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3rd Quarter | 2022

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Market Update 11/21/22

By Jerry Wagner

The major U.S. stock market indexes finished down last week. The Dow Jones Industrial Average dipped 0.01%, the S&P 500 slipped 0.7%, the NASDAQ Composite fell 1.6%, and the Russell 2000 small-capitalization index tumbled 1.8%. The 10-year Treasury bond yield rose 1 basis point to 3.825%, but most bonds increased slightly in value. Gold futures closed at $1,764.90, down $18.60 per ounce, or 1.04%.

Stocks

Stocks continued their long 2022 downturn last week, remaining mired between the 50-day and 200-day moving averages on the S&P 500 price chart.

Stocks did rally at times during the week as Wall Street’s opinions on inflation and the steadfastness of the Federal Reserve interest rate tightening efforts shifted. Negativity won out, though, as it so often has this year.

There were shafts of light among the gloom:

• The Producer Price Index report came in with a lower-than-expected inflationary reading. The Core reading was up just 0.1% on an annualized basis. This seems to have caused the Fed to take the here-to-now expected 75-basis-point December rate increase off the table and replaced it with a more moderate 50-basis-point increase.

• Two-thirds of the reports on the U.S. economy last week were rated better than expected. These covered a wide range of the economy, with positive surprises in manufacturing, retail sales, housing, inflation, and employment. Unfortunately, most of the surprises were simply better-than-expected declines and were not the positive readings that would signal that the economy was on the mend.

• Earnings too have been better than expected. Despite, or perhaps due to, the revisions lower in earnings expectations back in September-October and before reporting began, most companies reported better-than-expected earnings for the third quarter. In fact, more than 64% outperformed analysts’ earnings estimates and over 67% of the revenue forecasts. So far, the S&P has risen over 10% during the reporting season, which is now drawing to a close.

• The bullish technical indicators highlighted in my last Market Update (10/24/2022) did their job and boosted the S&P 500 and other indexes over their 50-day moving averages, as the stock market rallied from deeply oversold conditions. Bullish thrusts in the number and volume of advancing issues, a positive divergence in new lows, combined with the extreme pessimism exhibited by several sentiment indicators, propelled stocks higher.

Still, by week’s end, it appeared that the rally may be petering out. The market needs new fuel to move higher in the face of a still tightening Federal Reserve and the continuing downward trend in the stock indexes. Certainly, more good news on the inflation front will help. The return to $80-a-barrel oil this week supports this, as does the conclusion of the mid-term elections, which removes a big burden of uncertainty. Fourth-quarter bullish seasonality is also supportive, as it normally begins mid-October and accelerates beginning with the Tuesday of Thanksgiving week.

It was noted in most of the financial media that stocks celebrated their one-year anniversary of the all-time stock market high hit during Thanksgiving week in 2021. In that one-year period, the NASDAQ has fallen about 30% and was down earlier this quarter by over 34%. Bespoke Investment Group charted the one-year rolling performance of this index over its 50-year history.

They found that this is just the fourth 30%-plus decline in the index during that period. They also pointed out, as is obvious from the chart, that the last three times this occurred were in the middle of recessions (periods shaded gray).

While some may disagree, I have been saying since July that we are already in a recession and it would be of the double-dip variety, as was the case during a similar inflationary period in the early 80s. I think the chart supports this belief.

In addition, I think the chart supports a further belief of mine expressed in past Market Updates. This downturn likely has further to run. Reviewing the chart, you can see that in the past when the NASDAQ has slid at least 30%, it has moved past that mark and lost at least 50% at some point thereafter before an end could be declared for the bear market.

Also supporting the recession dialogue has been the continued yield inversion of different maturities of the various government bond issues. When the shorter term maturity’s yield exceeds the longer term, a recession normally is at hand or will soon occur. As shown in the chart below, two of the best performing inversions in terms of predicting recession can be seen to be more than 1% inverted. The last 10 out of 10 times this has occurred (since 1950), it has correctly heralded a recession.

We often focus on the interest rate policy of the Federal Reserve Board when it comes to ascertaining the extent of the Fed’s focus on tightening rates and slowing the economy. But given the extensive use of quantitative easing during the last Fed rate-lowering efforts, it is easy to measure the Fed’s commitment to tightening by watching its open market (SOMA) activities in the bond market.

When it wants to ease rates, it buys bonds in the open market. When it wants to raise rates, it can sell bonds from the substantial inventory it accumulated during its easing cycle.

As the chart below demonstrates, the Fed has been reducing its inventory and selling bonds at an increasing rate. Last week alone, the Fed sold over $42 billion in bonds to support its tightening efforts. It has exceeded this sale rate only twice before—both times occurring in March of 2008, just before the worst of the global economic crisis became apparent.

