The Grinch Who Stole the Santa Claus Rally

By Crest Capital Advisors on December 16, 2022

Dow: (1.66%) to 32,970.46
S&P 500: (2.08%) to 3,852.36
Nasdaq: (2.72%) to 10,705.41
Russell 2000: (1.85%) to 1,763.42
10-Year Yield: 3.48%
Outperformers: Energy 1.72%
Underperformers: Consumer Discretionary (3.63%), Technology (2.67%), Financials (2.50%)

US stock indices were broadly lower this week with the S&P 500 and Nasdaq both posting a second-straight weekly decline. The week started off on positive footing with a much tamer than expected CPI inflation report, only to have the Fed unwind the optimism with yet another “hawkish” press conference. The meeting concluded with an updated Summary of Economic Projections (SEP)…aka “the dot plots”…which increased the outlook for the fed funds rate through 2025 from September’s forecasts, including a median dot of 5.1% for 2023, or an additional 75 bp of hikes from what was anticipated just a few months ago.

Chair Powell struck his usual hawkish tone in the post-meeting press conference, sticking to the higher-for-longer messaging and earning him our title this week of the Grinch that stole the Santa Claus rally. Powell said that the Fed still has more work to do (seemingly ignoring the progress we’ve made in the last few months), warning that it will take substantially more evidence to give confidence that inflation is on a sustained downward path. (Editors Note: Whatever happened to “long and variable lags”?) However, Powell also suggested the Fed is getting close to the level that could be considered sufficiently restrictive and noted that the pace of rate hikes isn’t the most important question anymore (thus opening the door for another step-down in the rate hike pace).

But interestingly, the bond market continues to bet we will see fewer hikes from the Fed. Yields across all maturities actually fell on the week, whereas typically they would have risen to reflect the Fed’s outlook for higher rates. The bond market may be signaling that it’s time for the Fed to stop and policy rates are more than sufficiently restrictive.

Looking ahead to next week, we’ll get a number of reports on the state of the housing market and cap the week with yet another inflation report, this time via the Personal Consumption Expenditure (PCE). Overall we would expect lighter trading volumes as Wall Street looks to head into the holiday season. We hope all of our readers have a wonderful holiday season and a prosperous 2023!

The Out of Touch Fed

As noted above, the shift higher in the Fed’s dot plots (the committee members’ expectations for where the fed funds rate is likely to go in the years ahead) is a primary culprit behind the post-meeting stock market sell-off. But we would argue traders are making way too much of a big deal about these Fed dot plots. Frankly, dot plots may not be worth the paper they are written on. A year ago this week, facing rapidly accelerating inflation, all but two members of the FOMC thought the Fed Funds rate as of December 2022 would be less than 1%…only two thought it would be between 1-1.25% at this point! The Fed does not have any idea what they are doing. They have no forecasting ability so when they rattle the sabre suggesting the fed fund rates will be ratcheted above 5% and then stay there for the entirety of the next year, they really have no clue what they are saying let alone where rates will need to be.

On the notion that inflationary pressures have gotten worse from September 2022 to December 2022 (citing the dot plot changes in that time period): Nothing about inflation is worse today than September 2022! Secondly, using year-over-year inflation has nothing to do with informed decision-making. And worst of all, the housing index — which is 40% of the core CPI — lags dramatically. Powell acknowledged that housing data lags 6 months. If you put the true, current, rental housing indexes into the data today, you have 3 consecutive months of negative core inflation. Why are we using greatly lagged data to look at housing? And, we know that monetary policy proceeds with a great lag, but then Powell says we need to see year-over-year data to make decisions! This is crazy monetary policy!

So, why did the market go down this week? Because the market knows the data will continue to come in softer and Powell will ultimately be faced with the truth. There is a real chance in February 2023 (the next FOMC meeting) that data between now and then will bring this truth to Powell and he may not add a rate hike.

Labor is catching up to inflation, it is not causing inflation. Labor has nothing to do with the current inflationary problem and the Fed has no business intervening in the structural supply/demand of labor. If there are not enough people working (high vacancies) then companies will need to pay employees more. Powell has this completely wrong. For the Fed to suggest Americans need to lose their jobs (they are actively targeting a higher unemployment rate) in order for them to be able to tame the very inflation genie they let out of the bottle, well, it’s just plain wrong on so many levels.

