tag:blogger.com,1999:blog-63024096561956271262024-03-13T08:00:43.264-07:00The Fat PitchUrban Carmelhttp://www.blogger.com/profile/11008222748707680522noreply@blogger.comBlogger581125tag:blogger.com,1999:blog-6302409656195627126.post-37426164268039812312020-01-23T10:19:00.000-08:002020-01-23T10:19:14.556-08:00Advisor Perspectives' Top 25 Venerated Voices for 2019Many thanks to Advisor Perspectives for including the Fat Pitch in its list of the Top 25 Venerated Voices for 2019, placing ahead of much larger firms such as PIMCO, BlackRock, Northern Trust, AllianceBernstein and Franklin Templeton.<br />
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Advisor Perspectives publishes economic and market commentaries submitted by fund companies, advisors and independent research firms. In 2019, over 1,900 such commentaries were published and made available through a daily newsletter, Research Perspectives, which the company emails to its subscribers. The company's website currently attracts over 180,000 unique visitors per month, virtually all of them financial advisors serving high- and ultra-high net worth individuals.<br />
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The full list is <a href="https://www.advisorperspectives.com/articles/2020/01/20/venerated-voicestm-2019-rankings">here</a>.<br />
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Urban Carmelhttp://www.blogger.com/profile/11008222748707680522noreply@blogger.comtag:blogger.com,1999:blog-6302409656195627126.post-74061096071572959312019-12-31T11:20:00.003-08:002020-01-04T11:18:18.136-08:00Interview with Financial Sense on Running for Political Office and the Macro Outlook for 2020I was interviewed by Cris Sheridan of <a href="https://www.financialsense.com/">Financial Sense</a> on December 17th.<br />
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This was a two-part interview; in the first half, I discuss my current run for political office and the challenges facing small cities; in the second half, I discuss the macro and equity outlook for 2020. If you want to skip around, here are some guideposts:<br />
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<li>2 minute mark: my reasons for running for political office</li>
<li>11 minute mark: the challenges facing small towns like ours in the next decade</li>
<li>24 minute mark: the US macro outlook for 2020, with a focus on housing and other leading indicators</li>
<li>32 minute mark: what macro and things like investor sentiment mean for the stock market in the coming year</li>
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My thanks to Cris for the opportunity to speak with him and to his editor for making these disparate thoughts seem cogent.<br />
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Listen <a href="https://static.financialsense.com/audio/2019-12/financial-sense-20191218-urban-carmel-2020-outlook-ebee1452ec7.mp3" style="font-weight: bold;">here</a>.<br />
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<i>If you find this post to be valuable, consider visiting a few of our sponsors who have offers that might be relevant to you.</i>Urban Carmelhttp://www.blogger.com/profile/11008222748707680522noreply@blogger.comtag:blogger.com,1999:blog-6302409656195627126.post-70221560010112683962019-11-22T09:17:00.002-08:002020-04-12T07:52:30.257-07:00Some Personal NewsUpdate from March 4, 2020:<br />
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We won!<br />
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__________________<br />
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Original post on November 22, 2019:<br />
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I live in a town across the Golden Gate Bridge called Mill Valley. My wife and I moved here in 1999 with our two small children who were 4 and 1 years old at the time. It was near the end of the dot.com bubble. We were both consultants living in Silicon Valley and experienced this period up close.<br />
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I told my wife that I thought we were buying our house at the top of the market. She turned to me and said: "We are not buying a house, we are buying a home. This is where we raise our children. This is where we make our life."<br />
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As usual, she was right. I coached Little League and soccer for 10 years. My kids both ran the Dipsea Race every year. My son became an Eagle Scout. We all volunteered for our local library. Both kids started kindergarten here and graduated from the local high school, all public. They've now moved away. They're adults.<br />
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Outside of work and writing The Fat Pitch, I have run a 501(c) benefiting our library and chaired our town's Planning Commission. We love this town, we want to make it the best it can be, we will never leave. We believe in action, not words. We don't just talk, we do.<br />
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In September, I wrote a piece on the US economy and then went on a trip overseas for the rest of the month. When I returned, I started a campaign to run for elected office on our town's City Council. I met with every living former mayor, explained who I was and what I wanted to accomplish, and was endorsed by all, 19 in total. I am doing the same with as many other community leaders as I can and if they are in a position to endorse a candidate, then they have endorsed me. I am extremely grateful and humbled by everyone's support and encouragement. This feels right. I'm excited.<br />
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This has been time consuming, but I can't think of anything more important. I sat with an owner of a vital and iconic shop in downtown Mill Valley this week, a person raised here, retired here and who has over the past several decades met with every future mayor. He grilled me on housing, finances, traffic, human resources and every other topic of importance. 90 minutes went by like it was 5. It was thrilling, and I once again learned many things I didn't know the day before.<br />
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I have never run for public office. I never thought this is where life would lead me. I'm 56 years old, I have lived here for 20 years, I have been deeply involved in my community and I feel like I can make a difference. I don't have an answer for everything, there's a lot I don't know, but I will listen, I will ask questions, I will study, I will act with integrity and honesty, I will give this my every effort and I will try to do the right thing.<br />
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I have put a lot of effort into writing The Fat Pitch. I have wanted it to be the best source of financial and economic analysis that I could create. I wanted to help anyone willing to read it to learn and question and think and hopefully improve. It did all of those things for me. I don't believe in half measures, so I haven't written in a while. When I can commit the needed time, I will start writing again. I miss it, I'm committed to it and I will return to it.<br />
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If you are reading this and happen to live in Mill Valley, please get in touch. If you know someone here, spread the word. I am trying to run a different type of campaign, one where thousands of mailers and hundreds of lawn signs are replaced by email, phone calls, meetings at coffee shops and by my feet walking in neighborhoods. I want every voter to have met me, read about me or to have heard about me from a trusted friend. I don't want a vote based on a lawn sign or a piece of mail. That is all landfill. The recent fires and power shutdown in California are a timely reminder that we need to change the way we do things, and it starts with something as simple as a local election. It starts now.<br />
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You can read more here: <a href="https://urbancarmel.com/">https://urbancarmel.com/</a><br />
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<br />Urban Carmelhttp://www.blogger.com/profile/11008222748707680522noreply@blogger.comtag:blogger.com,1999:blog-6302409656195627126.post-35483672206582677272019-09-06T07:46:00.000-07:002019-09-06T07:46:39.234-07:00September Macro Update: Rising Possibility of a Recession in 2020<u>Summary</u>: The balance of the macro data remains positive. A <i>recession starting in 2019 is unlikely, but, for the first time, a recession in 2020 is a rising possibility.</i><br />
<span style="font-weight: normal;"><br /></span>The bond market sees weakening growth. The yield curve has 'inverted' (10 year yields less than 2-year yields) ahead of <i>every</i> recession in the past 40 years (dots). The lag between inversion and the start of the next recession has been long: at least 7 months and in several instances as long as 2-3 years. Notably, the <i>yield curve finally inverted in August</i>; on this basis, the current expansion will likely last through 2019 <i>but 2020 is now at risk</i> (from JPM). Enlarge any image by clicking on it.<br />
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High yield <i>spreads are normal and default rates remain below average</i>. This part of the bond market is not signaling trouble (from JPM).<br />
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Similarly, <i>real retail sales grew 1.6% and made a new all-time high (ATH) in July</i>. The trend remains higher, in comparison to the period prior to the past two recessions.<br />
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Unemployment claims reached a 50 year low in April (just 4 months ago). Historically, claims have started to rise <i>at least 7 months</i> ahead of the next recession.<br />
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<span style="font-weight: normal;">In July, housing starts rose 1% yoy, building permits rose 2% and new home sales rose 4%. In the past 50 years, a <i>median of 28 months</i> has lapsed between </span>new home sales'<span style="font-weight: normal;"> expansion high (arrows) and the start of the next recession; so far, the <i>cyclical high was in June, just 2 months ago, which suggests that the next recession is still a ways ahead</i></span>.<br />
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<span style="font-weight: normal;"><br /></span><span style="font-weight: normal;"><br /></span><span style="font-weight: normal;">New home sales have rebounded 4% in the first 7 months of the year compared to the same period last year. The 2017 peak in home sales came after mortgage rates troughed in late 2017, and the rebound so far this year corresponds with mortgage rates falling from 5% in November to under 4% this month.</span><br />
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<span style="font-weight: normal;"><br /></span><span style="font-weight: normal;"></span><span style="font-weight: normal;"><br /></span><span style="font-weight: normal;">The Conference Board's Leading Economic Indicator (LEI) Index reached a <i>new uptrend high in July</i>. This index includes the indicators above plus equity prices, ISM new orders, manufacturing hours and consumer confidence. This index can fluctuate during an expansion but the final peak has been <i>at least 7 months</i> before the next recession in the past 50 years, which also suggest that the next recessions is still a ways ahead (from Doug Short).</span><br />
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<span style="font-weight: normal;"><br /></span><span style="font-weight: normal;"><br /></span>Why does any of this matter for the stock market?<br />
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Equity prices typically fall ahead of the next recession, but <i>the macro indictors highlighted above weaken</i> <i>even earlier</i> and help distinguish a 10% correction from an oncoming prolonged bear market. On balance, these <i>indicators suggest a </i><i>recession starting in 2019 is unlikely, but a recession in 2020 is a rising possibility</i> (a recent post on this is <a href="http://fat-pitch.blogspot.com/2018/05/when-innocuous-correction-is-start-of.html">here</a>).<br />
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Here are the main macro data headlines from the past month:<br />
<blockquote class="tr_bq">
<b>Employment</b>: Monthly employment gains have averaged 173,000 in the past 12 months, with an annual growth of 1.4% yoy, the weakest in 7 years. Employment has been been driven by full-time jobs, which rose to a new all-time high in August. </blockquote>
<blockquote class="tr_bq">
<b>Compensation</b>: Compensation growth remains firm. Hourly wage growth was 3.2% yoy in August, while the 2Q19 employment cost index grew 2.9% yoy. </blockquote>
<blockquote class="tr_bq">
<b>Demand</b>: Real demand growth has been 2-3%. Real retail sales grew 1.6% yoy in July, making a new all-time high, and July real personal consumption grew 2.7% to a new all-time high. But 3Q19 real GDP is expected to fall to under 2%.</blockquote>
<blockquote class="tr_bq">
<b>Housing</b>: Recent housing data has improved, but growth is weak. In July, housing starts rose 1% yoy, building permits rose 2% and new home sales rose 4%. Multi-family units have been a drag on overall development for several years. </blockquote>
<blockquote class="tr_bq">
<b>Manufacturing</b>: Macro weakness has been most apparent in manufacturing. Core durable goods fell 0.5% yoy while the manufacturing component of industrial production fell 0.5% yoy in July. </blockquote>
<blockquote class="tr_bq">
<b>Inflation: </b>The core inflation rate remains near the Fed's 2% target. </blockquote>
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Our key message over the past 6 years has been that (a) growth is positive but slow, in the range of ~2-3% (real), 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.<br />
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This is germane to equity markets in that <i>macro growth drives corporate revenue, profit expansion and valuation levels</i>. The simple fact is that when the economy is expanding, the historical risk of a greater than 10% annual (not intra-year) decline in the stock market is just 4% (from Goldman Sachs).<br />
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The highly misleading saying that <i>"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</i>. When they diverge, it is normally a function of emotion, whether measured in valuation premiums/discounts or sentiment extremes.<br />
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A valuable post on using macro data to improve trend following investment strategies can be found <a href="http://www.philosophicaleconomics.com/2016/02/uetrend/">here</a>.<br />
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While the macro data is fine, a<i> wild card is the escalation in the trade war</i>, which reduces global demand, raises prices and eventually leads to lower investment (from <a href="https://www.stlouisfed.org/on-the-economy/2018/june/tariff-increases-potential-economic-effects">St Louis Fed</a>).<br />
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Let's review the most recent data, focusing on four macro categories: labor market, end-demand, housing, and inflation.<br />
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<b>Employment and Wages</b><br />
<b><br /></b>The August non-farm payroll was <i>130,000 new employees </i>minus 20,000 in net revisions for the prior two months.<br />
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<i>Employment growth is decelerating this year</i>. The average monthly gain in employment was 240,000 in 2015, 211,000 in 2016, 189,000 in 2017 and 204,000 in 2018. In the past 12 months, the monthly average has fallen to 173,000, the lowest in 7 years.<br />
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Monthly <i>NFP prints are volatile</i>. Since the 1990s, NFP prints near 300,000 (like in January) have been followed by ones near or under 100,000 (like in May). That has been a pattern during every bull market; NFP was negative at times during 1993, 1995, 1996 and 1997. This is normal, not unusual or unexpected.<br />
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Why is there so much volatility? Leave aside the data collection, seasonal adjustment and weather issues; appreciate that a "beat" or a "miss" of 120,000 workers in a monthly NFP report is within the 90% confidence interval (explained <a href="https://projects.fivethirtyeight.com/jobs-report-growth-unemployment/">here</a>).<br />
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For this reason, it's better to look at the trend; in August, trend <i>employment growth was 1.4% yoy</i>. Until spring 2016, annual growth had been over 2%, the highest since the 1990s. Ahead of a recession, employment growth normally falls, a watch out (arrows).<br />
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<i>Employment has been been driven by full-time jobs</i>, which rose to a new all-time high in August (blue line), not part-time jobs (red line).<br />
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The labor force participation rate (the percentage of the population over 16 that is either working or looking for work) has <i>stabilized over the past 5 years</i>. The participation rate had been falling since 2001 as baby boomers retire, exactly as participation started to rise in the mid-1960s as this demographic group entered the workforce. Another driver is women, whose participation rate increased from about 30% in the 1950s to a peak of 60% in 1999, and younger adults staying in school (and thus out of the work force) longer.<br />
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A better measure is the prime working age (25 to 54 year olds) labor force participation rate; it stands at 82%, <i>down only slightly from its peak in 2000</i> at 84%, and much higher than anytime prior to the 1980s.<br />
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Average hourly <i>earnings growth was 3.2% yoy</i> in August; February's rate of 3.4% was the highest in 10 years. This is a positive trend, showing demand for more workers. Sustained acceleration in wages would be a big positive for consumption and investment that would further fuel employment.<br />
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Similarly, 2Q19 employment cost index shows total <i>compensation growth was 2.9% yoy</i>, near the highest in the past 10 years.<br />
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For those who doubt the veracity of the BLS employment data, federal individual income tax receipts have also been rising<b> </b>to new highs<b> </b>(red line), a sign of better employment and wages (from Yardeni).<br />
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<b>Demand</b><br />
<b><br /></b>Regardless of which data is used, real demand has been growing at about 2-3%, equal to about 4-5% nominal.<br />
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Real (inflation adjusted) <i>GDP growth through 2Q19 was 2.3% yoy.</i> A pattern of deceleration is forming, another watch out.<br />
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Stripping out the changes in GDP due to inventory produces "real final sales". This is a better measure of consumption growth than total GDP. In 2Q19, this <i>also decelerated, to 1.8% yoy</i>.<br />
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The "real personal consumption expenditures" component of GDP (<a href="http://mic.com/articles/15097/us-gdp-is-70-percent-personal-consumption-inside-the-numbers">defined</a>), which accounts for about 70% of GDP, <i>grew 2.7% yoy</i> in 2Q19.<br />
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On a monthly basis, <i>real personal consumption expenditures grew 2.7% yoy</i> in July to a new ATH.<br />
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GDP measures the total expenditures in the economy. An alternative measure is GDI (gross domestic income), which measures the total income in the economy. Since every expenditure produces income, these are equivalent measurements of the economy. Some research suggests that GDI might be more accurate than GDP (<a href="http://www.nytimes.com/2014/09/27/upshot/gdp-report-emphasizes-the-problem-of-conflicting-economic-signals.html?abt=0002&abg=0">here</a>).<br />
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Real <i>GDI growth in 2Q19 was 2.3% yoy</i>.<br />
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<i>Real retail sales grew 1.6% yoy </i>in July, making a new ATH. Sales fell yoy more than a year ahead of the last recession which makes the negative annual growth in December notable.<br />
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Retail sales in the past three years have been strongly affected by the large fall and rebound in the price of gasoline. In July, real retail sales at gasoline stations fell by 1.8% yoy after having fallen more than 20% yoy during 2016. <i>Real retail sales excluding gas stations grew 1.9% </i>in July.<br />
