Weekly Update: Totality

08-25-2017

I went in for a routine checkup this week (after prepping overnight with a seriously nasty drink) and after a few words with the anesthesiologist, I was totally out (!). Waking up in a daze, I pondered all the things that could have been done to me during my slumber and … hey, where’s my handbag? Totality is spooky. This week’s eclipse brought total darkness to those lucky enough to be in its path. Surveying worldwide eclipse lore, 13D Research finds a constant theme is eclipses almost always occur during times of great disruptions of the established order. As E.C. Krupp, director of the Griffith Observatory in Los Angeles told National Geographic a few years ago: “People depend on the sun’s movement…. It’s regular, dependable, you can’t tamper with it. And then, all of a sudden, Shakespearean tragedy arrives and time is out of joint.” Disruption is all around us—technological change, geopolitical reshuffling, and political, social and environmental chaos. Are we heading toward market disruption? With what catalysts? Maybe valuations that appear historically high (even though very low inflation and interest rates may argue otherwise). Maybe a recession (even though various models see minimal risk of one anytime soon). Fed balance-sheet reduction? Much ado about nothing, in the view of MRB Partners. It notes a substantial portion of the quantitative easing that nearly quintupled Fed holdings was meant to shore up confidence and ultimately just became trapped in excess reserves. MRB believes the Fed can cut its balance sheet almost in half largely through the runoff of U.S. Treasuries and agency mortgage-backed securities, and a planned pace of sales easily absorbed by this bond market. Shrinking the balance sheet does not present a direct threat to equities since the liquidity provided by QE did not directly flow into the stock market. The risk for equities is if bond yields were to rise substantially.

The last two weeks of August are not only the most popular time of the year for vacations, its also notorious for giant air pockets. We got a taste of that with the recent spike in the VIX and a few rare (lately anyway) 1%+ sell-offs in the S&P 500. With seasonal weakness running through October, there may be more to come. While stock indexes overall have been enjoying a pretty uneventful eight months—the S&P has endured only one pullback in excess of 3%, far from the norm—there has been a lot of rotational churn. More than 40% of S&P components are off 10% or more from their 52-week highs, and 17% are down 20% or more! Moreover, the 10-day average of daily new highs vs. daily new lows suggests the short-term market trend is negative, with the deterioration in market internals suggesting a dip below the 200-day moving average (MA) is possible. With that average currently at 2,354, Fundstrat is looking for a decline to 2,300 or lower. This would be in line with the average 7% drawdown that has occurred in the blue chip index at least once every year since 1996. In most instances when 200-day MA is breached, a tradable bottom develops within a month. Longer-term, the trends remain bullish, supported by earnings. With most companies reporting, S&P earnings rose more than 9% in Q2, sales increased more than 5% and forward earnings reached record highs. However, the first half strength came on the heels of a notable reacceleration in economic activity beginning about this time last year, and against easy year-ago comps. So the natural progression is for the growth rate to slow, which Strategas Research says is now the consensus. Tax reform could be a game-changer for sentiment, but will it come in time to stem the tide of erosion in the fundamentals?

While it may take months, tax reform most definitely is not dead. Elements upon which the White House, Treasury and congressional leaders supposedly have settled include allowing U.S. companies to repatriate overseas earnings at a one-time low tax rate and a corporate rate that likely will fall between 22% and 25% depending on which deductions or breaks lawmakers are willing to scale back or eliminate. According to Bloomberg News, a growing number of key congressional Republicans also are considering a controversial maneuver that would allow for about $450 billion of tax cuts without offsets. Under the proposal, the GOP would not account for things like expiring tax breaks when gauging the budgetary impact of tax legislation—giving tax writers more room for cuts. Combined with dynamic scoring, that would mean the first $1 trillion of tax reform would not require any austerity measures. Politically, this would make a tax bill more palatable, allow for more pro-growth tax changes and give policymakers an out to cut taxes if reform is too difficult. If Congress moves in this direction, Strategas sees a 90% chance of a tax reform being completed in Q1 2018. This would be very positive for the markets, which have baked in little in the way of tax cuts. This doesn’t seem far-fetched—nothing like what 13D Research calls the almost incomprehensible “coincidence” that brings us totality: a moon that is 400 times smaller than the sun, but also floats 400 times near to us, making the two disks in our sky appear to be the same size. Imminently more romantic than the totality I experienced this week.

