Good Riddance, Fresh Beginnings

By Crest Capital Advisors on July 1, 2022

Dow: (1.28%) to 31,097.26
S&P 500: (2.21%) to 3,825.33
Nasdaq: (4.13%) to 11,127.85
Russell 2000: (2.15%) to 1,727.76
10 Year Yield: 2.89%
Outperformers: Utilities 4.11%, Energy 1.29%
Underperformers: Consumer Discretionary (4.69%), Consumer Services (4.54%), Technology (4.47%), Materials (3.14%)

This week closed out the first half of 2022 in what has been a historic series of moves in both price and duration. It also reversed last week’s outsized gains as US equities finished the week lower, although a Friday rally softened the blow. A couple of key themes were in focus, including concerns around consensus earnings for Q2 and the balance of 2022 still being too high, the Fed tightening into a recession, and still highly depressed sentiment.

However, there was some support around peak-inflation and peak-Fed themes, while Treasury yields fell sharply this week, with all durations up to 10 years well below 3% (the 10-year touched 3.49% just two weeks ago and closed at 2.89% today!). The Bloomberg Commodity Index also fell by more than (2.5%) this week, and now sits ~15% below early June levels and at the lowest levels since February. WTI crude didn’t do much this week as demand and recession fears offset tight inventories and OPEC+ spare capacity concerns. However, other energy commodities and metals also continued to soften, including natural gas, which in the US fell over (16%) on Thursday the biggest one-day decline since 2003.

As alluded to in the title of this week’s CMD, the first half of the year has brought about a set of extreme circumstances that we’re happy to put in the rear view mirror. And with that comes hope for a better second half. (See the Crazy Stats section below for even more unfortunate market-related milestones.) The S&P 500 closed the first half of 2022 formally in a bear market and was down by 21.22% in the first half of 2022….So according to Bloomberg data, this would be the worst start to a year since 1962….60 years ago! The Nasdaq is down 30% to start the year…and that is the worst start to a year ever!

During the first half of the year, 90% of trading days had an intraday range greater than 1% range. This is the highest level of intra-day volatility since 2009 when 99% of the trading days saw ranges greater than 1%. The chart below shows intra-day market volatility going back 40 years.

Recession Talk Is Premature

Markets and investors are in a gloomy mood and as a result, we are all grasping at reasons to justify the current price action. One of the newer themes that is taking hold in the financial media is the notion that we are not only heading to a recession…but that perhaps we are already in one (and just don’t have the data to prove it yet)! Well, we acknowledge the difficult position we are in today, with the Fed having to choose between supporting growth and markets v. fighting high inflation. These policy decisions are at odds with one another and there is a real risk they could drive us to a recession if they go too far. That said, we have to push back on the narrative that we are already in a recession. It’s just too premature to call it that when you look at high frequency data (e.g. restaurant seatings, airline/hotel travel, etc.) alongside record low unemployment. Consider the Fed has only raised the Fed funds rate to a more reasonable 1.75% thus far and while there may be a few more hikes, this is far below what the strong economy of late 2021 can handle. Yes, balance sheets are getting strained as asset values have become impaired, and we’re close to talking ourselves into a self-fulfilling recession, but we are not there yet. Any pivot in policy to a softer approach or avoidance of an outright recession could unleash a powerful recovery rally in markets.

But don’t just take our word for it. JP Morgan does not see a recession as the base case either, and thus an oversold equity market could be poised for a substantial rebound.

From JP Morgan…“While the probability of recession has increased meaningfully, we do not see it as a base case over the next 12 months. In fact, we see global growth accelerating from 1.3% in the first half of this year to 3.1% in the second half. Similarly, we see inflation declining from a 9.4% annualized rate in the first half to 4.2% in the second half, which would allow central banks to pivot and avoid producing an economic downturn.”

