Portfolio Trade Alert – 01-28-22

Trade Alert For Equity And ETF Models

This morning we are executing a few “clean up” trades as the market attempts an oversold rally. With the dollar rallying, and deflationary pressures showing up in the economic data, we are starting to trim some of our commodity trades to take in some gains.

As shown in the chart below, the market gyrations are working off the deeply oversold condition we had previously. We suspect that we will get a rally of 4-6% over the next couple of weeks as we progress through earnings. However, that rally will likely fail at resistance. As such we are trimming our PFF holdings and adding a short S&P 500 position incrementally into the rally.

As the market rallies, we will continue to add to the short and reduce our long equity exposures as needed. IF the market breaks above resistance and regains a bullish trend, we will remove the short and add back to our equity holdings.

Equity Model

  • Reduce Marathon Oil (MRO) to 1.5% of the portfolio
  • Reduce Exxon Mobil (XOM) to model weight of 2% of the portfolio.
  • PFF gets reduced by 2% of the portfolio.
  • Add 1% of the portfolio to SH

ETF Model

  • Reduce XLE from 4% of the portfolio to 3%.
  • PFF gets reduced by 2% of the portfolio.
  • Add 1% of the portfolio to SH

Five Dividend Aristocrat Stocks

This week’s scan seeks Dividend Aristocrats with low levels of debt. Dividend Aristocrats are companies that have increased dividends for at least 25 consecutive years. They must also be in the S&P 500 and actively traded to qualify. The entire listing of the 65 Aristocrats we scanned can be found HERE.

Ultimately, we are after low-volatility stocks with less sensitivity to interest rates and a long track record of consistent dividend growth.

In addition to our base criteria, we scanned for companies with reasonable valuations and expectations for future earnings growth.

As always, we encourage our readers to send us scan requests.  

Screening Criteria

This week’s scan resulted in three insurance companies, an asset management company, and a freight and logistics company. Analysts expect all five firms will grow EPS over the next five years, and two of them have no long-term debt on the books. Some of the companies are trading poorly and thus have weak technical backing now. Caution is urged at the moment with some of these stocks.

Company Summaries (all descriptions courtesy Zacks)

Aflac Incorporated (AFL)

The company is a general business holding company and oversees the operations of its subsidiaries by providing management services and making capital available. Its principal business is voluntary supplemental and life insurance, which is marketed and administered through American Family Life Assurance Company of Columbus (Aflac) in the United States (Aflac U.S.) and, effective Apr 1, 2018, through Aflac Life Insurance Japan Ltd. in Japan (Aflac Japan).

Aflac trades with a low P/E, as is typical for the insurance industry. Revenue growth has flattened out over the past five years, but earnings continue to grow as their profit margin has steadily increased over the past ten years. As shown below, AFL has a relatively high technical rating from SimpleVisor. Its stock price graph shows a steady rise except for the hiccups of 2008 and 2020.

Chubb Limited (CB)

Chubb Limited was formerly known as ACE Limited. ACE Limited after acquiring The Chubb Corp in Jan 2016 assumed the name of Chubb. Headquartered in Zurich, Switzerland, the company boasts being one of the world’s largest providers of property and casualty (P&C) insurance and reinsurance and largest publicly traded P&C insurer, based on market capitalization of $56.9 billion.

Like AFL, CB has a decent technical score, albeit a hold rating. Chubb had slightly negative earnings growth over the last five years but expectations for solid growth over the next five years. Such a forecast provides us some confidence the dividend will continue to increase. Chubb has slightly more earnings risk than Aflac as it insures property and casualty versus life insurance for Aflac.

Cincinnati Financial Corp (CINF)

Cincinnati Financial Corporation, formed in 1968 with its headquarters in Fairfield, OH, markets property and casualty insurance. CINF owns three subsidiaries: The Cincinnati Insurance Company, CSU Producer Resources Inc. and CFC Investment Company. In addition, the parent company has an investment portfolio.

CINF is another property and casualty insurance company. It is on a technical sell rating. CINF has a significantly lower level of debt than many of its competitors. Such a conservative stance reduces leverage and limits profits, but it has allowed for 61 straight years of increasing its dividend.

Expeditors Intl. of Washington Inc. (EXPD)

Expeditors International of Washington Inc. is a leading third-party logistics (3PL) provider. The company, based in Seattle, WA, is engaged in the business of global logistics management, including international freight forwarding and consolidation, for both air and ocean freight.

The trucking shortage and supply line problems have benefited EXPD’s top and bottom lines. Revenue this past year is running at almost twice the rate of the pre-pandemic years. At its peak a few weeks ago, the stock reflected strong growth as it was up two times its pre-pandemic level. It is on a strong sell rating as it has given up some of those gains. We suspect revenues and earnings will normalize, keeping the stock price subdued. Its conservative stance likely allows it to continue its streak of 27 years with a dividend increase.

T. Rowe Price Group Inc. (TROW)

Founded in 1937 and headquartered in Baltimore, T. Rowe Price Group, Inc. is a global investment management organization that provides a broad array of mutual funds, sub-advisory services, and separate account management for individual and institutional investors, retirement plans and financial intermediaries.

Over the last few weeks, TROW’s stock price has been hit relatively hard as the yield curve flattens and trading activity weakens. It has a strong sell rating reflecting its recent performance. 

Five for Friday

Five for Friday uses stock screens to produce five stocks that we expect will outperform if a particular investment theme plays out in the future. Investment themes may be relevant to the current or expected market, industry and/or economic trends. Investment themes may not always represent our current forecast. 

Disclosure

This report is not a recommendation to buy or sell the named securities. We intend to elicit ideas about stocks meeting specific criteria and investment themes. Please read our disclosures carefully and do your own research before investing.

Market Volatility Rules The Day

For those of you following the markets day and night, as we do, you likely have picked up on the massive price swings. Stock market volatility in the cash day sessions and nighttime futures sessions has been intense. The graph below shows that S&P futures are on a roller coaster, shooting up and down in 100+point increments. Since Monday, the S&P increased or fell by over 100 points, within 24 hours, seven times. Some of those gyrations were closer to 200 points. Buckle up, market volatility may be with us for a while.

market volatility

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What To Watch Today

Economy

  • 8:30 a.m. ET: Personal income, December (0.5% expected, 0.4% in November)
  • 8:30 a.m. ET: Personal spending, December (-0.6% expected, 0.6% in November)
  • 8:30 a.m. ET: PCE Deflator, month-over-month, December (0.4% expected, 0.6% in November)
  • 8:30 a.m. ET: PCE Deflator, year-over-year, December (5.8% expected, 5.7% in November)
  • 8:30 a.m. ET: PCE core deflator, month-over-month, December (0.5% expected, 0.5% in November)
  • 8:30 a.m. ET: PCE core deflator, year-over-year, December (4.8% expected, 4.7% in November)
  • 10:00 a.m. ET: University of Michigan sentiment, January final (73.2 in prior print)

Earnings

  • 6:00 a.m. ET: Chevron Corp. (CVX) to report adjusted earnings. of $3.13 on revenue of $44.95 billion
  • 6:00 a.m. ET: Synchrony Financial (SYF) to report adjusted earnings of $1.48 on revenue of $2.60 billion
  • 6:30 a.m. ET: Caterpillar (CAT) to report adjusted earnings of $2.27 on revenue of $12.63 billion
  • 6:55 a.m. ET: VF Corp. (VFCto report adjusted earnings of $1.21 on revenue of $3.61 billion
  • 6:55 a.m. ET: Colgate-Palmolive (CL) to report adjusted earnings of 79 cents on revenue of $4.42 billion
  • 7:00 a.m. ET: Charter Communications (CHTR) to report adjusted earnings of $6.84 on revenue. of $13.24 billion

Market Trading In A Very Tight Range

The market continues to trade in a very tight range between previous bottoms and the tops of recent bounces. The good news is that buy signals are in place, and support is holding. The not-so-good news is that a break of the current support will lead to a deeper decline.

One reason we continue to remain a bit more bullishly biased at the moment, and that can change if support fails, is that our money flow indicators are very close to triggering a buy signal. (You can use our index on your own holdings at SimpleVisor)

Post Fed Yield Curve Flattening- What Does it Mean?

The graphs below show the massive divergence of 2-year and 30-year bond yields following the Fed meeting. The red line highlights 2 pm ET on Wednesday when the Fed released its FOMC statement. As shown, yields in both bonds rose initially, but the 30-year bond reversed course quickly. As a result, the 2-30-year yield curve flattened by nearly 20 basis points in about 12 hours. The message from the bond market is the Fed will aggressively raise rates and in the process weaken economic growth and tame inflation. It is worth adding that recent stock market volatility also results in a good dose of bond market volatility.

treasury yield curve 2-30

GDP

Fourth-quarter GDP rose 6.9%, well above expectations of 5.5%. The gains were driven by a pickup in consumer spending and a surge in inventories. GDP is backward-looking but provides insight into current economic activity. In this light, we saw economic activity decline through Q4, telling us the aggregate GDP number is higher than the running rate at the end of the quarter. We are seeing continuing weaker economic growth this quarter thus far. Further, rising inventories contributed 4.9% of the 6.9%. The sharp rise in inventories is a good sign that some of the shortages are going away, but it is not sustainable. It is also worth noting that government spending is 36% of GDP, still above the 34% before Covid, but well off 56% at the peak of the crisis. Like inventories, government spending will not contribute much to growth and will likely detract from it in the future.

inventories  gdp

Negative Real Earnings Yields Are A Problem

The graph below shows that since 1960, the four instances in which the S&P 500 real earnings yields were negative, stocks fell anywhere from 19% to 46%. Currently, the real earnings yield is the most negative in over 60 years. At the same time, valuations are near the highest levels in well over 100 years. It is worth noting that once the real yield troughed, it rose rapidly in all four instances. The real earnings yield can rise if inflation declines, stock prices fall, or earnings rise. Like most valuation metrics, this is not a good timing tool.

real earnings yield valuations

The Dollar is Breaking Up

The graph below shows the dollar, after some recent weakness, is back to its highest level in a year and a half. A stronger dollar is typically not good for commodity prices and can be a problem for foreign borrowers of dollars. However, since we are a net-importer, a stronger dollar should help offset inflationary pressures.

dollar

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Fed Rate Hikes & Risks Of Financial Instability – Part II

What if the Fed can’t hike rates? It’s an interesting question and one we delved into in Part 1 – “Fed Won’t Hike Rates As Much As Expected.”

With the January FOMC meeting now behind us, we have much better visibility about the Fed’s intentions.

“With inflation well above 2 percent and a strong labor market, the Committee expects it will soon be appropriate to raise the target range for the federal funds rate.”FOMC

The post-meeting statement from the Federal Open Market Committee (FOMC) did not provide a specific time frame for increasing the overnight lending rate. However, there are many indications that such could happen as soon as the March meeting. As shown in the charts below courtesy of “The Daily Shot.”

About the Fed’s “Quantitative Easing” program, the FOMC noted its bond-buying program would fall to just $30 billion in February, down from $120 billion a month in 2021. In addition, the Fed will terminate purchases in March consistent with an increase in interest rates.

Interestingly, there was no specific indication of when the Fed might start to reduce its nearly $9 trillion balance sheet. The most significant risk to equities is the contraction of liquidity from “Quantitative Tightening. Such is what preceded the market rout in 2018.

However, while the Fed is intent on hiking rates and reducing accommodation, I am reminded of an age-old proverb:

“The road to hell is paved with good intentions.”

While the Fed may intend to hike rates and taper their balance sheet, the real question is, “can they?”

The Fed’s Inflation Trap

There are two primary considerations for the Fed as we progress into 2022. As noted in part-1, the reversal of liquidity is problematic.

As recently discussed, “deflation” is the overarching threat longer-term. However, in the short term, the flood of liquidity into the system created, as expected, surging inflationary pressures. With the measure of money in the system, known as M2, skyrocketing, the resulting surge in inflation is not surprising.

Furthermore, in a previous Bloomberg interview, Larry Summers stated:

“There is a chance that macroeconomic stimulus on a scale closer to World War II levels will set off inflationary pressures of a kind not seen in a generation. I worry that containing an inflationary outbreak without triggering a recession could be even more difficult now than in the past.”

As we indicated in part-1, inflation surged almost exactly 9-months after the massive infusions of fiscal policy. So while many, including the Fed, suggest inflation is problematic, M2 indicates disinflation remains the most likely outcome.

Inflation CPI vs M2

The current surge in inflationary pressures pushed the Fed to hike rates and reduce its bond-buying program. However, they could be acting precisely at the wrong time. In 1998, Alan Greenspan started aggressively hiking rates to combat an “inflation threat” that never materialized. The resulting consequence was the implosion of the “dot.com” bubble.

However, such is why inflation isn’t the most significant risk limiting the Fed.

The Fed “Instability” Trap

“When it comes to Federal Reserve policy, investors are focused on the wrong question. Investors continue to agonize over when the Fed will trim its $120 billion in monthly asset purchases. A more important question is when will the Fed raise interest rates. More important still: whether the Fed actually can raise rates.” – Joe LaVorgna, Barron’s

That is a critical question. As discussed previously, the Fed is dependent on “stability” to keep the financial “house of cards” from collapsing.

With the entirety of the financial ecosystem heavily dependent on debt, the “instability of stability” is the most significant risk to the Fed.

After more than 12-years of the most unprecedented monetary policy program in U.S. history, the Fed realizes there are significant risks in the financial system. The behavioral biases of individuals remain the most serious risk facing the Fed. 

The Fed’s actions have repeatedly led to adverse outcomes throughout history despite the best of intentions.

  • In the early 70’s it was the “Nifty Fifty” stocks,
  • Then Mexican and Argentine bonds a few years after that
  • “Portfolio Insurance” was the “thing” in the mid -80’s
  • Dot.com anything was a great investment in 1999
  • Real estate has been a boom/bust cycle roughly every other decade, but 2007 was a doozy
  • Today, it’s real estate, FAANNGT, debt, credit, private equity, SPAC’s, IPO’s, “Meme” stocks…or rather…”everthing.”
Fed funds, 2-year rates, and S&P 500 index.

“If easy money is the bedrock of valuations and the Fed is getting ready to shift the bedrock, investors best pay attention to market forecasts and how the Fed ultimately acts.Michael Lebowitz

With the Fed now reversing monetary accommodation, the question is how long before something breaks.

Trapped At Zero?

Looking at the long-term history of the overnight lending rate versus its exponential growth trend, it tells an interesting story.

Fed funds vs exponential growth trend.

The rise and fall of stock prices have very little to do with the average American and their participation in the domestic economy. Interest rates are an entirely different matter. As discussed in “Rates Do Matter:”

In the short term, the economy and the markets (due to the current momentum) can  DEFY the laws of financial gravity as interest rates rise. However, as interest rates increase, they act as a “brake” on economic activity. Such is because higher rates NEGATIVELY impact a highly levered economy:

  • Rates increases debt servicing requirements reducing future productive investment.
  • Housing slows. People buy payments, not houses.
  • Higher borrowing costs lead to lower profit margins.
  • The massive derivatives and credit markets get negatively impacted.
  • Variable rate interest payments on credit cards and home equity lines of credit increase, reducing consumption.
  • Rising defaults on debt service will negatively impact banks which are still not as well capitalized as most believe.
  • Many corporate share buyback plans and dividend payments are done through the use of cheap debt.
  • Corporate capital expenditures are dependent on low borrowing costs.
  • The deficit/GDP ratio will soar as borrowing costs rise sharply.

The debt problem exposes the Fed’s risk and why they continue to look for excuses NOT to hike rates. (Like “full employment” even though jobless claims are at record lows.) However, given economic stability was not achieved in the last decade, it is doubtful the withdrawal of monetary accommodation will be “risk-free.”

The evidence is quite clear that surging debt and deficits inhibit organic growth, and the massive debt levels are sensitive to increases in interest rates.

Economic growth by cycle vs debt

Wash, Rinse, Repeat

As we argued in part one, we believe the Fed’s ability to hike rates from the zero bound is minimal before “financial stability” becomes an issue.

The primary bullish argument for owning stocks over the last decade is that low-interest rates support high valuations.

If that is the case, higher rates will undermine the financial markets.

With exceptionally high market valuations, Fed rate hikes historically led to events that devastated investors. Those events created the Fed’s repetitive cycle of monetary policy.

  1. Monetary policy drags forward future consumption leaving a void in the future.
  2. Since monetary policy does not create self-sustaining economic growth, ever-larger amounts of liquidity are needed to maintain the same level of activity.
  3. The filling of the “gap” between fundamentals and reality leads to economic contraction.
  4. Job losses rise, wealth effect diminishes, and real wealth reduces. 
  5. The middle class shrinks further.
  6. Central banks act to provide more liquidity to offset recessionary drag and restart economic growth by dragging forward future consumption. 
  7. Wash, Rinse, Repeat.

Conclusion

“Financial markets’ sensitivity to monetary policy has never been higher. The Fed’s balance sheet doubled since the end of the last financial crisis and is now 40% of gross domestic product. By buying massive amounts of bonds, the Fed lowered rates and used asset prices, like stocks, as the primary tool for monetary policy. That’s through the so-called wealth effect, or the tendency for consumers (two-thirds of GDP) to spend more as their assets grow.” Joe LaVorgna

Therein lies the problem.

If the Fed tightens, the existing debt pile becomes more expensive to service, and stocks fall, hampering consumer confidence and economic growth.

