Rally On

By Crest Capital Advisors on July 22, 2022

Dow: 1.95% to 31,899.29
S&P 500: 2.55% to 3,961.63
Nasdaq: 3.33% to 11,834.11
Russell 2000: 3.58% to 1,806.90
10 Year Yield: 2.76%
Outperformers: Consumer Discretionary 6.79%, Materials 4.14%, Industrials 4.11%, Tech 3.61%
Underperformers: Communication Services (1.16%), Utilities (0.45%), Healthcare (0.34%)

Despite a risk-off session Friday, US equities finished the week higher, with the major indices each moving above their 50-day moving averages during the week’s trading. (We unpack more on this subject below) Growth was a big outperformer to value, though both factors were higher overall. Treasury rates declined, particularly in the belly of the curve. The 30-year yield slipped below 3% while the 2/10 spread remained in negative territory, still flirting with its most-negative levels since 2000.

There were many moving pieces in the market narrative this week, but a tight focus remained on the Fed’s hiking path and the meeting next week. Weaker economic releases, along with some indications of easing price pressures, contributed to the continued firming of expectations for a 75 basis point July move. Investors for the most part have pared back the more aggressive 100bp bets from the aftermath of the hotter-than-expected June CPI data. In the bullish column, there were also some better-than-feared Q2 earnings reports, some easing of the energy overhang in Europe with the resumption of Nord Stream gas flows, a pullback in the dollar, a further slide in oil, and analyst thoughts the market may be at or near the capitulation threshold.

Nevertheless, multiple bearish themes remained in view as well, not the least of which is persistent inflationary pressures and their impacts on consumer behavior. While it was a relatively light week of economic updates, the week’s releases did little to calm fears of a potential recession. There was another batch of disappointing housing data, with June existing home sales coming in at its slowest pace since June 2020 and July NAHB homebuilder sentiment logging its second-largest drop on record. To end the week, S&P Global PMIs for July both declined to mid-2020 levels, while the July Philly Fed manufacturing index moved further into contractionary territory. However, the price components of both of those reports showed slowing (but still elevated) price growth and were seen as relative bright spots.

Next week looks to be busy in terms of news flow as we move towards peak earnings season, the Fed meets to announce its latest move, and we get key economic reports on GDP and inflation.

The Housing Story & Taming Inflation

We all know the Fed has a supply/demand imbalance problem in the economy that has led to near-record high inflation readings. The primary culprit is the restriction of supply due to lingering effects of the government response to the pandemic (Lockdowns anyone?) while at the same time we massively stimulated demand by dropping money on the populace, both consumers and businesses alike. So, while the Fed is fast at work using its one blunt instrument to tamp down demand, you’d think there would be plans afoot to help repair the supply side. Alas, there doesn’t seem to be any. And in fact, there is evidence that the Fed’s attack on demand is causing suppliers to actually reduce supply further! Thus, the killing of demand is not alleviating the supply-demand imbalance!!! This is a problem and nowhere is it more apparent than in housing.

The overheated US housing market is starting to cool down in what some in the industry are calling a real estate shakeout. Sales of previously owned homes fell 5.4% month-over-month in June to 5.12m units, according to the National Association of Realtors, and were 14.2% lower when compared to the same month a year ago. At those levels, sales fell to their slowest pace since June 2020, when buying activity dropped briefly at the start of the coronavirus pandemic.

Bigger picture: Surging inflation is hammering potential buyers’ purchasing power and rising interest rates aren’t helping the situation. In fact, mortgage applications fell to a 22-year low last week, with the 30-year mortgage rate rising to 5.82% (compared to 3% at the start of the year). At the same time, the median existing-home price of all housing types climbed to $416k in June, from $407k in May (and surging from $285k just two years ago).

“It is clearly due to the plunging affordability,” explained National Association of Realtors Chief Economist Lawrence Yun. “We have never seen mortgage rates shoot up this fast at this magnitude. Even people who want to buy, they are priced out.”

So how to fix this? Typically we’d want to see home builders respond by producing more units, thereby satisfying the rising demand for single-family homes. Yet, single-family housing starts came in at a two-year low in June, down nearly 8% for the month and about 16% lower year-over-year. Things didn’t look any better in terms of single-family permits, which were off by similar percentages.

Earnings Season Report Card

With 103 (~21%) of companies in the S&P 500 reporting Q2 results, 73% have beaten consensus earnings estimates and 57% have beaten consensus revenue estimates. Compare this to 76% / 67% respectively for Q1 and an average of 80% / 70% since 2020.

