When we look at the history of inflation, the history of Federal Reserve policy, and recent economic data, it is easy to conclude that a recession is either at hand, or at least on the horizon. But before we explain why we believe a recession is likely, it is also important to point out that the next recession should be different than those recently experienced, and hopefully more manageable. The main reason for this optimism is the healthy financial condition of the US banking sector. Just the opposite was true of the 2008 financial crisis and the severely weakened state of the US banking system was a major risk for the overall economy. Today, not only are the banks’ balance sheets in good condition, but we find that household balance sheets are also in fine shape. And even though corporate debt has been on the rise, corporate America is not overextended. This is important since it suggests that any recession should be relatively short and contained.  

The one area of concern is the federal government where stimulus packages have added trillions of dollars to the national debt in a short period of time. Congress approved the $2 trillion CARES Act in March 2020, which was followed by a $900 billion Covid-19 relief package in December 2020. Some of this was necessary. During the mandatory shut down of the economy very few Americans could go back to work and collect a paycheck. Businesses were forced to remain closed. Plus, the mandatory Covid vaccinations and tests were paid for by the US government to prevent the spread of the virus.

This was less true in 2021, yet in March 2021 President Biden’s Build Back Better plan became the American Rescue Plan Act of 2021 which was an additional $1.9 trillion stimulus package. In total, the national debt increased by nearly $5 trillion, or nearly 25% of GDP, in a short 12-month period. As of October, the US debt stands at $31.12 trillion, which means the federal debt load is currently more than 120% of GDP — estimated to be $25.7 trillion at the end of the third quarter.

Unfortunately, interest rates are now on the rise and the cost of carrying this debt will become ever more costly. And the US is not the only country that increased its national debt during the pandemic. This was true of many countries impacted by Covid-19. In short, if there is a weakness, or a problem in the next recession it could be centered in the sovereign debt markets.

Inflation and Recession

We have written in previous weeklies that whenever inflation has been above average (3.5%), an economic recession has followed. More worrisome is the fact that the last time inflation was as high as it is in the current cycle, or a standard deviation above the norm (6.2%), the economy suffered a series of recessions. This is best represented by the 1968-1982 era. In the current cycle, the Federal Reserve has been very tardy in addressing inflation and as a result, a recession has been delayed. But this may only make inflation more difficult to tame today and keep interest rates higher for longer than expected. Historically, the fed funds rate rose ahead of, or in line with, inflation. See page 3. In our view, this is why it is imperative that the Federal Reserve Board be an independent, nonpolitical body. Raising interest rates during a presidential election year, for example, might be a difficult policy to follow; but failure to do so could be debilitating for many American households in the longer run.

Inflation is deceptive because it silently diminishes the purchasing power of households. Some economists worry that hourly earnings rose 0.6% in November; however, average weekly earnings rose 4.9% YOY in November while inflation rose 7.8% YOY in October. In short, inflation has exceeded the growth in wages for most of the last 18 months. Rising wages are not a source of inflation in our view. In fact, the fact that real hourly earnings are negative on a year-over-year basis is another indication a recession is ahead. See page 4.

Personal income has been in a steady uptrend for the last two years, but due to soaring inflation, just the opposite is true of disposable income or real disposable income. As a result, as of October, personal consumption expenditures have been exceeding income for 19 straight months. It is an unsustainable situation. See page 5. Not surprisingly, the savings rate declined to 2.3% in November, which is the lowest rate recorded by the BLS since the 2.1% reported in July 2005. However, in 2005, the savings rate quickly rebounded to 2.6% in August. We doubt that will happen in this cycle. Also noteworthy is the fact that the unemployment rate was unchanged in November at 3.7%, a historically low number. This gives the appearance of a strong economy, but we believe it is an economy of the haves and have-nots. Middle America is struggling. See page 6.

This combination of data suggests to us that the Federal Reserve will continue to raise interest rates in order to battle the now-ingrained inflation seen in this cycle. As a result, the economy is apt to slip into a recession in 2023. In recent months the Treasury yield curve has become inverted which is a classic financial sign of a recession on the horizon. See page 8.

Inflation and Equity Performance

We often look at history to see how stocks have performed whenever inflation has remained above average for a lengthy period of time. The most instructive period of time would be the 1968-to-1982-time frame when headline CPI remained consistently above 4%. The chart on page 9 is a quarterly chart and only records the S&P 500 index at the end of each quarter. But what it shows is that the S&P 500 Composite closed at 103.86 in December 1968 and closed at 102.09 in March 1980. In other words, the index was in a broad trading range and made no upward progress for over eleven years — or until inflation was brought back under control.

The experience of this previous era of inflation is why we believe the Fed may need to keep interest rates higher for longer than the consensus expects. The failure to get inflation under control in the first tightening cycle could result in multiple Fed tightening cycles — and recessions – like what was seen in the 1968 to 1982 period.

There are some markets that are already warning of a recession. The weakness in crude oil prices implies that traders expect energy demand to weaken as global economies slide into a recession. The decline in the 10-year Treasury bond yield represents a flight to safety in long-duration US Treasury bonds. See page 10. For all of these reasons, we believe the best strategy is to focus on recession resistance companies or areas of the economy that represent “necessities” to households, corporations, and governments. Sectors that represent these characteristics include energy, utilities, food, staples, and aerospace. See page 16.

Gail Dudack

Click to Download

Not a lot happened during the shortened holiday week. Economic releases were sparse, and earnings revisions were minor. Stock prices were erratic, but our indicators ended the week relatively unchanged. The months of November through January have historically been the strongest three-month period for stock prices and this favorable seasonality trait is dominating much of the discussion regarding equities. But in every cycle, ultimately the market’s trend will be determined by earnings growth, and unfortunately, earnings growth for the next twelve months remains questionable.

Energized Earnings

Energy has been a major contributor to S&P 500 earnings growth all year and yet the sector continues to have the lowest PE multiple of all eleven sectors at 8.4 times. Recent S&P Dow Jones data shows that energy is the only sector with a PE to growth multiple (PEG ratio) of less than one, which reflects value. This low PEG ratio arises from S&P’s estimate for energy’s 5-year growth rate of 10.3% and the sector’s current price-earnings multiple of 8.4 times.

According to Refinitiv IBES, the estimated earnings growth rate for the S&P 500 for the fourth quarter is negative 0.4%, but if the energy sector is excluded, the S&P 500 growth rate declines to negative 5.4%. Energy has the highest estimated earnings growth rate for the quarter at 72.8% and is expected to earn $50.1 billion in the last three months of the year versus earnings of $29.0 billion a year earlier. The second highest percentage is found in the industrials sector with an estimated 42.3% earnings growth rate, where earnings are anticipated to be $37.4 billion in the current quarter versus $26.3 billion a year earlier. The only other S&P sectors expected to have positive earnings growth in the fourth quarter are real estate (6.9%) and utilities (5.0%). In comparison, IBES estimates that technology earnings will decline 7.8% in the quarter. The materials sector comes in last with the lowest estimated earnings growth rate of negative 21.3%. When we look at these estimates for fourth quarter earnings, we do not see any positive catalyst for stocks in the near term; but keep in mind that fourth quarter earnings season does not begin until mid-January 2023.