On the other hand, if the Fed doesn’t tighten, debt across households, companies, and the government will continue to grow, making it more challenging for the Fed to act in the future

The Fed has put itself in a box that will be difficult to get out of, especially if economic growth slows, which is almost a certainty.

As we concluded previously:

Unfortunately, we doubt the Fed has the stomach for “financial instability.” As such, we doubt they will hike rates as much as the market currently expects.

 

Powell “Sooner and Faster” Shakes Markets

The moment Jerome Powell said the Fed will remove assets from their balance sheet “sooner and faster” equity markets stumbled. The S&P was up 95 points as Powell kicked off his press conference. By the time he spoke his final words, it was down nearly 40 points. It seems the term “sooner and faster” used to describe reducing the Fed’s balance sheet set investors off. As if “sooner and faster” were not enough bad news for the markets, he ended the conference with “asset prices do not represent a threat to financial stability.” Essentially Powell is not concerned with the recent swoon in stock prices. Keep in mind Jerome Powell is dovish. Over the coming week or two, Fed speakers will likely present more hawkish views.

sooner and faster  spy
SimpleVisor

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Economy

  • 8:30 a.m. ET: Initial jobless claims, Jan. 22 (265,000 expected, 286,000 during prior week)
  • 8:30 a.m. ET: Continuing claims, week ended Jan. 15 (1.653 million expected, 1.635 million during prior week)
  • 8:30 a.m. ET: Durable goods orders, December preliminary (-0.6% expected, 2.6% in November)
  • 8:30 a.m. ET: Durable goods orders excluding transportation, December preliminary (0.3% expected, 2.6% in November)
  • 8:30 a.m. ET: Non-defense capital goods orders excluding aircraft (0.4% expected, 0.0% in November)
  • 8:30 a.m. ET: Non-defense capital goods shipments excluding aircraft (0.5% expected, 0.3% in November)
  • 8:30 a.m. ET: GDP annualized, quarter-over-quarter, 4Q first estimate (5.5% expected, 2.3% in 3Q)
  • 8:30 a.m. ET: GDP price index, quarter-over-quarter, 4Q first estimate (6.0% expected, 6.0% in 3Q)
  • 8:30 a.m. ET: Personal consumption, 4Q first estimate (3.4% expected, 2.0% in 3Q)
  • 8:30 a.m. ET: Core PCE, quarter-over-quarter, 4Q first estimate (4.9% expected, 4.6% in 3Q)
  • 10:00 a.m. ET: Pending home sales NSA, year-over-year, December (-4.0% expected, 0.2% in November)
  • 10:00 a.m. ET: Pending home sales, month-over-month, December (-0.4% expected, -2.2% in November)
  • 10:00 a.m. ET: Kansas City Fed Manufacturing Activity Index, January (21, expected, 24 in December)

EarningsPre-market

  • Dow Inc. (DOW) is expected adjusted earnings of $2.01 on revenue of $14.30 billion
  • Southwest Airlines (LUV) to report adjusted earnings of $0.12 on revenue of $5.06 billion
  • Valero Energy Corp. (VLO) to report adjusted earnings of $1.84 on revenue of $28.47 billion
  • Comcast Corp. (CMCSA) to report adjusted earnings of $0.73on revenue of $29.63 billion
  • T Rowe Price Group (TROW) to report adjusted earnings of $3.16 on revenue of $1.95 billion
  • Danaher Corp. (DHR) to report adjusted earnings of $2.54 on revenue of $7.94 billion
  • Tractor Supply Corp. (TSCO) to report adjusted earnings of $1.86 on revenue of $3.23 billion
  • Sherwin-Williams (SHW) to report adjusted earnings of $1.4 on revenue of $4.76 billion
  • McDonald’s (MCD) to report adjusted earnings of $2.34 on revenue of $6.02 billion
  • Blackstone (BX) to report adjusted earnings of $1.37 on revenue of $3.31 billion
  • McCormick & Co. (MKC) to report adjusted earnings of $0.80 on revenue of $1.72 billion
  • Alaska Air Group (ALK) to report adjusted earnings of $0.24 on revenue of $1.85 billion
  • HCA Healthcare (HCA) to report adjusted earnings of $4.49 on revenue of $4.82 billion
  • JetBlue Airways (JBLU) to report an adjusted loss of $0.39 on revenue of $15.36 billion
  • Altria Group (MO) to report adjusted earnings of $1.08 on revenue of $5.03 billion
  • Western Digital Corp. (WDC) to report adjusted earnings of $2.13 on revenue of $4.82 billion
  • Nucor Corp. (NUE) to report adjusted earnings of $7.83 on revenue of $10.42 billion

Earnings Post-market

  • Mastercard (MA) to report adjusted earnings of $2.21 on revenue of $5.17 billion
  • Apple (AAPL) to report adjusted earnings of $1.90 on revenue of $119.05 billion
  • Robinhood (HOOD) to report adjusted losses of $0.34 on revenue of $370.92 billion
  • Visa (V) to report adjusted earnings of $1.70 on revenue of $6.80 billion
  • United States Steel Corp. (X) to report adjusted earnings of $4.41on revenue of $5.42 billion
  • Mondelez International (MDLZ) to report adjusted earnings of $0.73 on revenue of $7.59 billion

FOMC Statement

The redlined statement below, courtesy of Zero Hedge, shows the changes from the last FOMC policy statement to the current statement. In a nutshell, the Fed will end QE in early March, and it “will soon be appropriate to raise the target range for the Federal Funds rate.” Based on the words they removed regarding employment, we can assume they believe employment is at their goal of maximum employment. As such, policy, for the time being, will be all about inflation. There were no dissenting votes at this meeting, nor any mention of QT or financial stability.

fed fomc monetary policy

Jerome Powell’s Press Conference

Here are some takeaways from Jerome Powell’s press conference.

  • The negative economic effect of Omicron should end soon. This was a reason for hesitation to normalize policy.
  • The risk of high and sustained inflation is now the Fed’s biggest concern. He bemoaned this point numerous times.
  • QT will not begin until they raise the Fed Funds rate, but how and when to reduce the balance sheet will be a topic at upcoming meetings. They expect to shrink the balance sheet “sooner and faster” than the last time (2018).
  • Quite a bit of room to raise interest rates without harming labor markets.” Labor shortages and higher wages will be a big source of inflation however it will be partially offset as supply lines heal, albeit slowly.
  • Adjusting Fed Funds is the primary tool for the Fed, while balance sheet adjustments are in the “background.”
  • The “committee is of the mind to raise the Fed funds rate at the next meeting” (March).
  • In re the Fed’s balance sheet-substantially larger than it needs to be. There’s a substantial amount of shrinkage in the balance sheet to be done. We want that process to be orderly and predictable.”
  • It appears a QT schedule is on the docket for the May 4th meeting and possibly enacted at the mid-June meeting.
  • He raised his estimate of core PCE inflation by a few tenths from the last meeting and admits high inflation will be more persistent.
  • It is clear inflation is a much bigger problem for the Fed than they allude to via monetary policy.
  • “Asset prices do not represent a threat to financial stability.”

Uber Bearish Sentiment Is A Good Thing

Despite the market rattling Powell comment of “sooner and faster”, sentiment is already extremely negative.

The AAII sentiment survey can be used as a contrary indicator to identify an environment where sentiment has become too pessimistic on the future direction of stocks. When opinions become too bearish, stocks tend to rally. – Sentiment Trader

AAII Sentiment

“Dumb Money” traders have proven themselves to be bad at market timing over history. They get bullish after a market rally and bearish after a market fall. By the time most of them catch on to a trend, it’s too late – the trend is about to reverse. It tells us how confident we should be in selling the market. Examples of some Dumb Money indicators include the equity-only put/call ratio, the flow into and out of the Rydex series of index mutual funds, and small speculators in equity index futures contracts. Because the “dumb money” follows trends, they are usually correct during the meat of the trend but wrong at the extremes.Sentiment Trader

Dumb money sentiment gauge

Misplaced Anxiety in Junk Bonds

Over the last few weeks, we have been reading about growing anxiety among investors because junk bond yields are rising. It is pretty standard for the junk bond sector to be among the first of the fixed income sectors to show stress and illiquidity. The concern is that such stress will eventually appear in the liquid fixed-income markets. The graph below shows some of this anxiety, at least now, maybe misplaced. BB-rated junk bonds yields have risen a full percent since September. However, the spread (blue) is only up 0.38%. In other words, about two-thirds of the increase in the yield is not credit/liquidity related but solely a function of Treasury yields rising. The sector is not yet signaling danger but bears watching as it can change quickly as we saw in early 2020.

BB-rated junk bonds

The “Fear Gauge” Has Been Higher

The latest reading on the VIX is about 30, which is well above the average of about 18-19 from the last 15 years, but still some way from the readings of 80+ during the “call your family and go full panic mode” of the global financial crisis of ’08-09 or March 2020.

If the market was a person, telling a friend everything they were worried about, they’d have a lot to say:

  • Inflation is rising around the world, for the first time in a long time.
  • Tensions between Ukraine, Russia and NATO are rising.
  • The pandemic hasn’t gone anywhere, with the ongoing risk of new variants. 

Figuring out which of those is most responsible for the market jitters on any one day is more art than science, but all 3 together certainly aren’t helping. – Chartr

We could definitely now add Powell’s “sooner and faster” comment to that list of worries.

Vix index

Microsoft Whipsaws on Good Earnings

After the markets closed on Tuesday, Microsoft (MSFT) reported better than expected earnings and revenue. Initially, the good news didn’t matter to investors as the stock fell 5% in after-hours trading. The only excuse justifying the move was that it was the smallest beat in earnings in many quarters. The selling stopped abruptly when the markets reopened at 6 pm ET and MSFT quickly recouped its losses plus more. The graph below highlights the U-shaped price action. While MSFT recovered, there is an important lesson. Many stocks are priced for massive growth. Better said, they are priced for perfection. As we have seen repeatedly this earnings season, good but non-stellar earnings can result in stock declines. It doesn’t help that investors are very anxious as the Fed shifts its monetary policy.

Our equity model has a 3% stake in MSFT.

microsoft msft

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Diversity, Equity and Inclusion and its Impact on Retirement Plans

Today’s workforce spans a variety of abilities, skills, experiences, and cultural backgrounds that bring exceptional value. It is beneficial to understand and recognize these differences to achieve exceptional results. This remains true when offering, communicating, and promoting your company’s retirement plan.

Raising Awareness

Thankfully, your retirement plan is no stranger to reporting. From participation rates, deferral percentages, asset allocation mixes, benchmarking analysis, investment reviews, and other slice and dice metrics, retirement plan information is often shared based on your plan’s specific numbers and peer group comparison.
However, those calculations seldom include the lens of Diversity, Equity, and Inclusion (DEI). Now all that is changing.

Expanding the Scope

Nearly two—thirds of plan sponsors have noticed an increased demand for retirement plans to align with DEI efforts. So, now is a good time for employers and retirement plan committee members to revisit and re-evaluate how their 401(k) plans align with the workplace climate.

Four primary areas to review your workplace retirement plan DEI may include:

  1. Participant cohorts: Participants save and accumulate assets differently. Take a look at your company’s demographics to spot under savers (participation, deferral, asset allocation, etc.). Then implement a targeted strategy to help all groups take advantage of the opportunities offered by your plan.
  2. Committee composition: To foster a deeper understanding of your employees’ savings experience, reassess and consider expanding the retirement plan committee to include a representative structure that mirrors your workforce, potentially bringing greater insights that enhance retirement savings.
  3. Investment offering: Consult with us for a review of your investment menu and discuss how a DEI strategy could be reflected throughout your retirement plan’s investment offerings.
  4. Holistic mindset: For the majority of Americans, the workplace retirement plan is their primary savings and accumulation vehicle for retirement. Employers and committee members should address the current financial state of plan participants to ensure the diverse needs of their workplace are being addressed. Boosting the financial wellbeing of plan participants can drive the improvement of plan outcomes and allow all demographic groups to better engage with the benefits offered to them.

Financial Wellness

DEI is an essential part of a financial wellness program. A financial wellness program’s purpose is to help employees improve their overall financial situation. The best way to do this is by gaining an understanding of the differences that may exist between diversity groups (e.g. age, race, ethnicity, gender, physical abilities, sexual orientation, etc.), followed by viewing plan data to identify cohorts that could benefit from receiving additional resources. Sponsors can also use the data presented to look at demographic groups and see if they have different engagement levels in the plan.
One idea to address participation gaps is auto-enrollment. It is agnostic across all employees; it has been found that when auto-enrollment is implemented with Black, Latinx, and White Americans, the participation rate remains 80% across the board. Interestingly, when given the same auto-enrollment default, everyone saves the same when they have access. This is one example of how employers can address a coverage issue and, if applicable, address a racial disparity within 401(k) plan participation.

Financial Education

Diversity can extend not only to different cultural groups but varying generations as well. As such, employers should offer financial education resources that appeal to the different learning preferences (and languages) of each cohort along with the best way to communicate with them about retirement, all while working to improve experiences through effective DEI.
As the lifestyles and stages of employees evolve, so do their financial needs and priorities. For a retirement program to be successful, employers should take these changes into consideration.
One size doesn’t fit all. Plan sponsors should seek to employ a mix of communications — utilizing brochures, emails, videos, infographics, blog articles, and online calculators — to get the message out to different demographics within the plan.

Next Steps

To get started with your DEI strategy, consider these best practices:

  • Know your employees: Seek to understand their differing demographics and assess participant behaviors from multiple perspectives.
  • Talk with your service providers: Set up a meeting to learn what resources are readily available (e.g. financial wellness programs, plan data, different language options, etc.).
  • Communicate with purpose: Your communications should highlight your retirement plan as a valuable benefit. Help your diverse workforce understand why it is important to save and how your company is helping to promote retirement preparedness.

Using DEI to guide plan decisions can help ensure your company’s retirement plan is working to positively impact the different cohorts of your employees. DEI used wisely can increase the retirement engagement and security of all.

This information was developed as a general guide to educate plan sponsors and is not intended as authoritative guidance or tax/legal advice. Each plan has unique requirements, and you should consult your attorney or tax advisor for guidance on your specific situation. ©401(k) Marketing, LLC. All rights reserved. Proprietary and confidential. Do not copy or distribute outside original intent.

Stocks Or Inflation? The Fed Has A Choice To Make

At 2 pm ET, the Fed will conclude its FOMC policy meeting and inform us on how it plans to proceed with QE and potential rate increases. Of most importance, between the statement and press conference, is how much is the Fed is willing to fight inflation at the expense of the stock market. A focus on inflation entails aggressive actions to end QE, start QT and raise rates 4 or 5 times this year, undoubtedly to the detriment of stock prices. Please read our article – Instability or Inflation, Which Will The Fed Choose for more on the topic. The article ponders the delicate balance between supporting stock prices and broader financial stability versus reducing inflation.

Rate Hikes

{dmc}

What To Watch Today

Economy

  • 7:00 a.m. ET: MBA Mortgage Applications, week ended January 21 (2.3% during prior week)
  • 8:30 a.m. ET: Advance Goods Trade Balance, December (-$96.0 billion expected, -$98.0 billion in November)
  • 8:30 a.m. ET: Wholesale Inventories, month-over-month, December preliminary (1.3% expected, 1.4% in November)
  • 10:00 a.m. ET: New home sales, December (760,000 expected, 744,000 in November)
  • 2:00 p.m. ET: Federal Reserve Monetary Policy Decision

Earnings

Pre-market
  • 6:00 a.m. ET: Stifel Financial Corp. (SFto report adjusted earnings of 86 cents on revenue of $1.43 billion
  • 6:00 a.m. ET: Anthem Inc. (ANTM) to report adjusted earnings of $5.12 on revenue of $36.58 billion
  • 6:30 a.m. ET: AT&T (T) to report adjusted earnings of 75 cents on revenue of $40.47 billion
  • 7:00 a.m. ET: General Dynamics Corp. (GDto report adjusted earnings of $3.37 on revenue of $10.67 billion
  • 7:00 a.m. ET: Nasdaq Inc. (NDAQ) to report adjusted earnings of $1.73 on revenue of $867.80 million 
  • 7:30 a.m. ET: Kimberly-Clark Corp. (KMB) to report adjusted earnings of $1.24 on revenue of $4.89 billion
  • 7:30 a.m. ET: Boeing (BA) to report adjusted losses of 4 cents on revenue of $16.67 billion
  • 7:30 a.m. ET: Abbott Laboratories (ABTto report adjusted earnings of $1.21 on revenue of $10.73 billion
  • 8:15 a.m. ET: The Progressive Corp. (PGRto report adjusted earnings of 99 cents on revenue of $12.09 billion
Post-market
  • 4:00 p.m. ET: Intel (INTC) to report adjusted earnings of 90 cents on revenue of $18.38 billion
  • 4:05 p.m. ET: Las Vegas Sands Corp. (LVSto report adjusted losses of 26 cents on revenue of $1.05 billion
  • 4:05 p.m. ET: Whirlpool Corp. (WHR) to report adjusted earnings of $5.93 on revenue of $5.89 billion
  • 4:10 p.m. ET: ServiceNow Inc. (NOWto report adjusted earnings of $1.43 on revenue of $1.6 billion
  • 4:10 p.m. ET: Qualtrics International (XMto report adjusted losses of 2 cents on revenue of $297.72 million
  • 4:10 p.m. ET: Tesla (TSLA) to report adjusted earnings of $2.37 on revenue of $16.64 billion
  • 4:20 p.m. ET: Xilinx (XLNX) to report adjusted earnings of $1.02 on revenue of $949.44 million 

Support Holding, Is The Bottom In?

