Observations and Outlook July 2018

July 5, 2018

Selected Index Returns Year to Date/ 2nd Quarter Returns

Dow Jones Industrials    -.73%/1.26%        S&P 500   2.65%/3.43% 

MSCI Europe   -3.23%/-1.27%         Small Cap (Russell 2000)   7.66%/7.75% 

Emerging Mkts -7.68%/-8.66%     High Yld Bonds  .08%/1.0%

US Aggregate Bond -1.7%/-.17%       US Treasury 20+Yr -2.66%/.07%  

Commodity (S&P GSCI) 5.47%/4.09%  

The second quarter ended with a sharp decline from the mid-June highs, with US stock indexes retreating about 4.5% and ex-U. S markets losing upwards of 6%.  This pulled year-to-date returns back close to zero in the broad stock market indexes.  The only areas doing well on a year to date basis are US small cap and the technology sector.  Equity markets outside the US are in the red year to date languishing under the burden of a strengthening US Dollar and the constant threat of a tit-for-tat Trade War.  Areas of the market with exposure to global trade (US large cap, emerging markets, eurozone stocks) have had marginal performances while areas perceived to be somewhat immune to concerns about a Trade War have fared better.

Additionally, the bond market has only recently seen a slight reprieve as interest rates have eased as economic data has consistently come in below expectations—still expanding, but not expanding more rapidly.   Job creation, wage growth, and GDP growth all continue to expand but only at a similar pace that we have seen over the past several years.  The stronger US Dollar has wreaked havoc on emerging market bond indexes have fallen by more than 12% year to date.  And in the U.S., investment grade bond prices have fallen by more than 5% year to date, hit by a double whammy of higher interest rates and a widening credit spread (risk of default vs. US treasuries) has edged up.

On the bright side, per share earnings continue to grow more than 20%, with second quarter earnings expected to climb more than 20%, thanks in large part to the Tax Reform passed late in 2017.    As earnings have climbed and prices remain subdued, the market Price to Earnings ratio (P/E) has fallen making the market appear relatively less expensive and sentiment as measured by the AAII (American Assoc. of Individual Investors) has fallen from near 60% bullish on January 4th to 28% on June 28th, a level equal to the May 3 reading when the February-April correction ended. The Dow is approximately 800 points higher than the May 3 intraday low.

With reduced bullishness, increasing earnings, and expanding (albeit slow) GDP growth, there is room for equities to move up.  Bonds too have a chance for gains.  The meme of Global Synchronized Growth which justified the November-January run in stock prices and interest rates has all but died, given Europe’s frequent economic data misses and Japan’s negative GDP print in the first quarter.   This has taken pressure off interest rates and allowed the US 10-year Treasury yield to fall from a high of 3.11% on May 15 to 2.85% at quarter end.  I would not be surprised to see the 10-year yield fall further in the coming weeks.  Muted economic data with solid earnings growth would be beneficial to bonds and stocks respectively.

In my January Outlook I mentioned how the rise in ex-US stock markets followed closely the decline in the US Dollar.   The Dollar bottomed in late February and has gained dramatically since April.  This has been a weight around European and emerging market share prices and has been at the core of the emerging market debt problems mentioned above.  Fortunately, the Dollar’s climb has lost momentum and appears ready to pull back, likely offering a reprieve to shares priced in currencies other than the US Dollar.  It may also aid in US company earnings. So, while global economic and market conditions have changed since January, hindering prices of most assets, I believe we will see an echo of the 2016-2018 conditions that supported financial asset prices globally.   A declining dollar, muted investor bullishness, slowing global growth all should conspire to allow stock, bond and even precious metal prices to rise over the coming weeks, at least until investor bullishness gets well above average and the expectation of new lows for the US Dollar become entrenched again.

