Weekly Update: Cold winds blowing

11-03-2017

I began the week at home, speaking at a large end-client event. I talked of how remote the near-term possibility of recession is, and asked the group, “So what should we worry about?” Answer: “That we’re making too much money?” Huh? This sounded really odd to me, but it may be on point. On my plane to Nashville, I sat next to an advisor heading to the same meeting as me. He shared that an elderly client is quizzing him as to why he has 3% in cash and not the market! Prospects for tax reform are thought to be adding to animal spirits, but what was released this week got a mixed reception. Of course, what was published is unlikely to be what makes it to Trump’s desk, assuming something makes it to his desk. There’s no need to give this too much thought until a bill reaches the Senate and the real horse-trading begins. Regardless of the final product, tax reform is expected to add $1.5 trillion to the deficit, setting up potentially higher inflation. This means in real terms, we may not get much growth. SIS Research dubs this approach the candy bar program: first we get a sugar high (tax cuts), then a sugar low (higher inflation), with the low potentially more destructive than the high (slower to lower real growth). Cold winds are blowing. This legislative messiness comes as the market is experiencing narrowing breadth, not just in the cap-weighted S&P but also the price-weighted Dow. FBN notes the top 10 Dow components are basically responsible for the 2017 gains in that index. Not all negative breadth divergences create market tops, but often market tops are accompanied with breadth breakdowns. Cold winds, indeed.


In a large advisor meeting in Nashville, where I finished the week, I talked with a Raymond James executive who travels the country as much as I do. She, too, canvasses her audiences and reports there is no euphoria yet. But it seems we’re getting close. Investors Intelligence puts the percentage of newsletter writers identifying as bullish very near its record high just before the 1987 crash. Meanwhile, the percentage of bears is at its lowest since the depths of May 2015’s energy sell-off—a sign the bears may be giving up. U.S. equity funds did experience inflows for a third straight week, lifting cumulative flows for the year into positive territory. A solid October brought year-to-date (YTD) S&P 500 returns to 15%, a feat only accomplished 17 times since 1950. Historically, November and December returns have run stronger than average following such an occurrence. (Seems we’re in a melt-up, unfortunately.) Wolfe Research broke down this year’s gains and found roughly half came from rising earnings expectations, nearly half came from P/E multiple expansion and the remainder came from dividends. With more than three-quarters of market cap having reported, earnings and revenues are outperforming, with the former on pace to grow 11% and the latter projected to grow more than 5%. Europe and the emerging markets (EM) also are outperforming earnings expectations for the first time since 2011. Among sectors, Technology continues to have significant upside as it enters its strongest period of seasonality—Apple this morning was up strongly on blowout Q3 earnings, a theme for most of the tech behemoths. Financials also continue to surge, aided by the ongoing rally in 2-year Treasury yields and structural breakouts in big banks and insurers. When Financials and Technology (Value and Growth) lead like they did in the late ’90s (and are now), the result is a powerful bull market. Overseas, the reversal in the dollar has thrown fuel on rallies across Europe and Japan without dampening enthusiasm for EM, which continues to emerge from multiyear bases of support and relative underperformance vs. the U.S.

In the bond market, the gap between 2-year and 10-year Treasury yields hit multiyear lows this week, breaking slightly below 75 basis points, the most important technical support in the macro universe. A definitive break in support likely would inject an undesirable amount of volatility into the capital markets, making equities more susceptible to an eventual painful sell-off. Such a cold wind. The bond market has long been a better predictor of the economy than the equity market. It behooves us to watch the curve, inflation and central bank moves. A bond riot would make 2013’s taper tantrum look like a walk in the park. Otherwise, we will watch D.C. lawmakers as they attempt to deliver a tax plan. If it gets too complicated, drags on or in any way convinces the market that it won’t happen or won’t be enough to significantly add to earnings, we may get that elusive volatility and correction. But with earnings growing anyway and an economy far from recession, that cold wind may be just the thing to arrest a dangerous melt-up. And then … a second wind.

Positives

Where are we in the economic cycle? October’s ISM, Markit and Chicago and Dallas Fed surveys reflected healthy manufacturing activity, while the ISM services index hit a 12-year high. Housing similarly signaled improvement, with further increases in the Case-Shiller price survey, a nearly 10% jump in year-over-year (y/y) residential construction and homeownership at levels supportive of longer-term demand.

Very confident consumers A week after the Michigan sentiment gauge for October hit tech bubble-era levels, the Conference Board consumer confidence index jumped to a 17-year high. On the heels of strong back-to-school sales, which saw the biggest increase in consumer spending in September since August 2000, the ebullience being displayed by consumers bodes well for the holiday sales season.

Inflation still MIA This morning’s jobs report doused talk that wages may be set to take off, easing any worries that the Fed may consider a faster path. While Q2’s Employment Cost Index climbed at its fastest pace since Q4 2014, unit labor costs in Q3’s productivity report fell 0.1% y/y, signaling worker costs are stuck near historical lows despite an October jobless rate that fell to 17-year low. Rhino Trading Partners said the Phillips curve isn’t just flattening, it’s outright disappeared.

Negatives

Job report disappoints October’s nonfarm job growth of 261K came in at a well-below consensus, although an upward revision to September made up for most of the miss. Notably, hourly earnings were flat, causing the already subpar y/y rate to moderate further. No signs of wage pressures there, which should assuage any worries about the Fed being behind the curve. The participation rate also fell. The hurricanes may have been a factor but their impact appears to be diminishing, as weekly jobless claims fell to their third lowest level in 44 years.

Productivity better but … Nonfarm business output per hour rose 3% in Q3, continuing its climb off last year’s bottom. The improvement lifted y/y productivity growth off the floor, but once smoothed for quarter-to-quarter volatility, productivity growth still remains weak by historical standards.

Show me the money If there’s a single indicator for the health of the markets and economy, money supply growth would be it. But with bank lending down in all areas, especially commercial and industrial lending and real estate loans, money supply continues to contract—the main reason why the Fed initiated quantitative easing in the first place. Now that the Fed is reducing its balance sheet, this will be a headwind for growth.

What else

This is what a secular bull looks like Forward S&P earnings hit record highs in October, continuing an uptrend that began a year ago when the energy-led earnings recession ended. Forward revenues also have been on the rise, as have forward profit margins, which also reached a new high in October. This is frustrating the many bears who’ve been warning for years now that profit margins are at cyclical highs and vulnerable to reverting to their mean.

Active vs. passive The Institutional Strategist thinks the trade that has seen some $2 trillion move from active to passive management since 2008 is getting risky. Given there are primarily three market makers for many of the ETFs that use passive strategies, the risk of concentration and that one of those three firms cannot hold prices near their NAVs could prove decisive. Because passive funds are on the other side of the volatility trade, targeting volatility levels may force many to sell into market weakness if volatility rises sharply, spawning a wave of selling.

Einstein’s a genius! A notorious penny-pincher who wore shoes with holes and refused to pay for a barber, Albert Einstein ended up giving one of the biggest tips ever to a Japanese bellhop—although it took 95 years for the bellhop's family to collect. A piece of Imperial Hotel stationery with Einstein’s "theory of happiness" written on it in his handwriting was sold by the Winner’s Auctions and Exhibitions in Jerusalem for $1.56 million this week, the New York Times reports. The note, written in German, says, “A calm and modest life brings more happiness than the pursuit of success combined with constant restlessness.” (BTW, Houston strong, I’m just saying.)

 

 

 

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