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This expansionary cycle is not like others in the past 50 years. Households' savings rate typically falls as the expansion progresses; this time, <i>savings have risen</i> and remains at an elevated level.<br />
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The next several slides look at manufacturing. It's important to note that manufacturing accounts for less than 10% of US employment, so these measures are of lesser importance.<br />
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Core durable goods orders (excluding military, so that it measures consumption, and transportation, which is highly volatile) <i>fell 0.5% yoy</i> (nominal) in July. Weakness in durable goods has not been a reliable predictor of broader economic weakness in the past (arrows).<br />
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Industrial production (real manufacturing, mining and utility output) <i>growth was 0.5% yoy</i> in July. The more important manufacturing component (excluding mining and oil/gas extraction; red line) <i>fell 0.5% yoy</i>. Growth has moderated for both, with the cycle peak (so far) in December 2018. Industrial production is a volatile series, with negative annual growth during parts of 2014 and 2016.<br />
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Importantly, <i>just 35% of industrial production groups are expanding</i>. A drop below 40% has implied widespread weakness that typically precedes a recession, so <i>this is a watch out</i> (from <a href="https://blogs.uoregon.edu/timduyfedwatch/">Tim Duy</a>).</div>
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Weakness in total industrial production in 2015-16 was concentrated in the mining sector, with the worst annual fall in more than 40 years. It is not unusual for this part of industrial production to plummet outside of recessions. With the recovery in oil/gas extraction, mining rose 5% yoy in July. </div>
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Companies are often wrongly accused of underinvesting in lieu of greater share repurchases (buybacks). But capacity utilization is still under 80%, so there is plenty of room for production to expand within existing capacity. </div>
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For 3Q19, the <a href="https://www.frbatlanta.org/cqer/research/gdpnow.aspx">Atlanta Fed</a> estimates growth to be 1.4%.</div>
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<br />
<b>Housing</b><br />
<b><br /></b>Macro weakness had been apparent in housing, but recent data has shown improvement.<br />
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First, new single family houses sold was 635,000 in July, rising 4% yoy. The <i>cycle high was in June, only 2 months ago: </i>the cycle high has been a median of 28 months before the next recession (arrows). Overall levels of construction and sales are small relative to prior bull markets.<br />
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Second, housing s<i>tarts rose 1% in July,</i> an improvement from an 11% yoy decline in February<i>. </i>The cycle high was in January 2018, 19 months ago; the cycle high has typically been well over a year before the next recession (arrows).<br />
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Building permits (red line) <i>rose 2% yoy in </i><i>July</i> after rising 5% yoy in July 2018.<br />
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Single family housing starts (blue line) rose 2% yoy in July; multi-unit housing starts (red line) fell 5% yoy and have been a drag on overall starts for more than 5 years.<br />
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<b>Inflation</b><br />
<b><br /></b>Despite steady employment, demand and housing growth, core <i>inflation remains near the Fed's target of 2%</i>.<br />
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CPI (blue line) was 1.8% last month. The more important core CPI (excluding volatile food and energy; red line) <i>grew 2.2%</i>.<br />
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The Fed prefers to use personal consumption expenditures (PCE) to measure inflation; total and core <i>PCE were 1.4% and 1.6% yoy</i>, respectively, in July.<br />
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Some mistrust CPI and PCE. MIT publishes an independent price index (called the billion prices index; blue line). It has tracked both CPI (red line) and PCE closely.<br />
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<b>Valuation</b><br />
<b><br /></b>On balance, the major macro data so far suggest continued positive, but slowing, growth. This is consistent with corporate sales growth. SPX sales growth in 2019 is expected to be about 5% (nominal).<br />
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Valuations are slightly above their 25 year average. The consensus expects earnings to only grow about 3% in 2019 but there is room for faster equity appreciation through valuation expansion (chart from JPM).<br />
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<i>If you find this post to be valuable, consider visiting a few of our sponsors who have offers that might be relevant to you. </i></div>
Urban Carmelhttp://www.blogger.com/profile/11008222748707680522noreply@blogger.comtag:blogger.com,1999:blog-6302409656195627126.post-43549566603045376352019-08-19T15:07:00.000-07:002019-08-19T15:07:56.165-07:002Q Corporate Results: 2% Earnings Growth Expected in 2019<u>Summary</u>: Overall, corporate results in the second quarter of 2019 were fine, but growth has slowed. Sales and earnings were up were 5% and 4% yoy, respectively. Margins rebounded from the end of 2018 but are still below the cycle high made in 3Q18.<br />
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Looking ahead, analysts' expectations for 10% earnings growth in 2019 have been revised down to just 2%. This estimate will be about right if margins can be maintained at the current level and the dollar doesn't further appreciate, but another drop in oil prices could cause earnings growth to decline towards zero.<br />
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For 2020, analysts currently expect growth of 5% to sales and 11% to earnings. This is too optimistic. Assuming no change in the dollar, oil and margins, earnings growth is likely to be halved. Margin compression (likely) would lower growth much more.<br />
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Valuations are now back to their 25-year average. They are not cheap, but if investors once again become ebullient, there is room for valuations to expand. With earnings growth likely to be negligible, the key for share price appreciation in 2019 (and 2020) is likely to hinge almost entirely on valuations expanding.<br />
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93% of the companies in the S&P 500 have released their second quarter (2Q19) financial reports. The headline numbers were fine, but growth has slowed. Here are the details:<br />
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<b>Sales</b><br />
<i><br /></i><i>Quarterly sales grew 5% over the past year, to a new all-time high (ATH)</i>. On a trailing 12-month basis (TTM), sales were 7% higher yoy (all financial data in this post is from <a href="https://us.spindices.com/indices/equity/sp-500">S&P</a>). Enlarge any image by clicking on it.<br />
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The arrows in the chart above and those that follow indicate the period from 2Q14 to 1Q16 when oil prices fell 70% and the US experienced an "earnings recession." The negative affect on overall S&P sales (above) and the energy sector alone (below) is easy to spot.<br />
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The six sectors with the highest weighting in the S&P grew an average of 8% in the past year (box in middle column) and, since the peak in oil in 2Q14, their sales have grown an average of 39%. In contrast, energy sector sales have declined 29% (far right column).<br />
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Excluding the volatile energy sector, sales for the remainder of the S&P have continued to trend higher at about the same rate over the past 9 years (blue line; from Yardeni).</div>
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The <i>dollar has been a headwind for sales growth</i>: in the past year (thru 2Q19), the dollar appreciated by 6%; this accounts for about a 3 percentage point decline in corporate sales growth. For the current quarter (3Q19), the dollar is pacing a more modest 3% yoy appreciation.</div>
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How does the dollar impact sales growth? Companies in the S&P derive about half of their sales from outside of the US. When the dollar rises in value, the value of sales earned abroad (in foreign currency) falls. If foreign sales grow 5% but the dollar gains 5% against other currencies, then sales growth will be zero in dollar terms. The chart below compares changes in the dollar (blue line; inverted) with growth in S&P sales (red line): a higher dollar corresponds with lower sales (from Yardeni).</div>
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<b>Earnings and Margins</b></div>
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<i>Operating EPS grew 4% over the past year</i> on a quarterly-basis and 10% on a trailing 12-month basis (TTM). GAAP EPS was the same: 4% quarterly growth yoy and 11% growth TTM. More on the distinction between operating and GAAP EPS below.</div>
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<i>EPS fell from its recent ATH in 3Q18 into a low in 4Q18, </i>but then rebounded strongly the last two quarters<i>.</i></div>
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The arrows in the next chart again indicate the period when oil prices fell 70% between 2014 and 2016. The improvement in total EPS since then comes with energy sector EPS at one-third of its level in mid-2014, but note how energy EPS has been nearly halved in the past 9 months.<br />
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Margins reached a peak of 12.1% in 3Q18, fell to 10.1% in 4Q18 and have since <i>rebounded to 11.5% in 2Q19.</i><br />
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Excluding the energy sector,<i> margins rebounded to 12.1% in 2Q19 from 10.2% in 4Q18, but may have peaked in 3Q18 at 12.6%</i>.<br />
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The margins of the largest sectors are flat over the past two years, with the exception of financials and technology, although these have also flattened in the past year. </div>
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The fall and rebound in margins in the past year is most apparent in the financial sector, which fell from 17.7% in 3Q18 to 8.5% in 4Q18 before recovering to 17.4% this quarter.</div>
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<b>Misconceptions and Bad Memes</b><br />
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There are some popular misconceptions that are regularly cited with respect to corporate earnings.<br />
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First, companies have been accused of inflating their financial reports through a net reduction in shares through, for example, corporate buybacks. In reality, however,<i> 89% of the growth in earnings in the S&P over the past 9 years has come from better profits, not a net reduction in shares</i>. Better profits have driven growth, not "financial engineering."<br />
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That has been true over the past 17 years, during which the net change in corporate shares has accounted for just 4% of EPS growth (from JPM).<br />
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In fact, despite record buybacks, the difference between EPS and profits has been consistently narrow.<br />
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Second, equity prices are said to have far outpaced earnings during this bull market. In fact, <i>better profits accounts for about 72% of the appreciation in the S&P over the past 9 years</i>. Of course valuations have also risen - that is a feature of every bull market, as investors transition from pessimism to optimism - but this has been a much smaller contributor. In comparison, 75% of the gain in the S&P between 1982-2000 was derived from a valuation increase (that data from <a href="https://www.bloomberg.com/view/articles/2017-10-27/how-to-tell-the-bulls-from-the-bears">Barry Ritholtz</a>).<br />
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Over the past 2 years (since 2Q17), during which time the S&P has risen about 20%, earnings have risen 30%, i.e., faster than the S&P index itself thereby accounting for more than 100% of price appreciation. The same is true over the past 1 year (from JPM).<br />
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Third, financial reports based on "operating earnings" are said to be fake. This complaint has been a feature of every bull market since at least the 1990s. In truth, the <i>trend in GAAP earnings (red line) is the same as "operating earnings" </i>(blue line).<br />
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It's accurate to say that operating earnings somewhat overstate and smooth profits compared earnings based on GAAP, but that is not new. In fact, the difference between operating and GAAP earnings in the past 27 years has been a median of 10% and the recent history has been not much different (it was 14% in the most recent quarter). Operating earnings overstated profits by much more in the 1990s and earlier in the current bull market. The biggest differences have always been during bear markets.<br />
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<b>Outlook for 2019 and 2020</b></div>
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Looking ahead, <i>expectations for 10% earnings growth in 2019 have already been revised down to 2%</i>. In 2020, earnings growth is expected to be 11%, which is too optimistic and likely to be halved. Sales growth is expected to be 4% in 2019 and 5% in 2020 (from FactSet).<br />
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There are 5 considerations with a strong bearing on forward sales and earnings. Most of these appear likely to be a headwind in 2019 and maybe also in 2020.<br />
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First, as a baseline, it is reasonable to assume that corporate (non-energy) <b>sales growth</b> will be largely similar to the <i>nominal economic growth rate of 4-5%</i>, excluding currency effects. Right now, this seems achievable (from the OECD).<br />
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Second, the <b>dollar</b> weakened from the end of 2016 to early-2018 (a tailwind to growth) but has since appreciated 9%. That means that <i>currency effects are now a headwind</i> to growth<i>.</i> With half of corporate sales coming from abroad, even a small 3% appreciation in the dollar (the current pace for 2019) could cut 1.5 percentage points off sales growth this year.<br />
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Third, the price of <b>oil</b> was tracking more than a 30% yoy gain until October 2018; the price then fell 30% into year end. In 1H19, the average price of oil was 13% lower than a year earlier; in other words,<i> </i>the energy sector became a headwind to overall sales and EPS growth. The average price so far this year is $57; <i>below $65, oil will remain a headwind in 2019</i>.<br />
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As we have seen, the direct impact of oil prices on the energy sector is far more important than any ancillary affects on other sectors. As an example, consider this: the price of oil fell from over $100 to under $50 between mid-2013 and mid-2016 but non-energy sector operating margins were 10% in both instances. In short, <i>lower oil prices are a net negative for sales and earnings</i>.<br />
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Fourth, <b>corporate tax cuts</b> were a major tailwind to earnings in 2018. Analysts estimate that these likely added 10 percentage points to growth, meaning baseline growth of 5% could have jumped to 15% by virtue of tax cuts alone. But the <i>tax cut was a one-off adjustment, applicable only to 2018</i>, and recent evidence suggests that it did not permanently raise growth rates.<br />
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Fifth: <i>the biggest risk to earnings in 2019 is <b>margin contraction</b></i>. For earnings to grow as fast as sales, margins have to be maintained. But after trending higher over the past 7 years, margins jumped 140bp in 2018. This was a massive rise and sustaining that level (let alone expanding margins further) seems unlikely, especially given the fall in margins since 3Q18.<br />
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<b><br /></b><b><br /></b>In fact, average margins in 2018 were 11.3%, the same as in 1Q and 2Q19. If that level is maintained throughout 2019, <i>earnings growth will be 4% </i>(down from 22% in 2018)<i>.</i> If the dollar continues to appreciate, that growth could fall to 2%. If oil remains under $65/barrel, earnings will fall further.<br />
<b><br /></b><b><br /></b><b>Valuation</b><br />
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At the end of 2018, the combination of 22% earnings growth and a 6% fall in equity prices left valuations at 14.4x, the same level as in 2010 and well below their 25-year average. The rally since then has brought valuations only slightly above average (from JPM).<br />
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Valuations are not cheap, but if investors once again become ebullient, <i>there is room for valuations to expand</i>. Why? When investors become bullish (blue line), valuations rise (red line). Investors had been pessimistic in early 2016 and then became far too optimistic at the market peak in January 2018. <i>Importantly, that was greatly reset by the end of December 2018</i> and while sentiment has since rebounded, it has not reached an extreme (from Yardeni).<br />
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It's hard to believe that investors have already reached peak bullishness. Fund flows into equity mutual funds and ETFs was strong before both the 2000-02 and 2007-09 bear markets, and even before the 2015-16 mini-bear market (blue circles). In comparison, fund flows have been negative for 5 of the past 8 quarters (red circle; from JPM).<br />
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Valuations are influenced by more than investor psychology. Part of the reason equities have become more expensive over time is rising corporate profitability. <i>Margins have reached successive new highs with each economic cycle over the past 3 decades</i>: they are now more 100bp higher than in 2007, and that peak was more than 100bp higher than in 2000. Higher profitability (and growth) is typically rewarded with higher valuation multiples (from JPM).<br />
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While it is objectively impossible to know when or at what level margins will peak for this cycle, it's a reasonable guess that the cycle peak was in 3Q18.<br />
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Importantly, valuations have almost no bearing on the market's 1-year forward return (left side). But over the <i>longer term, current valuations suggest that single digit annual returns are odds-on</i> (right side; from JP Morgan).<br />
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In summary, corporate results in the second quarter of 2019 were fine, but growth has slowed. Sales and earnings were up were 5% and 4% yoy, respectively. Margins rebounded from the end of 2018 but are still below the cycle high made in 3Q18.<br />
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Looking ahead, analysts' expectations for 10% earnings growth in 2019 have been revised down to just 2%. This estimate will be about right if margins can be maintained at the current level and the dollar doesn't further appreciate, but another drop in oil prices could cause earnings growth to decline towards zero.<br />
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For 2020, analysts currently expect growth of 5% to sales and 11% to earnings. This is too optimistic. Assuming no change in the dollar, oil and margins, earnings growth is likely to be halved. Margin compression (likely) would lower growth much more.<br />
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Valuations are now back to their 25-year average. They are not cheap, but if investors once again become ebullient, there is room for valuations to expand. With earnings growth likely to be negligible, the key for share price appreciation in 2019 (and 2020) is likely to hinge almost entirely on valuations expanding.<br />
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<i>If you find this post to be valuable, consider visiting a few of our sponsors who have offers that might be relevant to you.</i>Urban Carmelhttp://www.blogger.com/profile/11008222748707680522noreply@blogger.comtag:blogger.com,1999:blog-6302409656195627126.post-64891744348657556862019-08-02T09:11:00.000-07:002019-08-02T09:11:41.293-07:00August Macro Update: Housing Weak But Recession Unlikely In 2019<u>Summary</u>: The 25bp rate cut by the FOMC this week was warranted given ongoing weakness in housing, but the balance of the macro data remains positive, meaning a<i> recession starting in 2019 is unlikely.</i><br />
