See charts on page 5. Unfortunately, credit card delinquencies are rising the fastest among 18 to 29-year-olds as compared to all age categories. This may become an even greater problem as interest rates rise.

Mortgages and auto loans grew at a relatively moderate pace in the fourth quarter. Mortgage balances rose to $11.92 trillion; auto loans rose to $1.55 trillion, and student loan balances rose to $1.60 trillion.

All in all, the increase in credit card debt and other revolving forms of credit will be unsustainable in a rising interest rate environment and consumption is apt to slow later in the year. But generally, most of January’s data releases pointed to a surge in economic activity. For example, January included an increase in new home sales to 670,000 (SAAR), an 8.1% rise in the pending home sale index to 82.5, and an increase in the University of Michigan consumer sentiment index from 64.0 to 67 in February. This sentiment index was offset a bit by the Conference Board consumer confidence index, also for February, which slipped from 106.0 to 102.9. Nevertheless, the present condition component of the Conference Board survey increased from 151.1 to 152.8.

The Fed Problem

Last week’s final straw was the report on the Fed’s favorite inflation benchmark, the PCE deflator, which rose by 0.1% in January to 5.4%. This aligns with the CPI which had inflation picking up at the start of the year. The combination of good economic statistics and no significant slowdown in prices sent interest rates higher all along the yield curve. Conversely, stocks fell. The decline in equities is understandable. As we show on page 6, the gap between inflation and the fed funds rate has been narrowing, particularly versus the PCE deflator. But without a further slowdown in inflation, the prospects for higher interest rates will become open-ended. With an effective fed funds rate of 4.57% and the PCE deflator of 5.4%, this 100-basis point gap implies more than two 25-basis point hikes will be required in coming months. And if the Fed is serious about attaining a positive real fed funds rate, it could be even more.

The ISM manufacturing and service surveys will be released this week, but in general, there is little in terms of important economic reports until the February employment report scheduled for March 11. In the meantime, investors will continue to ponder earnings reports and the FOMC meeting on March 21-22, 2023.  

Technical Update

Last week we discussed the 2000 level in the Russell 2000 index and its importance. The RUT has been a leader in the recent advance and the 2000 level was the first significant level of resistance. In our view, the 2000 level would be an important test of the strength of the rally. Unfortunately, to date, this level has rebuffed the advance.

Now our attention shifts from the Russell 2000 to the S&P 500 and its confluence of moving averages, but in particular, the 200-day moving average at SPX 3940. This is an important level of support, and if broken, it could trigger further selling in our view. The SPX’s 200-day moving average currently sits between the 50-day moving average at 3,979.23 and the 100-day moving average at 3919.32, creating a significant range of support between SPX 3919 and 3979. If this range does not hold as support, we would expect the optimism that increased during the January rally will dissipate.

Summary As we noted a few weeks ago, the easy part of the rally may be behind us. Our view calls for a broad trading range until inflation is clearly under control. As seen by January’s data, this process could take another 12 to 18 months. Historically, the popular stock indices have spent 50% of the time in flat trends, so this is not unusual. We expect the broad indices will be contained between the January 3, 2022 SPX high of 4796.56 and the October 12, 2022 low of SPX 3577.03. If we are correct about a trading range market, leadership may rotate throughout the year. But note, while “flat” cycles are unable to sustain an advance above the previous market peak, they can include several bull and bear market moves of 20% or more. In short, the days of a “buy and hold” strategy may have ended for a while. Core holdings in portfolios should include inflation and recession resistant companies and stocks with attractive dividend yields and predictable earnings growth.

Gail Dudack

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Last week we pointed out that the 2000 resistance level in the Russell 2000 index (“Russell 2000 at 2000” February 15, 2023) could be pivotal for the near term. Similar to the less delineated DJIA 34,000 level, the RUT’s 2000 resistance level presented the first real challenge for the advance initiated from the October 2022 low.

The market also revealed signs of exhaustion with daily NYSE volume falling consistently below the 10-day average and sentiment indicators reaching short-term extremes. The AAII bull/bear sentiment indicator had a sizeable 7.6% jump in bullishness to 37.5%, the highest level in over a year. Bearishness fell 9.6% to 25%, its lowest level since November 2021. It was too much, too soon in terms of a sentiment switch. Not surprisingly, in this week’s first session, the Dow Jones Industrial Average fell 697.1 points, or 2.06%, to 33,129.59, and wiped out its year-to-date gains. The S&P 500 lost 81.75 points, or 2.00%, to 3,997.34; the Nasdaq Composite dropped 294.97 points, or 2.5%, to 11,492.30; and the Russell 2000 fell 58.14 points, or 2.99%, to 1888.21. These indices shaved previous gains but remained positive for the year.

There were numerous reasons for the market sell-off, but the main catalysts have not changed: concerns about earnings growth, the risk of more-than-expected Fed rate hikes and worries of an escalation of the Russia/Ukraine conflict. As the fourth quarter earnings season draws to a close, it is the results of retail companies that now come into focus. To date, these results have been less than stellar. More importantly, forward guidance has been sobering as corporate leaders warn of an earnings slowdown.

Earnings Growth

On page 15 we display our quarterly and annual forecasts for S&P 500 earnings as well as those from S&P Dow Jones and IBES. It is worth noting that the S&P Dow Jones 2022 earnings estimate for 2022 is currently $196.31 and for 2023 it is $220.16. As recently as July 22, 2022, the 2022 estimate was $220.70, or higher than the current 2023 estimate. IBES currently estimates this year’s earnings to be $222.85, but as recently as October 7, 2022, it showed a consensus estimate for last year’s earnings of $223.34. In sum, earnings estimates are coming down, but the question is how much further might they fall? This is a difficult question since economic signs are mixed and to a large degree, confusing.

More Fed rate hikes

There are some worrisome signs for the economy. The Conference Board Leading Economic Index slipped 0.3% in January to 110.3 and represents the 11th consecutive monthly decline in the LEI. A long steady decline in the leading indicators has been a good predictor of a recession in previous cycles.

On the other hand, the latest S&P global flash PMI composites are telling a different story. The January US PMI Composite index rose from 46.8 to 50.2 to an 8-month high, led by strength in the service sector. The rise above 50 indicates an economic shift from contraction to modest expansion in the PMI indices. February’s Eurozone flash PMI rose for the fourth consecutive month to 52.3, indicating the strongest business activity since May 2022. The UK flash PMI for February also rose sharply from 48.5 to 53.0, registering the strongest expansion since June 2022. All in all, these flash economic surveys depict a rebound in economic activity in both the US and Europe.

An improvement in economic activity is usually good news, but when it is coupled with recent inflation data, it is a recipe for further Fed rate hikes, and this is upsetting for those who were expecting another “one and done” rate hike in March. It has been our view that the Fed would have to raise rates higher and keep them there longer than the consensus was expecting.