While the Fed debates between supporting stocks or fighting inflation, the market is holding support at the October lows. The deep oversold is beginning to reverse, and the stochastic “buy signal” has turned up suggesting we may have seen the lows temporarily. However, as noted the lows from last Friday’s option expiration washout continue to provide resistance.

We should get some better clarity on where markets are headed to after the FOMC announcement this afternoon. However, this morning futures are pointing solidly higher. After two days of accumulation, and the ongoing battle between stocks or inflation, the question is whether the bottom is in.

Chart Courtesy Of SimpleVisor.com

The Fed’s Calendar

The timeline below from The Market Ear is based on Goldman Sachs’s Fed forecast. We can use it to help assess whether the Fed is more hawkish or dovish than expected. The forecast below calls for QE to end in March. They believe the first of four rate hikes in 2022 start in March. Lastly, Goldman thinks the Fed could announce QT in July.

fed fomc meeting

Home Prices Remain on Fire

The Case-Shiller Home Price Index rose 18.8% year over year in November. While still a huge increase, the good news is the rate of change in annual prices is slightly lower than October’s 19% pace. Keep in mind mortgage rates are about .75% higher today than in November. It will be interesting to see how higher rates affect this index going forward. The graph below from the Calculated Risk Blog shows this latest reading is the first time the index has come in lower than the prior month in over a year and a half. Given housing is the largest component of CPI, this index bears following closely over the next few months.

home prices inflation

Time To Buy The Dip

This to shall pass. Yes, the markets have been under considerable pressure this year, but eventually, this will pass. Bank of America posted yesterday a list of candidates to start building your buy list from.

MicroStrategy MSTR Bitcoin-Backed Bonds

Led by crypto enthusiast Michael Saylor, Microstrategy has been aggressively buying bitcoin. Recently the company used the debt markets to fund and leverage bitcoin purchases. The graph below shows MSTR’s $2.2 billion bonds maturing in 2027 is now trading at 63 cents on the dollar, producing a yield of just under 10%. The bond, backed by bitcoin, has become a fixed income proxy for bitcoin as MSTR’s solvency has become very dependent on bitcoin prices.

mstr bonds bitcoin

Earnings Guidance

Bianco Research shows below that there has recently been more negative earnings guidance than positive guidance. This is the first time we have seen this since April 2020, when the pandemic devastated economic growth. Of greater concern, the negative to positive guidance ratio is worse today than in early 2020. Further, it is at levels last seen in 2009.

earnings guidance corporate

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Fear and Greed: An Investors Two Worst Enemies

Over the past two years, investors have had to balance fear and greed amidst market, economic, and political unpredictability. Since 2020, the divergence between asset price performance and fundamentals has never been starker. As a reminder, stock prices were surging higher in the spring and summer of 2020 despite double-digit unemployment and closures of large economic segments. It was not easy to be bullish with news like the New York Times front-page below.

new york times fear

The stock market bottomed the week the headline above was published. Since then, the S&P 500 has more than doubled. Those investors who could silence their fear and focus on technical signals and fiscal and monetary stimulus prospered.

Simultaneous feelings of fear and greed were overwhelming and detrimental to many investors over the past two years.

As we look ahead, we believe those same emotional biases will hinder investors. In this piece, we examine two biases that often handcuff investors and push them to make the wrong decisions at the wrong time. Our intention to make you aware of these subconscious forces is to help you manage both fear and greed and, ultimately, your wealth.

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Availability Bias – Fear

Proposals for new nuclear power plants often come under resounding negative pressure from local communities. According to Britannica, the phrase NIMBY (not in my backyard) was coined because of the “threat” of new nuclear power plants.

Ask your friends or neighbors, and they would likely be distraught at the prospect of a nuclear power plant in their neighborhood. The reason is Three Mile Island, Fukushima, and Chernobyl in most cases.

Nuclear power plant disasters, while very rare, are extremely powerful in terms of the public’s perception of nuclear power. No one wants nukes in their backyard, despite the fact they are low cost, reliable, and produce no carbon emissions. As the graph below shows, nuclear energy is not only one of the greenest forms of energy production, but it is also the safest. 

nuclear energy availability bias

Availability bias occurs when people base their sense of risk on examples that quickly come to mind when a topic arises. When most people think of nuclear energy, Chernobyl, Three Mile Island, and Fukushima are top of mind.

Our collective availability bias against nuclear energy arguably results in more environmentally unfriendly, costlier, and deadlier energy options. Simply it causes us to make poor risk/reward decisions.

Availability Bias – Market Crashes

Investors can face the same crippling fear that nuclear energy protestors harbor.

The years 1929, 1987, 2000, and 2008 elicit anxiety from investors. Those four stock market crashes erased massive wealth in relatively short periods. Many people believe the crashes appeared out of the blue with no ability to detect them in advance.

The reality is all four were predictable. Timing a crash is difficult but quantifying the risk of a crash and the conditions leading to a crash are manageable. For example, we wrote 1987 to highlight plenty of fundamental and technical warnings in advance of the most significant single-day market crash.

The combination of high valuations and the fear of a market crash inevitably left many investors over the last year on the sidelines. While such a stance may prove correct in the longer run, those investors are sorely missing the ability to compound wealth in the shorter run. In the case of availability bias, investors are putting too much emphasis on risk and not enough time properly managing the risk.

Herd Mentality – Greed

It is often at market peaks that investors fail to appreciate risk and instead follow the bullish herd. Jim Cramer, for example, and many others make a living promoting bullish views. They thrive in bull markets. When markets roar ahead, extreme optimism and promises of much higher prices make the promoter’s siren songs hard to ignore.

Famed investors, Wall Street analysts, and the media prey on ill-equipped investors by justifying high valuations and forecasting ever-higher prices.  Their narratives rationalizing steep valuation premiums and bold return forecasts become widespread. To some, they appear to be facts. Despite evidence to the contrary and historical precedence, investors buy the hype. “This time is different,” say the promoters.

As bull markets run at full steam, the call of the promoters elicits a fear of missing out (FOMO) or behavioral herding. Most investors blindly mimic the behavior of other investors without seeking the rationality behind it.

“There is nothing so disturbing to one’s well-being and judgment as to see a friend get rich” -Charles Kindleberger: Manias, Panics, and Crashes

In the case of herd mentality, we fail to manage risk as we become so focused on rewards.

Straddling the Line

In 1999, we showed current equity valuations are as extreme as those periods leading to the four crash events. A 40-50% market decline or even more would be statistically expected. There is no doubt our risk awareness should be on high alert. Blindly following your friends, neighbors, and Jim Cramer is a recipe for disaster. Do not ignore the palatable risks.  

While blindly following the herd is dangerous, focusing too heavily on prior market crashes is also problematic. There is no golden rule that says markets must correct when they appear too expensive. Valuations may stay grossly elevated this year and next year. It’s also feasible, although highly unlikely, prices are stable, but valuations correct because earnings growth is fantastic.

Solely focusing on prior crashes and current extreme valuations may result in the inability to compound your wealth. If you sat out the last year, you missed outsized returns, which could have cushioned recent declines and made risk management a little easier.  

Summary

Zen-like awareness allows us to run with the bulls and hide from the bears.” – Zen and the Art of Risk Management 

Growing wealth is complex, especially when markets are at extremes like today. Worrying about 1987 or 1929 can leave you woefully underinvested while markets roar ahead. Blindly following stock promoters may leave you dangerously at risk.

As important as it is to think for ourselves, it is equally important to understand our psychological makeup. A strong understanding of a market’s technical and fundamental backings and the ability to fend off the urges of fear and greed is the equation for long-term investment success. Such is far from easy, which helps explain why so few investors continually make fortunes over decades.   

How to Prepare for a 401(k) Audit

If the term ”audit” makes you uncomfortable, anxious, or even scared, you are not alone. Last year, the Department of Labor (DOL) closed 1,122 civil investigations with 754 (67%), resulting in fees, repayments, or corrective actions.[1] The agency collected over $3.12 billion in direct payments to plans, participants, and beneficiaries. This represents a whopping 300% increase in just five years.[2] 

From this perspective, you might think there is no chance that you’re walking out of an audit unscathed. However, the outlook is a little less bleak when you realize that in the US, there are nearly

722,000 retirement plans and only 1,122 escalated to an investigation.

So instead of viewing the DOL as the boogey monster or fearing a 401(k) audit, let’s take a look at the utility behind audits, identify red flags and establish best practices to help demystify the process. 

What is a 401(k) Audit?

Retirement plan audits are normal; in fact, they happen all the time. Generally speaking, a plan audit is the review of a company’s retirement plan with the primary objective of ensuring that it meets guidelines and regulations set by the DOL and IRS. For large companies with over 100 participants, audits are an annual occurrence, but small plans can also be under scrutiny if a red flag is raised.

What are Audit Red Flags?

The following red flags can prompt the DOL to take a closer look at your retirement plan.  

Employee Complaints

Individual complaints from employees are a frequent source of DOL investigations. From a total of 171,863 inquiries from workers, 357 resulted in the opening of new investigations and more than half of all monetary recoveries relate to benefits of terminated vested participants of defined benefit plans.[3] The simple lesson here is that plan sponsors must establish clear protocols for how participants can communicate questions or complaints about their benefits to the plan sponsor before filing complaints with the DOL. Quick and effective responses are critical.

DOL Enforcement Priorities

Examinations may also relate to enforcement priorities launched by the DOL.  As of this publication, the agency “continues to focus its enforcement resources on areas that have the greatest impact on the protection of plan assets and participants’ benefits.”[4]  Just like the old story about why a robber goes to a bank, this translates to the DOL likely focusing more on large plans because that’s where the money is.

Delinquent Contributions

Delinquent contributions are pursued as part of an ongoing national priority. These are easy pickings for the DOL and a clear violation of the most basic fiduciary standards. No employer should deduct contributions from employees’ wages and fail to contribute those deferrals to the plans without fear of significant and swiftly administered reprisals.      

Plan sponsors are encouraged to review their Form 5500 and other records to spot trouble points, such as:

  • Missed contributions
  • Assets not held in trust
  • Paying unreasonable compensation to service providers (conduct regular fee benchmarking to avoid this)
  • Paying expenses from the plan that are actually expenses of the employer (known as “settlor expenses”. These costs include consulting services regarding plan design or plan termination.)

Other areas of interest include lost or missing participants, and, of course, the DOL often accepts referrals from other agencies such as the IRS.

A Knock at the Door

If you happen to receive a notice from the DOL about an audit or an investigation, your response should be the same:

  • Take a deep breath.
  • Put your team together and choose a qualified primary contact person.
  • Strongly consider engaging ERISA counsel. Expert help may avoid missteps and provide an intermediary for difficult conversations.
  • Consider requesting an extension of time to respond. Many initial deadlines can be short for complex exams. Extensions, if reasonable, are routinely granted.
  • Review all documents prior to production. Be ready to report any issues found.
  • Deliver documents in neat and organized fashion.
  • Prepare employees for interviews. Treat it like a deposition. Caution them to take their time, thoughtfully consider their responses and ask for clarification of any questions they do not understand.
  • Always be truthful and respectful.

What Documents are Typically Requested?

The sheer volume of documents requested may at first seem overwhelming, but the requests will be for documents you should have readily available in your files. They include:

  • Plan document, Investment Policy Statement, plan records of fees/expenses
  • Form 5500, Summary Plan Description (SPD), Summary Material Modification (SMM), participant fee disclosures and benefit statements
  • Service provider contracts and fee disclosures
  • Participant claims and benefits data
  • Bonding and fiduciary liability insurance
  • Fiduciary committee charters, committee meeting minutes and other records
  • Organizational documents about your company and organizational charts
  • More recently, cybersecurity practices

Stay Prepared

Whether you are subject to a routine audit or a red flag prompts an investigation, it is important to remember that fiduciary vigilance is key. The best preparation is to follow sound operational procedures every day and don’t fall behind.


[1] Department of Labor. “Fact Sheet. EBSA Restores Over $3.1 Billion to Employee Benefit Plans, Participants and Beneficiaries.”  2020.

[2] Ibid.

[3] Ibid.

[4] Employee Benefits Security Administration. “Enforcement.” DOL.gov. Accessed 2021.

This information was developed as a general guide to educate plan sponsors and is not intended as authoritative guidance or tax/legal advice. Each plan has unique requirements, and you should consult your attorney or tax advisor for guidance on your specific situation. ©401(k) Marketing, LLC. All rights reserved. Proprietary and confidential. Do not copy or distribute outside original intent.

Do ESGs Fit Into Our Retirement Plan?

The value-driven workplace and its implications for retirement plans

Your workplace may be evolving in many facets, from remote options to new generations coming into the workforce. These changes reflect those of the larger social climate and, in turn, employee priorities, values, and expectations. Many professional and financial decisions are being influenced by these trends, as 53% of consumers are now “value-driven.”[1]

Some of the progressing values represent environmental, social, and governance factors, known collectively as ESGs. These factors correspond to an array of investments that reflect a company’s interest in sustainability efforts; they can be offered to employees as part of their 401(k) lineup. ESG funds are becoming increasingly present, with nearly $20 billion in annual flows during 2020.[2]

  • Environmental: greenhouse gas (GHG) emissions, climate change, renewable energy, energy efficiency, waste management, etc.
  • Social: human rights, labor standards, workplace health and safety, employee relations, diversity, consumer protection, etc.
  • Governance: board structure, size, diversity, skills and independence

Companies frequently look to display their devotion to the environment around them and in the workplace, ranging from efforts like Diversity, Equity, and Inclusion (DEI) within the workforce to issues regarding climate change.

Efforts that reflect a company’s commitments, like ESG investments and sustainable purposes, can project not only a positive brand image but also continually work to align company goals with investments and employer loyalties with employee values.

Four Types of Involvement

Now, don’t feel like you need to adjust your investment lineup right this moment. As a fiduciary, you have a duty to act in the best interest of the plan and its participants. ESG funds can also be considered at different levels of involvement. Before diving into sustainable investing, decide on which, if any, of the four approaches your investment lineup might want to take.[3]

  1. ESG Integration is the most conservative option for firms entering the landscape. This approach considers ESG factors along with others when creating investment profiles, with the primary goal of achieving promising returns.
  2. Exclusionary Investing entails the exclusion of certain companies or sectors that do not reflect a company’s sustainability values. An example would be not investing in the tobacco industry, as many have done in response to health concerns and the related environmental impact.
  3. Inclusionary Investing focuses on actively seeking out ESG-centered entities to invest in as opposed to rejecting certain companies or sectors.
  4. Impact Investing is the most engaged strategy, where a company dedicates its investing practices to achieving a positive difference in an environmental or social arena in addition to producing returns for its employees.

What Do You Believe In?

To get an idea of what sustainable topics you, your firm, and your employees may resonate with and consider investing in, the United Nations Sustainable Development Goals (SDGs) can help.[4] These goals “address the global challenges [the world] face[s], including poverty, inequality, climate change, environmental degradation, peace and justice”, and are the focus of many ESG funds.[5]

Examples of the SDGs:

  • Good Health and Well Being
  • Gender Equality
  • Affordable and Clean Energy
  • Decent Work and Economic Growth
  • Sustainable Cities and Communities
  • Climate Action

Identifying your firm’s values and objectives can help reveal the best ways to align with those of current and future employees and learn how they want their benefits packages to be structured.

Looking to the Future

As new generations enter the workforce, they expect diverse and sustainable portfolios. More than 85% of all investors now express interest in ESG investments, specifically those addressing global warming and climate change.[6] This percentage increases with each younger generation – the future of the American workforce. Sustainability, the impact of plastic on the oceans, and data fraud and theft are also top considerations for consumers interested in ESG fund investment.[7]  

ESG funds may be a promising element of 401(k) investment lineups for plans, employers, and employees in the coming years. Consider if and how they represent your firm and its employees, but more importantly, how they may or may not fulfill your fiduciary duty to act in the best interest of your plan and its participants.

As ESGs become more readily available and your company continues to evolve, we are here to help by discussing your options and identifying efforts that may help align your company with future goals and employee values.


[1] “Sustainable Investing for a Sustainable Business.” New York Life Investments, 2019.

[2] Hale, Jon. “Sustainable Funds U.S. Landscape Report.” Morningstar Direct, 10 Feb. 2021.

[3] “New York Life Investments Guide to ESG Investing.” New York Life Investments, 2020.

[4] “The 17 Goals | Sustainable Development.” United Nations, United Nations, 2015.

[5] “Take Action for the Sustainable Development Goals – United Nations Sustainable Development.” United Nations, United Nations, 2015.

[6] “Sustainable Investing for a Sustainable Business.” New York Life Investments, 2019.

[7] “Sustainable Investing for a Sustainable Business.” New York Life Investments, 2019.

This information was developed as a general guide to educate plan sponsors and is not intended as authoritative guidance or tax/legal advice. Each plan has unique requirements, and you should consult your attorney or tax advisor for guidance on your specific situation.

©401(k) Marketing, LLC. All rights reserved. Proprietary and confidential. Do not copy or distribute outside original intent.