Economic Backdrop

November’s employment report will be released on Friday, and this could be a market moving event. Expectations are for 190,000-200,000 new jobs and a relatively unchanged unemployment rate. Anything showing stronger job growth could trigger angst about monetary policy being tighter than expected. Anything showing extremely weak job growth will incite fears of a recession. However, it does appear that the economy is either in a recession or a recession is likely in 2023. The only questions are how deep and how long the recession will be.

It is very conceivable that the housing sector is already in a recession, and we believe this weakness will spread to other parts of the economy in coming quarters. We tend to look at sentiment indicators for guidance in uncertain times and unfortunately, this data is not reassuring. The bigger picture shows that there are 3-year downtrends in all sentiment benchmarks, and this resembles the pattern seen prior to or during all previous recessions since 1965. The Conference Board consumer confidence for November fell from 102.2 to 100.2 in November, the lowest since July, and the index for present conditions recorded an 18-month low. The University of Michigan sentiment indices were all down in November but remained above the cyclical lows recorded in the months of June and July 2022. See page 3.

Consumer credit has been expanding rapidly and attracting the attention of many economists. Total consumer credit hit $4.7 trillion in September, up $270 billion, or 6%, year-to-date and it expanded 8% YOY. Most of the growth in the last twelve months has come from revolving credit (lines of credit and credit cards) which grew nearly 16% YOY. This expansion in credit could be a sign of households using credit cards to spend ahead of the holidays, or to simply pay bills. This possibility is confirmed by the recent decline in the personal savings rate for September which fell from 3.4% to 3.1%. Data for personal income, consumption, and savings for October will be released later this week. But note, if consumers are digging into savings and extending credit lines for consumption, it is an unsustainable trend, particularly as interest rates rise. See page 5.

The correlation between an inverted Treasury yield curve and recessions has been historically strong. And the current yield curve already implies we should be anticipating a recession in 2023. Recent Fed funds rate hikes have had a dramatic influence on the Treasury yield curve; but more importantly, whether December’s rate hike is 50 or 75 basis points, the entire yield curve will soon be fully inverted and looking ominous. In short, consumption and corporate earnings will remain under pressure in 2023 and this is not a good foundation for an equity rally. See page 4.

Technical Ambiguity

The charts of the major equity indices are not uniform and produce a mixed message in terms of the outlook for stocks for the final weeks of the year. The Dow Jones Industrial Average is the only index to have bettered its long-term 200-day moving average and as a result, it appears to be in a relatively stable advance. The Russell 2000 and the S&P 500 are the next best-looking charts; however, they have been testing their 200-day moving averages without success for several weeks. This is an ambiguous pattern. Meanwhile, the Nasdaq Composite index remains in a bearish trend. This index has only exceeded its 50-day moving average and is trading well below its 200-day moving average. This results in a very mixed picture for the overall market. However, it is an interesting display of leadership shifting from growth to value. See page 8.

Our favorite 25-day up/down volume oscillator is currently neutral with a reading of 2.31. It had been in overbought territory for seven of 10 trading days in November, but it was unable to remain in overbought territory for five consecutive trading days. This is significant since bear markets rarely reach overbought territory and if they do the reading is brief. A true overbought reading should persist for at least five to ten consecutive trading days to be significant, therefore, the recent reading in this indicator is another sign of ambiguity in the equity market. Nevertheless, it remains one of our key indicators to monitor in the coming weeks to assess the strength of any advance in prices. See page 9. Similarly, the 10-day average of daily new highs is currently 73 and the 10-day average of daily new lows is 72. This combination is neutral since neither series is averaging more than 100 per day which is the minimum benchmark for defining a trend. Remember: the 10-day moving average of new lows was 1038 on September 26 and exceeded the previous peak of 604 made in early May, which means the October low was a confirmed new low and the bear trend continues. All in all, we remain cautious and suggest emphasizing stocks that have the most reliable earnings streams.

Gail Dudack

Click to Download

The Dudack Research Group wishes you and your loved ones a happy and healthy 2022 holiday season and a delicious and restful Thanksgiving weekend. We at DRG are grateful for many things and most especially for your continuous support and patronage.

Bear Markets and Transitions

Bear markets have a multitude of catalysts, but history shows that the most significant bear markets are triggered by one of two factors. A bear cycle often begins after an immense accumulation of debt and leverage that leads to massive defaults, a sharp decline in demand, a period of deflation, and falling profits. Or conversely, a bear cycle is triggered by a huge supply/demand imbalance that leads to an inflationary cycle, a loss of purchasing power, profit margin pressure, declining earnings, and lower PE multiples. The inflationary cycles of 1970-1974 and the current bear market were clearly linked to inflation driven by a lack of supply of oil. However, inflation preceded Russia’s invasion of Ukraine and most of today’s price cycle is due to the historic monetary and fiscal stimulus undertaken around the world to combat the worldwide economic shutdowns. In short, political decisions played a large part in today’s inflationary cycle.

But perhaps the most important characteristic of any bear market is that it almost always results in a major shift, or transition, in market leadership. It is this transition in leadership that is the key to outperforming, not only during the bear market, but in the bull market that follows.

“Follow the money” is a phrase that solves many financial and political mysteries, but “follow the earnings” is the simplest way to understand the leadership emerging in the current cycle. In 2020 our favorite sectors were those we described as “inflation-resistant” segments of the economy. In 2021 and 2022 we emphasized “recession-resistant” sectors and stocks for outperformance. Not surprisingly, inflation-resistant also tended to be recession-resistant and included sectors such as energy, utilities, staples, defense, and aerospace. These sectors can also be called defensive, household necessities, value, and total return, but they are most importantly the areas that have pricing power and profits in an era of rising costs and shrinking margins. Segments of healthcare can also be defensive and weather both inflation and recession. Technology has defensive segments such as security technologies. But in every case, it is a stock or sector with a predictable earnings stream in what is a difficult and unpredictable economic time.

Earnings Insecurity

The third quarter earnings season seems to have sounded the alarm that earnings are at risk for this year and next. In the last five weeks, the S&P Dow Jones consensus earnings estimate for 2022 has declined 3% — an unusually large decline in a short period of time. However, the erosion in forecasts actually began in April when estimates were 12% higher than they are today. We lowered our 2022 and 2023 earnings estimates two weeks ago to adjust for the weakness seen in the third quarter results. Unfortunately, the S&P Dow Jones estimate has dropped so quickly (it is now $201.58) that it is already below our $202 estimate for the S&P for this year. Although seasonality for the next three and six-month periods tends to be positive, the underlying erosion in earnings could prove to be quicksand for the overall market. Again, safety is equal to finding companies with solid earnings streams. See page 6. Unfortunately, the increase in interest rates and decrease in earnings estimates seen this year has lowered the midpoints of our valuation model to SPX 2625 for 2022 and to SPX 3020 for 2023. See page 7. In short, risk continues in the first half of 2023.

Real Estate Recession

There is little doubt that residential real estate and the homebuilding sector is in a recession. In September, new home sales fell 18%, the median new single-family home price fell 14% YOY, and the average home price fell 10% YOY. Existing home sales fell 28.4% YOY in October and the median existing single-family home price rose 6% YOY. See page 4.