In January, the CPI rose 6.35% YOY, down fractionally from the 6.44% YOY rise in December, yet a major improvement from the 9.1% YOY seen in June 2022. Still, prices are not falling as quickly as some had hoped. The PPI for finished goods rose 8.7% in January, down only 0.2% from the 8.9% reported in December. Wages rose a healthy 5.4% YOY in January but after adjusting for inflation, household purchasing power declined 1% YOY in January. We have been concerned about the disparity between inflation and wage growth for the last year. The spread is narrowing but it has not closed, and the consumer remains under pressure. See page 3.

Nevertheless, households continue to spend. Total retail & food services sales rose 6.4% YOY in January, and sales excluding motor vehicles and parts, rose 7.3% YOY. However, when nominal retail sales are adjusted for inflation, real retail sales only grew 0.2%. This is down from 1.1% in December, but up from the 1% decline seen in November. See page 4. Total vehicle unit sales rebounded strongly from December’s 13.9 million (SAAR) to 16.2 million in January, and this makes the 7.3% YOY rise in January’s retail sales excluding autos, and 7.4% rise in sales excluding autos and gas stations, even more impressive. The 25.2% increase in food services and drinking places was noteworthy. See page 5.

However, this spending comes at a cost. The latest Quarterly Report on Household Debt and Credit from the New York Federal Reserve showed total debt balances grew by $394 billion in the fourth quarter of 2022, the largest nominal quarterly increase in twenty years. The increase in credit card balances between December of 2021 and December of 2022 was $130 billion, the largest annual growth in balances seen in the data history which began in 1999.

In terms of debt and mortgages, housing remains in a slump. December’s new home sales totaled 616,000 annualized units, down nearly 27% YOY. Existing home sales fell to 4 million units in January, a decline of nearly 37% from a year earlier. See page 6. The NAR housing affordability index improved from 94.3 in November to 101.2 in December, yet it remains at one of the lowest readings since 1986. This is not favorable. Nonetheless, in February, the NAHB housing index reflected a bit more optimism about the next six months and rebounded from the year-end 2022 cyclical lows. See page 7. 

Summary

Our view has not changed. We expect a trading range market until inflation is clearly under control, a process that is apt to take another 12 to 18 months. In terms of the indices, we anticipate a 12-to-18-month range as high as the January 3, 2022 peak of SPX 4796.56 and the October 12, 2022 low of SPX 3577.03. The February overbought reading in our 25-day up/down volume oscillator is in line with this forecast. To date, the rally has been led by large-cap technology stocks, but we do not believe technology as characterized by FAANG stocks, will be the leadership of the next bull market cycle. Typically, a long-term trading range market will see leadership rotate throughout the year.

Keep in mind that the popular stock indices have a history of spending 50% of the time in flat trends. These trends are not boring; they can include several bull and bear market moves of 20% or more. However, these cycles are defined as “flat” since market rallies are unable to sustain an advance above the previous market peak. In short, the days of “buy and hold” may have ended for a while.

Gail Dudack

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Technical Indicators in the Spotlight

The easy part of the 2023 rally may now be behind us. We are concerned that daily volume on the NYSE has been consistently lower than the 10-day average for seven consecutive trading sessions. It is a sign of fading demand. More importantly, the Russell 2000 index, which was an excellent leading indicator at the 2021 peak and has been a decent leader at the October low, is now facing stiff resistance at the 2,000 level. The Russell index has the most attractive technical pattern of all the major indices and if it can better the 2000 level, the Russell could rally another 10%. However, in our view, it is more likely that the equity market is extended, a consolidation process has begun, and part of this process could include a retest of the lows. See page 10.

Another warning sign is found in the American Association of Individual Investors (AAII) survey which had some surprising shifts last week. The AAII readings showed a 7.6% increase in bullishness to 37.5%, its highest bullish reading in over a year. It is also the first time in 58 weeks that bullish sentiment is at or above its historical average of 37.5%.

Investors who indicated they were neutral, neither bullish nor bearish, rose 2% to 37.5%, and were also at the highest level in over a year. Conversely, a huge 9.6% decrease in bearishness took the bullish ratio to 25.0%, its lowest reading since November 11, 2021, or 15 months ago. Bearishness is now below its long-term average of 31.0%. The Bull/Bear Spread remains positive but it is moving toward neutral for the first time since January 2022. Sentiment readings were most extreme on September 21, 2022, and equity prices tend to be higher in the next six and/or twelve months following such extreme readings. Nevertheless, last week’s readings are a display of too much optimism appearing too quickly and it is a negative omen for the near term. See page 13.

Some technical indicators continue to be positive. The 10-day average of daily new highs is 130 and new lows are 26. This combination remains positive since new highs are above the 100 benchmark that defines the trend, and new lows are well below 100. The NYSE advance/decline line is currently 28,517 net advancing issues from its November 8, 2021 high, which is further away than it was a week ago. In general, the AD line is negative, but it has been improving since the end of the year. See page 12.

Inflation, the Fed, and PE multiples

January’s CPI data, on a non-seasonally adjusted basis, showed prices rising 6.4% YOY versus the 6.5% YOY reported for December. Core CPI rose 5.6% versus 5.7% a month earlier. This was slightly worse than the consensus expected, but not bad enough to change the outlook for Fed policy. Inflation is slowing, but at a slower pace than some had expected. The energy component of CPI rose 8.7% YOY in January versus 7.3% YOY in December, which was a surprise because the price of the WTI future fell 10.5% YOY in January versus a 6.7% YOY gain in December. The good news is that the energy component of the CPI remains well below the peak of 41.6% YOY seen in June 2022. See page 3.

Many inflation watchers like to exclude the owner’s equivalent rent component from the CPI to moderate inflation, however, the OER has been a part of the CPI for decades and without controversy prior to this cycle. What is interesting to us is that when we compare the OER and the fed funds rate, it is clear that the Fed had been far more aggressive in terms of fighting inflation in the past. The Fed typically increased rates ahead of any significant rise in the OER, or at the first sign of inflation. Today, the Fed remains well behind the curve and behind the rise in the OER. More importantly, housing is not the problem for the Fed since interest rates have had, and will continue to have, a significant impact on mortgage rates, housing demand and housing inflation. The problem has switched to the service sector where inflation is rising broadly. In January, service sector inflation rose from 7.5% to 7.6%. See page 4. All told, inflation may be more entrenched than previously thought and the Fed will need to keep interest rates higher for longer than many expect.

Lowering inflation is critical for many reasons, but in terms of equity valuation, high inflation usually translates into lower PE multiples. The current trailing PE for the S&P 500 of 20.9 times and the forward PE is 22.3 times based upon our 2023 estimate of $180, or 18.8 times based upon the current S&P Dow Jones estimate of $220.31. All of these PE multiples are extremely high with inflation over 6% YOY. The risk in the market is that equity valuations can only be supported if inflation is 2%. Unfortunately, that is unlikely to materialize this year. In other words, breadth has improved on this rally, but valuation has not.

Sentiment

There was a small increase in the University of Michigan consumer sentiment survey for February and it was due entirely to the present conditions component, which rose 4.2 points to 72.6. Ironically, the present conditions index is now more than 10 points above the expectations index. More confusing is the fact that this is in complete contrast to December’s detailed survey on personal finances, where personal finances were falling throughout 2022, but expectations rose in the final months of the year. The University of Michigan consumer sentiment is a timelier survey, so hopefully, this improvement in present conditions will be sustained.  See page 5.

