US Strategy Weekly: Does the Market Believe the Fed?

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

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

Inflation Can Bite

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

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

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

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

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

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

New 2022 S&P Earnings Estimates

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

Technical Update

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

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

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