Stop Watching the Fed – Focus on This

The S&P is at a critical level … a market tailwind from the 10-year Treasury yield? … more signs of a deteriorating U.S. consumer … is inflation really on its way out?

If the S&P can’t gather some bullish momentum quickly, watch out.From mid-October through the end of November, bulls pushed the S&P up 14%. But then came a major technical test.The S&P was running into the confluence of two big resistance points at once: its yearlong downward trendline and its 200-day moving average (MA).The downward trendline is self-explanatory. As we’ll show you in a moment, you simply connect the S&P’s peak prices on the year to identify the broader trend.Meanwhile, the 200-day MA is a line showing the average reading of the prior 200 days’ worth of market prices. This is an important long-term psychological line-in-the-sand for investors that helps them see the overall trend for a stock (or an entire market).Here’s how this looked last week. The yearlong downward trendline is in dotted red, and the 200-day MA is solid blue.

Chart showing the S&P 500 running into two different resistance lines

How did things play out?Well, after briefly peaking its head above this important level, the S&P fell…and has continued falling.

Chart showing the S&P 500 falling hard after hitting the two resistance lines

And that brings us full-circle to where we opened this Digest…If the S&P can’t gather some bullish momentum very quickly, watch out. This year’s price action suggests we’re at risk of beginning a new leg down.So, can the bulls break this downward pattern?Well, as we look for clues, there’s another important test playing out right now over in the bond market.

Will the 10-year Treasury yield bounce or break?

One of the most important numbers in all of finance/investments is the 10-year Treasury bond yield. All sorts of other global interest rates hitch themselves to the U.S. 10-year.This yield on this bond impacts your portfolio two ways:First, when the 10-year yield is soaring, this bond becomes a viable investment alternative to stocks. For example, as recently as a few weeks ago, the 10-year Treasury bond offered a 4.2% yield.So, if held to maturity, investors would receive more than 4% with zero risk of principal loss (unless the U.S. government implodes). Meanwhile, as I write, the S&P 500’s dividend yield clocks in at just 1.60%…and it comes with major risk to your principal.To conservative investors, it’s an easy choice.The second way treasury yields are very influential on your portfolio is their effect on stock prices. The higher that yields go, the higher the “risk free” rate that Wall Street uses in its valuation models when it tries to put a fair value on stock prices.In general, the higher this risk-free rate, the lower the forecasted stock price.All year long, the 10-year Treasury yield has been climbing. But in early November, the 10-year yield has dropped substantially. It’s now at its yearlong support line and it appears to be falling through it.The chart below shows the 10-year yield at 3.51%, but this charting service’s data is from yesterday. As I write Wednesday, the yield has slipped even lower to 3.45%.


Chart showing the 10-year Treasury yield's trendline and now the yield is falling below

If bond traders push yields higher from this level, it will continue to weigh on the S&P and make it harder for it to pierce its own critical resistance level.But if the 10-year yield continues to drift below this support line, it could be a tailwind the S&P needs to find its footing a give us a Santa Claus rally.Additionally, if we get softer inflation numbers from Friday’s Producer Price Index report and next Tuesday’s Consumer Price Index report, it could send the S&P sharply higher.

But whether these critical levels break in favor of the bulls or bears, it will likely drive market direction only for the short-term

We believe the more meaningful, longer-term influence on the S&P will be the condition of earnings as we move into 2023.And because earnings reflect the willingness/ability of U.S. consumers to continue opening their wallets, we’ve stayed focused in recent months on the condition of the consumer.Yesterday, JPMorgan CEO Jamie Dimon echoed our often-stated concern as we look ahead to next year.From CNBC:

While consumers and companies are currently in good shape, that may not last much longer, Dimon said Tuesday on CNBC’s “Squawk Box.”Consumers have $1.5 trillion in excess savings from pandemic stimulus programs and are spending 10% more than in 2021, he said.“Inflation is eroding everything I just said, and that trillion and a half dollars will run out sometime mid-year next year,” Dimon said.“When you’re looking out forward, those things may very well derail the economy and cause a mild or hard recession that people worry about.”

The bulls have a response to this: “But strong retail spending figures reveal that the U.S. consumer is strong, and that will enable us to skirt a recession”

To illustrate this point of view, here’s Bloomberg from yesterday:

Strong consumer spending could help the US dodge a recession in the coming year, the head of the biggest West Coast US port said.“The consumer continues to buy,” Port of Los Angeles Executive Director Gene Seroka told Tom Keene, Jonathan Ferro and Lisa Abramowicz on Bloomberg Television Tuesday.“The last four months of consumer-spend numbers are more encouraging than many thought coming into the holidays — Black Friday, Cyber Monday.”

