The countdown clock has started … looking at the main influences on your stocks … shopping behavior is changing … looking ahead to Q1 earnings season

Last week’s inversion of the 10-year Treasury yield and the two-year Treasury yield was like pressing “start” on a timer counting down to zero.

If history is our guide, there’s likely to be a recession and a challenging stock market when the clock runs out.

However, between now and then, history suggests stocks will produce some great returns.

Here in the Digest, we’ve used the analogy of the final dance at a party. It’s just begun and it’s a great song – you want to dance – but you don’t want to overstay and be the last one at the party.

So, how do get the most dancing in without getting stuck at the end of the night?

Well, no one has a crystal ball. But we’re going to be tracking this tradeoff as closely as possible over the coming months to help you pick a good time to head for the door. We’ll do this by monitoring the biggest variables that are impacting timing.

In a nutshell, those variables are inflation, the Fed and its policy changes, consumer spending, and corporate bottom-lines.

Today, let’s take a 30,000-foot view of where we are with these variables, as this (potential) last song of the party cranks up.

***Historic inflation means pain for Main Street wallets

Let’s begin with inflation.

If inflation was clocking in at the Fed’s targeted 2% rate, we’d all go ride off into the sunset and live happily ever after.

Instead, runaway inflation has been eating away at Main Street pocketbooks for months.

The latest numbers from the Bureau of Labor Statistics put the annual inflation rate at 7.9%, a four-decade high.

We’re seeing this begin to change the behavior of shoppers. And it’s not just by, say, delaying that vacation or buying the sensible Honda Accord instead of the luxurious Porsche Boxster.

Shoppers are becoming price-sensitive even to staples, which is not a good sign.

From The Wall Street Journal:

American consumers are starting to cut costs on mainstays from toothpaste to baby formula as inflation hits a swath of the economy that had thus far proven resistant to substantial price increases.

Procter & Gamble Co., Clorox Co., Kraft Heinz Co. and other consumer-products giants have made a bet that consumers will pay up for household products even as inflation takes hold.

Over the past year, the companies have seen profits and market share grow as they have raised prices on products from detergent and diapers to snacks and soda.

Now consumers, hit by soaring costs for everything from gasoline to child care, are drawing a line, analysts and retailers say.

Shoppers are buying staples in smaller quantities, switching to cheaper, store-name brands and more rigorously hunting for deals. The shift is especially pronounced among lower-income consumers who splurged on household products amid the heights of the pandemic, they say.

Wells Fargo just issued a report on the health of the consumer, with the takeaway that it’s cutting its 2022 earnings per share estimates for apparel and footwear companies.

From Wells Fargo:

There is building concern of a potential slowdown in the consumer — as geopolitical events, rising inflation and rising [interest] rates are already impacting consumer sentiment.

Now, obviously this will impact corporate bottom-lines, which is one of the big variables we’re tracking. But let’s hold off on that. We’ll circle back.

First, let’s jump to the Fed’s response to this consumer pain.

***The Fed’s tightrope of helping cost-conscious shoppers without pushing the economy into a recession

For months, the Fed told us inflation would be “transitory,” and so it did nothing to stamp out inflation.

Now admitting they were wrong, the Fed is scrambling to hike rates to ease inflationary pain. After all, it can’t allow this level of inflation to linger: it jeopardizes the health of the American consumer, and by extension the economy (consumer spending accounts for about 70% of the U.S. economy).

The problem is that Fed can’t raise rates too high, too fast, without the risk it will kneecap economic growth.

Rates that are too high discourage lending, which dries up investment capital and increases debt service costs. It’s the economic equivalent of trying to run in quicksand.

So, the Fed has a challenging tightrope to walk.

***As you know, last month the Fed raised the fed funds rate a quarter point, marking the first rate hike since 2018

It’s looking like the next Fed meeting in May will see the Fed ramp this up, raising rates by 50 basis points. We’re hearing this type of hawkishness from an increasing number of Fed presidents, one of which is Mary Daly, president of the San Francisco branch.

From Daly earlier this week:

The case for 50, barring any negative surprise between now and the next meeting, has grown. I’m more confident that taking these early adjusts would be appropriate.

(Please excuse our eye-roll at the description of “early.”)

In an interview with Financial Times, Daly went on to estimate that the effective fed funds rate will be “neutral” (neither helping nor hurting the economy) at a level of about 2.3% – 2.5%. She acknowledges that reaching this level by the end of the year will require “multiple” half-point adjustments.

Even the usually dovish Federal Reserve Governor Lael Brainard is becoming highly hawkish. Yesterday, when the 10-year Treasury surged to its highest level since May 2019, she said:

Inflation is much too high and is subject to upside risks.

