Weekly Update: It's simple math

08-18-2017

I traveled throughout Michigan this week, with stops in Detroit, Dearborn, Ann Arbor, Kalamazoo, Portage, Battle Creek and Jackson. No one wanted to come right out and speak about President Trump. At one client event with retirees, two lady friends next to me apologized that they would have to leave early. So I asked, “Well then, how do you feel about the market?” One said, “I’m uncertain.” Why? “Why do you think!!!” Then a gentleman at the table wondered, “How can the stock market stay where it is and even improve given everything that is going on?” These comments came the day after Trump backtracked from Monday’s forceful condemnation of the KKK, neo-Nazis and white supremacists, sparking a backlash that led to the disbanding of two business councils amid CEO defections. Trump is isolated now …. In Kalamazoo, an advisor asked me about the odds of a debt-ceiling fight or government shutdown this fall. I suggested the party who would shut down the government would likely be punished in the midterms. Since both parties know this, deals are likely to be struck at the 11th hour. With many advisors waiting for a pullback because of legislative troubles, any sell-off is likely to be modest. All the broad market indices are trading near record territory, yet none are at extreme percentages above their respective 200-day moving averages. At several end-client meetings, people were asking how the market can be at high levels amid all the dysfunction in Washington. It’s simple math—the math of improving earnings and revenues, in a broad way. People have a hard time separating D.C. from the market, but advisors don’t. They know their math.

With virtually all companies having reported, it appears S&P 500 operating earnings grew at a 12% year-over-year (y/y) rate in Q2, and more significantly, the percentage of companies beating revenue estimates was its highest in six years. While it’s difficult to get excited by a market trading at a 21.2 trailing P/E and 11.7% operating margins, a continuation of the expansion may allow companies to grow into current valuations, Strategas Research says, particularly if interest rates and inflation remain low. Any break higher in yields would require a significant rise in wage and price data, and there isn’t any evidence of such. Recent downward revisions to already restrained unit labor costs, an important driver of profit margins and inflation, now have Cornerstone Macro’s proprietary recession risk model pushing the next recession out to 2020. That would make the current expansion the longest in U.S. history. High and stable profit margins (thanks to a prolonged recovery) + sustained higher multiples (thanks to benign inflation) = a secular bull. That’s simple math. To be sure, there’s no sugarcoating the fact the president’s political problems will make it difficult to achieve ambitious tax reform. But it would be a mistake to discount the potential impact of even modest tax cuts on GDP in 2018 and 2019. If the 2003 tax cut is any guide, economic growth—and corporate profits—could surge. And make no mistake, Republicans are motivated to move ahead. They need legislative accomplishments to counter the weight of a president whose approval rating is the lowest ever for a newly elected president in the summer of his first term since Gallup began such polling in the late 1940s. Low presidential ratings historically have wreaked havoc on midterm elections.

Every historic metric suggests the House GOP majority is nearing a political dumpster fire. Regression analysis suggests that 90 percent of the swing in House seats in midterm elections can be determined by the generic ballot question asking voters which party they prefer to run Congress. Today, the latest generic ballot data suggests Republicans would lose 30 House seats, giving Democrats control of the chamber. The Senate, on the other hand, is the decided undercard as the Democrats arguably have the worst map in over 100 years. The likely worst-case scenario for the GOP is a 50-50 majority with Vice President Pence breaking the tie. If the House flips, Cowen & Co. thinks you can dust off the impeachment playbook and say goodbye to any pro-growth legislation for 2019 and the duration of the impeachment process. Then again, all presidents suffer in the dog days of summer, with August being the cruelest month. At this point in the Obama presidency, there was just a 15% probability of health-care reform getting completed, according to Intrade odds. Throughout my Michigan visit, I enjoyed warm receptions and encountered gentlemen who really knew their math. In the Detroit suburbs, my Federated wholesaler introduced me as having 33 years in the business—an advisor corrected him, “you mean she’s 33 years old, don’t you?” Swoon. After the meeting, in discussing boomer retirements, an advisor said “my purpose is to afford the lifestyle my ex-wife, current wife and children enjoy.” He won’t be retiring anytime soon. It’s simple math.

