As we move into the 101st month of the current economic expansion, the respective stock market indices have continued their climb further into nosebleed territory. On Thursday the S&P 500 avoided its first back to back daily declines in about a month after a rally into the close pushed it back into positive territory for the day, while today the Dow Jones Industrial Average touched a new all-time high. The headlines are all about ebullience in the markets, but in this week’s wrap up we’ll point out that there are plenty of yellow flags waving.
This week was seriously action packed from finally getting a tax bill proposal that the majority of House Republicans can support, to the issuance of indictments for Paul Manafort, Rick Gates and George Papadopoulos, to President Trump announcing current Fed Governor Jerome Powell as his pick for the next Chairman of the Federal Reserve and yet another brutal terror attack in Lower Manhattan. Mr. Powell will need to go through the formal Senate confirmation process, (otherwise known as politicians competing for airtime while sneaking in wholly unrelated topics they want to be seen as caring about and showing how they don’t really understand monetary policy) but is expected to be approved by a decent margin. If the current chair Janet Yellen does not stay on as a Governor, four out of seven Fed Board seats will have vacancies, giving the Trump team an unusually profound ability to dramatically reshape the Fed. If the markets have benefited to the extent we suspect from the Fed’s policies, a change in tenor is worth a close watch.
Thursday Apple’s stock gained over 3% after posting fourth-quarter results that beat expectations by a material margin at $2.07 EPS versus the consensus for $1.87 — and that doesn’t include sales for the iPhone X. We couldn’t be more pleased to have added Apple to the Tematica Investing Select List back on October 30th as shares have gained over 6.0% since then as of mid-day Friday. Of course, we’re even more pleased by the move higher in Disruptive Technologies company Universal Display (OLED) shares over the last year, which are up almost 185% since we added it to the Select List. While today that company is a “bullet” play to Apple’s smartphone adoption of organic light emitting diode displays, as that technology expands into TVs, automotive lighting and general lighting, we see OLED shares as just getting going.
Looking at the broader technology sector, it was by far the best performer in October, rising 6.5% while Consumer Staples took it on the chin, falling 1.6% during the month. In a telling indicator of the rather bipolar nature of this market, Utilities was the second strongest sector for the month, gaining 3.9% — talk about an odd couple.
That’s not the only oddity in the global landscape. The U.S. dollar has been strengthening, (watch out big cap stocks with hefty overseas revenue) but so have emerging market currencies. We’re seeing a stronger dollar, but also rising gold, oil and even basic material prices. Then there is my personal favorite, European junk bonds yielding less than U.S. Treasuries, because that makes sense. In this ZIRP world, the demand for any yield is so massive that risk-based pricing simply no longer exists.
The Federal Reserve Open Market Committee press release this week was pretty much the same as what we’ve been hearing for months, with the exception of more emphasis on core inflation remaining soft. On the other hand, it did reflect a view of a stronger economy, shifting from “rising moderately” back on September 20th to “solid rate” this week. Barring anything wild occurring between now and December, this makes it all the more likely that we will see another rate hike in December. Today the markets are pricing in about 90% chance of a hike versus back on September 8th when odds were more like 1 in 3. We’d point out that the bond market isn’t expressing the same optimism on the longer end of the curve and the spread between the 5-year and 2-year is down to just 40 basis points with the overall yield curve a mere two hikes away from inverting.
For all the headlines talking about a strong economy, the reality is the trend in after-tax, after-inflation, personal income on a per capita basis is less than 0.6% growth year over year. This long-term norm for this metric is more like 2.5% and we see this as a rather confirming data point that our Cash-Strapped Consumer investing theme remains strong.
For all the talk of a massive reflationary, pro-cyclical, risk-on rally, government bonds are giving a big yawn to the growth story. Look across the globe and you’ll see that 10-year yields haven’t shifted much at all despite all this supposed exuberance. But what about that jump in third quarter Employment Cost Index you ask? Looking into the details, the biggest pay increases were in those sectors that are most productive which means that when we look at it from a unit-labor cost perspective, inflation disappears.
Let’s get realistic about earnings while we are at it. While about 75% of S&P 500 companies that have reported have beaten their (let’s be honest here) lowballed estimates, earnings are on track for about 5% year-over-year improvement while the index is up more than 20%. The reality is that only about 25% of the total return for the S&P 500 has come from EPS improvement.
Let’s also look at those corporate balance sheets. Since 2010, the U.S. corporate sector has increased its debt load by a whopping $7.8 trillion with the median net debt now near a record high 1.5x aggregate earnings. Interest coverage ratios have been getting weaker and weaker over the past few years while earnings are down to less than 6x interest expense – that’s the weakest multiple since the onset of the credit crisis.
The bottom line is we are quite late in the cycle, which makes individual security selection all the more important. Same goes for reading beneath the headlines and understanding the dynamics of sentiment. That Conference Board’s big jump in consumer confidence to 125.9 in October, the highest reading since December 2000? Recall what happened three months later? We were in a recession. Confidence also peaked in July 1989, December 1972 and December 1969 — all late in the cycle and typically a year or so before we entered into a recession.