Weekly Update: Holding pattern

09-13-2018

Vacation is over and I was back to business this week with travel in the Kansas City and Houston areas. Everywhere there was discussion of disaster anniversaries and a worryingly upcoming one. This week is marked by both the 17th anniversary of 9/11 and 10th anniversary of the fall of Lehman Brothers. And now, the worst hurricane since 1989’s Hurricane Hugo is hours from arriving on the shores of the East Coast. Our thoughts and prayers are with everyone in Florence’s path. At an end client event in K.C., an advisor introduced me to a gentleman, noting “She appears on CNBC.” “I am not impressed,” he quickly responded. OK, so that’s how it’s going to be.... It was a raucous time, and I won him over eventually. The group was very conservative; ditto the rest of the K.C. area and Houston later in the week. All week, business owners shared first-hand stories of tariffs from China that have risen dramatically over recent years. In Topeka, a personal advisor talked about a family operation trying to do business in China, but first the Chinese demanded proprietary information—the family walked away. In Overland Park (one of the wealthiest ZIP Codes in America where I’m told a lot of K.C. Chiefs live), an advisor involved in a business that purchases steel parts from China has seen massive tariff increases in recent years. They all were fans of Trump’s tariffs and for a strong stance on trade.

It would be difficult to describe the current market as overly expensive (see “You might be surprised by this,” at bottom). It isn’t cheap either but, after 10 years of nearly zero-percent interest rates, investors are left with an almost unanswerable question—what’s the right P/E multiple for the market when earnings are growing at 20% and the long-term risk-free rate is under 3%? Cornerstone Macro opines that nothing new has happened of late and everybody knows it. Utilities, REITs, Consumer Staples and Telecoms did come to life in the May-August period, but now they’re sort of dull; they look stuck and headed neither higher nor lower. Same for Financials and Industrials, which awakened in July only to fall back asleep in August and remain so. Energy? Nothing new here. Health Care has been very strong and Consumer Discretionary and Technology sectors have been flaccid of late, but none of this is new, either. Also on this nothing-to-see-here-move-along list: the U.S. dollar, stuck in a well-defined range at levels where bulls and bears are having to fight it out, and the 10-year Treasury yield and crude oil prices, both also stuck in a well-defined range. It’s a holding pattern all over. From a technical perspective, late August highs have not been confirmed by consistent buying pressure, and the 10-day average new highs are in neutral territory. Both suggest the market is apt to remain in a trading range for the near term. Again, holding pattern.

Everywhere I went this week, I heard Middle America is on the mend and may be an unexpected source of growth. The American economy is not all about the coasts, though to watch the media, one would think so. Flyover land is booming and it is doing so without a preponderance of federal employees, Wall Streeters, Silicon Valley or oil well frackers. At my Topeka stop, we visited a fierce team of women advisors. Discussing 9/11 and the people we knew who died, along with the anniversary of the financial crisis, all agreed that we can deal only with those issues we control (this sentiment interestingly came up numerous times this week). That does not include midterm elections or trade wars. In Overland Park, a group of advisors wanted to discuss bigger picture concerns—likely modest returns for all manner of asset classes in the intermediate future, growing debt around the world and the likelihood (to which I disagree) of a big global inflation problem further down the road. Again, we agreed that we can only deal with what we can control, and apply behavioral finance when confronting end clients. I spent the last few days of the week in Houston, where the 1-year anniversary of Hurricane Harvey is fresh in everyone’s mind. I heard about neighborhoods where half the residents abandoned their property and the homes have been untouched for a year. Other residents have paid $200K just to install several feet of cinder blocks under their ranch homes for the next inevitable flood. But Houstonians are philosophical, “We can’t do anything about floods, anyway.” “It would be bad not to have hurricanes; they replenish the ecosystem. The fishing is phenomenal now!” Back in K.C., I was reminded the Chiefs play the Steelers this Sunday. For the Steelers, last week’s game ended in a tie vs. the Cleveland Browns. A tie! A holding pattern. Much like the market at the moment. Which way do you suppose it will break?

Positives

  • Small business animal spirits have never been greater The NFIB optimism gauge shot to a record high in August, with sales expectations consistent with 7% nominal GDP growth, capital spending plans at a 12-year high and both job creation plans and unfilled job openings also setting new records.
  • Jobs for the taking Job openings reached a record high in the July JOLTS survey, exceeding the number of unemployed for only the third time in 31 years. The last two times this happened, in September 1997 and June 1987, recessions followed a respective 42 and 37 months later, suggesting the next recession in this cycle may not come until September 2021 at the earliest. Also, the latest jobless claims set another 50-year low, a separate Manpower survey put Q4 hiring plans at nearly an 11-year high and the Employment Trends Index rose at its fastest pace in six years. Finding and keeping skilled workers were the biggest worries in the monthly NFIB and quarterly Duke/CFO Magazine surveys.
  • If we were ever going to get inflation, this should have been the year August producer prices unexpectedly declined, with the year-over-year (y/y) core rate slipping to 2.4%, its slowest pace since January. CPI followed a similar pattern, with the core y/y rate slipping to 2.2%. The reports were supportive of the Fed maintaining, not accelerating, its current rate-hike path.

Negatives

  • It’s not good if the U.S. is the only game in town Eurozone industrial production unexpectedly contracted on a y/y basis, causing Goldman Sachs’ eurozone GDP tracker to plunge. The U.K.’s forward-looking manufacturing and services PMIs deteriorated. In Asia, South Korea’s unemployment rate jumped to a 9-year high.
  • Blah Beige Book The headline on the periodic Fed survey may have suggested an upgrade, but the underlying details hinted at softening. Consumer spending was “modest,” manufacturing was described as "moderate,” home sales were lower, commercial real estate was “mixed” and agriculture was “weak.”
  • Cracks in the consumer story? Deutsche Bank thinks the robust aggregate picture of consumer health may be masking vulnerabilities at the micro level. It cites the large disconnect between household savings and wealth, with the former being considerably higher than would be implied by the latter. Survey data suggest this household “savings glut” is being driven by precautionary motives as households view job prospects and housing as riskier.

What else

You might be surprised by this Even after a strong run, the forward P/E of small caps is now just 4% below its long-term average since 1979. Interestingly, valuation dispersion among size segments is at record lows, Bank of America says, with the Russell 2000, Russell 1000 and Russell MidCap all currently trading at a forward P/E of 17.3.

Buyback boom There have been more than $750 billion in buybacks announced year-to-date, according to TrimTabs. And while they all may not be completed by year-end, the final number should trounce 2016's record of $500 billion. In addition to increased cash flow from tax reform, this buyback surge is being fed by ultra-low interest rates, which encourage companies to swap equity for debt, with share repurchases a method to execute such a strategy.

Black gold, Texas tea The state is the third-largest oil producing “country” in the world, behind only Russia and Saudi Arabia. In the past 10 years, its Permian Basin output has jumped from 902,747 barrels per day to 3,342,642 barrels, abetted by significant improvements in productivity. In 2008, it took 70 days to drill a well and then produce 140 barrels a day. Today, it takes 10 days to drill a well and produce 1,400 barrels.

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