A lack of inventory has been supporting existing home prices this year, however, that too is beginning to change. According to the National Association of Realtors, the months of supply of inventory have increased from the cyclical low of 1.5 in January of this year to 3.3 months in October. Housing starts were down 8.8% YOY in October and new home permits were off 10% from a year earlier. See page 5. And the outlook for the housing sector in 2023 continues to be dim, particularly since the Federal Reserve is expected to continue to raise rates in coming months. Affordability is already at its worst level in 37 years and the NAHB builder confidence survey has been declining for 11 consecutive months. November’s survey fell 5 points to 33, which is well below the neutral benchmark of 50. Both current traffic and the outlook for sales in the next six months are at recessionary levels. See page 6. Keep in mind that these dismal numbers are likely to get worse due to the Fed’s tightening policy in coming months. But, to a large extent this is the Fed’s goal – an economic slowdown.

October’s retail sales were stronger than expected, with total retail and foods service sales increasing 8.3% YOY and total sales excluding autos and gas stations rising 8% YOY. However, retail sales priced in 1982 dollars (adjusted for inflation) rose a mere 0.5%. Still, this small increase was better than the real retail sales data for April and June which were negative on a year-over-year basis. These declines were worrisome since negative YOY retail sales have been characteristic of all previous recessions. See page 3. However, investors should focus on where retail sales have actually been growing. In the post-COVID era. Sales have increased for six segments: gas stations, food service, building materials, sporting goods, miscellaneous and non-store retailers. This is in line with what we are seeing in terms of stock performance. See page 14.

Technical Watch

What we are seeing in terms of earnings performance is playing out in the popular indices. On page 9 we have ordered the indices in terms of their technical strength. The DJIA is by far the best-performing index, seen by the fact that it is now trading above its long-term 200-day moving average and has broken above a downtrend line off the January 4, 2022 peak of 36,799.65. The Russell 2000 index is the second-best performing index and is threatening to break above its 200-day moving average but is yet to do so. The S&P 500 is third best, and while trading above both its 50 and 100-day moving averages, it is trading 60 points below its 200-day moving average. The Nasdaq Composite index is by far the worst-performing index. It has barely exceeded its 50-day moving average and trades well below its 100 and 200-day moving averages. These differences are a display of the shifting leadership we noted earlier. Value has widely outperformed growth year-to-date and during the recent rally. See page 9. The 25-day up/down volume oscillator is neutral at 2.28 but was overbought for five of the last eight trading days. This is significant since bear markets rarely reach overbought territory and if they do the reading is brief. A true overbought reading should persist for at least five to ten consecutive trading days to be significant, therefore, the recent reading is ambiguous. Nevertheless, this will be a key indicator to monitor in the coming weeks to assess the strength of any advance in prices.

Gail Dudack

Click to Download

Breaking News

As we go to print there are a number of news headlines of significance. Unconfirmed reports suggest that a Russian-produced missile hit a Polish village near the border of Ukraine, killing two Polish citizens. This incident sparked a flurry of NATO leaders declaring that all NATO territories must be defended and as a result, fanned fears of an escalation and/or expansion in the Russia-Ukraine conflict. News of this explosion in Poland aborted an early-day rally that had been kindled by better-than-expected third quarter earnings from Walmart Inc. (WMT – $147.44).

Later this evening former President Trump is expected to announce his intention of running for re-election in 2024. This could split the Republican Party which is already showing signs of post-election fatigue and upheaval. The midterm elections did not produce a red or blue wave, but it is expected to create a shift in leadership in Congress. Rick Scott (R – FL) announced he will run against Senate Republican Leader Mitch McConnell (R – KY) for the role of minority leader in the Senate. And if the Republicans edge out the Democrats in the House of Representatives, Kevin McCarthy is expected to take the role of Speaker of the House from the indefatigable Democrat Nancy Pelosi. New leadership in Congress is unlikely to generate a meaningful difference in policy, but it is reassuring that a divided Congress is usually seen as a positive for the equity market.

These news events took the attention away from the collapsed crypto exchange FTX which has dominated financial news in recent days. The exchange, among the world’s largest, filed for bankruptcy protection on Friday after traders pulled $6 billion in three days from the platform and rival exchange Binance abandoned a possible rescue deal. FTX is the highest-profile crypto blowup to date and bankruptcy filings indicate the exchange faces a “severe liquidity crisis” and could have more than 1 million creditors. This is a warning of possible liquidity issues in unsuspected places in the upcoming weeks. Meanwhile, it is possible that FTX founder and former chief executive Sam Bankman-Fried will face felony charges due to what might be “unauthorized transactions” on its platform.     

The Rally

News of the wayward Russian missile threw a curve ball in what appeared to be an improving outlook for the Russia-Ukraine conflict. The retreat of Russian troops from Kherson left Russia with no forces on the right, or western, bank of Europe’s third largest river that bisects Ukraine and flows into the Black Sea. This is a vital conduit for Ukrainian grain exports. In fact, there were unsubstantiated reports that an agreement might be possible between Russia’s Putin and Ukrainian President Volodymyr Zelensky. We believe this possibility contributed to the massive rally in the euro and the decline in the dollar last week. This prospect, coupled with short covering, were catalysts for the rally in equities last week.

Yet stocks rose for a number of reasons including financial headlines like “US Fed could soon start easing rate policy.” We found this headline to be very misleading. Using the word “easing” in terms of monetary policy translates directly into the prospect of the Fed lowering interest rates. However, in this case, the media is actually referring to the possibility that interest rate increases could get smaller. However, these are two very distinct and different concepts. We question whether this headline was intentional and thereby playing with investor psychology or was it simply a symptom of naïve and inexperienced journalism. We do not know, but we do know that the market responded as if interest rates were about to decline. This makes us nervous about the rally.

Higher Interest Rates Ahead

As noted, investors celebrated better-than-expected CPI data for October with a massive rally, but as seen on page 5, the improvement was minor. Headline CPI was 7.8% YOY in October versus 8.2% YOY in September. Core CPI rose 6.3% YOY versus the 40-year high of 6.6% recorded in September. PPI data was somewhat better since it is coming down from cyclical highs recorded in June. In October, finished goods PPI rose 11.2%, core finished goods rose 8.1% and final demand PPI rose 8.0% YOY. Yet clearly, these rates remain well above the long-term average of 3% and remain at the highest pace in 40 years.

What is important to emphasize is that core CPI (6.3% YOY) and core PPI (8.1% YOY) remain well above the pace of wage growth (4.8% YOY) and this means household purchasing power continues to erode. This has been and will be a factor that will weigh on economic growth in the coming months. See page 6.

Another consideration that will slow economic activity is steady monetary tightening. Recent inflation data indicates that the fed funds rate continues to be negative and as a result, the Fed is not expected to stop raising rates in the foreseeable future. See page 7. All in all, we question the validity of the discussion around a Fed pivot. Even though the pace of interest rate increases may slow, this has very different implications from a reversal in interest rates. Sentiment on monetary policy is too optimistic, in our view. The Fed will continue to raise interest rates and depress economic activity in coming months making a recession likely in 2023.

