Category Archives: Markets

WEEKLY WRAP: Don’t Let the Debt Ceiling Deal Fool You

WEEKLY WRAP: Don’t Let the Debt Ceiling Deal Fool You

This week our Safety and Security investing theme, unfortunately, reigned supreme. Just days after the worst storm in modern U.S. history took nearly one quarter of U.S. refining capacity offline and dropped a biblical amount of rain on Texas, here comes Hurricane Irma, the most powerful Atlantic Ocean hurricane in recorded history after having done major damage in the Caribbean. Right behind her is Hurricane Jose, currently a Category 3.

Apparently not to be outdone, Mexico was struck by its strongest earthquake in a century, measuring 8.2 magnitude, just before midnight on Thursday local time, which resulted in a Pacific tsunami warning issued immediately after. Then there is Hurricane Katia, which could hit the eastern coast of Mexico in a few days.

Whoever has been ticking off mother nature, please knock it off. Of course, all kidding aside, our hearts and prayers go out to all those affected.

There is something distinctly unnerving seeing equity markets relatively calm when mother nature is tossing a whopping 4 apocalyptic-like disasters our way. But then if the South Korean Kospi doesn’t care about North Korea rattling its nuclear sword, then we suppose the S&P 500 might not be terribly fussed about nature tossing a little Armageddon our way.

These horrific natural disasters are also reflected in our Scarce Resources investing theme as the price of frozen concentrated orange juice, lumber, Brent crude, heating oil, nickel and aluminum rise. We’ve also seen shares of Home Depot (HD) and Lowe’s (LOW) both gain over 5% since the start of the month. Given the magnitude of these storms and subsequent destruction, we expect the fallout to dominate headlines over the coming days. We also recognize companies ranging from Disney (DIS) to Kroger (KR) will see disruptions that will weigh on expectations for the current quarter as well as the speed of the economy.

As investors, however, we continue to see signs of a stock market that is poised for greater volatility than we’ve seen over the last few months. Yes, we recognize that September tends to be that way, but it’s looking like this September will be more volatile than some. We say this given:

  • Federal Reserve Vice Chair Stanley Fischer announced he was stepping down for “personal reasons.” His term was to end June 2018. Between his departure and likely end of Fed Chair Yellen’s term, Trump needs to fill six out of seven positions, which just adds more uncertainty into monetary policy. Keep in mind that it will be a major challenge to find anyone that will be both dovish and pro-deregulation. We’ve heard that after his comments regarding Trump’s handling of Charlottesville, Gary Cohn is no longer being considered for Fed Chair when Yellen’s term ends in early 2018.
  • Treasury Secretary Mnuchin warned that the U.S. could seek to sanction any country trading with North Korea in an effort to put the kybosh on this missile and nuclear testing insanity. China and Russia quickly signaled their opposition, reducing the chances that this area of geopolitical uncertainty will be resolved diplomatically in the near-term.
  • Back in D.C., within hours of Paul Ryan announcing that the Democrats’ proposal on the debt-ceiling was “ridiculous and unworkable,” Trump overruled both his Treasury Secretary and GOP leadership by siding with the Dems over the three-month debt ceiling extension, which has some GOP conservatives already labeling it the “Pelosi-Schumer-Trump Deal.” So that relationship is going well.

Meanwhile, the U.S. economy continues to show signs of being long in the tooth, as even the Bureau of Labor Statistics has acknowledged that employment growth has been slowing.

The Fed’s Beige Book revealed that “contacts in many Districts expressed concerns about a prolonged slowdown in the auto industry,” and “low inventories of homes for sale continued to weigh on residential real estate activity across the country.” These are typical late stage indicators with slowing employment growth and peaking home and auto, (although the damage from the recent storms is likely to help with some of that excess auto inventory as folks will need to replace their submarined vehicles.)

While the ISM non-manufacturing business activity index did improve to 57.5 in August, up from 55.9 in July, this is the second weakest reading over the past twelve months and still well below the 60+ levels we saw at the beginning of the year. As for future growth prospects, the share of businesses expanding dropped to the lowest level of the year at 67% from 78% in June and July.

