Weekly Update: Mayday, mayday!

05-04-2018

After a quick visit to Miami, I spent the week in my office, reading report after report trying to make sense of a sideways market despite blowout earnings. Why is this happening? Nafta. China. Stormy. Quantitative tightening. High downside volume vs. low upside volume—we’ve had 18 days this year when downside volume was nine times upside volume. The lack of breadth—the April 2-18 rally was relatively narrow based on the percentage of stocks above their 10-day moving averages. 10 day! (My eyes are glazing over … it feels like reasons are being plucked to fit a narrative.) Now we’re entering a historically weak seasonal period, the six months from May 1 through Oct. 31, which has been particularly bad during midterm election years. The Dow averaged a 5% annual loss in the past seven midterm years that followed back-to-back double-digit annual gains, as is the case this year. As the market continues to waffle, the percentage of bullish to bearish respondents in the weekly Investor Intelligence survey is down from 5-to-1 in mid-January to just 2-to-1. Apart from Q1 2008, Bernstein’s proprietary sentiment indicator is at its most pessimistic level in its 14-year history. Pessimism is building and the bar for a positive surprise is being lowered. 

The blended Q1 earnings growth rate for the S&P 500 is 25% and the earnings-per-share (EPS) growth rate for companies that already have reported is an even higher 27.3%, according to the latest Thomson Reuters report. These percentages are substantially better than the 18.5% indicated on April 1 and well above the 14.8% year-over-year (y/y) growth rate recorded in 2017’s final quarter. More important, the current estimate for calendar 2018 earnings growth is 21.2%, up from the 19.8% forecast seen on April 1. While Q2 revisions have come in slightly, they’ve been reduced by the least since 2011. (My eyes are glazing over again.) The current bottom-up sell-side consensus implies EPS growth will peak in Q3, followed by more moderate but still positive EPS growth in 2019. History suggests this could be a short-lived problem for stocks. When the S&P EPS growth rate peaked in 1993, 2004 and 2009, the index was down six months later but higher 12 months later. Like today’s consensus forecast, EPS growth stayed positive but moderated after peak growth rates were hit in those years.

Rising bond yields have undermined risk appetites, prompting questions about whether the global economy can cope with higher interest rates. But one of the earliest reads for April, the global manufacturing PMI, rose for the first time in four months, signaling a modest recovery from Q1’s weather-induced soft patch. Seventeen of the 18 PMIs that Strategas Research tracks are expanding. In the U.S., the Philly Fed leading indexes project broad-based growth in the next six months—49 of 50 states were rising in its latest report, and its overall U.S. component was at its highest level since January 2017. Business and consumer optimism is high and both cohorts are spending, with capital expenditures (capex) accelerating, pending home sales rising again and car sales holding near March’s robust levels. Meanwhile, the worries out there have been well known, many for a long time. Blowout earnings may have reached peak growth rates but there is no recession in sight. (Excellent.) Yields and inflation are rising but gradually. (Fine.) The forward P/E has fallen to 16.3, its 20-year average, while the S&P bumps along its 200-day average. (Spectacular.) Mayday, mayday! (With the proviso that no bombs go off in D.C.), I’m not buying it.

Positives

Jobs not too hot, not too cold Despite April’s slight miss, upward revisions to prior months kept monthly job gains at a healthy 200K pace for the year. Many of the past month’s gains were in goods-producing industries as male participation rose—a sign of increased capex activity. African-American unemployment also fell to a record low. Meanwhile, muted wage growth reinforced Fed gradualism (more below).

ISMs solid April’s ISM manufacturing print of 57.3 slipped but stayed consistent with above-trend growth, with 94% of industries reporting increased activity, matching the highest share since May 2004. The services ISM services was similar, dipping a bit but remaining consistent with above-trend economic growth as all 18 industries expanded last month. Markit’s separate manufacturing and services surveys improved, with the manufacturing PMI reaching a 3½-year high. March factory orders also surprised, up 1.6% a second straight month, while capex has risen 24% y/y so far this earnings season.

The Fed’s in no rush Slack in the labor market—nearly 30% of the working age population is either unemployed or not actively seeking work—may help explain why there has been little acceleration in wages even as the jobless rate fell below 4% in April and could dip as low as 3.5% this year. This would indicate there is no reason for the Fed to speed up the pace of rate hikes, as some had suggested after parsing its post-meeting statement Wednesday and finding that policymakers had conceded that inflation now approximates its 2% target.

Negatives

If we’re ever going to get inflation, this would be the year PCE prices advanced y/y in line with the Fed’s 2% target, with the roll-off of year-ago negative prints abetting the higher comparisons. Reports elsewhere show pricing pressures building. ISM and Markit manufacturing prices were at or near 7-year highs and levels historically consistent with a pickup in consumer inflation. And retail gasoline prices have jumped 11% y/y; Cornerstone Macro predicts they’ll climb 15% for the year, negating the tax cut for the bottom 40%.

Where are we in the cycle? March’s 1.7% decline in construction spending was the most in nearly a year and the second most since January 2011. The drop-off was led by a 3.5% plunge in residential construction, the most since April 2009 and likely due to bad weather. But nonresidential construction spending also slipped. Still, on a y/y basis, construction spending was up 3.6%, with both private and public sectors contributing.

Did tough trade talk play a role? March’s trade deficit shrank the most in 18-years to a 6-month low, driven by a sharp narrowing in the trade gap with China, which fell to $25.9 billion from February's $29.3 billion. Despite the monthly decline, on a 12-month basis, the trade deficit continued to widen, reaching $594 billion, its highest level since March 2009, with deficits with China and the European Union posting fresh records.

What else

Tech not driven by tax cuts Taxes have contributed 7.4% to EPS growth in Q1, Credit Suisse estimates, but the benefit has hardly been uniform across sectors. While taxes are contributing 10%+ to growth for Discretionary, Financials, Telecom, Staples and Industrials, Tech’s upside is only 1.6%. Put differently, Tech’s strong results this quarter are driven almost exclusively by fundamentals.

What if FAANG were a country? Combined Q1 revenues for Facebook, Apple, Amazon, Netflix and Google totaled an annualized $635 billion, enough to rank the five as the world’s 21st largest economy, just behind Switzerland but ahead of Argentina, according to IMF data for 2017.

Welcome to ‘Name that decade’ We had the “Roaring Twenties,’’ Japan’s “Bubble Years’’ and the “U.S. Tech Boom,’’ decades of great expansions marked by low inflation thanks to technological revolutions. So what should we call this decade if the expansion, already the second longest on record, lasts another two or three years?

Connect with Linda on LinkedIn