The Committee is prepared to take stronger action if indicators of inflation and inflation expectations indicate that such action is warranted.

But what really impacted bond yields was Brainard’s comments on the Fed’s massive, $9 trillion balance sheet. She said a “rapid” reduction could happen as soon as May.

If the Fed reduces its balance sheet holdings rapidly, it will flood the market with supply. This will push bond prices down while yields soar.

Yesterday, we saw traders trying to get ahead of this, which spiked the 10-year Treasury yield.

As I write Wednesday morning, the yield continues to climb. It sits at 2.62%.

The big gamble is whether the economy can absorb a series of 50-basis-point hikes and a rapid reduction in the Fed’s balance sheet without keeling over.

Obviously, Fed officials proclaim it can…just as they proclaimed inflation would be transitory.

***So, how are companies faring so far?

Most companies have been able to protect their bottom-lines by passing along costs to consumers – because consumers have been willing to pay more.

For example, P&G has reported both pricing gains and volume gains since the start of 2019. In other words, shoppers have bought more toothpaste, deodorant, and whatnot at higher prices.

But we’re now seeing this change.

Let’s return to our cost-conscious consumer and shopping patterns from the same Wall Street Journal article as above:

The consumer-staples industry “has crossed a threshold,” said Krishnakumar Davey, president of strategic analytics for IRI.

“Consumers have been pinched for some time, they are observing that they are paying more and more, and they are beginning to drop some items from their basket because they can’t afford it.”

Now, this is just beginning to happen. So, for the most part, we haven’t seen substantial deterioration in corporate bottom-lines.

We’ll begin to get a better feel for this in about a week when Q1 earnings season starts. But even then, it won’t give us the full picture. We’ll need to wait for Q2 for more details.

Meanwhile, many companies are also going to run into the headwinds of Russia being cut off from the global economy. For example, McDonald’s, PepsiCo, Coca-Cola and Starbucks have all shelved operations in Russia.

The question is how much this will impact their bottom-lines. For McDonald’s, the 847 closed Russian locations will cost the company about $50 million each month.

Overall, McDonald’s monthly revenues come in at ballpark $2 billion. So, this $50 million isn’t going to tank the company by any means, but it’s certainly not helping. Plus, missing earnings estimates by even a penny or two can cause Wall Street to ding a stock price.

***So, what does all this mean for your portfolio?

Well, regular Digest readers know that a yield-curve inversion is initially bullish for stocks.

(If you’re new to the Digest, click here for a past issue that covers these details.)

Given that the inversion just happened last week, “the final song” is just getting started. So, we’re expecting plenty of dancing to be had.

That said, this is not a license to blindly throw money at any stock. As we noted yesterday, this is a fragmented market with a wide variety of winners and losers.

But let’s put this into real, actionable terms.

As noted earlier, Q1 earnings season begins in about a week. FactSet, which is the go-to earnings analytics company used by the pros, pegs the estimated earnings growth for the S&P at 4.7%. (By the way, if that is the actual growth rate, it will be the lowest rate since Q4 of 2020.)

But within the S&P, we have very different sector estimates that are changing.

From FactSet:

At the sector level, six sectors witnessed a decrease in their bottom-up EPS estimate for CY 2022 from December 31 to March 31, led by the Communication Services (-3.0%) and Industrials (-3.0%) sectors.

On the other hand, five sectors witnessed an increase in their bottom-up EPS estimates for CY 2022 during this time, led by the Energy sector (+35.9%).

FactSet goes on to translate this into what it means for analyst Buy Ratings on the various sectors:

At the sector level, analysts are most optimistic on the Energy (66%), Information Technology (64%), and Communication Services (62%) sectors, as these three sectors had the highest percentages of Buy ratings on March 31.

On the other hand, analysts are most pessimistic on the Consumer Staples (41%) and Utilities (49%) sectors, as these two sectors had the lowest percentage of Buy ratings on March 31.

Below is a chart showing FactSet’s research on the highest percentage of Buy and Sell Ratings in the S&P.

In the “Buy” chart up top, you see lots of tech. That’s no surprise to Digest readers, who know we’ve been saying the same thing thanks to research from our hypergrowth investor, Luke Lango.

And clearly, “energy” is the top sector overall, which Eric Fry and Louis Navellier have been taking advantage of in their various portfolios.

We’re running long, so we’ll wrap up.

In short, the countdown has started. Historically, we have between one and two years to make solid returns in the market.

That said, that window could be shortened depending on the interplay between inflation, Fed policy, consumer financial health, and corporate earnings.

This is what we’ll be watching. We’ll keep you updated here in the Digest.

Have a good evening,

Jeff Remsburg