Market Outlook: Market Closes Above The 4600 Level, Consolidation Or Pullback Could Be At Play

Summary

• We had another stellar week for equities, with markets reaching an all-time high again. Will this continue?
• GDP figures came below expectations: Should we be worried?
• Twitter CEO warns about hyperinflation, confirming HDO's viewpoint that inflation is only set to get much worse.
• Why the Fed cannot hike rates soon (not in the year 2022) and could delay tapering.
• Value stocks have lagged, but this will not last. The best course of action for HDI Members.
   

First, I would like to welcome all the new members that joined us this week! This "Market Outlook" is one of our most popular weekly features, and it is exclusive to members. Each week, we look at the "big picture" and discuss our broad strategy. It is important to know why we buy what we buy!

We had another stellar week for stocks, with the S&P 500 index closing on Friday at the 4604 level, another record high, and reaching my first target for the year. It has been quite a huge run for equities. We remain in a secular bull market driven by high liquidity in the system and a bubble of cash sitting on the sidelines, which is flowing into equities. The Government and the Federal Reserve both continue to inject cheap money into the financial system.

The excess liquidity in the system is only getting bigger with high government spending, high consumer savings, and a very dovish Fed. Congress is preparing to spend another $3 trillion+ into the economy, which will only flood the system with more liquidity. The environment remains very bullish for equities.

GDP Figures Came in Substantially Lower: Should we worry?

This week, the 3rd quarter GDP figures were released. GDP growth was down significantly from 6.7% in Q2 to 2.0% in Q3. The expectations were at 2.6%.  Should we get worried about GDP slowing down? No, for two main reasons: 

1. The auto sector substantially impacted GDP. Auto companies are having difficulty manufacturing, and volumes are down a lot. Durable goods consumption alone accounted for a -2.70% on total GDP, and -2.39% of that was autos alone. This can be directly attributed to the chip shortage, not a lack of demand.
2.  Consumer Confidence Report ('CCR') was out this week and rose from 109.0 in September to 113.8 in October. This is great news which shows that consumers feel good about the present environment and are willing to spend more.

U.S. consumers, in general, are enjoying high levels of liquidity, plenty of savings, and relatively low debt and credit card burdens. So clearly, the lower than expected GDP figures are primarily due to supply issues. For example, those consumers who want to buy a new car or make large investments in durable goods have to wait several months for their order to go through. 

People want to buy new cars; they just can't get them at any price. Similarly, housing market activity also dragged on GDP for a second straight quarter due to tight inventory levels after contributing to explosive growth earlier this year. As supply catches up, the demand is there, and these areas will contribute to GDP growth. So we do not need to worry about the lower GDP figures as they are set to look much better within the next year.

The Bad News 

The scarcity of basic materials, lack of labor, and large demand for goods that do not exist will continue impacting inflation, which is only set to go higher.

Some impacts, like the cost of autos, will come down when the chip shortage is resolved. However, we continue to see more "sticky" inflation occurring. For example, higher wages and rents are two major components of inflation that are extremely hard to reverse. Once they are embedded in the system, they tend to stay. While not as dramatic as the increase in material prices, this inflation is far more impactful in the long run.

Many dismissing inflation risks are being lulled into a false sense of security by inflation caused by shortages that can reasonably be resolved. They ignore the impact of more permanent inflation, which is slower to build up and much harder to stop. 

We can see inflation increasing from the data that was released this week:

1. On Friday, we received data on the labor markets. U.S. employment costs rose at the fastest pace on record in the 3rd quarter as companies across a variety of sectors raised wages against a backdrop of labor shortages.

   The employment cost index rose 1.3% from the prior quarter and 3.7% from a year earlier.

2. Eurozone inflation rises to 4.1% for October, hitting a new 13-year high.

So far this earnings season, 71% of S&P 500 companies cited the negative impact of the supply chain on their Q3 earnings call, with the vast majority stating that labor costs and shortages are one of the biggest contributors.