Meanwhile, consumer and business confidence continue to erode. NFIB’s Small Business Optimism Index declined 0.8 points in October to 91.3, the 10th consecutive month below the 49-year average of 98. Of the 10 Index components, two increased, seven declined, and one was unchanged. Small business earnings and sales are at levels last seen during the 2020 recession and employment plans are declining. See page 3. Headline University of Michigan consumer sentiment hit a record low of 50.0 in June before rebounding. Nevertheless, it fell from October’s 59.9 to 54.7 in November. Economic expectations in the University of Michigan and Conference Board consumer sentiment indices, as well as the small business survey, have been falling nearly every month in the last two years. See page 4.

Technically Good News

The 25-day up/down volume oscillator is currently overbought for the third consecutive trading day with a preliminary reading of 3.83. This is significant because bear markets rarely reach overbought territory and if they do the reading tends to be modest and brief. In sum, this will be a key indicator to monitor in the coming days to assess the strength of any advance in prices. A long and extreme overbought reading would change our view of this rally merely being a strong bear market rebound. We will keep you posted.

In the interim, it is clear that this bear market has defined a transition of leadership. The FANG phenomenon is over. This new cycle is shifting from classic growth to value, from large capitalization to mid-to-small capitalization, and from global to domestic. We continue to favor recession-resistant areas such as energy, utilities, staples, aerospace and defense and recession-proof healthcare. 

Gail Dudack

Click to Download

Politics and inflation are the features of this week; however, third-quarter earnings results continue to provide plenty of drama in the background.

Politics and Equities

In terms of this week’s elections, a number of strategists are noting that since WWII, the S&P 500 has had a perfect record of gains following the midterm elections. In addition, the S&P 500 has posted an increase in each of the 12-month periods after the midterm vote and these gains have averaged an impressive 15%. As we show on page 3, the fourth quarter of the midterm election year tends to be the best fourth quarter of any of the four years in the election year cycle. And more importantly, the first quarter of the pre-election year tends to be the best quarter in the entire election cycle for most of the popular indices. In short, the last quarter of 2022 and the first quarter of 2023 are periods that have a solid history of being strong periods for stock prices.  

To date, 2022 has been very volatile and has underperformed historical averages. This severe underperformance is best displayed by the chart on page 4. However, it is this underperformance that may have led to the strong rebound seen in October. Yet even apart from politics, November marks the start of the best 3-month and 6-month periods for equity prices. In short, the stock market should have the wind at its back in the coming months.

And we do not see anything in terms of election results that could hamper stock prices. History shows that equity investors tend to like a split Congress. According to Reuters, when a Democrat is president, the market performs best when Republicans hold either the House, Senate, or both. The average annual S&P 500 returns have been 14% with a split Congress, 13% with a Republican-held Congress, and a 10% gain when Democrats control both the White House and Congress. All in all, the midterm elections should have a positive effect on investor sentiment.

Earnings Revisions

While we do expect the election to be a positive for equities, we are less optimistic about the next six to twelve months due to the deterioration we see in corporate earnings. The steady decline in S&P 500 earnings for this year and next year has continued as the third-quarter earnings season passes its midpoint. This week the S&P Dow Jones consensus earnings estimates for 2022 and 2023 fell $0.57 and $2.76, respectively. Refinitiv IBES consensus earnings forecasts fell $0.36 and $3.28, respectively. What is notable about the last two weeks’ revisions is not just that they continue to fall but that estimates for 2023 are beginning to plummet. As a result, the 2022/2023 forecasts from S&P Dow Jones and IBES Refinitiv are now $204.17 and $230.11 for 2022 and $220.91 and $232.64 for 2023. Earnings growth rates for 2022 are (1.9%) according to S&P and 6.1% according to IBES.

We have been stating that our S&P 500 earnings estimates would be reviewed after third quarter results, however, results have been so poor that we believe our earnings estimates need addressing this week. Our 2022 and 2023 estimates are slashed this week from $209 to $202 and from $229 to $204, respectively. The decline in this year’s estimate reflects the weakness seen in 2022 earnings results to date. More importantly, and more dramatically, our revision for 2023 earnings is due to the negative impact we expect to see from current and future Fed rate hikes on economic activity. Although some economists are now placing odds on the ability of the Fed to maneuver a soft landing in 2023, we believe many parts of the economy are already in or will inevitably face a recession. As a result, this will continue to put pressure on consumers and therefore on top-line revenue growth. Plus, inflation will continue to pressure corporate profit margins. For these reasons, we continue to favor the more recession-resistant areas of the stock market such as energy, utilities, staples, and defense stocks. Healthcare is a DRG-neutral weighting (see page 13) but many health-related stocks are necessities and are therefore recession resistant. Note that this means one should emphasize value versus growth and growth at a reasonable price.

In terms of the economy, the ISM nonmanufacturing survey’s composite index fell from 56.7 to 54.4 in October and the details of the report were unfavorable. New orders and business activity declined, and employment slipped below the neutral 50 mark. Note that the service sector, which has been the relative outperforming sector of the US economy, now appears to be joining the manufacturing sector which has been in decline since early 2021. See page 5.

Valuation

The jump in short-term interest rates from nearly zero to 4.2% is currently having and will continue to have a dramatic impact on equity valuation. The current earnings yield of 5.4% and dividend yield of 1.8% still hold a slight edge over bonds, but this will continue to evaporate as interest rates rise and earnings forecasts fall. When we put our revised earnings forecasts of $202 and $204 into our valuation model, coupled with our estimates for headline CPI of 7.1% this year and 4.0% next year, and short-term interest rates of 4.75% this year and 5.0% for next year, equity valuations fall. The midpoints of our valuation model drop to SPX 2666 for 2022 and to SPX 3020 for 2023. In sum, equity risk due to inflation, rising interest rates, and falling earnings continues. See page 7.  

Technical Indicators Remain Interesting

The charts of the popular indices are as revealing as many of our technical indicators this week, and each tells a slightly different story about the equity market. On page 8 we have ordered the charts of the indices in terms of technical strength. The DJIA is the strongest index and has just exceeded its long-term 200-day moving average this week. It is less than 3% above the moving average that confirms a breakout, nevertheless, it is trading above all its moving averages. The Russell 2000 is approaching its 200-day moving average but remains below it. The S&P 500 continues to find resistance in the narrow range between its 50-and-100-day moving averages. And lastly, the Nasdaq Composite is the weakest of all the indices and is trading well below all its moving averages. This divergence in the indices is a demonstration of shifting leadership from growth to value. 

The 25-day up/down volume oscillator is currently neutral with a reading of 1.11. Last week we noted that the indicator was rising toward an overbought reading of 3.0 or greater, which could signal a turning point for the market. The significance of an overbought reading is that bear markets rarely reach overbought territory and if they do the reading is brief. However, in recent days this indicator retreated before reaching overbought territory – a sign of decelerating buying pressure on the rally. Nevertheless, this indicator will be important to monitor in the coming weeks since it could be a bellwether of the strength of future advances in prices. See page 9. With many indices at, or near resistance levels, it will be important to see if this week’s inflation data has a significant impact on investor sentiment.

Gail Dudack

Click to Download

This week is significant since it marks the heaviest five days of the third quarter earnings reporting season. It also includes the November FOMC meeting and October’s employment report and precedes the midterm election on November 8. Each of these issues has ramifications for the equity market, but in our view, earnings reports should have the biggest short- and long-term impact on stocks.

