Weekly Update: The devil didn't just go to Georgia

10-20-2017

I headed back to Houston this week, and since my previous visit in the aftermath of Harvey was focused on destruction, I determined to accentuate the positive. I prepared by watching the classic 1980 John Travolta movie tribute to Houston, “Urban Cowboy,” twice. The advisors we met certainly changed the subject—the Houston Astros were fresh off winning the first two back-to-back home games in the American League Championship Series, and were now in New York to face the Yankees at least two more times. Our first evening business dinner had to move along, as an advisor told me, “I have to be out of here by 7.” On the second night, since the game started during our dinner, our compromise was for me to speak in front of the television so that at least our clients were looking in my direction. A first for me, and I didn’t take the “boos” personally as it was the game that was going the wrong way. With the Dow touching 23,000 for the first time this week, an advisor told me his clients are concerned. They say everything is bigger here in Texas, so his clients aren’t worried about a pullback, but rather a collapse. At another advisor meeting, the veteran wanted to focus our entire discussion on how he can prepare his clients for “the collapse” in advance, expecting another 1987-style debacle. 1987 was bound to come up this week. We debated what asset class would be first to recover after a bursting of either “bond or ETF/index bubbles” and whether it was prudent to buy gold and store it in another country for safekeeping.


There are signs that conditions for a counter move in stocks may be building. The S&P 500 is trading at a high valuation on most metrics vs. the last 40 years, with the median stock trading at the 98th percentile, Goldman Sachs says. The latest Investors Intelligence survey shows bulls at a 2½-year high. Ned Davis’ proprietary sentiment model is at its highest level since December, and high-beta stocks are outperforming. This all is suggestive of possible excessive optimism. If the yield curve continues to flatten—the spread between 2-year and 10-year Treasuries has narrowed to near a 10-year low—it could awaken somnolent volatility and raise the potential for a sell-off. On the other hand, domestic equity funds and ETFs continued to see net outflows in Q3, and while there’s been some movement into stocks, a lot of cash has remained on the sidelines in anticipation of a pullback. This could cushion any downdraft if and when there actually is one. Low-beta names also have been holding their own—indicative of bullishness, not euphoria (yet). And intermediate-term indicators show increasing weekly momentum to the upside with no evidence of peaking. FundStrat notes we are entering a period of positive seasonals. Dating back to 1928, equities have tended to rise 77% of the time in a year’s final quarter if they were up 12% or more through the first nine months, as was the case this year. Moreover, because inflation is still low, odds are higher that the next recession is further out, abetted by a still highly accommodative global monetary environment. The BAA spread relative to AAA corporate bonds has plunged; such easy money suggests real GDP growth should accelerate in Q4 and Q1 2018.

Preannouncements for Q3 earnings were near historical lows; this often presages a muted earnings season. And while it’s still early, the impact from the hurricanes has been hard to ignore. Just prior to the initial earnings reports, FactSet slashed year-over-year (y/y) forecasted earnings-per-share (EPS) growth by more than half, citing the storms. Then again, Wolfe Research notes that guidance during and since the Q2 reporting season was the most positive it’s been since 2008. Credit Suisse estimates insurers only detracted 2.8% from aggregate S&P EPS in Q3, partially offset by easy comps in Energy. The bigger issue for the equity market: how much is tax reform already priced in? A precise answer is difficult, JPMorgan says. Roughly speaking, Wall Street is penciling in about $138-143 in S&P EPS for 2018, with a tax bill adding potentially $5 to $15 more. If politics should gum up the process enough to significantly water down the tax-cut benefits, and if this should cause a market correction, I would argue that would set up a nice buying opportunity while warding off a dangerous melt-up. (I’m still on melt-up watch—witness the 100-point opening drop in the Dow on Thursday’s anniversary of the 1987 crash before climbing back to end the session at a new record high, bellwether GE's big drop this morning that the market largely ignored and Bitcoin's surge today to $6,000!) In Houston, an advisor casually told me her house was flooded, forcing her to live in a shelter for three days. No big deal. Another advisor and his wife lounged on their sofa in their ranch home with water knee-high, drinking wine—red for him and white for her—and calmly planning to build their new home a few miles down the road. I left Houston, again inspired by the people and humming the Charlie Daniels tune from “Urban Cowboy”—“The Devil Went Down to (Texas)” … “Johnny said, Devil just come on back if you ever wanna try again. I done told you once you (so and so) I’m the best there’s ever been.”