Extreme Volatility May Be Here For A While

The S&P exhibited extreme volatility throughout the day on Monday. The market opened weaker and fell sharply until 1 pm ET, where the S&P 500 bottomed down by over 170 points. After a few false bounces, it surged back in the afternoon, closing positive for the day.

The 9% round trip was the largest intraday move since the spring of 2020 when pandemic fear gripped the market. We may continue to see volatility at extreme levels as the Fed seems to be walking into a trap. The market’s concern is the Fed is removing liquidity as the economy shows signs of slowing. Such a Fed mistake could lead to more volatility, and extreme trading ranges, as we saw on Monday. Making matters trickier is the growing risk of conflict with Russia over Ukraine.

Daily Market Commnetary

What To Watch Today

Economy

  • 9:00 a.m. ET: FHFA House Price Index, month-over-month, November (1.0%. expected, 1.1% in October)
  • 9:00 a.m. ET: S&P CoreLogic Case-Shiller 20-City Composite Index, month-over-month, November (0.93% expected, 0.92% in October)
  • 9:00 a.m. ET: S&P CoreLogic Case-Shiller 20-City Composite Index, year-over-year, November (18.00% expected, 18.41% in October)
  • 10:00 a.m. ET: Conference Board Consumer Confidence, January (111.1 expected, 115.8 in December)
  • 10:00 a.m. ET: Richmond Fed Manufacturing Index, January (14 expected, 16 in December)

Earnings

Pre-market

  • 6:45 a.m. ET: Johnson & Johnson (JNJ) to report adjusted earnings of $2.12 on revenue of $25.32 billion
  • 7:00 a.m. ET: American Express (AXP) to report adjusted earnings of $1.83 on revenue of $11.50 billion
  • 7:00 a.m. ET: Verizon (VZ) to report adjusted earnings of $1.28 on revenue of $34.03 billion
  • 7:00 a.m. ET: Invesco (IVZ) to report adjusted earnings of $0.75 on revenue of $1.77 billion
  • General Electric (GE) to report adjusted earnings of $0.84 on revenue of $21.38 billion
  • Polaris (PII) to report adjusted earnings of $2.03 on revenue of $2.13 billion
  • Raytheon Technologies (RTX) to report adjusted earnings of $1.02 on revenue of $17.28 billion
  • 3M (MMM) to report adjusted earnings of $2.01 on revenue of $8.60 billion
  • Lockheed Martin (LMT) to report adjusted earnings of $7.17 on revenue of $17.66 billion
  • Texas Instruments (TXN) to report adjusted earnings of $1.95 on revenue of $4.43 billion

Post-market

  • Microsoft (MSFT) to report adjusted earnings of $2.32 on revenue of $50.87 billion
  • Capital One Financial Corp. (COF) to report adjusted earnings of $5.29 on revenue of $7.93 billion

Blame the Fed

Looking for someone to blame for the extreme volatility?

fed

The Market May Have Called The Fed’s Bluff

As we discussed yesterday, the market was extremely oversold and due for a bounce. The reason for the rally yesterday afternoon and into the close was the collapse in expectations of Fed rate hikes.

However, the Fed is not done yet, and their meeting starts tomorrow. So, while the market may be thinking the Fed will back off its more hawkish stance, it is worth noting that extreme volatility, like yesterday, is rare and only during bear markets.

The last two times that the S&P 500 dropped 4% and rebounded into the green were as follows.” – Zerohedge

  • Oct 16, 2008 = down -4.63% and closed up 4.25% – EU, US, Japan coordinated action to guarantee bank financing, Paulson shifts TARP to buying equity in banks
  • Oct 23, 2008 = down -4.28% and closed up 1.26% – Fed bailed out MM funds

The only other days were Oct 28, 1997, Oct 26, 2000 and July 15, 2002. The 2000 and 2002 dates were during the Dot.com bear market. The Oct 1997 event was during the Asian financial crisis.

Top 10 Buys & Sells From TPA Research

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Don’t Forget The Biggest Buyers Of Equities

As Goldman’s Scott Rubner writes:

“…blackout window ended. Corporates will buy the weakness. The GS corporate buyback desk expects a record year for executions of $975B or >$4B per day”.

There is a lot of dry powder and many will be eager to pick up some of those hammered tech stocks. Why not even front-load some of the $1.234 Trillion authorized last year. – @TheMarketEar

Keep an Eye on Junk

Mention the Fed’s concern with financial stability, and many investors immediately think of the stock market. While they indeed appear to follow stocks, we believe their bigger concern in the realm of financial stability is the bond markets. The bond markets are the financial lifeline for many corporations and banks. As we saw in 2008, frozen bond markets are the death knell for the banking sector. The large banks own the Fed, and therefore the Fed’s attentiveness to bond markets should not be surprising.

As we watch the recent equity market decline, we must also observe the bond markets. Currently, they are orderly. Most importantly, junk debt tends to become illiquid before investment grade debt is trading well. The graph below shows that junk (BB-rated) spreads remain intact. If spreads start rapidly rising the Fed may become concerned but right now we see little instability in the credit markets.

junk bonds BB-rated

Economic Data Continues to Dissapoint

Monday’s economic data was decidedly weak. Leading off is the Chicago Fed National Activity Index, which tracks 85 monthly indicators. The index came in at -.15 versus .44 last month and expectations of .25. A reading below zero correlates to below-trend growth. Also of concern, the PMI Composite Index which includes manufacturing and services fell to 50.8. While it still points to economic expansion, it is straddling the line (50) and nearing contraction. The index is now at an 18 month low. Economic growth is slowing rapidly. The question is whether the slowdown is a function of Omicron or the normalization of economic activity and sharp reduction of fiscal stimulus. If it’s the latter, the Fed might be making a big mistake tightening monetary policy into a slowdown.

Per the report“Soaring virus cases have brought the US economy to a near standstill at the start of the year, with businesses disrupted by worsening supply chain delays and staff shortages”

economic data PMI GDP

Housing Imbalance

Last week we described coming headwinds for the homebuilders (XHB). Inflation, higher wages, increasing mortgage rates, and the potential for a glut of new supply later this year are increasingly likely to pose problems for the sector. The graph below further highlights the potential for an oversupply of new homes this summer. As shown, the University of Michigan Homebuyer Sentiment Index is well below levels of 2008 and at 40-year lows. At the same time, the number of housing units under construction surpassed the 2003-2008 housing bubble and is approaching levels last seen in the early 1970s. Again, we advise caution with homebuilders and those that supply homebuilders with materials to build new homes.

For More: “Why There Is No Housing Shortage

homebuyers housing

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Grantham: We’re In An Epic Bubble

Jeremy Grantham recently made headlines with his latest market outlook titled “Let The Wild Rumpus Begin.” The crux of the article gets summed up in the following paragraph.

“All 2-sigma equity bubbles in developed countries have broken back to trend. But before they did, a handful went on to become superbubbles of 3-sigma or greater: in the U.S. in 1929 and 2000 and in Japan in 1989. There were also superbubbles in housing in the U.S. in 2006 and Japan in 1989. All five of these superbubbles corrected all the way back to trend with much greater and longer pain than average.

Today in the U.S. we are in the fourth superbubble of the last hundred years.”

The bubble is easy to spot in the chart below of deviations of the market from its long-term exponential growth trend.

S&P500 Deviation from exponential growth trend.

As Grantham correctly notes, investors don’t want to admit that a correction of magnitude is possible. However, the possibility of a 40-50% contraction to revert the massive extension from the long-term growth trend is highly probable. All that is needed is a catalyst, which so far has yet to appear.

Could the Fed be the catalyst? Maybe.

The problem is that crashes start slowly and then all at once. Only in hindsight does the catalyst become obvious.

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What Makes A Bubble?

According to Investopedia:

“A bubble is a market cycle that is characterized by the rapid escalation of market value, particularly in the price of assets. Typically, what creates a bubble is a surge in asset prices driven by exuberant market behavior. During a bubble, assets typically trade at a price that greatly exceeds the asset’s intrinsic value. Rather, the price does not align with the fundamentals of the asset.

This definition is suitable for our discussion. There are three components of a “bubble.” The first two, price and valuation,  get dismissed or rationalized during the inflation phase. That rationalization is due to investor psychology and the “Fear Of Missing Out (F.O.M.O.)

Jeremy Grantham previously posted the following chart of 40-years of market bubbles. During the inflation phase, each got rationalized that “this time is different.” 

Jeremy Grantham market bubbles

However, we are most interested in the third component of bubbles: investor psychology.

Charles Kindleberger noted that speculative manias typically commence with a “displacement” that excites speculative interest. Then, the speculation becomes reinforced by a “positive feedback” loop from rising prices.

Such ultimately induces “inexperienced investors” to enter the market. As the positive feedback loop continues and the “euphoria” increases, retail investors then begin to “leverage” their risk in the market as “rationality” weakens. A look at margin debt suggests investors have leveraged their risk in the market.

Margin debt
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A 40-50% Correction

Grantham believes that exuberant investor psychology leads to a “blow-off” phase in financial markets. To wit:

“The penultimate phase of major bubbles is characterized by a “blow-off” which is an accelerating rate of stock price growth to two or three times the average of the preceding bull market. This pattern shows as clearly as any of history’s other great superbubbles in 2020 (see Exhibit 4).”

Jeremy Grantham market bubbles

With that understanding, is it possible for the market to sustain a 40-50% retracement in a “mean reverting event?” That answer is “yes.” A logical retracement to previous long-term trendlines, as shown below, would be well within the context of a typical mean-reverting event. Those levels would be roughly 3800, retracing to the accelerated trendline from the 2009 lows. From recent highs, such would encompass approximately a 21% decline.

However, a correction to the long-term trendline from the 2009 lows would be a 41% crash.

S&P 500 trend line support levels

Fibonacci Retracements

Another way to view a corrections potential is Fibonacci retracement levels. Here is a brief description:

“The Fibonacci retracement plots percentage retracement lines based upon the mathematical relationship within the Fibonacci sequence. These retracement levels provide support and resistance levels helpful in identifying target price objectives.

Fibonacci Retracements get displayed by first drawing a trend line between two extreme points. Next, a series of six horizontal lines intersect the trend line at the Fibonacci levels of 0.0%, 23.6%, 38.2%, 50%, 61.8%, and 100%.”

Using the beginning of the bull market rally in 2009, we can view the potential Fibonacci retracement levels.

S&P 500 Fibonacci retracement levels.

The two most important levels for market watchers, given Grantham’s view of a “mean reverting event,” are the 38.2% and 50% retracement levels. The 38.2% level intersects the running support trendline from 2009. The 50% retracement level aligns with the lows from 2018 and March 2020.

Should those two support levels fail, the market will likely search for a bottom at the 61.8% retracement level at the 2015-2016 lows.

That can’t happen, you say? Maybe.

But if previous “bubble history” serves as a guide, it is indeed a possibility worth considering. For example, the chart below shows the deviation of the market from the exponential growth trend overlaid with valuations and previous crisis events.

Valuations and S&P 500 deviation exponential growth trend.
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The Fed Put

“In the meantime, we are in what I think of as the vampire phase of the bull market, where you throw everything you have at it: you stab it with Covid, you shoot it with the end of QE and the promise of higher rates, and you poison it with unexpected inflation – which has always killed P/E ratios before, but quite uniquely, not this time yet – and still the creature flies. Until, just as you’re beginning to think the thing is completely immortal, it finally, and perhaps a little anticlimactically, keels over and dies.”Jeremy Grantham

The one consideration, of course, is where does the Federal Reserve rush back to the rescue of the market. In 2018, it only took a 20% decline to see them quickly reverse course in tapering. In March 2020, the market collapsed 35% before the Fed could organize enough to intervene.

The difference in both cases, as stated previously, is the Fed did not have 7% inflation to deal with.

If the Fed raises rates to break the inflation surge, such also retards economic growth. Higher rates historically equate to more negative market outcomes. Such is particularly true when valuations become elevated and low rates support the bullish thesis.

The most significant risk to investors is the Fed’s ability to “jawbone” the markets to maintain financial stability when reversing monetary accommodation. Such is the same environment we saw in 2018 where the Fed uttered the words “we are nowhere close to the neutral rate.”

Two months later, and 20% lower in the markets, Jerome Powell discovered he had magically reached the “neutral rate” and needed to ease off on monetary tightening.

S&P 500 Fed Funds and Inflation Spread

The biggest problem for the Fed is choosing between combating inflation or bailing out the markets.

Conclusion

Given the importance of “financial stability to the Federal Reverse, I suspect they will abandon their inflation mandate to support the financial system.

However, given the extreme buildup of debt and leverage in the financial system, a correction can quickly get out of their control. The resulting damage to the credit, financial, real estate, and labor markets will send economic growth plummeting too quickly for them to bail out.

Such is just my assumption, but when you look at the total amount of financial leverage in the system, you can understand why the risk is prevalent.

Total system leverage vs S&P 500

Whether you agree a bubble exists is largely irrelevant. Every investor approaches investing differently.

However, there are certainly a few points to consider, especially if you are nearing or in retirement. While Grantham’s view of a bubble is undoubtedly well documented with historical precedents, such doesn’t mean a crash happens immediately. Mean reverting events always occur slowly and then all at once.

Therefore, it is essential to understand that you can take action to mitigate the risk of such a crash.

  • Avoid “herd mentality”Just because everyone else is doing it, doesn’t mean its right.
  • Do your own research and avoid “confirmation bias.” 
  • Develop a sound investment strategy including “risk management” protocals.
  • Diversify your portfolio allocation to include “safer assets.”
  • Control your “greed” and resist the temptation to “get rich quick.”
  • Resist getting “anchoring” to a past values. Such leads to emotional mistakes. 
  • Remember that the larger the deviation from the mean, the greater the reversion will be. Invest accordingly. 

Is Grantham’s view possible? Yes. Will it happen with certainty? No one knows.

However, if a mean reversion comes, the media will tell you, “no one could have seen it coming.”

Of course, hindsight isn’t very useful in protecting your capital.

Portfolio Trade Alert – 01-24-22

Trade Alert For Equity And ETF Model Only

We added a QQQ trade for a technical oversold bounce in the market. We tried to give it a bit of room for a bounce, but such is not to be the case heading into the Fed meeting. We suspect the Fed will begin to back peddle on their hawkish stance, but we will wait for the bounce to manifest and we will buy back into it at that point. There is a very high probability we are getting stopped out at the bottom of this selloff.

Equity Model

  • Sell 100% of QQQ
  • Sell 100% of ASAN and the rest of NFLX (We sold half previous to the earnings miss)

ETF Model

  • Sell 100% of QQQ

Viking Analytics: Weekly Gamma Band Update 1/24/2022

We share the Weekly Gamma Bands Update by Viking Analytics. The report uses options gamma to help you better manage risk and your equity allocations.

The S&P 500 (SPX) fell sharply into the close each of last week’s trading days, fueled in part by re-hedging flows into a monthly option expiration. Our gamma band model enters the week with a 0% allocation to SPX. Our model will not add back exposure to SPX until we see a daily close above the lower gamma level (currently 4,510). The dashed black lines on the chart below show the dates of the recent monthly option expirations. 

The Gamma Band model[1] is a simplified trend following model that is designed to show the effectiveness of tracking various “gamma” levels. This can be viewed conceptually as a risk management tool. When the daily price closes below Gamma Flip level, the model will reduce exposure to avoid price volatility and sell-off risk. If the market closes below what we call the “lower gamma level” (currently near 4,510), the model will reduce the SPX allocation to zero.

The main premise of this model is to maintain high allocations to stocks when risk and corresponding volatility are expected to be low.  For investors who have been conditioned to “buy low and sell high,” it is counter-intuitive to increase allocations when the market rises, but this approach has shown to increase risk-adjusted returns in the back-test.  

The Gamma Band model is one of several indicators that we publish daily in our SPX Report (click here for a sample report).  

With stocks climbing to obscenely high relative valuations, risk management tools have become more important than ever to manage the next big drawdown. We incorporate many options-based signals into our daily stock market algorithms. Please visit our website to learn more about our trading and investing tools.

The Gamma Flip – Background

Many market analysts have noted that daily volatility in the S&P 500 will change when the value of the SPX moves from one gamma regime to another.   Some analysts call this level the “gamma flip.”  The scatterplot below shows how price volatility (on the y-axis) is increasingly lower as the value of SPX rises higher above the Gamma Neutral level (on the right side of the chart).  When the value of the S&P closes lower than Gamma Neutral (to the left of the chart), volatility increases. 

Gamma Band Model – Background

The purpose of the Gamma Band model is to show how tail risk can be reduced by following a few simple rules.  The daily Gamma Band model has improved risk-adjusted returns by over 60% since 2007.  The graph below demonstrates how this approach can limit drawdowns while maintaining good returns.  A quick video introduction of the Gamma Band model can be seen by following this link

Disclaimer

This is for informational purposes only and is not trading advice.  The information contained in this article is subject to our full disclaimer on our website.

[1] The Gamma Band model in our SPX Market Report adjusts position size DAILY based upon the daily closing levels of SPX value and calculated Gamma Neutral.  The Weekly Gamma Band model is shown for illustrative purposes only.

Authors

Erik Lytikainen, the founder of Viking Analytics, has over twenty-five years of experience as a financial analyst, entrepreneur, business developer, and commodity trader. Erik holds an MBA from the University of Maryland and a BS in Mechanical Engineering from Virginia Tech.

Rob McBride has 15+ years of experience in the systematic investment space and is a former Managing Director at a multi-billion dollar hedge fund. Rob has deep experience with market data, software and model building in financial markets.  Rob has a M.S. in Computer Science from the South Dakota School of Mines and Technology.

