Capitulation

It’s absolutely necessary. That’s what many of my Wall Street sources are saying. Temporary oversold conditions may spawn a short-term rally but market breadth and momentum are far from fully washed out. The percentage of oversold stocks based on the relative strength index, a technical momentum indicator, is roughly 18%. Readings exceeded 65% during the ’18 and ’20 lows. A violation of a head-and-shoulders top (three peaks in a market chart with the highest in the middle) puts technical support near 3,500 on the S&P 500. That lines up with a 50% retracement of the March ’20-January ’22 rally and February ’20’s peak. There’s intermediate support at 3,815, with 4,100 representing stiff resistance. The percentage of issues making 65-day lows is around 25%, not even the highest year-to-date (YTD) and well below a 50% reading indicative of a meaningful low. Despite falling bond yields, the tech-laden Nasdaq keeps trending deeper into its bear market. For the first time in 13 years, the macro backdrop is hostile toward tech and growth. But there are too many dip buyers. YTD, inflows into a highly popular meme/tech stock ETF that’s down roughly two-thirds continue to dwarf inflows into a big energy stock ETF that’s up roughly a third. More broadly, equity fund redemptions are running at a sixth of the pace for redemptions in credit bonds, Bank of America shares, even though equity’s drawdown has been much larger. Meanwhile, the VIX is struggling to hold above 30, well short of 40, which is associated with “proper” capitulation. AAII bullish and neutral sentiment in fact rose this week while bearish sentiment fell. Maybe it’s because an estimated third of retail investors never endured a 20% drawdown, having only become involved in stocks after the Covid crash. Where’s the panic?

Panic is not necessary. A good Q1 earnings season, more reasonable valuations and moderating wage growth (more below) prompted Barclays to turn neutral from underweight on risk assets this week. Fundstrat, who says its clients are exhibiting “a great deal of despair” and “anger” toward equities, also argues the risk-reward is improving. Fed tightening is starting to bite, feeding a building wave of tech layoffs (more below) and a slowing in housing (more below). Core PCE inflation is its lowest since January, and BCA Research projects goods prices to plunge from +12% year-over-year (y/y) in Q1 to -3% in Q4, lopping 4 points off core CPI by year-end. Inflation expectations actually declined slightly this week. Also, rising stock correlations are nearing levels that in the past were associated with gains over the next three months. Then there’s the Fed “put’’ 2.0. Not an about-face. But markets are interpreting Powell’s comments yesterday as a sign the Fed could end “tighter” sooner if the economy weakens too much (did you hear that??). With the base case avoiding recession and 9% earnings-per-share growth on track (though forward earnings came off their record high this week), valuations look favorable in many areas. Credit Suisse says stocks that usually benefit from higher rates of inflation are trading at big discounts relative to norms; value stocks as a group are 3.8 P/E multiple points below their historical average. Growth stocks are half a point above. From 1990 to 2019, the 10-year Treasury yield averaged 5.3% and forward P/E averaged 17.7x. It’s below that now, suggesting the overall market doesn’t have to de-rate.

So do we need capitulation or not??! With the proviso that cash is king, this is a great time for traders who like to press shorts (and take advantage of GenZers and crypto fanboys whose Robinhood accounts are plummeting—the swagger is sadly gone) and for stock pickers. Since no one knows how the Russia-Ukraine war will advance, when China will reopen, how long it will take to tame inflation and how draconian must be the medicine, and whether we’ll have a “softish” landing or recession, then what should we do? We don’t know anything of these things, so let’s look at what’s priced in. The 50-day change in the Nasdaq 100 is in the first percentile historically. Pretty good odds. Despite recent weakness, Energy remains in an outstanding position on both a relative and absolute basis—going back 15 years, it remains the least expensive sector on a relative P/E basis. Nice odds! Much of the defensive, dividend-wielding value complex still trades at a significant discount to the S&P after five years in the wilderness. Excellent odds with a yield bonus! At a most enjoyable advisor dinner in Cincinnati, I started my presentation with, “I have a sobering message.” No matter, this group was stubbornly jovial. An advisor asked, “What is capitulation?” “It’s when your client calls saying, ‘Sell everything. I want out.’” Though my Wall Street sources report clients asking for bottom-fishing ideas, these Cincinnati advisors report capitulating clients. I see a labor market which has never been stronger. Consumers still sitting on over $2 trillion in cash. Corporations with record debt but a record ability to service that debt, 90% of which is fixed rate and not set to mature for six to eight years. Indeed, the market’s damage YTD had nothing to do with earnings but P/E re-rating for higher inflation. YTD P/E multiples have contracted from 22X (given 2% Goldilocks inflation for 40 years—I will miss you dearly) to 16.5X. A lot of progress compared to an average 14.5X since 1965 and Christmas Eve 2018’s 13.5X. Cash is the king of my shopping list, which is getting longer.

