Weekly Update: Defense
I went to Denver this week, where I love to visit because each time I go, I can spend time with one of my dear lifelong friends. I spoke at a new venue for me there—Coors Field. In my year-to-date uncanny ability to find a colder place to visit than Pittsburgh, I landed in Denver on a cloudy day (that hardly ever happens!) in the mid 20s. My cab driver reported the city would experience 4-8 inches of snow that night. I thought for sure our event at the ballpark would be cancelled, along with the scheduled baseball game. They did cancel the game on the day I arrived, but for our event, it became a doubleheader. Now, I have yet to meet a Denverite who doesn’t just love living there, and largely because of the great outdoors. And so the doubleheader went on, with temperatures in the 20s-30s and the fine people of Denver cheered on their Rockies. I complained about the cold, and my hosts said it’s too bad I wasn’t there just two days before, the weather was delightful! This makes me laugh. I have heard that the weather was delightful just two days prior so many times over the years, that I think I should have started my career two days earlier than I did! In any event, the mood was relaxed and accepting of my dividend theme.
It wasn’t an eventful week in the markets. The economic reports (more below) were indicative of a possible spring swoon, nothing worse. Events bear watching in Europe, where the April PMI suggested the euro-area GDP is contracting at around a 0.4% to 0.5% quarterly pace and Germany’s composite PMI fell to 48.8, the weakest since October last year. But the UK’s first-quarter GDP rose more than expected, and Italian bond spreads narrowed following a relatively favorable outcome in another round of new elections. Back home, earnings so far have been OK, nothing great. With 190 companies in the S&P 500 having reported, 69.3% beat expectations against a norm of 66%. But revenue gains were soft, with 33.6% of the reports beating consensus. The issue was corporate guidance, which was poor, causing second-quarter earnings estimates to begin to slide lower. We did see some shifting from defensive names to cyclicals and small caps this week, which is good news for the continuation of the overall market rally. ISI notes stocks go up 68% of the time when cyclicals lead, versus 61% when defensive sectors lead. But as we have written, this rally has for the most part has been led by defense, and on a seasonal basis, cyclicals tend to lag their defensive peers from this point through the summer.
Along those lines, S&P Capital IQ’s chief equity strategist issued an interesting report after reviewing the S&P’s performance over rolling six-month periods since 1945. Of the 12 periods, May-October had the lowest return, 1.2% on average compared to 4.1% for all periods. The best period has been November-April with a return of 6.9%. The study also found the weakest period had the second-lowest frequency of advances (63%), while the strongest period had the highest frequency (78%).The author’s advice isn’t to go away during May-October, but rather to buy the sectors with a history of outperforming during that lackluster period. Using data from April 30, 1990, to April 19 of this year, the two biggest outperformers were the defensive sectors Consumer Staples (4.6%, advancing 70% of the time) and Health Care (4.4%, advancing 65% of the time). The absolute losers were Consumer Discretionary (-1.1%), Industrials (-1.1%) and Materials (-2.8%). In Denver, one speaker on the docket before me lamented the likely bad end to this global uncontrolled printing press and all-time record low global bond yields. (BTW, all this printing has kept the dollar strong—best house in a bad neighborhood. And studies going back to the 1970s show defensive sectors tend to lead during periods of a strong dollar). The next one described a very bullish outlook for equities. Both can be correct, as easy money always finds its way to financial assets. There may be trouble in the future, but for now, it is risky to be bearish.
Consumer mood brightens somewhat The University of Michigan’s consumer sentiment gauge surprised, coming in at a final April read of 76.4 versus an initial read of 72.3, a nine-month low. The rise relative to the first estimate was broad-based, as both current conditions and expectations improved. This index has been volatile this year, rebounding at the start of the year, before cooling in March and April. The improvement in this month’s second half suggests as recoveries in the housing and labor markets continue, sentiment should follow.
All roads lead to jobs The four-week moving average of initial jobless claims fell in the week of April 20 to 357,000—a level that historically has indicated modest job growth. Claims have been the one of the few data series that has not disappointed of late. In other details of the report, continuing claims declined 93,000 to 3 million, their lowest since May 2008, and the insured unemployment rate declined to a new post- recession low of 2.3%. In the past, this rate—the percentage receiving unemployment insurance relative to those eligible to receive it—has tended to track the unemployment rate fairly well.
