The Week On Wall Street – Economic Purgatory (SP500)

“I have civilized my own subjects; I have conquered other nations; yet I have not been able to civilize or to conquer myself” – Peter the Great

The Present

In the last 12 months, investors have had to weather a storm. They recently watched the Fed announce its eighth consecutive interest rate hike. The committee slowed the pace as expected, as the 25 basis point increase brought the target range (4.5-4.75%) to the highest level since 2008. However, this remains the most aggressive rate hiking cycle in history.

Economists are divided. First, there are those forecasting two additional 25 basis point hikes at the March and May meetings before the Fed ends this tightening cycle. By doing so they are dismissing Powell’s confirmation that rate hikes would be “ongoing.” Then some are forecasting rate cuts in the latter half of this year. Powell did say that whenever the Committee did stop, the range might be in place for some time. So, that also dismisses the Fed’s message and when they call for rate cuts they are also dismissing the “Strong” January jobs report which was more than 2½ times the consensus forecasts. They view that as an outlier and are focusing on the bulk of economic data that is signaling recession.

There is a third group with an entirely different outlook that does see the Fed ending the hiking cycle by the summer, but envisions a “higher for longer” view of the situation. If nothing else it is a view that is aligned with what the Fed has been saying for months. I’ve been in this group since last year.

This continues to present conflicting messages. It’s not so much what the economists believe, it is what the stock market is eventually going to price in. In essence, what do the institutions believe has the highest probability of occurring for the remainder of the year? Based on the current rally the “market” is starting to buy into the soft landing scenario. Rate hiking ends, and the economy avoids a recession entirely. That is of course a positive catalyst for both the equity and fixed-income markets.

A Confusing Reality

However, although some economists reason this “strong jobs economy” may be less rate-sensitive today than during other equilibrium periods, ultimately rates will matter. When they do, economic data will more universally show additional slowing. That leaves a hard landing a very real possibility as demand is likely to fall substantially once backlogs are refilled across industrial America and consumers start normalizing their savings rate.

The Fed has told the markets they will be ULTRA cautious “declaring victory” on inflation. It’s implied in EVERY fed statement since last year. Therefore anyone that is dismissing the Fed’s message may be setting themselves up for disappointment and eventually failure. So the unanswered question that remains is can the Fed start lowering back to neutral before this occurs and execute a soft landing? It seems unlikely, but as stated earlier this rally indicates the market is pricing a greater chance of this “soft landing” potential as earnings season has unfolded, and inflation has decelerated.

Listening to all of the different opinions and options that are on the table leaves most investors confused. For example, Larry Summers recently proclaimed that the odds for the Fed to pull off a soft landing have increased. After the strong jobs report, he comes back to the scene and says there could be trouble ahead. That’s not a criticism of Mr. Summers, it shows how difficult this economic backdrop is. There is NOTHING in THIS economic backdrop that is set in stone. It is a fluid situation that changes on a daily/weekly basis. That makes for a difficult stock market to navigate.

There is some Good News

Let me explain. Investors don’t have to make decisions based on what the Fed is going to do at the next FOMC meeting. They don’t have to be concerned about soft landings with no recession, a short and mild recession, or a hard landing with a deep recession. There is never any need to make the situation more complex than it already is. The Fed is “reacting” to the data. They do not know what they are going to do until they see the latest data.

Across the entire economic scope, ALL of the data that is being reported is at or near contraction levels. The Jobs environment contradicts that, leaving us in what I would call an economic purgatory. Therefore how can anyone come up with a forecast of what could happen regarding the Fed? The FED doesn’t know what they are going to do and they have said as much. That is why they can’t conclude today if the next hike is 25 basis points or 50 basis points or no hike at all. Exactly where is that light at the end of the tunnel? Those that continue to ask Chair Powell what he expects aren’t listening to the “data-dependent” message that was sent at the start of the rate hiking cycle.