 


Technical Value Scorecard Report – Week Ending 1/21/2022

The scorecard report uses a series of technical studies to quantify how various sectors, factors, and indexes score on a technical basis versus the S&P 500 (relative value) or versus a more appropriate benchmark, as well as on an absolute stand alone basis (absolute value).

Relative Value Graphs

  • On average, the sectors beat the S&P 500 by over 1%. The stark outperformance is largely because the S&P weighted heavily by Technology which led the market lower. XLK lost 1.15% to the S&P 500, while Staples and Utilities picked up over 4% versus the index. Technology has a 28% weighting while Staples and Utilities account for 8% in aggregate.
  • The performance of sectors and factors/indexes points to an apparent movement toward safety and quality/value.
  • The third table shows excess returns by sector. Note that the more conservative sectors at the top are outperforming the market and are shaded in yellows and greens. The bottom half, excluding energy, is negative and orange and red.  
  • Energy remains grossly overbought versus the market. Staples are also in the same camp.
  • The discretionary sector is becoming very oversold versus the market.
  • The factor/index graph also shows the gravitation toward value and away from growth stocks, i.e., Technology and Momentum. Small-cap and mid-caps continue to trade poorly. Many smaller companies are susceptible to rising prices and wages yet cannot offset higher expenses with higher prices to their clients.

Absolute Value Graphs

  • Starting with the S&P 500 graph on the bottom right, we see the index is well oversold and its lowest point in over a year. While it appears due for a bounce, it is not at -80%, which would give us more confidence a bounce is imminent.
  • Communications are grossly oversold while Technology and Discretionary are close to similar levels. We suspect the market will bounce this coming week, and if we are correct, it will likely be led by these sectors. Assuming it turns higher, we must ascertain if the bounce is sustainable, ultimately propelling the market back to new highs or a chance for investors to reposition for more downside.
  • Energy, Staples, and Utilities are still overbought, while every other sector is oversold.
  • On the bond graph in the upper right, TLT improved on the week, while the junk bond sectors (HYG) did poorly. It appears bonds like stocks are experiencing a flight to quality.
sector
absolute
excess returns

Users Guide

The technical value scorecard report is one of many tools we use to manage our portfolios. This report may send a strong buy or sell signal, but we may not take action if other research and models do not affirm it.

The score is a percentage of the maximum score based on a series of weighted technical indicators for the last 200 trading days. Assets with scores over or under +/-70% are likely to either consolidate or change the trend. When the scatter plot in the sector graphs has an R-squared greater than .60, the signals are more reliable.

The first set of four graphs below are relative value-based, meaning the technical analysis is based on the ratio of the asset to its benchmark. The second set of graphs is computed solely on the price of the asset. At times we present “Sector spaghetti graphs,” which compare momentum and our score over time to provide further current and historical indications of strength or weakness. The square at the end of each squiggle is the current reading. The top right corner is the most bullish, while the bottom left corner is the most bearish.

The ETFs used in the model are as follows:

  • Staples XLP
  • Utilities XLU
  • Health Care XLV
  • Real Estate XLRE
  • Materials XLB
  • Industrials XLI
  • Communications XLC
  • Banking XLF
  • Transportation XTN
  • Energy XLE
  • Discretionary XLY
  • S&P 500 SPY
  • Value IVE
  • Growth IVW
  • Small Cap SLY
  • Mid Cap MDY
  • Momentum MTUM
  • Equal Weighted S&P 500 RSP
  • NASDAQ QQQ
  • Dow Jones DIA
  • Emerg. Markets EEM
  • Foreign Markets EFA
  • IG Corp Bonds LQD
  • High Yield Bonds HYG
  • Long Tsy Bonds TLT
  • Med Term Tsy IEI
  • Mortgages MBB
  • Inflation TIP
  • Inflation Index- XLB, XLE, XLF, and Value (IVE)
  • Deflation Index- XLP, XLU, XLK, and Growth (IWE)

Stocks Bounce Around But End Down In Front Of The Fed

Stocks bounced around Friday as investors look ahead to Wednesday’s important FOMC meeting. Fueling some of the volatility was options expiration and the associated trading, hedging, and rolling of options contracts. Stocks may continue to wildly bounce around going into the Fed meeting; however, many stocks and indexes are grossly oversold and sitting on important support.

Nasdaq QQQ oversold condtion

Further, as we share below, sentiment is stretched to extreme bearish levels. As such, we suspect the market will rally into the Fed meeting. Friday’s frustrating bouncing stock action is well exemplified in the two headlines below, coming an hour apart from each other.

09:22 CT *NADSAQ 100 EXTENDS DROP TO 2%

10:23 CT *NADSAQ 100 ERASES EARLIER LOSSES

Daily Market Commnetary

What To Watch Today

Economy

  • 8:30 a.m. ET: Chicago Fed National Activity Index, December (0.37 in November)
  • 9:45 a.m. ET: Markit U.S. Manufacturing PMI, January preliminary (56.8 expected, 57.7 in December)
  • 9:45 a.m. ET: Markit U.S. Services PMI, January preliminary (54.8 expected, 57.6 in December)
  • 9:45 a.m. ET: Markit U.S. Composite PMI, January preliminary (57.0 in December)

Earnings

Pre-market

  • 6:45 a.m. ET: Halliburton (HAL to report adjusted earnings of 34 cents on revenue of $4.09 billion

Post-market

  • 4:10 p.m. ET: IBM (IBM) to report adjusted earnings of $3.23 per share of $16.00 billion
  • 4:30 p.m. ET: Steel Dynamics Inc. (STLD) to report adjusted earnings of $5.69 on revenue of $5.29 billion

The Week Ahead

The big story this week will be the Fed’s FOMC meeting on Wednesday, and with it, some critical questions will hopefully be answered. For example:

  • Will they end QE now or wait until March?
  • Is a March rate hike probable?
  • Might they suprise markets with a hike now?
  • Is financial stability, i.e. weak markets, a growing concern?
  • Will Fed member(s) dissent, in favor of more aggessive action?
  • Is QT as early as this spring possible?

Corporate earnings will also be front and center this week. Given the large declines from notable companies such as NFLX, GS, and JPM on earnings, we advise paying close attention to upcoming releases. Microsoft and Apple report this week, followed by Google and Amazon next week.

The economic calendar will pick up. We get housing data throughout the week, including New and Existing Home sales and the Case Shiller Home Price Index. Also of note will be the monthly PCE price index. The forecast is for an increase from 5.3% to 5.4%. This is the Fed’s preferred measure of inflation. Personal income and spending will also be helpful to assess better how consumers are coping with inflation.

3-Standard Deviations Below The Mean

As noted in this past weekend’s newsletter, the S&P 500, and the Nasdaq, above, are both trading more than 3-standard deviations below their 50-dma. Such extreme deviations should provide a stock bounce to sell into.

“The selling pressure took the S&P 500 below its trendline support, deep into oversold territory, and well into 3-standard deviations below the mean.”

S&P 500 oversold condtion.

While such does NOT mean the market can not go lower in the short-term, such extreme deviations often precede at least a short-term bounce. In this case, such a bounce would likely take the S&P 500 back to the broken December lows. However, we can not rule out a retest of the October lows first.

Given the more extreme oversold and negative sentiment in the market, a counter-trend bounce to reduce equity exposure with is more likely than not.

Where Are The Bitcoin Bulls

“Where are all the bitcoin bulls predicting $100,000-plus prices now? You know the fine folks pumping bitcoin as some sort of life-changing technology created by a higher life form with DNA ties to ET. You know, the ones rolling up to crypto conferences in used Lamborgini’s (more on Lambo below) and wearing an entry-level Rolex. I could tell you where they aren’t — out there on social media pounding the table on bitcoin’s amazingness and doubling down on their bullish calls. It also doesn’t look like they are buying, either.

Bitcoin had another terrible weekend mostly on regulatory concerns and the broader pullback in tech stocks, with prices cratering to a shade over $35,000 compared to about $43,000 on Jan. 20. Prices are at a six-month low, per Yahoo Finance Plus data, and are down 26% year-to-date — badly lagging the major stock indexes. Sources tell Yahoo Finance cryptocurrency reporter David Hollerith the selling may not yet be done.” – Yahoo Finance

Problems in FAANG Land – Netflix

Netflix opened 20% lower on Friday as they missed growth expectations. Its streaming rival Disney (DIS) is lower in sympathy. Disney will not report earnings for a couple of weeks. The four other FAANG stocks (Apple, Amazon, Google, and FaceBook – Meta) report over the next two weeks. Given the leadership role of this group over the last year, these earnings could prove important to the broader market.

netflix nflx faang
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Bearish Sentiment is Extreme

The first graph below shows the Hulbert Sentiment Index is now at its most bearish reading since the Pandemic started in 2020. The AAII Investor bullish minus Bearish Sentiment Index, in the second graph, is also nearing similar extremes. While the equity markets do not feel good, such low sentiment should lead to a bounce. We need to ask whether the bounce will result in new highs and keep the bullish trend intact, or does a bounce provide us a chance to reposition to a more conservative stance. Currently, we are in the latter camp.

bearish sentiment
sentiment bulls bears

Our weekly technical composite is also pushing into more extreme oversold territory. This gauge is published weekly with all of our SENTIMENT indicators at Simplevisor.com

Technical composite.

Inflation Isn’t Good For Stock Valuations

The graph below, courtesy of the Daily Shot, shows the correlation between inflation and price to earnings. It’s worth noting the correlation is good at .4428, and the current reading in red is well above the trend. We have harped on whether or not companies can pass on higher costs to consumers. As we have seen, albeit early in earnings season, many companies fail to increase prices enough to offset higher wages and input prices. If inflation remains persistent at or near current levels, we suspect valuations could fall meaningfully. If inflation can fall back below five percent, the exceptionally high current valuation would not be as unreasonable per the chart.

valuation inflation S&P 500

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Rate Hikes: The Fed Won’t Hike Nearly As Much As Expected

Rate hikes will be far fewer than the markets currently expect.

Currently, with inflation pushing more than 7%, the highest level in decades, it is not surprising to see the market “pricing in” a more aggressive rate-hiking campaign by the Federal Reserve. As shown via the Daily Shot, the markets expect a certainty of 4-rate hikes in 2022.

Implied Fed Funds Level

As Michael Lebowitz previously discussed, such is essential because the market tends to UNDER-estimate the Fed. To wit:

“The graph below shows how much the Fed Funds futures market consistently over or underestimates what the Fed does. The green areas and dotted lines quantify how much the market underestimates how much the Fed ultimately reduces rates. The red shaded areas and dotted lines are akin to today’s potential rising rate situation. They show estimates for rate cuts fall short of the Fed’s actual actions.”

Market consistently underestimates the Fed.

As shown in the graphs above, the market has underestimated the Fed’s intent to raise and lower rates every single time they changed the course of monetary policy meaningfully. The dotted lines highlight that the market has underestimated rate cuts by 1% on average, but at times during the last three rate-cutting cycles, market expectations were short by over 2%. The market has underestimated rate increases by about 35 basis points on average.”

Notably, the market’s margin of error for rate hikes is more accurate than when the Fed is cutting.

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Walking Into A Liquidity Trap

In July 2020, we suggested the massive surge of monetary liquidity would lead to a rise in inflation in roughly 9-months. To wit:

“While ‘deflation’ is the overarching threat longer-term, the Fed is also potentially confronted by a shorter-term “inflationary” threat.

The ‘unlimited QE’ bazooka is dependent on the Fed needing to monetize the deficit to support economic growth.  However, if the goals of full employment and economic growth quickly come to fruition, the Fed will face an ‘inflationary surge.”’

Inflation and M2 original

I have updated that chart below. Not surprisingly, inflation surged almost exactly 9-months later. So while many, including the Fed, are suggesting inflation will remain rampant in 2022, the M2 Money Stock indicator is suggesting “disinflation” is more likely.

Inflation and M2 updated

As we stated in 2020:

Should such an outcome occur, it will push the Fed into a very tight corner. The surge in inflation will limit the ability to continue “unlimited QE” without further exacerbating inflation.

It’s a no-win situation for the Fed.

As shown, with inflation running well above their target of 2%, much less the long-term average of 2.7%, the Fed is now getting pushed into aggressively hiking rates.

Inflation above and below Feds target rate

The problem, of course, is that deflation pressures are likely to return sooner than expected, given the contraction in liquidity. Such was a point made by David Rosenberg recently.

“This time next year, demand is going to be quite a bit weaker. Recurring large rounds of fiscal stimulus have been the key component of demand growth, and that is going to decline. People have not appreciated the extent of the fiscal boost on aggregate demand. That [demand]is going to dissipate substantially. At the same time, supply will come back on stream. We know that because that is what history tells us.

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Fed Rate Hikes Likely Short-Lived

David is correct. The massive liquidity dump created a demand surge amid a shutdown of the economy due to the Covid pandemic. In the future, both will reverse. We also know that disinflationary pressures will resurface due to the labor force participation rate. While the employment rate may be nearing the Fed’s target of “full employment,” the participation rate tells a very different story.

Labor force participation rate

If the participation rate is correct and remains low, the economy is weaker than headline numbers suggest. Moreover, if the Fed aggressively tightens monetary policy in an already overleveraged economy, such will likely slow growth rates quicker than anticipated.

That market is already suspecting such is the case predicting an end to rate hikes by the end of 2022.

Implied Fed funds target rate

That last point is essential.

As shown below, since 1982, every time the Fed has started a rate hike campaign, there were two outcomes.

  1. Each round of rate hikes ended in a recession, crisis, or bear market; and,
  2. The level at which higher rates sparked an economic or market crisis was consistently lower than the last.
Fewer rate hikes than expected.

Again, with a market and economy more heavily levered than ever, the peak of the Fed’s rate hike cycle will likely be lower once again.

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A Policy Mistake In The Making

As noted, the Fed is in a tough spot. While they should be aggressively tightening policy, they are also aware of the ramifications of losing market stability.

If the Fed raises rates to break the inflation surge, such also retards economic growth. Higher rates historically equate to more negative market outcomes. Such is particularly true when valuations become elevated and low rates support the bullish thesis.

Inflation Surge, Inflation Surge Pushes Fed To Hike Rates Faster

The most significant risk to investors is the Fed’s ability to “jawbone” the markets to maintain financial stability when reversing monetary accommodation. Such is the same environment we saw in 2018 where the Fed uttered the words “we are nowhere close to the neutral rate.”

Two months later, and 20% lower in the markets, Jerome Powell discovered he had magically reached the “neutral rate” and needed to ease off on monetary tightening.

Inflation Surge, Inflation Surge Pushes Fed To Hike Rates Faster

Of course, in 2018, Powell didn’t have 7% inflation to deal with.

This time could indeed be different.

The Lesser Of Two Evils

Once again, bond yields are confounding the “bears” by remaining low while inflation surges. As noted, the bond market suggests that the surge in economic growth and inflation will fade along with monetary liquidity. As we said previously:

“However, over the last decade, a reversal in Fed policy has repeatedly provided bond-buying opportunities. In the past, rates rose during QE programs as money rotated out of the “safety of bonds” back into equities (risk-on.).

When those programs ended, rates fell as investors reversed their risk preferences.

Fed funds and effect on yields.

Even before the Fed begins to taper and hike rates, investors’ risk preferences are changing. The Fed will likely exacerbate the problem further by removing monetary accommodation precisely at the wrong time.

While the Fed likely understands they should not be aggressively hiking rates, the consensus view is they will remain on their current path. While raising rates will accelerate a potential recession and a significant market correction, it might be the ‘lesser of two evils from the Fed’s perspective. 

Being caught near the “zero bound” at the onset of a recession leaves few options to stabilize an economic decline.

Unfortunately, we doubt the Fed has the stomach for “financial instability.” As such, we doubt they will hike rates as much as the market currently expects.

Five From the SimpleVisor Screening Tool

Our weekly scan idea comes from a subscriber’s request for a second week in a row. In this case, he is looking for guidance on using the SimpleVisor stock scanning tool to find Value Stocks.

We encourage you to send us a note with any scan requests you may have.  

This week’s article provides five S&P 500 value stocks from the SimpleVisor Screener. This report is slightly different from prior reports as the primary purpose is to walk you through how we used the Screener tool to find our five stocks.

Using SimpleVisor

The SimpleVisor Screener is found in the menu to the left under Ideas and Screener. The function allows you to save screens and create new ones.

The first step is to select the parameters or filters to screen stocks. As we show below, there are four categories to choose from: Descriptive, Fundamentals, Performance, and Technical. 

Next, look through the options in each of the four categories and make selections. You can choose as many or as few of the options as you like. The more factors you select, the fewer the resulting stocks, but the more refined your results will be. We will be adding a customizable field, so you can choose any range of options to refine your search further.

Once you finish selecting the options, click on Filter (blue). The area with the filter options will compress, and the results will appear. You can click through the four broad categories to see the stocks and their respective data. If you want to make changes to the filters, click on the down arrow to the left of Filters, and the box with scanning options will reappear. Make changes and hit Filter again for the new results.

If you like the scan and would like to save it, click the green Save As Screen button to the right of the blue Filter button. It will ask you for a name and description. Upon saving it, you can recall it in the Saved Screens box in the upper left corner. If you like the scan, you can add it to a Portfolio Watchlist and track how the group of stocks trades.

