Weekly Update: Linder, things are messed up beyond all recognition

06-23-2017

That represented the prevailing view during my trip this week through New York City, Long Island and Buffalo, which evoked fond memories of my college years at the University of Pennsylvania, where I was mostly called Linder. I met with numerous plain-spoken veteran advisors who are not complacent even as the market has made 24 new highs so far this year! They voiced concerns about the flattening yield curve, the Fed’s June statement, oil prices, a stubbornly low VIX, the inability to get a decent correction so as to invest “dry powder,” increasingly greedy clients—client complaints included how much more their friends’ portfolios are up year-to-date (YTD) and how their diversified portfolios are lagging the S&P 500 YTD—and politics. “Every one of my clients is worried about politics,” I was told by one advisor. At one meeting, a veteran with cash at the ready for a pullback asked me repeatedly if I could remember a time when we went so long without a 5% correction. As of June 22, we’ve gone 250 days without such, compared to 84 days for past secular bulls dating to 1928. Stocks rarely decline materially against a quiet backdrop—FBN Securities observes the S&P has garnered 211% of its gains when its session range is thin, as has been the case. It also shares my view that possible Fed action may represent the biggest potential headwind. Chair Yellen is sure to face pushback if she seeks to march boldly ahead in the face of diminishing price pressures. Noted Fed dove Charlie Evans, a member of the policy-setting committee, said in a recent CNBC interview that he’s “nervous’’ inflation may be rolling over (more below).

It seems messed up that global growth is accelerating as inflation and global bond yields are falling. The Composite Leading Indicator for OECD countries plus nonmember economies rose a 14th straight month in May to a 2-year high, Ifo’s World Economic Climate Index has risen 3 straight quarters to near a 3-year high, the Sentix Global Economic Conditions Index has stabilized at a 7-year high and U.S. leading indicators have now risen 6 straight months. To be sure, the Citigroup Economic Surprise Index turned negative (more below) for the first time since last October, and the OECD leading indicator is only in line with its long-term average of 100—indicating no boom, but no bust, either. The same could be said for the U.S., where the expansion is on track to become the longest on record but also among the weakest, with soft consumer outlays the biggest drag. But is it really that bad? Adjusted for inflation, purchasing power has been remarkably strong, with real U.S. wages rising at a 1.7% pace since December 2007—one of the strongest gains of any recovery since the 1960s, Leuthold Group notes. Similarly, annualized real personal consumption has risen 2.7% in the last 4 years, well above annualized real GDP growth. Profits have been remarkably good, with S&P EPS up 14% in Q1 and Q2 estimates up 2.6% over the past month, better than the 14-year average of 1.9% over the May 15-June 15 timeframe. Both job openings and real investment spending have spiked (more below), despite the lack of any legislative successes in Washington. This suggests growth may turn out to be stronger than anticipated, further lowering recession odds that Goldman Sachs puts at 1-in-3. Despite evaporating expectations for the “Trump Bump,” the most underappreciated impact of his administration may be the first regulatory rollback in 30 years.

I repeatedly was asked where oil prices are headed and responded as I always do—I don’t know and no one does. Too many supply, demand and geopolitical factors go into it. But as a commodity in a secular bear, a wide trading range is likely for some years to come. Oil futures have traded between $38 and $55 a barrel for 14 months and may remain there since U.S. shale is profitable in this range. While Energy high-yield spreads have widened, Strategas Research observes weakness has been modest and hasn’t spread to Industrials, Materials or Financials (an important distinction from 2014/15). As for talk that tech is being led by just a few big stocks (more below), the evidence suggests otherwise. Ned Davis notes there’s always been 5 stocks contributing more than others, with the S&P ex-the top 5 monthly contributors down 0.27% since 1972. Moreover, the uptrend in earnings revisions highlights that the move in the tech sector has been broad-based, with the highest percentage of companies in the sector outperforming relative to other sectors. The rollover in last fall’s economic re-acceleration has caused banks and cyclicals to underperform, leading many investors to ring alarm bells that valuations are problematically stretched and a pullback is imminent. RBC Capital Market sees two flaws with these warnings: 1) the majority of the market’s upside in 2017 has actually come from earnings, not higher stock multiples; and 2) elevated valuations are a weak near-term indicator for the direction of the market (more below). Things may seem messed up, but it’s quiet out there. And quiet is good.