We all get caught up in the “news”, so it is time to get back to what has been said here time and time again. The price action determines investors’ actions. Based on where the stock market is trading today, it is telling us it is expecting, and pricing in at the very least a mild recession, and if we see prices move higher, it is forecasting a soft landing. I also believe this rally is focusing on the impact the Chine re-opening will have on the global scene. On the other hand, if prices crumble from here then we are back to a more troublesome recession, and instead of China being a net positive, it increases the risk of inflation returning.

It is straightforward. As that story changes so will the action in the stock market.

The Macro View

This isn’t a forecast, because I’m not going to present a time frame or price parameters. Therefore, it is more of a history lesson on how the stock market works over time.

When I look over the MACRO backdrop, one of the issues that still trouble me remains. Over long periods, the equity market moves in cycles. Secular trends come along and they last for several years. Then they revert, always looking to work off excess on both gains and losses over time.

There is no doubt that since 2013, the year the S&P broke out of a 13-year trading range, the equity BULL market has produced outsized gains. If I view the period from March 2013, (S&P 1570), to the last high at S&P 4800 in January 2022, that adds up to a gain of ~300%. This BEAR market at the lows gave back 23% of that large move. The long BULL market has been described as the easiest investment landscape in history due to liquidity born by the zero-interest rate policy. It’s also described by some as a massive “bubble” because of that abundance of liquidity.

Suffice it to say history shows us that periods of outsized gains lead to periods of flat markets that underperform. In essence, we witnessed one of the easiest investment backdrops of all time immediately followed by the most aggressive rate-hiking policy in history. The change in interest rate policy comes after the unprecedented stimulus that was added to the economy, which revisited historic all-time highs in inflation. An economy that was effectively “shut down” due to a health crisis. None of this has ever been seen before, and these “shocks” should take quite a while to work their way through the global economies.

One has to wonder if the 23% giveback is all we will see in terms of a reversion that comes after the 300% rally and a backdrop that offers plenty of long-term uncertainty. Will we get out of this situation without a recession or deeper pullback in a stock market that remains historically overvalued? Is it possible? Sure, but it’s not something I want to bet heavily on right now.

While my instincts tell me that giveback is hardly enough, this is NOT something that I am acting on today.

That is what separates the MACRO view from the present-day activity. We deal with today (present) and watch how tomorrow (macro) develops.

The Week On Wall Street

This week started the way it has preceded every CPI report in the last 3 months. Monday’s strong rally came before another much-anticipated CPI report on Tuesday. That report resulted in a volatile back-and-forth session today but was never really resolved either way. It sure looked like a “Turnaround Tuesday” was in order when the S&P traded down to an intraday low of 4095. However, a rebound rally brought the index back to the flat line. It was a mixed bag for the indices. The two-day winning streaks for the DJIA, S&P, And Russell came to an end, while the NASDAQ posted a gain for a second consecutive day.

The midweek session was more of the same choppy price action that did resolve to the upside with small gains for the S&P 500. The NASDAQ made it three in a row with another rally resulting in a 1% gain. Inflation reared its ugly head in the form of a HOT PPI report on Thursday and after a battle between the BULS and BEARS, the BEARS triumphed. It resulted in another one of those all-or-nothing days and this day fell into the nothing category as every index and sector was in the RED. The 3-day win streak for the NASDAQ ended with a 1.7% loss for the day. Consumer Discretionary (XLY) gave back the two-day 2.2% gain suffering a 2.1% loss today. Another example of a quirky market.

This quirky market ended the week with mixed messages as investors grapple with the thought of more rate increases ahead. While the S&P made it two consecutive weeks with losses, the DJIA extended its losing streak to three. The Russell 2000 and NASDA did manage to buck the trend with small gains for the week. It’s the same situation, nothing seems to be in sync these days.

The Economy

This week it was more ‘contractionary’ economic reports sandwiched between HOT CPI and PPI data.