The Importance of Earnings

To date, third quarter earnings results are coming in lower than much-reduced expectations. Last week the Refinitiv IBES estimates for this year and next fell $0.87 and $2.86, respectively. The S&P Dow Jones consensus estimates, which are important since S&P follows GAAP methodology, fell $2.00 and $2.52, respectively. As a result, the respective consensus estimates for this year are currently $221.27 and $204.70, which represent growth rates of 6.3% YOY for IBES and negative 1.7% YOY for S&P. See page 8. The steady decline in earnings estimates is a concern because we believe bear markets bottom out when the outlook for valuation is improving, or at least hopeful. Unfortunately, assuming the Federal Reserve will raise interest rates this week and again in December, and since rising interest rates suggest a weaker economy in 2023, the outlook for earnings is not optimistic. As a result, estimates for 2023 earnings are probably still too high and one can expect more negative surprises in the quarters ahead. Earnings disappointments erode investor confidence over time. In the short run, this week’s battery of earnings reports could set the tone for whether there is hope for 2023 earnings, or if estimates are still too high.

Nonetheless, our skepticism on S&P 500 earnings is not broadly based. In fact, we have been in favor of recession-resistant sectors and seek stocks where earnings growth is most predictable. In general, the current economic environment favors value stocks versus growth stocks, and we have been emphasizing necessities such as energy, staples, defense/aerospace, and utilities. The utility sector has shifted from being an outperformer to an underperformer in the last month, but keep in mind that “performance” in utilities should not be measured just by price, but by total return. We have a neutral weighting on healthcare, however, since healthcare is another household necessity with pricing power, it should not be overlooked in our view. See page 13. From a historical perspective, bear markets tend to be a transition period for a significant shift in leadership. We believe this is true of the current market. Notably, S&P sectors labeled as “growth” have varied over the decades, but they have had one thing in common and that is that they have represented the highest earnings growth rates of all 11 S&P sectors. In the next few years, or at least until inflation has come under control, we believe recession/inflation-resistant companies will provide the best earnings and price performance and will outperform the S&P 500 index. In truth, energy has been the growth sector of 2021 and 2022.

A Fed Pivot

The Federal Reserve is expected to raise the fed funds rate from its current range of 3% to 3.25% to 3.75% to 4.0% this week. This would be the fifth interest rate hike in a twelve-month period and the fourth consecutive 75 basis point increase this year. It would also constitute an increase of 375 basis points in the last 20 months. This will certainly have a major dampening effect on economic activity in the first half of next year and it has already put the residential real estate market in a recession. We would challenge market pundits who are focused on whether a 50-basis point increase at the December FOMC meeting would constitute a “Fed pivot” and a key buying opportunity, because we believe this misses a very important point — a 375-basis-point increase in the fed funds rate in a mere twelve months is likely to trigger a recession in 2023. Again, there are many reasons to focus on recession and/or inflation resistant companies at this juncture, even though we would note that the best three-month period for stocks (November, December and January) has just begun.

A Critical Technical Juncture

Technical indicators are at an interesting and, in some cases, critical juncture just as important information from earnings, the Fed, economic data, and political elections loom on the horizon. The most important indicator this week is the 25-day up/down volume oscillator which is currently neutral with a reading of 2.61. However, this is surprisingly close to an overbought reading of 3.0 or greater. Since bear markets rarely reach overbought territory and if they do the reading is brief, there is the possibility of a turning point in this indicator. In sum, we will be watching the 25-day up/down volume oscillator very carefully in coming weeks.

And as the oscillator faces a potential turning point so does the S&P 500 index. A convergence of the  50- and 100-day moving averages at roughly SPX 3900 represents a key resistance level. If bettered, it would be a positive for the intermediate-term outlook and fall in line with the favorable seasonality that is typical of year end. If it proves to be resistance, it will confirm that the bear market cycle remains intact. See page 9. Nevertheless, the indices are not moving in unison, and it is worth noting that the DJIA is trading above its shorter-term moving averages and currently testing its 200-day moving average. The Russell 2000 is similarly close to its 200-day moving average. This divergence and relative outperformance of small capitalization stocks is favorable since the large capitalization stocks tend to be the last to fall in a bear market.

Economic Data

After contracting in the first two quarters of the year, GDP grew 2.6% (seasonally adjusted annualized rate – SAAR) in the third quarter. However, trade contributed 2.8% to the quarter as exports of oil & gas to Europe increased and a strong dollar translated into fewer dollars spent on imports. In short, these may be short-term influences and the domestic economy continued to struggle. See page 3.

Household consumption contributed less to third quarter activity than it did in the second quarter and consumer spending was disproportionately in services. Businesses slashed spending on structures and residential investment fell at a 26.4% annual rate. Residential fixed investment was the largest drag on third quarter GDP falling 1.4% (SAAR), followed by inventories which fell 0.7% (SAAR). Third quarter typically sees an inventory build ahead of the holiday season; however, real retail sales have been weak in recent months and retailers appear to be cautious. The one bright spot in the GDP report was a small decline in the GDP deflator from 7.6% to 7.0%. See pages 4 and 5.

In September, personal income grew 5.2% YOY and personal disposable income grew 3.2% YOY. But the true measure of household consumption is demonstrated by real personal income which declined 1.0% YOY and real disposable income which fell 2.9% YOY. See page 6. Yet despite a lack of purchasing power, personal consumption expenditures rose 8.2% YOY in September and grew 8.4% over the last three months. Not surprisingly, the savings rate fell from 3.4% to 3.1% in the same month. Overall, consumption may not be sustainable at this level.

Gail Dudack

Click to Download

World News

It was a quiet week in terms of domestic economic news, but it was far from dull in terms of global news. In the UK, Rishi Sunak took over as Britain’s 57^th prime minister, replacing Liz Truss, whose 45 days in office was the shortest tenure in UK history. Sunak will be the first prime minister of South Asian descent, the first person of color, the first Hindu prime minister, and at 42 years old is the youngest person to hold the office in modern times. He has previously worked for Goldman Sachs, was a managing director of a hedge fund, and might be the richest person to ever hold the office. He formerly served as the Chancellor of the Exchequer (finance minister) in Boris Johnson’s cabinet. Sunak inherits a difficult economic environment, but the market’s first reactions were favorable and British sterling rallied on the news. Separately, the Bank of England is expected to raise interest rates 75 basis points on November 3, one day after the Federal Reserve is expected to raise the fed funds rate by another 75 basis points.

This week Russia took allegations to the UN Security Council implying that Ukraine is preparing to use a “dirty bomb” on its own territory. Western and Ukrainian officials dismissed these charges as misinformation, but many worry that this could be a pretext prior to Putin escalating the war. Simultaneously Putin notified the US of plans to carry out annual exercises of its nuclear forces.  

Over the weekend, the Chinese Communist Party unanimously chose Xi Jinping to be its leader for another term of five years, while also granting him a breadth of institutional power not seen since the days of Mao Zedong. In 2017 Xi removed term limits for the presidency. And in a blatant expression of power, Xi had China’s former president, Hu Jintao, forcibly removed from the final session of the 20^th National Congress, a sign that Xi is pushing all but his most loyal allies out of positions of power.

