March Madness, equity edition March Madness, equity edition

March Madness, equity edition

Stocks may be poised to reverse their recent weakness.
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Bottom Line Amid the distraction of busted brackets, buzzer beaters and a wave of shocking upsets in the NCAA men's hoops tourney, the S&P 500 was down nearly 8% over the past nine days—with last week’s 6% collapse the worst 1-week plunge in two years—due to rampant fears about tariffs and trade wars. As we discussed just last week, however, these tariff threats are a negotiating ploy orchestrated by President Trump in an effort to reverse a rapidly widening trade deficit, currently at its worst level in a decade.

In like a bear, out like a bull? The good news is that the S&P seemed to capitulate on Friday, right back to a potentially successful retest of its 200-day moving average of 2,585, a level at which stocks are oversold. Along with an oversold spike in the volatility index () to 26 on Friday, and a near-overbought reading of a 2.79% benchmark 10-year Treasury yield, stocks are already showing today that they may be poised to reverse their recent weakness over the next several weeks for three reasons.

First, earnings season kicks off in mid-April, with consensus expectations for a powerful 17% year-over-year gain expected for S&P companies. This is the first full quarter for companies to report their benefit from Trump’s tax-law changes.

Next, small-cap companies already are starting to feel the love, outperforming large-cap stocks by more than 4% since the end of February. Domestic small-cap companies, which typically generate 80% or more of their revenue and earnings at home, are benefitting from the acceleration of economic growth to a trend-line 3% run rate over the past three quarters. Large-cap companies, in contrast, usually conduct more than half of their business overseas, which is fueling concern among investors that a Trump trade war will harm their operating results. Small-cap companies had underperformed large caps by more than 20% since the beginning of 2017, so the pendulum is now starting to swing the other way, a positive trend that we expect to continue.

In response to the aforementioned factors, Federated’s macroeconomic policy committee today adjusted its PRISM® asset allocation model, adding 1% to small-cap growth domestic equity and raising the stock-bond model’s overall equity overweight to 80% of maximum.

Several of the key economic metrics that we monitor have surged to multiyear cycle highs in recent weeks, which suggests that consumer spending, manufacturing activity and inventory re-stocking will likely improve in coming months, eventually boosting economic and profit growth and share prices.

  • Leading Economic Indicators (in February rose 0.6% to a new 58-year cycle high of 108.7, up sharply from its recent trough of 99.2 in February 2016. The average workweek, jobless claims and ISM new orders contributed to the LEI’s recent strength.
  • Conference Board’s consumer confidence index spiked to a new 18-year cycle high of 130.8 in February, up from 124.3 in January and well above its 100.8 reading in October 2016.
  • Michigan Consumer Sentiment Index surged to a new 14-year cycle high of 102 in March 2018, compared with 99.7 in February and up from a 2-year low of 87.2 in October 2016.
  • small-business optimism index rose to a new 34-year high at 107.6 in February 2018, versus 106.9 in January and up sharply from 94.1 in September 2016.
  • manufacturing index in February 2018 soared to a new 14-year cycle high of 60.8 from 59.1 in January, well above its recessionary reading of 49.4 in August 2016.

Risk/reward attractive Stocks are now in negative territory by 2% since the start of 2018, but we are sticking by our full-year target price for the S&P of 3,100 ($155 in earnings and a P/E ratio of 20 times). That implies potential capital appreciation of 20% over the balance of this year, which we believe represents an attractive risk/reward profile. Investors have recently used their concern about tariffs and trade wars—as well as the Federal Reserve’s leadership transition—as a convenient excuse to execute their intended retest of the market’s February lows. With that process now largely complete, investors should turn their attention to strong underlying economic fundamentals and solid first-quarter corporate profits. March came in like a bear, but it should leave like a bull.

We wish everyone a blessed Passover and Easter holiday!

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