CPI and Inflation

The consensus was for an acceleration from December’s rate, which was a decline of 0.1%. The 9% surge in gas prices during January alone would suggest an increase of 0.5%, which coincidentally is right where consensus forecasts had settled heading into the report. It’s also exactly where the report came in. Ex Food and Energy, the reading came in at 0.4% which was also right in line with forecasts. The only issue was the year-over-year readings which both came in higher than expected.

The Fed’s preferred measure of inflation, headline PPI popped 0.7% in January and the core rose 0.5%, both stronger than forecast. The headline is the biggest rise since June. The January prints follow a 0.2% decline in the December headline. The 12-month headline pace slowed to 6.0% year over year from 6.5% y/y previously, and the core rate decelerated to 5.4% y/y from 5.8% y/y. This report aligns with the CPI data that is indicating inflation is “sticky”.

Bottom Line; Inflation remains “sticky”. Year-over-year CPI is now at 6.4%, with CORE CPI Year over a year at 5.6%. We’ve seen the top at 9% last year. Inflation stopped going up but as I thought the bottom isn’t dropping out either. That keeps the FED in the picture with its focus on lowering inflation.

The US leading index fell 0.3% in January to 110.3 after dropping 0.8% to 110.6 in December. The index has posted ten straight monthly declines since an unchanged print in March 2022 (but it is still far from the record of 24 consecutive months of declines from 2007-8).

The index is at its lowest level since February 2021.

NFIB Small Business Optimism Index declined 2.1 points in December to 89.8, marking the 12th consecutive month below the 49-year average of 98. Owners expecting better business conditions over the next six months worsened by eight points from November to a net negative 51%. Inflation remains the single most important business problem with 32% of owners reporting it as their top problem in operating their business.

NFIB Chief Economist Bill Dunkelberg;

“Overall, small business owners are not optimistic about 2023 as sales and business conditions are expected to deteriorate. Owners are managing several economic uncertainties and persistent inflation and they continue to make business and operational changes to compensate.”

Yesterday, the job board website Indeed.com updated their data through February 10th on national job postings.

As shown on left, the past month has seen postings accelerating to the downside with the index reaching the lowest levels since the summer of 2021. While postings have declined by over 4% month over month (the fastest rate of decline since the spring of 2020), that reading remains fairly healthy and is above the pre-pandemic baseline.

Manufacturing

The Empire State manufacturing index bounced 27.1 points to -5.8 in February, better than expected, after crashing 21.7 points to -32.9 in January. This is the best since November while January was the weakest since May 2020 and the fifth lowest in the history of the index.

However, the index has been in the contractionary territory (below zero) in 10 of the last 14 months. The components were mixed.

Industrial production was unchanged in January. That reflects a 0.8% year-on-year increase, the smallest increase since the pandemic recovery started in March of 2021. Manufacturing expanded a meager 0.3% and utility output sank 8.9%. Production has not increased since September.

The Philly Fed manufacturing index plunged 15.4 points to -24.3 in February after rising 4.8 ticks to -8.9 in January. This is the weakest print going back to May 2020 and is the sixth straight month in contraction. Most of the components remained in negative territory.

Notice anything about every prior time the reading has gotten this low?”

Consumer

Retail sales surged 3.0% in January and rose 2.3% excluding autos, both well above expectations. The former is the strongest since October, and the latter is the best since March 2021. Those follow respective declines of -1.1% and -0.9%. November posted a drop of -1.1% for the headline. Strength was broad-based with no negative prints across the major components.

The breadth shown in this month’s report was very strong. Of the thirteen sectors that make up the report, every one of them showed growth on a month-over-month basis, and even on a year-over-year basis, Electronics and Appliances is the only sector showing negative growth. The biggest gainers this month were Bars & Restaurants (+7.2%), and they continue to outpace everything else by a wide margin.

After being locked down during COVID and then dealing with restrictions well after, people are eating out. If I connect the dots that could explain why the “services” sector has seen the largest employment gains, as restaurants gear up to meet that demand.

Housing

Homebuilder sentiment from the NAHB showed a significant rebound in sentiment as the headline reading has risen in back-to-back months from the low of 31 in December up to 42 this month.