Looking Ahead

As second quarter earnings begin in earnest in mid-July, expectations are for approximately 20% climb in earnings.  A large portion is estimated to be due to tax reform passed late in 2017.  With market prices subdued and earnings climbing, the market’s valuation (Price to Earnings ratio) is looking more attractive.  While not cheap by any metric, this should give investors a reason to put money to work.  In the first quarter, analysts underestimated profits and had raised estimates all the way into the start of earnings season.  This is very rare.  The chart below shows us that generally analysts’ estimates decline going into earnings season.  Estimates start off high and then get lowered multiple times usually.   Second quarter of 2018 is setting up to be another rare event where we see again earnings estimates being raised into reporting season.
factset earnings 7 2018

The downside to the effect tax reform is having on earnings will be seen in 2019.   When comparisons to 2018 and 2019 quarterly earnings start to come out (in late 2018) the impact of lower taxes on the change in earnings will be gone.  In 2019 we will only see the change in earnings without the impact of tax reform.   Earnings growth will likely come down to the upper single digits.   How investors feel about this dramatic slowing in 2019 will dictate the path of stock prices.

Quantitative Tightening (QT) will dominate the headlines towards the end of the year.  Over the past 9 years central banks have pumped more than $12 trillion in liquidity into financial markets.  The US Fed stopped adding liquidity and has begun to let its balance sheet shrink, removing liquidity from financial markets.    During 2017 and 2018 the European Central bank and Bank of Japan more than made up for the US absence.   Europe and Japan are scheduled to reduce and eventually cease all new liquidity injections during 2019.  Combined with the Fed’s liquidity reductions, global financial markets will see a net reduction in liquidity.   This will have an impact on markets.  It is argued whether this will cause bond prices to fall (rates to rise) or it will have an impact on equity markets.   I believe it is likely this will impact both areas and the likelihood of falling bond and stock prices at the same time is significant.

US Dollar liquidity is another topic just starting to show up in the press.   The rise in 2018 of the US Dollar after a long decline has taken many market participants by surprise.  The “short US Dollar” and “short Treasury” trades were the most popular at the beginning of the year and have been upended.  It is often that once ‘everyone’ knows something, like that the US Dollar will continue to weaken, its about the time that area reverses and goes against how most are positioned.   The mystery really was given rising interest rates in the US and a stronger economy, why was the US Dollar weak to begin with?  Now the causes of a stronger Dollar are the weakness in Eurozone and Emerging market growth.    But which came first, the stronger Dollar or the weaker economies?

Below we can see the relationship of the US Dollar (UUP) and the TED Spread which is the difference in short term rates in the US and Europe.  The recent spike in funding costs (rates) parallels the rise in the Dollar index.  The rapid Dollar rise in 2014 was partly responsible for the Earnings Recession we saw in 2015.  There’s about 6 months to a year lag from when the Dollar strengthens to its impact on earnings.

ted spread july 2018

Ironically, part of the Tax Reform passed is a cause of poor Dollar liquidity (higher short-term rates result) and the strengthening Dollar.  The ability for US firms to repatriate earnings from abroad at a lower tax rate is causing Dollars to move from Eurozone back to the US.  Additionally, the $1 trillion plus budget deficit the US will run in 2018 and on into the future is also soaking up liquidity.  Repatriation, US deficits, and Fed tightening are all pushing the US Dollar up, and will likely see the Dollar stronger in 2019, which may impact US earnings in 2019.

Finally, there is China.   China is the largest consumer of raw materials.  Besides US PMI, the China Credit Impulse impacts base metals and other raw materials that other emerging market economies export.  When China is creating more, new credit we can see a rise in prices and in the growth of raw material exporting countries and a rise in US PMI with about a 12-month lag.  The chart below indicates that beyond the first half of 2018 the impact from the past China impulse will be fading.   This fade is happening at the same time global Central banks will be withdrawing liquidity and the US Dollar likely strengthening.   This scenario doesn’t bode well for risk assets in 2019.

china credit impulse pmi

Adam Waszkowski, CFA

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May Turn Up in Stocks Likely to Last

After a very volatile correction lasting just over 4 months, May 3 marked a turn up in markets.   During the correction some indices made consecutively lower highs, and either higher lows (creating a triangle formation, small cap indices) or held at support multiple times (large cap stocks).    May 3 saw a price reversal and only a few days later many indices were making higher highs, breaking up through the downtrend.  During the rest of May stock price marched higher, despite on going geopolitical concerns and a disruptive Italian bond market.

International stocks also turned up early May, but were thwarted by the ongoing difficulties, politically and regarding the US Dollar strength.   Ex-US stocks appear to have retested correction lows at the end of May but have yet to catch up to US markets in exceeding high-water marks during the January-April correction.

