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May you have very happy holidays

Stocks must work through headwinds to accomplish the typical end-of-year rally.
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My last trip of the year included stops in Richmond, Williamsburg, Virginia Beach, Wilmington, King of Prussia and Lancaster. (Incidentally, I spoke for the 12th year in a row to the Lancaster Chamber of Commerce, with 600 attendees, my largest group of the year. Afterward, we had a roundtable meeting with local small businessmen and discussions so fascinating and too numerous to recount here.) Now, some advisors we met were in quite a holiday mood. In discussing the size and power of the FAANGS, one Williamsburg advisor protested, “You have a choice. If you don’t like Facebook, don’t go on Facebook.” And the fact that Jeff Bezos is the richest person in the world, “I hope he takes over the world. Amazon is the best thing that has ever happened to me!” At another Williamsburg meeting, complete with lots of laughs, the gentleman wanted my choice for the most-hated investment. “I don’t want to buy what everyone favors!” Then again, a Virginia Beach advisor is a self-described “contrarian.” Continuing with the holiday spirit in King of Prussia, we lunched with a senior executive of a large national firm, who set the tone by arriving in a bold holiday sweater complemented by Christian Louboutin shoes, which outfit he rocked. What are today’s most-hated groups? Energy and financials, emerging markets (EM), the U.K. and semiconductors get votes. But signs of a potential value play in the EM are flashing, while high free-cash-flow yields suggest opportunities in the U.K. and semiconductors. Buying opportunities are never comfortable, though, are they?

While the S&P 500 is about 10% off its 52-week high, the average constituent is down more than 20%, suggesting it may take several months to repair the damage. The latest Investors Intelligence survey shows bulls outnumbering bears 2-to-1, a sign a final market “flush’’ of buy-and-hold investors has yet to hit. Less than 11% of S&P 1500 stocks are up so far this month, and less than 18% have produced positive returns this quarter. This week, the 50-day moving average fell below the 200-day moving average for the first time since 2015, a technical indicator that suggests further risk remains to the downside, as do low-beta stocks besting high beta and large-caps besting small in recent bounces. Then there’s ever-tightening liquidity, with the 2-year/10-year Treasury yield curve holding near recent lows, BBB bond yields relative to Treasuries still elevated, Chinese foreign reserves contracting and China’s money supply slumping to its lowest reading on record. With U.S. banks required under post-crisis regulations to maintain a high level of reserves and the Fed continuing to shrink its massive balance sheet, a growing fear is bank reserves could become scarce. This would force them to fight for available reserves, potentially causing overnight rates to move higher. Goldman Sachs thinks these tighter conditions are still manageable but could trim up to a full percentage off GDP growth next year.

The seasonal low in the S&P historically comes today (December 14), with stocks rallying afterward into the coming year. Combined with macroeconomic news that’s still a lot more good than bad (more below) and P/E valuations at or near 5-year lows, the S&P could be setting up to take a run at resistance at 2,750-2,800. But any sustained move probably requires financials to participate and the news out of China to not get worse—this morning’s report that production and retail sales weakened and land sales plunged won’t help. With a quarter-point hike baked in when the Fed meets next week, it’s all about whether the dots fall in line with recent near-neutral narratives from policymakers. The 10-year Treasury term premium (a gauge of interest-rate volatility) has collapsed to levels that prevailed in the summer of 2016, when the Fed introduced the “new neutral rate” concept, which investors took to mean it would never raise rates above 1%. A negative term premium, as is the case now, implies a low and stable inflation backdrop, little recession risk and a dovish Fed. If the central bank delivers, it would make for a nice Christmas present.

Positives

  • Must be Santa The holidays got off to a strong start as November retail sales jumped 4.6% year-over-year after factoring out gas (which fell on lower prices) and autos. Gains were broad-based across categories, and online was especially robust. October’s increases also were revised up significantly, suggesting consumers entered the season with ability (thanks to strong job growth and wage gains) and willingness to spend.
  • Watch for wage hikes and more jobs in those stockings Workers are benefitting from the tightening labor market, as the NFIB’s monthly survey found increases in compensation tied a 30-year high last month and the percentage of small businesses planning to raise pay this month at its highest level since 1989. This comes as Manpower’s quarterly survey rose to a 12-year high, with all 13 industries it polls planning to add to payrolls in Q1 2019 and more than half forecasting stronger payroll growth than at the end of this year.
  • If we were ever going to get inflation, this should have been the year November’s headline and core consumer and producer prices continued to reflect moderation off higher levels earlier in the year—not enough to dissuade the Fed next week, but supportive of its recent near-neutral narrative. Ex-energy, core prices edged up on both fronts to still relatively subdued levels, while import and export prices fell. So far, increasing wage pressures cited in the NFIB and Duke/CFO surveys (below) have yet to show up in the CPI and PPI reports.