If the Fed does stick to their current word and raise and hold rates above 5% for this upcoming year, we can be sure we are going to have a recession. However, we still believe Powell will have to pivot in 2023 as inflation slows dramatically and the economy slows to a stall. Based on tightening measures to date, we believe a labor market softening is imminent, and firms will improve their margins and productivity — and then we’ll likely see a far better profit outlook than what the market now expects. That’s the good news in all of this.

Quite the likeness…unfortunately.

Some Important Perspective, Otherwise Known as “Green Shoots”

As we exited the Great Financial Crisis of 2008-9, the amount of pessimism and gloom, and doom was palpable. It was difficult to find anything “good” as unemployment had sky-rocketed to double digits, people’s homes were worth about 30-40% less than they were prior to the GFC, and the banking system had nearly collapsed. So, when there was anything positive to point to in the spring of 2009 as we began to exit that crisis period, it was popular to refer to those positive developments as green shoots. The beginnings of a new Spring in the market.

Today, we find ourselves in a similar sentiment world of persistent pessimism, starkly in the midst of a cold winter as the Fed has once again thrown cold water on the recent budding optimism of the stock market. But despite the stock market wobbles on the back of yet another hawkish rinse/repeat speech from Jerome Powell this week, the reality is the Fed is NOT the only game in town…despite the media (and color us a bit guilty from time to time on this subject as well) obsession over every word and utterance from Fed officials. Indeed, we can’t recall a time when the Fed’s “open mouth operations” have carried so much weight.

All that said, we see many “green shoots” out there that are worth considering…all of which can provide some good stimulus to the market and the broader economy as we enter 2023. And, inevitably, the Fed will stop raising rates, and with the combination of these green shoots, along with a more settled monetary policy path, the pre-conditions to set up a rally in the stock market just might be in place. Let’s take a look at some of the under-reported developments….

• Unit labor costs in the most recent quarter have declined to just 2.4%, this is down from 8.5% in Q1 2022.
• Commodity prices are down across the board, and many of them significantly. Companies are now enjoying a 20% cut in industrial commodity input costs at the same time that labor costs are declining.
• The 10-year US treasury yield is hovering at a 3-month low, nearly 1 full percent below the October high. Yields are down across the entire treasury curve as the bond market is decidedly moving in the opposite direction of Fed policy.
• The US dollar is off nearly -10% from peak to trough. This will provide a tailwind for US multi-national earnings whereas the rising dollar has been a headwind throughout the first 3 quarters of 2022.v

In short, lower commodity costs, lower labor costs, and lower capital costs may all combine to provide a better bottom-line profit outcome for S&P companies than Wall Street analysts expect.

Now, turning to the consumer…we see the following:

• Gas prices are below $3 at the pump.
• Real wages are running at a 3% annualized pace, and
• Mortgage rates have dropped for a 4th week in a row, the longest stretch since May 2019.

Overall, we can’t remember a time when the CEOs in this country are almost 100% universal that we are going to have a recession. Usually, recessions are something that come out of left field and surprises the market. That’s not the case today as everyone is bracing for the slowdown.

Ultimately, we think there may be too much pessimism. Perhaps too much has already been discounted and that may open the door for a positive surprise. IF that is the case, then the need to catch up could provide an unexpected boost to the economy and financial markets in general.

Marcia, Marcia, Marcia

For the non-believers that inflation is indeed heading markedly lower…here is a chart of gas prices at the pump overlayed with CPI. Gas at the pump is the white line whereas CPI is the orange line. Based on this data…and the strong historical correlation, where would you expect CPI is headed?

Next, if we look at the internals from the latest CPI report we just received on Tuesday of this week, we take note of several very positive developments that seem to be slipping by many in the financial media. First, we note the 3-month annualized rate of change for the headline CPI (not the core which is always lower) has declined significantly to 3.7%. While this is still well above the Fed’s 2% target, it’s a huge improvement from the 9%+ reading earlier this year and the 7.1% 12-month rate of growth. We are heading decidedly in the right direction. Next, we focus on the line (highlighted in yellow) that is noted as OER. This stands for Owners Equivalent Rent and is the BLS’s calculation for housing inflation. As we’ve noted in the past, this number lags real-time data by as much as 6-12 months so we are not surprised to see this figure is actually still moving higher. We KNOW that real-time housing data is decidedly negative…everyone knows that…and even the Fed has finally acknowledged this. So, we can reasonably postulate that inflation today is being overstated due to OER. In fact, OER is more than 40% of the Core CPI!!

