Orlando's Outlook: Buy on weakness

02-06-2018

Bottom Line The S&P 500 has plunged nearly 10% over the past seven trading days in what we believe is a healthy and long-overdue correction from its record Jan. 26 high. Over this same period of time, the volatility index (VIX) has spiked from 10 to 50, while the benchmark 10-year Treasury yield has more gradually risen from 2.00% to 2.85% over the past five months. All of these moves, in our view, are well overdue, reflecting technical capitulation rather than a deterioration in what we believe are solid fundamentals. Consequently, we are adding 1% to our PRISM® equity allocation from these oversold levels, taking stocks up to a 7% overweight in a balanced portfolio.

Why are investors spooked? In a global environment in which economic and corporate earnings growth have improved noticeably over the past year, investors are now rabidly concerned about central bank regime change. Will a sharply tighter monetary policy abruptly end the free-money accommodation that has existed since the depths of the Great Recession a decade ago?

Here at home, we have long discussed the market risk associated with leadership and policy transition at the Federal Reserve (Fed). It’s now come home to roost that retired Chair Janet Yellen has passed the monetary policy baton to incoming Chair Jay Powell. But investors fear we may be swapping Yellen’s more dovish bias for a more aggressive tone from Powell. Could we be looking at four rate hikes this year instead of three? Might the Fed substitute some half-point hikes for Yellen’s quarter-pointers? Will Powell eventually adopt a faster pace of balance-sheet shrinkage?

The rest of the world, of course, takes its cues from the U.S., so tighter monetary policy here will lead to a faster withdrawal of accommodation globally, which will slow economic growth and eventually push the U.S. back into recession. Or so the whispered fears go. We disagree, of course, and believe that this recent equity air pocket is an excellent chance to add to positions against the backdrop of solid economic fundamentals. We continue to forecast a 3,100 target price for the S&P this year on our $155 earnings estimate, which implies nearly 20% appreciation potential from today’s depressed prices.

Positive January Barometer gives us confidence for a strong full year Despite the carnage that started last week, the S&P enjoyed a positive January, rising 5.62% for the full month on a price-only basis. The “January Barometer” remains one of the stock market’s most popular rules of thumb: As the month of January goes, so goes the full year. Jeffrey and Yale Hirsch at the Stock Trader’s Almanac say that since 1950 whenever the S&P started the New Year with a positive month—as it has done 41 times since 1950—it finished the year higher in 37 of those instances. That’s a powerful success rate of 90%.

How did we perform in January 2018? For the full month, the S&P enjoyed a nominal price increase of 5.62%, starting from 2,673.61 on Dec. 29, 2017, and ending at the closing price of 2,823.81 on Jan. 31. The total return (which includes dividends) over this period was a gain of 5.72%. This represents the eleventh-best January for the stock market since 1950 and the strongest first month for the S&P since the market’s 6.1% gain in 1997. So if we look at the other 20 years in which the S&P started January with a 4% gain or more, every full year was positive, with a total return averaging 22.5%, within a wide range of 2% to 45%.

What are the best sectors to own in 2018? The January Barometer Portfolio indicator also holds that the best- and worst-performing S&P sectors in January tend to follow that performance trend the rest of the year. Here are the S&P’s 11 sectors, sorted by their total-return performance in January 2018. Note the more cyclical and growth bias at the top of the list and the more defensive, dividend-oriented bias toward the bottom: 

  • Consumer Discretionary, 9.34%
  • Information Technology, 7.63%
  • Health Care, 6.65%
  • Financials, 6.48%
  • S&P 500, 5.72%
  • Industrials, 5.31%
  • Materials, 4.14%
  • Energy, 3.81%
  • Consumer Staples, 1.59%
  • Telecommunication Services, 0.55%
  • REITs, -1.89%
  • Utilities, -3.07%

 

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