<span style="font-weight: normal;"><br /></span>The bond market sees continued but modest growth. The yield curve has 'inverted' (10 year yields less than 2-year yields) ahead of <i>every</i> recession in the past 40 years (dots). The lag between inversion and the start of the next recession has been long: at least 7 months and in several instances as long as 2-3 years. The <i>yield curve has not yet inverted</i>; on this basis, the current expansion will <i>likely to last through 2019</i> at a minimum (from JPM). Enlarge any image by clicking on it.<br />
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Likewise, high yield <i>spreads are normal and default rates remain well below average</i>. This part of the bond market is not signaling trouble (from JPM).<br />
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Similarly, <i>real retail sales grew 1.7% and made a new all-time high (ATH) in June</i>. The trend higher is strong, in comparison to the period prior to the past two recessions.<br />
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Unemployment claims are back in a declining trend, reaching a 50 year low in April (just 3 months ago); <i>this week's figure fell to the lowest level since April</i>. Historically, claims have started to rise at least 7 months ahead of the next recession.<br />
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<span style="font-weight: normal;"><i>Housing has been the primary macro concern</i>. In June, housing starts rose 6% yoy, building permits fell 7% and new home sales rose 4%. In the past 50 years, a median of 28 months has lapsed between </span>new home sales'<span style="font-weight: normal;"> expansion high (arrows) and the start of the next recession; so far, the <i>cyclical high was 20 months ago</i></span>.<br />
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<span style="font-weight: normal;"><br /></span><span style="font-weight: normal;"><br /></span><span style="font-weight: normal;">New home sales have rebounded 10% in the first 6 months of the year compared to the last 6 months of 2018. The 2017 peak in home sales came after mortgage rates troughed in late 2017, and the rebound so far this year corresponds with mortgage rates falling from 5% in November to under 4% this month.</span><br />
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<span style="font-weight: normal;"><br /></span><span style="font-weight: normal;"></span><span style="font-weight: normal;"><br /></span><span style="font-weight: normal;">The Conference Board's Leading Economic Indicator (LEI) Index declined slightly in June after reaching a new uptrend high in May. This index includes the indicators above plus equity prices, ISM new orders, manufacturing hours and consumer confidence. This index can fluctuate during an expansion but the final peak has been <i>at least 7 months</i> before the next recession in the past 50 years (from Doug Short).</span><br />
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<span style="font-weight: normal;"><br /></span><span style="font-weight: normal;"><br /></span>Why does any of this matter for the stock market?<br />
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Equity prices typically fall ahead of the next recession, but <i>the macro indictors highlighted above weaken</i> <i>even earlier</i> and help distinguish a 10% correction from an oncoming prolonged bear market. On balance, these <i>indicators are not hinting at an imminent recession</i> (a recent post on this is <a href="http://fat-pitch.blogspot.com/2018/05/when-innocuous-correction-is-start-of.html">here</a>).<br />
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Here are the main macro data headlines from the past month:<br />
<blockquote class="tr_bq">
<b>Employment</b>: Monthly employment gains have averaged 187,000 in the past 12 months, with an annual growth of 1.5% yoy. Employment has been been driven by full-time jobs, which rose to a new all-time high in July. </blockquote>
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<b>Compensation</b>: Compensation growth is on an improving trend. Hourly wage growth was 3.2% yoy in July, while the 2Q19 employment cost index grew 2.9% yoy, near the highest growth in the past 10 years. </blockquote>
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<b>Demand</b>: Real demand growth has been 2-3%. Real retail sales grew 1.7% yoy in June, making a new all-time high. June real personal consumption grew 2.5% to a new all-time high. 2Q19 real GDP grew 2.3%.</blockquote>
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<b>Housing</b>: Macro weakness has been most apparent in housing. In June, housing starts rose 6% yoy, building permits fell 7% and new home sales rose 4%. Multi-family units have been a drag on overall development for several years. </blockquote>
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<b>Manufacturing</b>: Macro weakness has also been apparent in manufacturing. Core durable goods rose 2.6% yoy while the manufacturing component of industrial production grew just 0.5% yoy in June. </blockquote>
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<b>Inflation: </b>The core inflation rate remains near the Fed's 2% target. </blockquote>
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Our key message over the past 6 years has been that (a) growth is positive but slow, in the range of ~2-3% (real), 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.<br />
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This is germane to equity markets in that <i>macro growth drives corporate revenue, profit expansion and valuation levels</i>. The simple fact is that when the economy is expanding, the historical risk of a greater than 10% annual (not intra-year) decline in the stock market is just 4% (from Goldman Sachs).<br />
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The highly misleading saying that <i>"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</i>. When they diverge, it is normally a function of emotion, whether measured in valuation premiums/discounts or sentiment extremes.<br />
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A valuable post on using macro data to improve trend following investment strategies can be found <a href="http://www.philosophicaleconomics.com/2016/02/uetrend/">here</a>.<br />
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While the macro data is fine, a <i>possible wild card is the escalation in the trade war</i>, which reduces global demand, raises prices and eventually leads to lower investment (from <a href="https://www.stlouisfed.org/on-the-economy/2018/june/tariff-increases-potential-economic-effects">St Louis Fed</a>).<br />
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Let's review the most recent data, focusing on four macro categories: labor market, end-demand, housing, and inflation.<br />
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<b>Employment and Wages</b><br />
<b><br /></b>The July non-farm payroll was <i>164,000 new employees </i>minus 41,000 in net revisions for the prior two months.<br />
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<i>Employment growth accelerated last year</i>. The average monthly gain in employment was 240,000 in 2015, 211,000 in 2016 and189,000 in 2017 but it increased to 204,000 in 2018. In the past 12 months, the monthly average is 187,000, a small contraction from last year.<br />
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Monthly <i>NFP prints are volatile</i>. Since the 1990s, NFP prints near 300,000 (like in January) have been followed by ones near or under 100,000 (like in May). That has been a pattern during every bull market; NFP was negative at times during 1993, 1995, 1996 and 1997. This is normal, not unusual or unexpected.<br />
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Why is there so much volatility? Leave aside the data collection, seasonal adjustment and weather issues; appreciate that a "beat" or a "miss" of 120,000 workers in a monthly NFP report is within the 90% confidence interval (explained <a href="https://projects.fivethirtyeight.com/jobs-report-growth-unemployment/">here</a>).<br />
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For this reason, it's better to look at the trend; in July, trend <i>employment growth was 1.5% yoy</i>. Until spring 2016, annual growth had been over 2%, the highest since the 1990s. Ahead of a recession, employment growth normally falls, a potential watch out (arrows).<br />
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<i>Employment has been been driven by full-time jobs</i>, which rose to a new all-time high in July (blue line), not part-time jobs (red line).<br />
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The labor force participation rate (the percentage of the population over 16 that is either working or looking for work) has <i>stabilized over the past 5 years</i>. The participation rate had been falling since 2001 as baby boomers retire, exactly as participation started to rise in the mid-1960s as this demographic group entered the workforce. Another driver is women, whose participation rate increased from about 30% in the 1950s to a peak of 60% in 1999, and younger adults staying in school (and thus out of the work force) longer.<br />
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A better measure is the prime working age (25 to 54 year olds) labor force participation rate; it stands at 82%, <i>down only slightly from its peak in 2000</i> at 84%, and much higher than anytime prior to the 1980s.<br />
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Average hourly <i>earnings growth was 3.2% yoy</i> in July; February's rate of 3.4% was the highest in 10 years. This is a positive trend, showing demand for more workers. Sustained acceleration in wages would be a big positive for consumption and investment that would further fuel employment.<br />
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Similarly, 2Q19 employment cost index shows total <i>compensation growth was 2.9% yoy</i>, near the highest in the past 10 years.<br />
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For those who doubt the veracity of the BLS employment data, federal individual income tax receipts have also been rising<b> </b>to new highs<b> </b>(red line), a sign of better employment and wages (from Yardeni).<br />
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<b>Demand</b><br />
<b><br /></b>Regardless of which data is used, real demand has been growing at about 2-3%, equal to about 4-5% nominal.<br />
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Real (inflation adjusted) <i>GDP growth through 2Q19 was 2.3% yoy.</i> A pattern of deceleration is forming.<br />
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Stripping out the changes in GDP due to inventory produces "real final sales". This is a better measure of consumption growth than total GDP. In 2Q19, this <i>also decelerated, to 1.8% yoy</i>.<br />
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The "real personal consumption expenditures" component of GDP (<a href="http://mic.com/articles/15097/us-gdp-is-70-percent-personal-consumption-inside-the-numbers">defined</a>), which accounts for about 70% of GDP, <i>grew 2.6% yoy</i> in 2Q19.<br />
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On a monthly basis, <i>real personal consumption expenditures grew 2.5% yoy</i> in June to a new ATH.<br />
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GDP measures the total expenditures in the economy. An alternative measure is GDI (gross domestic income), which measures the total income in the economy. Since every expenditure produces income, these are equivalent measurements of the economy. Some research suggests that GDI might be more accurate than GDP (<a href="http://www.nytimes.com/2014/09/27/upshot/gdp-report-emphasizes-the-problem-of-conflicting-economic-signals.html?abt=0002&abg=0">here</a>).<br />
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Real <i>GDI growth in 1Q19 was 2.0% yoy</i>.<br />
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<i>Real retail sales grew 1.7% yoy </i>in June, making a new ATH. Sales fell yoy more than a year ahead of the last recession which makes the negative annual growth in December notable.<br />
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Retail sales in the past three years have been strongly affected by the large fall and rebound in the price of gasoline. In June, real retail sales at gasoline stations fell by 3.3% yoy after having fallen more than 20% yoy during 2016. <i>Real retail sales excluding gas stations grew 2.2% </i>in June.<br />
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This expansionary cycle is not like others in the past 50 years. Households' savings rate typically falls as the expansion progresses; this time, <i>savings have risen</i> and remains at an elevated level.<br />
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The next several slides look at manufacturing. It's important to note that manufacturing accounts for less than 10% of US employment, so these measures are of lesser importance.<br />
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Core durable goods orders (excluding military, so that it measures consumption, and transportation, which is highly volatile) <i>rose 2.6% yoy</i> (nominal) in June. Weakness in durable goods has not been a reliable predictor of broader economic weakness in the past (arrows).<br />
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Industrial production (real manufacturing, mining and utility output) <i>growth was 1.3% yoy</i> in June. The more important manufacturing component (excluding mining and oil/gas extraction; red line) grew just 0.5% yoy. Growth has moderated for both, with the cycle peak (so far) in December 2018. Industrial production is a volatile series, with negative annual growth during parts of 2014 and 2016.<br />
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Importantly, <i>52% of industrial production groups are expanding</i>. A drop below 40% has implied widespread weakness that typically precedes a recession (from <a href="https://blogs.uoregon.edu/timduyfedwatch/">Tim Duy</a>).</div>
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Weakness in total industrial production in 2015-16 was concentrated in the mining sector, with the worst annual fall in more than 40 years. It is not unusual for this part of industrial production to plummet outside of recessions. With the recovery in oil/gas extraction, mining rose 9% yoy in June. </div>
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Companies are often wrongly accused of underinvesting in lieu of greater share repurchases (buybacks). But capacity utilization is still under 80%, so there is plenty of room for production to expand within existing capacity. </div>
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For 3Q19, the <a href="https://www.frbatlanta.org/cqer/research/gdpnow.aspx">Atlanta Fed</a> estimates growth to be 1.9%.</div>
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<b>Housing</b><br />
<b><br /></b>Macro weakness has been most apparent in housing.<br />
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First, new single family houses sold was 646,000 in June, rising 4% yoy. The <i>cycle high was in November 2017, 20 months ago: </i>the cycle high has been a median of 28 months before the next recession (arrows), a watch out now. Overall levels of construction and sales are small relative to prior bull markets.<br />
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Second, housing s<i>tarts rose 6% in June,</i> a rebound from a 11% yoy decline in February<i>. </i>The cycle high was in January 2018, 16 months ago; the cycle high has typically been well over a year before the next recession (arrows).<br />
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Building permits (red line) <i>fell 7% yoy in </i><i>June</i> after falling 1% yoy in June 2018.<br />
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Single family housing starts (blue line) fell 1% yoy in June; multi-unit housing starts (red line) rose 25% yoy but have been a drag on overall starts for more than 4 years.<br />
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<b>Inflation</b><br />
<b><br /></b>Despite steady employment, demand and housing growth, core <i>inflation remains near the Fed's target of 2%</i>.<br />
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CPI (blue line) was 1.7% last month. The more important core CPI (excluding volatile food and energy; red line) <i>grew 2.1%</i>.<br />
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The Fed prefers to use personal consumption expenditures (PCE) to measure inflation; total and core <i>PCE were 1.4% and 1.6% yoy</i>, respectively, in June.<br />
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Some mistrust CPI and PCE. MIT publishes an independent price index (called the billion prices index; blue line). It has tracked both CPI (red line) and PCE closely.<br />
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<b>Valuation</b><br />
<b><br /></b>On balance, the major macro data so far suggest continued positive, but modest, growth. This is consistent with corporate sales growth. SPX sales growth in 2019 is expected to be about 5% (nominal).<br />
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Valuations are slightly above their 25 year average. The consensus expects earnings to only grow about 3% in 2019 but there is room for faster equity appreciation through valuation expansion (chart from JPM).<br />
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Urban Carmelhttp://www.blogger.com/profile/11008222748707680522noreply@blogger.comtag:blogger.com,1999:blog-6302409656195627126.post-35173007007417732152019-08-01T11:45:00.002-07:002019-08-01T11:54:39.995-07:00High Consumer Confidence Is A Notable Stock Market Warning<u>Summary</u>: In July, the Consumer Confidence Index (CCI) jumped to its highest level since last September, right before stocks started a 20% correction. Sometimes a high in the CCI coincides closely with a 5% or greater fall in stocks, but at other times the lag has been many months. In general, however, the risk/reward for investors over the next 6 months has not be favorable.<br />
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In July, the Conference Board's Consumer Confidence Index (CCI) jumped to the highest level since last September. According to the Conference Board: “Consumers are once again optimistic about current and prospective business and labor market conditions. In addition, their expectations regarding their financial outlook also improved."<br />
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The CCI was created in 1967, based on a monthly survey of 5,000 households. The report gives details about consumer attitudes (how would you rate the current business and employment situation; do you think your income will be higher or lower in 6 months) and buying intentions.<br />
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Increasing confidence is generally good for the economy as it drives consumption, which is 70% of the US economy.<br />
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But excessive confidence is not good, especially for the stock market. The timing is far from perfect but risk/reward and forward returns are often poor.<br />
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The current CCI is now 136. It has been higher in only 3 other periods: the late 1960s, the late 1990s and last year (the next 4 charts are from <a href="https://www.sentimentrader.com/">Sentimentrader</a>; to become a subscriber and support the Fat Pitch, click <a href="https://partners.sentimentrader.com/idevaffiliate.php?id=101">here</a>). Enlarge any chart by clicking on it.<br />
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The CCI was 135 last September (lower than now) before SPX started a 20% fall that ended on Christmas Eve. There was virtually no lag between the high in CCI and the start of the fall in SPX.<br />
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That's not always the case. See the annotations in the chart above. The CCI reached current levels in January 1998 and SPX rose another 20% over the next 6 months before giving all of those gains back. SPX rose another month after a high CCI in May 1999 and another 8 months after a high CCI in November 1999 before the big bear market of 2000-02.<br />
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That was also the pattern in 1968-69: SPX rose another 5% a month after the high CCI before the 1969-70 bear market started. On the other hand, two highs in CCI in 1967 and 1968 coincided closely with 5% and 7% falls in SPX, respectively.<br />
