The market has been extremely quiet over the past few weeks. This week, the Dow and S&P were down slightly, and the Nasdaq was up just a tiny bit. Dark clouds loom on the horizon. Let’s explore each one together.

The First Dark Cloud: Corporate Earnings

According to Fact Set, 92% of S&P 500 companies have reported their Q1 2023 earnings results, with 78% beating their earnings estimates and 75% reporting revenues above estimates.

This was 4% better than the 6% decline expected in corporate earnings. Wall Street analysts had modeled all the earnings scenarios and determined that we were already in the middle of a six-month earnings recession. We learned over the past few weeks that their models were correct. This past quarter (Q1) was indeed a struggle for many of America’s biggest companies.

That quarter is over. We are in the middle of Q2, and inflation is trending lower (ever so slightly, as we will explain shortly). Guidance from the hundreds of conference calls that took place after earnings announcements was far lower than expected. Many of these negative calls resulted in a sudden decline in share prices, even though the company’s earnings may have beaten estimates.

There was no catalyst for growth. What came through from corporate CEOs addressing earnings was that there has been no miraculous recovery in the past year’s business cycle and trends. If anything, we may get a few unwelcome shocks in the near-term, which could saddle the current market malaise a bit longer.

Some estimates have the current quarter experiencing a 5% or more earnings decline. Therefore, it is easy for many analysts, portfolio managers, and people managing money (including Bank CEOs like Jamie Dimon) to think we are headed for a recession and negative growth for the remainder of 2023.

It is also likely why many professional investors and economists are betting on a decline in interest rates in the latter half of the year. After you read the next section on inflation, you may agree with our assessment that interest rates are likely to stay higher for longer. I still do not see the pivot that many market pundits believe will take place (and I have been known to be wrong many times).

The Second Dark Cloud: Inflation

We think the markets (and analysts) have it wrong about inflation. We are not alone. Last Wednesday, the Consumer Price Index (CPI), the most widely-watched inflation indicator, came in at 4.9% (year-over-year) for April. Yes, that is lower than the 5% for March and, yes, that is the tenth straight monthly decline in the annualized rate of inflation.

The stock market had a positive reaction to that news. The Nasdaq rose 1% on Wednesday and the S&P 500 was up about 0.5%. Let’s examine further.

In March, the CPI did not rise 5% above March 2022, as it was reported. It actually rose 4.9850% above it. And April’s reading wasn’t really 4.9%. It was 4.9303%. The difference between these two readings was really 0.0547% percentage points, not 0.1% as reported by the press.

By rounding the numbers, the actual difference was reported as twice as large as what really took place. The question remains, did inflation fall in April as was reported or did it stay flat? (You would be right whichever answer you pick). If you look at the chart below, it is plain to see that inflation is falling.

After going basically sideways for a couple of decades, inflation broke out to 40-year highs last year. Clearly, it has started to decline and head back down due to the Fed raising interest rates for a historical 10 times. You would be correct if you look at the chart and buy into declining inflation. It looks that way to me. And the trendline of measuring year-over-year points to that evidence. But hold on one second.

The CPI rose 0.4% in April, in line with expectations. But the March month-over-month number was 0.1%. April was 0.4%. Would you say that inflation is falling, staying flat, or rising? Look at the chart below.

To me it seems that inflation is steadily continuing to rise with a couple of lower months. Those are likely due to energy prices coming down. However, food and rents continue to trend sideways to upward. Therefore, one could easily conclude that inflation remains flat and is not really declining. Core CPI is even more ominous-looking.

If you look deeper into the numbers at core CPI (which is the CPI number that excludes food and energy prices), core CPI rose 5.5% in April. The reason they produce the core reading is that food and energy prices are volatile and may have too much influence on the overall inflation picture.

If you exclude those parts from CPI, many believe you get a more accurate view of real inflation. That number remains elevated. Again, inflation has not come down as fast as you are being told by the media.