While that is not a screaming endorsement of strength from homebuilders (in the past decade, the only times the index was this low was the past few months and the start of the pandemic), it does mark an improvement in sentiment that is consistent with the recent turnaround in mortgage rates and the rise in weekly mortgage applications.

Housing starts tumbled 4.5% to 1.30 million in January, the slowest since June 2020. Starts dropped 3.4% in December to a 1.37 million clip in December.

Starts have declined since September.

After reading these reports which continue to be POOR, the soft landing crowd has plenty of explaining to do.

The Yield Curve

The 10-year treasury closed this Friday at 3.82%, and the recent spike is now challenging the 3.88% close on December 30th. The rate of accent has been swift, and perhaps the stock market is just now digesting this move. The last time the 10-year was at 3.8+% the S&P closed at 3839, it closed at 4075 on Friday. That could be suggesting more market weakness ahead.

Earnings

We’re now well past the peak of earnings season in terms of both the number and market cap of companies reporting. Through early last week, a total of 848 companies had reported, and most analysts would agree that it could have been worse. Two-thirds of companies managed to beat on the bottom line while 63% exceeded top-line results, and both of these readings are above the historical average. In terms of guidance, 8% of companies reporting have managed to raise forecasts while 10% have lowered guidance. Again, given the economic weakness in Q4, we would have expected more companies to lower guidance.

While there are several factors that will move the markets. Since this earnings season started in Mid January the S&P is up ~1.7%. So this season has not been a drag on the market.

Food For Thought

Job Creation? A strong economy? Where? The labor force at the beginning of the recession was 164.5 million workers. Based on the labor department statistics that represent the number of people who were either employed or actively seeking employment.

But suddenly in December and January, the labor force rose by 1.3 million workers. As the chart below shows there are now approximately 166 million workers.

Whatever twist we put on this jobs market there is no mystery. The notion that millions upon millions of jobs were created is false. The data shows an increase of ~1.5 million workers since January 2020. Jobs that already existed were just being filled. Now with savings dwindling and inflation keeping the pressure on a group that is getting squeezed, the folks who left the labor force are actually back and looking for jobs. Now if one wants to make the argument that the last two jobs report is the start of a “revival”, the following evidence destroys that argument.

The labor statistics regarding Federal withholding & employment tax collections, as published by the U.S. Treasury are in direct contrast to a strong “jobs” picture. It’s simple, more people employed, more withholding taxes. On a 3-month basis, there is no indication that the job market is doing anything but decelerating, pretty rapidly from peak growth in late 2021.

Withholding statistics now confirm what I’ve been saying since 2021. There never was and is no job creation taking place. People went back to work, and now in a slowing economy, employers are cutting back.

What we have heard is a false narrative since the pandemic ended. There are many ways to interpret data points, but if the decelerating “withholding” trend is taken at face value then the only straw in the strong economic argument is gone. This has major ramifications for the economy and the markets going forward.

The Daily Chart of the S&P 500 (SPY)

After a second week of losses, the S&P teetered and then broke below its first support level.

Friday’s low (4047) will now become the short-term line in the sand for the BULLS. A break below and the BEARS start to believe they can take the index to the 3980 – 3990 range.

Investment Backdrop

For all the fanfare and billions of dollars that have been plowed into AI and Chat GPT tools, what good is it if they can’t even tell us if this week’s pullback was a sign that the rally is over?

I asked ChatGPT if the stock market rally was over and it replied;

It’s not possible to determine if a stock market rally is over until it actually ends.”

It’s not ready to offer much in the way of financial information, and from what has been reported this week it’s not ready for much at all. So I’ll give it a try and see if I can make some sense of this confusing situation.

We have enjoyed a nice run in the stock market over the past several weeks. Not only have prices generally risen, but the action has been fairly textbook with a pattern of higher highs and higher lows and key support levels holding on shallow dips. That has changed, however, as we’ve seen the S&P drift back down to support, and once again stabilize keeping the very short-term trend on course. It becomes fairly important that we see any further decline hold that recent support, as any break would more than likely signal a trading top has been put in.