Saudi Arabia’s energy chief Prince Abdulaziz bin Salman blasted the use of emergency oil reserves to manipulate prices in a direct warning to President Biden who just released millions of barrels from strategic petroleum reserves. Saudi’s energy minister stated, “Losing emergency stocks may be painful in the months to come.” President Biden has signed off on historic use of the US Strategic Petroleum Reserve (SPR) this year, releasing 180 million barrels of oil since April, with another release of 14 million barrels this month. This supply has helped to keep a lid on energy inflation in the weeks before the midterm elections, but it is also putting oil markets under pressure with the SPR at its lowest level since 1984. 

Earnings

At the end of the week, slightly more than half of the S&P 500 component companies will have reported third quarter earnings. This week the S&P consensus EPS estimate for 2022 declined to $206.74 and IBES fell to $222.14 bringing EPS growth rates for 2022 to -0.7% and 6.7%, respectively. These estimates are down from $227.51 and $230, respectively, at the end of April. This means the S&P consensus estimate has declined nearly 10% in the last five months and it is still falling. This week forecasts for 2022 declined 59 cents and for 2023 fell 28 cents. And estimates are apt to fall again this week. Google parent Alphabet (GOOGL.O – $104.48) reported earnings of $1.06 per share versus $1.40 a year earlier, based upon disappointing ad sales. Last week Snap Inc. (SNAP – $9.60) reported its slowest ever revenue growth rate and the stock collapsed. Microsoft (MSFT – $250.66) reported earnings of $2.35 per share in its fiscal year ending in September, versus $2.71 a year earlier, and projected quarterly revenue below Wall Street targets across its business units. Microsoft suffered its worst quarterly net income decline in two years and the weakest revenue growth in more than five years. These results fanned fears of a slump in personal computer sales and slowing growth in its cloud computing business. General Electric Co. (GE – $73.00) trimmed its full-year forecast after reporting a decline in third quarter earnings due to higher raw material costs in its renewable energy business and demand uncertainty due to the expiration of renewable electricity production tax credits. In sum, we expect consensus earnings estimates for the S&P 500 will continue to decline. This fact puts our current 2022 estimate of $209 at risk. We will be reassessing our estimates at the end of third quarter earnings season.

A Bounce

There have already been two bear market rallies that tested the 200-day moving averages in the indices in this bear market cycle, and the recent oversold condition suggests we may be in the midst of a third test. This implies there is room at the top for this rally, but we would keep in mind where resistance could be expected. Key resistance levels are Dow Jones Industrial Average: 32,703; S&P 500 index: 4,126; Nasdaq Composite index: 12,458; and Russell 2000 index: 1891. We are monitoring the Russell 2000 index most closely since it is currently testing key resistance at 1,800. This could prove to be significant this week. Failure to better this level would be a sign that the broader rally is weakening. Remember, the Russell had been a lead indicator of the broad market in 2021 when it failed to move in step with the larger capitalization indices, warning of market weakness ahead. And more recently, October’s decline failed to slip significantly lower than the June low, a subtle sign of outperformance. As long as the Russell 2000 stays between resistance at 1,800 and support at 1,640 the technical trend is neutral. However, a break above 1,800 or below 1.640 could be a trigger for the next intermediate term move. See page 7.

The 25-day up/down volume oscillator is currently neutral with a reading of negative 1.21. However, back on September 30, the oscillator hit an oversold reading of negative 5.6 which was a deeper oversold reading than the negative 5.17 reading seen on July 14, 2022. It was also in oversold territory for 8 of 10 consecutive trading sessions in July and oversold for 18 of the 24 consecutive trading sessions in September/October. This was a longer oversold reading than at the previous low and a sign of intense selling pressure. In short, October’s test of the June lows was unsuccessful by several measures, and the bear market cycle continues. This is true despite the nearly 6% two-day gain seen in the market to open October, the 4% two-day gain seen last week and this week’s 1.6% up day. See page 8.

Our views on the stock market and economy are unchanged. With interest rates apt to move higher, the economy is likely to slow. This suggests a focus on recession resistant stocks and sectors, which means finding companies that can have the most predictable earnings streams in a difficult economic environment. In general, this favors value rather than growth as a strategy. We maintain an overweight status on energy, utilities, staples, and defense-related companies in the industrial sector. Our recommendation on healthcare is a neutral weighting, but we do appreciate its defensive qualities. See page 11.

Gail Dudack

Click to Download

Technical Indicators

Our view of the recent rally is quite simple. The popular equity indices fell well below their moving averages in recent weeks and a rebound to at least the 50-day moving averages is likely in coming trading sessions. The levels to look for are 31,277 in the Dow Jones Industrial Average, 3,915 in the S&P 500, 11,637 in the Nasdaq Composite, and 1,822 in the Russell 2000 index. Note that a test of these levels equates to another 2.5%, 5.3%, 8.0%, and 3.7% upside, respectively, in the indices. See page 9.

The good news is that the current rebound has more potential; but unfortunately, the market’s action in recent weeks also suggests the bear market is ongoing. In short, the lows are yet to be found. Breadth data deteriorated in September, and in particular, the 25-day up/down volume oscillator hit an extreme oversold reading of negative 5.6 on September 30. This was a deeper oversold reading than the one seen at the June low. The 25-day oscillator was also in oversold territory for 10 consecutive trading sessions in September and to date, it has been oversold for a second time in six of the last seven trading sessions. This represents a much longer and persistent oversold condition than the six out of eight consecutive trading sessions seen at the June low. All in all, it indicates an escalation in selling pressure which means the test of the June lows was unsuccessful by several measures and the bear market continues. See page 10.

The current reading in the 25-day oscillator is oversold at negative 3.3, which is rather amazing given the nearly 6% two-day gain seen in the market to open October and the 4% two-day gain seen this week. This oversold reading reveals that despite these sharp rallies, selling pressure has overwhelmed buying pressure over the last 25 trading sessions, typical of a bearish trend. A successful test of a bear market low materializes when a new low in price is accompanied by less selling pressure and a less severe oversold reading. This indicates that selling pressure and downside risk is abating. In other words, a “non-confirmation” of a major low is a positive sign. Sadly, that is not what has been seen in October, to date.

Sentiment indicators have also been extreme recently, but this is favorable. Last week’s AAII readings showed bullishness at 20.4% and bearishness at 55.9%. Also noteworthy was the 17.7% bullish reading seen the week of September 17th since it was among the 20 lowest readings since the survey began in 1987. Bearish sentiment has been above 50% for seven of the last eight weeks which is also rare. Equity prices tend to be higher in the next six and/or twelve months following such extreme readings. Keep in mind that sentiment indicators are never good at timing market peaks or troughs, but they are good at indicating which way to lean. In this case, it suggests that investors should not be overly bearish on equities and should be looking for a buying opportunity ahead. See page 12.

Earnings Forecasts

We are happy to report that some anchors on CNBC are now pointing out that even though some companies are reporting third quarter earnings results that exceed consensus expectations, these earnings are nonetheless weaker than a year earlier. That is a step in the right direction, since the market had been ignoring the fact that earnings have been weakening in 2022.