They go on…”IF there is no recession – which is our view – then risky asset prices are too cheap. For instance, small-cap stocks in the US currently trade near the lowest valuations ever. Many equity market segments are down 60-80%. Positioning and sentiment of investors is at multi-decade lows. So, it is not that we think that the world and economies are in great shape, but just that an average investor expects an economic disaster, and if that does not materialize risky asset classes could recover most of their losses from the first half. Our bullish and out of consensus view is hence a forecast of a lost year, ie. a recovery of H1 losses in risky assets.”

Will Powell Take Yes For an Answer?

We know now that we’ve seen peak inflation. But have we seen peak Powell? (aka Fed ‘hawkish’ rhetoric on rate hikes) On Thursday of this week, we learned that the Core Personal Consumption Expenditure (PCE) data, the Fed’s favored measure of inflation, came in lower yet again at a year-over-year rate of 4.7% vs 4.8% expected by economists. The month-over-month rate also cooled to 0.3% vs 0.4% expected. Core PCE has now dropped for 3 consecutive months and is at the lowest level since January. PCE headline data was expected to rise, but it came in the same as April. This is all good news and follows the downward revisions to the University of Michigan’s June survey of consumer inflation expectations, also an important consideration from the Fed’s point of view.

While the positive moves in inflation (less bad) did not help the market on Thursday when the data was released, we believe this is good news for investors. The Fed will have more flexibility to relax the tightening measures the better the inflation data gets. (Is this ‘compelling’ enough for them?) We expect a continuation of this trend of lower readings in future reports as well thanks to a rapid decline in money supply (M2) growth. See the chart below.

And finally, some good news in the commodity markets…albeit perhaps catalyzed by recession fears. The price of gasoline futures fell below its 50-day moving average for the first time in 2022. See below noted by the blue circle. Typically when trends like this finally reverse, a break below the moving average is the first sign of a potential change in direction. Obviously, any downside in gas prices would be a welcome relief to inflationary readings and therefore the Fed’s actions with respect to interest rates.

In summary, we expect that Powell will soon realize that he doesn’t have to destroy the village in order to save it. He can take yes for an answer on inflation and acknowledge that conditions are improving and heading back towards the Fed’s target range. But will he? What is the better choice for the average consumer? Pay $6 gas prices amidst declining real wages or not pay $3 gas prices because you don’t have a job?

Biotech Bottom?

For the better part of a year, the speculative/’growthier’ corners of the market have been aggressively sold. Biotech is one such group that has experienced a historical sell-off, greater than during the Great Financial Crisis and more recently during the Covid bear market in early 2020. But, that may be changing…at least the technical evidence is piling up that a turn is at hand. Consider the following:

The XBI Biotech ETF has broken out from a double-bottom formation, after bouncing off a key support level that has been in place since 2018.

Relative Strength = Yes

The XBI Biotech ETF/S&P 500 ratio chart (compares the relative performance of biotech to the S&P 500) has registered consecutive lower highs since early May and reversed a downtrend. Biotech is starting to outperform again (See chart below).

Momentum = Yes

Momentum indicators have turned bullish. Relative strength (RSI) is back above the midline and we’re seeing positive momentum divergence in the moving averages. This is an indication of investor accumulation.

Volume & Fund Flows = Yes

The 30-day moving average of the XBI Biotech ETF trading volume reached a record high in May. In addition, fund flows into the XBI have been positive during 8 of the last 10 weeks.

Biotech Breadth = Yes

59% of the 360 NASDAQ Biotechnology Index constituents are now trading above their 50-day moving averages, compared to only 14% of stocks within the SPX.

Of course, volatility will remain, and stock selection may be critical, but we think the sector is showing enduring signs of investment life for the first time in a long time.

Paging Jerome Powell

As the Fed attempts to engineer the elusive “soft landing”, we note they are indeed playing with fire here. Looking at the drawdown in US equities from a market value perspective as a percent of GDP shows that the current decline stands at -46%! This current drawdown now exceeds all declines since 1980, except the one that was seen during the financial crisis. Whether or not we reach those crisis levels is yet to be seen, but the decline in equities so far has destroyed $11 trillion in value. And when you factor in the bond market and credit losses, we really are forging new ground here in terms of a reverse wealth effect.