Positives

Consumers pick it up Retail sales jumped 0.6% in July, the most this year, and June was revised up to a 0.3% gain from an initial decline. The upward revision suggests faster GDP growth in Q2 than originally estimated, and July’s increase bodes well for growth in Q3. Notably, control sales—ex-autos, gasoline and building materials—that track directly into GDP rose at their fastest pace since March. On a y/y trend basis, retail sales were up 3.9%, suggesting consumer spending continues to underpin the ongoing expansion amid low unemployment, steady (although unspectacular) wage gains, favorable credit conditions and a strong stock market. August's unexpected jump in Michigan sentiment to its highest level since January adds to this momentum.

Manufacturing solid Industrial production picked up in July, despite weak vehicles output, on increases in computer, electronics and other manufacturing activity. Along with the solid gain in retail sales last month, this suggests the economy is off to a strong start in Q3, a view reinforced by the Philly Fed and Empire gauges. Both posted sizeable gains in new orders and shipments in August, with the Empire index having its best showing in three years. In another plus for the back half, July leading indicators rose for the 10th time in the past 12 months.

Contrarian positive Last week’s VIX spike triggered a buy signal because it occurred in an uptrend. Since 1990, Oppenheimer says, the S&P has averaged an 8.4% gain over the next six months when this signal of selling exhaustion is triggered vs. a 4.3% gain during any 6-month period. Also, the S&P has posted higher returns following periods of outperformance vs. the Russell 2000, suggesting large over small-cap stocks.

Negatives

Housing softens Starts fell in July, the fourth decline in five months, and permits also dropped. The drop-off was driven almost entirely by multifamily units, which fell the most since last November to the second-lowest annual rate since September 2013. Single-family activity slipped off a sharp rise the month before. On a 6-month average basis, both starts and permits have rolled over, indicating a moderation in the near-term construction trend. That said, builder sentiment remains healthy, improving in August for the first time in three months and, on a 12-month basis, at its highest level since December 2005. Supply constraints remain the biggest issue.

Inflation still MIA Import prices ticked up in July for the first time in three months but held at a 1.5% annual rate on a y/y basis, down sharply from the year-ago 4.7% pace. Soft import price inflation is contributing to downward pressure on PPI and CPI inflation. In July’s meeting minutes, Fed policymakers generally viewed the recent softness as transitory, although “several" suggested inflation risks are skewed to the downside. The minutes hinted balance-sheet reduction is likely to start in September. There was little clarity on the timing of the next rate hike.

Waiting for an entry point With 45% of issues above their 50-day moving average, it’s too soon to call momentum washed out, Strategas says, particularly given the overhang of the weaker seasonal period (September historically is the worst month for the S&P). Tactically speaking, over the next month or two, this market may need to see more widespread oversold conditions develop before a tradable rally can take shape.

What else

Tepid wage growth is a structural problem According to a new study by the San Francisco Fed, the overall exchange of new workers for new retirees is holding earnings down by a little under 2 percentage points. U.S. Labor Department data show median weekly earnings actually rose in Q2 to 4.2% y/y, the fastest pace since 2007. Adjust for baby boomers and that would rise to +5.2%.

Perhaps I’m nobody’s type A "disturbingly high" 1 in 5 Americans find their workplace hostile or threatening, according to a study of 3,066 workers by Rand, Harvard Medical School and UCLA. The study reminds me of my once father-like CIO, who would often ask me after a series of business meetings if anyone had harassed me. I would always reply, “Nope, still nothing yet to report.’’ He was a gentleman; may he rest in peace.

Men in Michigan are under siege! At one client event this week, we started talking about boomers and members of the Greatest Generation who are dying. I asked two ladies, are you widowed? The first said, yes, her husband had died in 2008. Then the other said her husband didn’t die, “we are divorced.” I said, he must have been horrible; look at how perfect you are. Her reply: “He is.’’ … In Kalamazoo, an advisor who has a swimming pool at his home related that he came back from a long day of work in the hot Michigan summer. He walked by his wife and friends lounging around the pool and remarked how he was the one paying for all this. She replied, “Hey pool boy, how about another drink?” He won’t be retiring anytime soon—it’s simple math.