Bottom line: The short-term rally I have been forecasting has occurred. While it may continue higher due to positive year-end seasonality (see discussion of our Political Seasonality Index strategy below), the macro view is for eventually more downside. Most of our intermediate strategies (for example, our QFC Multi-Strategy Core, QFC Self-adjusting Trend Following (QSTF), and Volatility Adjusted NASDAQ (VAN) strategies) have been positioned for just such an occurrence, with large allocations to cash, the U.S. dollar, and short and variable fixed-income instruments, as well as some inverse positioning.

Bonds

The yield of the Treasury’s 10-year bond has reversed direction. After a sustained uptrend that coincided with the Fed’s move to raise interest rates (see the relentless string of rate hikes illustrated in the Recession Monitor chart in the preceding section of this Update), the yield on the 10-year bond shifted sharply lower two weeks ago. It has now settled just under its 50-day moving average, a half a percent below its October high-water mark.

As we have seen in the past, the yield on the 10-year often tracks its 50-day moving average. These bonds may find resistance to their yield moving higher in the short term.

As a result of the drop in yield, bond prices have risen, reflecting the rally in yields (the movement and direction of bond prices and yields are inversely correlated). As illustrated by the chart of the long-bond ETF (TLT) above (with a maturity of 20-plus years), bond prices have rallied off of their October lows, although the longer term downtrend remains intact.

To the extent that this rally has been caused by better-than-expected inflation reports, like last week’s PPI, the rally may continue. As the next chart discloses, the PPI often foreshadows moves of the Fed’s favorite inflation measure, the Personal Consumption Expenditures Price Index (PCE). A lower rate of change in the PCE could mean that the Fed may have room to further moderate its tough money approach, further benefiting bondholders.

The high-yield sector of the bond market continues to track stocks better than rates. It is down, but less than half of what the long-maturity Treasurys have experienced. Still, high-yield bonds, as reflected in the prices of the high-yield ETF (HYG), confirmed the stock market’s fall to new lows, as the ETF also registered a new low on this down cycle.

With stocks recently rallying, high-yield bonds have also rallied. But notice that the rally has been much milder. HYG has barely exceeded its previous bottom, and, like stocks, has not exceeded the highs in price made back in August.

Gold

Gold has spent most of November in rally mode. It reached its 50-day moving average and sliced right through it, running up to a new high at mid-month. Since then it has sold off a bit as the dollar has rallied.

As has been the case all year, gold’s decline had been inextricably linked to the rising dollar. However, with better-than-expected inflation news and a moderation in Fed policy two weeks ago, the dollar suddenly sank dramatically lower. Its 50-day moving average provided no resistance, and this greatly benefited gold.

Flexible Plan Investments (FPI) is the subadvisor to the only U.S. gold mutual fund, The Gold Bullion Strategy Fund (QGLDX), designed at its introduction more than nine years ago to track the daily price changes in the precious metal.

The indicators

The short-term-trend indicators for stocks that I watch remain bullish, and our very short-term-oriented QFC S&P Pattern Recognition strategy is 60% leveraged to the S&P 500.

Our QFC Political Seasonality Index (QPSI) strategy has been fully invested since Friday’s (11/18/22) close. It continues to be one of our top-performing strategies for 2022. It will remain on the offensive until the close on December 7. The strategy is available separately and is also included in our QFC Multi-Strategy Explore: Special Equities and QFC Fusion portfolios. (Our QFC Political Seasonality Index—with all of the 2022 daily signals—is available post-login in our Weekly Performance Report section under the Domestic Tactical Equity category.)

Our intermediate-term tactical strategies are mixed. Classic is fully invested in stocks. The Volatility Adjusted NASDAQ (VAN) strategy is 60% inverse to the NASDAQ, the Systematic Advantage (SA) strategy is 30% in equities, and our QFC Self-adjusting Trend Following (QSTF) strategy is positioned 100% in cash. VAN, SA, and QSTF can all employ leverage—hence the investment positions may at times be more than 100%.

Flexible Plan’s Growth and Inflation measure is one of our Market Regime Indicators. It shows that we remain in a Normal economic environment stage (meaning a positive monthly change in the inflation rate and positive monthly GDP reading). Historically, a Normal environment has occurred 60% of the time since 2003 and has been a positive regime state for stocks, bonds, and gold. Gold tends to outpace both stocks and bonds on an annualized return basis in a Normal environment but carries a substantial risk of a downturn in this stage. From a risk-adjusted perspective, Normal is one of the best stages for stocks, with limited downside.

Our S&P 500 volatility regime is registering a High and Falling reading, which favors gold over bonds and then equity from an annualized return standpoint. The combination has occurred 13% of the time since 2003. It is a stage of lower returns for equities and higher volatility for both gold and stocks. The S&P 500 registered a maximum drawdown of over 29% during one of these regimes, while gold’s maximum price loss was over 21%.

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