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In general, risk/reward has been unfavorable over the next 6 months following a high in the CCI. In half of the instances listed below, SPX fell more than 4% during the next month. The median fall in the next 3 months was more than 5%, jumping to 9% in the next 6 months. Only 2 of the 17 instances (12%) avoided any serious trouble (in green). The odds strongly favor trouble.<br />
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<a href="https://www.marketwatch.com/author/mark-hulbert">Mark Hulbert</a> reaches a similar conclusion: SPX tends to underperform following a high CCI (his article is <a href="https://www.marketwatch.com/story/this-highly-accurate-stock-market-predictor-just-hit-its-most-bearish-level-since-the-internet-bubble-2019-08-01?mod=mark-hulbert">here</a>).<br />
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While the outlook for US equities suffers after a high CCI, it's hard to make the case that the economy is <i>necessarily</i> in immediate trouble. It took more than 3 years for the next recession after the CCI hit a similar level in 1997, and recessions have started from lower levels four other times in the past 40 years. There are not enough instances or consistency to draw a firm conclusion (from <a href="https://www.advisorperspectives.com/dshort">Doug Short</a>).<br />
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Urban Carmelhttp://www.blogger.com/profile/11008222748707680522noreply@blogger.comtag:blogger.com,1999:blog-6302409656195627126.post-9207713602704087572019-07-30T14:47:00.000-07:002019-07-31T09:42:37.753-07:00Weekly Market Summary<u>Summary</u>: The broadest US equity indices made new all-time highs last week. Stocks have risen 6 of the past 7 months and by more than 20%. The summer months can see interim weakness, but this level of momentum has a strong propensity to carry stocks higher into year-end.<br />
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The FOMC is likely to lower its guidance rate tomorrow. When the economy is expanding and stocks are near their highs (like now), this has been a net positive for equities.<br />
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Sentiment data is inconclusive, but a 3-5% decline wouldn't be unusual at this point, especially as the typically weak August-October period is now here.<br />
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The rally since early June has carried SPX more than 10% higher in just two months. July will likely end with US equities higher for the 6th time in the past 7 months (table from <a href="https://alphatrends.net/">alphatrends.net</a>). Enlarge any chart by clicking on it.<br />
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It's hard to argue that the trend is anything but higher. In the past week, SPX, NDX, COMPQ, and the very broad NYSE, Russell 3000 and Wilshire 5000, have all closed at new all-time highs (ATH).<br />
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The worst that can be said about trend is that there is a loss of momentum (top panel). In real-time, timing when that will matter is very hard, but a drop of 2-3% (or more), until momentum is 'oversold' (circles), would be normal.<br />
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SPX continues to grind higher (top panel) as volatility remains embedded under 16 (bottom panel). 2950 marks the point at which SPX broke out higher, making it the main level of interest on weakness.<br />
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Remember, stock markets don't normally remain placid for very long. It's been two months since a fall of more than 2%; even the 2013-14 period, during which SPX rose more than 50%, saw drops of 3% or more 11 times, or every other month on average.<br />
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The Bollinger Bands on SPX are the tightest since October 2018 (lower panel), just before the sell-off that lasted until Christmas Eve. Similar compressions in volatility in the past have typically been followed by a spike in VIX (middle panel). It would be normal for SPX to make a move to its lower Bollinger in the days/weeks ahead (top panel).<br />
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The longer term trend in equities has strong historical probability of continuing higher into year-end.<br />
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First, since 1950, when SPX has risen strongly in the first half of the year (like now), it has risen further (by a median of another 10%) in the second half <i>86% of the time</i>. The two exceptions were in 1983 and 1986, in which SPX closed the year a scant 2% and 3% lower, respectively (from <a href="https://www.schaeffersresearch.com/content">Schaeffer's</a>).<br />
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Likewise, since 1950, any 6 month rally that carries SPX at least 15% higher (like now) has been followed by further gains (of 8% on average) the next 6 months <i>93% of the time</i> (from <a href="https://twitter.com/bullmarketsco">Troy Bombardia</a>).<br />
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Similarly, since 1954, when SPX has risen 6 of the first 7 months of the year (like now) it has closed the year higher (by a median of 8%) <i>15 of the last 16 times (94%)</i>. The minimum draw-up during the next 5 months has been 6% from <a href="https://twitter.com/SJD10304?lang=en">Steve Deppe</a>).<br />
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The strong rally has already exceeded Wall Street strategists' year-end target for 2019. Since 1999, when SPX has already met the year-end target by mid-year, the index has continued to rise through year-end by a median of 10% (from <a href="https://www.sentimentrader.com/">Sentimentrader</a>; to become a subscriber and support the Fat Pitch, click <a href="https://partners.sentimentrader.com/idevaffiliate.php?id=101">here</a>).<br />
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Tomorrow, the FOMC is very likely to announce a cut in its guidance rate. Two months ago, we wrote why that has been bullish for equities (read that post <a href="http://fat-pitch.blogspot.com/2019/06/dont-fear-first-rate-cut.html">here</a>). Some further context follows (from <a href="https://www.bespokepremium.com/interactive/research">Bespoke</a>).<br />
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Since 1971, SPX has <i>always risen 3, 6, 9 and 12 months after</i> the first rate cut when the Leading Economic Index (LEI) has been positive (like now; the next two charts from <a href="https://twitter.com/fundstrat">Thomas Lee</a>).<br />
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It might seem strange that the FOMC is cutting rates with equities near their ATHs. It's not. Since 1980, the Fed has cut rates with SPX within 2% of an ATH 17 times. Stocks have been higher (by a median of 10%) a year later <i>all 17 times</i> (the next two charts from <a href="https://twitter.com/RyanDetrick">Ryan Detrick</a>).<br />
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That the rate cut is coming during the summer months could be a short term headwind for equities: August and September have historically been weak months for SPX.<br />
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That has especially been the case in pre-election years (like now). Both SPX and NDX have tended to drop and chop the next 3 months before rallying strongly from a low in October through year-end (from <a href="http://jeffhirsch.tumblr.com/">Jeff Hirsch</a>).<br />
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Could this year be different? Yes. NDX has done well in August and September in those years when both SPX and NDX have started the year strongly (like now). That doesn't preclude interim weakness, but it could well be short-lived (from <a href="https://twitter.com/SJD10304?lang=en">Steve Deppe</a>).<br />
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Sentiment data is inconclusive. Fund flow data and retail sentiment suggest upside; newsletter writers and options data suggest caution.<br />
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First, Investor Intelligence bulls now exceed bears by more than 40%. That's been an inconsistent tell but, on balance, it suggests more caution is now warranted (red lines).<br />
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Similarly, over the past month, options traders have been buying more calls and fewer puts - a bullish bias. Again, that isn't always bearish for SPX - see 2013 and 2017, for example - but a 3-5% decline wouldn't be unusual at this point (red lines).<br />
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Retail investors polled by AAII, however, are not bullish: over the last 4 weeks, bulls barely exceed bears. A 5% correction can happen any time, but anything more is almost always preceded by retail sentiment that is far more bullish than now.<br />
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Interestingly, active investors polled by NAAIM were 96% bullish last week. You'd guess that was an extreme worth noting, but in the past, SPX has underperformed in the next 1-2 weeks but not beyond that. A month (or more) later, SPX was higher more often than normal (from <a href="https://twitter.com/bullmarketsco">Troy Bombardia</a>).<br />
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While it might seem like the IPO market is especially hot and bubbly, it's not. It's acting normally and, thus, not sending a signal that investors are too bullish (from MarketWatch).<br />
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Economic data has not been great - that's why the FOMC will likely cut rates tomorrow - but it hasn't been terrible either. On the downside, home sales/permits and manufacturing have been weak; on the upside, employment and consumption have been strong.<br />
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The LEI, which weighs all of these and other data, is near its ATH from May. This index can fluctuate during an expansion but the final peak has been <i>at least 7 months</i> before the next recession in the past 50 years (from <a href="https://www.advisorperspectives.com/dshort">Doug Short</a>).<br />
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But investors have responded to troubling economic news headlines by becoming <i>exceptionally bullish on the safety of bonds</i>, meaning they expect bond prices to rise further (and yields to fall further; from <a href="https://twitter.com/biancoresearch">Jim Bianco</a>).<br />
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The last 3 times sentiment was this extreme, treasury yields rose very strongly (arrows)...<br />
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... and SPX also rose (arrows).<br />
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10 year yields need to exceed 2.2% (the June high and the 50-dma, blue line) to have a clear bottoming pattern.<br />
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On the calendar, the FOMC rate decision is Wednesday and the employment report is on Friday (from IBD Investors; for a trial subscription, <a href="https://shop.investors.com/offer/splashresponsive.aspx?id=mssharpenpopup&src=A00452A&refcode=UC_Links">please use this link</a>).<br />
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Urban Carmelhttp://www.blogger.com/profile/11008222748707680522noreply@blogger.comtag:blogger.com,1999:blog-6302409656195627126.post-78161504527147988392019-07-08T10:12:00.000-07:002019-07-08T10:12:32.572-07:00July Macro Update: Housing Remains The Weakest Link<u>Summary</u>: A small "insurance" rate cut by the FOMC later this month appears warranted given ongoing weakness in housing, but the balance of the macro data remains positive, meaning a<i> recession starting in 2019 is unlikely.</i><br />
<span style="font-weight: normal;"><br /></span>The bond market sees continued but modest growth. The yield curve has 'inverted' (10 year yields less than 2-year yields) ahead of <i>every</i> recession in the past 40 years (dots). The lag between inversion and the start of the next recession has been long: at least 7 months and in several instances as long as 2-3 years. The <i>yield curve has not yet inverted</i>; on this basis, the current expansion will <i>likely to last through 2019</i> at a minimum (from JPM). Enlarge any image by clicking on it.<br />
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Likewise, high yield spreads never blew out during the late-2018 market correction and have since declined/normalized. <i>Default rates remain well below average</i>. This part of the bond market is not signaling trouble (from JPM).<br />
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Similarly, real retail sales grew 2% and made a new all-time high (ATH) in May. The trend higher is strong, in comparison to the period prior to the past two recessions.<br />
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Unemployment claims are back in a declining trend, reaching a <i>50 year low in April (just 2 months ago)</i>. Historically, claims have started to rise at least 7 months ahead of the next recession.<br />
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<span style="font-weight: normal;"><i>Housing has been the primary macro concern</i>. In May, housing starts fell 5% yoy, building permits fell 1% and new home sales fell 4%. In the past 50 years, a median of 28 months has lapsed between </span>new home sales'<span style="font-weight: normal;"> expansion high (arrows) and the start of the next recession; so far, the cyclical high was 19 months ago</span>.<br />
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<span style="font-weight: normal;"><br /></span><span style="font-weight: normal;"><br /></span><span style="font-weight: normal;">New home sales rebounded 4% in the first five months of the year. The 2017 peak in home sales came after mortgage rates troughed in late 2017, and the rebound so far this year corresponds with mortgage rates falling from 5% in November to under 4% this month.</span><br />
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<span style="font-weight: normal;"><br /></span><span style="font-weight: normal;"></span><span style="font-weight: normal;"><br /></span><span style="font-weight: normal;">The Conference Board's Leading Economic Indicator (LEI) Index reached a <i>new uptrend high</i> in May. This index includes the indicators above plus equity prices, ISM new orders, manufacturing hours and consumer confidence. This index can fluctuate during an expansion but the final peak has been <i>at least 7 months</i> before the next recession in the past 50 years (from Doug Short).</span><br />
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<span style="font-weight: normal;"><br /></span><span style="font-weight: normal;"><br /></span>Why does any of this matter for the stock market?<br />
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Equity prices typically fall ahead of the next recession, but the macro indictors highlighted above <i>weaken</i> <i>even earlier</i> and help distinguish a 10% correction from an oncoming prolonged bear market. On balance, these <i>indicators are not hinting at an imminent recession</i> (a recent post on this is <a href="http://fat-pitch.blogspot.com/2018/05/when-innocuous-correction-is-start-of.html">here</a>).<br />
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Here are the main macro data headlines from the past month:<br />
<blockquote class="tr_bq">
<b>Employment</b>: Monthly employment gains have averaged 192,000 in the past 12 months, with an annual growth of 1.5% yoy. Employment has been been driven by full-time jobs, which rose to a new all-time high in June. </blockquote>
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<b>Compensation</b>: Compensation growth is on an improving trend. Hourly wage growth was 3.1% yoy in June, while the 1Q19 employment cost index grew 3.0% yoy, nearly the highest growth in the past 10 years. </blockquote>
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<b>Demand</b>: Real demand growth has been 2-3%. Real retail sales grew 1.3% yoy in May, making a new all-time high. May real personal consumption grew 2.7% to a new all-time high.</blockquote>
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<b>Housing</b>: Macro weakness has been most apparent in housing. In May, housing starts fell 5% yoy, building permits fell 1% and new home sales fell 4%. Multi-family units have been a drag on overall development for several years. </blockquote>
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<b>Manufacturing</b>: Macro weakness has also been apparent in manufacturing. Core durable goods rose just 0.7% yoy while the manufacturing component of industrial production grew just 0.9% yoy in May. </blockquote>
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<b>Inflation: </b>The core inflation rate remains near the Fed's 2% target. </blockquote>
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Our key message over the past 6 years has been that (a) growth is positive but slow, in the range of ~2-3% (real), 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.<br />
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This is germane to equity markets in that <i>macro growth drives corporate revenue, profit expansion and valuation levels</i>. The simple fact is that when the economy is expanding, the historical risk of a greater than 10% annual (not intra-year) decline in the stock market is just 4% (from Goldman Sachs).<br />
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The highly misleading saying that <i>"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</i>. When they diverge, it is normally a function of emotion, whether measured in valuation premiums/discounts or sentiment extremes.<br />
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A valuable post on using macro data to improve trend following investment strategies can be found <a href="http://www.philosophicaleconomics.com/2016/02/uetrend/">here</a>.<br />
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While the macro data is fine, a <i>possible wild card is the escalation in the trade war</i>, which reduces global demand, raises prices and eventually leads to lower investment (from <a href="https://www.stlouisfed.org/on-the-economy/2018/june/tariff-increases-potential-economic-effects">St Louis Fed</a>).<br />
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Let's review the most recent data, focusing on four macro categories: labor market, end-demand, housing, and inflation.<br />
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<b>Employment and Wages</b><br />
<b><br /></b>The June non-farm payroll was <i>224,000 new employees </i>minus 11,000 in net revisions for the prior two months.<br />
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<i>Employment growth accelerated last year</i>. The average monthly gain in employment was 240,000 in 2015, 211,000 in 2016 and189,000 in 2017 but it increased to 204,000 in 2018. In the past 12 months, the monthly average is 192,000, a small contraction from last year.<br />
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Monthly <i>NFP prints are volatile</i>. Since the 1990s, NFP prints near 300,000 (like in January) have been followed by ones near or under 100,000 (like in May). That has been a pattern during every bull market; NFP was negative at times during 1993, 1995, 1996 and 1997. This is normal, not unusual or unexpected.<br />
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Why is there so much volatility? Leave aside the data collection, seasonal adjustment and weather issues; appreciate that a "beat" or a "miss" of 120,000 workers in a monthly NFP report is within the 90% confidence interval (explained <a href="https://projects.fivethirtyeight.com/jobs-report-growth-unemployment/">here</a>).<br />
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For this reason, it's better to look at the trend; in June, trend <i>employment growth was 1.5% yoy</i>. Until spring 2016, annual growth had been over 2%, the highest since the 1990s. Ahead of a recession, employment growth normally falls, a potential watch out (arrows).<br />
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<i>Employment has been been driven by full-time jobs</i>, which rose to a new all-time high in June (blue line), not part-time jobs (red line).<br />
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The labor force participation rate (the percentage of the population over 16 that is either working or looking for work) has <i>stabilized over the past 5 years</i>. The participation rate had been falling since 2001 as baby boomers retire, exactly as participation started to rise in the mid-1960s as this demographic group entered the workforce. Another driver is women, whose participation rate increased from about 30% in the 1950s to a peak of 60% in 1999, and younger adults staying in school (and thus out of the work force) longer.<br />
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A better measure is the prime working age (25 to 54 year olds) labor force participation rate; it stands at 82%, <i>down only slightly from its peak in 2000</i> at 84%, and much higher than anytime prior to the 1980s.<br />
