They were talking DEE-fence in Chicago and it wasn't about Da Bears They were talking DEE-fence in Chicago and it wasn't about Da Bears March 15 2019

They were talking DEE-fence in Chicago and it wasn't about Da Bears

Advisors are turning defensive even as stocks flirt with new highs.
Published September 19 2018
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[Editor’s Note: Because of vacation schedules, this week’s edition is being published two days earlier than normal.]

I spent the week in Chicagoland, to include not only the Loop but Rockford, Elgin, Naperville, Oak Brook, Deerfield, Glenview and Lombard. As in last week’s travel, advisors here were starting to feel defensive, a view reflected in the market. The biggest gainers this month have been defensive names. Tech, on the other hand, has been selling off. Even with the Dow and 500 on the verge of new highs, advisors say their clients are still “not feeling the bull.’’ They complain that “diversification is killing me”—small caps and growth are all that’s been working; international definitely has not. “Is that about to change?” I was asked numerous times. While international markets are oversold, the long-term performance profiles of non-U.S. developed and emerging markets () indexes continue to be weak in established downtrends. The 65-day performance spread between the S&P and the MSCI EM index suggests everybody hates EM. Arguably, this performance chasm is a favorable setup for international over U.S. stocks. And historically, it’s been unwise to be short much of anything into mid-October, particularly high-beta EM stocks. With the bulls pushing a 17 multiple on consensus 2019 S&P earnings, JPMorgan thinks the risk/reward outlook favors non-U.S. equities, especially EM and China in particular. I remain Team U.S.A. for now, with the proviso that if significant progress is made in the trade dispute with China, EM stocks should have a much bigger bounce than the S&P.

Technical signals continue to give a conflicting take on this market. At around 50%, the percentage of NYSE issues above their 30-week moving average is surprisingly low. On the other hand, all of the key weekly and daily advance/decline lines have been making new cycle highs. Market breadth also seems somewhat concentrated, despite robust GDP growth, improving margins and P/Es that are declining even as earnings per share rise—the last time this happened was 2011. Amazon, Apple, Microsoft, Alphabet (Google) and Netflix have accounted for nearly half of S&P’s return so far this year. Still, Dudack Research reports the late August record high in the NYSE cumulative advance/decline line reflects good underlying breadth, and notes various sentiment indicators show no signs of excessive optimism. Meanwhile, the 10-year Treasury yield broke through 3% this week and global yields followed suit. Yields should be higher on the back of a stronger U.S. economy, potential stabilization in EM & eurozone activity and a tightening global labor market that’s starting to bleed into inflation. At 8.3%, eurozone unemployment is 100 basis points away from a euro-era low. In the U.S., core CPI is at the top of its 10-year range and average hourly earnings are at cycle high 2.9% (still muted relative to past cycles). The concern is equity P/Es may have to de-rate, i.e., compress, as bond yields move higher. However, the valuation cushion remains substantial—the MSCI World P/E is in line with 30-year averages and global bond yields are still almost 250 basis points below long-term averages. This week’s run-up in yields was across maturities but caused some slight steepening in what is still a fairly flat yield curve; at current levels, it’s consistent with a 10%+ equity return over next 12 months.

What would be the biggest surprise for investors in the final months of the year? A “Red Wave’’ that keeps Republicans in control of both the House and Senate. Nothing in the polling today suggests this is likely (see “A wave or a ripple,’’ at bottom). If it were to happen, it undoubtedly would embolden the Trump administration to double down on already-expansive fiscal policies. Tax cuts 2.0 would include making the last year’s tax reform permanent and other concepts such as indexing capital gains to inflation. The equity market would love this. Interestingly, the S&P has not declined in the 12 months following a midterm election since 1946, most likely due to the fact that presidents usually lose seats in their midterms and become more pro-growth to aid their re-election. At Federated, we’re sticking with our forecast of 3,100 on the S&P by year-end; a strong close in the final months has been typical of midterm election years. Bumps along the way are likely—we have a Fed meeting next week, and the trade war with China appears to only be getting uglier. But even with an expected two additional rate hikes this year, Fed policy is far from restrictive. And as Trump keeps tacking more tariffs on China imports, China is running out of U.S. imports to counterpunch. The only way it may be able to break this tit-for-tat cycle is inflict pain through the financial markets. Perhaps these concerns are why defensive names have taken the recent lead. DEE-fence! Hey, any Steelers out there want to give us some D?