Also, 66% of these companies cited inflation (directly or indirectly) as a risk in their earnings call. The latest major companies were Amazon (AMZN) and Apple (AAPL), which reported their earning on Thursday, stating that labor and supply-chain challenges resulted in higher costs and inability to meet demand. These higher costs will translate into higher prices for the products and services these two companies provide and will reduce future profitability.

Furthermore, inflation expectations are running very high. As noted in my market outlook last week, inflation expectation (or forward-looking inflation) increased to 5.3% in September, the 11th consecutive monthly increase and a new high since the series' inception in 2013.

Inflation has become "well-anchored" into the system. This means that businesses, consumers, and labor expect that inflation will run at +5% next year. This will become a self-fulfilling prophecy as individuals and businesses make decisions based on their inflation expectations, which causes prices to rise accordingly.

Twitter CEO Warns about Hyperinflation

At HDI, we have been warning about the risks of inflation and hyperinflation for well over a year and have positioned our portfolio accordingly, with most of our picks being either inflation-resilient or inflation-beneficiaries.

Interestingly, during October, a search for "inflation" on the media research site Factiva shows more hits in October than during any month in the past decade. Inflation has a way of becoming entrenched and becoming a persistent trend as companies succeed in pushing through price increases and workers demand higher pay.

Just this last week, Twitter co-founder Jack Dorsey weighed in on escalating inflation in the U.S., saying things will get considerably worse.

Hyperinflation is going to change everything,...It’s happening.” Dorsey tweeted last week on Friday. 

These statements come with consumer price inflation running near a 30-year high in the U.S. and growing concern that the problem could be worse than policymakers have anticipated.

Dorsey is currently the CEO of both Twitter and Square. Responding to a question, Dorsey said that he sees the inflation problem escalating around the globe.

It will happen in the U.S. soon, and so the world,” he tweeted. 

The interesting part is that Dorsey used the word "hyperinflation", a condition of rapidly rising prices that can ruin currencies and bring down whole economies. This further strengthens the hyperinflation thesis that we have been warning about at HDI.

Furthermore, on Friday, Federal Reserve Chairman Jerome Powell acknowledged that inflation pressures "are likely to last longer than previously expected," noting that they could run "well into next year." 

Why the Fed Cannot Hike Rates Soon and Could Delay Tapering

The Fed is in an extremely difficult position as far as interest rates are concerned.

1. The current inflation problem starts with a lack of basic materials, lack of labor, and supply bottlenecks in the supply chain, which are driving prices higher. Hiking rates will NOT resolve the lack of supplies, will not force people back into the labor force, nor resolve the scarcity of raw materials. Many are talking about the Fed needing to prick the bubble through rate hikes. How will that fix the supply-chain issues? If the Fed decides to hike rates too soon, this will make matters worse as suppliers will scramble to adjust their prices accordingly. In theory, rate hikes work by reducing demand. Companies and people can borrow fewer funds because of a higher cost of debt will have less demand to buy things. The problem? Companies and consumers already have plenty of cash. The genie is already out of the bottle. It is too late for rate hikes to have a meaningful impact on demand.
2. Hiking rates too soon will result in higher inflation. When the Fed hikes rates, businesses and suppliers will have to increase their prices to make up for the higher cost of borrowing. Furthermore, companies that need to invest capital to resolve the supply chain problems will have less incentive to do so and thus making shortages and inflation even worse.
3. Even with a faster-projected pace of job growth next year, the labor market is set to face a meaningful employment gap for the entirety of 2022. Rate hikes will crush the labor market, making the supply chain problems more difficult than they are today and further eroding the labor force's purchasing power. 

What is even more dangerous is that hiking rates will reduce future GDP growth. Inflation is running at 5%, with GDP at 2%. This is the perfect storm for stagflation if GDP does not grow above the rate of inflation. As discussed in this week's article about the risks of stagflation, stagflation happens when GDP growth cannot keep up with inflation. If you did not get a chance to read the article, this is the link:

    Stagflation's Significant Risks

Therefore, I would like to reiterate my views that the Fed will not be able to hike rates next year as supply issues are not expected to be resolved until the end of 2022, which was also acknowledged by Fed Chair Powell.

