US Strategy Weekly: Valuation Readjustment

January’s job growth was well above the consensus estimate and the 467,000 increase was a welcomed event. But this number was in sharp contrast to other economic series also released in the last week. Both of January’s ISM indices are indicating that the recovery is slowing. The ISM manufacturing index fell from 58.8 to 57.6. The manufacturing employment component rose modestly from 53.9 to 54.5, but this and imports, were the only parts of the survey to show any improvement. The ISM service index had consistently been the stronger of the two surveys, but it also fell in January from 62.3 to 59.9. All components in the service group fell with the exception of inventory. In general, both ISM surveys have been deteriorating for the last two months. Not surprisingly, the small business survey, the NFIB Optimism Index, had a large slump in January as small business owners pointed to rising inflation as the number one challenge for their companies and profits. See page 7.

The jobs report also had a counterpoint to the nice job increase in that the unemployment rate ratcheted up from 3.9% to 4.0%. The unemployment rate is part of the BLS household survey which showed that while employment grew strongly in January, so did the number of unemployed. This accounted for the rise in the unemployment rate. The civilian noninstitutional population grew less than the growth in employed and for this reason there was fractional improvement in the participation rate and the employment population ratio. See page 3.

In our opinion, the only employment data point that is important is that there are 2.9 million fewer people employed today than at the peak in February 2020. Typically, total employment will exceed its previous peak level twelve months after a recession ends. Yet, despite all the stimulus and fiscal programs initiated in the last two years, employment remains well below peak levels. There are many reasons for this; but the most significant one may be that the administration has not focused on job growth much at all. Perhaps distracted by COVID-19, the Delta and Omicron variants, vaccines, inflation, North Korean missiles, and the Russia/Ukraine problem, it has not been a focal point.

Inflation is the domestic threat

Inflation is the major threat facing the US economy and its ramifications are clear. One of these is also found in January’s employment report. Average hourly earnings were $26.92 in January, up 6.9% YOY and average weekly earnings rose to $912.59, a 5.4% YOY. These gains are impressive at first glance; however, adjusting for inflation, real weekly earnings were down 1.2% YOY in January. This is the unfortunate part of inflation — it destroys buying power. On page 4 we have a chart of average weekly earnings that are inflation-adjusted to represent 1964 dollars. The chart shows how average real earnings steadily declined throughout the high inflationary period of 1968 to 1990. See page 4. For this and many other reasons, the administration and the Federal Reserve should make fighting inflation their number one domestic priority.

On a positive note, we present the misery index this week. This index is the sum of inflation and unemployment which are the two variables that can impose great hardship on households. The misery index jumped to 15.1% in April 2020 when the unemployment rate jumped to 14.7% and was well above the standard deviation level of 12.7%. However, this was a man-made unemployment level triggered by the pandemic and fiscal stimulus offset much of this “misery” with checks to households and augmented unemployment benefits. Currently, the rise in inflation is wreaking havoc with households but the misery index is at 10.6%. This is well within the long-term “normal” range. See page 6.

Still, we do not see inflation coming under control very soon. The WTI crude oil future moved above $90 a barrel this week. The $90 level was one of the technical targets we wrote about once crude broke out of an 8-year base pattern in the fourth quarter of 2021. The chart pattern also suggests targets of $100 and $110 are possible in the coming months. This will keep inflation high, put more pressure on households and make the Fed’s job of controlling inflation more difficult. Interest rates are also rising this week and the 10-year Treasury note yield is challenging the psychological 2% level. See page 9. Keep in mind that stocks with dividend yields of 2% or more that also have a predictable earnings stream remain very competitive to bonds.

Valuation readjustment

The combination of rising inflation and rising interest rates is a big hurdle for equities, and it explains why value stocks are outperforming growth stocks in 2022. This shift could continue for most of the year and in simple terms, it is a valuation readjustment. We remain cautious in the near term, primarily for stocks with high multiples. Overall, we believe stocks that benefit from, or are immune to, inflation are the best holdings in the near term. These include sectors such as energy, financials, and staples. Nonetheless, we would not ignore the technology sector since 2022 is likely to provide an excellent long-term buying opportunity.   

As part of the current valuation readjustment, we believe the market’s PE could return to normal levels. As an example of what this means, a PE multiple of 18 coupled with our 2022 earnings forecast of $220 equates to an SPX target of 3960. Applying the long-term average PE multiple of 17.5 to $220 equates to SPX 3850. In both cases, it implies that good long-term value is found at levels directly below SPX 4000.

It would not surprise us if PEG ratios, or a comparison of a stock’s PE to its 5-year earnings growth estimate, came back into style. Historically, a PEG ratio of 1.5 in a growth stock represented table-pounding “value.” Value stocks were typically viewed as excellent buys with PEG ratios of 1.0 or less. Again, these are good benchmarks for uncertain times.

Technical update

We remain intrigued by the similarity in the charts of the Russell 2000 index and Amazon (AMZN – $3228.27). After AMZN reported solid earnings last week, the stock rebounded sharply, generating a small difference in the charts. However, the patterns remain largely similar and AMZN is yet to move above its first level of resistance which is the 50-day moving average now at $3255.86. This will be an interesting level to watch. There are no other major changes in technical indicators. The new high/low averages and cumulative advance/decline line are bearish. Our 25-day up/down volume oscillator remains neutral, which means the market is not washed out on an intermediate-term basis. The AAII bull/bear sentiment indices have shown extreme bearish readings for the last three weeks and as a result, the AAII Bull/Bear Spread index is favorable. The good news is that this AAII survey suggests the market is undergoing a normal correction. The survey never showed the extreme optimism that is typical of a bubble peak. Nonetheless, we believe the current rebound is simply a rebound and we do not believe the lows have been found. It would not surprise us if the Fed increased rates 50 basis points in March and this could trigger a sell-off that could characterize the end of the correction.

Gail Dudack

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