Weekly Market Summary

Summary: All of the US equity indices made new all-time highs again this week. Treasuries were the biggest winner. A drawdown of at least 5-8% in SPX is odds-on before year year end, but there are a number of compelling studies suggesting that 2017 will probably continue to be a good year for US equities.

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On Friday, SPX and DJIA made new all-time highs (ATH). During the week, COMPQ, NDX, RUT and NYSE also made new ATHs. All the indices moving to new highs together suggests that this is a broadly based rally. The trend remains up.

For the week, SPX and DJIA gained 1%. NDX notched a 0.4% gain and RUT closed lower. The biggest gain came from treasuries, with TLT gaining 1.4%. We continue to like the set up in treasuries, as explained in detail last week (here).

Little has changed from last week's summary. Instead of repeating those the same messages, we'll highlight four new studies that show a favorable longer term outlook for US equities.

First, SPX has now gone 76 days since the last 3% drawdown ended on November 4, right before the US election. That is the longest streak since July 2006 to February 2007, when the SPX went 150 days without a 3% drawdown. The chart below shows the duration and magnitude of the current rally relative to other long streaks in the past 14 years (yellow highlighting equals the current rally). Enlarge any chart by clicking on it.

Weekly Market Summary

Summary: US equities continue to make new all-time highs each week, supported by strong equity fund inflows and macro data that has exceeded expectations. Surprisingly, equities outside the US are actually outperforming the S&P. The current trend is very extended and there are four notable headwinds that may impact equities in the weeks ahead. There is, conversely, a favorable set up in the bond market.

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On Friday, SPX, DJIA, COMPQ and NDX all made new all-time highs (ATH). During the week, RUT and NYSE also made new ATHs. All indices moving to new high together suggests that this is a broadly based rally.

The equity rally is broad in another sense as well. In the past 3 months, markets outside the US have outperformed the SPX. Europe and emerging markets have led, and the World ex-US index has gained 9%. In the US, the NDX is leading. Enlarge any chart by clicking on it.

Fund Managers' Current Asset Allocation - February

Summary: Global equities are more than 25% higher than in February 2016. A tailwind for this rally has been the bearish positioning of investors, with fund managers persistently shunning equities in exchange for holding cash.

That's no longer the case.  Fund managers became bullish again in December, and remain so now. Optimism towards the economy has surged to a 2-year high. Cash remains in favor (a positive) but global equity allocations are back above neutral for the first time since late 2015. Another push higher and excessive bullish sentiment will become a headwind.

The US is the most overweighted equity market on a relative basis. Emerging markets are the most underweighted.

Findings in the bond market are of greatest interest. Fund managers' allocations to global bonds are now at prior capitulation lows. Moreover, inflation and growth expectations have jumped to the highest level since early 2011, after which US 10-year yields fell in half over the next several months.

The dollar is considered the most overvalued in the past 10 years. Under similar conditions, the dollar has fallen in value in the month(s) ahead.

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Among the various ways of measuring investor sentiment, the BAML survey of global fund managers is one of the better as the results reflect how managers are allocated in various asset classes. These managers oversee a combined $550b in assets.

The data should be viewed mostly from a contrarian perspective; that is, when equities fall in price, allocations to cash go higher and allocations to equities go lower as investors become bearish, setting up a buy signal. When prices rise, the opposite occurs, setting up a sell signal. We did a recap of this pattern in December 2014 (post).

Let's review the highlights from the past month.

Cash: Fund managers' cash levels dropped from 5.8% in October 2016 to 4.9% in February. Recall that 5.8% was the highest cash level since November 2001. Cash remained above 5% for almost all of 2016, the longest stretch of elevated cash in the survey's history. Some of the tailwind behind the rally is now gone but cash is still supportive of further gains in equities. A significant further drop in cash in the month ahead, however, would be bearish. Enlarge any image by clicking on it.

Sales and Earnings Back At Highs, But So Are Valuations

Summary: In the past year, S&P profits have grown 46% yoy. Sales are 4.5% higher. By some measures, profit margins are back at their prior highs. This is a remarkable turnaround from a year ago, when profits had declined by 15% and most investors interpreted this as a sure sign that a recession and a new bear market were underway.