The earliest the Fed can move is in the year 2023. Note that when the Fed hikes rates in 2023, I expect these hikes to be small and spread over a long time span. The Fed is already too late, and any rate hike will risk sparking a recession. I do not believe that the current Fed is willing to press the substantial rate hikes that would be required to reign in demand and inflation, knowing that such hikes would cause a large recession. The Fed Funds rate will likely remain well under 1% as far out as 2024. That's hardly restrictive by any historic measure, which is very bullish for stocks.

In the meantime, the bubble of liquidity in the system, supply chain problems, and government spending will continue to drive inflation higher.

Furthermore, as explained in previous updates, the Fed is quite happy having inflation high with near-zero interest rates. This resolves several problems for them.

1. High inflation alleviates the burden of Debt/GDP: High inflation increases GDP (by rising asset prices) and reduces the value of the enormous national debt that it carries on its balance sheet. Therefore, this will result in a much lower Debt/GDP ratio.
2. It reduces the risk of a financial crisis due to high leverage, lower-quality loans by banks and financial institutions. With interest rates running so low, and investors hungry for yield, a record number of companies have been issuing bonds, many of which are poor quality. If the Fed hikes aggressively, we may face a very painful financial crisis whereby many banks will fail, and a credit crisis will cripple us.

Furthermore, the Fed may slow down on its planned tapering due to lower quarterly GDP figures reported this week.

Mr. Market is currently pricing a 100% chance of rate hikes starting in 2022, and it is wrong about it. I expect that the Fed will start raising rates in 2023 at a very slow pace in order not to disturb today's fragile (and dangerous) credit conditions. The last thing the Fed wants is another recession that will be an extremely costly problem to manage and difficult to solve. The Fed will continue to support the financial markets (as it has done over the past +10 years) and do everything in its power to avoid a market crash.

Once investors realize that interest rate hikes will be delayed or will come at a slower than expected pace, equities are set to see another big rally. This is another reason why I remain very bullish on equities. The Fed has our backs as investors.

Cash is Trash: Don't Erode Your Money with Negative Rates and Inflation

With the current effective negative yield interest rates and rising inflation, your cash is trash and is being eroded every day. For investors like us, we are faced with a clear path to a red-hot economy fueled by liquidity, resulting in soaring inflation and asset prices. The Fed will not be able to hike rates, meaning that inflation will continue to soar unchecked.

It has become our urgent priority to keep ahead of inflation to protect both our asset base's value and our income stream's purchasing power. This means that we want to be invested in economically sensitive companies that will benefit from an economy that is running hot and will benefit from 0% short-term rates.

In this kind of environment, you want to be invested in cyclical stocks, financials, BDCs, CLOs, industrials, commodities, and value "small-cap" stocks, such as the ones that we hold in our HDO model portfolio. Furthermore, companies with real assets, debts that are eroded by inflation (such as Property REITs), and those that have the ability to raise prices can do well and have done so at other times when inflation was elevated. BDCs and CLOs that have reported so far have seen stellar earnings. Currently, the HDI "model portfolio" is overweight the above sectors, and we are very well positioned to outperform. I am very excited about the prospects of our picks!

'Value' is set to Strongly Outperform Growth

While growth stocks are still going higher, their momentum has started to lag. Also, they are the ones that will be the most impacted by higher interest rates (long-term or short-term ones). We are already seeing long-term rates starting to rise. As inflation heats up, long-term rates (10-year+) are set to go even higher. Especially when the Fed starts reducing its support of the treasury market by tapering. 

Note that growth stock valuations are trading extremely high with investors' money pouring blindly into ETFs that are heavy in growth and tech stocks. If and when we will see a market pullback, growth and mega stocks will be the most vulnerable, and potential losses will be painful. On the other hand, value stocks are still trading at much cheaper valuations, at roughly a 25% discount to growth stocks.

Small-cap value stocks are looking even better. Despite the big run we saw from October 2020 until May 2021, they are trading at the cheapest valuations in 20 years. We are currently seeing a broad strength in small-cap stocks, which looks like the beginning of a strong rally going forward.  We will likely see a new market rotation from growth to value and small-caps, which will propel our portfolio higher, and result in significant capital gains. 