The NFIB small business optimism index rose 0.5 points to 90.3 in January but remained below the long-term average of 98 for the 13th consecutive month. Eight subcategories improved this month and five deteriorated. However, even though the outlook for business conditions rose from -51 to -45, it lingers well below the zero line, although 16 points above its June 2022 low of -61. See page 6. Plans to increase capital expenditures or inventories declined in January while plans to increase employment and expand rose modestly. Small businesses were gloomier about the prospect of real sales increasing even though plans to raise prices also rose in January. See page 7. There were small increases in actual sales and earnings in January which may have contributed to the rise in the uncertainty index to 76, up 5 points for the month and up from the June 2022 low of 55. See page 8.

Summary We expect the equity market will remain in a broad trading range until inflation is clearly under control, a process that is apt to take another 12 to 18 months. In the interim, we expect the broad indices will be contained between the January 3, 2022 SPX high of 4796.56 and the October 12, 2022 low of SPX 3577.03. The improvement in our 25-day up/down volume oscillator is in line with this forecast. To date, the rally has been led by large-cap technology stocks which we do not believe will be the leadership of the next bull market cycle. Technology stocks had been at the center of heavy short selling, and it is likely that short covering contributed to the current advance. If we are correct about a trading range market, leadership may rotate throughout the year. Keep in mind that historically, the popular stock indices have spent 50% of the time in flat trends. Flat trends can include several bull and bear market moves of 20% or more, but we define them as “flat” since rallies are unable to sustain an advance above the previous market peak. In short, the days of “buy and hold” may have ended for a while.

Gail Dudack

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There were a number of developments in economic, fundamental, and technical data over the last week, but the most significant change was technical and the performance of our 25-day up/down volume oscillator. In our last strategy report, we indicated that it would be important to monitor this indicator because it could be close to making a positive shift. That is what it did this week. The oscillator has now been in overbought territory for ten consecutive trading sessions. Ten is an important number because bear markets rarely have rallies that can sustain an overbought reading for five to ten days. The initial advance in a bull market will have an extended overbought reading and it usually includes an extreme reading of 5.0 or greater. Currently, the oscillator has been as high as 4.81 but it has not exceeded the 5.0 reading generally seen at the start of a new bull cycle. Nonetheless, this long overbought reading is a positive change in this indicator. See page 12.

And there are other positives in the technical arena. The 10-day average of daily new highs has been over 100 for the last week and the 10-day average of daily new lows has been below 30. This combination is bullish since 100 or more defines the trend. The current rally also carried the popular indices above their 200-day moving averages, including the lagging Nasdaq Composite Index. And as we noted recently, the Russell 2000 has an attractive technical chart after bettering the 1900 resistance level. The move above this resistance price is a good near-term sign for small cap stocks and the market overall. However, the 2200 level in the RUT represents significant resistance for the advance which means, the current advance may be a good trading opportunity, but investors should be cautious. 

Our longer-term view is that the market is apt to remain in a broad trading range until inflation is clearly under control. We believe this will take another 12 to 18 months. But in the interim, we expect a broad trading range to contain stock prices with the January 3, 2022 SPX high of 4796.56 as a ceiling and the October 12, 2022 low of SPX 3577.03 as a probable floor. This signal from our 25-day up/down volume oscillator is in line with this forecast. And even though this is a better outcome than we expected earlier this year, we would not chase the current rally. Much of the shift is taking place in large capitalization technology stocks which we do not believe will be the leadership of the next bull market cycle. Technology stocks have been at the center of heavy short selling, and it is likely that short covering is contributing to the current advance.

Nonetheless, the technical improvement seen in recent sessions implies that the underlying bear cycle is diminished, and a neutral range is ahead. We reviewed our concept of a flat market trend last week (“Reviewing Flat Trends” February 1, 2023) and showed that historically, the popular stock indices have spent 50% of the time in flat trends. Flat trends can include several bull and bear market moves of 20% or more, but we define them as “flat” since rallies are unable to sustain an advance above the previous market peak. Note that flat cycles tend to be linked to periods of inflation or deflation. In our opinion, this is why it is critical that the Fed deal firmly with the current inflation cycle. History shows that inflation is difficult to control once it exceeds 7% YOY and it has only been resolved with a series of recessions. We believe the Fed understands this issue and is attempting to be a slow and steady force to undermine inflation without igniting a recession. It will not be easy.

Fundamentals/Earnings

As we expected, fourth quarter earnings season is tempering expectations for 2023 earnings. Last week the S&P Dow Jones earnings forecast for 2023 fell $2.62 and the Refinitiv IBES consensus earnings forecast fell $1.70. This brought the consensus 2023 full year estimates to $219.29 and $224.31, respectively. What is interesting in our view is that these 2023 estimates now match the estimates analysts had for last year’s earnings back in May 2022. See page 10.

Economics

Some economic data releases also suggest corporate margins may be under severe pressure this year. Labor productivity fell 1.3% in 2022. This followed a 2.4% increase in 2021 and a 4.4% rise in 2020. Keep in mind that falling productivity often means a rising cost of labor. Total labor compensation costs rose by 5.1% YOY in June 2022, the highest pace since June 1990. And the compensation cost index remained consistently high at 5.1% YOY at year end. Labor costs increased across the board, for both wages and benefits. See page 6. What may keep the Fed awake at night is the fact that while inflation peaked at 9.1% in June of 2022, the employment cost indices have not declined, and they remain high for both private and government workers. This will have two negative impacts: it will encourage the Fed to keep interest rates high long enough to reduce this trend and, in the interim, it will erode corporate profits. See page 7.

Total nonfarm payroll employment rose a surprisingly large 517,000 in January, and the unemployment rate was slightly lower at 3.4%. Job growth was widespread, but it was led by gains in leisure and hospitality, professional and business services, and health care. However, there were a number of reasons to not place too much emphasis on this report.

As seen on page 3, the seasonally adjusted payroll employment rose to a new cyclical high, whereas the not-seasonally-adjusted employment number fell well below the high recorded in November 2022. Nevertheless, there were underlying reasons for the inconsistencies in January’s release. The BLS introduced its annual revision of the establishment survey in January. This is a once-a-year re-anchoring, based on March 2022 data, of employment estimates from the unemployment insurance (UI) tax records filed by nearly all employers with State Workforce Agencies. As a result of the adjusted estimate for March 2022, total nonfarm employment had an upward revision of 568,000 or 0.4%. The not-seasonally adjusted total nonfarm employment estimate was revised by 506,000, or 0.3%. Over the prior 10 years, these benchmark revisions have averaged 0.1%, with a range from −0.3% to 0.3%. In short, this was a very large revision that “technically” erased January’s outsized job gain.

