Weekly Update: Time and hope

04-06-2018

Back on the Pennsylvania country club circuit this week, this time to the Lancaster Country Club, the host venue for the 2015 U.S. Women’s Open. I spoke to an investor audience who, based on their many questions, were astute students of the markets. How appropriate, also, that I should meet a gentleman who was once a pro golfer, having lunched with our own Arnold Palmer. I also met a golf course owner who is worried that millennials aren’t coming out to play. He asked me if my husband golfs. I said yes, but poorly, and he hasn’t played for quite awhile. Unfortunately, although the Mr. can hit the ball quite far, he has a terrible hook, then can’t find his ball. The golf course owner suggested I encourage the Mr. to get out and play, for all it takes is “time and hope.” I’m not a big fan of the word “hope”—it suggests we have no control. Which brings to mind the “trade war.’’ Weeks ago, President Trump tweeted that “trade wars are good and easy to win.” And this week, “we are not in a trade war with China, that war was lost many years ago.” And today, Trump threatens tariffs on an additional $100 billion in Chinese goods. Evercore ISI says this is in response to the Chinese tariff threat to U.S. Midwest agricultural interests, largely Trump’s base, and patently political rhetoric. Yardeni doesn’t expect a trade war, as global trade remains at a record high and countries have become too interdependent to resort to widespread prohibitive protective barriers. Surely Trump knows this. Do you suppose Trump is simply campaigning for 2020? I hope so. Only time will tell.

The year began with the highest level of bullish sentiment since late 2010, based on tax cuts and belief that the global economy is great. But after having its best January in eight years, the first quarter ended in the red, making it the worst first quarter in eight years. Volatility returned even as S&P 500 earnings expectations improved at a record pace. Bottom-up forecasts project increases of 18%, 20% and 23% in Q1, Q2 and Q3, respectively! After 442 consecutive trading days, the S&P closed below its 200-day average this week, breaking the sixth-longest streak in history. But even as the S&P hit a fresh 1-month low, fewer stocks did so compared to the early February lows (53% vs. 80%), often an early sign a tradable low is within striking distance. And retesting the February low on significantly less volume is a common characteristic of a market trying to bottom. The current volatility is much more consistent with a correction than a bear market, with the VIX posting lower highs on sell-offs since its spike in early February. Meanwhile, Ned Davis Research’s proprietary global sentiment gauge dropped to its most pessimistic level since the February 2016 bottom, when pessimism was driven by an actual global economic contraction and earnings slowdown. This time, a bullish fundamental backdrop is wrestling with escalating investor nervousness, not such a bad thing from a contrarian perspective. Vanguard’s retail-oriented S&P ETF has been much weaker than State Street’s institutional-minded version, a sign individual investors are spooked. Another sign investor “aggressiveness” has continued to fade: relative performance of both the stock market and cyclical stocks has declined to lower lows than reached in early February. Sell-offs have been exacerbated by high-volume algorithmic trading, something we are going to have to get used to.

Not only is sentiment at extreme levels, the MSCI World Index P/E has dropped to its lowest since the summer of 2016, well before the markets had to contend with the distractions of a Trump presidency. Yet even if a Trump unpredictability premium represents a limit to multiple expansion potential, the benchmark’s current 20 P/E appears reasonable given high and rising percentages of positive earnings revisions, earnings expectations and global valuations that are around historical norms. Global mergers and acquisitions represent another major source of demand. Global M&A volume through March nearly doubled its 23-year average, Dealogic says, its fastest buildup on record. It’s too soon to say the market is out of the woods. While there have been four 90% down days year-to-date, history suggests the worst of the decline isn’t over until there is a 90% up day (although there was an 86% up day on March 26). Immediate S&P support remains in the 2,533 (February low) to 2,589 (200-day average) range. Strategas Research suggests that the worst case is S&P 2,467, roughly another 5% from current levels. That’s where hope comes in. Protectionism threatens the global recovery and stock market rally. Its escalation would really hurt Trump’s re-election chances. What do you suppose he wants most?

Positives

Jobs mixed but positive At 103K, March nonfarm jobs came in well below expectations and January was revised sharply down, lowering the Q1 monthly average to 202K, below Q4 2017’s 221K. Still, the overall jobs picture remained one of moderate strength, with ADP private payrolls rising a well above-consensus 241K as hiring accelerated notably. ADP said the current pace of job growth is running at twice the pace of labor force growth, with goods-producing jobs posting their fourth-biggest gain since February 2006. Online help-wanted also rebounded, up 3.7% year-over-year (y/y), matching their fastest pace since January 2016.