Drivers of the renewed bullishness in prices are both fundamental and sentiment driven.  Fundamentally, earnings in Q1 grew by more than 25% year over year, with upwards of half that coming from tax reform.  After hitting a 7-year bullish extreme in January at 59%, sentiment towards stocks became quite negative after the correction took hold, bottoming at 26% bulls in early March.  Recently bullish sentiment was back up to 35%, and I expect bullish sentiment to increase to very high levels again prior to any significant declines in stock prices.

Additionally, the record earnings (and Q2 forecasts) have driven down the market Price to Earnings ratio from nearly 25x in January into the mid 22x range, based on trailing 12 months as-reported earnings.  Furthermore, according to FactSet analysts have been raising Q2 forecasts, contrary to history where estimates steadily decline into earnings season (setting up easy ‘beats’).   The decline in prices and increase in earnings, past and forecast, has pushed the ratio down, and essentially removed the discussion of how expensive the market is.   Sentiment moving up from lows, and earnings (be they tax driven or economic) climbing should make it easy for investors to push money into stocks over the coming weeks or months.

This Correction Was Different

The dive in stocks in February came on the heels of a rise in interest rates.  The yield on the 10-year Treasury went from 2.38% December 29, 2017 to 2.85% on January 29.  This significant rise is akin to the rise in rates after Trump’s election and the ‘Taper Tantrum’ when Fed Chair Bernanke stated that the Fed will raise rates ‘sometime in the future’ in the summer of 2013.  Both post-election and in the summer of 2013 stock prices rose as bond prices fell (bond prices and rates move inversely to each other).    This time however rates were ‘too high’ and would either effect corporations’ profits or the relative attractiveness of stocks vs bonds, causing (or at least giving a reason) for both stocks and bonds to fall at the same time.

The significant prior declines in stock prices late 2015/early 2016, as well as 2nd half of 2011 (US credit rating downgrade) were accompanied by a decline in interest rates, pushing up bond prices.  The past several large moves in either rates or stock prices were met with opposite reactions from the other asset class.  This behavior is the root of Modern Portfolio Theory, investing across asset classes to reduce volatility.   This natural diversification that has been at the root of finance academia for over 30 years, but may be coming to an end.

The result is that investors who are more conservative, seeking a traditional 60/40 stock and bond split may encounter fluctuations like those more aggressive investors who are much more exposed to stocks.   And the worst-case scenario of a bear market in stocks may be accompanied by rising rates/falling bond prices.   Investors who are not aware of this and who do not have a plan on how to reduce volatility in both asset classes will have a very difficult time when the current bull market ends.  It will be important going forward to have a strategy in place if both assets decline in price and not rely on traditional diversification concepts.

Adam Waszkowski, CFA

April Recap: Narrative Changes

Stocks rose a fraction of a percent, gold fell 1%, and the bond index fell 1% in April, continuing the very choppy sideways price movement we’ve experienced this year.   The month ended just below middle of the price range we’ve seen since the market top on January 26th.

Over the past few weeks, earnings have been spectacular, growing over 20% on an annual basis.  Unfortunately, stock prices have not reacted well to this great news.  Earnings season appears to have a ‘sell the news’ feel to it.  This could support the notion that stocks were priced to perfection going into reporting season.    The decline in prices and increase in earnings has reduced the market P/E (Price to Earnings) multiple, which could allow stocks to rise back to January levels.   Tax Reform has accounted for about 1/2 of the earnings growth.  There are two issues going forward.  One is that continuing

to grow at that pace will be difficult since we cannot cut taxes every year (and the tax changes to individuals are front loaded—the reductions we have seen will fade in the coming years). Secondly, earnings’ growth slowing, even from 20% to maybe 12%, can be seen as a negative: “slowing earnings growth”.   Surprising positive economic data because of tax reform needs to show up immediately, otherwise, the ‘hope’ baked into stock prices may be removed in the coming months.

Through the month of April, the narrative of ‘global synchronized growth’ has changed as European economic data has come in softer than expected and the US economy has pressed on.  So now we see the US as a main driver of global growth.  In the very short term, this narrative change has given the US Dollar a boost up.   Over the past few months, ‘dollar short’ and ‘rates higher’ have been very popular trades and have begun to unravel.   A stronger dollar will do harm to future US corporate earnings, make $-denominated emerging market debt more difficult to pay back, and serve as a headwind to ex-US assets (emerging, Asian and European stocks and bonds).  And slower growth will not support higher rates for longer term bonds.

