Weekly Update: The gentlemen are plentiful in Chi-Town

11-17-2017

I spent the entire week in Chicago, my kind of town, especially now that my beloved daughter is living and working there. The active vs. passive debate came up in numerous advisor meetings, in part because despite strong flows in such vehicles as S&P 500 index funds, the correlation between the 500 stocks themselves is breaking down. An outstanding team of lady advisors agreed that there is a dangerous view now that “if a stock is in an index, it can only go up.” “What do you suppose happens when everyone is on one side of the boat?” The senior advisor likened it to the tragedy of the Eastland excursion boat in 1915, in which all the passengers moved to one side to view a passing vessel on the Chicago River, only to capsize the boat. It remains the largest ever loss of life from a single shipwreck in the Great Lakes. The junior advisor keeps her clients in check whenever they want to focus their investment discussion on Twitter or Trump. “They get the blow gun. Thwump!” Outstanding ladies! A recent Wealth Management magazine survey indicated that 68% of wealth advisors were somewhat (50%) or extremely (18%) concerned about the Fed’s balance sheet. In that vein, 57% of advisors have adjusted clients’ portfolios in anticipation of higher interest rates, with 44% adding dividend-paying stocks instead of bonds in their search for income for retirement portfolios. Half of those surveyed believe equities are currently overvalued as a result of the Fed’s easy-money policies; yet 62% think the market will be higher at the end of 2018, with 35% of advisors expecting gains between 5% and 10%.

A longtime Chicago advisor believes we are in an environment where there will be no bulls or bears, “just swings,” suggesting only corrections of 10% or so, which will be about inflation worries. (We saw worries of such swings this past week, when AAII bulls-bears sentiment flipped overnight, going from 45% bullish last week to 29% bullish. Investors Intelligence’s Bull-Bear ratio made a similar move, falling from last week’s 20-year high of 4.47 to 3.17—still bullish, but not excessively so.) Another advisor in a different office had thoughts along those same lines. “How expensive is the stock market, really, when technological advancements are keeping inflation down?” (Yes! Good low inflation, and stocks will love that.) “So, then, serious inflation is not currently in sight.”


Amen! We’re in the same choir and we’re both altos! What drives the economy is psychology and the Fed, which largely controls the yield curve. An inverted curve, where short-term rates are above long-term rates, has a much better record in calling bear markets and recessions than any consensus of leading economists, or any Washington action. This was discussed numerous times during my trip to Chicago. While the curve has flattened to 2007 lows in the past month, it’s still far from inversion. History suggests the cyclical Energy and Technology sectors tend to perform best during flattening periods. If inflation continues to stumble along (more below), there’s little reason to expect the yield curve to invert or a recession anytime soon. A correction? Possibly, hopefully, particularly if the Republicans can’t get real tax reform done. In my opinion, it would just represent a better entry point since all signs point to continued economic growth, continued Fed accommodation and continued earnings growth. If tax reform passes, Bank of America projects it would add 0.3-0.4 points to GDP growth, which ironically would likely prompt the Fed to hike faster.

At about $103, the average price of a stock in the S&P has never been higher. Strategas Research says conversations it has had with some corporate executives have revealed some view high stock prices as protection from market manipulation. In stark contrast to other speculative periods, companies appear to have little interest in capturing the imagination of individual investors. In that sense, a sign of euphoria that comes with significant retail participation appears to be a long way off. Renaissance Macro agrees, saying it does not buy into the “stock market has peaked” talk. It sees very few signs of a breakdown in uptrends. There does appear to be a slight reversionary tendency, possibly reflecting evidence that the smart money is taking some chips off the table and calling it a very good year. FBN Securities says manager equity exposure is at its lowest level on the year. As we head into the second half of the year’s final quarter, the relative performance spread between growth and value strategies continues to widen, adding to a 10-year string of growth outperformance vs. value—the longest since the Great Depression. Slower global growth over this period is likely the major reason, as it has coincided with less leverage, less investment, less trade and ultimately less earnings growth. For value strategies to shine their brightest, earnings growth must be broad-based and sustainably robust. That simply hasn’t been the backdrop in the post-crisis era. Back in Chicago, at a large client event, I showed off my beautiful, painful shoes. Suggesting that one day I will get out of them and be comfortable in the audience, a gentleman said afterwards that he hopes I don’t get out of those shoes yet—“we want you back next year.” Blush.

Positives

Where are we in the economic cycle? October manufacturing and industrial output increased the most in six months, Empire and Philly Fed manufacturing remained robust and Empire’s separate services gauge surged to a 10-year high. Consumers also are stepping up. On a 3-month basis, October retail sales posted their second-best gain since May 2015, weekly chain-store sales doubled forecasts and the Bloomberg consumer comfort index’s 52-week average hit a 15-year high. This bodes well as we get into the meat of the holiday sales season.

Builders bullish After an early summer lull, homebuilder confidence rose for the third time in the past four months in November to its second-highest level since July 2005. This indicates a near-term pickup in housing starts is likely—we got a taste of that this morning with the surprise surge in October starts and permits—and that the housing sector remains on track for a steady albeit modest recovery.

Small businesses optimistic NFIB sentiment rose in October, the 11th straight month it’s been above 100. Expected sales and the near-term outlook for expansion drove the increase. Citing difficulties in finding workers, small businesses said they are raising pay and benefits, lifting compensation plans to a 13-year high.

Negatives

Inflation watch Inflation appears to have moved definitively off the global deflationary bout of the past several years, with both headline and core PPI rising in October at their fastest pace since February 2012 and import and export prices also up. However, inflation still remains below Fed targets, as October headline CPI slowed on oil’s drop, core CPI was 1.8% and the core PCE is at 1.3%. Ned Davis’ inflation timing model is at a 2½-year low.

Deficit watch October’s federal budget deficit topped $63 billion, slightly ahead of Congressional Budget Office projections that call for a $563 billion deficit this fiscal year. On a 12-month total basis, the federal deficit widened to $683 billion, or 3.6% of nominal GDP. Nominal outlays rose more than 6%, led by increases in Social Security and Medicare, which together account for nearly 40% of spending.

Where are we in the economic cycle? Ex-Energy, S&P earnings-per-share growth has stalled since mid-year. Unless economic growth accelerates sharply, this suggests healthy earnings estimates for 2018 could be at risk.

What else

Political watch The threat of losing a Senate seat has made the Senate move with speed not seen in years—if ever. With a narrow 52-49 majority and a Dec. 12 Special Election in Alabama where all heck has broken loose (and subsequent seating of the new senator on Dec. 22 after a 10-day canvassing period), a bill if it is passed and signed into law likely will come by Dec. 22. One plus: the NFIB, a grassroots powerhouse for small businesses, has endorsed the Senate version.

‘SALT’ in the wounds It’s hard not to notice that states with the largest share of the middle class (households in the $25K-$100K range) are red states with little to lose if the state and local tax deduction (SALT) is slashed or eliminated (South Dakota, Idaho, Indiana, Montana, Iowa and Utah). By contrast, states/districts with the smallest share of households in that range are blue and have some of the highest state and local taxes (D.C., New York, New Jersey, Connecticut and Massachusetts).

Talking turkey In Chicago, an advisor said he started his career in the mid-’70s, working in HR for an Albert Lea, Minn., turkey processing company where he saw the sausage being made, if you will. Those workers with dreadful jobs—because it was “the only place to get a job”—were earning $2.03/hour in 1975! Given what they were being asked to do, that’s low even in today’s dollars, $9.31/hour.

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