What about the PCE? Anybody who has followed the Fed’s hawkish rhetoric for the past two years knows that the Fed is fixated on the PCE (Personal Consumption Expenditure) and not the CPI. When they meet for their periodic Fed policy meetings, they discuss the PCE, not likely the CPI. Let’s look closer at the PCE (the same chart the Fed is looking at).

Again, we see the same things as we did for the CPI -.a few decades of sideways action and then a straight up trajectory in the rate of inflation as illustrated by the PCE. But look closer. After peaking at 5.4%, the last four readings have been steady between 4.6% and 4.7%. That is less than a 1% difference in the monthly PCE numbers.

Inflation has been holding steady at around 5% for the better part of 16 months. And that is approximately 3% greater than the Fed’s target level of 2%.

In my humble opinion, the idea that inflation is subsiding is a false narrative. The rate of inflation has been manipulated to provide the best possible light. They began to recalculate these numbers a few years ago to avoid using the older, more traditional way that had been used. That calculation would likely have put inflation in double digits and as high as 12-15%.

Therefore, the current inflation numbers, in our opinion, are under-reporting the actual pain that most Americans are feeling. To us, this likely indicates a prolonged period of keeping interest rates higher to fight sticky inflation. And no pivot anytime soon. The Fed lowering interest rates anytime soon may be wishful thinking.

In fact, the Fed may have more work to do, and this is why we continue to say we wouldn’t be surprised to see one or two more 25 basis point hikes.

The Third Cloud: Debt Ceiling

We have the pending debt ceiling scenario, including a possible default, which Janet Yellen says is a mere few weeks away from happening. She said, “if Congress doesn’t raise the debt limit, and soon, the unthinkable could happen.”

“If Congress fails to do that, it really impairs our credit rating. We have to default on some obligations, whether it’s Treasuries or payments to Social Security recipients,” Yellen said Friday in an interview with Bloomberg Television. She continued, “That’s something America hasn’t done since 1789. And we shouldn’t start now.”

Accordingly, the US Treasury said on Friday it had just $88 billion of extraordinary measures left to help keep the government’s bills paid as of May 10. That is down from around $110 billion a week earlier, and it means about a quarter of what was $333 billion in authorized measure is all that is left.

This is occurring while the US economy is slowing and the Federal Reserve is making progress, albeit slowly, to fight inflation. If we should default, and one must believe it is possible, it may shock the US economy in an unprecedented fashion.

Republican leaders are expected to meet with the President next week. While these appear to be negotiating tactics on both sides, a growing chorus is warning that the fallout from a default could lead to a deep recession, a spike in unemployment, higher borrowing rates, and other material government negative consequences.

The problem, as we see it, is this is political jostling in its truest form. While we could explain all the reasons why each side will maintain its position, the fact remains that we may be on the precipice of a cliff which will have severe and negative consequences, especially for the public investment markets. Clearly this is a pending dark cloud that could create quite a fiscal storm for the US.

The Fourth Dark Cloud: The Markets

As you likely have witnessed, the markets have not gone anywhere in the past few weeks. We remind you that over a year ago, our own Mish had commented that we were in for a long period of range-bound trading along with stagflation. This commentary is echoed now, almost daily, by analysts, economists, and the news media.

We present a few good charts to better illustrate the continuing grind in the markets.

Also disconcerting is the non-participation of small-cap stocks (Russell 2000), which is down -1.0% year-to-date for 2023. The S&P 500, which is dominated by just a handful of mega-cap technology stocks, is up 7.5% year-to-date, yet the equal weighted S&P 500 (RSP) is up about 0.25%.

Even the Dow Jones Industrial Average, a diversified benchmark with 30 stocks, is currently underperforming the S&P 500 (cap weighted) benchmark at the widest amount in the history of the two indices.

The markets are showing a few cracks in the foundation. The sideways chop combined with the lack of participation across all stocks causes concern. We either break out or break down. 

Given the previous dark clouds, many investors have opted to sit on the sidelines in safer investments like cash, cash equivalents, or money markets. Cash deposits currently are over $5 trillion and waiting for more positive investment signs.

