HUGE INSIGHTS: The Big Picture - Issue #11
Please enjoy this monthly newsletter with our compliments. To get full access to our Idea Generator Lab content, which includes our top stock or ETF idea each week, become a dues-paying member for just $10 a month by clicking here.
If it Looks Like a Duck, and Quacks Like a Duck
Oh what a tangled web they weave. A long list of government officials have been paraded out in a series of high profile public appearances over the past couple of weeks to ensure that we all understand that despite what we think we know, the U.S. economy is definitely not in recession. It reminds us of an old joke that goes something like this: "Q: How do you know when a politician is lying? A: Their lips are moving."
The Bureau of Economic Analysis reported on Thursday that the U.S. economy contracted by an annualized rate of -0.9% in Q2. Following their final revision to Q1 GDP growth of -1.6%, that marked the second consecutive quarterly decline in real economic output, a condition which has coincided with every U.S. recession since 1947. Each recession in post-war history has followed a similar path. It starts with a slow down in housing, followed by a contraction in manufacturing, then overall profits turn down, and finally, employment rolls over.
A near doubling of mortgage rates over the past year has led to a dramatic decline in new home sales in first half of this year. According to the U.S. Census Bureau and the Department of Housing and Urban Development, new home sales declined 8.1% m/m, and 17.4% y/y in June. YTD, the number of new houses sold is down 13.4% vs. the same period in 2021. The median sales price in June dropped to $402,400 from $449,000 in May.
Top-ranked housing analyst Ivy Zelman, of Zelman & Associates, noted in a recent presentation that homebuilders reported an average customer cancelation rate of 17% nationally in June, led by a record cancelation rate of 34% in the hottest markets -- California, Arizona, and Nevada. This was unprecedented.
The month of June also witnessed a collapse in new orders for manufactured goods. The ISM Manufacturing New Orders Index implies an expansion when it's above 50, and a contraction when it's below 50. The June reading of 49.2 indicates the first contraction since May 2020, and signals that rising interest rates are beginning to impact demand for manufactured goods as well.
Credit and financial conditions are already tight. Since March 16th, the Fed has embarked upon an epic mission to quash the highest inflation rate observed in over 40 years. The June CPI and PPI reports came in at 9.1% and 11.3%, respectively. This in turn, led the FOMC to raise the Federal funds rate on Wednesday by another 75 bps to 2.25-2.50%, up from zero just four months ago. According to the CME Group, the market still expects an additional 50 bps increase at the September 21st FOMC meeting with 74% probability, and ascribes a 26% probability to the potential for a third 75 bps hike. None of this even considers the fact that the Fed has barely begun the planned process of quantitative tightening, which will shrink their balance sheet by 4.5% this year, and 13.2% next year.
With 56% of the companies that comprise the S&P 500 having reported 2Q22 results through Friday's close, including the big-six: TSLA, MSFT, GOOG, META, AAPL, and AMZN, we now have a pretty good feel for how EPS growth will look for the quarter -- and it's not great!
According to FactSet Research, the blended earnings growth estimate for Q2 is now 6.0%. But, excluding the Energy sector, earnings growth for the index is actually expected to be -2.6%. Both are a far cry from the overtly optimistic 9.6% annual S&P op-EPS growth that the street is forecasting for the full-year. The biggest declines so far, have come from the Financial, Consumer Discretionary, Communication Services, and Utility sectors.
Employment is the single most lagging indicator of economic health. But since April, we've seen a steady uptrend in the 4-week moving average of U.S. unemployment applications. Indeed, according the Bureau of Labor, despite the low headline unemployment rate of 3.6%, there are currently more than 1.35 million Americans receiving unemployment benefits, while weekly jobless claims hover near an 8-month high. As the saying goes, "When your neighbor loses his job, it's a recession. When you lose your job, it's a depression."