So far this week, 70 S&P 500 companies have reported Q2 earnings and 54 of them beat consensus EPS expectations. That’s a 77% beat rate.

While S&P 500 companies are beating estimates this quarter, it’s by less than average, particularly on the revenue line. While that’s not great, it’s pretty darn good when you consider the growing voices calling for a recession and corresponding earnings hit. So far, the hit to earnings is not evident in the data. Recession calls are therefore premature.

At this point in the earnings cycle, we’d give it a……….

Inflation Tailwinds

A short read on inflation in one chart should leave the Fed feeling pretty good that they’ve managed to crush long-term inflation expectations. The chart below shows the market implied inflation rate 5 years out and it shows we have declined significantly, to the lowest level since March 2021. Note the Fed’s target for inflation is 2% and the 5-year forwards imply we will be at 2.04% in 5 years’ time.

Call It a Come Back

The bulls finally have some upside momentum to work with as the Nasdaq 100 and S&P 500 both broke back above their 50-day moving averages this week. The 50-day moving average smooths out daily price action and gives investors a read on the short-term directional trend of the market. This moving average is still drifting lower for major indices, but getting prices back above the 50-day is the first step in the process of turning downtrends back into uptrends.

You can see this week’s break above the 50-day (blue line) for the Nasdaq 100 (QQQ) in the chart below. Not only did the Nasdaq re-take its 50-day, but it also closed above two previous highs made over the last month that were acting as resistance. It’s not an “all-clear” signal by any means, but this is certainly more positive action than we’ve seen for most of 2022. And, filed under the ‘green shoots’ category, we note that the Nasdaq has outperformed the S&P 500 by ~5.5% since late May.

The next chart below takes a look at prior periods where the Nasdaq index spent a lengthy time below its 50-day moving average. Going back to 1990, there have only been 7 prior streaks of closes below the 50-day moving average for 3 months or longer. This current period now qualifying as the 8th. Interestingly, the index has struggled to see continued gains in the very near term, over the next week and month, but other than 2001, when tech stocks were starting a dramatic fall from their dotcom peaks, average returns were very high over the subsequent 3, 6, and 12 months.

Shifting to the broader S&P 500 index, we note that we are seeing increasing breadth in the number of advancing issues on some of these up days. We’re not quite at surge levels that typically indicate a more enduring rally is at hand, but we are getting closer. We’ll be watching for a potential move above the 99th percentile over the coming days/weeks.

An accompanying graph to look at is the percentage of S&P stocks that are trading above their 50-day moving average. Should this data-set manage to get to the 90% level (something akin to a bull market and not observed in a bear market), then that could signal an all-clear for investors. We currently stand at about 58% as of Friday morning and rising. Historically 90% is an all-clear signal. In the past 18 months, we haven’t been able to crack the 80% threshold.

Recession Risk

Early on Friday, we got the release of the S&P Global US Composite PMI for July and it was not great. The reading came in at a surprising level of 47.5 v. 52.3 last month. Any reading below 50 is considered a contraction in private sector output. And the rate of decline in this report is the lowest since May 2020 as we were just emerging from the pandemic lockdown lows. All in all, this report is clear and compelling evidence that the Fed has a demand problem on its hands now.

And with that, we just can’t see the FOMC raising by a large amount (some have called for another 100 basis points after the high inflation print a few weeks back) and then running off for vacation for two months. There is clear evidence that the excess heat in the economy is cooling rapidly and equally good data showing that price pressures are easing. Job growth continues to be strong, but many large employers, especially in the technology sector, have announced pauses in hiring. Consumers are still flush with cash and retail spending is strong, unless you are looking at bigger ticket purchases like a car or house. This 250-basis point increase in interest rate expectations has taken the wind out of the economy’s sails just as intended. Now we watch the slowdown and keep a close eye on jobs data and credit quality data to see if there is any real economic damage. A cooling of the economy could mean that current equity and debt prices should be bought. A worse slowdown that leads to a meaningful jump in unemployment and credit lending losses could send S&P 500 earnings down and the index along with it. This is the crossroads we face today and it will take time for the data to make clear which path we will be on.

