August 14, 2022
Weekly Market Outlook
By Donn Goodman
Will the positive market bias continue?
Did we see the bottom in the stock market, and are we on a new bullish trajectory?
Has the economy improved enough to say that we are out of the woods?
We, along with the rest of Wall Street, the banks and stock market analysts and every institutional as well as retail investor, have no idea.
However, we provide the following unbiased information for both sides of the argument and help you to create your own opinion. Recent media reviews point out that the bulls and bears are about evenly divided.
We remain observant, reactive, and nimble as we always have. We have no opinion, and our investment strategies quickly adapt to the changing winds.
Please note 6 MarketGauge investment strategies (including Mish and Crypto) are positive on the year and up in double digits. Please reach out to Rob Quinn, our Chief Strategy Consultant, if you would like more information.
It was another positive week for the stock market. The S&P tacked on 3.3%, the tech-heavy NASDAQ was up 2.7% (and technically in a new market due to its 20% rally?).
However, the big winner this past week was the small cap stocks up 5%. This is the 4th straight week of gains for the stock market after a damaging and negative first 6 months of the year. This is the best stretch for stocks since November of 2021. Will it last?
As we have previously written about, there is renewed hope and optimism pervading the investment markets. However, as we have also been saying, there are plenty of wildcards. See this article from last week to read more about the wildcards.
Much of this newfound optimism has been based on an appropriate cooling off of the economy leading to a potential Fed pivot to dampen their hawkishness, declining interest rates from multi-year highs, and a robust job market filled with plenty of jobs openings. Some even call it a worker shortage and estimate that this phenomenon may keep the economy humming without a “hard landing” recession.
More hope came out of a positive earnings season that was much better than expected. Even though many companies reported declining sales, revenue growth, and earnings, most of this was already “baked in” (in the form of lower expected earnings).
As we reported last week, at least 75% of companies have beaten their earnings estimates, with 70% or more beating on revenues. A positive development that helped kick off the rally in mid-July.
There is a belief that Investors have learned to live with pain in the markets. Some of this is due to a previous good few years before (5 year returns of the S&P through June 30 were still 13.4% annualized (July 2017-July 2022) which is well above long-term averages.
The other likely reason is that investors lived through the 2020 bear market decline (down more than 20%) and quickly watched the market’s remarkable recovery in a few short months. They did not want to get caught again sitting on cash (not invested) and decided to stay the course and “take the pain.”
If (a big if) investors have more than a 10-year time horizon, they have also learned that in the past 30 years (their lifetimes), the market has rarely produced a losing ten-year period. See graph below:
It is this quick recovery mentality that also fueled $245 billion in new ETF purchases this year, more than the whole year 2020 when the S&P 500 was up 16%. We caution however, that this number may be tilted from investors liquidating stocks and putting more cash into ETF’s that are energy and commodity related. This helped fuel new highs in many of these investment vehicles.
This past week saw $11 billion of inflows into US stocks. This represented the best week in 8 weeks. $6.7 trillion in stock market value has been restored over the past month. The news is improving, and many investors think it will just keep on getting better.
The narrative now being told is much different than earlier this year and perhaps as recently as 1-2 months ago. Then, it was still: soaring inflation, earnings will be disappointing, and interest rates have gone up 100% to lofty levels we have not seen in many years. But have things changed that much? We will explore the wildcards.
Remember the recipe for a good stable market are the Big 3: earnings, interest rates and inflation. Earnings were better than expected, interest rates have been declining and inflation has so far cooled off. So much so, that the President (of the United States) declared with the CPI announcement this past week, we now have zero inflation. Laughable when you look more closely at the numbers. Let’s look under the hood and evaluate some of the wildcards that we believe still persist.
The issue with both CPI and PPI is that they are running 6%-8%, well above the Fed’s targeted rate of 2%. It may take several years to get the rate of inflation down to these acceptable levels. Even if it stabilizes at 4-5% over the next 2 years, this is well above the tolerance level of most Americans. This will inevitably force an ongoing aggressive (and contracting/non-accommodating) hand of the Federal Reserve.
If the Fed continues hiking rates, as they should, we could see overnight lending rates in the range of 3.5%-4%, and that would put the brakes on the economy in a bigger way.
Wildcard: The Fed stays aggressive, short-term rates go up much more, and the yield curve inverts even more than it already has. This is a big negative for stocks. Caution advised.