As of the close on Friday, I don’t have enough evidence to declare this rally over, but I will need to see a lot of other factors fall into place before I declare the next BULL market is upon us. I may not always get it right, but at least I won’t tell anyone to wait until the results are in before I form a strategy. What it will eventually come down to is the nature and severity of the next significant pullback. That will provide some clues as to how investors should be positioned over the next few months.

Reverting to the “Mean”

Performance to begin 2023 has been a sharp mean reversion from the performance last year. For example, the worst-performing stocks last year are up 18.3% on average to begin this year. Conversely, the best-performing stocks last year are flat so far in 2023.

This relationship of flipped performance is fairly consistent across industry groups. While these higher-beta areas reflect where the opportunity lies in a recovery scenario, many stocks are also at overbought levels in the short term.

I am exercising plenty of patience at current levels, as any “recovery” (economy or stock market) is still in flux. I’ll note that many stocks still reside in Longer term downtrends. Since it’s difficult to forecast the short-term market outlook with any degree of confidence, it is best to err on the side of caution. If I’m going to add any trading positions now I intend to keep it simple. In an uncertain economic outlook for ’23, I want companies that will grow earnings in this environment. That sounds difficult BUT in reality, there is a way to gain an edge in completing that task. Companies that are raising guidance are TELLING us they are in that category. Sometimes simple is best, and those companies could remain in rally mode for a while.

Growth Vs. Value

It’s been a “growth” trade-in ’23, which is confirmed by the NASDAQ (+12%). It has doubled the gain for the S&P (+6%) this year.

Interestingly, the Small-cap value ETF (AVUV) (+10%) is dead even with Small-cap growth (VBK) (+11.5%). It is another example of conflicting signals.

Sectors

Consumer Discretionary

This group is leading the way. After getting decimated last year, the Consumer Discretionary ETF (XLY) has rallied 16+%.

Energy

The latest EIA data on petroleum inventories showed domestic production is beginning to ramp back up. For crude oil, domestic production topped 12.3 mm bbls/day, the highest level since the pandemic. Refinery capacity came back online as well with utilization rising to 87.9%, the highest level since December 23rd, and resulted in refinery throughput sitting only slightly below the 5-year average. Excluding strategic reserves, crude inventories are now at the highest level since June 2021.

There is a slew of factors that come into play when anyone tries to forecast the prices of oil. While oil production may be ramping up here, Russia just announced a production cut, and then the China re-opening also tosses in an unknown. The strategic reserve will also have to be replenished at some point. A strong recovery in China increases demand, but if it is tepid or turns out to be a start-and-stop affair that alters the entire demand picture.

The Energy ETF (XLE) failed to break out, but once again is back in the middle of a short-term trading range. The sector is acting pretty much the way I thought it would so far. After a strong year in ’22, it will consolidate these gains and that could take a while. That sets up the potential for a nice trading range to deal with.

There aren’t many areas of the stock market that I feel great about buying right now, but one would have to be Oil Services, which continues to project strength despite the back-and-forth action in crude oil. The bigger picture pattern still looks bullish. The sector ETF (IEZ) posted a new high in December and has now pulled back to a good support level. If I’m going to take risks in positions, I want to be in stocks/sectors that have momentum and are in BULL trends.

Financials

The Financial sector ETF (XLF) is giving the BULLS something to talk about. It has broken the string of LOWER highs, by surpassing the August ’22 highs. I’d have to consider it a leader now and that is usually a very good sign for the overall market. The sector is very close to breaking the long-term BEAR trend and taking the first step in establishing a longer-term BULL pattern.

If the ETF fails at this important test, the BEARS will wake up and once again try to wrestle control away. Liek the rest of the financial backdrop, everything is still in flux.

