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Jun 22 2022

“PSsss”

  • Jun 22, 2022

The most brutal bear markets occur when falling earnings are accompanied by shrinking valuations, producing a compound negative effect on stock prices. Investors in 2022 have (so far) avoided this double-whammy in that valuations have taken a hit, but EPS estimates are holding strong. We are intrigued by the notion that 2022’s bear market has, to date, been all about valuation compression rather than earnings weakness. Investors are coping with the problems of the day by letting the air out of bubbly valuations, and this report takes a closer look at the valuation squeeze underlying the current selloff.

The 2022 economic backdrop is nothing like the near-Goldilocks environment accompanying the first few innings of the Y2K Tech bust. However, the action to-date in the former Growth stock leaders has followed the 2000-2002 path very closely—and almost on a point-for-point basis, when it comes to some  indexes. With the stock market “weight of the evidence” still negative, we wouldn’t be surprised if the Y2K analog holds for a while longer.

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Recession mania has gripped Wall Street: Surveys consistently show a high percentage of respondents expect that a recession is inevitable. That is true for investors, company leaders, and consumers. These fears are understandable because fighting against rapid inflation often ends in recession.

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The fight against runaway inflation is intense, and recession fears are rampant. The stock market has collapsed while bond yields have surged, and the panicked Federal Reserve is rapidly catching up with 75-basis-point fed fund hikes. In addition, Putin’s invasion of Ukraine shows no end in sight, and the U.S. Supreme Court is now at war with the Executive Branch.

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Read this week's Major Trend update. 

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High inflation continues to dominate the headlines, but it is only one piece of the “weight of the evidence” that’s stacked against the stock market. Still, in ironic fashion, stock-market action itself suggests that inflation is set to peak.

 

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“Quantitative Policy” by the Federal Reserve is a very recent addition to the monetary tool kit, and we are still learning about its significance. For example, does QT directly and consistently impact the money supply? Is it equivalent to raising the fed funds rate? Is QT really another substantial tightening force—or is its impact overstated? Unfortunately, nobody yet knows the answer to these questions. They will become understood only after many more years of data becomes available.

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Read this week's Major Trend update.

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The current inflation spike has already ended the bull market and is widely expected to end the economic recovery soon. Nonetheless, rather than a “cycle-ender,” the contemporary environment could alternatively play out as a “rate hiccup,” which often occurs as the Federal Reserve and bond vigilantes react to signs of overheated growth during a recovery.

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Higher energy and services prices caused the headline Consumer Price Index (CPI) to reach 8.6% in May, its highest level since 1981! Friday’s disturbing report has sent bond yields to new recovery highs and the S&P 500 into bear market territory. Yet, despite its ongoing persistence, as illustrated in the following pictorial, U.S. inflation is nonetheless likely topping out.

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The CPI figures were hotter than expected and point to more Fed intervention. The most careful consumers and lower-income households are getting slammed in categories of spending we would classify as unavoidable.

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There is widespread consternation that a recession is imminent because the Federal Reserve has been hesitant to act, which has left it woefully behind the curve in fighting inflation. Many fear the Fed will feel compelled to be extremely aggressive in contracting monetary policy, making a soft landing nearly impossible.

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Inflation continues to be the focal point for policy officials and the financial markets. Has inflation peaked yet? How fast will it come down? Will the Fed orchestrate a soft landing, or can inflation only be slayed by a recession? Finally, how will the stock and bond markets respond to such high inflation, particularly if the Fed is forced to raise interest rates significantly more and implement aggressive quantitative tightening?

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From the end of 2020 through May, stocks in the top quintile of both value and momentum have returned 60% versus 7% for the overall universe. That compares to the brutal stretch from 2016-2020 when the only way momentum investing worked was to not only disregard valuations, but to actively buy the most expensive momentum stocks.

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Overall, there are now more warning signs, but it still doesn’t suggest a recession is imminent.

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Intuitively, what happens in the credit market is usually echoed by lending activities. This was a key concern when the credit market joined the stock-market rout in May. Another big leg up in real interest costs, through higher rates and/or lower growth, will surely create more headwinds for profit margins.

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In mid-May, S&P 500 Homebuilders officially became a COVID “round-tripper”: After a one-month COVID collapse of 53% and an ensuing rally of almost 250%, this year’s selloff drove Homebuilders to a May 11th close that was a few ticks below its pre-COVID high. Imagine what might happen if the housing market cracks? 

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The dot-com bust was so long ago, most are likely unaware just how catastrophic the long-term Tech-stock returns are when measured back to March 2000. Technology has been the third-worst sector performer on a cumulative basis through May 2022; its +5.2% return has barely beaten 10-year Treasuries.

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In 2022, the quintessential stock-market inflationary beneficiaries—energy stocks—have dominated leadership. However, defensive investments have also been popular in a turbulent overall market, including Utilities, Staples, Pharma, dividend aristocrats, high-quality stocks, and low-vol investments. On the flip side, investors have focused on the demise of new-era stocks within Technology and Communications Services, and the destructive impact of rising inflation on Consumer Discretionary stocks.