The change in the growth narrative/data has been substantial enough for the Federal Reserve to remove from its FOMC Statement, “The economic outlook has strengthened in recent months.”   Often the Fed will change a word or two in certain sentences.  They could have change it from ‘strengthened’ to ‘remains strong’ or ‘continues to expand’.  Instead they dropped it altogether.   This is influencing perceptions of how many times more this year the Fed will raise short term rates.  In the WSJ today the front-page headline, “Fed is On Course for Rate Increases”.  Given the boldness of this headline, its odd to see in the article an inference that even if inflation was stronger, the Fed wont raise rates more than already indicated, which is twice more this year.  There is a dichotomy in the Fed’s statement: taking out the growth story but keeping to the idea that rising inflation is OK, or even good.  Last time I checked, slowing growth and rising interest rates weren’t a good combination: stagflation.   The Fed needs to review the difference between ‘cost-push’, and ‘demand-pull’ inflation.

AAII sentiment for the week ending May 2 came out this morning and Bullishness declined, and Bearishness increased.  This is as expected given that stocks were down over those survey days.  Bullishness isn’t quite as low as I’d like to see for a good bottom, but if stocks can undercut February’s lows, we should see Sentiment get negative enough to support a rally in stock prices going into the late Spring.

Adam Waszkowski, CFA

Lions, Tigers, Bears & Trade Wars – Oh My!

Volatility has returned to the markets. What to make of it and how to respond accordingly.

While it may seem like ages ago, the bull market was at historic highs earlier in the year (January 26th), but since then headwinds have picked up. It’s fair to wonder if things could get even worse from here on growing geopolitical tension.

2018 has been a whole lot different than 2017. Last year, stocks marched higher with only minor pullbacks; the largest peak to trough decline for the S&P 500 was less than 3%. 2017 was a year that lacked turbulence and rewarded investors handsomely.

Since early February, volatility has returned, taking stocks on varying swings of good days and bad. Many of those episodes were based on errant tweets that became de facto policy statements. Investors have had a hard time knowing how to respond to the daily barrage of tweets.

I’m sure I’m like most in that I abhor uncertainty, but every day we seem to be awaking to surprise policy moves that could start to harm the economy. I generally disdain discussing politics, so my thoughts aren’t political statements rather commentary on events that affect investors’ monies in the capital markets.

For long-term investors, we should all look past it, but I know that in the short-run discounting such hyperbole can be tough to do.

I like to look at more persistent measures that better gauge the markets. I consider them 3 legs to a bar stool – the nation’s overall economic situation (+); corporate profitability (+); and investor sentiment or crowd psychology (~).

National Economic Growth
We’re in the 3rd (very soon to be the 2nd) longest economic expansion in U.S. history, an expansion that’s broad-based across a full range of sectors with consumer spending, manufacturing activity and construction all showing robust figures as part of a global trend of stronger-than-expected growth. Looking ahead, U.S. gross domestic product (GDP) growth could well average 2.5% this year and next.

For now, there aren’t any real signs that the economy has fundamentally down-shifted. The expansion that started 9 years ago is still underway, buoyed by near record-level stock market performance, low unemployment, robust job growth and other key economic indicators heading in the right direction.

While job productivity has slackened, it’s made for an environment where unemployment is extremely low, allowing for wage gains to build as talent becomes increasingly scarce, forcing competition amongst businesses to bid for workers. While that’s good for workers finally getting their fair shake, it’s wage inflation that the Fed Reserve likes to tamp down so look for 2-3 more benchmark interest rate hikes over the remainder of the year.

1st Quarter Corporate Earnings Outlook
Corporate earnings, the primary driver of stock prices, still look great according to FactSet. For the first quarter, earnings growth rate for the S&P 500 is expected to increase by 17.1% (reports have started to come in, and we’ll get most throughout the rest of the month). The forward 12-month price-to-earnings (P/E) ratio for the S&P is currently around 16.5, above the 5-year average of 16.1 but down significantly from overstretched P/E valuation in January. While earnings are expanding, valuation multiples are contracting (at least until stock prices start to pick up again).