The weight of the evidence suggests that the U.S. economy is currently in recession. But don't take our word for it. Trust your own eyes. The yield curve is presently inverted at all vector variations except the 10-year minus 3-month spread. But, perhaps most important, is the 10-year minus 2-year spread, which is now inverted by 22 bps. In every instance in which an inversion has occurred in the 10s/2s over the past 75 years, the NBER has declared the economy to be in recession within 10-33 months thereafter. Honestly, they don't call the bond market the 'smart money' for nothing. To quote my old friend Harley Bassman, creator of the MOVE index, "It's a stone-cold fact that the best predictor of a recession is the yield curve."
Don't Be Fooled...It's a Bear Market Rally!
If the economy is in recession, as the canaries above suggest, then what are the implications for the stock market? The effects of a tighter Fed policy will take time to manifest -- historically, around 18-24 months -- before they fully filter through the economy enough to permanently quash inflation.
Indeed, it was reported on Friday that the Core PCE (Personal Consumption Expenditure), the Fed's preferred inflation gauge, ticked up to 4.8% in June, from 4.7% in May. As such, it seems premature to suggest that the Fed will immediately pivot toward an easing mode to begin fighting a recession that they claim does not exist, before there is any evidence that the original policy goal of quashing inflation has been realized. In short, we may be much earlier in this process then most pundits believe.
That being said, stock market bulls have been tripping over each other to call a market bottom. Following the S&P's June 17th intraday low of SPX 3637, we pointed out that the index was trading at a valuation that was far more consistent with past epic market tops (a CAPE ratio of 28.7x), than any historic market bottom.
But we also conceded that the market was deeply oversold and poised for a bear market rally. The countertrend advance witnessed since has now met the mid-point of our expected upside target range -- the 50% retracement of the decline off the March 29th high.
The full-range extends from SPX 4017 to SPX 4255, but price is currently caught in a tight resistance zone marked by the May 17th and June 2nd closing highs, which also coincides with the 100-DMA, and the aforementioned 50% retracement. Together these levels should collectively act as formidable resistance. That, coupled with the fact that the advance has reached an extreme overbought condition, suggests that the bear market rally is quite mature.
As such, while there is room for a modest further advance, we would advocate taking advantage of the market's recent strength, and using this as an opportunity to reduce equity exposure and raise cash levels going into the upcoming seasonally treacherous August-September-October period.
If a slowing economy, deteriorating earnings growth, and historically extreme stock market valuations aren't enough to deter you from throwing caution to the wind, another reason to doubt the sustainability of the current rally can be gleaned from taking a longer-term perspective. We've analyzed the advance using the Elliott Wave principle, looking back a Fibonacci 13 years. From the March 2009 low, we are able to count a valid five wave impulse pattern that appears to have terminated on January 4th of this year at intermediate, primary, and cycle degrees of trend. The count meets all of Elliott's rules and guidelines and therefore has a high probability of being correct.
If our cycle degree count for the advance is correct, then we are very likely in the early stages of a corrective wave form of at least cycle degree as well. A cycle degree correction should retrace between one-third and two-thirds of the previous five wave advance at the same degree of trend. That would establish a target range of SPX 3450 to SPX 2050. But we could fine tune that range by focusing on areas where Elliott's guidelines coincide with the most common wave relationships and other common support levels.
Combining R.N. Elliott's observation that corrective waves tend to terminate in the vicinity of prior fourth wave extremes, with the fact that corrective wave forms also have a strong tendency to retrace in common Fibonacci proportions (eg. 38.2%, 50.0%, and 61.8%), and the proclivity for the market to gravitate toward key moving averages, we can further conclude that there is a high probability that the S&P will continue its cycle degree correction until it retraces at least 61.8% to terminate near the primary wave (4) low of the prior cycle degree advance, which coincidentally, will be just above the rising 200-month moving average before year-end.
Integrating our short-term technical view with our long-term preferred Elliott Wave count, we can observe that the decline from the January 4th ATH to the June 17th interim low traced out a "Leading Diagonal" triangle wave form to complete primary wave (a) down. Primary wave (b), a countertrend advance, is currently in progress. If it's a simple [a-b-c] zigzag, as we've illustrated above, then it's likely to terminate within the range that we previously indicated. Once countertrend wave (b) is complete, it will be followed by primary wave (c) down.
