Weekly Update: Why the face?

03-29-2018

On the road again for this holiday-shortened week, with rainy four-hour drives to/from York, Pa., and lots of time to think. I spoke before several hundred local executives at a meeting of the Rotary Club of York, introduced as the 26th-largest club in the world. The meeting started with the leader asking us all to rise, then ringing a brass bell, which resembled the Liberty Bell, followed by the Rotarians singing “God Bless America,” then reciting the Pledge of Allegiance. This was followed by a prayer, where our leader noted that God told us not to worry. He asked the group to “pray for those who would advise us,” then introduced me! (Blushing) Most of 2018’s bullish backdrop remains unchanged. Wages are rising, inflation appears set to remain relatively low and stable, and earnings are on the rise. Thomson Reuter’s consensus forecasts are indicating S&P 500 earnings growth should top 18% in Q1, and since the end of 2017, Q1 estimates have risen 5.5% and the full-year estimate has risen 7.3%. This Goldilocks scenario suggests investors should remain bullish for the longer term despite recent messiness that’s not atypical for midterm election years. Stocks historically have trended down the first nine months of such years before rallying strongly in the fourth quarter. The average Q4 return in the S&P in midterm years is 7.9%, Strategas Research says, with small caps following a similar pattern. Moreover, midterm election-year corrections typically represent a great buying opportunity, with stocks up one year later from their low every time since 1962 by an average of 36%! And the S&P has not declined in the 12 months following a midterm election since 1946, regardless of which party wins.

Tuesday’s sharp reversal of Monday’s even larger run-up was driven by the best-performing stocks over the last 12 months. The leaders are getting hit, with Facebook as the sixth-largest S&P component creating a cloud over the broader technology sector that has been core to the market’s leadership. While this is often one of the most uncomfortable moments of a corrective phase (the widely owned stocks go down), it’s also a sign we’re likely getting closer to the end or at least through the worst of it. The S&P is holding above the 200-day average at 2,587 and the Feb. 9 low at 2,533. Beneath that, 2,467 marks the 38% retracement of the February 2016 low to the January 2018 market high. That’s about another 5% from here—likely the worst the market will do as it washes out. Good lows are almost always followed with exceptional breadth, which hasn’t happened yet. An equally-weighted index of FAANG stocks (Facebook, Apple, Amazon, Netflix and Google) is still some 14% above its 200-day moving average. That said, seasonality is supportive through April. Also, the percentage of stocks hitting 20-day lows continues to decline from the high-water mark set in early February and equity put/call ratios are in the 98th percentile—both levels that consistently mark interim bottoms, particularly in uptrends. From an intermediate-term perspective, weekly momentum indicators are back to neutral after hitting overbought levels in January. A positive technical setup is now developing heading into earnings season. Since bumping up against its pre-presidential election ceiling two weeks ago, the S&P forward P/E multiple has fallen to its lowest point since Brexit.

It is important to note that while nominal bond yields have been on the rise, the real 10-year Treasury bond yield remains historically low. The 65-year average inflation-adjusted yield on the 10-year is 230 basis points, which represents the long-term cost of money. But at the end of February, the real Treasury bond yield was 70 basis points, less than a third of that long-term average. And after this week’s action, which saw 10-year Treasury yields snap out of a 22-day range to close below 2.80% for the first time since early February, the real yield is even lower. This indicates yields remain very stimulative and bullish for stocks. Interest rates would have to move substantially higher to be a significant handicap to economic activity, an outcome that doesn’t look likely on the near-term horizon. This week’s collapse in long yields has narrowed the spread between 2-year and 10-year notes to below 50 basis points, but that’s still a long way from an outright inversion that historically has signaled recession a year or longer out. Current trends suggest an inversion is still at least a year away, and secular tops in the broader equity indexes consistently don’t occur until 22 months after such an event. Back in York, the Rotarians were a great group, laughing at all the right moments, asking many questions. An 80-year-old gentleman told me that he is 80% in stocks and has been a bull for 50 years. I love his attitude. The first person I met there, when I told him I was the speaker, remarked “You have my prayers.” What! No worries ... why the face?

Positives

Consumers remain very confident The Conference Board gauge eased a tad in March but remained just off February’s 18-year high, with job availability its highest since 2001. Michigan sentiment followed a similar pattern, slipping below last month’s 14-year high. This bodes well for consumer spending, up only a modest 0.2% in February. The International Council of Shopping Centers (ICSC) weekly retail chain store sales index shot up 4.2% last week, the most in six months and the sixth-biggest gain on record, and the ICSC expects the Easter holiday to support further growth.

More signs of Big Mo Real Q4 GDP was revised up to a better-than-expected 2.9%, led by the biggest increase in consumer spending in three years. Nonfarm inventory investment, capital expenditures (capex) and government spending also were revised up. On a year-over-year (y/y) basis, real GDP increased 2.6%, the fastest pace in 2½ years and above the 2.2% gain per annum in this expansion. Forecasts see real growth in the 3% range this year, aided by tax cuts and increases in government spending.

More signs of housing rebound Pending home sales jumped the most in four months and more than double the consensus for a 1.5% gain. Activity picked up across the country, led by a double-digit gain in the Northeast. The report followed last week’s improvement in new and existing home sales. Also, the MBA Purchase Index and the Case-Shiller price gauge both rose again, reflecting tight inventories and healthy demand.

Negatives

If we’re ever going to get inflation, this would be the year Core PCE ticked up in February to a still-subdued 1.6% y/y rate, led by a fourth-straight robust gain in wages & salaries. Y/y PCE is expected to tick further up in coming months as negative and flat prints of a year ago roll off. The 6-month annualized rate is now 2.4%, and the annualized rate for the quarter-to-date is 2.7%.

Trade’s drag deepens The goods deficit widened in February to $75.4 billion, second only to July 2008. Led by food and capital goods, imports rose the most since January 2012. Partly due to the widening, the Atlanta Fed’s GDPNow Model is now tracking real Q1 GDP growth at 1.8%, down from as high as 5.4% in early February.

Regional moderation The Chicago, Dallas Fed and Richmond Fed manufacturing surveys all fell in March, with the Richmond gauge off the most in 10 months as shipments, new orders, capex, inventories and employment all slowed. The services component also slipped, as did the Texas services gauge, which hit a 6-month low. However, all three surveys still remained well into expansion territory.

What else

If we’re ever going to get inflation, this would be the year The closing of output gaps this year could potentially drive up inflation, putting growth at risk as central banks respond by tightening more than anticipated. The latest data shows 66% of countries are growing above their long-term growth potential, the largest share since 2007. Peaks in breadth at around 71% last happened in 2000 and 2007, right before major recessions. Unless these countries can increase their potential through faster labor force and productivity growth, Ned Davis Research thinks the dangerous output-gap threshold could be reached in the next year or so.

Trade’s going strong On the same day the U.S. and China exchanged fire in what is potentially the beginning of a trade war, data published by the CPB Netherlands Bureau show that world trade made a great start to 2018. And leading indicators point to world trade volumes continuing to grow strongly in the coming months, with 3-month y/y trade expanding at its fastest rate since it rebounded from the global recession in 2011. Of the 20 largest trading nations, only Switzerland, Mexico and Canada dragged on global export growth.

Who said we could use a little more volatility? The four trading days through Tuesday saw Dow point moves of 345, 669, 425 and 724 for an average of 541 points.

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