While this much cash is often a contrarian indicator and will thrust the markets higher if and when good news comes out, we continue to believe we remain in the Danger Zone.

The Fifth Dark Cloud: Regional Banks

With three of the largest bank failures in the past few months, we remain in a credit crunch. Further evidence came out this past week about how many depositors are taking their money out of the regional banking system and redirecting this money into brokerage firms and obscure places like Apple’s new savings program.

It is no wonder given the biggest and safest Banks, like JP Morgan, Bank of America, Wells Fargo, and others are paying tiny interest on depositors checking and savings accounts (these banks were reported to be paying less than 0.5% versus brokerages paying 3-4% or higher). The only explanation for this is if you want the “safety” of a large bank, then you get paid nothing to park your money there.

It was also reported this past week that many corporations are setting up backup corporate checking accounts at the largest banks as a safety precaution should their local/regional banks get into more trouble and they have to “switch gears quickly.”

Banks here in Ohio, like Key, Huntington, Fifth Third, to name a few, are seeing battered stock prices and business struggles as fearful depositors withdraw their assets to move them to a “safer” institution.

For months now, we have often repeated that we felt we were a long way from being cured of regional bank problems. We also criticized the narrative that the Federal Reserve and the current administration’s attestation that the banking system was sound and secure.

This dark cloud will continue to weigh heavily on the markets. It is one reason why the small-cap stocks continue to struggle. Small businesses are already having a difficult time dealing with much higher interest rates on top of escalating operating costs. In our opinion, it will be very difficult for the stock market to get legs while the banking sector is under pressure.

Look at the regional banking index below. This is not a healthy chart by any stretch of the imagination.

While we are feeling the slowdown in the economy and the problems with the banks, the commodity sector is now starting to breakdown, indicating a much more severe economic slowdown may arrive.

Now, here are some things of note of the past week.

Risk-On

• The Nasdaq new high/new low ratio improved on the week, and it is off its lowest levels from March.
• The volatility ratio remained positive from the trend that started in March.
• For small-caps, sentiment readings improved this week and are now stacked positively. The IWM has been the weakest index for 2023, and it now shows signs of improving.
• Growth stocks continued to outperform value stocks.

Risk-Off

• As markets put in a sideways week, market internals weakened marginally and remained negative.
• Market internals on the Nasdaq Composite are stronger relative to the S&P.
• The S&P 500 new high/new low ratio has been giving a mixed read, showing slight short-term strength but also a medium-term negative trend.
• Copper failed to hold its bullish phase, and it is now in a warning phase while underperforming the S&P.
• Oil (USO) broke out significantly this week above major resistance levels, including the 50-day and 200-day moving averages, as well as the 50-week moving average. It seems to have plenty more room to run.
• The US dollar (UUP) improved into a recovery phase despite a looming debt ceiling crisis.

Neutral

• Three out of four major indices had inside weeks, with the Nasdaq barely squeezing out a new high on the year.
• Vietnam (VNM) posted a strong week relative to other Asian countries. Gold miners and precious metals were down on the week, mean-reverting from overbought.
• Volume was neutral, with markets trading within a small range.
• 11 of the 14 sectors were down, with energy and materials leading to the downside. Consumer discretionary was the lone sector to post a positive gain.
• Risk gauges backed-off to neutral territory with several of the intermarket ratios potentially flipping.
• Even with a spike on Friday, volatility remains below last week’s highs.
• Long-term bonds have seen confusing market action, with the 50-DMA about to cross over the 200-DMA while prices closed down on Friday and under all key daily moving averages..
• Large-cap S&P 500 stocks are holding up better than small- and mid-cap stocks.
• Foreign equities, on a short-term basis, gave up leadership versus U.S. equities, with emerging markets moving into a warning phase.
• With slightly cooler-than-expected inflation readings, gold (GLD) closed marginally down on the week. It has entered a seasonally weak period, but it is still in a bull phase and outperforming.

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