The household survey also had an annual update to total civil noninstitutional population based upon revised Census data. This impacted the participation rate and the employment population ratio modestly. Lastly, there were changes to the North American Industry Classification System (NAICS) which resulted in some work categories being delisted and others added. These changes are typical of most January reports, but this year the revisions were larger than normal. See page 4.   The ISM surveys will be important to monitor in coming months. In the December reports, the weakness seen in the manufacturing sector appeared to be spreading and the service sector fell below 50, reflecting a contraction. But in January, a rebound in the ISM nonmanufacturing index reversed most of December’s weakness. The recovery in the service sector could be significant and has the potential of boosting economic activity, perhaps even in manufacturing. In sum, it is worth monitoring the ISM indices in the months ahead. The rate of change in the manufacturing index has been highly correlated with the rate of change in the S&P Composite. It could be pivotal. See page 9.  

Gail Dudack

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The month of January ended with a gain of 2.8% in the Dow Jones Industrial Average and a 6.2% gain in the S&P 500 Composite. See pages 3 and 4. This was the 25^th best January in the DJIA and the ninth best January for the SPX. January’s performance has been significant over the decades, and since 1950, a gain in the DJIA has correctly predicted an annual gain 89% of the time. In the SPX, a January gain has resulted in an annual gain slightly less than 79% of the time.

Technicals Improve

And at the same time, the January rally has generated several improvements in our technical indicators. The biggest change is the improvement in the 25-day up/down volume oscillator. It is currently showing an overbought reading of 4.49, and more importantly, has been overbought for five consecutive trading sessions. In addition, the month of January ended with a strong 90% up-volume day. This is an upgrade from the overbought reading recorded in November, off the October low. That reading was not sustained. The current reading needs to remain overbought for another week to be truly convincing, however, bear markets rarely reach overbought territory, and if they do, the reading is typically brief. An overbought reading that persists for at least five to ten consecutive trading days – and reaches a new overbought high reading — is significant and is an indication of a shift from bearish to positive, or at least from bearish to neutral. This week will be pivotal for this indicator. See page 14.

As a result of this broadening rally, all the popular indices are presently trading above their 200-day moving averages, including the Nasdaq Composite. This is another solid improvement in the technical arena. And as we noted last week, the Russell 2000 has an attractive technical chart, having bettered the 1900 resistance level, which is a good near-term sign for small cap stocks and the market overall. See page 13.

Flat versus Trending Markets

Given the strength of the January rally we believe this is a good time to review the long secular outlook for equities in order to put the current advance into a broader perspective. First, it is important to remember that a study of historical stock performance shows that equities spend only half their time in a persistent “trending market” i.e., a bull market with modest intervening corrections of 10% or more. When stocks are in a trending market a “buy and hold” strategy is beneficial and profitable. And in most trending cycles the economic backdrop is favorable for most industries and corporate profitability is good. In sum, it is an environment that “lifts all boats.”

However, the other 50% of the time the equity market and the economic backdrop are not as favorable. Usually this is due to the impact and/or aftermath of either inflation or deflation; as a result, the market vacillates in what we call “flat trends.” These flat trends can include several bull and bear markets that rise and fall of 20% or more, but the key distinction is that the benchmark indices usually fail to sustain an advance that moves higher than the previous peak. In short, the market tends to have a ceiling price near the peak of the previous bull market. We believe the inflationary cycle we are currently experiencing is the catalyst for such a market. What is important is that this means a “buy and hold” strategy will be less profitable and instead, investors should be alert to unique buying and selling opportunities when they arise. In most cases, the stock market is driven by a rotation of leadership among industries, value and/or growth at a reasonable price tend to be solid strategies, and taking profits and reinvestment becomes a preferable tactic over “buy and hold”. Also note that history shows that these flat trends tend to last for more than a decade. See page 5.

Another way to analyze the stock market’s “flat trend” phenomenon is to monitor the 10-year compound annual growth rate in the S&P 500. We do this on both a simple price basis and on a total-return basis. As we have pointed out in recent years, it is unusual for the S&P’s 10-year compound annual growth rate to exceed 13%; and when it has reached this level it typically presages a major decline is on the horizon. The 13% level was reached at the end of 2021. See page 6.

Conversely, whenever the 10-year compound annual growth rate approaches or falls below zero, it has been an good signal of an excellent long-term buying opportunity. The growth rate declined to 8.3% as of the end of January, but this is not a level that defines a major buying opportunity. Nevertheless, we do not expect “zero” to materialize for a long while, but we do expect there will be several bull and bear market cycles before the growth rate ever approaches zero.

In sum, we would not anticipate an equity rally will sustain an advance bettering the SPX high of 4796.56 made on January 3, 2022 for several years.

Fed and Economics

The preliminary estimate for fourth quarter GDP was 2.9% which was much better than the consensus view and it followed the 3.2% growth rate generated in the third quarter. Fixed residential investment declined 9.2% in the quarter and it is highly unusual for residential investment to decline this much without the overall economy being in a recession. We are not sure if this is good or bad news, but since we expect the Fed to raise rates at least two more times this year, housing will likely drag economic activity lower in coming months. See page 7.

In December, personal income rose 4.7% YOY, disposable personal income rose 3.2% YOY, yet real personal disposable income fell 1.7% YOY. Still, this was an improvement from July 2022 when real personal disposable income fell 5% YOY, and purchasing power was seriously eroding. However, inflation is taking a toll on consumption, which fell 0.2% in December after falling 0.1% in November. And though the pace of PCE has been decelerating in recent months, it was still rising 7.3% YOY in November and December. The question is how strong or weak will PCE be in 2023? See page 8.

There were clear signs that inflation was decelerating in December. The CPI fell from 7.1% YOY to 6.4% and core CPI declined from 6.0% YOY to 5.7%. Inputs to the CPI are also slowing. PPI for finished goods eased from 10.7% YOY to 9.0%, core PPI was modestly lower from 8.0% to 7.89%, and final demand PPI fell from 7.3% YOY to 6.2%. Equities appear to be celebrating this deceleration in inflation, but remember, these inflation rates remain multiples higher than the Fed’s target of 2% inflation. See page 9. The Federal Reserve’s preferred measure for inflation is the PCE deflator and that eased from 5.5% YOY to 5% YOY in December. Even so, this means the PCE deflator remains 70 basis points above the current fed funds rate. In short, there is plenty of incentive for the Fed to increase interest rates 25 basis points at this week’s meeting and another 25 basis points at the next meeting that ends on March 22. See page 10. We expect the Fed’s statement will be hawkish this week, as it should be. Inflation is not as easy to reverse as many investors appear to believe, and though the current rally could have further upside, we would remain focused on maintaining a portfolio tilted toward value.

Gail Dudack

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Inflation

S&P Global said its flash US Composite PMI Output Index, which tracks the manufacturing and services sectors, rose to 46.6 this month from a final reading of 45.0 in December. This was the first uptick since September; nevertheless, the index remains well below a key reading of 50 that is used to define contraction or growth in the private sector. Yet in a more worrisome sign in our view, the survey’s measures of input prices for both US services firms and goods producers rose month-over-month for the first time since last May. This bump in input prices may signal to the Federal Reserve that it needs to keep monetary policy tight and move interest rates higher if it is going to bring inflation back to its 2% target. And, inflation is a global problem as seen in Australian inflation, which shot to a 33-year high in the last quarter as the cost of travel and electricity jumped. Australia’s central bank is expected to raise interest rates again at a policy meeting next week. The Federal Reserve is expected to raise interest rates 25 basis points at its next meeting which ends on February 1.