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Average hourly <i>earnings growth was 3.1% yoy</i> in June; February's rate of 3.4% was the highest in 10 years. This is a positive trend, showing demand for more workers. Sustained acceleration in wages would be a big positive for consumption and investment that would further fuel employment.<br />
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Similarly, 1Q19 employment cost index shows total <i>compensation growth was 3.0% yoy</i>, nearly the highest in the past 10 years.<br />
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For those who doubt the veracity of the BLS employment data, federal individual income tax receipts have also been rising<b> </b>to new highs<b> </b>(red line), a sign of better employment and wages (from Yardeni).<br />
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<b>Demand</b><br />
<b><br /></b>Regardless of which data is used, real demand has been growing at about 2-3%, equal to about 4-5% nominal.<br />
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Real (inflation adjusted) <i>GDP growth through 1Q19 was 3.2% yoy</i>, the best growth rate in nearly 4 years.<br />
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Stripping out the changes in GDP due to inventory produces "real final sales". This is a better measure of consumption growth than total GDP. In 1Q19, this <i>grew 2.7% yoy</i>. A sustained break above 3% would be noteworthy.<br />
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The "real personal consumption expenditures" component of GDP (<a href="http://mic.com/articles/15097/us-gdp-is-70-percent-personal-consumption-inside-the-numbers">defined</a>), which accounts for about 70% of GDP, <i>grew 2.7% yoy</i> in 1Q19.<br />
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On a monthly basis, <i>real personal consumption expenditures grew 2.7% yoy</i> in May to a new ATH.<br />
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GDP measures the total expenditures in the economy. An alternative measure is GDI (gross domestic income), which measures the total income in the economy. Since every expenditure produces income, these are equivalent measurements of the economy. Some research suggests that GDI might be more accurate than GDP (<a href="http://www.nytimes.com/2014/09/27/upshot/gdp-report-emphasizes-the-problem-of-conflicting-economic-signals.html?abt=0002&abg=0">here</a>).<br />
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Real GDI growth in 1Q19 was 1.7% yoy.<br />
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Real retail sales grew 1.3% yoy in May, making a new ATH. Sales fell yoy more than a year ahead of the last recession which makes the negative annual growth in December notable.<br />
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Retail sales in the past three years have been strongly affected by the large fall and rebound in the price of gasoline. In May, real retail sales at gasoline stations grew by 1.3% yoy after having fallen more than 20% yoy during 2016. <i>Real retail sales excluding gas stations grew 1.3% </i>in May.<br />
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This expansionary cycle is not like others in the past 50 years. Households' savings rate typically falls as the expansion progresses; this time, savings has risen and remains at an elevated level.<br />
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The next several slides look at manufacturing. It's important to note that manufacturing accounts for less than 10% of US employment, so these measures are of lesser importance.<br />
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Core durable goods orders (excluding military, so that it measures consumption, and transportation, which is highly volatile) <i>rose 0.7% yoy</i> (nominal) in May. Weakness in durable goods has not been a reliable predictor of broader economic weakness in the past (arrows).<br />
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Industrial production (real manufacturing, mining and utility output) <i>growth was 2.0% yoy</i> in May. The more important manufacturing component (excluding mining and oil/gas extraction; red line) grew just 0.9% yoy. Growth has moderated for both, with the cycle peak (so far) in December 2018. Industrial production is a volatile series, with negative annual growth during parts of 2014 and 2016.<br />
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Importantly, <i>52% of industrial production groups are expanding</i>. A drop below 40% has implied widespread weakness that typically precedes a recession (from <a href="https://blogs.uoregon.edu/timduyfedwatch/">Tim Duy</a>).</div>
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Weakness in total industrial production in 2015-16 was concentrated in the mining sector, with the worst annual fall in more than 40 years. It is not unusual for this part of industrial production to plummet outside of recessions. With the recovery in oil/gas extraction, mining rose 10% yoy in May. </div>
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Companies are often wrongly accused of underinvesting in lieu of greater share repurchases (buybacks). But capacity utilization is still under 80%, so there is plenty of room for production to expand within existing capacity. </div>
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For 2Q19, the <a href="https://www.frbatlanta.org/cqer/research/gdpnow.aspx">Atlanta Fed</a> estimates growth to have declined to 1.3%.</div>
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<b>Housing</b><br />
<b><br /></b>Macro weakness has been most apparent in housing.<br />
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First, new single family houses sold was 626,000 in May, falling 4% yoy. The <i>cycle high was in November 2017, 19 months ago: </i>the cycle high has been a median of 28 months before the next recession (arrows). Overall levels of construction and sales are small relative to prior bull markets.<br />
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Second, housing s<i>tarts fell 5% in May,</i> a rebound from a 11% yoy decline in February<i>. </i>The cycle high was in January 2018, 16 months ago; the cycle high has typically been well over a year before the next recession (arrows).<br />
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Building permits (red line) <i>fell 1% yoy in </i><i>May</i> after rising 8% yoy in May 2018.<br />
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Single family housing starts (blue line) fell 12% yoy in May; multi-unit housing starts (red line) rose 14% yoy but have been a drag on overall starts for more than 4 years.<br />
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<b>Inflation</b><br />
<b><br /></b>Despite steady employment, demand and housing growth, core <i>inflation remains near the Fed's target of 2%</i>.<br />
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CPI (blue line) was 1.8% last month. The more important core CPI (excluding volatile food and energy; red line) <i>grew 2.0%</i>.<br />
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The Fed prefers to use personal consumption expenditures (PCE) to measure inflation; total and core <i>PCE were 1.5% and 1.6% yoy</i>, respectively, in May.<br />
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Some mistrust CPI and PCE. MIT publishes an independent price index (called the billion prices index; blue line). It has tracked both CPI (red line) and PCE closely.<br />
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<b>Summary</b><br />
<b><br /></b>On balance, the major macro data so far suggest continued positive, but modest, growth. This is consistent with corporate sales growth. SPX sales growth in 2019 is expected to be about 5% (nominal).<br />
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Valuations are slightly above their 25 year average. The consensus expects earnings to only grow about 3% in 2019 but there is room for faster equity appreciation through valuation expansion (chart from JPM).<br />
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Urban Carmelhttp://www.blogger.com/profile/11008222748707680522noreply@blogger.comtag:blogger.com,1999:blog-6302409656195627126.post-50842973820134062232019-06-26T11:56:00.000-07:002019-06-27T07:45:50.946-07:00Small Caps Are Lagging. Investors Should Be More Concerned When They Lead<u>Summary</u>: SPX made a new all-time high (ATH) last week. DJIA and NDX were not far behind. And the broadest measure of the US stock market comprising 98% of stocks came just 0.1% shy of a new ATH.<br />
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By contrast, small caps are lagging. They have retained none of their gains made over the past 1-1/2 years and haven't been close to a new ATH in 10 months. Should investors be worried?<br />
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By most measures, the answer is probably not. Small cap underperformance has more often marked a low in SPX, not a high. Investors should be more worried when small caps - which are highly speculative and high beta - lead, as this has most often been a feature of major bull market tops, the reverse of the situation we have now.<br />
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Last week, SPX made a new all-time high (ATH). The DJIA equalled its ATH from October 2018 and NDX came within 1% of its ATH from just last month. The broadest measure of the US stock market, the Russell 3000, which comprises 98% of stocks, exceeded its May high and came within 0.1% of its October 2018 ATH. By most measures, US stock prices are doing well. Enlarge any chart by clicking on it.<br />
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So naturally some investors are highlighting the relative weakness of the small cap index, the Russell 2000, which is lagging every other index. It's currently 12% below its ATH from August 2018, under both its 50-d and 200-d and has retained none of the gains made since November 2017, 1-1/2 years ago.<br />
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There's no doubt that RUT is weak and that investors in small caps should take note. But should investors in the broader market care more about the weakness in RUT or the strength of the other indices?<br />
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Fund managers interviewed by Bloomberg believe they should care more about RUT, calling small caps a good barometer on the economy and a leading indicator for the broader indices (that article is <a href="https://www.bloomberg.com/news/articles/2019-06-24/two-groups-of-stocks-about-to-send-crisis-era-signals-on-economy">here</a>).<br />
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In particular, the relative weakness in RUT versus the broader market is highlighted as being prescient of domestic economic weakness that usually presages a fall in the large cap indices.<br />
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In truth, however, that has usually not been the case. The next chart shows those times in the past 11 years where RUT has significantly lagged SPX (the lower panel is the same as the chart above). Most have not signified valid economic weakness and SPX (upper panel) has, in fact, been near a low.<br />
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Going back further, it is also hard to make the case that RUT has been a useful tell for the economy or the broader market. Most of the 1990's boom (green arrow) was accompanied by persistent underperformance in small caps (red arrow). That divergence lasted 6 years. Moreover, the exact final top in 2000 came after a year in which small caps strongly outperformed (circle).<br />
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That RUT's underperformance should not be a primary concern is further shown by two studies from <a href="https://www.marketwatch.com/author/mark-hulbert">Mark Hulbert</a>.<br />
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First, SPX has done much better when it leads RUT than when RUT leads SPX. In fact, RUT leadership has been market negative.<br />
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Second, in the 29 bull market tops since 1926, RUT has peaked <i>after</i> SPX in more than half the cases. That means that strong <i>outperformance</i> by RUT now, after SPX's recent ATH, would be a concern. A lagging RUT has marked a top in the broader stock market in just 1/3 of these cycles. Recall that RUT last made an ATH 10 months ago.<br />
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What's going on here?<br />
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First, RUT is a much smaller index than SPX, DJIA or NDX. SPX represents about 74% of the total market capitalization of US equities. RUT is just 8%. The 6 largest components of DJIA have a greater combined market capitalization than all 2000 components of the RUT. It's not clear why a small subset should be expected to provide more useful insight on the health of US equities than SPX itself.<br />
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Second, RUT comprises 2000 companies with an average market capitalization of $1.3b. For the 500 companies in SPX, the average is nearly $50bn. These are small companies, much less followed by Wall Street analysts, in turn making them more speculative. The average beta of RUT is about 30% higher than SPX. This is key. When investors are bullish, you should expect RUT to outperform SPX, as it has most often done into an important top. The reverse is also true when investors are bearish; investors sell speculative small cap stocks into an important low.<br />
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Finally, it's worth putting the recent underperformance of RUT in perspective. The index's performance is in line with SPX since both the October 2007 bull market top and the March 2009 bear market bottom. Since then, periods of outperformance have been followed by periods of underperformance. In other words, what we are seeing now could well be nothing more than mean reversion, similar to mid-2010, mid-2011, early-2016 and late-2018.<br />
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In summary, the main stock indices in the US are near their ATHs. The small cap index is the exception. Their underperformance has most often marked a low in SPX, not a high. Investors should be more worried when small caps - which are highly speculative and high beta - lead, as this has most often been a feature of major bull market tops, the reverse of the situation we have now.<br />
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Urban Carmelhttp://www.blogger.com/profile/11008222748707680522noreply@blogger.comtag:blogger.com,1999:blog-6302409656195627126.post-8776950799847098962019-06-19T13:02:00.000-07:002019-06-19T13:02:53.105-07:00An Extreme In Investor Fear And Pessimism<u>Summary</u>: Fund flows out of equities and into the safety of bonds is the most extreme in more than 15 years. Retail investor bearishness is consistent with that at Christmas, early 2016 and other durable lows in equities.<br />
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Fund managers surveyed by BAML are similarly pessimistic. Their cash allocation is one of the highest in 16 years. Their equity allocation is the lowest since the bear market bottom in March 2009. And their allocation to bonds is near an 8-year high.<br />
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All of this suggests a continued upside tailwind for equities and a strong headwind for bonds. Could investors, especially fund managers, be right this time? Of course, but it's not likely. The last bear market started with strong equity inflows and bond outflows. Cash levels were relatively low. All of this is the reverse now. <br />
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The US dollar is considered the most overvalued in 16 years, a possible tailwind for US multi-nationals and ex-US equities.<br />
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By most accounts, the fall in equities in May was exacerbated by investor fear. That fear does not appear to have dissipated with the rise in equities so far in June.<br />
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Let's review several recent studies of sentiment.<br />
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First, a study from Bernstein shows that flows out of equities and into bonds so far in 2019 is the <i>most extreme in more than 15 years</i>. Enlarge any image by clicking on it.<br />
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This is an outlier event more than <i>3 standard deviations</i> from the mean. Prior instances are few but equities have done very well in the months ahead.<br />
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Those dates are highlighted in the chart below. This is not how bear markets, or even big corrections, begin.<br />
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Second, a similar view from Deutsche Bank on <i>equity outflows - the largest on record</i> - tells the same tale. Equities rose over 20% in the year following similar outflows in 2011 and 2016.<br />
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Third, retail investors polled by AAII were recently <i>as bearish as they were at Christmas</i> and in early 2016. Over the past 15 years, such bearishness has come at durable lows, with just two exceptions (red arrows), one of which was at the end of the 2-year bear market following the tech bubble.<br />
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Fourth, this week's Bank of America Merrill Lynch (BAML) survey of global fund managers is consistent with the data presented above. These managers oversee a combined $600b in assets and their views reflect how managers are allocated in various asset classes. Our sincere gratitude to BAML for the use of this data. A more detailed review of their findings follows.<br />
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<b>Overall</b>: Relative to history, fund managers are<i> extremely overweight cash and extremely underweight equities</i>.<br />
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Within equities, the US is slightly overweight while Europe, in particular, is very underweight. Emerging markets are close to neutral. A pure contrarian would overweight equities relative to cash and bonds, and European equities relative to the US and emerging markets.<br />
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<b>Cash</b>: Fund managers' <i>cash balance is extremely high at 5.6%</i>, a big jump from 4.6% last month. BAML considers cash levels above 4.5% to be a contrarian buy for equities, and below 3.5% to be a contrarian sell.<br />
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This is supportive of further gains in global equities. Recall that in October 2016, fund managers' cash levels rose to 5.8% (similar to now). Global equities rose over 30% in the next year. In the past 15 years, cash allocations have very rarely been higher than now.<br />
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Likewise, fund managers are a net <i>+43% overweight cash (+1.7 standard deviations</i> above its long term mean). In the context of a bull market, cash should underperform a 60-30-10 basket (equity-bonds-cash).<br />
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<b>Global equities</b>: Fund managers' global equity allocations plummeted to<i> </i>+21% underweight <i>(</i>-2.1 standard deviations below its long term mean) from +11% overweight last month. <i>This is the lowest equity allocation since the bear market bottom in March 2009</i>.<br />
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This is supportive of further gains in global equities, with bottoms in 2010, 2011 and 2016 at less extreme equity allocations. It is true, however, that allocations were even lower during the 2008 bear market.<br />
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Equity allocations relative to bonds is likewise at an extreme not seen since the end of the bear market in 2009. In other words, fund managers have sold equities for the safety of bonds. This is consistent with the fund flow data presented earlier.<br />
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<b>Global bonds: </b>Fund managers are -22% underweight bonds, <i>the highest allocation in nearly 8 years </i>(+1.1 standard deviations above its long term mean).<br />
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Fund managers' bond allocation has been a less helpful indicator of performance. For one, fund managers are almost always underweight. Still, when fund managers have been less than -35% underweight (e.g., mid-2016 and early-2019), bonds have subsequently underperformed (red arrows). A contrarian would expect global bonds to underperform equities.<br />
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What is driving the shift from equities to bonds?<br />
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First, in November, 70% of fund managers expected higher inflation over the next 12 months; this was near a 14-year high. <i>Since then, inflation expectations have collapsed by the largest amount since the 2011</i> (first chart). As in the past, a strong consensus view on inflation preceded a drop in US 10-year yields in the following months (second chart).<br />