What’s driving a good amount of earnings-per-share (EPS) guidance is good end-demand growth, both domestically and abroad. Secondarily, this is the first earnings report where we’ll feel the impact of the new tax act in lowering corporate tax rates. While the statutory rate is now lower, many multinational companies’ effective rates are already much lower. The effects of lower individual tax rates on investments made are more indirect and probably won’t be felt in earnest until tax season next year.

Global Growth
Spurred on by higher profits and buoyant stock markets, companies around the world appear to be loosening up their purse strings as capital spending starts to tick up (barring growing worrisome protectionist trade friction). Hopefully as the global economic expansion gathers speed, capital investment will stoke not just demand, but ultimately higher wages and inflation, especially when employers have been reluctant to spend even amid an economic upswing.

Analysts’ S&P 500 Price Target
For the 1st quarter of 2018, the S&P 500 lost -1.2% in value, the first down quarter since the 3rd quarter of 2015. Since then, we’ve had a rocky start to April.

According to FactSet, industry analysts (bottom-up price targets) see roughly a 16% increase for the S&P 500 over the next 12 months. At the sector level, Health Care is expected to growth by 18.8%, Information Technology by 18.2%, and Energy by 18.0%. The Utility sector is expected to see the smallest price increase, +4.8%.

Corporate leaders, in their earnings announcements, will also give us guidance on how they expect their businesses to be impacted by the threat of tariffs. Economists and Wall Street analysts will also be chiming in as to the cost in terms of economic growth, jobs, and earnings.

Investor Sentiment
According to the American Association of Individual Investors (AAII) weekly sentiment survey, for the week ending April 4th, pessimism about the short-term direction of stock prices has spiked to its highest level in more than 7 months.

The reason for the dramatic change in mood? Tariffs, counter-tariffs and an escalating trade war with China, let alone a pending renege on NAFTA which would ensnarl all 3 of our largest trading partners, accounting for about $1.7 trillion of trade annually, according to the U.S. Census Bureau.

If there’s a somewhat positive take-away, it’s that tariffs will take several months to implement, so there’s time to negotiate, find common ground, and curtail escalating the matter.

Détente will surely be at hand. But, ramifications of irreconcilable ideological and economic differences between an aging superpower and a rising superpower will linger on in some form or fashion (similar to the Soviet area).

Technology Stocks
Another concern weighing on investors is within the technology sector. Facebook is embroiled in a controversy over privacy and data sharing, and Amazon, up 50% in the past year, sank after the president renewed his attack on the online retailer.

Because of Facebook’s scandal, techlash has been gaining momentum. Since consumer data is the key competitive edge of social media firms, it means there’s always a heightened level of risk and uncertainty surrounding one’s personal information. I don’t think the Cambridge Analytica scandal even remotely compares to Equifax’s data breach in which Social Security numbers, names, addresses and even some bank information was stolen. And, nearly half of the nation has not taken any action to protect their data since the Equifax breach, according to a recent MagnifyMonyey survey. Wow!

While other tech companies fell in sympathy over Facebook’s problems, I don’t see that much follow-through collateral damage to other tech companies and industries. This whole issue may blow over just as quick as it started.

FAANG Stocks Bursting?
I don’t necessarily think so, but these stocks were/are ripe for profit-taking as investors have been increasingly risk-off and looking to lock in gains. Sure, some of the shiny veneer has come off, but tech stocks, specifically FANG stocks (Facebook, Amazon, Netflix, Google) or FAANG (inclusive of Apple), or Fab 5 (inclusive of Microsoft, minus Netflix) have been some of the biggest bull market gainers, even after their recent price drops. These mega-cap tech stocks have lured investors with momentous gains more than triple the market since 2016.

Will technology, in general, be out of favor? Not likely, but there could be a rotation out of FAANG into more fundamentally sound growth stocks elsewhere in the space. There will still be money earmarked to the technology sector, especially big-cap names that offer ample liquidity.