The Debt Ceiling

Meanwhile, there are a few important issues brewing in the background. The current standoff in Washington over raising the $31.4 trillion federal debt ceiling is a significant risk to equity investors. Government shutdowns may seem like a routine part of governing since it has happened three times in the past 10 years. A partisan fight over healthcare spending led to a 16-day shutdown in October 2013. Disputes over immigration led to a three-day shutdown in January 2018 and a 35-day shutdown between December 2018 and January 2019. Last week Treasury Secretary Janet Yellen indicated that although the country has reached its current $31.4 trillion borrowing cap, the Treasury can continue to pay its bills until June by shuffling money between various accounts. But after that point, when the “normal” extraordinary measures are exhausted, the Treasury would run out of money from tax receipts to cover bond payments, workers’ salaries, Social Security checks and other bills. In short, the US Congress has a five-month window to find a solution, but a missed debt payment by the US government would send shockwaves through the global financial markets.

The FAANGS

This week the US Justice Department took a big step toward reducing big tech dominance when it accused Alphabet Inc.’s (GOOGL.O – $97.70) Google of abusing its dominance in digital advertising. The government said Google should be forced to sell its ad manager suite, which generated about 12% of Google’s revenues in 2021, however this suite also plays a vital role in the search engine and cloud company’s overall sales. Advertising is responsible for about 80% of Google’s revenue. The federal government also said its Big Tech investigations and lawsuits are aimed at a group of powerful companies that include Amazon.com, Inc. (AMZN.O – $96.32), Facebook owner Meta Platforms, Inc. (META.O – $143.14) and Apple Inc. (AAPL.O – $142.53) with a goal of leveling the playing field so smaller rivals can compete. In our opinion, these government lawsuits also mean that earnings for many of the stock market’s biggest players and largest earners are unsustainable and are likely to come down. And while many of these stocks have been beaten down in the last twelve months and have rallied smartly in the early part of this year, their leadership role in the equity market is most likely over.

It’s All About Earnings

The stock market has been driven wildly up and down in recent months based upon its changing view of inflation and Fed policy. However, the actual performance of the equity market will be ultimately based upon the pace of economic activity and the trend in earnings. The initial estimate for fourth quarter GDP will be released later this week, but the data for third quarter GDP showed that corporate profits at the end of September were basically unchanged year-over-year. According to S&P Dow Jones, S&P 500 profits are estimated to be negative on a year-over-year basis in the fourth quarter. Note that S&P earnings growth has turned negative only 15 times since 1946, and eleven of those times it was linked to an economic recession. See page 7.

Moreover, the relationship between GDP and S&P earnings is meaningful since the two are highly correlated. Therefore, it is also meaningful that S&P earnings have been outperforming GDP since June 2020, due in large part to post-pandemic stimulus that has now ended. In short, both monetary and fiscal stimulus gave a temporary and artificial boost to earnings growth for a time. However, whenever corporate earnings have been outperforming underlying economic activity, history shows that this outperformance in earnings is unsustainable. In other words, outperformance is typically followed by underperformance. See page 7. This combined with the government’s attack on the business models of many large technology companies implies a risk to S&P earnings in the quarters ahead. Again, we would emphasize sectors and companies with defensive and predictable earnings growth streams such as energy, staples, utilities, aerospace & defense, and companies where the PE multiple is in line with the company’s earnings growth rate.  

Weak Economic Signals

Signs of a slowing economy continue to grow, and this includes the third consecutive month of weakness in industrial production, and the tenth consecutive decline in the Conference Board Leading Economic Indicator. The LEI displayed widespread weakness in December, indicating deteriorating conditions for labor markets, manufacturing, housing, and financial markets. Conference Board economists have indicated that the persistent weakness in the LEI is signaling a recession in the near term. See page 3.

Historically, home prices and retail sales have been strongly correlated and both have been decelerating for all of 2022. Worrisome for us is the fact that real retail sales (adjusted for inflation) have been negative in five of the last ten months. Negative readings have been linked to recessions. Also note that as the Fed continues to raise rates, the affordability of homes is deteriorating and is apt to send the residential housing market into a deeper recession. See page 4. Although the NAHB Single-Family Index has been declining since its peak in November 2020, January’s survey experienced a small increase from recessionary levels. Meanwhile, December’s new residential permits and housing starts were down 29.9% YOY and 21.8% YOY, respectively. See page 5. New home sales in November were 15.3% lower than a year earlier, down to an annualized level of 640,000 units. Existing home sales were down 34% YOY in December to a new cyclical low of 4.02 million units on an annualized basis. As seen on page 6, similar declines have occurred in recession years. In sum, January’s rally has been impressive in many ways, and we particularly like the breakout in the Russell 2000 chart (see page 9) but there are storm clouds on the horizon. We fear prices are beginning to price in a Fed pivot and this would be premature. We remain cautious.

Gail Dudack

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Equities have demonstrated some impressive price momentum in recent weeks, and this inspired us to look at a range of markets to see what might either support or counter this advance. Unfortunately, what we found triggered more questions than answers.

Oil, the Dollar, Gold, and Treasury Bonds

We began by looking at the WTI crude oil future (CLc1 – $80.71) which peaked on June 8, 2022 at a price of $122.11. Much of the weakness in oil was attributed to the shutdowns being implemented in China due to a string of outbreaks of a Covid variant. This was logical since China’s actions implied factory shutdowns, less global economic activity, and less demand for oil. Plus, it was not only China that was a concern since there were growing fears of recessions in Europe and the US.

On September 27, 2022 the dollar (.DXY – $102.39) peaked at a price of $114.11. This was counter to the fact that the Fed was in tightening mode, but it was logical because most energy trades are done in dollars and a weakening global economy, and a lower price of oil would reduce global demand for dollars. However, we found it intriguing that the gold future (GCc1 – $1907.20) troughed on the very same day, September 27, 2022, at a price of $1626.70. This has different implications for the dollar. Gold, which had historically traded in line with inflation, was not an outperformer like most commodities and in fact, it continues to trade below its August 6, 2020 peak of $2051.50. The corresponding high in the dollar and the low in gold implies a possible switch by global investors from the dollar to gold as a safe-haven global currency. This suggests a lack of faith in the US dollar. But in fact, the underlying strength in gold and weakness in the dollar may be directly tied to China. Beijing rarely telegraphs its purchases of gold, yet it recently announced it had purchased 32 tons of gold in November and 30 tons in December. China’s stockpiling of gold resembles that of Russia before its invasion of Ukraine. Before invading Ukraine, Russia de-dollarized its economy and stockpiled gold and Chinese yuan. Some geopolitical analysts theorize that China may be building its gold coffers in preparation for an attack on Taiwan. Should this theory become reality, it would be a major negative for global stability and equities, in our view.