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Second, fund managers are not bullish on profits, with a net -41% expecting a contraction in the next 12 months. Negative profit expectations marked equity lows in mid-2010, late-2011, mid-2012, early 2016 and January 2019, and earlier in 1998 and 2006. Like cash, it's true that profit expectations were even lower during the 2001 and 2008 bear markets.<br />
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Similarly, a net -50% expect a better economy in the next year, near the lows in January. Investors are not bullish on the global economy: they are most often wrong, but were right in both 2000 and 2008.<br />
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<b>Regional equities: </b>Fund managers have only slightly increased their allocations to <i>US equities, to +5% overweight</i> (+0.5 standard deviations above its long term mean).<br />
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On the one hand, the US is now the 2nd most favored region. On the other hand, the region has not typically underperformed until allocations have been more than +15-20% overweight (e.g., December 2016 and November 2018; red arrows). Net, there is room for US equities to rise further.</div>
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Fund managers are now -<i>8% underweight European equities</i> (-0.9 standard deviations below its long term mean), similar to the low in January (which was a 6-1/2 year low).<br />
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The region should outperform: when fund managers have been underweight, European equities have usually outperformed (green arrows) although that was not the case in 2008 and 2011 (red arrows).<br />
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Fund managers are <i>+21% overweight emerging market equities </i>(+0.1 standard deviations above its long term mean).<br />
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EM remains the consensus long although, relative to history, the current allocation is close to neutral. The region has usually started to outperform after fund managers drop their allocation to underweight (green arrows). A contrarian would expect the region to underperform.<br />
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<b>Dollar</b>: The US Dollar is considered the <i>most overvalued in the history of the BAML survey </i>(+2.1 standard deviations above its long term mean).<br />
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Since 2004, fund managers surveyed by BAML have been good at determining when the dollar is overvalued (red arrows); the last year has been an exception (green arrow). Risk is to the downside. A weaker dollar benefits US multi-nationals as well as European and emerging markets equities.<br />
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Survey parameters are below.<br />
<ol>
<li><b>Cash</b>: The typical range is 3.5-5.0%. BAML has a 4.5% contrarian buy level but we consider over 5% to be a better signal. More on this indicator <a href="http://fat-pitch.blogspot.com/2013/01/fund-manager-cash-balance-at-extremes.html">here</a>. </li>
<li><b>Equities</b>: Over +50% overweight is bearish. A washout low (bullish) is under +15% overweight. More on this indicator <a href="http://fat-pitch.blogspot.com/2013/01/fund-manager-equity-exposure-at-extremes.html">here</a>. </li>
<li><b>Bonds</b>: Global bonds started to underperform in mid-2010, 2011 and 2012 when they reached -20% underweight. -60% underweight is often a bearish extreme.</li>
<li><b>Commodities</b>: Higher commodity exposure goes in hand with improved sentiment towards global macro and/or inflation.</li>
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Urban Carmelhttp://www.blogger.com/profile/11008222748707680522noreply@blogger.comtag:blogger.com,1999:blog-6302409656195627126.post-47035126472416717202019-06-17T11:50:00.000-07:002019-06-20T09:48:03.090-07:00What The New High In The Advance-Decline Line Means For Stocks<div class="separator" style="clear: both; text-align: center;">
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<u>Summary</u>: The cumulative advance-decline (A-D) line for both the NYSE and SPX made a new all-time high (ATH) last week. That's good news for stocks, as they most often move higher in the following weeks/months, also to new highs.<br />
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This is probably the best way to use the A-D line in equity research. Other common uses of A-D line are fraught with issues.<br />
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For example, while it's true that the A-D line has often weakened before stocks have encountered a major decline, you'll need hindsight to make use of this information. For every time a weakening A-D line has signaled a major fall it has signaled nothing special at least twice as often. "Negative divergences" happen all the time. In real-time, it is impossible to know when a divergence is worth paying attention to.<br />
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Last week, the cumulative advance-decline (A-D) line for both the NYSE and SPX made a new all-time high (ATH). The A-D line sums the net number of stocks moving up on the day added to yesterday's total. The idea is that when the A-D line is rising, more stocks are moving higher and breadth is considered healthy. In other words, it's a bullish sign for stocks.<br />
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Let's start with the good news.<br />
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The charts below show every "breakout" in the NYSE A-D line to a new high (top panel) and what happened next to SPX (lower panel) in the past 30 years. What we find is that in every case, SPX has moved higher in the weeks/months ahead. Enlarge any chart by clicking on it.<br />
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The not so good news is that the gains haven't always been right away. In the chart above, note how SPX went nowhere for several months in 2016. That was also the case in 1993 and 1996, for example.<br />
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But, all things considered, the breakout to a new high in the A-D line while SPX is still below it's own ATH looks bullish. With SPX not even 2% from its April ATH, we should expect a new ATH in the weeks/months ahead.<br />
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Those results are confirmed by Sentimentrader: since 1950, a new high in the A-D line when SPX was less than 10% from a 52-week high has been followed by a new ATH within 3 months in 81% of instances. The median gain 3 months later was about 4% (to become a subscriber to <a href="https://www.sentimentrader.com/">Sentimentrader</a>, and support the Fat Pitch, click <a href="https://partners.sentimentrader.com/idevaffiliate.php?id=101">here</a>).<br />
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This is probably the best way to use the A-D line in equity research. Other common uses of A-D line are fraught with issues.<br />
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The most popular way to use the A-D line is to identify major stock market tops (defined as a fall greater than 15%). It's true that the A-D line has generally (but not always) peaked and started to decline before stocks have encountered a major decline, but you'll need hindsight to make use of this information.<br />
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The charts below compare the NYSE A-D line (top panel) to SPX (bottom panel) since 1980. The green lines indicate periods before a larger than 15% fall in SPX that were preceded by new high and then decline in the A-D line. In the first chart, between 1980 and 1993, there were 4 major falls in SPX and the A-D line weakened from a peak before each one.<br />
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Likewise, between 1997 and 2008, the major declines, including both the 2000-02 and 2007-09 bear markets, were preceded by the A-D line weakening from a peak.<br />
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There have been 4 major declines in stocks since 2009. The A-D peaked before 3 of these (although the time lag was very short). The 2011 decline was an exception in that the A-D line peaked after SPX had already started to fall (red line).<br />
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So, out of 11 major declines in stocks since 1980, the A-D line has started to fall ahead of 10 of them. That looks pretty good. But can you use this in real-time?<br />
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Unfortunately, the answer is no. For every time the A-D line has signaled a major fall (green line) it has signaled nothing special at least twice as often (red lines). "Negative divergences" happen all the time. In real-time, it is impossible to know when a divergence is worth paying attention to.<br />
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The A-D line peaked in 1958 and declined for the next 16 years during which the SPX more than doubled. By the time the A-D line made a new high, almost 50 years had passed and SPX was 30 times higher. That's a pretty long and hard to time negative divergence.<br />
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Another problem in using the A-D line is this: the vast majority of declines in stocks of at least 5% are virtually <i>coincident</i> with a high in the A-D line. <i>Just as stocks are peaking, so is the A-D line</i>. In real time, this is often viewed as bullish, that "breadth is confirming price." It's not bullish.<br />
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The chart below shows just the last 10 years, with red lines indicating new highs in the A-D line coincident with an uptrend high in SPX. This is the majority of cases before a fall of 5% or more. The green lines show when the A-D line peaked and started to decline before stocks, which is the minority outcome.<br />
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So if you are expecting the A-D line to signal weakness in stocks ahead of a decline in stocks of 5-10%, you're in for a bad surprise.<br />
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Why is the utility of the A-D line so limited?<br />
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We have previously described the problems in using breadth for identifying market inflection points. In short, the conventional wisdom that new highs in the stock indices should be confirmed by an expansion in breadth is empirically false. Indices have typically been driven higher based on a small number of stocks contributing disproportionately large gains. Over the past 20 years, just 4% of stocks have accounted for an astounding 68% of the gains in the SPX (read further <a href="http://fat-pitch.blogspot.com/2017/06/using-breadth-to-anticipate-market.html">here</a>).<br />
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Moreover, stock market returns have typically been best when breadth is worst. From 2012 to 2017, the SPX has gained more than 3 times as much over the following month when breadth was weak compared to when breadth was "healthy." Risk/reward was more than twice as favorable when breadth has been weak as when it was healthy.<br />
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The A-D line has specific conceptual issues. Again, the A-D line sums the net number of stocks moving up on the day added to yesterday's total. But if a lot of small stocks move up by <i>one penny</i> on low volume but slightly fewer large companies move down <i>a dollar</i> on high volume, the cumulative advance-decline line still moves higher. Or, if a large number of defensive stocks move up while "risk-on" cyclical stocks move down, the cumulative advance-decline line moves higher. Neither of these is a sign of market health.<br />
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In summary, the new ATH in the A-D line for both the NYSE and SPX last week is good news for stocks, as they most often move higher in the following weeks/months. This is probably the best way to use the A-D line in equity research.<br />
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Urban Carmelhttp://www.blogger.com/profile/11008222748707680522noreply@blogger.comtag:blogger.com,1999:blog-6302409656195627126.post-50497671650525654942019-06-07T08:39:00.000-07:002019-06-17T06:44:44.741-07:00June Macro Update: Employment and Housing Strong, Manufacturing Weak<u>Summary</u>: It's been a noisy few months for macro. The prolonged government shutdown in December significantly delayed many data reports. Into this mess, several reports were ugly:<br />
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Retail sales in December fell into yoy contraction for the first time since 2009. </blockquote>
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New employment in February fell to the lowest level since 2010. </blockquote>
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New home sales growth in December dropped 14% yoy, the lowest rate since 2011.</blockquote>
<span style="font-weight: normal;"><br /></span><span style="font-weight: normal;">That weakness now looks anomalous: the </span>data from the past month mostly point to positive growth<span style="font-weight: normal;">.</span><span style="font-weight: normal;"> <i>A recession starting in 2019 is unlikely.</i></span><br />
<span style="font-weight: normal;"><br /></span>The bond market sees continued growth. The yield curve has 'inverted' (10 year yields less than 2-year yields) ahead of <i>every</i> recession in the past 40 years (dots). The lag between inversion and the start of the next recession has been long: at least 7 months and in several instances as long as 2-3 years. On this basis, the current expansion will <i>likely to last through 2019</i> at a minimum (from JPM). Enlarge any image by clicking on it.<br />
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Likewise, high yield <i>spreads never blew out during the market correction and have since declined/normalized.</i> Default rates remain well below average. This part of the bond market is not signaling trouble (from JPM).<br />
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Unemployment claims are back in a declining trend. Historically, claims have started to rise at least 7 months ahead of the next recession: <i>claims reached a 50 year low in April (1 month ago)</i>, a big positive.<br />
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Less positive is recent consumption data. Real retail sales declined on a yoy basis in December, but rebounded to just <i>1.1% growth in April</i>. The trend flattened in the period prior to the past two recessions and there is some risk that the same is beginning to happen now. Continued improvement in the months ahead is needed.</div>
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<span style="font-weight: normal;">Housing had been the primary macro concern. In April, housing starts fell 3% yoy and building permits fell 5%. But new <i>home sales in March reached a new cycle high</i> and grew 7% yoy in April: in the past 50 years, a median of 28 months has lapsed between </span>new home sales'<span style="font-weight: normal;"> expansion high (arrows) and the start of the next recession, so the recent cyclical high 2 months ago is a significant positive</span>.<br />
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<span style="font-weight: normal;"><br /></span><span style="font-weight: normal;"><br /></span><span style="font-weight: normal;">New home sales have rebounded 20% in the first four months of the year. The 2017 peak in home sales came after mortgage rates troughed in late 2017, and the new cyclical peak in March corresponds with mortgage rates falling from 5% in November to 4% this month.</span><br />
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<span style="font-weight: normal;"><br /></span><span style="font-weight: normal;"></span><span style="font-weight: normal;"><br /></span><span style="font-weight: normal;">The Conference Board's Leading Economic Indicator (LEI) Index reached a <i>new uptrend high</i> in April. This index includes the indicators above plus equity prices, ISM new orders, manufacturing hours and consumer confidence. This index can fluctuate during an expansion but the final peak has been <i>at least 7 months</i> before the next recession in the past 50 years (from Doug Short).</span><br />
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<span style="font-weight: normal;"><br /></span><span style="font-weight: normal;"><br /></span>Why does any of this matter for the stock market?<br />
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Equity prices typically fall ahead of the next recession, but the macro indictors highlighted above weaken <i>even earlier</i> and help distinguish a 10% correction from an oncoming prolonged bear market. On balance, these <i>indicators are not hinting at an imminent recession</i> (a recent post on this is <a href="http://fat-pitch.blogspot.com/2018/05/when-innocuous-correction-is-start-of.html">here</a>).<br />
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Here are the main macro data headlines from the past month:<br />
<blockquote class="tr_bq">
<b>Employment</b>: Monthly employment gains have averaged 196,000 in the past 12 months, with an annual growth of 1.6% yoy. Employment has been been driven by full-time jobs, which rose to a new all-time high in May. </blockquote>
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<b>Compensation</b>: Compensation growth is on an improving trend. Hourly wage growth was 3.1% yoy in May, while the 1Q19 employment cost index grew 3.0% yoy, nearly the highest growth in the past 10 years. </blockquote>
<blockquote class="tr_bq">
<b>Demand</b>: Real demand growth has been 2-3%. In 1Q19, real GDP grew 3.2% and real personal consumption grew 2.8%. Real retail sales grew 1.1% yoy in April, just below a new all-time high in March. April real PCE grew 2.7% after making a new all-time high in March.</blockquote>
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<b>Housing</b>: New home sales rose 7% yoy in April and made a new cycle high in March. That said, housing starts fell 3% yoy and permits fell 5% yoy in April. Multi-family units remain a drag on overall development. </blockquote>
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<b>Manufacturing</b>: Macro weakness has been apparent in manufacturing. Core durable goods fell 2.6% yoy in April while the manufacturing component of industrial production was flat in April. </blockquote>
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<b>Inflation: </b>The core inflation rate remains near the Fed's 2% target. </blockquote>
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Our key message over the past 6 years has been that (a) growth is positive but slow, in the range of ~2-3% (real), 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.<br />
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This is germane to equity markets in that <i>macro growth drives corporate revenue, profit expansion and valuation levels</i>. The simple fact is that when the economy is expanding, the historical risk of a greater than 10% annual (not intra-year) decline in the stock market is just 4% (from Goldman Sachs).<br />
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The highly misleading saying that <i>"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</i>. When they diverge, it is normally a function of emotion, whether measured in valuation premiums/discounts or sentiment extremes.<br />
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A valuable post on using macro data to improve trend following investment strategies can be found <a href="http://www.philosophicaleconomics.com/2016/02/uetrend/">here</a>.<br />
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While the macro data is fine, a <i>possible wild card is the escalation in the trade war</i>, which reduces global demand, raises prices and eventually leads to lower investment (from <a href="https://www.stlouisfed.org/on-the-economy/2018/june/tariff-increases-potential-economic-effects">St Louis Fed</a>).<br />
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Let's review the most recent data, focusing on four macro categories: labor market, end-demand, housing, and inflation.<br />
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<b>Employment and Wages</b><br />
<b><br /></b>The May non-farm payroll was <i>75,000 new employees </i>minus 75,000 in net revisions for the prior two months.<br />
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<i>Employment growth accelerated last year</i>. The average monthly gain in employment was 240,000 in 2015, 211,000 in 2016 and189,000 in 2017 but it increased to 204,000 in 2018. In the past 12 months, the monthly average is 196,000, similar to last year.<br />
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Monthly <i>NFP prints are volatile</i>. Since the 1990s, NFP prints near 300,000 (like in January) have been followed by ones near or under 100,000 (like in May). That has been a pattern during every bull market; NFP was negative at times during 1993, 1995, 1996 and 1997. This is normal, not unusual or unexpected.<br />
