This week is going to be a real hurdle for the market. Last week, the Federal Reserve Open Market Committee dropped a bombshell on the market that took a couple of days to sink in. The FED not only increased its inflation outlook for this year by 100 basis points but the outlook for future rate hikes has been well advanced. Now it's time for the market to decide which way it wants to go and we think the next move is lower.
James Bullard, president of the Federal Reserve Bank of St Louis, said on Friday that economic activity head advanced quicker than the Federal Reserve anticipated and that inflation was coming in hotter than expected. In his view, the first-rate hike will come in 2022 and we're on the same page with that. It is our view that hyperinflation may be transitory but inflation is here to stay.
The weekly chart of the S&P 500 is not promising for the bulls. The market formed the second of two peaks at a concurrent price level creating a dark cloud cover and indicating range-bound conditions if not a correction or reversal.
The good news is that, in our opinion, a pullback in stocks would be healthy, and ultimately lead to another fantastic buying opportunity for long-term-oriented investors. We are still deep in the throes of a secular bull market that has many years to run. The shift in FED policy is a sign the economy is healthy as much as anything else. At the pace we're going it may be five to ten years before interest rates become debilitating for economic growth.
A more pressing concern for economic growth is employment. While employment is strong there is still quite a bit of slack in the market that is yet to be taken up. If the S&P 500, or businesses in general, can't fill their jobs then economic growth projections are meaningless. At this point, with over 8.2 million jobs open, the only thing limiting economic acceleration is employment and last week's initial claims data was not promising. Although the total number of jobless claims decreased by over half a million, the number of initial claims picked up, and total claims lag initial claims by 2 weeks. Initial claims are still trending at the post-pandemic low but, with so many jobs open, the market needs to see initial claims and total claims start coming down.
There wasn't much else of excitement on the economic calendar last week. Although most signs still point to economic expansion, the pace of that expansion appears to be slowing. Retail sales fell more than expected, the Empire State Manufacturing Index slowed more than expected, the home builders index came in below expectation, building permits were below consensus, and jobless claims were ahead of expectations. Worst, the producer price index came in at 0.8%, 0.3% hotter than expected, and a 0.2% acceleration from the previous month. At this level, producer prices are 6% above last year's level and getting more expensive.
Commodities, one of many input costs for producers, began to sell off this week but we don't want to read too much into that. The sell-off was sparked by a slightly stronger dollar and that could weigh on prices in the near term. Longer-term, rising demand should help support commodity pricing over the next several quarters at least. Assuming commodity producers are having the same trouble filling jobs as everybody else it, may be more than several quarters before commodity pricing truly softens. Even then, the bias in trading in markets like the iShares S&P 500 GSCI commodity index tracking stock is definitely upward.
This week the economic calendar is a little bit light. There's nothing reported on Monday, Tuesday will get existing home sales and Wednesday will be new home sales. Thursday is the weekly jobless claims figures and durable goods as well as the first revision to first-quarter GDP. If you remember, the first-quarter GDP came in at 6.4%, we're looking for an upward revision.
Friday will be the big day for the market in terms of economic data this week. Friday is the release of the May personal income and spending figures which include the core PCE price index. The PCE price index is the FED's favorite tool for measuring core consumer inflation and it accelerated above the FED's target rate 2 months ago. A hot number can only increase the expectation for the FED to act.
Oracle NYSE: ORCL reported earnings last week marking the midpoint between earning cycles. The company gave what otherwise would have been a great report if not for mixed guidance. Oracle is expecting 3% to 5% year-over-year growth in the coming quarter, above the 3% target set by the analysts, but the EPS target fell short. Shares of the stock fell in the wake of the report and may fall another 15% before finding the bottom.
With the peak of the second-quarter reporting season still 5 or 6 weeks away there aren't a lot of earnings reports on tap for next week. That said, there are still quite a few names of interest including Winnebago, Steelcase, Nike, the Patterson Companies, KB Home, Federal Express, Rite Aid, and CarMax. In total there are 7 S&P 500 components reporting this week and 1 Dow member.