If your screen yields too many results, you can limit the results with the Sort and Limit functions. In the example below, we restrict the scan to the top 20 results sorted by Momentum. Hit filter to run this function. You can then sort results by clicking on any column header in the results table.

Value Screen

Now, on to this week’s results.

The screenshot below shows the filters we chose for this Value scan.

Screening Criteria

The first table below provides an overview of our results. The following three tables highlight the technical, fundamentals, and performance of the five stocks.

Technicals

Fundamentals

Performance

As shown above, our scan resulted in strong value selections. All five stocks have a P/S ratio of less than 1 compared to 3.20 for the S&P 500. Four of the five have forward P/E ratios of less than 10, less than half of the S&P 500. We used Monhanram and Pitroski scores to refine the search further to ensure we have financially healthy companies.

Company Summaries (all descriptions courtesy Zacks)

DOW Chemical (DOW)

Dow Inc. is a material science company, providing a world-class portfolio of advanced, sustainable, and leading-edge products. It recorded revenues of around $38.5 billion in 2020, offers a vast range of differentiated products and solutions across high-growth market segments such as packaging, infrastructure, and consumer care.

Its shares trade at the lowest PEG ratio on the list. This is due to the combination of its low P/E ratio (7.88) and lofty 3 to 5-year earnings growth expectations (~66%). In addition, the stock offers a healthy dividend yield (4.7%) and delivers the highest ROE of the five companies.

Fedex Corporation (FDX)

Based in Memphis, TN, FedEx Corporation is the leader in global express delivery services. The company, founded in 1971, provides a broad portfolio of transportation, e-commerce and business services through companies competing collectively, operating independently, and managed collaboratively, under the FedEx brand.

After a rangebound 2021 that ended essentially flat, FDX trades at a reasonable P/E of 14.3. FDX is enjoying strong demand and pricing power throughout the pandemic as ordering online becomes a larger share of consumption. That said, energy and payroll expenses have been rising as well, offsetting increasing revenue. FDX will likely continue seeing strong demand and solid earnings growth as supply chains recover and retailers re-build inventory.

General Motors (GM)

One of the world’s largest automakers, General Motors leads the U.S. market share with 17.1% of the industry’s total sales in 2020. From going bankrupt in 2009 to becoming one of the world’s best-run car companies, General Motors has indeed come a long way.

GM is the largest option by market cap and trades at the 2nd lowest P/E (8.2). As a highly capital-intensive company, it carries the highest Debt to Equity ratio (180%). GM’s push for the EV market presents an opportunity for the automaker to gain market share and deliver outsized returns to shareholders at deep value. Car sales tend to fluctuate with economic activity; therefore, its value may falter if we enter a recession.

Everest RE (RE)

Founded in 1973 and based in Hamilton, Bermuda, Everest Re Group Ltd. writes property and casualty, reinsurance and insurance in the U.S, Bermuda and international markets. The company also offers other innovative products like excess and surplus lines of insurance.

RE is the smallest of the screen results and trades at the second-lowest PEG ratio (0.19), with expectations for 3 to 5-year EPS growth of ~60%. In addition, the company has a relatively low D/E ratio of 19.2%, paired with solid financial liquidity.

Westrock (WRK)

Headquartered in Norcross, GA, WestRock is a multinational provider of paper and packaging solutions for consumer and corrugated packaging markets. The company is one of the largest integrated producers of containerboard by tons produced, and one of the largest producers of high graphics preprinted linerboard on the basis of net sales in North America. It is also one of the largest paper recyclers in North America.

WRK trades at the highest trailing P/E yet has the 2nd lowest forward P/E on the list, which indicates that WRK could see relatively strong earnings growth in FY22. Further, the stock trades at a very low P/S ratio of 0.66. It appears to be a good mid-cap value option.

 Five for Friday

Five for Friday uses stock screens to produce five stocks that we expect will outperform if a particular investment theme plays out in the future. Investment themes may be relevant to the current or expected market, industry, and/or economic trends. Investment themes may not always represent our current forecast. 

Disclosure

This report is not a recommendation to buy or sell the named securities. We intend to elicit ideas about stocks meeting specific criteria and investment themes. Please read our disclosures carefully and do your own research before investing.

Portfolio Trade Alert – 01-21-22

Trade Alert For Equity & ETF Model Only

As shown below, after a rash of selling over the last two weeks, the Nasdaq is extremely oversold and 3-standard deviations below its 50-dma. Such extreme oversold conditions can’t, and don’t, last for long. With AAII sentiment now extremely bearish, investor positioning negative, and technicals stretched, we think there is a decent setup for a tradeable bounce into next week.

This morning we are adding a 5% position in QQQ for a bounce to the previous trend line. We are carrying a 2% loss as our stop level.

Also, we have been stopped out of three other positions in our portfolio: ASAN, NFLX, and ADBE. However, given the extreme oversold condition on those positions we are looking for a rally to sell those positions into. Also, on that rally, we will reduce GOOG and AMZN as well.

Overall we are looking to reduce portfolio exposure to 50% of the portfolio during the next rally.

  • Buy 5% of the Portfolio in QQQ

Peleton – Another Lockdown Winner is Losing

Over the past year, many stocks that benefited from the Pandemic lockdowns have given up substantial gains. One of the more popular among investors, Peleton (PTON), got hid particularly hard on Thursday. Peleton announced they are halting the production of its bikes and treadmills. Per CNBC: “The company said in a confidential presentation dated Jan. 10 that demand for its connected fitness equipment has faced a “significant reduction” around the world due to shoppers’ price sensitivity and amplified competitor activity.” The graph below from Charlie Bilello shows the amazing journey Peleton shares have been on since early 2020.

pton peleton

Daily Market Commnetary

What To Watch Today

Economy

  • 10:00 a.m. ET: Leading Index, December (0.8% expected, 1.1% prior)

Earnings

Pre-market

  • 7:00 a.m. ET: Schlumberger (SLBto report adjusted earnings of 39 cents a share of $6.09 billion
  • 7:30 a.m. ET: Ally Financial (ALLYto report adjusted earnings of $1.97 on revenue of $2.07 billion

Market Selloff Continues Into Options Expiration

While the market attempted an oversold rally yesterday morning, it failed miserably in the second half of the trading session as Peleton was getting crushed. As we discussed yesterday, the market is very oversold short-term and is due for a sellable bounce. However, the market has not been able to string a couple of positive days together for some selling pressure relief.

As shown, the market did take out the December lows violating important neckline support. However, it has also completed a 61.8% retracement of the rally from the October lows and has pushed our indicators into more extreme oversold territory. With the market well into 3-standard deviations below the 50-dma, a counter-trend rally remains a high probability. While selloffs are never fun, try not to let emotion drive investment decisions and sell into rallies as they come.

SP500 index chart
Chart Courtesy Of SimpleVisor

More on Homebuilders (XHB)

In yesterday’s Commentary, we wrote how the confluence of inflation, higher mortgage rates, and a surge in new home construction may pose trouble for homebuilders (XHB). We just stumbled across the graph below which puts more perspective on the supply of new homes coming to market in the next 6-9 months. The graph shows there are significantly more new homes coming to market versus those recently completed. Prior to the last few months, it was a very instance when such a circumstance occurred.

homebuilders new homes

Can Oil Prices Temper Inflation?

The question seems crazy with crude oil up 30% in recent months, yet the charts below make the case inflation should fall if the historical relationship between oil and inflation holds true. The first two graphs show the relationship between the annual changes in oil and CPI. The statistical relationship is strong with an R-squared of .64. Recent instances are well outside of the trend. Per the trend, oil prices should be up 250% over the last year or CPI should be 3%. The last graph forecasts future CPI given oil prices. The graph assumes crude oil stays at $80 and calculates its annual change moving forward. Toward late 2022, the annual change will be zero. Per the trend, expect 2% CPI. However, there are many reasons, beyond oil that inflation is high.

crude oil prices
cpi and crude oil
future crude oil prices

Debt = Consumption

Over the past few decades, we have increasingly become more dependent on debt to drive consumption. The first graph below from Brett Freeze shows the strong correlation between the change in debt and its contribution to demand. As a result of this symbiotic relationship, more consumption requires increasingly more debt and cheaper debt to induce more consumption. Further, those conditions are also needed to roll maturing debt without bankruptcies. The second graph shows the continual downtrend in yields over the last 30 years. Note that almost every local peak in yields is followed by a lower peak. As the ten-year yield reaches 2%, we once again are running into the problem where higher yields reduce consumption and make rolling over maturing debt more costly. Essentially interest rates are a strong regulator of economic activity, and that regulator is getting closer and closer to being tripped once again.

consumer spending consumption debt

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Wage Increase – The Good, Bad, & Ugly

Wage increases are undoubtedly good for workers. However, as we will explore, wage increases are a double-edged sword that often has more negative economic consequences.

Importantly, wage increases are undoubtedly good for consumers. There is no arguing that point. After all, who doesn’t want to make more money for doing their job? However, as we discussed in “$15/Hour Cost & Consequences,” wage increases are not a “free lunch.” To wit:

“Labor costs are the highest expense to any business. It’s not just the actual wages, but also payroll taxes, benefits, paid vacation, healthcare, etc. Employees are not cheap, and that cost must be covered by the goods or services sold. Therefore, if the consumer refuses to pay more, the costs have to be offset elsewhere.

For example, after Walmart and Target announced higher minimum wages, layoffs occurred and cashiers were replaced with self-checkout counters. Restaurants added surcharges to help cover the costs of higher wages, a “tax” on consumers, and chains like McDonald’s, and Panera Bread, replaced cashiers with apps and ordering kiosks.”

The CBO also reported similarly:

  • By increasing the cost of employing low-wage workers, a higher minimum wage generally leads employers to reduce the size of their workforce.
  • The effects on employment would also cause changes in prices and in the use of different types of labor and capital.
  • By boosting the income of low-wage workers who keep their jobs, a higher minimum wage raises their families’ real income, lifting some of those families out of poverty. However, real income falls for some families because other workers lose their jobs, business owners lose income, and prices increase for consumers. For those reasons, the net effect of a minimum-wage increase is to reduce average real family income.

Read that last sentence again.

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Wage Increase – Good Until You Get Inflation

As noted, “the net effect of increasing wages,” if not broad-based, “reduces average real family income.” The reason is “inflation.”

The current wage increase focuses primarily on lower-tier jobs such as health care, leisure and hospitality, and restaurants. Labor turnover is exceptionally high as employees jump jobs for higher pay. As labor costs rise, so do prices, as businesses pass along higher costs to consumers.

Compensation wage and salary disbursements.

The surge in wages is certainly notable until you factor in inflation. However, as shown below, real wages for the bottom 80% of income earners are negative.

Wages bottom 80% of workers

In other words, the increases in their cost of living are outpacing their incomes. As such, they have to turn to credit to fill the gap. (Such is why we have seen a surge in credit usage in recent months as liquidity drains from the system.)

(The chart below shows the gap between real incomes plus savings and the cost of living. It currently requires $4531 annually in debt to fill the cost of living gap.)

Consumer spending gap and debt.

When real wages fall short, it ultimately weighs on consumption.

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Wage Increase – The Bad Of Shrinking Margins

Employers are in a tough spot when it comes to protecting profit margins. As noted in “Inflation Surge,” the massive spread between input and consumer prices suggests corporations cannot pass along inflation entirely. Such means there is considerable pressure on profit margins in the quarters ahead.

Spread between PPI and CPI vs Net Profit Margins.

While input costs are on the rise, the single most significant cost to businesses, as noted above, is labor. The NFIB monthly survey shows labor costs are one of the biggest concerns of small businesses. Importantly, note that while they understand they will pay more for labor, increasing wages will mark the peak of economic growth.

NFIB planning to raise compensation versus economy

However, higher costs (input prices, labor, benefits, etc.) also directly affect profits and earnings.

Sharp increases in compensation vs earnings

As the CBO study noted, employers will respond to higher labor costs.

  • Higher wages increase the cost to employers of producing goods and services. The employers pass some of those increased costs on to consumers in the form of higher prices, and those higher prices, in turn, lead consumers to purchase fewer goods and services.
  • The employers consequently produce fewer goods and services, so they reduce their employment of both low-wage workers and higher-wage workers.
  • Lastly, when the cost of employing low-wage workers goes up, the relative cost of employing higher-wage workers or investing in machines and technology goes down.

Read that last sentence again.

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The Ugly Leading Indicator Of Recessions

What economists tend to forget about rising wages is that businesses will respond to protect profit margins. Wages and costs rise, companies lay off workers, consumption decreases, and the economy slips into recession. There is a very high correlation between rising compensation and economic growth.

Rising compensation and the economy

Such is because earnings are a function of economic growth, which is 70% comprised of consumer spending. Therefore, as higher costs get passed onto consumers in the form of inflation, their disposable income shrinks. In turn, they spend less, which leads to economic and earnings contraction.

Change in real disposable incomes vs S&P 500

To explain this, let’s revisit what the CBO said about the macroeconomic effects of higher wages.

  • Reductions in employment would initially be concentrated at firms where higher prices quickly reduce sales.
  • Over a longer period, however, more firms would replace low-wage workers with higher-wage workers, machines, and other substitutes.
  • A higher minimum wage shifts income from higher-wage consumers and business owners to low-wage workers. Because low-wage workers tend to spend a larger fraction of their earnings, some firms see increased demand for their goods and services, which boosts the employment of low-wage workers and higher-wage workers alike.
  • A decrease in the number of low-wage workers reduces the productivity of machines, buildings, and other capital goods. Although some businesses use more capital goods if labor is more expensive, that reduced productivity discourages other businesses from constructing new buildings and buying new machines. That reduction in capital reduces low-wage workers’ productivity, which leads to further reductions in their employment.

Our last chart confirms the CBO analysis.

Economic prosperity - 5-year average of GDP, Productivity and Wages

Conclusion

The surge in wages resulted from the confluence of $5 trillion in liquidity, creating a massive level of artificial demand with production shut down. With that liquidity reversing, demand will fall as higher costs impact corporate profitability who, in turn, react by curtailing employment. Such will lead to an eventual recession.

As shown in the chart above, rising wage growth has also preceded recessions in the economy. This time will likely be no different.

The unintended consequences of an artificial surge in demand in a weak economic environment are not inconsequential. For investors, 2022 will likely be a year of disappointment in earnings and economic growth expectations. Those disappointments will likely become magnified by the Fed’s coming policy mistake.

Portfolio Trade Alert – 01-20-22

Trade Alert For Equity and ETF Models

We have been waiting for a rally in the market to reduce equity exposure a bit further. Today’s rally was expected but remains very weak and may not stick. However, if we get some follow-through tomorrow and next week heading into the Fed meeting we will likely reduce equity exposure further.

Equity Model

  • Sell 1% of Adobe (ADBE)
  • Reduce Netflix (NFLX) by 1%

ETF Model

  • Sell 2% of SPDR Technology ETF (XLK)

Small-Cap Stocks Struggle Again

The Russell 2000 Small-Cap Stock index continues to struggle. On Wednesday, it fell 1.56% and is now down 9.2% for the year. The index is flat since the beginning of 2021. The S&P 500 is up about 30% since 2021. Many Russell 2000 Small-Cap stocks struggle in the current environment. They tend to lack pricing power, therefore are unable to offset higher wages, interest rates, and inflation. If the economy weakens and the Fed raises rates, we suspect many Small-Cap stocks will continue to struggle versus larger-cap stocks. Also from a technical perspective, the graph below shows the Russell 2000 is on the verge of breaking lower from its one-year trading range.

russell 2000 small-cap stocks
Daily Market Commnetary

What To Watch Today

Economy

  • 8:30 a.m. ET: Initial Jobless Claims, week ended January 15 (225,000 expected, 230,000 during prior week)
  • 8:30 a.m. ET: Continuing Claims, week ended January 15 (1.563 million expected, 1.559 million prior week)
  • 8:30 a.m. ET: Philadelphia Fed Business Outlook, January (19.0 expected, 15.4 prior)
  • 10:00 a.m. ET: Existing Home Sales, December (6.43 million expected, 6.46 million during prior month)
  • 10:00 a.m. ET: Existing Home Sales, month over month, December (-0.5% expected, 1.9% during prior month)

Earnings

Pre-market

  • 6:55 a.m. ET: Travelers (TRV) to report adjusted earnings of $3.84 on revenue of $8.69 billion
  • 7:00 a.m. ET: American Airlines (AAL) to report adjusted loss of $1.48 on revenue of $9.41 billion
  • 7:35 a.m. ET: Northern Trust (NTRS) to report adjusted earnings of $1.81 on revenue of $1.65 billion

Post-market

  • 4:00 p.m. ET: Netflix (NFLX) to report adjusted earnings of 88 cents on revenue of $7.71 billion

Market Very Oversold – Look For A Bounce To Rebalance

Notwithstanding the small-cap stock struggle, the border market is now deeply oversold and extended to the downside. As shown below, the S&P 500 is now trading more than 2-standard deviations below the 50-dma with our indicators now in deeply oversold conditions. Such is usually a good setup for a counter-trend bounce.

While the market selloff has been fairly brutal, it has not violated support at the December lows, nor the uptrend. Therefore, be careful making emotionally driven changes to portfolios. Look for a counter-trend rally back to the 50-dma to start rebalancing risk and raising cash levels.

Chart Courtesy of SimpleVisor.com

Three Minutes On Markets

Why Fed rate hikes aren’t good for Energy stocks.