Positives

Existing home sales solid … Instead of an expected decline, they rose in May to a new cycle high, lifting the 3-month average of single-family home re-sales to their highest level since February 2007. The median sales price also rose to a record high, in part on tightening inventories—a key factor in the FHFA’s separate gauge of prices which rose more than expected. Supply constraints may be inhibiting sales but with 6- and 12-month sales averages near 10-year highs, the upward trend in housing demand appears sustainable.

… New home sales, too They rose at their second-fastest pace of the year in May, lifting the year-over-year (y/y) gain to nearly 9%, and April’s decline was revised up sharply, too. Notably, the median price also jumped 11.5%, pushing the y/y increase to almost 17%. This isn’t all good news given that prices are rising because inventories are tightening—an issue that could slow future sales if builders don’t pick up the pace.

Capex climbing Real business fixed investment jumped at a 9.4% annualized rate in Q1, and over the last 2 quarters, real nonresidential fixed investment has expanded at its fastest pace in nearly 3 years. Moreover, corporate credit rose sharply in Q1 and is now near a new record high. Also auguring well for capital expenditures (capex): the ABC commercial real estate construction backlog is at a new high, the Business Roundtable’s CEO Economic Outlook Index is at a 3-year high and the Architecture Billings Index’s inquiries and design components are near 3-year highs.

Negatives

Why inflation is a worry With headline and core CPI falling back well below the Fed’s 2% target—on a 3-month and annualized basis, they were -1% and 0.0% through May—many market participants worry the Fed’s in danger of tightening too much and pushing the economy into recession. While tight credit spreads and the resilience of the stock market argue against a large increase in recession risk, Evercore ISI says policy error may fail to arrest deterioration in various indicators of inflation expectations, which in turn may ensure that inflation stalls out modestly below target, causing wage increases and growth to remain subdued.

Manufacturing moderates U.S. manufacturing activity this month slipped to its slowest pace since last September, according to Markit’s flash composite PMI, as both new orders and output fell. The Kansas City Fed’s take on regional factory activity also indicated waning momentum, with both new orders and backlogs turning negative.

Citi very negative The Citigroup Economic Surprise Index continues to plunge, from a recent high of 57.9 in mid-March to -78.6 last week, its lowest since August 2011. The good news, Yardeni Research says, is this highly cyclical series has lots of short-term swings, a result of soft and hard data not always aligning with expectations. Historically when it’s dropped this much this fast, the index has tended to rebound strongly. For now, it suggests the expected rebound in animal spirits that could boost the economy hasn’t been realized.

What else

This isn’t tech 2000 Today’s top 5 YTD stocks—Facebook, Amazon, Apple, Microsoft and Alphabet—represent 13% of S&P market cap, contribute 17% and 12% to forward index revenue and earnings growth, and trade at forward P/E multiples relative to market of 2.8. By contrast, the top 5 dot-com stocks in March of 2000 represented 16% of S&P market cap, contributed 8% each to forward revenue and earnings growth, and traded at forward P/Es of 46.9. The late 1990s growth trade was driven by hockey-stick earnings projections and investor/analyst euphoria, whereas today’s growth trade has more balanced expectations and often is used as a shelter from weaker growth.

A new normal valuation range? Compared to the entire 137-year history of the popular Shiller CAPE P/E ratio, stock market valuations have been extraordinarily high most of the time the past quarter century. It has been above average 98% of the time, above the 70th percentile 96% of the time, above the 80th percentile 74% of the time and amazingly, above the 90th percentile (i.e., higher than 90% of the monthly P/E multiples since 1880) more than half the time, Leuthold Group says. How pessimistic should an investor get when valuations are high if they are “always” high? It attributes this shift up to an economy that’s less dependent on manufacturing and oriented more toward services and tech—changes that help reduce cyclicality and extend recoveries.

Shaking my head U.S. workers use only 54% of their vacation time on average, according to the job-search firm Glassdoor. Only 23% of those surveyed used all of their vacation time, and about 10% didn't use any paid time off. What’s wrong with these people?! Why, that would be like skipping my hair salon appointment!