No recession in sight The ISM manufacturing Index slipped in March but still was just off 60, a level consistent with above-trend growth. Seventeen of 18 industries were expanding, matching a 14-year high. Markit’s companion PMI was similarly robust, reaching a 3-year high, and ISM and Market services reports were easily expansionary, just less so. Elsewhere, the Philly Fed State Coincident Indexes increased in 47 states, signaling broad-based growth, while Markit’s global manufacturing PMI declined to a 2-year low but remained at a high level, suggesting the world economy will still expand by a decent 3.5% this year.

Auto sales surprise Light vehicle sales rebounded 2.5% in March, the first increase this year, to a 17.4 million unit annual rate, contrary to WardsAuto’s forecast for a 0.5% decline to 16.9 million. Job and wage growth, as well as high consumer confidence, supported demand but sales incentives played a strong role. According to TrueCar, the average incentive increased 2.6% from the prior month and 5.5% from a year ago. The sales increase was due entirely to domestic light trucks, which climbed the most since last September. On a y/y basis, vehicle sales were up 4%, led by a 13.3% increase in light trucks.

Negatives

More fuel to Trump’s fire The trade deficit rose again in February and on a 12-month basis, reached $589.6 billion, its highest level since March 2009. The biggest gap was with China at a record $386.2 billion. The deficit with Mexico also climbed to $71.5 billion, the most since September 2008, and hit a record $156.1 billion with the European Union. Strong domestic demand drove the increase, but it was a good month for exports, too, led by automotives, industrial supplies and capital goods. Import increases were led by a jump in capital goods, boding well for investment activity in the near future.

If we’re ever going to get inflation, this would be the year Despite Q1’s slightly slower job gains, today’s employment report showed y/y average hourly earnings rising a tick to 2.7%. Elsewhere, higher raw materials prices caused the ISM price gauge to jump to a 7-year high and a level consistent with upward pressure on consumer prices. Cost burdens in the separate Markit PMI increased at their fastest pace since November 2012, partly due to the announced tariffs. Prices charged also picked up, rising at their quickest rate since December 2013. In the regional ISM survey for New York, prices paid increased at their quickest rate since November 2016.

What’s good for China is good for GM, and Apple, and … GM sold more cars in China than in the U.S. last year, and there are 310 million active iPhones in China, more than double the number in the U.S. These cars and phones did not show up as U.S. exports to China, as they were made and sold in China. Put simply, U.S. business interests in China are much larger than what trade data show. A potential trade war would put these interests at risk. From an ownership perspective, the imbalance between China and the U.S. was large but has corrected in the past 10 years, with U.S. and Chinese firms now benefiting equally from each other’s market, Deutsche Bank says.

What else

A dovish signal? SF Fed President John Williams was selected to head the New York Fed. He’s viewed as a pragmatist and one of the intellectual fathers of the Fed’s estimation of the neutral rate—a theoretical level considered neither stimulative nor restrictive to trend growth. Cornerstone Macro says he knows all too well that the neutral rate is low (currently just about 2-2.5% in nominal terms) and that if the Fed significantly exceeds the neutral rate, a recession typically occurs. It’s thought this may make the Fed less likely to raise rates unless a clear inflation problem emerges, making it more willing to tolerate inflation a bit above 2.5%.

A plain speaker Based on his inaugural FOMC press conference, new Fed Chair Powell will be easier to understand than his two predecessors. That’s according to the Flesch-Kincaid score, which calculates how easy it is to understand what is being said by looking at how long sentences are and the number of syllables. It could just be that Powell is not an economist and thus not as acquainted with Fedspeak.

On the other hand, dividends are dollars in your pocket A Goldman Sachs (GS) analysis found stock buybacks no longer are as good a predictor of future excess returns as they used to be, with the average excess return five years on from a buyback now in negative territory. Historically, buybacks in bear markets have outperformed those in bull markets. Ironically, they’re more frequent in the latter. GS also said larger buybacks appear to be inversely related to excess return, with companies with quarterly buyback yields (buyback amount/market cap) under 1% outperforming on average. One possible reason for buybacks’ fading predictive power? Their increasing ubiquity.