We are seeing some improvement in productivity, with nonfarm productivity rising 1.5% on an annualized basis in Q2 versus expectations for 1.3% after having growth of a mere 0.1% in the first quarter. Obviously, we like to see productivity improving, but the longer-term trend is still nothing to get excited about. Remember that the potential growth of an economy is a function of just two things: improvements in productivity and growth in the labor pool. The civilian labor has been growing at less than 1% for much of the time since the post-financial crisis.

 

 

In other cheery news, the U.S. Dollar is on course for its biggest weekly slide in almost fourth months, dropping to its lowest level in 33 months. Mario Draghi’s recent comment that the European Central Bank could start QE tapering as early as October pushed the euro up over $1.20 and further weakened the dollar. Weakness has also been driven by the decreasing likelihood of further rate hikes in 2017, made more unlikely by the ongoing natural disasters coupled with the North Korea-related tensions. The dollar has declined for six consecutive months, the longest slide in 14 years, and is down over 12% from post-election highs. The Amex Dollar Index (DXY) has broken down through major support levels and sits at levels last seen at the start of 2015.

The Treasury market is also reflecting the less-rosy outlook with the 10-year Treasury yield hitting its lowest level since the election, on its way towards 2%. While the major U.S. indices are mostly unchanged since the start of the month, the SPDR Gold Shares ETF (GLD) has gained over 3% and the iShares Silver Trust ETF (SLV) is up nearly 4% and the long-dated iShares 20+ Year Treasury Bond ETF (TLT) has gained over 1.3%. Risk-off is the new black so far in September.

The bond market is also indicating we are in the later stages of this business cycle with the rather pronounced decline in yields. The pullbacks we’ve seen in shares of the more cyclical segments of the stock market also indicate that the coming months are more likely to see further slowing in the economy.

The current bull market is the second longest since WWII, outpaced only by the one ending in March 2000. That one also saw record high valuations and much talk of “this time it’s different.”

 

 

Stepping back, we have valuations that remain heady, with the decidedly meh reactions to earnings and revenue beats, (most shares actually fell on reaction day) in the last reporting round reflecting the priced-to-perfection. We have an economy and a bull market that are both long in the tooth heading into what is typically the most volatile time of the year on top of unusually high domestic and geopolitical tensions.

The U.S. economy is no longer the “cleanest shirt” in the laundry in terms of economic growth as Europe and emerging markets look increasingly more robust and have more attractive valuations. Don’t forget that going back to even before 1900, the U.S. has experienced a recession within 12-months of the end of every two-term presidency. We have experienced the second longest run in history of trading days without a 5% or more pullback in the S&P 500. Reversion to the mean demands that prolonged periods of hyper-low volatility must result in heightened volatility.

While we may see some market relief as the debt-ceiling battle has been pushed back 3-months — removing the possibility of a technical default in October — the upside potential from here, versus the downside risk, indicate caution. Investors would be wise to put on some protection and have a plan for getting out if things get wiggly. Yes, that is one of the technical terms we use here at Tematica.

 

 

Inflation waning while bonds dispute moves in stocks

Inflation waning while bonds dispute moves in stocks

Wednesday the Federal Reserve, as expected, raised rates, but even more importantly they release an outline of their plans to shrink the Fed’s balance sheet, which you can read here. We must also note that raising rates in a period of falling bond yields and where the 3-month change in core CPI is collapsing is unheard of, but then very little of U.S. monetary policy these days in within the bounds of normal.

Here are just a few reality checks to keep in mind.