Positives

• Peak sticky inflation? The NFIB’s survey of small businesses reported compensation plans appeared to be passing their peak surge, and the 3-month annualized growth rate in average hourly earnings for production and nonsupervisory workers slowed to 3.8% from 7.2% in the second half of 2021. In housing, there was less urgency on the part of buyers amid a shift from the usually strong spring to typically slower summer seasons, with tight inventory, strong pricing and higher mortgage headwinds. Sellers who dropped their asking prices shot up to a 6-month high 15% this month.
• The economy is strong Proprietary Evercore ISI trucking and housing surveys moderated but remained elevated, and after surging the prior week on leisure demand, its airline survey held at its highest level since 2012. Elsewhere, auto production levels jumped, with Q2 output set to hit pre-pandemic levels.
• Consumers have a lot of firepower Revolving credit grew at blistering pace in March, 42% annualized, or $30 billion. The good news is that revolving credit balances remain well below normal and household leverage still does not look problematic. As a percentage of household disposable income, revolving credit sits at 5.9%, below the pre-pandemic levels of 6.6%, suggesting there’s room for consumers to spend even with prices rising pretty much everywhere (more below).

Negatives

• Everything’s expensive April’s CPI slowed less than expected, led by airlines fares, which spiked a record 18.6% month-over-month to 11% above their pre-pandemic high. Hotel prices also jumped, now 16% above pre-Covid levels. The sustainability of huge increases in these reopening areas is doubtful as pent-up demand gets met, but it illustrates the shift from goods to services inflation will still pack a punch. Producer prices slowed but most goods categories saw solid gains, many more than 1%.
• Consumer is still miserable Despite healthy balance sheets, the consumer mood is as bad as it’s been since just after the global financial crisis. This morning’s initial take on May sentiment from the University of Michigan fell more than forecast, with the current conditions component at a 13-year low and the durable-goods buying component at its lowest level since the survey began in 1978.
• If you can squint, you can find stagflation An article in TechCrunch, an online publication focusing on start-ups, says the rising cost of money is starting to generate layoffs in the start-up world as typically unprofitable young ventures struggle to raise capital and cut costs. The pace of layoffs is running 5,000 weekly and industry watchers say the total could quickly reach into the millions.

What else

This is what a bear looks like Most investors remember the last bear market, the rapid one from 2020 that only lasted a few months. It was quite rare. Thus far, we’re 4.5 months from the January high, shy of the average bear market which lasts for about 15 months. Not incidentally, the average decline is closer to 34%, which would imply 3,200 on the S&P.

Ode to dividends Amid the worst month for the S&P since Covid (-8.7% on a total return basis in April), high dividend yield was the most resilient of all 50 factors Bank of America follows, returning -1.8% on the month. It also had returned 1.4% month-to-date through this past Tuesday, the best factor so far in May and second-best performer YTD (+7.3%). Dividend growth also did well on a relative basis, -4.8% in April and -5.8% YTD.

Lots of investors have never seen this Last week’s decline marked the fifth straight week the S&P has fallen, the first time it’s had such a stretch since June 2011, ending the longest run without a 5-week pullback since weekly data started in 1928. In the 83 years between 1928 and 2011, there were 61 such runs, or one every year and third on average.

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