Lastly, and on October 21, 2022, the 10-year Treasury yield index (.TNX – $35.35) peaked at $42.13 or the equivalent of a 4.2% yield in the 10-year bond. It has been declining ever since. A decline in long-duration Treasury bonds yields can have many explanations, but when investors are fearful of an economic slowdown, demand for Treasuries typically increases and yields fall. Global investors will shift to US Treasuries as a safe-haven investment in times of economic weakness or geopolitical uncertainty. This could explain the decline in long-term interest rates.

In sum, the weakness in oil, the dollar and long-term interest rates could make sense in times of impending economic weakness. The rise in gold and fall in the dollar could have ominous implications for Taiwan and geopolitics. In general, this threat could trigger an even greater shift toward gold for stability. Nevertheless, none of this explains or supports the advance in US equities from the October 12, 2022 S&P 500 low of 3577.03.    

Still Jumping the Gun

Headline CPI fell from 7.1% YOY to 6.5% YOY in December, which led to a rally in the equity market. However, this decline in inflation was concentrated in energy, the energy-derivative category, transportation, and apparel. All items less food and energy had a smaller decline from 6% to 5.7% YOY as prices continued to rise at a faster pace in housing, owners’ equivalent rent and services. See page 3. There were items to celebrate in the inflation report. Areas of the economy like new and used cars, transportation (public and private), lodging away from home and household furnishings and operations are experiencing major decelerations in price gains. On the other hand, food at home and all areas of the service sector continue to show stubbornly strong price rises. See page 4.

We remain concerned. Whenever inflation has exceeded a standard deviation above the norm (3.4%), a recession, or string of recessions, has ensued. We do not believe this time will be different. Plus, the Fed has indicated that its goal is to beat inflation and return to a real fed funds rate. Today the real fed funds rate is negative 210 basis points to CPI and negative 170 basis points to November’s PCE index. In short, all signals point to more Fed hikes in 2023. See page 5.

Consumer sentiment improves

Consumer sentiment has improved in recent months as seen by the headline Conference Board Consumer Confidence index rising nearly 7 points to 108.3. The University of Michigan released preliminary results for January which showed an increase from 59.7 to 64.6 in the overall survey, a jump from 59.4 to 68.6 in the present situations and an increase from 59.9 to 62.0 in the expectations survey. Both surveys are clearly improving and rebounding from recent recession levels. See page 6.

But we remain concerned about the consumer. The savings rate was 2.4% in November and has been below 3% for five of the last six months. Readings below 3% were last seen in April 2008 (2.9%), November 2007 (2.8%), and seven of nine consecutive months between February 2005 and October 2005. The record low savings rate of 2.1% was recorded in July 2005. Another indication that consumers are stretched is the rise in credit. As of November, total consumer credit grew 8% YOY, but since August 2022 revolving credit has been steadily expanding at a pace of 15% YOY or more. This is worrisome; however, one consolation is that revolving credit remains below levels seen prior to the 2008 recession. Nevertheless, real consumer credit is just modestly below its 2020 peak and is a sign that consumers are financially strained. See page 7. 

Technicals are Looking UP

The current rally has broadened to include most of the popular indices which are now trading above their 200-day moving averages. The one exception is the Nasdaq Composite. However, January’s advance is reminiscent of the August 2022 rally which also resulted in tests or breaks of the 200-day moving averages but became a failed rally. Nonetheless, the current rally could have staying power and it is significant that this rally is materializing in January, a month that can be predictive of the year’s performance. See page 9.

The 25-day up/down volume oscillator is currently neutral with a reading of 2.44 but is close to recording an overbought reading. An overbought reading that persists for at least five to ten consecutive trading sessions would be significant and a sign of a positive shift in the cycle. See page 10. Also interesting is that the 10-day average of daily new highs is 103 and new lows are 39. This combination is now positive since new highs are above the 100 benchmark and new lows are below 100. New highs have not consistently outnumbered new lows since April 2022. The advance/decline line is currently 33,545 net advancing issues from its 11/8/21 high – still negative yet a big improvement in the last two weeks. See page 11. We remain cautious but are carefully monitoring technical indicators, particularly the 25-day volume oscillator, for potential good news.

Gail Dudack

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The price performance of the equity market during the first few days of the new year provided a nice respite for investors who weathered a very difficult 2022. But this year’s good start will face several hurdles in the upcoming days. Later this week the CPI report for December has the ability to reverse the current optimism on inflation. The consensus view is that inflation is steadily decelerating, but if that does not prove to be true, there will be disappointment. More importantly, fourth-quarter earnings reports begin at the end of the week, and these could set the tone – and the trend — for earnings over the next few quarters.

In our opinion, while some market commentators believe pessimism is currently too extreme and overdone, investors have not truly come to grips with the status of the current economy, the determination of the Fed to fight inflation and what that means, and the prospect for corporate earnings.  

The Economy

It is widely accepted that the real estate sector of the economy is in a slowdown or recession. But we see warnings in recent data releases that the downturn is broadening. For example, for the first time since April and May of 2020, both ISM indices ended below the 50-bench mark denoting a contraction in economic activity. Plus, in both surveys the “new orders” components slipped well below 50, signifying a weakness in future activity. In other words, both the manufacturing and the service segments of the economy appear to be declining. See page 3.

The one positive we found in the two ISM reports is that both the manufacturing and the non-manufacturing survey showed prices falling or decelerating. In the ISM manufacturing report, the price index fell from an already low of 43.0 to 39.4; while in the non-manufacturing report the price component fell from 70 to 67.6 – a sign of deceleration.

There were also encouraging inflation signs in the Small Business Optimism survey for December. The NFIB report indicated that fewer small businesses plan to raise prices in the coming months and the index fell from 34 to 24. However, fewer small businesses plan to increase employment and that component fell from 18 to 17. All in all, the NFIB Optimism index fell 2.1 points to 89.8, in December, recording its 12^th consecutive month below the 49-year average of 98. See page 4.

In December, payrolls increased by 223,000 and the unemployment rate edged down to 3.5%. These are actually robust numbers that could have worried investors, but the report was well received since average hourly earnings rose 5.0% YOY, down from November’s 5.5% YOY pace. This deceleration in wage gains was viewed by many as a positive thing, but we disagree. First, we do not think the deceleration is significant. Second, we do not believe the current economy is at risk of demand-pull inflation due to rising wages. In fact, the opposite is true. Inflation has had a very negative impact on real weekly earnings and in December real weekly earnings were actually down 2.6% YOY and were 4% lower than their May 2020 peak. In short, households have been losing purchasing power for nearly three years and are not a source of potential inflation. See page 5.

More signs that households are struggling are found in retail sales. In the nine months ended in November, total retail and food services sales grew at an average monthly pace of 8.4% YOY. This sounds healthy, but after adjusting for inflation, total real retail sales grew only 0.5% YOY. This lack of substantial revenue growth is a hurdle for many retailers and for future earnings. And though auto production has normalized, vehicle sales also declined in November. Weakness in the auto sector is also seen in used car prices which have been on the decline. See page 6. In sum, we have been anticipating a recession this year and recent economic data is falling in line with our theory.