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Why is there so much volatility? Leave aside the data collection, seasonal adjustment and weather issues; appreciate that a "beat" or a "miss" of 120,000 workers in a monthly NFP report is within the 90% confidence interval (explained <a href="https://projects.fivethirtyeight.com/jobs-report-growth-unemployment/">here</a>).<br />
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For this reason, it's better to look at the trend; in May, trend <i>employment growth was 1.6% yoy</i>. Until spring 2016, annual growth had been over 2%, the highest since the 1990s. Ahead of a recession, employment growth normally falls, a potential watch out (arrows).<br />
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<i>Employment has been been driven by full-time jobs</i>, which rose to a new all-time high in May (blue line), not part-time jobs (red line).<br />
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The labor force participation rate (the percentage of the population over 16 that is either working or looking for work) has <i>stabilized over the past 5 years</i>. The participation rate had been falling since 2001 as baby boomers retire, exactly as participation started to rise in the mid-1960s as this demographic group entered the workforce. Another driver is women, whose participation rate increased from about 30% in the 1950s to a peak of 60% in 1999, and younger adults staying in school (and thus out of the work force) longer.<br />
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A better measure is the prime working age (25 to 54 year olds) labor force participation rate; it stands at 82%, <i>down only slightly from its peak in 2000</i> at 84%, and much higher than anytime prior to the 1980s.<br />
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Average hourly <i>earnings growth was 3.1% yoy</i> in May; February's rate of 3.4% was the highest in 10 years. This is a positive trend, showing demand for more workers. Sustained acceleration in wages would be a big positive for consumption and investment that would further fuel employment.<br />
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Similarly, 1Q19 employment cost index shows total <i>compensation growth was 3.0% yoy</i>, nearly the highest in the past 10 years.<br />
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For those who doubt the veracity of the BLS employment data, federal individual income tax receipts have also been rising<b> </b>to new highs<b> </b>(red line), a sign of better employment and wages (from Yardeni).<br />
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<b>Demand</b><br />
<b><br /></b>Regardless of which data is used, real demand has been growing at about 2-3%, equal to about 4-5% nominal.<br />
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Real (inflation adjusted) <i>GDP growth through 1Q19 was 3.2% yoy</i>, the best growth rate in nearly 4 years.<br />
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Stripping out the changes in GDP due to inventory produces "real final sales". This is a better measure of consumption growth than total GDP. In 1Q19, this <i>grew 2.7% yoy</i>. A sustained break above 3% would be noteworthy.<br />
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The "real personal consumption expenditures" component of GDP (<a href="http://mic.com/articles/15097/us-gdp-is-70-percent-personal-consumption-inside-the-numbers">defined</a>), which accounts for about 70% of GDP, <i>grew 2.8% yoy</i> in 1Q19.<br />
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On a monthly basis, <i>real personal consumption expenditures grew 2.7% yoy</i> in April after notching a new ATH in March.<br />
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GDP measures the total expenditures in the economy. An alternative measure is GDI (gross domestic income), which measures the total income in the economy. Since every expenditure produces income, these are equivalent measurements of the economy. Some research suggests that GDI might be more accurate than GDP (<a href="http://www.nytimes.com/2014/09/27/upshot/gdp-report-emphasizes-the-problem-of-conflicting-economic-signals.html?abt=0002&abg=0">here</a>).<br />
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Real GDI growth in 1Q19 was 1.8% yoy.<br />
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Real retail sales grew 1.1% yoy in April. Sales declined yoy in December but March's sales were just below the ATH set in November. Sales fell yoy more than a year ahead of the last recession.<br />
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Retail sales in the past three years have been strongly affected by the large fall and rebound in the price of gasoline. In April, real retail sales at gasoline stations grew by 2.8% yoy after having fallen more than 20% yoy during 2016. <i>Real retail sales excluding gas stations grew 0.9% </i>in April.<br />
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This expansionary cycle is not like others in the past 50 years. Households' savings rate typically falls as the expansion progresses; this time, savings has risen and remains at an elevated level.<br />
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The next several slides look at manufacturing. It's important to note that manufacturing accounts for less than 10% of US employment, so these measures are of lesser importance.<br />
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Core durable goods orders (excluding military, so that it measures consumption, and transportation, which is highly volatile) <i>fell 2.6% yoy</i> (nominal) in April. Weakness in durable goods has not been a useful predictor of broader economic weakness in the past (arrows).<br />
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Industrial production (real manufacturing, mining and utility output) <i>growth was 0.9% yoy</i> in April. The more important manufacturing component (excluding mining and oil/gas extraction; red line) was flat (0%) yoy. Growth has moderated for both, with the cycle peak (so far) in December 2018. Industrial production is a volatile series, with negative annual growth during parts of 2014 and 2016.<br />
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Importantly, just 30% of industrial production groups are expanding. A drop below 40% has implied widespread weakness that typically precedes a recession (from <a href="https://blogs.uoregon.edu/timduyfedwatch/">Tim Duy</a>).</div>
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Weakness in total industrial production in 2015-16 was concentrated in the mining sector, with the worst annual fall in more than 40 years. It is not unusual for this part of industrial production to plummet outside of recessions. With the recovery in oil/gas extraction, mining rose 10% yoy in April. </div>
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Companies are often wrongly accused of underinvesting in lieu of greater share repurchases (buybacks). But capacity utilization is still under 80%, so there is plenty of room for production to expand within existing capacity. </div>
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<br />
<b>Housing</b><br />
<b><br /></b>Macro weakness had been most apparent in housing. But new sales has rebounded although starts remain weak.<br />
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First, new single family houses sold was 673,000 in April - the third highest level of the current expansion - with growth of +7% yoy. The <i>cycle high was in March, 2 months ago</i>. Overall levels of construction and sales are small relative to prior bull markets.<br />
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Second, housing s<i>tarts fell 3% in April,</i> a rebound from a 12% yoy decline in March<i>. </i>The cycle high was in January 2018, 15 months ago; the cycle high has typically been well over a year before the next recession (arrows).<br />
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Building permits (red line) <i>fell 5% yoy in </i><i>April</i> after rising 9% yoy in April 2018.<br />
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Single family housing starts (blue line) fell 4% yoy in April; multi-unit housing starts (red line) rose 1% yoy but have been a drag on overall starts for more than 4 years.<br />
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<b>Inflation</b><br />
<b><br /></b>Despite steady employment, demand and housing growth, core <i>inflation remains near the Fed's target of 2%</i>.<br />
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CPI (blue line) was 2.0% last month. The more important core CPI (excluding volatile food and energy; red line) <i>grew 2.1%</i>.<br />
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The Fed prefers to use personal consumption expenditures (PCE) to measure inflation; total and core <i>PCE were 1.5% and 1.6% yoy</i>, respectively, in April.<br />
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Some mistrust CPI and PCE. MIT publishes an independent price index (called the billion prices index; blue line). It has tracked both CPI (red line) and PCE closely.<br />
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<b>Summary</b><br />
<b><br /></b>On balance, the major macro data so far suggest continued positive, but modest, growth. This is consistent with corporate sales growth. SPX sales growth in 2019 is expected to be about 5% (nominal).<br />
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Valuations are slightly below their 25 year average. The consensus expects earnings to only grow about 3% in 2019 but there is room for faster equity appreciation through valuation expansion (chart from JPM).<br />
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Urban Carmelhttp://www.blogger.com/profile/11008222748707680522noreply@blogger.comtag:blogger.com,1999:blog-6302409656195627126.post-22399449789967291202019-06-05T15:36:00.002-07:002019-06-06T15:44:48.117-07:00Don't Fear The First Rate Cut<u>Summary</u>: The Fed may soon cut rates and that prospect is making investors nervous. Is the start of easing necessarily bad for equities? In short, probably not, at least not immediately. There's more to it than that.<br />
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Equities have most often risen after the first rate cut. The only times when equities have consistently traded lower was when they were already doing poorly.<br />
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Moreover, the economic data had already been persistently weak for many months (even years) prior to the times when the first rate cut was followed by a recession and an equity bear market. That's not at all the case this time, making it similar to years like 1984, 1995 and 1998 when rate cuts were subsequently reversed with further rate hikes.<br />
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There are never any guarantees but it's probably different this time, in a good way.<br />
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The Fed is now expected to cut its overnight rate 3 times in the next year (from <a href="https://twitter.com/biancoresearch">Jim Bianco</a>). Enlarge any chart by clicking on it.<br />
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It's probably worth taking those 3 rate cuts with a tablespoon of salt. Look again at the chart above: just 5 months ago, expectations were for at least one rate <i>hike</i> in the next year, and last September the expectation was for <i>more than 3 hikes</i>. Things have swung wildly in the other direction and they may well do so again. Rate expectations have very frequently wrong (from DB).<br />
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Investors are viewing this as the end for stocks. This is ironic because many have spent the past 3-1/2 years, when rates were being increased, fearing that the Fed would choke the recovery just as it was getting going. They now fear the exact opposite. Apparently, any action the Fed takes should be assumed to be the end for stocks.<br />
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More to the point, is the start of easing necessarily bad for equities? In short, probably not, at least not immediately. There's more to it than that.<br />
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True, Fed rates were cut starting in January 2001 and September 2007 and SPX was 30-50% lower within about a year both times. This is why investors are now fearful of a rate cut.<br />
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But the Fed started to cut rates in 1984, 1989, 1995 and 1998, too (lower panel). And within 6 months, SPX was at least 7% higher each time (upper panel). In fact, the bull market continued for at least another year and often for several more years after the first rate cut. It was nowhere near the end.<br />
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That's true more generally. A month after the September 2007 rate cut, SPX rose nearly 7% and made a new all-time high.<br />
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The last time the first rate cut led to consistently lower stock prices (and SPX wasn't already well on its way to a bear market) was nearly 40 years ago: the May 1981 rate cut came a <i>half year after SPX had peaked </i>and<i> </i>was barely out of a recession that had begun 17 months earlier. The 1974 rate cut came <i>7 months into a recession</i> and a year and half after the peak in SPX. The 2001 rate cut came 9 months after the peak in SPX when it was <i>already down 15%</i> and well on its way to a bear market. It's different this time, in a good way (<span style="text-align: justify;">from</span><span style="text-align: justify;"> </span><a href="https://twitter.com/ISABELNET_SA" style="text-align: justify;">Isabelnet</a><span style="text-align: justify;">).</span><br />
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"Hindsight bias" makes you believe there were no really serious economic threats during prior rate cuts in the 1980s and 1990s, because you know the outcome (stocks rose by a lot). But that was not true in real time. Each time, investors and economists feared an oncoming recession that was eventually avoided (maybe because of the Fed!). Our current situation might be no different (from WSJ, NYT and CNN, respectively).<br />
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Leave aside the rate cuts that started in 1984, 1995 and 1998, all of which were eventually reversed before the expansion ended. The current economic data is much stronger than that prior to the first rate cut in all the examples above over the past 45 years that were followed by a recession and a bear market.<br />
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Assume that rates are cut later this month. It would be just 2 months after a 50 year low in unemployment claims, 3 months after a cycle high in new home sales, 2 months after a peak in the Leading Economic Indicator and <i>before</i> the 10-2 yield curve has even inverted (which would be a first). The average for all of these in prior cycles is between <i>10 months and two years before</i> the first rate cut.<br />
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In other words, the economic data had already been persistently weak. Not so this time, making it similar to those other dates (1984, 1995 and 1998) where rate cuts were subsequently reversed with further rate hikes (in November 1984, March 1997 and June 1999).<br />
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Equities have most often risen after the first rate cut. The only times when equities have consistently traded lower was when they were already doing poorly. Moreover, the economic data now are relatively strong. There are never any guarantees but it's probably different this time, in a good way.<br />
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Urban Carmelhttp://www.blogger.com/profile/11008222748707680522noreply@blogger.comtag:blogger.com,1999:blog-6302409656195627126.post-68180054526786635362019-06-02T15:46:00.001-07:002019-06-06T15:54:08.116-07:00Weekly Market Summary<u>Summary</u>: US equities rose four months in a row and ended the month of April at new all-time highs (ATH). They then fell 4 weeks in a row during May, losing more than 6%.<br />
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So far, this is not that unusual. Almost every year has a drawdown greater than 5%, and most have at least 3 of these. What was unusual was the calm and steady rise from January through April, not the fall in May.<br />
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For the remainder of 2019, the evidence leans bullish. That's not a guarantee or a sure thing. But sentiment and breadth are close to a washout (they could be more so) and the usual set up is a seasonal low in June leading to a rally into July.<br />
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Could this time be different? Yes. For one, the US is engaged in a seemingly unending and escalating trade war with two major trading partners. No one knows how this will end and that uncertainty could well cause equities to plunge much further. All the market technicals, sentiment and fundamental data available cannot predict what happens next.<br />
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US equities started May at new ATHs but ended the month more than 6% lower (table from <a href="https://alphatrends.net/">alphatrends.net</a>). Enlarge any chart by clicking on it.<br />
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As May began, our perspective was the following:<br />
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The strong start to the year <i>strongly suggests further gains</i> in the months ahead.</blockquote>
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A <i>recession starting in 2019 is unlikely</i>, also supporting continued equity gains. </blockquote>
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2019 has had one of the least volatile starts to a year in the past 90 years. A <i>drawdown of at least 5% is odds on</i> in the weeks and months ahead (read further <a href="https://fat-pitch.blogspot.com/2019/05/weekly-market-summary.html">here</a>).<br />
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In all but 2 of the past 40 years, a drawdown of at least 5% has occurred, equalling an historical probability of 95%. With this month's drop, 2019 has simply done what almost every year before it has done.<br />
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Is that it? Maybe not. The average drawdown in the past 40 years has been 14%. SPX could drop another 9% in the next few months and 2019 would still be nothing more than a typical year. The average gain by year end has been more than 8%, so a rise from that slump would also be likely (from JPM).<br />
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Drawdowns of 5% or more during the course of the year are common; the typical year has seen at least 3 separate drawdowns of this size. Even excluding bear markets, the average bull market experiences 2.7 drawdowns of 5% or more per year. Each feels like the end of the bull market but most are not. This is the market's way of never letting investors feel comfortable, or of shaking them out of their complacency whenever they do (from <a href="https://twitter.com/RyanDetrick">Ryan Detrick</a>).<br />
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At the end of April, the trend in US equities looked strong. The trend was up. Stocks were at ATHs. Breadth was supportive. But sentiment (by some measures) was starting to get frothy, a potential warning.<br />
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The situation a month later is now the reverse. The trend looks weak, with SPX and NDX now below their respective 200-dmas. All the gains during March and April have been given back. Breadth is weak. But sentiment is now looking overly bearish.<br />
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This pattern - of strong trend and breadth but too many bulls leading to poor trend and breath and too many bears - happens perpetually in the stock market. This is literally how every undulation up and down during the course of every bull market has unfolded. In hindsight, it all looks simple; in real time, it can be a confusing mess.<br />
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Take the nearly 50% total return during 2013-14 as an example. In hindsight, this appears to be period where stocks simply ground higher. But in real time, SPX fell 3-7% more than 10 times, about every other month. Vix spiked from 12-13 to 20 or more each time. Each fall felt like the end of the bull market, but that's not the way that period is now remembered.<br />