As this rotation within the all-important tech sector transitions, it’s incumbent upon investors to identify where the next big moves are coming – artificial intelligence (AI), robotics, cybersecurity, financial technology (fintech), mobile computing, cloud computing, autonomous cars to environmental technology. Health care too will be a beneficiary as we witness genetics research break-throughs, which will hasten people living longer – and they’ll need income to support themselves in their golden years.

Should you lower your overall tech exposure? That depends. As a Bloomberg Businessweek article recently stated, “Investors comfortable with risk and who have years of earnings power ahead might be happy with their tech exposure. They can ride out market cycles. It’s more complicated for those approaching or in retirement, who have less time to rebuild savings. It’s important to know whether your retirement fund is heavy in tech and to be comfortable with the increased volatility that may bring. Panic selling rarely turns out well.”

Heightened Volatility Weighing on Investors
Investors seems particularly worried right now that a big change is under way. That’s at least what the financial news headlines would have you believe; these news outlets are media companies vying for your attention as much as Facebook.

There are important concepts to remember however. In every decline, no matter how severe, markets ultimately tend to stabilize, and so far, this correction is run-of-the-mill.

Cognitive Dissonance
Remember the last time stocks fell so hard? You probably don’t, and that’s making it all seem a little harsher than it is.

It’s a fact of life of the mind that things always seem worse in the present. But in fact, they’re not. Behavioral economist & Nobel prize winner, Richard Thaler, explored biases and cognitive shortcuts that affect how people process information.

[Read more here: https://www.bloomberg.com/news/articles/2017-10-27/how-to-profit-from-behavioral-economics].

In this bull market alone, there’s been 5 other corrections like this one, and it’s taken around 7 months on average for equities to climb out of their hole, data compiled by Bloomberg show. Based on that path, investors’ anxieties will linger until August.

At the same time, just because bouts of losses are normal doesn’t mean they’re painless, especially when momentum stocks (FANG) are leading the way lower. But the statistic is a reminder that it’s unrealistic to expect a market recovery to involve a straight line back up.

It seems even worse because of how placid markets have been since the last disruption. While individual stocks seem to be regularly rising and falling 5% these days, consider that in 2016 and 2017 the S&P 500 went through several long stretches without posting a single up or down day of more than 1%. Through April 10th, 1% daily moves in the S&P 500 has occurred 28 times this year. In 2017, we only had 8 such days.

“You had this incredible low-volatility environment, but markets are supposed to go up and down,” stated Michael O’Rourke, Jones Trading’s chief market strategist.

A move back to a normal market environment is usually hard to take. According to LPL Research, the average intra-year pullback (peak to trough) for the S&P 500 since 1980 has been 13.7%; half of all years had a correction of at least 10%; 13 of the 19 years that experienced an official correction (10%+ down) finished higher on the year; and the average total return for the S&P during a year with a correction was 7.2%.

The take-away? Turbulence surfaces more often than we recall and patient investors who don’t react emotionally have historically been rewarded. Don’t let short-term market volatility guide your allocation; your investments should reflect your time horizon.

Moving Forward
Springtime is here – a time of rebirth and regeneration, so while the weather may still be a bit cold or inclement, it offers up to evaluate the year so far, to review one’s long-term goals, and clean one’s minds (and homes) as we get ready for summer fun.

Your money life should never be ignored, but it shouldn’t be all-encompassing that it captures too much time away from what you love and care about. The idea is to find a workable balance between your money life and the rest of your life.

I have a hunch that most people would agree they should invest for the future. My second hunch is that many individuals don’t know how to start and are afraid of making serious mistakes, so initial impetus fades.

The work I do, and that of my fellow advisors, is about creating better outcomes for investors. I hope you find my communications informative and not too heady. Please contact me with any questions you may have, and if you or anyone you know is in need of advice, please send them my way.

Observations and Outlook April 2018

First quarter of 2018 turned out much differently than investors had been expecting at the turn of the New Year.  In January’s note, there were many sentiment indicators that had eclipsed their all-time highs. The highest percentage of investors expecting higher prices in twelve months was recorded.  Equity markets peaked on January 26 and fell 12%, followed by a large bounce into mid-March then subsequent decline that left us at quarter end about 4% above intraday lows from February.  We may be seeing the first stages of the end of the 9-year-old bull market.  Looking back at 2007 and 2000, the topping process can be choppy with market gyrations of +/-10%.   This is a complete 180 degree turn from the past two years where volatility was non-existent and equity markets went the longest period ever without a 5% decline.  Expect continued choppiness as the impact of Tax Reform filters through the economy and if corporations can continue the blistering pace of earnings growth going forward.  At the same time for mostly the same reasons, interest rates are likely to be range-bound.  Very recently the price of oil climbed on a news release that the Saudis would like to see $80/bbl oil.  Rising oil prices would be akin to a tax on consumers and hamper US growth.