The critics were wrong because they confused a collapse in one sector - energy, where sales dropped by 60% - with a general decline in all sectors. But in the past two years, sales in the other sectors have continued to grow and margins have mostly remained strong. A rebound in oil prices (and only modest appreciation of the dollar, another headwind in the past two years) bodes well for forward sales and earnings growth.

Where critics have a valid point is valuation: even excluding energy, the S&P is now more highly valued than anytime outside of the 1998-2002 dot com bubble. Valuations rise with investor sentiment; that sentiment is now very bullish. With economic growth of 4-5% (nominal), it will likely take outright exuberance among investors to propel S&P price appreciation at a significantly faster rate.

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A year ago, profits for companies in the S&P had declined 15% year over year (yoy). Sales were 3% lower. Margins had fallen more than 100 basis points. The consensus believed all of this signaled the start of a recession in the US.

These dire prognoses for the US have not worked out. Jobless claims are at more than a 40 year low (first chart below) and retail sales are at an all-time high. US demand growth, measured a number of different ways, has been about 4-5% nominal yoy during the past two years (second chart below). There has been no marked deterioration in domestic consumption or employment.

February Macro Update: Strong Start to 2017

Summary: The macro data from the past month continues to mostly point to positive growth. On balance, the evidence suggests the imminent onset of a recession is unlikely.

That said, there are some signs of weakness creeping into the data. Employment growth is decelerating, from over 2% last year to 1.6% now. Housing starts and permits have flattened over the past 1-2 years. There is nothing alarming in any of this but it is noteworthy that expansions weaken before they end, and these are signs of some weakening that bear monitoring closely.

Overall, the main positives from the recent data are in employment, consumption growth and housing:

• Monthly employment gains have averaged 195,000 during the past year, with annual growth of 1.6% yoy.  Full-time employment is leading.
• Recent compensation growth is the highest in 7-1/2 years: 2.8% yoy in December, falling to 2.5% in January. 
• Most measures of demand show 3-4% nominal growth. Real personal consumption growth in 4Q16 was 2.8%.  Retail sales reached a new all-time high in December, growing 2.0% yoy.
• Housing sales grew 12% yoy in 2016. Starts made a new 9-year high in October.
• The core inflation rate has remained near 2% since November 2015.

The main negatives are concentrated in the manufacturing sector (which accounts for less than 10% of employment):

• Core durable goods growth rose 3.4% yoy in December, it's best growth since April 2015. It was weak during the winter of 2015 and is slowly rebounding in recent months. 
• Industrial production has also been weak, rising by just 0.5% yoy due to weakness in mining (oil and coal). The manufacturing component grew 0.4% yoy.

Prior macro posts are here.

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Our key message over the past 4 years has been that (a) growth is positive but slow, in the range of ~3-4% (nominal), and; (b) current growth is lower than in prior periods of economic expansion and a return to 1980s or 1990s style growth does not appear likely.

Modest growth should not be a surprise. This is the typical pattern in the years following a financial crisis like the one experienced in 2008-09.

This is germane to equity markets in that macro growth drives corporate revenue, profit expansion and valuation levels. The saying that "the stock market is not the economy" is true on a day to day or even month to month basis, but over time these two move together. When they diverge, it is normally a function of emotion, whether measured in valuation premiums/discounts or sentiment extremes (enlarge any image by clicking on it).

A valuable post on using macro data to improve trend following investment strategies can be found here.

Let's review each of these points in turn. We'll focus on four macro categories: labor market, inflation, end-demand and housing.


Employment and Wages

The January non-farm payroll was 227,000 new employees minus 39,000 in revisions.

In the past 12 months, the average monthly gain in employment was 195,000.

Monthly NFP prints are normally volatile. Since 2004, NFP prints near 300,000 have been followed by ones near or under 100,000. That has been a pattern during every bull market; NFP was negative in 1993, 1995, 1996 and 1997. The low prints of 84,000 in March 2015 and 24,000 in May 2016 fit the historical pattern. This is normal, not unusual or unexpected.