New Home Construction, Inflation, and Homebuilder Stocks

The picture below shows that double-digit inflation affects every primary product used to construct new homes. The prime question facing homebuilders and makers of those goods is whether they can pass higher costs on to new homebuyers. Further, adding to the pressure on homebuilders is higher mortgage rates. Homebuyer affordability has fallen by nearly 10% over the last few months due to higher mortgage rates, leaving buyers with less wiggle room to pay up for a house.

inflation

HomeBuilders (XHB) – Housing Starts and Permits

Wednesday’s data on housing starts and new building permits were robust. Starts reached 1.702 million, a 12% increase from the prior month. Permits, a good proxy for future starts, rose 9.1% from the preceding month. The data point to an increase in new homes available in the second half of 2022.

The SimpleVisor graph below shows XHB, the homebuilder ETF, is up over 50% from the pre-pandemic highs. Given the combination of inflation and higher mortgage rates, along with the sharply rising future supply of new homes, we would exercise caution trading this sector and many of its underlying stocks.

homebuilders xhb

Four Interest Rate Hikes in 2022

The Fed Funds Futures chart below shows there are four 25bp interest rate hikes priced into the market for 2022. The blue bars represent the month when the first hike or each additional hike is fully priced in. According to the graph, we could have two rate hikes before summer starts and a total of six through the summer of 2023. While we show the first expected hike in April, it is actually in March. due to the timing of the March FOMC meeting and the fact that Fed Funds contracts cover the entire month. The math actually implies a 20% chance the Fed raises rates by 50bps at the March meeting.

interest rate hikes fed funds

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Consumer Spending Decline Makes A Recession More Likely

“How are you feeling?”  That’s often the way we greet people these days.  As the Omicron variant becomes widespread, negatively impacting most Americans’ lives.  Add worries about inflation to the mix. Finally, some schools are going back to online learning, forcing parents to work from home with kids at home. Consumers are stressed, anxious, and uncertain about the future. If the drop in consumer sentiment continues, retail sales will fall. 

Consumer spending is 70% of GDP.  Thus, if consumer spending continues to decline, a recession becomes more likely.  The Federal Reserve plan to speed up monetary tapering and start interest rate increases will add momentum to a decline in economic activity. Rising costs of credit cards, mortgages, and personal loans will trigger a drop in consumers applying for new loans.  As credit tightens, consumers will pull back on spending. Let’s look at trends in consumer sentiment, spending, and inflation to see why economic headwinds are building.

Consumer Sentiment Falls Along with Retail Sales

A significant drop in consumer sentiment reflects the consumer’s plight.  The University of Michigan January consumer sentiment indicator printed 68.8%. The drop is the second-largest drop in ten years. The survey found the number one consumer issue was surging inflation.  A third of consumers felt they were financially worse off than a year ago, near the same level as April 2020.

inflation consumer sentiment

Sources: University of Michigan, Bloomberg – 1/15/22

Consumers’ unease with their financial condition was recently expressed in a substantial decline in retail sales for December of 1.9%.  Buyers before the Omicron variant started buying from pent-up demand for goods in particular.  That pent-up demand buying seems to be waning.

retail sales

Sources: Commerce Department, New York Times – 1/15/22

Twenty-five percent of respondents said their reduction in spending was due to inflation.

Also, retail sales fell fast due to buyer concerns about leaving home.   Consumer mobility indicated by Google mobility indicators shows a drop off in outside of the home trips.  Plus, the Langer Buying Climate index declined as consumers continued to see the present buying environment worsen due to both Omicron infection risk and inflation. A double whammy for retail sales. While spring may bring a decline in Omicron virus infections, inflation is likely to persist.

retail sales buying climate

The Langer Index posted its most significant one-week drop in 36 years!  The critical component causing the considerable drop was consumer concerns about this being a ‘good time to buy things,’ showing a 6.9% decline. The component drop was the largest since 1985. 

Will Inflation Persist Driving Consumer Sentiment Lower?

Yes. This is the short answer from a macro perspective. The Federal Reserve has increased the money supply significantly above the pre-pandemic trajectory as the following chart shows a surge in the M2 money supply.  The second chart shows a lag of 2 to 3 years in inflation after shifts in the money supply.  So, on a macro basis, inflation is likely to be a continuing issue.

inflation sentiment

Sources: St. Louis Federal Reserve, The Daily Shot – 1/12/22

money supply inflation

Sources: Labor Department, Haver Analytics, The Daily Shot – 1/7/22

Several components are likely to keep inflation high even as waning demand in other sectors may decrease inflation.  A significant persistent inflation sector is housing.

Housing Costs Fuel Inflation

Housing is the most expensive cost for most families.  An increase in shelter costs hits family budgets hard. As millions of workers were forced to work from home during the pandemic, the demand for housing outside major core cities soared.  Owner equivalent rent (OER) is how the Bureau of Labor Statistics computes home costs to compare to rent.  Note the surge in OER and rent for 2021 and the Nomura forecast for 2022.

nomura housing

Source: Apartment List, Bureau of Labor Statistics, Nomura, The Daily Shot – 1/14/22

Along with housing inflation, price increases are becoming embedded in the broad-based economy.

Inflation Becoming Embedded into the Economy

The headline Consumer Price Index (CPI) posted a 7.0% increase for December 2021. A 20 year high.  Consumers feel the price pinch in the cost of gas, food, new and used vehicles, and furniture.  The following heat map shows how inflation is increasing across multiple sectors of the economy.

consumer inflation

Sources: Bureau of Labor Statistics, The Daily Shot – 1/13/22

The components of most concern to consumers: housing, food, and energy, are excluded or minimized in key indicators that the Federal Reserve uses to measure inflation like the Core CPI or Trimmed CPI.  This lack of focus on what is essential to consumers and affecting their buying habits is a significant policy-making blind spot. As such the focus on lower inflation figures caused the Fed to underestimate inflation related to buying power. As a result, the Fed must slam on interest rate brakes to grab executive and consumer attention that they are serious about controlling inflation.

Consumer buying power is declining as well due to negative real wage growth.

Real Wage Growth is Negative

Consumers are rightly worried about their financial future.  Worker real wage growth is negative. Real wage growth accounting for inflation was – 1.5% for December. The following chart from BOC Research shows using Federal Reserve data that inflation is ‘eating into’ wages in the U.S.

wages

Sources: BOC Research, Federal Reserve of Atlanta, The Daily Shot – 1/7/22

Consumers see high prices and look at their paychecks, concluding they are not keeping up with costs.  They are right.  Consumer perception of inflation limiting their buying power drives reluctance to spend. Buyer frustration with high prices is a critical factor in the December 24.6% drop in vehicle sales. Also, rent prices are beginning to decline in many major U.S. markets, as renters decide to stay in their present apartment. 

Will Inflation Go Back to Pre-Pandemic Levels?

Not likely.  A new trend is emerging globally, affecting inflation that may persist for many years – green inflation.  The ability of the energy sector to create new renewable sources of power while continuing to supply the needs of world energy users is tight.  Not enough investment in green technologies is happening, according to Isabel Schnabel, executive board member at the European Central Bank.  In a recent Bloomberg interview, she further stated that fossil fuel prices might stay elevated to make green investments possible.  Plus, higher fossil fuel prices will force corporations and consumers to shift to renewable sources quicker.

As fuel costs feed into the cost of transporting goods, inflation may stay elevated for some time.  Further, other transportation issues cause concern about inflation. Shipping unloading bottlenecks continue at West Coast ports, causing a container’s cost to rise incredibly from $1,400 in February 2020 from Shanghai to Los Angeles to $10,200 in December. As demand falls, the number of containers to be unloaded will fall, but it takes a long time to solve the bottleneck problem as trucking companies can’t hire enough drivers.

Fed Liquidity Tightening, Consumer Spending Decline Increases Chances of Recession

The latest Fed Funds futures report shows growing investor sentiment that rate increases could begin as soon as March of this year. The recent Federal Reserve FOMC meeting minutes spooked the markets when it became apparent that the Fed was turning more serious about persistent inflation.  Forecasters expect at least three rate increases this year, maybe four.  So, a liquidity crunch will start sooner and faster than investors had expected just two months ago.

The decline in consumer sentiment, we have noted in this post, will drive a drop in consumer spending.  The combination of liquidity tightening with a fall in consumer spending will create downward momentum in economic activity.  As a result, a decline in economic activity will result in a recession.

Mitigating the possibility of a recession is the surge in hiring and construction from the $1.8B infrastructure spending bill approved by Congress.  Another factor is the waning of Omicron in the spring, so mobility and retail sales move up. 

But the Fed is in a difficult position as the economy seems to be slowing due to inflation, the Omicron virus continuing to spread, and supply bottlenecks.   Mohamed El-Erian, Chief Economist at Allianz, offers this observation on the impact of inflation on consumers and their sense of financial insecurity in a January 12th tweet:

“Inflation isn’t just a number to be managed by the Fed that few Americans know well. It also influences economic, social, and political outcomes.  When its high, as it is today, it fuels financial insecurity among the most vulnerable, both immediately and over time.”

Goldman Sachs Shares Tumble as Wages Soar

Shares of Goldman Sachs tumbled Tuesday as earnings fell $1.30 short of expectations and were flat versus last year’s earnings. The 7% decline in its shares is the largest since June 2020, as shown below. Goldman Sachs shares follow JPM’s 5% tumble last week on its weaker than expected earnings.

Like some other large banks such as JPM and Citi, operating expenses are weighing on earnings. Goldman Sachs expenses soared 33% last year, with compensation and benefits being the largest contributor. Expenses would have declined 9% without the changes in wages. We suspect many more companies will fall short on earnings as they can’t offset rising wages with revenue.

Daily Market Commnetary

What To Watch Today

Economy

  • 7:00 a.m. ET: MBA Mortgage Applications, week ended January 14 (1.4% during prior week)
  • 8:30 a.m. ET: Building Permits, month-over-month, December (-0.8% expected, 3.6% during prior month, upwardly revised to 3.9%)
  • 8:30 a.m. ET: Housing Starts, month-over-month, December (-1.7% expected, 11.8% during prior month)

Earnings

Pre-market

  • 5:55 a.m. ET: UnitedHealth (UNHto report adjusted earnings of $4.31 on revenue of $72.95 billion
  • 6:45 a.m. ET: Bank of America (BACto report adjusted earnings of 76 cents on revenue of $22.23 billion
  • 7:00 a.m. ET: Procter & Gamble (PG) to report adjusted earnings of $1.65 on revenue of $30.35 billion
  • 7:30 a.m. ET: Morgan Stanley (MS) to report adjusted earnings of $1.94 on revenue of $14.44 billion
  • 7:30 a.m. ET: State Street (STT) to report adjusted earnings of $1.88 on revenue of $3.00 billion

Post-market

  • 4:20 p.m. ET: Discover Financial (DFSto report adjusted earnings of $3.76 on revenue of $3.01 billion
  • 4:30 p.m. ET: United Airlines (UALto report adjusted losses of $2.11 on revenue of $7.95 billion

Be Careful Selling The Dip

Despite the tumble in Goldman Sachs shares, and banks in general, as well as most everything else particularly in the tech space, be careful not to panic sell the dip. As shown below, via TheMarketEar, the extreme spread between Russell 1000 growth and SPX realized volatility is extreme. The current level was only seen during the COVID era and the 2000 bubble.

Spread between Russell 1000 and teh S&P 500

Furthermore, the Nasdaq is very stressed and volatility is at levels normally where at least a short-term bottom forms. The chart is based on “at the money” options (the two nearest in-the-money and out-of-the-money puts and calls for the next four weekly expirations). This is how VIX was calculated “back in the days” and it is trading very squeezed again. (H/t TheMarketEar)

Nasdaq volatility

Another Sign of a Bubble

The graph below from Charles Schwab shows that 15% of the S&P 500 companies have a price-to-sales ratio of greater than 10. That is nearly double the number from before the pandemic and the peak of the dot com bubble in 1999.

price to sales bubble

To highlight what a P/S ratio of 10 entails, we quote Scott McNeely, the CEO of Sun Microsystems, from 1999.

“At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. It assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are?”

Empire State Is In Contraction

The New York Fed’s U.S. Empire State Manufacturing Index fell to -0.7 and is pointing to economic contraction as it’s now below 0. The sharp decline from 31.9, as shown below, is the third-largest monthly drop since the early 2000s. New Orders, a key factor driving future growth, slumped to contraction at -5.0. Prices paid and prices received fell slightly but remained at very high levels. Future expectations for both price gauges rose.

While the report appears dour, forward expectations remain high at 35.1. We guess that Omicron may be the cause for the sharp decline in the current index.

empire state

Small Businesses Have Weak Expectations

The following quote and graph come courtesy of David Rosenberg.

“I was watching former Fed VC Alan Blinder struggle on CNBC to explain how Treasury yields could have the temerity to stay so low. I wanted to send him this chart. Econ expectations from the small-biz sector are lower today than at the trough of all 5 prior recessions!”

nfib small businesses

Surprise Surprise

As we show below, the Citi Economic Surprise Index is back below zero. The index measures how economists aggregated economic data forecasts fared versus the actual data. A declining index means they are overestimating economic growth. To wit, recent ISM, Payrolls, and Retail Sales data were well below expectations. The index tends to oscillate over time as economists over or underestimate economic activity.

citi economic surprise

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Instability or Inflation, Which Will the Fed Choose?

Over the past few weeks, Fed speakers are bemoaning inflation and voiced their wishes to squash it. They frequently mention how effective their monetary toolbox is in managing inflation.

There lies a massive contradiction between words and actions within these numerous speeches and media appearances. If the Fed is so intent on fighting inflation, why are they still stimulating the economy and markets with crisis levels of QE? Why is the Fed Funds rate still pinned at zero percent?

Within this ambiguity comes an abundance of risk for investors. If the Fed walks the walk and fights inflation vigorously, markets appear ill-prepared for a sharp decline in liquidity and resulting market instability. Conversely, the Fed may be just talking the talk and hoping inflation starts abating soon. In such a circumstance, they may not be as forceful as they appear.  

The Fed is walking a tightrope between instability and inflation. Can they successfully tame inflation without causing severe market dislocations? The tightrope is thin, and the consequences of falling off to one side or the other are severe. Investors best think about the Fed’s perilous act they are getting ready to attempt.  

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The Monetary Toolbox

Since March 2020, the Fed has purchased nearly $5 trillion in government bonds, mortgage-backed securities, and corporate bonds. As the graph below shows, the current annualized pace is more than at the 2008-09 Financial Crisis peak.

QE Fed balance sheet monetary toolbox

In addition to QE and the abundant liquidity, it fortifies financial markets with, they are also keeping the Fed Funds rates at zero percent. The graph below shows that the real Fed Funds rate level is obscenely negative.

real fed funds monetary toolbox

The combination of massive liquidity and near-zero percent borrowing rates have made speculative behavior commonplace among individual and institutional investors. Consider, the Fed removed $5 trillion of assets from the market resulting in more demand for all other remaining assets. Further, they encouraged investors with near-zero interest rates to use leverage to buy more assets than they could otherwise afford. The result is the stunning rise in asset prices and speculative fervor.

margin debt  leverage tightrope

Now, ask yourself what happens when the Fed removes liquidity and raises short-term borrowing rates.

Financial Stability

Financial stability has become a critical element of the Fed’s vernacular since the Financial Crisis. While the Fed’s congressionally chartered mandate only mentions stable prices and maximum employment, Fed members consider financial stability a third objective.

For example, Cleveland Fed President Mester recently opined on reducing the Fed’s balance sheet.

I would like to reduce it — let me say this carefully so that people don’t misunderstand — as fast as we can, conditional on not being disruptive to the functioning of financial markets.”

Despite the Fed being woefully misaligned with their inflation goal, her comments clarify that financial market stability is of equal or even greater concern than high inflation. 

Does The Fed’s “Third Mandate” Make Markets Unstable?

In supplying generous levels of liquidity to markets and incentivizing leverage and speculative behaviors, we think it’s easy to make a strong case that asset valuations are well above where they might have been without the Fed’s aggressive actions.

There are those with a different opinion, so let’s focus on some facts.

  • Using many different methods, Equity valuations stand at record levels or just shy of those seen in 1999. Almost all valuations have eclipsed those from 1929. Economic growth trends and forecasted growth rates are much lower than those periods.
  • The ten-year U.S. Treasury note trades at 1.80% despite inflation running at 7%.
  • BB-rated junk bonds trade at a record low 2.15% above Treasury yields despite more corporate debt than any time in history.

Do the underlying economic fundamentals justify such extremes, or are they the result of massive liquidity and absurd amounts of speculation the Fed fosters?

Walking The Tightrope  

The Fed is making it clear they want to reduce inflation. They are also telling us they will ensure financial stability. Sounds like a good plan, but walking the narrow tightrope successfully by achieving lower inflation without destabilizing markets is an incredibly tough task.

We think the odds of success are poor. As such, we must carefully consider which goal they will prioritize when push comes to shove.

Is the Fed willing to let some air out the financial markets to help get inflation moving toward its goal? Conversely, will market instability halt any Fed action toward reducing inflation?

These are the vast questions to which no one has the answers. That said, if the Fed falls off the tight rope, investors best start thinking about which option they will choose.

Political Pressure

A key factor in answering the questions revolves around politics. The Democrats are at risk of losing the House and or Senate. As November nears, it becomes increasingly likely the President will pressure the Fed to stem inflation. However, like the Fed, Biden may have to choose whether market instability or low inflation is a better outcome.

