Wring of Fire

Jul 11, 2022

By Pete Biebel, Senior Vice President

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The past month or so of trading has been the market’s best effort yet at stopping its year-to-date skid. Sizeable net gains in two of the past three weeks have generated a little breathing room for the averages above their June lows. The NASDAQ Composite Index (COMP) was the biggest winner last week (+4.56%) and over the past three weeks (+7.75%), but it’s still the biggest loser year-to-date (-25.63%). Of the three popular indices, the Dow Jones Industrial Average (DJIA) had the smallest bounce last week (+0.77%) and over the past three weeks (+4.85%), but it still has the smallest net loss year-to-date (-13.76%). The S&P 500 Index (SPX) gained 1.94% last week, has a net gain of 6.11% over the past three weeks and is now down 18.19% for the year.

While the stock market has exhibited a new and improved tone in recent weeks, with the rebound rally displaying more stamina and stickiness than earlier attempts, the biggest change has been the performance of the two leading sectors. Both the Energy sector and the Commodities sector, which had been sopping up big gains while other sectors dribbled lower, got wrung out over the past month.

Measures of the Energy sector and Commodity sector performance peaked in early-June with year-to-date gains of about 60% and 45% respectively. But both groups were put through the wringer beginning in mid-June. While nearly all other sectors were attempting to gain altitude, Energy and Commodities were going down in flames. From its June peak, the S&P Energy Sector Index has plunged about 27%. That loss represents a retracement of a bit more than 50% of its rally from its December 2021 low. An overall commodity index that I track also retraced about 50% of its six-month rally in a matter of weeks. That index is now about 15% below its June peak. For those two sectors, after climbing steadily and impressively higher through the first five-and-a-half months of the year, it was really their first wring in the New Year.

The shift in market sentiment from fear of inflation to fear of recession undoubtedly contributed to the sudden weakness in those two sectors. But two other factors exacerbated the speed and size of the drawdown: First, both sectors were technically extended and overbought, and second, both sectors had become, in Wall Street parlance, “over-crowded trades.” Two years ago, “nobody” wanted to own energy or commodities. They were clearly underperforming sectors while the U.S. stock market continued to go up, up, up. Then, as inflation began to increase and geopolitical factors contributed to supply-chain bottlenecks (and an overvalued stock market began to deflate), commodity and energy prices began to climb. Investors gradually went back to those forgotten sectors. As prices and performance relative to the rest of the stock market continued to climb, the popularity of the sectors grew. The impressive strength early this year made owning exposure in those sectors almost mandatory. When recession fears began to drive commodity prices lower, traders, especially those who had been late to the party, were quickly stopped-out of their positions.

The rallies in energy and commodities generated the strongest upward momentum in more than a decade for those sectors. That alone suggests that another leg higher is still likely. And, although the potential for a recession may have increased, the economic and geopolitical factors that have been contributing to energy and commodity price inflation don’t seem likely to abate anytime soon. If the uptrends are going to resume in the coming months, then both sectors will need to avoid making significantly lower lows over the next few weeks.

One area that also had a certain wring to it is the Basic Materials sector. As commodity prices declined, the impact was sorely felt in the stock prices of companies whose primary business is in base metals. Stocks of aluminum, copper, steel and even gold mining companies have been much weaker than the overall market in recent weeks.

The growing fears of a recession that wrung out commodity and energy prices also had a significant impact on the bond market. The yield on 10-year Treasuries, which peaked near 3.5% in mid-June, plunged to 2.8% in less than three weeks. The sudden decline in interest rates helped the Utilities sector rally about 10% over that same period.

Going forward, two things seem fairly certain: One, the Fed is likely to continue pushing its benchmark rate higher over at least the next few months. Recent reports have revealed strong employment and job openings numbers along with persistent evidence of inflation. And two, the rate of quarterly earnings growth is likely to decrease. Many analysts have been busily reducing their earnings estimates for the S&P 500 stocks for both 2022 and 2023. The multiple of current and future earnings, at which the market trades, is partly a function of interest rates (higher=worse) and the expected rate of earnings growth (lower=worse). So, the potential for the market to move significantly higher in the coming months seems pretty slim.

But the potential for the market to move a little higher in the coming weeks looks pretty good. Based on the short-term momentum and the oversold condition from which the recent rally began, the rebound in the overall market is likely to wring out some additional gains in the weeks ahead. If SPX can climb into the 3980 – 4000 range, it would not only lift the index above its 50-day moving average, but it would also register the first rebound higher high of the year. Beyond that, there’s not much resistance to further gains until into the 3990 – 4110 area.

For investors sitting on cash and waiting to do some bargain hunting, a few thoughts:

  • I still think it’s too soon to be an aggressive buyer, but not too soon to do a little window shopping and begin creating a wish-list.
    • Focus on stocks with stable earnings growth.
    • The Healthcare sector may be a good choice as a defensive sector.
  • There’s still a real possibility that the broad averages could fall another 10% or so from current levels.
  • Some signs that we’re getting close to a low might be:
    • The prevailing market mood shifts from, “It can’t get much worse,” to “The end of the world is coming. Get me out.”
    • Stock market performance becomes a punchline on the late-night talk shows.
    • A high volume, wide range day in the overall market that hits a new low but ends the day with a net gain.
  • If/when the averages get near those lower ranges, many stocks of companies with solid balance sheets, strong sales growth and a reasonable valuation will be holding above their previous lows. Such stocks should probably represent good buying opportunities at that time.

One other point to keep in mind: Don’t focus on a stock’s high last year in determining “value” today. That is especially the case for companies that are still not profitable. Many companies that were beneficiaries of the need to shelter-at-home through the pandemic, saw their stock prices soar to dizzying heights. But buying in those stocks was driven by free money and momentum. Their stock prices continued to climb irrespective of value. The fact that many of those stocks are down 50% to 70% or more from their high does not imply that those stocks are necessarily cheap.

This week’s economic report calendar is more impressive in its length than in its substance. It’s a storybook calendar with a bunch of dwarfs and a couple giants. The two behemoths are the inflation numbers, the CPI data on Wednesday and the PPI data on Thursday. Inflation figures even a little bit tamer than expected could elicit a fairytale reaction in the stock market.

Date Report Previous Consensus
Monday 7/11/2022 No Reports Scheduled
Tuesday 7/12/2022 NFIB Small Business Optimism Index, June 93.1 92.9
Wednesday 7/13/2022 Consumer Price Index, June, M/M +1.0% +1.1%
CPI, ex-Food & Energy, June, M/M +0.6% +0.5%
CPI, ex-Food & Energy, June, Y/Y +8.6% +8.6%
Fed Beige Book
Thursday 7/14/2022 Initial Jobless Claims 235K 234K
Continuing Claims 1,375K 1,395K
Producer Price Index, June, M/M +0.8% +0.8%
PPI, ex Food & Energy, June, M/M +0.7% +0.5%
PPI, ex Food & Energy, June, Y/Y +9.7% +9.4%
Friday 7/15/2022 Retail Sales, June, M/M -0.3% +0.9%
Retail Sales, ex Vehicles & Gas, June, M/M +0.1% -0.2%
Empire State Manufacturing Index, July -1.2 -1.3
Import Prices, June, M/M +0.6% +0.7%
Export Prices, June, M/M +2.8% +1.0%
Industrial Production, June, M/M +0.2% +0.1%
Consumer Sentiment, July 50.0 50.0


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