'Value Stocks Beat Growth Stocks During Inflationary Periods: Decades like the 1940s, 1970s, and 1980s saw value stocks beat growth amid high inflation. By contrast, decades with low inflation or deflation, such as the 1930s, 1990s, and 2010s, saw the opposite trend, where growth beat Value.

In a strong bull market like today, all stocks tend to do well, but growth will start lagging value as inflation hits higher. With the Fed most likely hiking rates in 2023 rather than 2022 as Mr. Market expects, this would be one tailwind for growth stocks. However, their main headwinds will be longer-term interest rates that are set to increase along with inflation and lofty valuations. 

I am personally leaving my cash levels at a minimum and maximizing my exposure to our value and economically sensitive dividend stocks.

Technical Analysis

This week, the S&P 500 index closed slightly above the 4600 level on Friday, which is my first initial target for the year 2021. As you recall, in my market outlook back on June 6, 2021, I expressed my bullishness on equities by stating that:

We remain in an extraordinarily strong market. The main trend remains up. The S&P 500 is likely to head to the 4400 level soon, and I expect it to reach the 4600 level (or 8.7% higher from here) by end of summer or early autumn.

Currently, we are at 'extreme' overbought conditions, and as stated last week,  the 4600 level is a big psychological resistance for this market. Although overbought conditions are typically followed by pullbacks or a consolidation period, keep in mind that these "overbought conditions" are based on technical analysis. This does not mean that members should "lighten up" or sell positions. In a bull market like today, overbought conditions can last for a long time. 

We will probably need some sort of consolidation or a pullback in order to climb higher, which would be healthy for this market. But as we have seen over the past year, pullbacks have been shallow and short-lived, followed by a big rebound resulting in stocks taking on new highs. I expect the same to continue.

However, when the index has a clear break above the all-time high of 4600, we will continue to see further upside – and that is another real possibility that could happen soon even without any significant pullback. This should drive the index up to the 4700 level, making the index even more over-extended and more overbought. During a strong bull market such as today, surprises to the upside should not be discounted.

Note that my next target for the S&P 500 index is at the 4900 level and likely higher. We should get there over the next 6 to 8 months. 

If we do pull back from here, there is major support for the S&P 500 index at the 4500 level, which I would expect to be the "floor" for the index. Most likely, the index will not reach the 4500 level, even in case of a pullback, as investors keep buying every dip.

As a reminder, I would avoid trading or timing this market as trying to catch a shallow dip can result in lost opportunities. Here at HDI, we are long-term investors and happy to "buy and hold" for the long term as long as we are in the right stocks and sectors depending on the market and macro-economic conditions.

Best Course of Action for HDI Members

This great bull market is far from over. Despite its recent gains and all-time highs, there remains a huge upside left. Still, markets do not go up in a straight line indefinitely like we have seen lately, and we may be set to see some volatility.

The objective of my market outlook is to explain the forces driving the market and my views on where the markets are likely heading over the next 12 to 16 months. This should help our members keep in mind the "big picture" and hopefully feel comfortable holding equities in general and our portfolio in particular.

Even if we see some volatility at this point in this great bull market, I would consider every pullback as a buying opportunity. The monster flow of liquidity continues to be the major driver for stocks. Keep in mind that there is no other real alternative to stocks because yields are nonexistent at this point. So massive cash inflow will drive this market much higher over the next year.

The best course of action is to ride out any volatility we may see, having the confidence that this bull market is far from over. The future is even brighter for our value stocks and those that are inflation beneficiaries.

Our advantage at HDI is that not only do we keep a close eye on the macro picture to guide our members where the markets are likely heading next, but we get to collect our high income regardless of market gyrations.

When the time to become bearish arrives, we are ready to take a more defensive high-yield strategy such as a higher allocation to non-cyclical stocks such as utilities, telecoms, preferred stocks, and bonds. We may even use some hedging strategies. But today, the best course of action is to keep a high allocation to economically sensitive and inflation-resilient stocks and less to defensive ones.

Long-term investors are set to be rewarded! 

Have a great Sunday!

Rida MORWA