Food and rents are priced into core CPI. What allowed the CPI (and PPI) to tick down slightly year-over-year was due to energy prices falling (gas prices typically fall late summer anyways). Food prices continue going up. Food prices rose 13.1% year-over-year and do not seem to be slowing.
Rising food prices are due to several factors. Persistent global supply chain issues, the war in Ukraine halting many of the important agricultural shipments (think Wheat), global climate variance hindering farming around the world, transportation costs (trucking and fuel), and a shift in diets around the world putting more demand on better, more nutritious products.
Wildcard: This will put additional pressure on the Fed to keep raising rates and will create demand destruction in other parts of the economy. This has had a negative effect on consumer discretionary spending. It may do more damage.
Speaking of consumer demand. This indicator is closely watched by the Fed. It helps the Fed with their economic forecasting and whether or not they should hike interest rates. Our suspicion is that they decided to raise 75 basis points (historic) twice because this chart is not showing a positive bias. This is highly negative and portends that they may again hike as much as 75 basis points in September if this input doesn’t improve.
Wildcard: As long as this is negative the Fed will keep raising rates. Inflation remains very high and their mission (if you believe them) is to get inflation to 2%. This will put increasing pressure on the stock and bond markets.
As a result of the previous two points, the yield curve remains inverted. Estimates are that the Fed will remain hawkish in the near term. However, many of the prognosticators believe we slow down enough that in 2023, the Fed pauses, and longer-term rates begin to decline. The ten-year is now range bound between 2.75% and 3.0%. If ten-year rates climb above 3.0 again, this will have a negative effect on stocks.
Right now, short-term rates are about 40 basis points higher than the 10-year. This has always forecasted a recession within 6-12 months. Will it this time? Only time will tell. See the inverted yield curve graph below. Notice that when these periods occur, they are soon followed by the grey bar of a recession:
Yesterday the important and closely watched (University of Michigan) Consumer Sentiment indicator came out and went up. This is a good and critical sign. Yet, it is well below the positive sentiment numbers from earlier in 2022.
The numbers deteriorated quickly and dropped fast due to the rising costs of fuel, food products as well as spiking interest rates and mortgage rates (see affordability next). While improving, we are currently at the precipice where these readings can continue getting stronger or be quickly derailed by a turn for the worse. I have included commentary and a chart courtesy of Charles Payne.
Last month we reported on the fall in home purchases (resale and new) as well as the fall in mortgage applications. It is no surprise that home affordability has dropped by over 30%. See graph below:
This implies that homebuyers that want to “move up” by selling their homes and buying another may have a difficult time doing so. Continued high resale prices in many markets in the US coupled with much higher mortgage rates makes it more difficult for consumers to afford bigger homes.
New home buyers also may no longer be able to afford them. Those starting out (or relocating) are resorting to renting apartments and homes. The price of renting has jumped 50-75% depending on the city (the average apartment in Phoenix went from $1500 to $2500 over the last two years).
Wildcard: This will continue to put inflationary pressures on the economy and is also a motivation for the Fed needing to continue raising rates to bring down the euphoric pricing of housing. This is negative for the stock and bond market.
As we noted above, investors swooped in over the last 4 weeks and bought stocks with no hesitation. It was estimated that there was an excess of cash on the sidelines that was being put back in the market, especially with stocks that had been most beaten up.
Also, corporate buybacks (already approved but waiting on timing) were ramped up after the 2nd quarter ended and earning announcements. Add in huge merger & acquisition activity and secondary offerings, and one can recognize why so much “new” money has come into the markets recently. See graph below:
But are stocks attractively priced now? Not hardly.
Based on many economists and stock analysts too numerous to name here, we remain in a bear market and stocks are vulnerable to more selling pressure. (Mike Wilson of Morgan Stanley still believes the S&P 500 needs to get to 3400 before this period of Fed contraction is all over).
The S&P 500 is currently valued at a Price-Earnings multiple above 19x. After the last recession of 2008-2009, stocks were selling at a multiple of 14x, and nobody seemed interested in putting new money in the market. Many believe this has to happen yet again.
The Buffet Indicator looks at the price of the stock market as a % of GDP, and currently we are at another historical high of 179% of GDP and 40% over the historical fair value trend line (recently we had been higher). See graph below:
Wildcard: With higher inflation, slowing economic activity, and continued Fed hiking, investors may want and need to see lower prices to become fully invested. Right now, many hedge funds and short-term traders have participated in this rally but are ready to move out, go to cash or even short the market. This may put near-term pressure on stocks going into the fall.
Here is what else we are seeing from Big View:
Risk-On
Risk-Off
Neutral
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