Sentiment as seen by the AAII % bullish rolling 8-week average has declined from its euphoric high at 49% in January, down to 33%.  At the bottom of the last correction in early 2016 this average was 23%.  The current correction may be over and a lot of selling pressure has been exhausted there is room to the downside still. A reading in the mid 20% has been a good area to mark a low in the markets.  Sentiment is often a lagging indicator.  Investors are most enthusiastic after large price gains.  The opposite is true too in that sentiment numbers go low after a price decline.   It can be helpful to take a contrarian view as sentiment measures move to extremes.

aaii rolling bulls 4 2018

Blame for the downturn in January was due to a slightly hotter than expected print of Average Hourly Earnings (AHE), and the resulting concern over how quickly the Fed will raise interest rates.  The rapid change in AHE has not followed through into February and March, yet stocks remain well off their highs.  Analysts have been looking for wage pressures due to very low unemployment numbers for a long time.  The lack of wage growth is likely to the re-entrance of discouraged workers back into the labor force.  As a discouraged worker, who ‘hasn’t looked for work in the past month’, they are removed from the workforce.  When the number of unemployed decreases (the numerator) along with the total workforce (the denominator), the unemployment percentage rate goes down.  A low unemployment rate at the same time there is little wage pressure is due to the workforce participation rate being very low.  Focusing on the total number of people employed, which is still growing on a year over year basis, may give us a better read on employment situation without looking at the unemployment rate.  Any impact from Tax Reform should show up in an acceleration of year over year Total Employees growth.

total employed 4 2018

A more telling chart, and perhaps the real reason behind President Trump’s fiscal stimulus is the following chart. Using the same raw data that created the above chart, the chart below tracks the monthly, year over year percentage change in total nonfarm employees in the United States.  There are no seasonal adjustments etc.  While we are growing, the rate of increase in the total number of people working, is slowing.

% change in total employed 4 2018

Forward guidance from companies will be critical.  Expectations are still quite high regarding full year earnings and end of year price target for the S&P500, currently about 3000, 15% higher than todays price level.  During the first quarter, when earnings from Q4 2017 were reported, companies beating earnings estimates were rewarded only slightly, while companies missing earnings had their stock prices pushed down.  It seems there is still a ‘priced to perfection’ hurdle that companies must overcome.

 

The largest macroeconomic driver for the remainder of the year is the now global shift from QE (quantitative easing) to QT (quantitative tightening).   This global liquidity spigot the Central Banks have been running on full blast for the past 9 years has begun to end.  The US Federal Reserve stopped buying bonds (adding dollars to markets) and began raising rates.  These are tightening liquidity.  While in 2017 the European and Japanese central banks more than made up for the Federal Reserves actions, both have been broadcasting plans to temper their liquidity injections.  China is tightening as now in preparation for increased stimulus to coincide with the Communist Party’s 100th anniversary in power in 2021.

Over the past 9 years global liquidity additions has been the key driver to global asset prices.  As these additions slow and become subtractions, one must assume it will impact financial markets.  Most importantly global US Dollar-liquidity is the most important as the Dollar is the global reserve currency.  Recently the LIBOR-OIS has been in the news, having risen dramatically over the past few months.  This index is a rate that compares the overnight cost of interbank dollar borrowing in the US vs Europe.  The cost to borrow US Dollars in Europe has gone up dramatically.  A low cost would reflect ample Dollars for those who need them, a higher cost reflects a shortage of dollar-liquidity.  The TED Spread compares the interest rate on 90-day treasury bills and the 90-day LIBOR rate.  The TED spread is 90-day rates and the LIBOR OIS is overnight rates, and they follow each other closely.    The crux of it that they both measure the availability of funds in the money markets.  If these rates go up, it is seen as a decrease in available funds.

ted spread and us dollar 4 2018

The chart above tracks the TED spread and the US dollar.  The relationship is loose but fits well over multiple quarters.  If this relationship is correct, the US dollar should dramatically increase in value in the coming months.  An increase in the US Dollar will push the prices of non-US assets lower, make dollar denominated debt widely used in emerging markets more difficult to pay back and have further repercussions in debt markets.  A weak US Dollar is the underpin of global asset prices, and a stronger dollar, along with Quantitative tightening will be a strong headwind to asset prices in the second half of 2018.  If earnings can continue to growth strongly and more workers can be added at a strong pace, both leading to more credit growth, this headwind may be able to be offset.

