Weekly Update: Laughs, hugs and a winter respite

01-12-2018

Travel this week took me to sunny and warm California, where we made stops in Los Angeles, Newport Beach, Rancho Santa Fe and La Jolla. Chock full of breakfasts, lunch and dinners, Californians are health-conscious for sure! At one luncheon the buffet consisted entirely of “healthy” salads. No chance to misbehave there. Menus listed healthy start, healthy this, health that. And everybody ordered these items. They will never know what I really wanted to eat. Discussions with advisors centered on their clients’ fears of investing “at the top.” On the other hand, their mostly quite well-to-do clients voiced interest in bitcoin and marijuana stocks (I was told that cool Colorado cocktail parties offer both drinks and marijuana). There also was talk of the hard-to-miss euphoria as retail investors, long a holdout in this secular bull market, have turned much more optimistic. The AAII’s bull-bears ratio is at a 3-year high, near levels last seen in 2005. The S&P 500 and Dow are off to their best start to the year since 2006, leading analysts and companies to increase estimates and strategists to raise year-end index price targets that were set only days or weeks ago. Despite the run-up, valuations are cheapening as Wall Street scrambles to boost earnings forecasts out of deference to the rewriting of the tax code. The forward P/E multiple for the S&P has dropped 1.18 points from its peak even as the benchmark has been climbing.

The next few weeks should prove whether the upwardly revised forecasts are too optimistic. It's rare to see estimates move up as the reporting season nears. Consensus now expects year-over-year (y/y) S&P earnings per-share growth of 10% for Q4 2017, up from Q3’s 7%, and sales growth to hit 9%, its fastest pace since 2011. Strong earnings growth is consistent with a favorable macro environment. Oppenheimer’s proprietary indicator of activity hit a 13-year high in Q4, and Wall Street estimates for GDP growth this year are trending up on tax-cut stimulus and more regulatory relief in an already accelerating economy. When President Trump came into office, he was seen as pouring gas on a fire that ignited in the spring of 2016, when the income growth of the bottom 80% of the population turned up. There is upside to earnings estimates for companies/industries that have paid tax rates at the top end of the range, as well as a likely temporary tax-driven pop in capital expenditures (capex)—adding more fuel to the fire. Increased capex could drive margins higher for two sectors that have mattered most to the margin story: tech and capital goods, with rails, autos, banks, retailers and metals going along for the ride, Empirical Research says. The key will be what happens to wages and inflation. While this week’s numbers suggest they remain subdued (more below), an acceleration of any magnitude could threaten to put the Fed on a faster path, an outcome the markets would not like. If inflation is ever to breakout, this would be the year.


So as we move through a year that is starting off with a bang, we’re watching two things: inflation & the Fed, and what companies will do with their tax savings. Last year’s nominal GDP growth rate was just above 4%, helping lift top-line S&P revenue growth 6% and margins well into the teens. It’s estimated the tax cuts could add around 50 basis points to GDP growth, further boosting earnings and revenue growth. Empirical sees a 5-6% punch this year to S&P earnings from tax reform, little if any of which has been accounted for in estimates. One technical warning sign: sector weights are as concentrated as they’ve been since 2000-01, 1989 and the late 1970s-early 1980s—periods just before or in steep market sell-offs. But periods of such concentration have seen gains, too. And we're watching for the possibility of a government shutdown if Democrats, Republicans and the White House can't reach agreement on "dreamers.'' Back in California, when I offered a positive view of the ramifications of the new tax bill, I touched a nerve. Californians are not pleased at all with the thrashing of the state and local tax (SALT) deductions. Californians in particular like to invest in real estate, and advisors know that their clients are not considering the implications of the $10,000 SALT cap. An advisor with tax expertise told us that she will be renting out her home in order to take the many write-offs that will be available, and then go rent somewhere else herself. “But won’t you be unhappy to leave your home?” I asked. She said she thought about the emotional fallout from this decision … “for about five minutes.”

Positives

Consumers confident Bloomberg’s consumer comfort index rose sharply to a 17-year high, reflecting households’ eagerness to spend. December retail sales were solid, up a fourth straight month with November revised higher, signaling a robust holiday season. Sales for the year rose the most since 2014. November consumer credit came in nearly $10 billion higher than estimates, rising the most since 2001. The month saw the biggest jump in credit card balances in 16 years (a worry for another day).

CEOs confident CEOs are the most optimistic they have been in a decade, with the Conference Board index rebounding strongly in Q4. The increase is consistent with stronger growth in profits and capex, both of which have been revised higher by analysts. Estimates for the latter have tripled since the tax bill’s passage.

Small businesses confident While the NFIB gauge fell back in December, it matched its average for the 12 months and remained near its 13-year high. Hiring and expansion plans stayed strong, and plans to increase wages rose the most since March 2000.

Negatives

Labor market loosening? The number of job openings slipped in November for the third time in four months, while the latest weekly jobless claims unexpectedly jumped without any unusual factors, lifting the 4-week average well above month-ago trends. However, 6- and 12-month job openings were still at record highs, and jobless claims were still very low on an historical basis.

Inflation watch Import and export prices weakened, while headline December producer prices contracted for the first time since August 2016, dropping the y/y rate 5 ticks to 2.6%. Core PPI also fell, a sign inflation pressures at the producer level are limited. Consumer prices remained restrained, up 0.1% on a headline basis. However, core CPI rose a stronger-than-expected 0.3%, although at 1.8%, the y/y core rate was still below the Fed's target.

Contrarian negative Last year’s Investors Intelligence Sentiment Survey, which tracks the opinions of about 130 market newsletter writers, posted the second-highest annual average percentage (77%) of stock market bulls in its 54-year history. Years with average sentiment readings above 70% are usually followed by years with disappointing stock market returns, with an average S&P loss of 0.2% in the nine prior instances.

What else

A stock tailwind Weak IPOs and equity-offering activity, combined with increased buybacks, caused global equity supply to turn negative in 2016 for the first time and to be only marginally positive last year. JPMorgan sees little change this year—a positive for equity market performance as it magnifies the impact of any given increase in equity demand.

Momentum matters Momentum chasers have been the winners over the past 45 years—with the prior year’s #1 and #2 performers handily beating the buy-and-hold S&P benchmark, Leuthold Group says. In particular, the “Bridesmaid” asset class (last year’s runner-up) has been spectacular, delivering an annualized 15.2% total return since 1973 versus 10.4% for the S&P.

Geeks rule Digital prowess has become one of the most powerful bargaining chips in the American job market over a relatively short period of time, according to a report from the Brookings Institute. The study looked at jobs in three categories: those requiring high, medium and low levels of digital skills and found that between 2002 and 2016, the percentage of jobs requiring low digital skills plunged from 56 to 30.

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