Contrarian Corner

Something to consider….

In January of 2022, the Wall Street consensus was that the S&P 500 would rally to the 5,000 – 5,200 range by year end. As of June 30th, the S&P 500 stands a long way from those levels at 3,735. It would take a 33%+ second half rally to reach the lower end of this targeted range.

Yet, now that the market has dropped, the Wall Street consensus is now calling for the S&P 500 to drop even further to the 3,000 – 3,200 range.

The moral of the story? Perhaps, be careful when relying on consensus. And for the record, bearish directional calls are no more valid than bullish calls. Yet for some reason, our brains seem to be wired to accept the former more readily than the latter.

Crazy Stat(s) of the Week

Here are this week’s crazy stats:

As of the mid-way point in 2022, the performance of markets has been abysmal. Here is a short summary of where we stand as of the end of the 2nd quarter.

The S&P 500 was down 21.01% in the first half of 1970. We are currently down 21.22% in the first half of 2022…so according to Bloomberg data, this would be the worst since 1962….60 years ago!
The Nasdaq is down 30%+ to start the year…that is the worst start to a year ever. Worse than the first half of 2002 collapse…the bear market after the dot com implosion.
The only sector in the green year-to-date is Energy.
US Treasuries suffered their worst first half of a year ever!
The credit side of the bond market has also been a bloodbath with High Yield bond ETF (Ticker: HYG) suffering its worst first half losses ever.
Crypto carnage has been pervasive as Bitcoin fell 59%, which is the worst start to a year ever for the cryptocurrency surpassing the 57.99% drop in 2017.
In the event you thought real assets would be a good place to hide, we find it notable that Commodities have crashed this past month and are falling towards pre-Putin invasion levels. So much for rotating to hard assets as a diversifier and inflation hedge.

Looking overseas, and as of the middle of last week, we noted that China tech stocks were up 48% off the lows made in March! We wrote about this in a prior CMD. China tech stocks were the first major group to take hits heading into this bear market period and they appear to be the first major group showing signs of strength on the way out.

Quote of the Week

“We are raising interest rates, and the aim of that is to slow growth down so that supply will have a chance to catch up. We hope that growth could still remain positive. But if you look at the strength of the economy, households are in very strong financial shape, they’ve still got a lot of excess savings – from forced saving of not being able to travel and things like that – and fiscal transfers. The same thing is true with business, with very low rates of default and lots of cash on the balance sheet. The labor market is also tremendously strong, still averaging very high job growth per month. Overall, the US economy is in the position to withstand tighter monetary policy, we think.”

-Jerome Powell

(Editors Note: Our least favorite part of the quote above is the final two words. It’s all a guessing game.)

Calendar of Events to Watch for the Week of July 4th

The big events for the holiday shortened week will center around the economy. First on deck will be the ISM Services PMI for June. On the back of a lower than expected Manufacturing PMI on Friday, it will be interesting to see if Services holds up better (as the generally accepted narrative of a consumer shift from goods to services is tested.). Then we will wrap the week with a check-in on the labor market. Other than anecdotal stories here and there about hiring slowdowns and modest layoffs, this dataset has remained robust with record low unemployment rates. A gold-i-locks type number (not too hot, not too cool) will probably help alleviate rising ‘recession fears’.

Monday 7/4 – Markets Closed in Observance of the 4th of July Holiday. Happy Independence Day Everyone!

Tuesday 7/5 – US Durable Goods for May will be out with a final reading where economists are expecting a 0.2% rate, down from 0.7% in April.

Wednesday 7/6 – The ISM Services PMI for June is expected to come in at 54.0, down from 55.9 last month. We’ll also have the release of the minutes from the latest FOMC meeting that could move markets as well.

Thursday 7/7 – The ADP Employment Survey for June is expected to show a net 230k jobs, up from last month’s 128k level.

Friday 7/8 – The monthly Nonfarm payrolls report for June is expected to show 250k net new jobs and a 3.5% unemployment rate. Employment continues to be the one spot that has not shown signs of difficulty thus far in 2022.

Source: FactSet