Weekly Update: I really must get a pedicure

08-04-2017

Did you ever go on a beach vacation and sit looking at the ocean waves, waiting for peace, wisdom and clarity? Me neither, but I was able to try that this week at my favorite business destination, Honolulu, where every day my body clock woke me three hours before the patio restaurant started brewing Kona coffee. The week kicked off with a seasoned professional worrying the market is entirely too expensive and set up for a nasty correction, a sentiment repeated numerous times in our advisor meetings. Yes, lots of us are anticipating one as August and September historically are the year’s weakest months, the S&P 500 already has had a terrific run, D.C. fiscal progress is a big disappointment and central banks are poised to take the punch bowl away. Still, the global backdrop is supportive, with growth balanced between developed and emerging economies, inflation muted (July’s headline and core PCE Indexes were again well below the Fed’s 2% target) and the weaker dollar bolstering exports and earnings. Despite the seeming chaos in Washington, stocks are on track for a 2017 total return of 21% and risk premia actually are lower, suggesting risk-tolerant markets can handle the havoc of President Trump’s ecosystem. Trend Macro says it actually may be “informationally efficient” to reveal distasteful processes that were there all along but concealed. Behind the scenes, the tax reform working group has given up the border-adjustment tax idea, clearing the path for tax cuts this year. This would be an upside surprise for the market.

In Hawaii, I heard from numerous advisors that their clients feared Trump and wanted to know how the market will react if tax reform/cuts don’t occur and if there is an impeachment. In every meeting in this liberal state, Trump was disparaged. I increasingly use that opportunity to suggest that investors give D.C. doings way too much credit for market returns. As I have said more than anything else over the years, it is about earnings and the appropriate P/E. It’s as clear to me as the chipped nail polish on my sandy toes. To be sure, at 36% this Wednesday, Trump’s approval rating merits monitoring. Since 1959, the Gallup daily poll indicates stocks are unaffected unless the approval rating falls to 35% or below. Earnings continue to be strong, with 73% of companies beating consensus on the bottom line and nearly 60% beating on the top line—both well ahead of their averages since the recovery began. The technical background also appears healthy. The NYSE cumulative advance/decline line made a new high again this week, confirming the Dow’s new high. Moreover, while most valuation metrics show the market as expensive on an absolute basis, relative valuations tell a different story. With interest rates so low, stocks historically are cheap compared to bonds, Ned Davis Research says. Ned reminds us that high valuations do not necessarily mean a secular bull is near its end. In the late 1980s, for example, stocks were extremely expensive but the pace of the ascent slowed so that by the mid-1990s, stocks were fairly valued again.

History suggests the positive market trends will continue through year-end. In all the years when the S&P was up 10% or more through July, that’s been the case, FBN Securities says. The fact that there is little stress on the market is helping. The Chicago Fed's survey of financial conditions just dropped to its lowest reading since 1993 (the lower the model, the less financial stress present). Reflecting the sentiment of individual investors toward the stock market over the next 6 months, AAII sentiment polls are in a sweet spot. Bears have dropped to the lowest level this year and, along with the current bulls, are not at extremes. So, I was watching the sunrise in paradise as the surfers headed in for the early morning waves, and my crazy bullish Phoenix friend shouted out by email. “Here is a question to ask your next audience? How many of you have a family member that got their Series 7 stockbroker license in the last year? (Very few hands will go up, if any.)  How many of you the last time you went out to dinner talked about the stock market? … We are in a secular bull market and returns are typically 15% to as much as 19% per year. In fact, did you know the S&P compounded at over 19% per year from 12/31/1974 to 12/31/1999? These returns are very normal and all the strategists, or 99% of them who for the last several years have predicted [much lower returns] are not studying secular bull-market returns.” It’s a secular bull market with benign inflation and rising earnings. Right here, it’s as clear as my toes in the warm sand.