King Dollar

Netflix called the dollar strength “historic” which of course reminded us that history may not repeat, but it does rhyme. Thus, we are near historic levels of year-over-year rate of change Dollar strengthening (+16%) comparable to the Yuan devaluation (2015-16), Global Financial Crisis (2008-9), Tech/Dotcom Bubble Bursting (2000-2), and the Asian financial crisis (1998). Dollar momentum may extend further, however, we are at a point where such a pace rarely sustains.

So while it’s true that massive US dollar strength tends to occur and/or contribute to difficult market conditions, the good news is we are at levels where historically the trend begins to reverse. Bad stuff happens when the dollar is ultra-strong. But good things tend to happen once the reversion happens.

Earnings Season Heats Up

This season peak weeks will fall between July 25 – August 12, with August 4 predicted to be the most active day with 1,087 companies anticipated to report. Only ~38% of companies have confirmed at this point (out of a universe of 10,000 global names), so this is subject to change. The remaining dates are estimated based on historical reporting data.

Crazy Stats of the Week

Here are this week’s crazy stats:

• Equity futures positioning for asset managers and leveraged funds is now the MOST SHORT on record according to Deutsche Bank. This could provide some major fuel to a second-half rally with the right catalyst.

• In the 2008-09 financial crisis, investors endured some $9 trillion of capital destruction. That was painful. But the pain investors experienced in equity and mortgage bond losses was eased by an impressive rally in government bonds. No such luck this time; in today’s unfolding bear market, investors are losing on all fronts at once. The overall capital destruction is therefore much greater at $23 trillion and counting.

Quotes of the Week

“We’re up and around Main Street USA every single day and we’re watching it really closely. And it seems as though demand is quite strong — As I mentioned earlier, I hope — I think we’d all be better off if nobody read the news or listened to the news because it seems like we’re trying to talk ourselves into it. But that being said, we’re watching it really, really closely because as Mike mentioned, we’ll pivot, we’ll pivot appropriately. But to date, it appears as though Main Street USA is doing just fine, and we’re encouraged by that.”

– Cintas (CTAS) CEO Todd Schneider

“Little of the data I see tells me the US is on the cusp of a recession. Consumer spending remains well above pre-COVID levels with household savings providing a cushion for future stress. And as any employers will tell you, the job market remains very tight. Similarly, our corporate clients see robust demand and healthy balance sheets with revenue softness attributed to supply chain constraints so far. So, while a recession could indeed take place over the next two years in the US, it’s highly unlikely to be a sharper downturn as others in recent memory.”

– Citigroup (C) CEO Jane Fraser

Calendar of Events to Watch for the Week of July 25th

Next week will be the busiest of Q2 earnings season with the major market capitalization leaders all set to report results for Q2. There will be plenty of earnings reports and CEO comments to help drive near-term risk sentiment. But aside from earnings, perhaps the main event will be the FOMC meeting on Wednesday where it is widely believed the Fed will jack up the Fed funds rate by at least another 0.75%, with some pundits calling for a 1%+ hike. Not to be outdone, the US Economic Calendar will also be quite busy with major reports due out on Q2 GDP (Thursday) and Personal Consumption Expenditure (PCE) on Friday. All in all, it will be a very busy final week of July with a lot of market-moving events.

Monday 7/25 – The Chicago Fed and Dallas Fed activity index reports for June and July respectively will be out. Both reports are expected to confirm recent regional reports showing a sharp decline in activity.

Tuesday 7/26 – July Consumer Confidence is expected to post a reading of 97.0, down from last month’s 98.7. We’ll also get data on June New Home Sales which is expected to post a decline of about -3.7%.

Wednesday 7/27 – US Durable Goods for June is expected to show a modest increase of 0.15%, down from last month’s 0.81% pace. Pending Home Sales for June are expected to decline -1.0% month-over-month. And finally, the FOMC will be out mid-day with its decision on the fed funds rate. Of course, every word of the press conference will be dissected as investors begin to anticipate an eventual “pivot” in terms of the Fed’s forward guidance for future rate hikes.

Thursday 7/28 – US Q2 GDP will be more anticipated than usual (Due to Q1’s negative print and many looking for the Fed to cause a recession via too many rate hikes). Economists are forecasting a 1.5% quarter-over-quarter rate and a 2.3% year-over-year.

Friday 7/29 – The Personal Consumption Expenditure (PCE) report for June is expected to show a headline of 0.88% month-over-month (6.7% annualized) and a core (ex-food/energy) increase of 0.5% month-over-month to a 4.8% annualized rate. Note: Last month’s core ready was 4.7% so we really want to see the forecasters wrong on this report with another monthly decline in the core.