Negatives

  • Manufacturing moderating This morning’s big jump in November industrial production masked disappointing performance in the manufacturing component, which accounts for three-fourths of all production. Factory activity was flat as increases in durable goods were offset by declines in nondurable goods; October also was revised down. A broad cold snap drove the headline production number on increased utility usage.
  • More evidence that we’re in the back half of the cycle The NFIB small optimism index dipped in November to an 8-month low, 4 points off August’s record high—a sign optimism may have peaked this cycle. The Duke/CFO Magazine outlook survey suffered a similar drop to its lowest level in a year, with nearly half of CFOs expecting a recession by year-end 2019 and 82% forecasting one by the end of 2020. The results indicate the post-2016 election “Trump bump” in confidence has nearly evaporated.
  • U.S. recession watch The OECD U.S. Composite Leading Indicator fell a seventh straight month in October to its lowest level since July 2017, with the annualized 6-month rate of change suffering its biggest decline since April 2016. Despite portending weakening momentum in the months ahead, the headline reading is still solidly expansionary, indicating a potential soft patch but nothing worse.

What else

‘Shanghai Accord II’? Early 2016’s so-called “Shanghai accord” saw China stimulus, the Fed hold back on rate hikes and OPEC cut production to help stabilize oil. Synchronized global growth resulted, with the dollar weakening. Amid China slowdown questions, a Fed walking back rate increases, OPEC+ capping production and a recent reversal in dollar strength, a “Shanghai Accord II” could be underway. Fiscal stimulus also looks to be getting more popular (and perhaps more necessary) outside the U.S., with Macron’s call for French tax cuts the latest example.

Will the dollar weaken? A 5% decline by year-end 2019 is the Bloomberg consensus. But global economic growth isn’t expected to accelerate next year, and both the euro area and China are facing headwinds. Such conditions historically have worked against dollar weakness, much as occurred in 2015 when the dollar defied projections and remained stubbornly high. Continued dollar strength wouldn’t be good for earnings.

It’s not too early to talk 2020 Fast forward 689 days to the 2020 election and it may just come down to Pennsylvania to secure 270 electoral votes and the presidency, given how Ohio and Florida stood up to the Blue Wave. In terms of the 2020 Democratic field, it’s likely to eclipse the 2016 Republican field in terms of numbers, Cowen & Co. says. Gone are the previous norms and barriers to entry in presidential politics. One million social media followers and at least 35 years old? You can run—and win.

Editor's note: This will be the last regular weekly installment from Linda in the current year. Happy holidays!

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Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

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DISCLOSURES

Beta is a measure of the volatility, or systematic risk, of a security or a portfolio, in comparison to the market as a whole.

Consumer Price Index (CPI): A measure of inflation at the retail level.

Free cash flow is a measure of a company's financial performance calculated by subtracting capital expenditures from operating cash flow.

Gross Domestic Product (GDP) is a broad measure of the economy that measures the retail value of goods and services produced in a country.

Producer Price Index (PPI): A measure of inflation at the wholesale level.

S&P 500 Index: An unmanaged capitalization-weighted index of 500 stocks designated to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. Indexes are unmanaged and investments cannot be made in an index.

The S&P Composite 1500 Index combines three leading indices, the S&P 500, the S&P MidCap 400 Index and the S&P SmallCap 600 Index to cover approximately 90% of the U.S. market capitalization. The index is unmanaged, and it is not possible to invest directly in an index.

The National Federation of Independent Business (NFIB) conducts surveys monthly to gauge how small businesses feel about the economy, their situation and their plans.

The quarterly Duke/CFO Business Outlook survey polls CFOs of public and private companies around the globe.

Yield Curve: Graph showing the comparative yields of securities in a particular class according to maturity. Securities on the long end of the yield curve have longer maturities.

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