Positives

Jobs chugging along At 209K, July nonfarm payrolls surprised, and a strong June was revised up further. Notably, manufacturing jobs rose 16K, more than five times the consensus, and the prior month’s negligible gain was revised up a sharp 11K. In other signs of strength, the participation rate rose, the jobless rate ticked down to 16-year low of 4.3%, jobless claims continued to hang around multigenerational lows and Challenger layoff announcements remained significantly under last year’s subdued pace. At 178K, ADP’s July private payrolls weren’t as robust but, over the past 12 months, have averaged 197K, indicating a steady pace of job creation.

A good summer for manufacturing On top of today’s gains in factory payrolls, the ISM gauge for July also signaled a strengthening trend in activity, with the 6-month average reaching its highest level since December 2014. Markit’s separate PMI rose to a 4-month high on accelerating production, new orders and business optimism, and June factory orders jumped more than expected, with the prior month’s decline also revised up significantly. Regional gauges in Chicago and Dallas reflected similar upward trends.

Pending sales add to better housing vibe They rose modestly above expectations in June, ending a 3-month streak of declines. The improvement was broad-based by region and consistent with June’s sequential improvement in housing starts, building permits and new home sales, suggesting the negative impact of past mortgage-rate increases has run its course. The National Association of Realtors said while inadequate supply is inhibiting home sales growth, it expects existing sales to rise 2.6% this year and the median home price to increase about 5%.

Negatives

Consumers under pressure Personal income was flat in June, its weakest performance in seven months, and year-to-date real disposable income rose at a fraction of its historical 2.8% annual rate. This morning’s jobs report showed wage growth also remains muted. This income weakness is inhibiting consumer spending, with personal consumption expenditures in June increasing at their slowest pace in 1½ years. Auto sales have plateaued—July’s below-consensus 16.7 million annual sales rate was considerably below last year’s 18.1 million peak.

An infrastructure bill might help June construction spending unexpectedly dropped as broad-based public expenditures plunged 5.4%, the most since March 2002 and the fifth biggest drop on record. The two largest public sector categories, education and highway and street construction, drove the decline. Year-over-year (y/y) construction spending growth has decelerated to 1.6%, its slowest pace since November 2011, led by a 9.5% y/y drop-off in the public sector, the most since February 2010 and the second most since March 1982!

Growth in services slips While still easily expansionary, the pace of growth in ISM’s non-manufacturing survey dipped to its slowest level since last August, as both new orders and business activity decelerated. On the other hand, the companion Markit services PMI rose more than expected in July on a surge in new orders, pushing its headline level above the ISM gauge for the first time this year. Combined, the two reports suggest continued moderate growth in the nation’s largest economic sector.

What else

Political watch Washington Analysis believes risk for armed conflict between the U.S. and North Korea is at its greatest point since the 1953 armistice, and tensions likely will continue to intensify as the communist dictatorship demonstrates its growing capability. The standoff is likely to lead to a U.S. policy of containment and deterrence, as has occurred with other rising nuclear powers, rather than to all-out warfare. However, the approach of Washington, Tokyo and to a lesser degree South Korea appears to center on making it clear to Kim Jong-Un that he is personally at risk, which in the past has only pushed North Korea to redouble its efforts.

Political watch Former White House Chief of Staff Reince Priebus was very close with House Speaker Paul Ryan and was the primary White House contact point for many GOP lawmakers. While highly regarded for his previous service, new Chief of Staff John Kelly does not have those relationships, and according to press reports, never met Trump until after the election. Given this White House/Capitol Hill relationship vacuum, Cowen & Co. see Vice President Mike Pence assuming even more legislative influence and power.

Hawaiians are very kind I received a fragrant lei and many hugs during my stay this week. The state enjoys a 2.5% unemployment rate, although there is a large homeless population. Concerns were voiced for families who lived in their grandparent’s homes, but had to sell because they couldn’t afford the bills, and then couldn’t afford another home. Where do people who live in paradise vacation? Las Vegas, which they refer to as the “9th island.”

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