Fed Policy – Too Soon for a Pivot

Many market commentators have suggested that the Fed will end rate hikes, or pivot once the economy shows signs of weakness. In our view, this is naïve thinking for several reasons. First, inflation does not materialize or end quickly. Prices were rising for several years before the CPI peaked at 9% last year. It is apt to take at least several years to get it back to the Fed’s target of 2%. Second, Fed tightening cycles have historically ended when the real fed funds rate reaches 300 basis points, or more. See page 7. It may not have to reach a full 300 basis points in this cycle, but the Fed has clearly indicated that a real fed funds rate is its objective. If this is true, the fed funds rate may need to move well above the 5% to 5.25% most economists are forecasting. For example, if inflation falls to 4% this year (our target) the fed funds rate could rise as high as 7% to break the inflationary cycle. There are other scenarios as well. Inflation could fall to 3% and the fed funds rate could peak at 6%. Nevertheless, this suggests the fed funds rate could move higher than most expect this year. In our opinion, nothing above a 5.25% fed funds rate has been discounted by recent equity prices.

Earnings

The fourth quarter earnings season could become a disappointment for those looking for a rally, or at least a January rally. Some analysts believe investors will look past an anticipated trough in earnings and actually rally on bad earnings news. But in our view, it is nearly impossible to estimate how weak earnings might be in 2023. The combination of fed rate hikes and a weakened consumer is what led us to reduce our S&P 500 earnings estimate for this year to $180, reflecting a 10% decline from an estimated $200 in earnings in 2022. A 10% decline in corporate earnings is “average” during an economic recession.

It is important to point out that while S&P Dow Jones is currently estimating 2022 earnings to be $200.19, this is only a preliminary estimate. See page 8. Fourth quarter earnings have not yet been reported and this forecast is likely to move lower. This scenario may explain why the fourth quarter earnings season could become a market moving event. Weak fourth quarter earnings results would not only require analysts to bring their earnings estimates down for last year and this year; but corporate guidance may have a substantial negative impact on this year’s forecasts — which ironically continue to anticipate year-over-year gains, despite expectations of a recession.

Technical Update The DJIA is the only index that is currently trading above all its key moving averages and looking positive. Conversely, the Nasdaq Composite is trading below all its key averages and looking bearish. The SPX and Russell 2000 have somewhat mixed pictures in terms of their moving averages. This divergence in performance is a result of a market leadership shift from growth to value that took place in 2022 and which we believe will continue this year. To a large extent, it reflects our thoughts of “follow the earnings” which tend to be clustered in energy, staples, aerospace, utilities, and stocks that reflect other necessities.

Gail Dudack

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History may not repeat itself exactly, but there is always something to learn from past economic cycles. In 2022, inflation was the highest in 40 years and there is much to be learned from this. In fact, whenever inflation has been greater than one standard deviation above the norm, a recession has followed. In fact, very high inflation has usually been followed by a series of recessions over a period of years.

Looking for a Recession

We believe Chairman Jerome Powell knows this part of history very well and it explains why we believe he will keep interest rates higher for longer than most forecasters expect. In previous cycles the Fed lowered interest rates at the first sign of a recession, only to see inflation reappear 12 to 18 months later. Discussions today center on when investors believe the Fed will “pivot” and most expect weakness in the economy will be the catalyst for easier monetary policy. In our view, although the Fed may not speak of it publicly, it expects a recession and is unlikely to be frightened at the first signs of economic weakness. It will, however, keep its eye on its goal, which is to get inflation down to, or close to 2% YOY. Some believe a Fed pivot will begin with inflation at 4% YOY but we disagree. Inflation at that level is still above the long-term average of 3.4% and is debilitating to consumers and businesses.

Another reason we believe the economy will slip into a recession is the weakness we see in the consumer. The savings rate was 2.4% in November which ranks among the lowest rates in history. We are not surprised that savings are falling, because real purchasing power has been negative most of last year. Personal income rose 4.7% in November, but after taxes and inflation, real personal disposable income fell 2.5% YOY. And for many Americans, the numbers are even worse. Proprietors’ income rose 3.7% in November, well below the 4.7% headline level; and non-farm proprietors’ income rose a measly 1.3% YOY. This is just one example of how small businesses are struggling in the current inflationary environment. The CPI decreased to 7.1% YOY in November, but it continues to destroy purchasing power. This is just one example of why inflation of 4% is still too high.

Some parts of the economy are already in recession. The residential housing market is a prime example. Pending home sales decreased to 73.9 in November and have been falling steadily since the October 2021 peak of 122.4. November’s reading is just slightly above the historic low of 71.6 recorded in April 2020 during the pandemic shutdown. Most consumer and business confidence indices were lower in November, yet they remain above the cyclical lows reported in June. Confidence levels bear watching since they can be good lead indicators of recessions and recession lows.

History of Negative Performances

Several market commentators have noted that it is rare to get broad-based back-to-back price declines in the equity averages. This is true, but it is possible. Annual losses were seen in the periods inclusive of 1929-1932, 1939-1941, 1973-1974, and 2000-2002. What each of these bear market periods have in common is that they were either the aftermath and unwinding of a stock market bubble, or in the case of 1939-1941 it was the prelude to the US being drawn into a major world war. See page 4.

This may explain why we are seeing major declines in the FAANG components, meme stocks, cryptocurrencies and the “Covid-shutdown” beneficiaries, where speculation was most extreme in the previous advance. In short, the bubbles in these areas are unwinding.

The good news is that the declines in 2022, particularly in high PE stocks, appear to be a major step in terms of wringing out excess and moving toward value in the US equity market. Still, we are not convinced that investors have discounted an actual decline in earnings in 2023. Many analysts are talking about a recession but have not factored it into earnings forecasts. In fact, we have heard some strategists suggest it is time to look across the valley of earnings and focus on an earnings rebound. This would have been true if we had already seen earnings forecasts turn negative, but they have not. At this juncture we do not know how deep, or how long, the valley in earnings may be.

Last year the S&P 500 Composite index fell 19.4%, and according to S&P Dow Jones consensus, earnings are expected to have declined 3.8% for the year. See page 3. But there are two caveats to this earnings decline. First, the fourth quarter earnings season will begin in several weeks, and in the last three reporting seasons estimates have declined significantly as quarterly earnings reports were released. In short, the estimate for 2022 may still be too high. Second, the S&P Dow Jones consensus earnings forecast for 2022 may be negative, but 2023 shows a growth rate of 13%. It is very likely that earnings will decline again in 2023, so this implies earnings disappointments are ahead. And do not forget that the S&P’s earnings decline in 2022 was muted by the outsized earnings gains seen in the energy sector. Most corporations had difficult comparisons in 2022 due to stimulus-boosted gains in 2020 and corporate margin pressure from higher raw material prices, soaring transportation costs and wage increases. The challenge in 2023 in our view, will be a lack of revenue growth. For this reason, we would focus on necessities and companies with reliable earnings streams such as energy, utilities, staples, aerospace & defense, and health insurance companies.  