Housing’s inventory issue The National Association of Realtors says the number of potential home buyers jumped 25% in March from a year ago, but supplies shrank17%, causing existing-home sales to slip 0.6% as those buyers couldn’t find homes. New home sales did better, rising 1.5% after plunging in February, but builders say a lack of choice in healthy markets also kept buyers at bay. Still, sales continue to trend well above year-ago levels, as do prices—year-over-year, March’s FHFA house price index was up 7.1% and real median existing-home prices were up 9.5%, the most since December 2005. These trends are consistent with a broad-based recovery in housing.
GDP disappoints First-quarter growth came in at 2.5%, up significantly from the fourth-quarter’s anemic 0.4% increase but below consensus expectations for a 3.0% rise. Much of the improvement was owed to inventories, which added a full percentage point to growth after slicing 1.5 points off last year’s fourth quarter. Final sales, a key measure of underlying demand, slowed to 1.5% from 1.9%, indicating weakening momentum to start off the year. Plunging government expenditures, primarily related to defense and related sequester-driven cuts, were a key factor. Consumer spending rose a solid 3.2%, but was fueled by savings as personal income fell a 3.2% annualized rate, lowering the savings rate to 2.6%. This is not the way we want to fund spending growth.
Manufacturing hits a soft patch Surveys for April softened with the Markit Flash PMI unexpectedly dipping to 52 from a previous 54.6 and the Richmond Fed index dropping to -6 from a +3. These follow lower readings for both the Empire and the Philadelphia Fed surveys. With the national ISM index at just 51.3, any downdraft in activity could push the national index into contractionary territory (it comes out next Wednesday), raising more concerns about a spring “swoon.’’ Separately, the Chicago Fed’s National Activity Index also raised cautionary flags, with the three-month average falling to -0.01 from +0.12, the first negative reading in five months.
More evidence of a soft patch Durable goods orders sank 5.7% in March after surging 4.3% in February, a further sign of the slowing reflected in the regional indicators. Even excluding aircraft, March orders ex-transportation were down 1.4% after falling 1.7% in February. Electrical equipment, machinery and primary metal orders were notably weak. On the positive side, nondefense capital goods shipments (both headline and ex-aircraft) rose again, and nondefense capital goods orders ex-aircraft rose 0.2%. Unless the employment data continue to weaken significantly, this soft patch, like those in previous years, should prove temporary.
‘QE to infinity’ yields an impact (pun intended) With Fed policymakers set to meet next week, the debate is shifting away from “tapering” towards possibly extending the present quantitative easing program, Bloomberg News reports. With the jobs market remaining weak and inflation non-existent, Fed officials will probably experience little pressure to lighten up on the current QE pace. History would suggest that even sluggish real growth (below 2%) with subdued inflation (also below 2%), the 10-year Treasury yield should be between 3% and 4%. If markets expect just a second quarter “soft patch,” with above 4% nominal growth in the second half and beyond, then the 10-year yield should be closer to 4%. In either case, today’s yield of about 1.70% appears to be about 150 to 200 basis points below fair value for the current trend in nominal growth. This doesn’t prove yields are in bubble territory, but it adds to the theory that in an unencumbered market, i.e., without Fed intervention, yields would be higher.
Hacking’s a very costly nuisance As witnessed this week when the markets dived within seconds of a fake AP tweet that Obama was hurt in a White House explosion, cybercrime’s economic impact is very real. It affects nearly 1.5 million people per day and costs consumers $110 billion per year, according to Symantec. International cyber-hacking gangs have substantial infrastructure: A recently uncovered fraud utilized 60 servers to make thousands of attempts to steal money from bank accounts. Prices for computer code known as “exploits” (which let hackers infiltrate and control computers) range from $20,000 to over $250,000 apiece, up fivefold since 2004.
Baby, it was cold outside Last month was the second-coldest March in the continental United States since 2000, the National Weather Service reports, with an average temperature that was 13 degrees Fahrenheit lower than in March 2012. A late-winter blizzard also broke snowfall records in many areas. This—and a very early Easter—likely played havoc with seasonal adjustments to the month’s economic data. Utility output, for example, jumped 5.3% as Americans had to use more heat, the biggest one-month increase since February 2007.