US Strategy Weekly: Sentiment and Inflation Warnings

One of the first warnings signs of the year was the rise in bullish sentiment reported by the Association of American Individual Investors (AAII) in their weekly survey. In the first week of 2021, bullish sentiment rose from 46.1% to 54.0% which means bullish sentiment has remained above the historical average of 38% for nine consecutive weeks. Bullish sentiment is also at its highest level since the November 11, 2020 reading of 55.8% which was a 12-month high. An early preview to current data suggests bullish sentiment may increase again in the current week. Nevertheless, the 8-week Bull Bear spread is negative for the second week in a row which is similar to the warning seen in early 2018. See page 18. As a reminder, 2018 was a roller coaster year of big price swings that ended with a loss of 5.6% in the Dow Jones Industrial Average and 6.2% in the S&P Composite.

It is important to keep in mind that sentiment indicators are not useful for timing market peaks or troughs, however they do provide good discipline for investors who may become too optimistic or pessimistic about equities. With bullish sentiment above 50%, investors should remain alert to other signs of risk in the markets. Nevertheless, most technical indicators are confirming the indices’ recent highs. The NYSE cumulative advance decline line made an all-time high on January 12, the 10-day average of daily new highs is robust at 433 and the 10-day average of daily new lows is 28, and well above the 10 or less per day that can appear at the end of a major advance. The one ambivalent technical indicator is the 25-day up/down volume oscillator which is currently neutral at 1.52. This oscillator was in overbought territory for 16 of 19 consecutive trading days between November 23 and December 18 and reached an extreme overbought reading of 5.52 on December 4. This combination was a solid confirmation of the new highs seen at year end. But if we see further gains in stock prices in 2021, we would also like to see an overbought reading to show that price gains are supported by solid buying pressure. See page 11, 12 and 13.

Last week we noted the favorable signal emanating from the Santa Claus rally given the gain during the last five trading days of the year and the first two trading days of the new year. The January Barometer, devised by Yale Hirsch of the Stock Trader’s Almanac in 1972, is another Wall Street adage that states “as goes January so goes the year.” This parable makes sense to us since liquidity, or cash, tends to at its best early in the year as a result of year-end tax-loss selling, year-end bonuses and annual funding of pension funds and IRA’s. History also suggests that the first five trading days of January predicts the month of January. On page 7 we show the performance history of the Dow Jones Industrial Average during the first five days of January, the month of January and the full year beginning in 1950. It indicates that the first five trading days of January has predicted the year’s action 79% of the time. However, the January Barometer has an even more impressive 95% accuracy in predicting the full year’s action if, and only if, January has a positive performance. The Barometer is less accurate when January ends with a loss. As the table shows, there have been 24 instances of losses in early January, 14 years with losses in the full month of January, and eleven years of negative performances for the full year. In short, January losses are far less predictive. But to date, the 1.6% gain in the first five days of January 2021 bodes well for the month and for the overall year. See page 9.

Anyone Focusing on Jobs?

The ISM manufacturing index increased from 57.5 to 60.7 in December, with most components, except for trade, also rising. Prices paid soared from 65.4 to 77.6. We remain nervous that inflation could be a big risk for equities this year. The nonmanufacturing index rose from 55.9 to 57.2 in December, but the employment index fell from 51.5 to 48.2. With the employment index below the 50 breakeven point, it suggests job growth in the service sector may weaken in coming months. See page 3.

The loss of 140,000 jobs in December did not surprise us given the extended shutdowns of businesses in states like New York and California; so, we are encouraged that Governor Cuomo appears to be ready to ease some restrictions. Still the risk of lengthy shutdowns is that businesses and entrepreneurs have been and will continue to face bankruptcy, which weakens the economy, and foreshadows more jobs losses. In December, the number of people employed was down 6.2% from a year earlier. Typically, any negative growth rate in employment suggests the economy is in the midst of a recession. The US economy has been buoyed by extraordinary fiscal and monetary stimulus for much of 2020, but stimulus cannot solve all problems. The unemployment rate in December was unchanged at 6.7%, but this is still well above the 3.6% seen in December 2019. Plus, when we look at the breakdown of unemployment, we find it is not evenly distributed. Those hurt the most in 2020 were workers with less than a high school degree which means households in the lower end of the job market remain under the greatest pressure. This dilemma is linked to the closure of food and drink establishments, hotels, and all employees tied to business and leisure travel. In our opinion, a weak job market will be another risk factor for the economy, earnings, and investors in 2021. Strangely, politicians seem focused on other matters and are ignoring this fact. See pages 4 and 5.

Small Business Confidence is Crumbling

Entrepreneurs and small businesses were feeling the impact of the pandemic at the end of 2020. The NFIB small business optimism index fell 5.5 points in December to 95.9 and all components with the exception of inventory satisfaction were lower. Owners expecting better business conditions over the next six months plummeted 24 points to a net negative 16. Sales expectations for the next three months fell 14 points to a net negative 4. Hiring plans fell 4 to 17, which was down but only to the lower end of the range seen over the last three years. This survey makes it clear that small businesses are concerned about their future in 2021.

The two areas of strength in the 2020 rebound have been housing and auto. Existing home sales were fairly robust at 6.69 million (SAAR) units in November, down slightly from October, yet up nearly 16% YOY. New home sales were 841,000 in November which was down from 945,000 units in October, but still up 21% YOY. The one warning sign we see for homebuilders is the pending home sales index which fell for the third consecutive month in November to 125.7. See page 7.

Earnings Forecasts are Stabilizing Consensus earnings estimates were revised significantly lower at year end but edged up slightly last week. S&P Dow Jones estimates rose $0.20 for 2020 and $0.17 for 2021 while IBES estimates rose $0.13 for 2020, $0.36 for 2021 and $0.37 for 2022. The S&P Dow Jones and IBES estimates for 2020 are $120.54 and $135.79 and for 2021 they are $164.57 and $167.61, respectively. Keep in mind that PE multiples have expanded dramatically in the last twelve months due in large part to low interest rates and indications from the Federal Reserve that monetary policy will not change before 2023. However, our valuation model indicates that the current low inflation/low interest rate environment translates into a 20 PE multiple. If we apply a 20 PE to the IBES $167.61 estimate for this year it implies a target for the SPX of 3352. In other words, the SPX has a 12% downside risk should optimism regarding earnings, the economy, interest rates or inflation change in the near term.

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