This week the S&P Dow Jones consensus earnings estimates for 2022 and 2023 fell $0.79 and $2.62, respectively. Refinitiv IBES consensus earnings forecasts fell $0.76 and $1.17, respectively. To date third quarter results are triggering larger earnings cuts than what was seen in the second quarter. The S&P consensus EPS estimate for 2022 is now at $207.33 and the IBES estimate fell to $222.58 bringing EPS growth rates for 2022 to negative 0.4% and positive 7.7%, respectively. See page 8. Our 2022 and 2023 estimates are currently $209 and $229, respectively, but remain under review. Based on early releases, our S&P 500 earnings estimates could come down significantly before year end. Unfortunately, this means the fair value range for the SPX will also fall. The range in our valuation model currently shows a low of SPX 2354, a high of SPX 3430, and a midpoint of SPX 2890. It is the midpoint of the range that is the most likely to contain downside risk, in our view. However, this explains why lowering our earnings forecast poses even more downside risk in the marketplace.

Inflation

September’s inflation data disappointed many and this disappointment will continue in coming months unless analysts look deeper into CPI data. Forecasters were expecting lower inflation numbers because energy prices fell 6.2% month-over-month in September. Nevertheless, September’s CPI was unchanged year-over-year and core CPI rose. And note, this was not due entirely to owners’ equivalent rent, as some are saying. See page 3.

As we expected, healthcare prices are rising in the fourth quarter which tends to be a seasonal trend. Housing prices may be peaking in some regions of the country, but housing is still rising in the CPI index. More importantly, unnoticed by many is the fact that food and beverage prices rose 10.8% YOY in September. This should be a concern for all investors because food inflation is not impacted significantly by energy (except for transportation costs) but will be impacted by the conflict in Ukraine since Ukraine – the breadbasket of Europe — is a major grain producer. We expect grain shortages will drive prices higher for the foreseeable future. In addition, Hurricane Ian damaged large portions of agricultural land in central Florida which could have an impact on the supply of fruits, vegetables, and beef. In our view, food shortages are likely to add to inflation in the months ahead. See page 4.

Some economists are fixated on owners’ equivalent rent which has a 24% weighting in the CPI and rose 6.7% YOY in September. They are challenging the validity of homeowners’ equivalent rent as a measure of housing costs since it is measured not by transactions, but from a survey of home prices and rents in various neighborhoods. Some say the surveys are not reflecting the deceleration in home prices. This is true since rents always lag home prices, sometimes by quite a few months, but this has always been true. Still, when we compare the history of owners’ equivalent rent to the National Association of Realtors median single-family home price, we find the homeowners’ equivalent rent has been much more subdued than home prices and has been a slow and steady measure of costs over time. However, the 6.7% increase seen in September was above the normal range of zero to 6%. See page 6. Rents are likely to fall in time since housing is clearly in a down-cycle. Signs of a housing recession are numerous, including the year-long decline in NAHB confidence. See page 6. However, this is not the problem that we see. Food and beverages have a 14.5% weighting in the CPI and rose a greater 11% YOY. This combination concerns us. Moreover, inflation is rising 8.2% YOY and wages are rising 4.8%. This equates to a 3.4% loss of purchasing power. See page 5. We remain cautious and continue to favor recession resistant sectors and stocks.

Gail Dudack

Click to Download

Earnings season will begin later this week as financial stocks begin to report third quarter results. And for the first time this year, investors seem to be taking a close look at the quality of earnings and earnings guidance. Expectations turned lower for the banking sector after several global banks indicated they plan to raise reserves in anticipation of a weakening economy. Friday will be our first look at how the financial sector managed in the third quarter.

Global Woes

But the economic backdrop for earnings has come under review recently. This week The International Monetary Fund warned that “colliding pressures from inflation, war-driven energy and food crises and sharply higher interest rates were pushing the world to the brink of recession and threatening financial market stability.” Citing new 2023 global growth forecasts from its World Economic Outlook, the IMF said that countries representing a third of the world’s output could be in a recession next year. More disturbingly, the IMF highlighted that financial stability risks have increased, and it warned of disorderly repricing in markets.

Disorderly markets are not new news actually. Instability has already appeared in Britain. Last week the Bank of England expanded its program of daily bond purchases to include inflation-linked debt. It noted a “material risk” to British financial stability and “the prospect of self-reinforcing ‘fire sale’ dynamics” leading to chaos in its gilt market. The Bank pledged as much as 65 billion pounds of long-dated government bonds to allow for a more orderly disposal of assets in the pension fund sector. However, the risk continues, and investors are watching to see what happens when, or if, the Bank of England ends its purchasing program, perhaps as soon as later this week. History has shown how disorderly markets often reflect illiquidity and this instability can ripple through the global financial markets in unexpected ways. This is one of our main concerns for the latter part of the year.

It is important to note that these financial problems emanate partly from the US. The combination of inflation and rising interest rates in the US has driven the trade-weighted dollar to its highest level in 20 years. The Federal Reserve’s new nominal broad dollar index is currently at a 50-year high. See page 7. The strength in the dollar, coupled with rising interest rates, means that other central banks, like the Bank of England, will have to raise their interest rates to prevent their currencies from collapsing. In cases like England, where economic growth is already weak, rising interest rates compound the problem it already faces from higher energy costs, inflation, and a weakening economy. It can become a circular problem that is difficult to solve. Moreover, since crude oil is priced in dollars, energy becomes more expensive to non-US buyers, adding to inflation.  

Exacerbating these financial woes were reports from China that Shanghai and other cities have seen COVID-19 infections rise. Some local authorities began to close schools and entertainment venues, reigniting fears of more shutdowns, slower Chinese growth, and global supply shortages. Again, there are a number of issues outside the US that could have a significant impact on our financial markets in the remaining months of the year. This keeps us cautious.

Focus on Earnings

In terms of earnings, FedEx Corp. (FDX – $152.08) shocked investors last week when it revealed that it was preparing for a further decline in the number of e-commerce packages it would handle in the upcoming holiday season. The stock is down nearly 30% in the last month.

This week S&P Dow Jones consensus earnings estimates for 2022 and 2023 fell $0.63 and $0.25, respectively. Refinitiv IBES consensus earnings forecasts fell $0.38 and $0.86. But the most important news of the week was that the S&P consensus earnings estimate for 2022 declined to $208.12 and is now below 2021’s level of $208.17. This means that if economists are correct about a recession in 2023, investors could be facing two consecutive years of little or no earnings growth in equities. However, keep in mind that earnings in the energy sector continues to be strong, and when excluded from the S&P total, earnings growth in 2022 is already negative. We want to reinforce our view that investors should continue to focus on recession resistant stocks, such as energy, utilities, consumer staples, and special areas like defense-related companies.

Technical Indicator Update

The charts of the popular indices are quite similar this week with all four of the popular indices trading below all their moving averages. This is bearish. However, the one positive sign is the Russell 2000 index which is outperforming the other indices at the moment since the June lows have not been decisively broken. We focus on this small capitalization index since it was an early leader at the market top, and it could also be an early leader at the lows. Conversely, the Nasdaq Composite is the worst performing chart in a major decline. See page 10.

The 25-day up/down volume oscillator can be one of the best technical indicators at defining peaks and troughs. The oscillator fell to an oversold reading of negative 5.6 on September 30 which was a deeper oversold reading than the one seen at the June low, and it was in oversold territory for 10 consecutive trading sessions. This was longer than the oversold reading for six of eight consecutive trading sessions in June. In short, the test of the June lows was unsuccessful by this measure, and the bear market continues. The 25-day up/down oscillator is currently neutral with a reading of negative 2.93 but this is close to an oversold reading. A second oversold reading of greater than five consecutive days would confirm the market has not yet found its capitulation low. See page 11.