So, what happens if we remove OER….well take a look at the “All less OER” reading and take note of the 3-month annualized pace at just 1.8%!!! Bingo, a mission accomplished by the Fed if this condition can remain persistent.

And even though the last 2-months of much better than expected inflation data has been roundly dismissed by the Fed as “not sufficient” enough to change policy course, we note that we are now 5-months in a row of lower inflation and that we have definitively seen peak inflation for this cycle.

And finally, we leave you with this headline from today, December 16th, 2022 courtesy of Zillow….

Yes, we are just about as sick of writing about inflation coming down as Jan Brady was of hearing about her sister Marcia Brady. Marcia, Marcia, Marcia! Hopefully, 2023 will bring us new and better topics to cover!

The Most Anticipated Recession

We’ve talked in the past about how recession talk has reached such a crescendo that it has become the base case for nearly every Wall Street strategist, corporate CEO, and financial media spokesperson. Dare to utter that you don’t believe we are heading to a recession and you may just find yourself ostracized from the ‘in crowd’!

So, naturally, Wall Street price targets are reflective of this ‘obvious’ pessimism. Listed below is a table showing most of the major banks and their year-end targets for the S&P 500. Yet, notably, despite the low targets on the S&P, earnings and sales estimates for aggregate S&P companies have barely budged lower. There is quite a disconnect here between these two datasets. We wonder which will be wrong?

The Tightening Cycle

The Fed’s aggressive tightening cycle continues…this week’s 50 bps rate hike takes the upper bound on the Fed Funds rate to 4.5%. You may also notice the rate of ascent in this cycle is the steepest we’ve seen, even greater than the rate of ascent in the early 1980s.

Economic Funnies

Too bad the Fed doesn’t see it this way…

Crazy Stat(s) of the Week

Here are this week(s) crazy stats!

• The last time the US Fed Funds rate was 4.5% is January 2006!
• The 30-day average of the CBOE put/call ratio has moved to the highest since April 2020, and before that December 2018. This chart is an indication of investor bearishness reaching a crescendo.

Quote of the Week

“Business conditions are worsening as 2022 draws to a close, with a steep fall in the PMI indicative of GDP contracting in the fourth quarter at an annualized rate of around 1.5%. Jobs growth has meanwhile slowed to a crawl as firms across both manufacturing and services take a much more cautious approach to hiring amid the slump in customer demand. The upside is that weaker demand has taken pressure off supply chains which had been stretched during the pandemic. December saw a 2nd consecutive month of faster supplier delivery times, a phenomenon which not only signals improving supply conditions but also tends to herald the shifting of pricing power away from the seller towards the buyer. Hence price pressures continue to moderate sharply. In fact, December saw the largest monthly cooling of firm’s input cost inflation seen in the 13-year history of the survey barring only the lockdown related slump in April 2020.”

-Chris Williamson, Chief Business Economist at S&P Global Market Intelligence

Calendar of Events to Watch for the Week of December 19th

Monday 12/19– No major economic reports due out today.

Tuesday 12/20 – November Housing Starts and Building Permits are both expected to show modest contractions from the prior month. Builders have responded to higher mortgage rates by slowing down supply. Not exactly the desired outcome of the Fed.

Wednesday 12/21 – US Existing Home Sales data for November is expected to contract by another -5.2% as sellers and buyers continue to have difficulty coming to agreement in this higher mortgage rate environment. The Government’s report on Consumer Confidence is expected to decline to 99.0 from last month’s 100.2 reading.

Thursday 12/22 – The final reading on Q3 GDP is expected unchanged from prior reports. The year-over-year rate is anticipated to be 1.9%. Investors will also be watching the weekly jobless claims data which comes out every Thursday morning. These reports will be taking on added significance given the Fed’s continued focus on what they refer to as the “overly tight” labor market. Basically, the Fed wants to see job losses occur and rising claims will be the first place this shows up in the data.

Friday 12/23 – Happy Festivus! On deck today is another critical inflation report. The November Personal Consumption Expenditure (PCE) report is due out and economists are predicting a headline rate of 5.5% year-over-year, down from 6.0% last month and a Core PCE (Ex-food/energy) of 4.7%, down from 5.0% last month. Both measures are expected to show month-over-month gains of ~0.25%.

Source: FactSet