Positives

Regional manufacturing accelerating The Empire manufacturing index unexpectedly rose in October to a 3-year high, while the Philly Fed’s reading also was strong and well above consensus. The reports continue the trend of regional and national manufacturing surveys coming in stronger than the hard data (see industrial production, below). Notably, hiring was robust in both regions, with the Philly Fed the highest in its 48-year history.

Housing sentiment better but … Builder confidence unexpectedly rebounded in October to a 5-month high, suggesting activity could strengthen in the near term. Buyer traffic increased for the first time since March, and mortgage purchase applications rose 4% in the Oct. 13 week, lifting the y/y rate by 2 percentage points to 9%. September existing home sales also modestly surprised, up 0.7%. This comes against the sixth decline in seven months in housing starts, which hit a low for the year in September; permits also fell. The decreases were expected because of the hurricanes, but the 6-month averages also turned negative, reflecting deteriorating trends.

Industrial production better but … Overall September activity rose an in-line 0.3%, but the manufacturing component just managed a 0.1% increase, well below expectations and only its second gain in five months. Harvey and Irma were factors, but even before the storms, July manufacturing shrank a downwardly revised 0.4%. The report's other two components, mining and utilities, bounced back into positive ground, with mining volumes particularly strong. The big manufacturing drag was motor vehicles and parts, which could turn around with the post-storm spike in replacement sales.

Negatives

September leading indicators slip but … The first dip in a year in the Conference Board gauge was all about Harvey and Irma, which temporarily impacted initial jobless claims and building permits that drove the decline. Indeed, the latest weekly jobless claims fell by the most in seven months to their lowest level since 1973. Still, the 6-month rate of change in the indicators was 1.7%, the slowest pace since January. The temporary deterioration had no impact on Ned Davis’ economic timing model, which continues to signal solid economic expansion.

Inflation watch Largely on fuel, import prices rose in September by the most since June 2016. But even ex-fuel, prices advanced the most since February, led by nonfuel industrial supplies, materials (mostly metals) and food. Y/y import prices were up 2.7%, a notable recovery from September 2015’s cycle low of -11.6%. Export prices also rose, led by the biggest increase in non-ag products since March 2011. The report is the latest to suggest inflation may be trending up, making a December Fed rate hike and at least two in 2018 more likely. If inflation were to spike, it could lead the Fed to tighten quickly, thus threatening the recovery/bull market.

Inflation watch Evercore ISI’s proprietary survey found 44% of CFOs surveyed expect the growth rate for wages to rise over the next 12 months, up from 41% in July. Cargo transport companies, retailers and homebuilders were the most likely to anticipate wage acceleration. Benefit-cost growth is forecast to rise more broadly than wage growth, with particular increases at auto dealers and consumer companies. If inflation were to spike, it could lead the Fed to tighten quickly, thus threatening the recovery/bull market.

What else

Ten years later, where are we in the economic cycle? Perhaps back to normal. Influential economists Carmen Reinhart and Kenneth Rogoff suggest it takes 10 years to get back to normal after a financial crisis. With the past crisis having started in 2007, we’re right in that sweet spot, with the next 12 months a potential “breakout year,’’ Ned Davis says. In other words, there could be a lot of life left in this expansion, now the third-longest in U.S. history and a half dozen or so months away from becoming the second-longest, overtaking the go-go 1960s.

Is capex ex-energy growing? Most of the capital expenditures (capex) in this recovery have been in the energy sector, not broadly based across the economy. As a consequence, there is no reason to believe that the past year’s elevated business confidence will lead to a surge in investment, UBS says. If true, this bodes ill for a hoped-for bounce in productivity. It has grown more slowly in this cycle than in any recovery of the post-war era, the Leuthold Group notes, despite a revival in corporate profits to record highs, long-term interest rates near record lows and uncommonly high levels of business net cash flow relative to capex.

Tax reform watch House Republicans appear to be closing in on a compromise that could limit but not do away with the entire the state and local tax (SALT) deduction, although in the name of expediency, it’s possible SALT stays and the highest-income households get hit instead. Details could be known soon—with a Senate budget resolution now in hand, it’s possible a traditional conference between the two chambers to iron out differences may not be necessary. Once a budget is in hand, House Ways and Means Committee Chair Kevin Brady is expected to unveil an 800-1,000-page tax bill, starting the process toward final legislation. A big wild card remains President Trump, who is still talking about a massive middle class tax cut—a near mathematical impossibility given a supposed $1 trillion reduction over 10 years that’s being discussed only represents a 40 basis-point cut for the masses. (And no one is talking about the hundreds of billions of dollars to be spent on hurricane relief.)