Stocks are experiencing below average volatility and volume

  • On average, the S&P 500 experiences around 50 days where the market moves +/- 1 percent, but so far in 2017 we have experienced only 6 such days.
  • The 30-day NYSE average daily volume is down 16 percent from the post-election peak

Concentrated Gains

  • According to Barron’s, Facebook (FB), Apple (AAPL), Amazon (AMZN), Microsoft (MSFT) and Alphabet (GOOGL) collectively account for about 56 percent of the $1.16 trillion gain in the NASDAQ 100 market cap since the start of the year and are responsible for around 40 percent of the gain in the S&P 500 year-to-date: recall that back in 2000 Microsoft, Qualcomm (QCOM), Cisco (CSCO), Intel (INTC) and Oracle (ORCL) represented about 50 percent of the NASDAQ 100.
  • Collectively the FAANG trade trades at a P/E ratio of 39x, (versus 2017 EPS), which represents a 7-point expansion in 2017 alone.
  • 32 percent of actively managed funds are overweight the tech sector
  • 71 percent of actively managed funds are overweight FANG
  • The returns for the S&P 500 equal weight index is over 3 percent below the S&P 500 market cap weighted index year-to-date

Bonds are not telling a growth story

  • US 10-year Treasury yield has fallen from 2.6 percent in March to just over 2.1 percent today.
  • US 30-year Treasury yield has dropped from a peak of over 3.2 percent in the first quarter to less than 2.8 percent for the first time since November.
  • The Treasury curve, which has been flattening for some time, accelerated this trend this week, with the 10-year to 2-year spread falling below 80 basis points for this first time since last September.

10-2 Year Treasury Yield Spread Chart

The Bottom Line

  • Tops never look like tops until after they are well behind you.
  • They typically occur when investors are most confident.
  • They always occur before we are ready.
The Market Climbs Higher, But Look at These Two Charts and It’s Ruh-Roh Time

The Market Climbs Higher, But Look at These Two Charts and It’s Ruh-Roh Time

As the stock market continued to get further and further out over its ski tips last week, as investors we have a split mind on the current state of things. On the one hand, we’re certainly enjoying the higher stock prices. On the other hand, we are mindful of the increasingly stretched market valuation. One of the common mistakes see with investors is they all too easily enjoy the gains, but tend not to be mindful of the risks that could wash those gains away.

Over the last few weeks, we here at Tematica have been pointing out the growing disconnect between the stock market’s valuation and the current economic environment. We have a snootful of data points that underscore our cautious stance in this week’s Monday Morning Kickoff, but we wanted to share two charts from our weekend reading that caught our cautious eye.

There have been some who call into question the use of Robert Schiller’s Cyclically Adjusted Price to Earnings (CAPE) ratio, but Tematica’s Chief Macro Strategist Lenore Hawkins does a pretty good job handling that criticism. Exiting last week the CAPE to GDP growth of 19.77 has far surpassed the 1999 peak and all points back to at least 1950. As we like to say when looking at data, context and perspective are key to truly understanding what it is we’re looking out. So here’s that context and perspective for the current CAPE to GDP reading —  it is over three times the average for the last 66 years. Going back to 1900, the only time today’s ratio was eclipsed was in 1933 and that reflected the Great Depression when GDP has been running at close to zero for nearly a decade.

Students of CAPE will point out that in order for the CAPE to GDP to fall back to more normalized levels, we either need to see a dramatic increase in GDP (not likely in the near-term) or we need to see a pullback in the CAPE. Here’s the thing, as Michael Lebowitz of 720 Capital points out, “if we assume a generous 3% GDP growth rate, CAPE needs to fall to 18.71 or 35 percent  from current levels to reach its long-term average versus GDP growth.” Based on the data we’re seeing, there is a rather high probability 2017 GDP is more likely to be closer to 2.5 percent than 3.0 percent per The Wall Street Journal’s Economic Forecasting Survey of more than 60 economists, which means to hit normalized levels, the CAPE would need to fall further than 35 percent.

As you ponder that and think on why it has us a tad cautious, here’s more food for thought:

 

 

Coming into 2017, forecasts called for the S&P 500 group of companies to grow their collective earnings more than 12 percent year over year, marking one of the strongest years of expected growth in some time. Granted energy companies are likely to be more of a contributor than detractor to earnings growth this year, but we as can be seen by the graph above, earnings expectations for the S&P 500 are already coming down for the current quarter. Those revisions now have year over year EPS growth for the collective at up just over 10 percent.