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Read this week's Major Trend.

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The last four years have been a remarkably wild ride for stock investors. The S&P 500 Index has experienced unprecedented volatility but with fantastic overall results. That is, investors have simultaneously survived and enjoyed “Fantastic Volatility”—a stock market perhaps best described as VOLTASTIC!

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The surge in bond yields this year has certainly wreaked havoc across the economy. The abrupt and sizable rise in the yield structure has proven to be a shock for consumers, homebuyers, and businesses on Main Street; it has also been destructive for stock and bond investors on Wall Street. Although higher yields should help moderate inflation, they have slowed real economic growth and raised recession fears.

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In the MTI update published this morning, we should have mentioned a bullish development in one of our weekly Sentiment indicators. Specifically, Net Insider Big Block Sales have dropped below 1% of issues traded, which boosted the measure to maximum bullish as of last Friday, May 20th.

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Read this week's Major Trend. 

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Well, the drama is over. The S&P 500 reached the bear market threshold (at least intraday), slipping below the -20% Mendoza line. The concern now is how much lower it will go—and where and when a bottom may finally emerge.

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Investors looking to diversify away from the U.S. interest rate environment and/or the domestic business cycle may wish to consider Emerging Market bonds, an asset class with lower correlations to the U.S. Agg. Bond Index. EM bond investors can choose between several investment attributes to find the risk / return profile with which they are most comfortable. This study surveys the investment tradeoffs offered by each sub-category, as defined by ETFs focused on each particular asset class.

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These are just some random remarks about a few unrelated concepts of interest.

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As illustrated by the accompanying chart, every post-WWII bull market has experienced at least one separate correction (defined as a market decline of at least 10% but less than 20%) before ending in a bear market (a drop of 20% or more). But today, the S&P 500 is knocking on the door of a bear-market collapse without having yet experienced an isolated correction.

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Read this week's Major Trend.

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By the end of last year, the annual Consumer Price Inflation (CPI) rate soared to 7% and rose above 8.5% by March. So how did bond yields react to the biggest inflation surge in over 40 years? Since April 2021, the inflation rate has been greater than 4% and ended the year at 7%, yet the 10-year U.S. Treasury yield was only 1.5% as of December and is currently just 2.9%—the lower end of U.S. history. Indeed, looking back to 1872, today’s inflation rate is higher than 88% of the time, whereas the 10-year Treasury yield is still lower than about 80% of the time!

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Losses in the Russell 2000 Growth Index and the NYFANG+ Index have topped 40%, and the only true equity rockstar, spawned by a 13-year secular bull market, has watched her fund’s value drop by more than three-quarters. Yet there’s still a televised debate as to whether this decline is even a bear! Could there be a more devious creature on the face of the planet?

 

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The CPI numbers were hotter than expected. Our Scorecard still suggests cost-push inflation continues to have an upper hand in driving inflation higher, an unfavorable scenario for risky assets.

 

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Could the recent surge in bond yields finally be reaching a standstill? Who knows for sure, but there are some encouraging signs signaling at least a temporary intermission?

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Read this week's Major Trend Index.

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Consumers have enjoyed some positives in the last year, including a strong jobs market and rising wages. Overall, however, they have faced an increasing array of challenges that have dampened spirits. Fiscal stimulus has run dry, budgets have been pressured by a price upswing in nearly everything, interest rates are much higher, and despite elevated wages, the real wage rate has been declining. In addition, the headlines have turned increasingly dark: a protracted war in Ukraine, yet another COVID-variant upwelling, a potential policy mistake by the Federal Reserve, a stock market collapse, and widespread talk of an imminent recession.

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The group is back to where it was before the pandemonium began, both on a price and valuation basis. While the move is likely to overshoot below median and historical lows, we think we’re closer to the final chapter than the midpoint.

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Bulls have been quick to assure us that this market “bears” no resemblance to the dot-com bust. We agree—but probably for very different reasons. Among them are the conventional breadth measures, which provided little warning of this year’s January peak. And, the initial decline off January’s top has been much broader than during the first phase of the dot-com bust.

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Those once high-flying FAANG stocks continue to run into rough pockets of air. Following Facebook’s 33% dive in February, Netflix (-49%), Amazon (-24%), and Google (-18%) followed suit in April as the latter two trillion-dollar firms posted their worst monthly returns since 2008. Only Apple—which still carries an enormous 7% weight in the S&P 500—has avoided a recent gut-wrenching plunge.

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Market conditions leading up to the May rate hike were similar (if not worse) than those that triggered Powell’s late-2018 “pivot.” Free-market tightening of 2022 is apt to play into the path of policy. There’s likely a dovish “pivot” in store later this year—one that may be aggressively sold rather than bought.

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Most U.S. dollar drivers point to a stronger dollar: attractiveness of U.S. assets; policy differentials; real interest-rate differentials; terms of trade; weaker Yuan; and capital flows/hedging activity. Speculative positioning, however, is a negative and suggests the dollar rally might at least take a pause in the near term.

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