Santa Baby

There has been much discussion about a Santa Claus rally this year, including controversy about its timing and effectiveness. For the record, Yale Hirsch of the Stock Trader’s Almanac monitored this phenomenon over the years and the Santa Claus rally is composed of the last five trading sessions of the year and the first two trading days of the new year; however, some analysts have added an extra day at either end of this period. Either way, a Santa Claus rally has materialized in seven of the last nine years. See page 5.

But that is not the real significance of the Santa Claus rally. The adage is: If Santa Claus should fail to call, bears may come to Broad and Wall. In short, it is not simply that a year-end rally tends to materialize, but that a rally, or the lack thereof, has some predictive value. We believe the tendency for a year-end rally arises from the fact that the last few days of the year often have a positive tilt from waning tax-loss selling, free cash as a result of tax-loss selling, rebalancing of mutual funds, pension fund inflows at the end of the year, and employee bonuses and Christmas money. In short, liquidity should be better than average at the very end of each year and should produce positive results in stocks. If not, it could be that either investor pessimism is high, or liquidity is below average. Neither would be a positive sign. As noted, rallies have appeared in seven of the last nine years and in each of the last six years. Four of these six years ended with double-digit gains in the S&P (66% accuracy) and two years ended with losses, including 2022. We do not put a lot of credence into year-end performances, but to date, the 2022-2023 Santa Claus rally has a 0.07% gain. It will be interesting to see if the market can hold on to this gain. See page 5. What has more predictive value in our view, is the January Barometer. See page 6.

Gail Dudack

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Stocks have seen a year-end rally in each of the last six years and this phenomenon can be explained by a number of seasonal factors such as the end of tax-loss selling, mutual fund window dressing, and stock purchases due to liquidity from year-end and Christmas bonuses, among other things. However, we believe a year-end rally may be less robust than usual since thoughts of 2023 and its various hurdles could weigh on investor sentiment.

Recent market action suggests that investors are very willing to look on the bright side of the street. We prefer to be optimistic ourselves, however, the financial media is persistently focused on news that would suggest peak interest rates are directly ahead. This is viewed as a reason to expect the worst to be over and that a market advance is at hand. In some situations, it might be profitable to look past the economic valley of 2023 and look to invest for the longer term; but this time we think the valley may be deeper and wider than expected. For this reason, we remain prudent and look to keep our portfolio concentrated in necessities, recession resistant companies and sectors and stocks with predictable earnings streams and above average dividend yields.

Lowering Earnings Forecasts

The probability of higher interest rates and the likelihood of a recession in 2023 is high, in our opinion. Though we have been expecting a recession, we have not fully addressed it in our earnings forecasts. Our economic forecast included a weak first half of 2023 followed by an economic rebound, but even that may be too hopeful. This week we are lowering this year’s S&P 500 earnings forecast from $202 to $200 to reflect the decline seen in the third quarter earnings results. And since the typical recession results in a 10% decline in corporate earnings, we are lowering our 2023 estimate from $204 to $180.

Looking for an Average Recession

Since WWII, the last twelve recessions have persisted for an average of 10 months, have generated a 2% decline in real GDP, resulted in a loss of an average of 4 million jobs and led to a 10% decline in corporate earnings. Few recessions “match” the average, however, we believe inflation is more embedded in the economy than even the Fed would like to admit. If so, it means interest rates will remain higher for longer than expected. Chairman Jerome Powell was late to address inflation; however, we expect he has studied the last inflationary cycle that began in 1968 and continued until 1982. The error that Federal Reserve Chairman Arthur Burns made in the 1970 decade was to not keep interest rates high enough or long enough to get control over inflation. As a result, there were four recessions between 1970 and 1982, until inflation finally began to recede.

With this in mind, it follows that interest rates will remain higher for longer next year than many expect. If so, the 2023 recession may last for more than two quarters and have a more debilitating impact on corporate earnings. For all these reasons, we are lowering our earnings estimate once again.

The Inflation Problem

November’s CPI came in softer than expectations, and while the peak level of inflation may be behind us, the underlying details of November’s report are not as favorable as some market commentators seem to believe. Much of the decline in prices is the result of decelerating energy prices (which are still rising 13.1% YOY!); meanwhile, food and beverage prices are rising at a double-digit pace, and housing, transportation, and “other goods and services” inflation are increasing 7% YOY or more. See page 3.

It is very likely that headline inflation peaked at 9% YOY in April 2022, but the Fed’s lack of attention in 2021 to stimulus-driven inflation allowed price increases to become embedded in the economy. This is making inflation difficult to combat. As a result, core CPI has been hovering between 6.0% YOY and 6.5% YOY for several months — the highest in 40 years — and is far from the 2% target rate indicated by the Fed. See page 4. And inflation is no longer driven solely by the price of energy, nor is it a problem linked primarily to the rise in owners’ equivalent rent. The current drivers of the CPI include food and beverage pricing and a wide range of consumer services. See page 5.

It should be noted that prices for services have been on the rise since early 2021. The composite service component of the CPI rose 7.2% YOY in November, rose 7.2% YOY in October, and fell only slightly from the peak rate of 7.4% YOY recorded in September. With inflation now embedded in the largest segment of the economy, the Fed’s job has become more difficult than most expect. And as seen in the chart on page 6, the price of WTI crude oil has typically had a direct impact on inflation when it rises but has had less of an impact when prices fall. In our view, the consensus remains too sanguine about the path of inflation over the next 12 months. 

Moreover, 32% of small business owners indicated that inflation was their single biggest problem. The small business optimism index rose 0.6 points in November to 91.9, but this is the 11^th month below the 49-year average of 98. Of the 10 components, 6 increased and 4 decreased in November. The percentage of owners that plan to raise prices was more than 50% earlier in the year but now sits at 35%. Owners who think it is a good time to expand improved one point to six in November, but this is well below the long-term average of 13. See page 7.

2023: The Year of Earnings Adjustment

In 2022, investors began to take inflation seriously and focused on tightening monetary policy. As a result, there has been a steady decline in price earnings multiples this year. But the adjustments are not over. In our view, the challenge in 2023 will be the reality of a recession and the negative impact it will have on earnings.

As noted, we are lowering our S&P 500 2022 earnings estimate slightly to $200 and taking our 2023 estimate down $180 to reflect a 10% decline. However, even without a recession in 2023, S&P 500 earnings have been extremely high relative to the trend in nominal GDP. Earnings growth and nominal GDP tend to be highly correlated and the relative outperformance of S&P earnings versus economic activity in 2021 and 2022 is an unsustainable trend. A period of earnings outperformance has usually been followed by a decline in earnings. See page 8.

The recent earnings outperformance in this cycle is easily explained by the historic level of stimulus pumped into the economy both during and after the Covid shutdown. In short, corporate earnings were artificially elevated. As stimulus fades, earnings are apt to underperform, even without a recession in 2023. However, we expect the Fed will remain on track to raise short-term rates to 5% or higher next year and this makes a recession a high probability in the next twelve months. As we have often noted, inflation in excess of 4% has characteristically resulted in a recession. Double-digit inflation has historically been followed by multi-year rolling recessions. In sum, 2022 was a year of multiple compression and 2023 is apt to be the year of earnings deterioration. We remain cautious.

Gail Dudack

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