As you think about how Biden might ponder his choice, think about the following fact: 40% of the public has less than $1,000 of savings and rents. They do not have stocks to offset higher prices.

Can The Fed Control Inflation?

Another vexing problem facing the Fed is how much they control inflation. The Fed can raise rates that will impede economic growth and dampen demand for products. However, they have zero control over the supply line problems and shortages. While some are alleviating, Omicron results in a fresh round of new shortages and production problems. Our deep dependence on imports provides a reduced ability for the Fed to affect supply-side issues.

Also, consider wages are rising quickly, and the economy is at maximum employment. Companies aiming to preserve profit margins are being forced to raise prices with wages. A wage-price spiral is occurring already.

Lastly, let’s consider the role of the Fed and its management over the money supply. In The Fed’s Inconvenient Truth we wrote:

“The amount of money greatly matters, but equally important is how it moves through the economy. The graph below compares the money supply chart above with the velocity of money and inflation.”

money supply velocity inflation

The circle above shows that during the high inflation of the 1970s, the money supply and velocity of money were rising. Today, we see a steep decline in velocity, offsetting a surge in the money supply. As such, we believe most of today’s inflation is not the result of the Fed but the pandemic.

The bottom line is the Fed has a limited ability to affect inflation. They risk taking steps to halt inflation that does not meaningfully slow inflation but creates market instability.

Summary

We ask many questions in this article, and quite frankly, we do not have many answers. Given how high the stakes are, it is vital to consider the tradeoff between fighting inflation and risking market instability.

We think it is improbable the Fed can remove liquidity at the pace they are discussing without harming markets. We also recognize that the Fed can affect inflation but cannot truly manage it. It is possible inflation will diminish on its own over the coming months. However, we can make a convincing case it stays elevated throughout the year.

Predicting the future is difficult. Understanding and preparing for the many possible paths is how to achieve success. We hope this article gets you to think about what diverse paths lay ahead and the choices facing the Fed.

Portfolio Trade Alert – 01-18-22

Trade Alert For Equity & ETF Models Only

This morning we trimmed exposure in energy and Ford (F) due to their more extreme overbought conditions. As shown in our MoneyFlow indicator (Under the Research tab) XLE is extremely stretched and will likely turn lower in the next few days. At the same time many of the technology names are in the exact opposite position, so be careful making wholesale portfolio changes.

Equity Model

  • Reduce XOM and MRO back to model weights of 2% of the portfolio each
  • Reduce F back to 3.5% of the portfolio.

ETF Model

  • Reduce XLE back to model weight of 3.5% of the portfolio.

No Vaccine Mandate Is Bad News For Vaccine Makers

Pfizer and Moderna shares struggled on Friday as the Supreme Court overturned a federal (OSHA) vaccine and testing mandate. States and individual employers can now decide if they want to have and enforce vaccine mandates. The OSHA mandate would have covered companies with 100 or more employees. The vaccine mandates would have impacted approximately 80 million workers and may have resulted in further labor shortages.

Despite the bit of bad news for Pfizer (PFE), SimpleVisor rates it a “strong buy” with very bullish medium and long-term technicals. Its shorter-term outlook is bearish.

pfe pfizer vaccine
Daily Market Commnetary

What To Watch Today

Economy

  • 8:30 a.m. ET: Empire Manufacturing, January (25 expected, 31.9 prior)
  • 10:00 a.m. ET: NAHB Housing Market Index, January (84 expected, 84 prior)
  • 4:00 p.m. ET: Net Long-Term TIC Flows, November ($7.1 billion prior)
  • 4:00 p.m. ET: Total Net TIC Flows, November ($143 billion prior)

Earnings

Pre-market

  • 5:45 a.m. ET: Truist Financial (TFC) to report adjusted earnings of $1.21 on revenue of $5.583 billion
  • 6:30 a.m. ET: Bank of New York Mellon (BK) to report adjusted earnings of $1.01 on revenue of $3.979 billion
  • 6:45 a.m. ET: PNC Bank (PNC) to report adjusted earnings of $3.50 on revenue of $5.151 billion
  • 7:30 a.m. ET: Goldman Sachs (GS) to report adjusted earnings of $11.65 on revenue of $12.010 billion

Post-market

  • J.B. Hunt Transport (JBHT) to report adjusted earnings of $2.02 on revenue of $3.289 billion
  • 4:00 p.m. ET: Interactive Brokers (IBKR) to report adjusted earnings of 83 cents on revenue of $669.8 million

Market Holds Important Support On Friday

With the market closed on Monday for MLK day, we pick up where we left off on Friday.

Notably, despite the market’s failure to hold previous gains, it successfully retested and held the lower trend line. However, sell signals remain in place and have not yet reached more oversold levels. It will be important for the market to muster a bit of a rally this week to defend that lower trend. Our concern comes on Friday with the expiration of options which could pressure markets.

Inflation Surge, Inflation Surge Pushes Fed To Hike Rates Faster
SimpleVisor.com

The Week Ahead

From an economic viewpoint, the holiday-shortened week will be quiet. The Fed now has up-to-date employment and inflation data for their coming January 27th policy meeting and will enter its self-imposed black-out period this week. As such, investors will get a brief reprieve from the barrage of hawkish commentary coming from many Fed members.

Earnings will likely guide the markets. Thus far, with limited data, earnings have resulted in large stock price swings. Thursday saw the airlines soar on better than expected earnings from Delta. JPM was down about 5% on Friday despite beating earnings estimates. Given valuations are so high and the macroeconomic and monetary environment riskier than prior quarters, we are likely to see heightened volatility surrounding earnings releases and management commentary.

It will also be interesting to see how companies like Apple and Google’s response to not comply with the “No Vaccine Mandate” ruling will be received by employees.

Sentiment Fading

The University of Michigan Consumer Sentiment Survey continues to decline faster than expected. On Friday, they reported sentiment at 68.8 versus 70.6 last month. The graph below shows that a recession has always occurred when the survey falls 25% from its peak. It is not there yet but getting close.

michigan consumer sentiment

A Policy Mistake In The Making

As noted, the Fed is in a tough spot. While they should be aggressively tightening policy, they are also aware of the ramifications of losing market stability. As shown, the massive spread between input and consumer prices suggests corporations cannot pass along inflation entirely. Such means we could see a contraction in profit margins in the quarters ahead.

Inflation Surge, Inflation Surge Pushes Fed To Hike Rates Faster

Furthermore, as noted, the surge in inflation erodes consumer confidence. As prices rise, so does the cost of living for the average American struggling to make ends meet.

Inflation Surge, Inflation Surge Pushes Fed To Hike Rates Faster

That loss of confidence quickly translates into lost sales (demand reduction). Consider that retail sales comprise roughly 40% of PCE, which is approximately 70% of GDP.

Inflation Surge, Inflation Surge Pushes Fed To Hike Rates Faster

The decline in retail sales suggests weaker economic growth ahead.

Weak Retail Sales

December Retail Sales were much weaker than expected, falling 1.9% versus expectations for a slight increase. More troubling, the control group, a subcomponent of the data, was down 3.1%. The control group directly feeds the GDP report. As we discussed in prior months, we offered caution at the strong retail sales data in the prior few months. We suggested that shopping behaviors were drastically altered due to the pandemic and the related shortages of goods. Retail sales are now back to the same levels as in March of 2021. The graph below shows that the aggregate’s October, November, and December retail sales are basically unchanged. It is also worth reminding you that retail sales include inflation. On a nominal basis, retail sales are down around 7% from the prior year. People aren’t buying more, they are paying more!

retail sales

Bearish Sentiment = Rally, or Is This Time Different?

The Bank of America graph below shows AAII Investor Sentiment has fallen to levels that suggest a rally may be in store. The last time the index fell below 25% was in late September 2021 after stocks fell for the better part of the month. In early October that year, the market troughed and headed higher. From that point, it was a one-way street upwards until early November, racking up a 10% gain. From October 13th until November 5th, there were only two down days in the S&P 500. In the fall of 2021, the market did not have to contend with a hawkish Fed. Today, the Fed seems to become more hawkish by the day.

investor sentiment aaii

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Market Selloff Into January

The market selloff into January rattled investors as concerns of So Goes January, So Goes The Year” began to dampen expectations. Combined with a more aggressive stance from the Federal Reserve, rising inflation, and a reduction in liquidity, investor concerns seem to be well-founded.

As discussed last week in Passive ETFs Are Hiding A Bear Market,” the “blood bath” in the high-beta stocks is particularly humbling for the retail crowd that piled into risk with reckless abandon last year.

“Probably one of the best representations of the disparity between what you see ‘above’ and ‘below’ the surface is the ARKK Innovation Fund (ARKK). While the S&P 500 index was up roughly 27% in 2021, ARKK is down more than 20%. That is quite a performance differential but shows the disparity between the mega-cap companies and everyone else.”

S&P vs ARKK

During the market selloff in the first two weeks of January, things did not improve for that group of stocks. However, retail traders have now set their sights on a new target: “value stocks.”

“Retail investors have been plowing a great deal of money into the markets in recent days. But remarkably, in addition to the broad index ETFs, they’ve been buying value sector ETFs (according to JP Morgan Research). So this rotation is not limited to institutions.”The Daily Shot

Retail etf flows

Despite the market selloff to start to the New Year, Wall Street continues to push overly optimistic projections of year-end returns. But, as noted, reality will likely be something entirely different.

So Goes January

For now, let’s set aside assumptions of year-end outcomes and focus on the statistical evidence. From this analysis, we can potentially respect the risks that might lay ahead.

According to StockTrader’s Almanac, the direction of January’s trading (gain/loss for the month) has predicted the course of the rest of the year 75% of the time. Starting from a broad historical perspective, the chart below shows the January performance from 1900.

January historical returns

Furthermore, thirteen of the last seventeen presidential election years followed January’s direction. Speaking of Presidential election years, the second year of the Presidential cycle statistically has the second-lowest average return rate with roughly a 63% chance of being a positive year.

Presidential election data

Of course, unlike most years since 1980, this year, stocks will be dealing with the highest inflation rate since the late 1970s, excessively high valuations, and an aggressive policy change by the Fed.

While that doesn’t necessarily mean poor outcomes for investors, it certainly increases the risk.

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Digging In

The table and chart below show the statistics by month for the S&P 500. As you will notice, there are some significant outliers like August with a 50% one-month return. These anomalies occurred during the 1930s following the crash of 1929.

Monthly market statistics

The critical point is that January tends to be one of the best return months of the year. January also sees the most inflows into equities as asset managers put cash to work. Last week, Net flows into global equity funds remained strong (+$30bn vs +$26bn in the prior week).

Net fund flows

However, while fund inflows remain positive, January is significantly underperforming the long-term median and average, so far.

January average media returns.

While January also holds the title for the most favorable return months since 1900, followed only by December and April, negative returns occur about 33% of the time. Such is a high enough risk not to get ignored.

January positive negative months.

But January is not always a winner. While the statistical odds are high, it does not always end that way, even with a strong start. It is worth noting that while January’s maximum positive return is 9.2%, the maximum drawdown for the month was the lowest for all months at -6.79%.

January best worst returns months

However, that is history. Let’s talk about where we are now.

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A Rough Start

As noted, it has been a rough start to the new year so far as the market selloff caught investors off-guard. As shown below, the market failed to hold December’s gains, negating most of the “Santa Claus” rally. However, on Friday. the market successfully tested and maintained the lower trend line from last October. 

Stock market technical view
SimpleVisor.com

Risk is still prevalent. With sell-signals still intact, and the market not back to short-term oversold levels, there is still downside pressure on stocks.

Stock market retracement levels.
SimpleVisor.com

As shown, the current correction has already retraced 38.2% of the rally following the October correction. A full correction would wipe out all of the gains since December by completing a 61.8% retracement. While not shown, the 200-dma currently resides around 4400 on the S&P index, which would encompass roughly a 10% correction from the peak.

With earnings season kicking into gear this week, it would not be surprising for the market to hold current support, given that earnings should be reasonably robust. In addition, given we are looking at earnings for the 4th quarter of 2021, where there was still substantial liquidity in the system and the Fed was still highly accommodative. However, as we get into the later quarters of 2022, the support for earnings will fade considerably.

As noted in this past weekend’s newsletter:

“As shown, the massive spread between input and consumer prices suggests corporations cannot pass along inflation entirely. Such means we could see a contraction in profit margins in the quarters ahead.”

Net profit margins PPI CPI
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A Year Of Challenges

From the mainstream media’s view, expectations are high that 2022 will continue 2021. Maybe such will be the case. However, as we laid out just recently, many of the headwinds that supported the ramp in speculative behaviors have, or will, reverse in the months ahead. To wit:

  • Tighter monetary policy, and high valuations.
  • Less liquidity globally as Central Banks slow accommodation.
  • Less liquidity in the economy the previous monetary injections fade.
  • Higher inflation reduces consumption
  • Weaker economic growth
  • Weak consumer confidence due to inflation
  • Flattening yield curve
  • Weaker earnings growth
  • Profit margin compression
  • Weaker year-over-year comparisons of most economic data.

The media is correct that “Fed rate hikes” won’t cause a bear market.

As is always the case, the event that changes the “bullish psychology” is always unknown. However, the eventual market reversion is almost always a function of changes in liquidity and a contraction in earnings. Such was a point I made Friday on Twitter:

Twitter post Fed rate hikes crisis

The biggest problem for investors is the bull market itself.

When the “bull is running,” we believe we are more intelligent than we are. As a result, we take on substantially more risk than we realize as we continue to chase market returns allowing “greed” to displace logic. Like gambling, success breeds overconfidence as the rising tide disguises our investment mistakes. 

Unfortunately, our errors always return to haunt us. Always too painfully and tragically as the loss of capital exceeds our capability to “hold on for the long-term.” 

Conclusion

I have no idea what this year holds. Maybe it will be another wildly bullish year where throwing caution to the wind pays off once again.

Maybe, it won’t be.

The current market selloff, and rotation to value, may undoubtedly be essential clues. With market valuations elevated, leverage high, and economic growth and profit margins set to weaken, investors should be paying close attention.

Pay attention; things are beginning to get interesting.

Viking Analytics: Weekly Gamma Band Update 1/17/2022

We share the Weekly Gamma Bands Update by Viking Analytics. The report uses options gamma to help you better manage risk and your equity allocations.

The S&P 500 (SPX) could not overtake the gamma flip level last week and remains in an amplified volatility regime as we head towards the January monthly opex this Friday. Our gamma band model enters the short holiday week with a 30% allocation to SPX. The dashed black lines on the chart below show the dates of the recent monthly option expirations. Please note the sharp moves before and after the opex. The programmatic delta hedging programs tend to be long calls and short puts, which can result in supportive “charm” flows as the options decay (this is a complex issue which can be understood better by following and listening to Cem Karsan). 

The Gamma Band model[1] is a simplified trend following model that is designed to show the effectiveness of tracking various “gamma” levels. This can be viewed conceptually as a risk management tool. When the daily price closes below Gamma Flip level, the model will reduce exposure to avoid price volatility and sell-off risk. If the market closes below what we call the “lower gamma level” (currently near 4,570), the model will reduce the SPX allocation to zero.

The main premise of this model is to maintain high allocations to stocks when risk and corresponding volatility are expected to be low.  For investors who have been conditioned to “buy low and sell high,” it is counter-intuitive to increase allocations when the market rises, but this approach has shown to increase risk-adjusted returns in the back-test.  

The Gamma Band model is one of several indicators that we publish daily in our SPX Report (click here for a sample report).  

With stocks climbing to obscenely high relative valuations, risk management tools have become more important than ever to manage the next big drawdown. We incorporate many options-based signals into our daily stock market algorithms. Please visit our website to learn more about our trading and investing tools.

The Gamma Flip – Background

Many market analysts have noted that daily volatility in the S&P 500 will change when the value of the SPX moves from one gamma regime to another.   Some analysts call this level the “gamma flip.”  The scatterplot below shows how price volatility (on the y-axis) is increasingly lower as the value of SPX rises higher above the Gamma Neutral level (on the right side of the chart).  When the value of the S&P closes lower than Gamma Neutral (to the left of the chart), volatility increases. 

Gamma Band Model – Background

The purpose of the Gamma Band model is to show how tail risk can be reduced by following a few simple rules.  The daily Gamma Band model has improved risk-adjusted returns by over 60% since 2007.  The graph below demonstrates how this approach can limit drawdowns while maintaining good returns.  A quick video introduction of the Gamma Band model can be seen by following this link

Disclaimer

This is for informational purposes only and is not trading advice.  The information contained in this article is subject to our full disclaimer on our website.

[1] The Gamma Band model in our SPX Market Report adjusts position size DAILY based upon the daily closing levels of SPX value and calculated Gamma Neutral.  The Weekly Gamma Band model is shown for illustrative purposes only.

Authors

Erik Lytikainen, the founder of Viking Analytics, has over twenty-five years of experience as a financial analyst, entrepreneur, business developer, and commodity trader. Erik holds an MBA from the University of Maryland and a BS in Mechanical Engineering from Virginia Tech.

Rob McBride has 15+ years of experience in the systematic investment space and is a former Managing Director at a multi-billion dollar hedge fund. Rob has deep experience with market data, software and model building in financial markets.  Rob has a M.S. in Computer Science from the South Dakota School of Mines and Technology.