I continue to be baffled by this response.Isn’t the relevant issue the financial condition of the U.S. consumer? Not his behavior?After all, as we’ve pointed out here in the Digest, an unhealthy consumer can still shop up a storm thanks to debt and leftover pandemic savings that are not being replenished.But when those savings are gone and when credit dries up because the balance is too great and/or the interest payments too large, the true condition of the consumer will emerge.So, how close are we to reaching that point?Well, Dimon sees savings headed to $0 by mid-next-year, and he’s not the only one.Here’s a graphic from BEA and Deutsche Bank showing where we are today (on the downslope) and when they project savings will be full depleted (roughly fall of 2023).

Chart showing the excess savings from the pandemic expected to be depleted by Q3 2023
Source: BEA & Deutsche Bank

As to the “debt” part of this, here’s Lisa Shalett of Morgan Stanley Wealth Management:

The spending spree that has kept real spending growing at close to a 7% annualized rate, based on November data, increasingly seems to be coming at the expense of savings and credit card balances.Revolving credit card balances now exceed the pre-pandemic peak, and the savings rate has plummeted to 2.7% … suggesting that unless the labor market remains very strong in 2023, belt tightening might lead to further economic slowing.

Wall Street always looks forward. If this exhaustion of consumer dollars is likely to hit this coming summer/fall, why isn’t Wall Street factoring it into its earnings projections?Unless the Fed’s “soft landing” materializes, at some point they’ll have to.

“But Jeff, inflation is on its way out, which will solve everything”

When you follow the thread of many bullish arguments, this is the cornerstone.And theoretically, it’s sound. If inflation does recede to 2% over the next handful of months, it will eliminate so many of the problems investors face today.But concluding that recent, cooler inflationary data mean that inflation is conquered is a big leap.The main metric the Fed watches when it comes to inflation is the “core PCE, excluding food and energy.” The Fed wants to get this measure of inflation back to 2%.So, how much progress are we making?Here’s Federal Reserve Chairman Jerome’s Powell’s comment on the core PCE from last week:

Over 2022, core inflation rose a few tenths above 5 percent and fell a few tenths below, but it mainly moved sideways.

Below, you can see what Powell is talking about. We look at the core PCE excluding food and energy since June, measuring the percent change from the preceding month.

  • June – 5.0%
  • July – 4.7%
  • August – 4.9%
  • September – 5.2%
  • October – 5%

Can you look at these figures and conclude we’ve conquered inflation?In the past, Powell has divided inflation into three components: 1) core goods, 2) housing services, and 3) core services less housing.So, what’s happening with inflation when we get this granular?Well, as we’ll show in a moment, core goods inflation is down. We can likely thank improving supply chains for a great part of this.But housing services are still sloping higher. And core services less housing have turned north again after having declined earlier this year.That last detail alone kneecaps the bullish argument of “we’re on the downslope now.” Obviously, if “core services less housing” can go from downsloping to upsloping, why couldn’t it happen to other inflation components?Here’s the chart.

Chart showing the three components of core inflation and how they've been performing
Source: Bureau of Economic Analysis; Bureau of Labor Statistics

This chart does not say we have “conquered” inflation.Now, a bull might say the chart shows inflation is stalling out and suggests we’ll be headed lower soon.Perhaps. But inflation does not have to remain at or near peak levels to continue inflicting pain on the consumer. Even if inflation drops some, elevated levels can continue to hurt the U.S. consumer, which is the real concern.Let’s not miss the forest for the trees. The issue here isn’t some arbitrary inflation number. It’s whether consumers will still open their wallets to pad the earnings of the stocks in your portfolio (with organic, disposable income, that is – not with snowballing levels of debt credit card debt with astronomical interest rates).To that end, hypothetically, let’s say a hamburger’s price tag started at $8, shot up to $14, but is now back to $12.You can cheer “14% lower than the peak price” all you want. But isn’t the more important variable how long consumers can spend 50% more for their burgers relative to the original price?

So, how do wrap up today?

Well, short-term, let’s see which direction we break in the S&P and the 10-year Treasury yield. At present, it appears the 10-year yield is rolling over, which could support the S&P.Longer-term, we continue to urge you to focus at least as much (if not more) on the health of the U.S. consumer as you do the Fed and inflation.On this note, let’s end by returning to Shalett of Morgan Stanley Wealth Management:

U.S. stock investors have fixated on the Federal Reserve for most of 2022, waiting for the rate hikes aimed at fighting inflation to end.Recent signs of cooling inflation encouraged investors, pushing the S&P 500 Index up 14% since a low in October. Meanwhile, Treasury rates have fallen notably, reflecting expectations for both lower inflation and lower inflation-adjusted interest rates.However, by focusing only on Fed policy and expectations for lower rates, investors are missing the troubling implication of the policy tightening: an economic slowdown…At this point, we think investors should shift their focus from the Fed’s rate hikes to consumer activity.

Have a good evening,Jeff Remsburg

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