Assuming Friday's close marked a level very near the wave (b) high, there are two very common wave relationships that could prove germane to this discussion. The first is, if wave (c) is equal to wave (a), then wave (c) would terminate at approximately SPX 2950. The second is, if wave (c) equals 1.618 times wave (a), then wave (c) would terminate at approximately SPX 2220. In addition, given its current trajectory, we can estimate the value of the 200-month moving average to be approximately SPX 2140 by year-end. Given that the 61.8% retracement resides at 2260, and the prior fourth wave low comes into play around SPX 2190, it would then be reasonable to establish SPX 2250 +/- 50 S&P handles as an optimized target for primary wave (c) down.
Conclusion
As if the news couldn't get any worse, there is one last point for consideration. What if the market is correcting at a larger degree of trend than cycle degree? We can also count five waves up over the past 90-years at supercycle degree, in a well-defined trend channel, from the 1932 low to the 2022 high. If the 1929 high marked the top of supercycle wave (I), and the 1932 low marked the bottom of supercycle wave (II), then the 2022 high could mark the top of supercycle wave (III). If so, then the cycle degree corrective wave form that we have been discussing may only be wave A of supercycle corrective wave (IV).
There is no way to know for certain whether or not the fractal geometry of the stock market that is observable in the framework of the wave principle will continue to produce self-similar wave forms at ever higher degrees of trend. But if what can be observed of this same concept in nature, also applies equally to human nature, then there is good reason to believe that it will.
Alternately, we could be wrong. It would not be unprecedented for the stock market to look through the aforementioned economic doom and gloom as laid out in the pages above, and make a bottom well-before a recession has ended. It did it in March of 2020. But, never before has it done so at valuations as lofty as they are today, nor during a period of high and increasing inflation, nor when the Fed was tightening policy as aggressively as they are today.
According the Stock Trader's Almanac (using data since 1946), during a midterm election year -- and one that is also the 2nd year in office for a new Democratic President (red line) -- the S&P 500 has tended to bottom in late June, rally into early August, then decline to new lows in late October. There are two dates that we are targeting for a market low this year. They are both major cycle turn-dates as modeled by the late, great cycle analyst Paul Macrae Montgomery. The first is October 25th, which would coincide well with the midterm election year cycle as discussed above. The second is November 8th, election day.
The bullish consensus view is that the the Fed will engineer a soft landing -- that is to say that they will quash inflation and pivot before a recession is declared. We hope that they're right. But the bulls make that call EVERY time, and it has NEVER worked out that way before. The massive fiscal and monetary stimulus that was pumped into the global economy during the pandemic-lockdown period from March 2020 through March 2021 has created an epic, worldwide spending binge and a concomitant asset bubble. Today's high global inflation has been the predictable result.
There are two solutions to inflation. One is to increase production -- but there is a huge shortage of raw materials that will take years to replenish, and far too few workers to do so any sooner. The other is to withdraw the stimulus. The Fed knows this and is now attempting to do just that -- something that has never been done before. Keep this in mind if you're bullish on the U.S. economy and the stock market: It could take the Fed years to complete the process.
Disclaimer
All information and data contained on this site and in reports, analytics, etc. produced by Jeffrey W. Huge (the “author”) is for informational purposes only. The author makes no representations as to accuracy, completeness, suitability, or validity, of any information. The author will not be liable for any errors, omissions, or any losses, injuries, or damages arising from its display or use. All information is provided AS IS with no warranties, and confers no rights.
External links are often provided within the author’s newsletter for the convenience of the reader. The author will not be responsible for any material that is found at the end of these external links.
The author is NOT registered as a securities broker dealer or investment adviser with either the U.S. Securities and Exchange Commission or with any state securities regulatory authority.
The content of the author’s newsletter should not be considered professional financial investment advice. The ideas and strategies should never be used without first assessing your own personal and financial situation, or without consulting a financial professional. The author may hold positions or other interests in securities mentioned, including positions inconsistent with the views expressed.
The user bears complete responsibility for their own investment research and should seek the advice of a qualified investment professional before making any investment decisions.
Past performance is no guarantee of future results.