  • Capex is doing fine While stock buybacks and dividends have eaten a chunk of the corporate tax cuts, companies continue to shell out more for capital expenditures (capex). First-half S&P capex jumped 19% to $341 billion, and capex surged in this month’s New York Empire services survey. The Associated Builders and Contractors reports that construction backlogs stand at a record high 9.9 months, led by a record backlog in the industrial sector.
  • The consumer is doing fine The University of Michigan’s initial take on September sentiment rebounded to its second-highest reading since January 2004, bringing it in line with other measures that suggest consumer attitudes are at multi-decade highs. This should continue to support spending—despite some moderation in vehicle sales, August retail sales rose at their fastest year-over-year (y/y) pace on a smoothed basis since December 2011.
  • Manufacturing is still strong Although the New York Empire manufacturing index fell to a 5-month low in September on moderating shipments and new orders, this follows a 10-month high in August, which was a strong month for the ISMs and industrial production, with the latter rising at its quickest y/y pace in eight years.


  • Housing is slowing Housing starts rose in August and were revised up in prior months, but the increase was powered by a surge in multifamily units—an indication that houses are becoming increasingly too expensive for a lot of people. Permits fell, and builder sentiment held at its lowest level of the year as the outlook has diminished.
  • Not many are talking about this Depending on what happens in this final month, the federal budget deficit’s on track to possibly exceed $1 trillion this fiscal year, a figure we’re likely to see and hear for years to come as rising rates drive up net interest payments and defense spending keeps climbing. It will be important to remember that the deficit currently represents about 4.1% of GDP, less than half the 10% share the last time the deficit reached $1 trillion.
  • No choice but to keep working The median retirement account balance among working-age Americans is zero, according to a research report by the National Institute on Retirement Security, a nonprofit research group based in Washington.

What else

This cannot stand With technological dominance key to geopolitical dominance over the next 10-20 years, the years of China running afoul of intellectual property rules has come to a head. Western leaders beyond just the U.S. are telling the World Trade Organization that allowing what has happened over the past 20 years in the intellectual property space to continue over the next 20 years would be sovereign suicide. This was a hot discussion topic in my visit to K.C. and Texas last week.

Not many are talking about this America’s deregulation binge since President Trump took office is totally unlike what is happening in Europe, where the Institutional Strategist reports hearing story after story of increased regulation that is choking off activity in fields as diverse as finance to sterilizing dental instruments. The deregulation push under Trump may be the most underpriced and under-appreciated economic policy of the past two years.

A wave or a ripple? A Congressional Generic Ballot poll recently published on the Drudge Report had Democrats with a record 14 point lead over Republicans in the midterm elections. But a poll by Rasmussen Reports, which surveys likely rather than registered voters and was the most accurate in calling the Trump presidency, said an 8-point, late-winter Democrat advantage fell to zero a month ago and now stands at 4 points.

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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.

Beta analyzes the market risk of a fund by showing how responsive the fund is to the market. The beta of the market is 1.00. Accordingly, a fund with a 1.10 beta is expected to perform 10% better than the market in up markets and 10% worse in down markets. Usually the higher betas represent riskier investments.

Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices.

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

Diversification does not assure a profit nor protect against loss.

Dow Jones Industrial Average ("DJIA"): An unmanaged index which represents share prices of selected blue chip industrial corporations as well as public utility and transportation companies. The DJIA indicates daily changes in the average price of stocks in any of its categories. It also reports total sales for each group of industries. Because it represents the top corporations of America, the DJIA's index movements are leading economic indicators for the stock market as a whole. Indexes are unmanaged and investments cannot be made in an index.

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

International investing involves special risks including currency risk, increased volatility, political risks, and differences in auditing and other financial standards. Prices of emerging-market and frontier-market securities can be significantly more volatile than the prices of securities in developed countries, and currency risk and political risks are accentuated in emerging markets.

The MSCI Emerging Markets Index was created by Morgan Stanley Capital International (MSCI) to measure equity market performance in global emerging markets.

MSCI-World Index: An unmanaged index representing the stock markets of 23 countries, comprising 1482 securities-with values expressed in U.S. dollars. Investments cannot be made directly in an index. Indexes are unmanaged and investments cannot be made in an index.

Price-earnings multiples (P/E) reflect the ratio of stock prices to per-share common earnings. The lower the number, the lower the price of stocks relative to earnings.

The Empire State Manufacturing Index gauges the level of activity and expectations for the future among manufacturers in New York.

The Empire State Non-manufacturing Index gauges the level of activity and expectations for the future among non-manufacturers in New York.


The New York Stock Exchange (NYSE) advance/decline line measures the ratio of advancing stocks to declining stocks.

There are no guarantees that dividend-paying stocks will continue to pay dividends.

The University of Michigan Consumer Sentiment Index is a measure of consumer confidence based on a monthly telephone survey by the University of Michigan that gathers information on consumer expectations regarding the overall economy.

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