In addition to international money market rates, the slowing velocity of money has been a constant impediment to economic growth.  Or, rather, the low velocity of money is indicative of an economy that continues to languish despite massive amounts of new money put into the system.  If the pace of money flowing through the economy slows, GDP can be increased by putting more money into the system.  More money moving slowly can be like a small amount of money moving quickly.   If money is removed from the system via tightening measure from central banks, and we do not see an increase in the velocity of money, GDP will decline.  The slowing of VoM has been a problem since 2000 and is likely directly related to ‘why’ the Fed keeps rates extremely low for very long periods of time.  Of course, if VoM were to return to 1960’s levels, interest rates would be substantially higher, causing a re-pricing of all assets—which is a topic for another day.

fredgraph

Adam Waszkowski, CFA

awaszkowski@namcoa.com    239.410.6555

This commentary is not intended as investment advice or an investment recommendation. Past performance is not a guarantee of future results. Price and yield are subject to daily change and as of the specified date. Information provided is solely the opinion or our investment managers at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Information provided has been prepared from sources deemed to be reliable, but is not guaranteed by NAMCO and may not be a complete summary or statement of all available data necessary for making an investment decision.  Liquid securities, such as those held within managed portfolios, can fall in value. Naples Asset Management Company, LLC is an SEC Registered Investment Adviser. For more information, please contact us at awaszkowski@namcoa.com

Was that the Top or the Bottom?

The Wall Street Journal had a very good article detailing one of the root causes of the February decline.  A classic ‘tail-wagging-the dog’ story about derivatives and how they can impact other markets that are seemingly unrelated.  While the outlook for global equities informs the level of the VIX, we have just seen an incident where forced trades of VIX futures impacted futures prices of equity markets.   Its as though the cost of insuring against market declines went up so much that it caused the event it was insuring against.

Even with that being known, the impact to market sentiment has been dramatic.  Most sentiment indices went from extremely optimistic to extreme fear in a matter of days.  This change in attitude by market participants may have a lasting impact.  A rapid decline like we saw in February will reduce optimism and confidence (which underpin a bull market rise), and increase fear and pessimism, which are the hallmarks of a bear market.   Short term indicators turned very negative and now are more neutral, but longer-term sentiment indicators will take a longer decline to move negative.

Often the end of a bull market is marked by a rise in volatility, with equity prices falling 5-10%, then climbing back up only to get knocked down again, until finally prices cease climbing back up.  This can take several weeks or months.  We can see this in the market tops in 2000 and 2007.  This may be occurring now.  Many of the market commentary I follows the approximate theme of ‘markets likely to test the 200-day moving average’.  This is the level the February decline found support.  This would be about 7% below current prices, and have the makings of a completed correction, finding support once and then retesting.

Since the market highs in late January the major stock indices fell 12%, then gained 6-10% depending on the index.  Since that bottom and top; markets moved down about 4.5%, then again up into yesterday (3/13/2018) gaining 4% to 7%.  Tech shares and small caps have outperformed large cap along the way, rising more, but falling the same during this series.   Recognizing the size of these moves and the time frame can help manage one’s risk and exposure without getting overly concerned with a 2-3% move in prices.  But if one is not aware of how the 3% moves are part of the larger moves, one might wait through a series of small declines and find themselves uncomfortable just as a decline is ending—contemplating selling at lower prices as opposed to looking to buy at lower prices.  Hedging is a process to dampen the markets impact on a portfolio in the short term while looking for larger longer-term trend turning points. The high in January and current decline and bounce are likely a turning point over the longer term and in the near term provide investors with parameters to determine if the bull trend is still intact.