Winnebago NYSE: WGO is of particular interest to us as we have been closely watching the RV industry for the last 2 years. The company is expected to produce flat revenue on a sequential basis but up about 100% from last year. Based on the company's commentary to the effect it was ramping production to meet demand, we think this estimate is too low, the question is how much too low. Shares of this stock are down pretty hard from the recent peaks and could easily rebound on stronger-than-expected results. Competitor Thor Industries reported about 2 weeks ago and delivered 106% year-over-year growth to beat the consensus by 1500 basis points. What we really want to see in the report though is that this company is able to manage its supply chain and make product.
KB Home (NYSE: KBH) will also be a hot name this week when it reports. Its competitor Lennar reported this week and absolutely dazzled the market. Despite headwinds within the housing sector, Lennar produced sequential growth, year-over-year growth, and an acceleration of growth that led them to increase guidance. We expect the same results from KB Homes. Shares of that stock are pulling back from a recent high like the rest of the market but may find support at the $48 level.
The consensus estimate for Q2 earnings for the S&P 500 ticked lower over the last week but don't read much into that either. The consensus estimate is trending strongly higher and, based on the first few reports of the season, will continue doing so until the end of the season. Right now, the analysts are expecting about 62% growth over last year, which’s up from about 45%, and growth is expected in the back half of the year as well. Growth will slow in the back half of the year but that's versus an increasingly more difficult comparison and still expected to be double digits. In our view, barring the odd pullback or correction so long as earnings estimates continue to rise the S&P 500 should continue to rise with it.
The Dollars Strength
A new headwind for S&P 500 earnings is emerging as well in the wake of the FOMC shift. The dollar has gotten noticeably stronger and appears to be in a reversal that could lead to long-term dollar strength versus the basket of world currencies. What this means for the market is two-fold, on the one hand, dollar-based commodities like oil and gold may come under some price pressure while on the other companies whose earnings are firmly centered outside of the US will face currency conversion headwinds. It will become more and more expensive for US companies to repatriate overseas revenue and earnings and that will cut into profits.
Traders need to pay attention to the Vix as well. The Vix appears to be forming a reversal in tandem with the broader market that doesn't bode well for the bulls, at least not in the near term. the Vix rose more than 16% on Friday alone to close above the 20-level and looks like it could at least spike above the 25-level if not sustain a longer-term uptick in volatility. The weekly chart is particularly bullish in regards to volatility as it confirms the bullish signals that have already fired on the daily charts.
A Look Ahead
What should we expect next week? That depends on what happens Monday. After last week's Fed shocker and market rout, our bet is that we'll see some more downside. Not only is the index below the short-term 30-day moving average but both indicators are firmly moving lower. The question is how deep will the index go? The index is already down 2% and could easily fall 5% before finding firm support. If there's no rebound on Monday we think 5% is virtually guaranteed. Beyond that, if support near the 4050-level can hold we see range-bound conditions developing. If not then we may be in for a 10% to 20% correction.
Market action was led by the NASDAQ Composite and the tech sector last week but it was not immune to the selling. The NASDAQ Composite closed down 1% on Friday to post a slight loss for the week, create a red candle, and confirm resistance at the recent highs. The indicators are a little mixed so it's hard to be sure exactly which direction this market is going, it might be forming a bullish triangle or it may still be range-bound but Monday's price action will likely tell the tale. If there's no follow-through by the bulls, we see price action moving down to retest the 150-day moving average before making its next move.
Selling was heaviest in the blue-chip Dow Jones Industrial Average which looks set to retest support at its 150-day moving average if not move lower. The indicators are throwing off a clear bearish signal that is in tandem with price actions pulling back from a peak. This signal suggests support will at least be retested at current levels and there's no reason to think that support will be present unless some news emerges Monday morning to reinvigorate bullish sentiment.
The takeaway for investors this week is that the bull market is intact but at a peak. The question that needs to be answered is how deep will the pullback be. We think the selling isn't over but don't think we're going to see a 20% correction, but it depends on the data. The two biggest risks to the market right now are inflation and employment and there is a host of data due out over the next couple of weeks. This week is the PCE price deflator index that we expect to be hot and the next week brings the monthly employment bundle which includes the non-farm payrolls report. A combination of hot inflation and tepid labor data will not be good for the market.
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