Positives

PMIs solid The Markit flash U.S. PMIs rose sharply in August, led by the biggest jump in services in 10 months to its highest level since April 2015. Manufacturing wasn’t as positive but was still easily expansionary as it eased off its early year spike. Both the regional Kansas City and Richmond Fed manufacturing gauges reflected robust activity—Kansas City’s index rose to a 5-month high, while the 6-month outlook was close to a 12-year high.

More good capex news Core durable goods orders and shipments rose more than expected in July, a positive sign that businesses keep picking up the pace of capital expenditures (capex). Core capital goods orders rose 0.4% and core capital shipments increased a robust 1%. Both feed directly into GDP, causing Barclays GDP tracker to rise two ticks to 2.7% for Q3. The improvement masked a sharp but expected decline in headline durable goods orders, as the volatile non-defense aircraft component plunged after surging the prior month.

More good consumer news A week after the Michigan sentiment gauge jumped to a high for the year, the Bloomberg Consumer Comfort Index rose a sixth straight week to its highest level since August 2001. Both are indicative of strengthening consumer sentiment, which bodes well for consumer spending in the coming months and supports market expectations for a pickup in economic growth in this year’s second half.

Negatives

Housing softens New and existing home sales unexpectedly fell in July, with the drop-off in new homes the biggest since last August. The decline in existing homes wasn’t as dramatic; year-over year (y/y) sales actually rose 2.1%. New home sales weren’t as bad as the headline, either, as upward revisions to the prior three months kept the annualized sales rate on a longer-term upward trend line. Higher prices and insufficient supply were deterrents.

Growth among states softens The Philly Fed coincident indexes showed weakening growth across states, with only 33 expanding, 15 contracting and 2 unchanged in July—the lowest dispersion of growth among states since February 2010. The one-month average percent change of growth across all 50 states was its lowest since January 2010 and well below the overall U.S. coincident measure, which rose the most since last November. This indicates the overall macro picture remains sound for now as most of the largest states continue to grow.

Mixed messages around the world There are no signs that China’s economy will slow in the second half as y/y data is showing strong across-the-board growth. However, much as in the post-election U.S., an improving Europe is seeing a tempering of euphoric optimism as structural changes aren’t coming as quickly as some have hoped. The German ZEW expectations indicator has slipped lately, and sentiment is easing in France where new President Emmanuel Macron is facing union resistance to proposed workplace reforms.

What else

Growth vs. value Based on their respective Russell 1000 indexes, growth stocks relative to value stocks enjoyed their second-best start to a year on record through May. History suggests after such strong moves, mixed performance is typical over the short term, as has been the case. But the mid-cycle earnings rebound that has been led by the value-oriented Energy sector may not go deep into 2018 as y/y comparisons get tougher. During periods of decelerating earnings growth, Ned Davis says stable growth names typically outperform economically sensitive value names.

A widening great divide Since the Great Recession, wealth has become concentrated in fewer hands, with 63% of financial wealth and 30% of housing assets held by the top 10% of the income distribution. In 1992, it was 54% and 25%, respectively. Housing wealth historically has been distributed more evenly between upper and middle income groups, but since the recession there are fewer households with access to housing wealth.

The sun is pretty amazing Eclipses come and go yet the sun is always shining even at night, on the other side of our planet. It’s a star that is almost three-quarters hydrogen, with the rest mostly helium. Lucky for us earthlings, it is brighter than 85% of the stars in the Milky Way. It’s hot up there; the sun’s core around 15 million Celsius. It’s a bit cooler in the photosphere (5,500 degrees C) and chromosphere (4,320 degrees C). The latter could be seen as a red rim around the sun during this week’s eclipse. The sun's light and heat take about eight minutes to reach us.

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