Are we getting data that shows the current quarter isn’t likely to break out of the low-gear GDP we’ve been seeing for most of the last few years?

Yep.

Are earnings expectations for 2Q-4Q 2017 still calling for 8.5 to 12.5 percent earnings growth year over year?

Yep.

Is it increasingly likely that President Trump’s fiscal policies won’t have a dramatic impact until late 2017 and more likely 2018?

Yep and yep.

The bottom line is we have the stock market melting higher, pulling a Stretch Armstrong-like move in terms of valuation even though earnings expectations for 2017 are starting to get trimmed back.

Yep, you can color us cautious at least for the near-term. While we continue to use our thematic foresight to ferret our companies poised to ride several of our thematic tailwinds, the current market dynamic has us being far more selective.

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What The Financial News Isn’t Telling You That You Need to Know

What The Financial News Isn’t Telling You That You Need to Know

Investors as a group are notorious for chasing returns, which means everyone piles into whatever has been working best lately and more often than not tends to be late to the party. The catch this time around is whatever has been working best lately is whatever has gone up in price the most. All this is completely antithetical to the mantra, “Buy low and sell high,” as that requires selling that which was been performing stupendously and buying that which has been getting gut punched like Rocky did my Mister T in the first half of Rocky 3. Imagine hearing that kind of advice on mainstream financial TV!

 

In our defense, we humans are genetically programmed to buy high and sell low because that’s what you do when you follow the herd and rely on headlines for insight. Remember, our ancestors were the ones that had the good sense to run deep in the crowds when that sabre-toothed tiger got the munchies.

With that in mind, recall that yesterday we talked about how investors have been choosing passively managed funds over active funds at an accelerating rate in a market that has gained more in the past three months, (S&P 500 up 7.6 percent) than in the two years prior to the election, (S&P 500 up 3.3 percent).

That move up has been oddly calm, with the S&P 500 having moved less than 1 percent intraday now for 40 consecutive trading days. That is the longest streak in at least thirty-five years! As Real Vision Television founder Raoul Pal likes to say, suppressed volatility invariably leads to hyper-volatility.  The following chart shows just how low volatility has been relative to historical norms.

 

The VIX is currently just slightly above the lowest levels we’ve seen in the past twelve years and is well below the average over that time frame. This stands in stark contrast to the level of global economic policy uncertainty and the current P/E valuation accorded to the S&P 500.

Within just the States, the level of political uncertainty is also well above the median, reaching the 82nd percentile!

 

So we have volatility at exceptionally low levels with significantly heightened policy uncertainty both in and outside the U.S., yet stocks are trading at historically very pricey levels according to a wide range of metrics. The chart below shows the S&P 500 Cyclically Adjusted Price-Earnings Ratio (CAPE) going back all the way to 1881. According to this metric, stocks have only seen these levels just prior to the 1929 crash and the dotcom bust.

 

As of 12/30/2016, (the latest date for which comparative data is available) the U.S. was quite expensive on a relative basis, with a CAPE of 26.4, the third highest in the world, trailing behind Denmark at 33.3 and Ireland at 31.2. The CAPE of the U.S. was trading at a 60% premium over developed Europe and an 89% premium over emerging markets.

If we look at trailing-twelve-month price to cash flow ratio, as of 12/30/2016, the U.S. was trading at a 25% premium to developed Europe and a 41% premium to emerging markets.

If we look at trailing-twelve-month price to sales ratio, as of 12/30/2016, the U.S. was trading at a 73% premium to developed Europe and a 46% premium to emerging markets.

If that doesn’t have you convinced that we are in heady territory, BMI Research recently pointed out that the technicals in the U.S. market are setting up for some seriously unattractive returns over the next three months based on historical norms.

 

The bottom line is investing is all about probabilities and with stocks in the U.S. at such lofty level with a whole lot of perfection expectation priced in, the downside risk relative to upside potential is something that ought to not be ignored.

So the question is, what could push U.S. equities higher aside from P/E ratios moving further out into the stratosphere? Check back tomorrow for our discussion on just that.