The 10-day average of daily new highs is 29 and daily new lows are 547. This combination is negative with new highs below 100, and new lows above the 100 benchmark. More importantly, the 10-day moving average of new lows was 1038 on September 26 and exceeded the previous peak of 604 made in early May. In addition, NYSE the advance/decline line fell below the June low on September 22 – is currently 56,191 net advancing issues from its 11/8/21 high – a negative sign. See page 12.

Jobs The increase of 263,000 jobs in September and a decline in the unemployment rate to the post-pandemic low of 3.5% was enough for investors to believe that the next Fed meeting will result in a 75-basis point increase. However, the number of people no longer counted in the labor force – 229,000 –increased nearly as much as job growth. This led to the participation rate falling 0.1 to 62.3% in September. Data also shows that 5.7% of those no longer counted in the labor force want a job. See page 5. And it is important to note that this is an economy of “haves” and “have-nots.” College educated workers are seeing growth in employment while those with less than a college degree struggle. But all workers are seeing a negative trend in real weekly earnings this year due to high inflation. See page 6.

Gail Dudack

Click to Download

The S&P 500 index jumped nearly 6% in the first two days of October, as investors once again focused on the possibility that a Fed “pivot” is near. The incessant focus on a Fed pivot lacks an understanding of how difficult the Fed’s job is in terms of conquering an inflationary trend that has persisted for two years and reached double-digit levels. In our view, the Fed pivot mania is an attempt to simplify a global financial environment that is getting more complicated by the day. More importantly, it could be a misguided and potentially dangerous strategy for a number of reasons.

Forget the Pivot

First, it underestimates the Federal Reserve’s commitment to fight inflation. Most Fed governors have indicated that they are serious about lowering inflation and that they will remain vigilant and steadfast until it gets back to the Fed’s 2% goal. That will take a long time. Second, even if prices remain unchanged for the next several months, headline CPI will still be above the 6% level. This is far from nearing the Fed’s goal. The one piece of good news for inflation is that oil prices appear to be stabilizing at lower levels. But this will not be enough to get to lower levels of inflation. Even with WTI futures (CLc1 – $86.35) below $90 a barrel and down 25% from its May closing high, WTI is up 3.3% on a year-over-year basis. And in the background, OPEC+ is discussing cutting output. In short, the CPI is unlikely to come down substantially until 2023. Third, what could get the Fed to “pivot” on interest rates would be a financial crisis, or more specifically, a liquidity crisis in the banking system. However, such an event would be a disaster and rather than sparking an equity rally it would likely trigger a sizeable selloff. Unfortunately, this risk cannot be ruled out, particularly in an environment of rising rates and a strengthening dollar. There is instability in the global system as seen by the fact that the Bank of England had to employ emergency gilt purchases when British pension funds were swamped by margin calls. There are rumors of liquidity issues at Credit Suisse Group AG (CSGN.S – $4.29) and the government of Finland had to extend credit packages totaling 3.55 trillion euros to stabilize the power industry and the energy debt derivative sector, due to a deteriorating debt market. These events may seem unrelated, but we have seen lesser matters ripple through the global banking system and create chaos. It brings back memories of the financial crisis of 2008.

In other words, the focus on a Fed pivot is not a practical exercise in our opinion. Even if the Fed were to pause rate increases, it would not necessarily reflect a change in monetary policy and bring back the easy money policies that had encouraged speculators to the markets. All in all, it is a very short-term view. But it did spark an impressive two-day rally, to date.

A Focus on Earnings

We think a more appropriate focus for investors would be on corporate earnings. Although the financial press places its emphasis on whether or not a company has beaten its quarterly consensus earnings forecast, we think it would be more insightful to focus on whether quarterly earnings growth is positive or negative on a year-over-year basis. Companies have been beating consensus earnings, but that is a bit of a charade since corporations have lowered guidance and analysts have reduced estimates as earnings season approaches. Therefore, the charts from Refinitiv on page 10 are important. They show that the earnings estimate revision trend has been negative for most weeks at least since the middle of July. For the week ending September 30, the earnings revisions for S&P 500 companies were 67% negative and 33% positive. For all US companies, revisions for the week were 62% negative and 38% positive. And it is important to note that since April, according to S&P Dow Jones consensus estimates, the 2022 forecast has declined 8.2% and the 2023 forecast has decreased 4.4%. At present, the S&P Dow Jones earnings growth rates for this year and next are 0.3% and 14.3%. Both of these numbers include earnings for the energy sector which is providing most of the growth.

However, if the Fed continues its tightening policy the risk of recession increases and earnings forecasts for 2023 are apt to fall from positive to negative. In our opinion, this is where the financial press, analysts, and investors should concentrate. And this is what keeps us cautious.

Technical Breakdown

The two-day October rally has been impressive and included a 91% and 95% up day in volume. The advance was triggered from a deeply oversold condition and gained momentum on softer economic news and a smaller than expected increase of 25 basis points by the Reserve Bank of Australia. This combination refueled predictions of a Fed pivot. However, despite the strength of the two-day rally, breadth statistics remain negative. Sadly, the 25-day up/down volume oscillator hit an oversold reading of negative 5.6 on September 30 and was in oversold territory for a string of 10 consecutive trading sessions. The current reading is neutral at negative 2.66. Nevertheless, the 10-day oversold reading was more extreme than the oversold reading at the June low. This means September’s test of the June lows was unsuccessful and the bear market continues. See page 12.

This was not the only indicator that broke down at the end of September. The 10-day average of daily new lows reached 1,038, exceeding the previous peak of 604 made in May. The NYSE cumulative advance/decline line fell below its July 2022 low and is now 47,465 net advancing issues away from its all-time high. See page 13. The charts of the indices show prices are well below their 200-day moving averages and could rally back to test their 100-day moving averages. However, the long-term trend would still remain bearish.

The one positive is sentiment. Last week’s AAII bull/bear readings showed a 2.3% increase in bullishness to 20.0% and a 0.1% decrease in bearishness to 60.8%. Last week’s 17.7% bullish reading was among the 20 lowest readings since the survey began in 1987. Sentiment indicators are not good timing indicators, but they do suggest that this is not the time to become too bearish. Equity prices tend to be higher in the next six and/or twelve months following such extreme readings.

Economic Review

Many housing statistics were released in the last week, and they paint a picture of a housing sector experiencing an accelerating slowdown. Pending home sales have been declining since October 2021. Affordability is at its lowest level since 2006. Median home prices reached a record level relative to income in June 2022, and when coupled with rising mortgage rates, make this a difficult time to buy a home. The NAHB confidence index has been falling all year and in the September survey, dropped to levels last seen in 2014. Census Bureau data indicated that building permits fell in August to its lowest level in two years. But in a surprise, housing starts picked up from 1.404 million to 1.575 million in August. The ISM manufacturing index fell from 52.8 in August to 50.9 in September. New orders dropped from 51.3 in August to 47.1 in September and have been below 50 (neutral) for three of the past four months. Employment fell from 54.2 to 48.7 and has been below 50 for four of the last five months. These weak statistics may increase the hope of a Fed pivot, but they will not be good for earnings growth in coming quarters. Stay cautious.

Gail Dudack

Click to Download