Healthcare

The Healthcare sector (XLV) is battling a short-term downtrend line while it clings to intermediate support. The group has been sideways for a while as it carved out a large trading range in ’22. I think the healthcare sector will stabilize and provide select opportunities. AbbVie (ABBV) was under pressure but has now rallied off the lows in the last week or so. It pays a ~4% dividend. Dexcom (DXCM) reported EPS and rallied 14% since its January lows.

Biotech

The Biotech ETF (XBI) ($84) continues along in a trading range. There is plenty of overhead resistance in the $94 region and the group has pulled back after an attempt to take that level out. It will be important to see the pullback contained as it tries to eventually take out that resistance. If there is a break above $94 then it’s a long runway until the next resistance level at $114. Unless I see this move completely break down, I’m holding for that eventuality.

Gold

I decided to eliminate the Gold Miner’s position for a modest 6% loss when the chart pattern deteriorated on Monday.

Silver

Last week I noted that the $20 level was my mental stop for the Silver ETF (SLV) position. I sold that On Tuesday for an 8% gain.

Technology

If you haven’t heard, AI ( Artificial intelligence) received its share of headlines in the last couple of weeks. First, there was the failed experiment by Google that sent its stock plummeting. While Alphabet (GOOG) was falling Microsoft (MSFT) released its version which is coupled with its BING search engine and that sent GOOG even lower.

I am hard-pressed to believe Microsoft’s search engine BING is going to uproot GOOGLE search. The search game is over, GOOG is the winner. As far as AI, GOOG isn’t a newcomer to this game, here and to believe that they are way behind in this race is silly. MSFT is a good company so is GOOG, and GOOG isn’t going to just fade away because MSFT rolled out an AI platform and it’s on BING. There won’t be a mass exodus to the BING platform.

As far as the respective stocks, I do own both. While I wouldn’t be adding to MSFT, but if the selling persists in GOOG, I’m inclined to add more as a ‘trade”.

Semiconductors Sub-Sector

Another mixed signal is coming from a very important group. The semiconductors (SOXX) have also eclipsed the August highs effectively breaking the downtrend. This mini-rally still looks fine as the near-term support line is now being tested. Even a slight pullback to the next support level won’t necessarily kill the move.

The group loses 35% last year and gains 20% in 6 weeks. So trying to figure out these “signals” has been nearly impossible. A bullish view says this group will lead the market higher. A bearish case says this is nothing more than a bounce in an over-sold group that is in a Deep BEAR market.

The problem is, I can easily buy into each one of those cases with no problem.

Cryptocurrency

Crypto assets have undergone a reversion to the mean in the past week or so with declines across actual crypto assets as well as adjacent stocks and ETFs. Overall, the declines have been sizable with many of the largest cryptos having dropped by high single-digit percentages with the bulk of those declines occurring in the second half of the week.

Final Thoughts

The technical picture continues to send mixed signals. The DJIA, Financials, and Semiconductors broke above their respective downtrends. The S&P, NASDAQ, and Russell 2000 have all improved to start the year. If the adage “as goes January, so goes the year” holds, 2023 is supposed to be a positive year for the S&P 500. Cyclicals are beginning to see relative performance improvement vs. defensive areas.

Semiconductors and Financials, two sectors that any BULL would want to see lead the way, have rallied and are poised to overtake their BEAR market trends. However, we have seen the action is getting more volatile and complex, which is also consistent with a trend that is nearing an end rather than a beginning. That prompts some to say the “easy money” has likely been made during this mini rally and rather than trying to squeeze out every last dime of the move, the more prudent play is to protect the gains that have been made so far this year.

Overall, the interpretation feeding this recent rally seems to reflect a goldilocks scenario. That said, I believe that given the quickly shifting economic backdrop and market interpretations of every move by the Fed, leaves me with a reason not to get overly aggressive. Longer-term investors have a distinct advantage because equities present attractive risk/reward setups for those that have time on their side. But those active traders and investors would be better served by being pragmatic and patient. As the opening quote suggests, it’s best to know, and then control yourself in this uncertain backdrop.

THANKS to all of the readers that contribute to this forum to make these articles a better experience for everyone.

Best of Luck to Everyone!