HUGE INSIGHTS: The Big Picture - Issue #5
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The S&P 500 index hit our published target of SPX 4800 this week. Now what? In the pages that follow, we will discuss our outlook and key concerns for the broad equity market in 2022.
Structural Momentum Diverging
A common precursor to a major market top is a long-term momentum divergence. The market’s momentum can be measured in a variety of ways. One very illustrative approach is to measure the distance between price and a key moving average. We’ve long held that the 36-month EMA is an excellent measure of the long-term trend. The ebb and flow of price relative to that key moving average is a way of de-trending the market's price action and looking at it purely as a function of its long-term rate of change.
The lower panel of the chart below illustrates that dynamic. As price accelerates above the EMA, momentum expands. As price mean-reverts, the momentum tends to contract. But momentum can contract even when price continues to move higher, if it does so at a lower rate of change. This results in what market technician's refer to as a "negative divergence" between price and momentum. Historically, pronounced declines in price are almost always preceded by such negative divergences. Sometimes the divergence can persist for years, other times for just a few months. A negative divergence is now evident.
The 7-Year Cycle is Entering the "Shmita" Year
While most cycle analysis focuses on price action to identify cycle peaks and troughs, we’ve found that cycles can appear even more pronounced when viewing them through the lens of momentum. Again, looking at the lower panel on the chart above, we overlaid a 7-year cycle upon our momentum study.
This periodicity is not arbitrary. It dates back over 6,000 years and derives from the Hebrew tradition, as mandated by the Torah (Ex 23:10-11, Lev 25:20-22, Dt 15:1-3). The “Shmita” or “Shemitah,” which means to “release” or “let go,” refers to the seventh year of the biblical Jewish agricultural cycle. The ancient Israelites considered the Shmita to be a sabbatical year, a year of renewal, whereby Jewish law forbade landowners from working their land, and required them to forgive all outstanding debts except those of foreigners. This allowed the economic cycle to reset or refresh.
An interesting observation is that negative momentum divergences, as discussed above, have tended to occur at regular intervals that coincide closely with, or precede the beginning of the Shmita year (blue dotted vertical line). As can also be observed in the table below, there is an apparent history of adverse market events that have occurred during Shmita years.
Valuation Has Reached an Historical Extreme
Total U.S. Market Cap-to-GDP closed the year at a new all-time record extreme of 209%. That compares with its prior cycle high of 148% recorded in March of 2000. In addition, the Shiller Cyclically Adjusted Price-to-Earnings ratio (CAPE) reached 39.7x vs. its March 2000 record high of 43.8x, and a historical average of 17.2x. The S&P 500 Dividend Yield remains below the 10-year Treasury yield, while its Price-to-Sales ratio set a new all-time record high of 3.2x, exceeding the prior extreme of 2.0x by more than 50%. To add insult to injury, the largest seven stocks in the S&P 500 (AAPL, MSFT, GOOGL, AMZN, FB, TSLA, & NVDA), which now account for nearly 27% of the market cap of the index, reached a peak weighted average Price-to-Sales ratio of 12.0x this month.
Inflation at Highest Y/Y Growth Rate in 40 Years
Today, the monthly percentage increase of the Median CPI is hovering around 6%, just below its recent high of 7.1%, and well-above every other monthly report since 1982. While largely linked to pandemic related supply chain disruptions and logistical bottlenecks, at the end of the day, inflation is a function of too much money chasing too few goods. Or as the venerable economist Milton Friedman famously put it, “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” The key question on our mind is whether or not the Fed can engineer a soft landing, whereby the withdrawal of policy support can adequately address inflation without deflating the attendant asset bubble it created.
2022 Earnings Growth Will Be Down 80% Y/Y
Earnings for 2021 appear poised to end the year up 45% Y/Y, according to FactSet. The good news is, this was the best annual earnings growth since the great financial crisis. The bad news is, the consensus of analysts on Wall Street are currently estimating 2022 earnings growth to be just a touch above 9%, or a mere 20% of the past year's growth rate. While still respectable growth, the slowing of earnings growth tends to result in P/E multiple contraction.
Total Global Debt Approaching $300 Trillion
A rise in the level of margin debt tends to coincide closely with bullish sentiment toward stocks. As the absolute level scales new heights, it reinforces the animal spirits that are driving stock prices higher. It acts as incremental liquidity for buyers. But once the rate of change (ROC) begins slow, it is oftentimes a harbinger of a looming peak in bullish sentiment. That occurred in March of this year when the ROC peaked at 71%. It has since plunged to just 26% as of November 30th. The absolute level of margin debt peaked seven months later at $935B in October, and declined by $17B in November. The decline in the absolute level of margin debt is akin to a withdrawal of liquidity from the system. It reflects a directional change in the trend of investor sentiment from bullish-to-bearish. The decline in margin debt from a new all-time record high, typically precedes a market trend change from bullish-to-bearish as well.
More concerning though, is the level of total global debt in the world today. Estimated to reach $296.5 Trillion before year-end, according to the Institute of International Finance, global debt was up another 16.5% Y/Y in 2021. The vast majority of this debt is short-term in nature, making it especially sensitive to interest rate increases. As many are aware, the Federal Reserve maintains a running tabulation of the timing and magnitude of estimated rate hikes forecasted by the voting members of the board of governors -- aka the "Dot Plot." As of December, these members are collectively forecasting three rate hikes in 2022, beginning in June. This would put the mid-point of the Fed Funds rate at an estimated 0.875% by this time next year.
Conclusion
While we are not forecasting an impending calamity for 2022 just yet, the ingredients exist for a drawdown of 20% at some point during the year. As we ponder what to expect for the next year, the scenario that appears most plausible, in our view, is one where the US equity market experiences a Q1 melt-up. More specifically, the Santa Claus rally that we've experienced into year-end carries into early January and ends the month in positive territory, giving the bulls the confirmation that they desire from the January barometer for another year of gains ahead. This would help fuel a resurgence in bullish sentiment, a condition that is necessary before a durable market top can be achieved.
A Q1 market top, followed by a period of sustained weakness would dovetail fairly well with the 2022 Shmita year, as discussed above. It also fits the fundamental backdrop of rising inflation, slowing earnings growth, tightening liquidity conditions, and the timing of expected Fed rate hikes. In addition, we know that seasonality favors market strength through the end of May, and market weakness from June through October. But 2022 is a mid-term election year. Looking back at mid-term election year market data since 1931, the S&P 500 has tended to trade up modestly into mid-April, and then decline into mid-September, coinciding with above average levels of volatility as measured by the VIX. The mid-September low has typically been followed by a rally into year-end.
During 2018, the last mid-term election year, the S&P 500 experienced a Q4 drawdown of nearly 20%, while the R2000 collapsed by more than 27%. Then, the decline in equities occurred much later than the seasonal norm, highlighting the fact that these seasonal and cyclical tendencies are anything but homogeneous events, by which one can set their watch. Nevertheless, chance favors the prepared mind.
Given that the S&P 500 has hit our target for 2021, we will use this opportunity to establish a new 2022 target. But first, we expect the market to peak in Q1 at or below SPX 5000, then experience a 10-20% drawdown into Q3, before bottoming for the year. Upon bottoming, we believe the market can then rally smartly into year-end, reaching a high of at least SPX 5200, for a net gain of roughly 9% -- in-line with earnings growth for the year.
Best wishes to all for a healthy and prosperous New Year!
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