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None of this is to say that 2019 is going to be equivalent to 2013-14. In fact, it probably won't be. The calamity in May was primary the result of an escalating trade war, first with China and then with Mexico. This might persist, it might even broaden to other countries. If it does, expect the stock market to continue to fall by a lot more than 5%. Investors hate uncertainty and no one honestly knows where this is headed. Market technicals, sentiment and lagging fundamental data are not going to predict the future.<br />
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Whether the stock market has over reacted to the threat of the trade war is virtually impossible to say. If the trade war leads to an economic recession because firms stop investing, causing employment to fall, then the answer is no. A recession would lead to a stock market fall of at least 20% and probably a lot more.<br />
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The China tariffs themselves are estimated to reduce GDP in the US by less than 1% in 2021, equal to about $220b (from the OECD).<br />
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In response to this threat, US equities lost $1.95 trillion in market cap in May, a sum nearly 9 times greater. On first blush, the sell off looks overdone. That's not surprising: equity prices are a function of fundamentals and emotions and the latter is what drives short term stock market movements (from <a href="https://twitter.com/hsilverb">S&P</a>).<br />
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Of course the stock market discounts future value but even if we adjust the numbers above to account for this, the over reaction is about 5 times too great. In the US, market cap is about 1.3 times greater than GDP; adjusting for this, the over reaction is still about 3.6 times too great. The balance then is the uncertainty discount that this trade war devolves into something much worse than tit for tat tariffs.<br />
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For it's part, Goldman Sachs estimates that US firms could offset the full extent of the Chinese tariffs by raising prices by just 1%. If they do not, EPS might fall by 6% this year (from the <a href="https://ftalphaville.ft.com/2019/05/24/1558684850000/Who-s-paying-for-the-US-China-trade-war-/">FT</a>). Again, estimating whether the stock market has over reacted is virtually impossible to pin point.<br />
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A trade war that expands to Mexico would be much more consequential. The US and Mexico engage in a half trillion dollar in annual trade. 5 million US jobs depend on this trade; to put that in perspective, total job growth in the US last year was 2.6 million (from <a href="https://twitter.com/LizAnnSonders">Liz Sonders</a>).<br />
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In the absence of a trade war, <i>the US macro picture is fine</i>.<br />
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On the downside, retail sales are growing just 1% yoy, which is pretty weak. Industrial production is likewise growing at just 1% yoy; worse, <span style="text-align: justify;">just 30% of industrial production groups are expanding, with a drop below 40% having historically implied the widespread weakness that typically precedes a recession. This is not good (from </span><a href="https://blogs.uoregon.edu/timduyfedwatch/" style="text-align: justify;">Tim Duy</a><span style="text-align: justify;">).</span><br />
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<span style="text-align: justify;">But the positives in the economy outweigh these negatives. Employment is the most important economic indicator and it has not been this strong in 50 years. New home sales grew 7% last month and reached a cycle high in March. Trucks, which carry 70% of US freight, increased their tonnage by nearly 8% yoy in April (from <a href="https://twitter.com/ISABELNET_SA">Isabelnet</a>). </span><br />
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<span style="text-align: justify;">Most of these indicators roll over to weakness well ahead of a recession and even ahead of a peak in equities. It would be very unusual for the US to slide into a recession this year under these circumstances (read more <a href="https://fat-pitch.blogspot.com/2019/04/april-macro-update-employment-and.html">here</a>).</span><br />
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<span style="text-align: justify;">The yield curve is also <u>not</u> indicating an imminent recession. </span>The point of watching out for an inverted yield curve is that future growth is expected to be weaker than today’s; hence lower yields further out in time. A textbook example was in early 2000.<br />
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<span style="text-align: justify;">Technically, the curve inverted in 2007 as well, but it was essentially just flat. Still, future growth was deemed at risk relative to the present, and a recession soon followed.</span><br />
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<span style="text-align: justify;">In contract to both 2000 and 2007, today’s curve clearly has a positive slope; future growth is still expected to be stronger than today’s. Only the very very short end has inverted due to the uncertainty over federal funds rates, which are expected to be cut at least once during 2019.</span><br />
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<span style="text-align: justify;">Likewise, the fall in treasury yields in 2019 does not preordain a recession. </span>Are there economic worries now causing rates to fall? Of course; there is always a reason when rates are falling and in real time, the reasons always feel dire. In hindsight, when we know the outcome, they seem benign. The chart below shows the causes for rates to fall in the past 10 years (upper panel); after an initial reaction, equities continued to rise (lower panel), with the main exception being late 2015 and early 2016.<br />
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After making a new ATH at the end of April, SPX fell 4 weeks in a row in May. The worst part is that SPX is now back in the 'hot mess' from October to early December (yellow shading). There's an apparent 'head and shoulders' pattern that targets a fall to 2650, which is the bottom of the hot mess. This would equal another 5% downside. A more immediate target is about 0.5% lower at 2730, the ledge formed in February and early March (blue line).<br />
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If the markets bounce this week, 2810 is 2% higher and the top of the hot mess as well as the mid-May low. That is likely to be strong resistance. The 50-d is at 2870, equal to the mid-May high, and its the next level of important resistance. A prudent investor would not be wrong to wait until at least one of these resistance levels was regained. <i>At this point, there is not even a low to trade long against</i>.<br />
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Breadth is weak, with just 30% of the SPX trading above their 50-dma. That has often been <i>close to a washout</i> low (green lines), but not always (blue lines). A drop to 20% would a truer washout.<br />
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Sentiment, by at least a few measures, has turned <i>overly bearish</i>.<br />
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Most prominently, $22b was withdrawn from equity ETF and mutual funds last week. Outflows greater than $15b have had a very high propensity to occur near tradable lows, with SPX rising 4% or more in the subsequent weeks, except in October 2018 (red arrow). That doesn't mean equities won't again roll over after a pop, as they did in 2010, 2011, 2014, 2015 and 2018.<br />
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The daily sentiment index (DSI) for SPX dropped to just 12 on Friday. When sentiment has been very bullish and then falls to this level, equities have often (but not always) been near a tradable low, even if equities rolled over again later (from <a href="https://twitter.com/TommyThornton">Thomas Thorton</a>).<br />
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Retail investors polled by AAII are mostly bearish (40%). When this has occurred when SPX is near a 1-year high, SPX has gained an average of 3-5% over the next 6 months. The only failure was in 2015, an historical win rate of 95% (from <a href="https://twitter.com/bullmarketsco">Troy Bombardia</a>).<br />
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The money pulled from equities has gone to the safety of treasuries and money markets, the latter of which has seen inflows of $100bn (that's very high). The DSI for US bonds is now 91 (from DB).<br />
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With the trade war driving the sell off, all the losses in the US have occurred overnight. SPX lost 6.3% in May but fell 7.5% overnight. Cash hours actually rose. That is highly unusual, the only precedents being near the lows of the two prior major bear markets (from <a href="https://www.sentimentrader.com/">Sentimentrader</a>; to become a subscriber and support the Fat Pitch, click <a href="https://partners.sentimentrader.com/idevaffiliate.php?id=101">here</a>).<br />
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May and June are historically weak months for US equities. The usual trade set up is a low sometime in June followed by a rally into July before late summer weakness (next two charts from <a href="http://jeffhirsch.tumblr.com/">Jeff Hirsch</a>).<br />
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When the year has started strong (like 2019), the May-December period has risen another 7% and been positive 85% of the time. When May fell, June was higher in 7 of 9 (78%) instances, as was the May-December period.<br />
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Finally, it is worth recalling a few of the positives from the strong momentum that started the year:<br />
<blockquote class="tr_bq">
<u>SPX made a new ATH in April</u> after having not done so for at least a half year. In the past 100 years, the index has made a higher ATH at some point between 2 weeks and 6 months later in <i>96% of cases</i> (n=28)<i>.</i></blockquote>
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<u>SPX rose every month to start the year</u>. In the past 65 years, the index closed higher at the end of the year in <i>all but one (93%) by a median of 10% </i>(n=14).</blockquote>
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<u>SPX rose more than 15% in the prior 4 months</u>. In the past 50 years, the index has closed higher between 1 and 8 months later <i>in all but one instance (95%) and by a median of 9% after 8 months</i> (n=21). </blockquote>
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SPX closed below its 10-dma on only 10 days through the first 75 days of the year. In the past 65 years, the index closed the year higher in <i>all but one (88%) by a median of 9%</i>. SPX has not fallen into a bear market during the year since Great Depression (n=8). </blockquote>
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To add one more, when SPX has risen 4 months in a row and then fallen the next month (like 2019), it has added sizable gains over the next several months in all cases except 3, an historical win rate of 93% (n=42). The last failure was in 1987 (from <a href="https://twitter.com/bullmarketsco">Troy Bombardia</a>).<br />
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On the calendar this week is the employment report on Friday. The FOMC has its next policy meeting on June 19 (from IBD Investors; for a trial subscription, <a href="https://shop.investors.com/offer/splashresponsive.aspx?id=mssharpenpopup&src=A00452A&refcode=UC_Links">please use this link</a>).<br />
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Urban Carmelhttp://www.blogger.com/profile/11008222748707680522noreply@blogger.comtag:blogger.com,1999:blog-6302409656195627126.post-65847833715604139802019-05-29T15:41:00.000-07:002019-05-29T15:41:58.813-07:001Q Corporate Results: 3% Earnings Growth Expected In 2019<u>Summary</u>: Overall, corporate results in the first quarter of 2019 were good, but not great. Sales and earnings growth were 6% and 8%, respectively. Margins rebounded from the end of 2018 but are still below the cycle high made in 3Q18.<br />
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Looking ahead, analysts' expectations for 10% earnings growth in 2019 have been revised down to 3%. This estimate will be about right if margins can be maintained at the their 1Q19 level, but if the dollar continues to appreciate, earnings growth could be close to zero and another drop in oil prices could cause earnings to decline.<br />
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Valuations are now back to their 25-year average. They are not cheap, but if investors once again become ebullient, there is room for valuations to expand. With earnings growth likely to be negligible, the key for share price appreciation in 2019 is likely to hinge almost entirely on valuations expanding.<br />
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96% of the companies in the S&P 500 have released their first quarter (1Q19) financial reports. The headline numbers were good, but not great. Here are the details:<br />
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<b>Sales</b><br />
<i><br /></i><i>Quarterly sales grew 6% over the past year</i>. On a trailing 12-month basis (TTM), sales were 8% higher yoy, a strong result (all financial data in this post is from <a href="https://us.spindices.com/indices/equity/sp-500">S&P</a>). Enlarge any image by clicking on it.<br />
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The arrows in the chart above and those that follow indicate the period from 2Q14 to 1Q16 when oil prices fell 70%. The negative affect on overall S&P sales (above) and the energy sector alone (below) is easy to spot.<br />
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The six sectors with the highest weighting in the S&P grew an average of 9% in the past year (box in middle column) and, since the peak in oil in 2Q14, their sales have grown an average of 36%. In contrast, energy sector sales have declined 37% (far right column).<br />
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Excluding the volatile energy sector, sales for the remainder of the S&P have continued to trend higher at about the same rate over the past 8 years (blue line; from Yardeni).</div>
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The <i>dollar has become a headwind for sales growth</i>: in the past year (thru 1Q19), the dollar appreciated by 8%; this accounts for about a 4 percentage point decline in growth in corporate sales growth. For the current quarter (2Q19), the dollar is pacing 6% yoy appreciation.</div>
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How does the dollar impact sales growth? Companies in the S&P derive about half of their sales from outside of the US. When the dollar rises in value, the value of sales earned abroad (in foreign currency) falls. If foreign sales grow 5% but the dollar gains 5% against other currencies, then sales growth will be zero in dollar terms. The chart below compares changes in the dollar (blue line; inverted) with growth in S&P sales (red line): a higher dollar corresponds with lower sales (from Yardeni).</div>
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<b>Earnings and Margins</b></div>
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<i>Operating EPS grew 5% over the past year</i> on a quarterly-basis and 16% on a trailing 12-month basis (TTM). GAAP EPS was better: 8% quarterly growth yoy and 17% growth TTM. More on these differences below.</div>
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Importantly, <i>EPS has fallen from its recent all-time high in 3Q18, </i>the first substantial fall<i> </i>since the "profit recession" in 2015<i>.</i></div>
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The arrows in the next chart again indicate the period when oil prices fell 70% between 2014 and 2016. The improvement in total EPS since then comes with energy sector EPS at one-third of its level in mid-2014.<br />
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Likewise, overall S&P profit margins peaked at 10.1% in early 2014, fell to 8% at the end of 2015 and have since <i>rebounded to 11.3% in 1Q19</i>, an improvement from 10.1% in 4Q18 but well below the<i> high of 12.1% in 3Q18.</i><br />
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Excluding the energy sector,<i> margins rebounded to 11.9% in 1Q19, but may have peaked at 12.6% in 3Q18</i>.<br />
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Most of the largest sectors have increased their margins 1-2 percentage points in the past 2 years but their margin peak, so far, was last year. </div>
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The fall in margins is most apparent in the important technology sector, where margins shot up from 15% in 2016 to 23% in 2018 but have since fallen back to 20%. This is weighing on overall margins for the S&P.</div>
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<b>Misconceptions and Bad Memes</b><br />
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There are some popular misconceptions that are regularly cited with respect to corporate earnings.<br />
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First, companies have been accused of inflating their financial reports through a net reduction in shares through, for example, corporate buybacks. In reality, however,<i> 90% of the growth in earnings in the S&P over the past 9 years has come from better profits, not a net reduction in shares</i>. Better profits have driven growth, not "financial engineering."<br />
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That has been true over the past 17 years, during which the net change in corporate shares has accounted for just 4% of EPS growth (from JPM).<br />
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In fact, despite record buybacks, the difference between EPS and profits has been consistently narrow.<br />
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Second, equity prices are said to have far outpaced earnings during this bull market. In fact, <i>better profits accounts for about 75% of the appreciation in the S&P over the past 9 years</i>. Of course valuations have also risen - that is a feature of every bull market, as investors transition from pessimism to optimism - but this has been a much smaller contributor. In comparison, 75% of the gain in the S&P between 1982-2000 was derived from a valuation increase (that data from <a href="https://www.bloomberg.com/view/articles/2017-10-27/how-to-tell-the-bulls-from-the-bears">Barry Ritholtz</a>).<br />
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Over the past 2 years (since 1Q17), during which time the S&P has risen about 20%, earnings have risen 34%, i.e., faster than the S&P index itself thereby accounting for more than 100% of price appreciation. The same is true over the past 1 year (from JPM).<br />
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Third, financial reports based on "operating earnings" are said to be fake. This complaint has been a feature of every bull market since at least the 1990s. In truth, the <i>trend in GAAP earnings (red line) is the same as "operating earnings" </i>(blue line).<br />
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It's accurate to say that operating earnings somewhat overstate and smooth profits compared earnings based on GAAP, but that is not new. In fact, the difference between operating and GAAP earnings in the past 27 years has been a median of 10% and the recent history has been no different (it was 9% in the most recent quarter). Operating earnings overstated profits by much more in the 1990s and earlier in the current bull market. The biggest differences have always been during bear markets.<br />
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<b>Outlook for 2019</b></div>
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Looking ahead, <i>expectations for 10% earnings growth in 2019 have already been revised down to 3%</i>. Sales growth is expected to be 5% in both 2019 and in 2020 (from FactSet).<br />
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There are 5 considerations with a strong bearing on forward sales and earnings. Most of these appear likely to be a headwind in 2019.<br />
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First, as a baseline, it is reasonable to assume that corporate (non-energy) sales growth will be largely similar to the <i>nominal economic growth rate of 4-5%</i>, excluding currency effects. Right now, this seems achievable (from the OECD).<br />
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Second, the dollar weakened from the end of 2016 to early-2018 (a tailwind to growth) but has since appreciated 9%. That means that <i>currency effects are now a headwind</i> to growth<i>.</i> With half of corporate sales coming from abroad, even a small 4% appreciation in the dollar could cut 2 percentage points off sales growth this year.<br />
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Third, the price of oil was tracking more than a 30% yoy gain until October; the price then fell 30% into year end. In 1Q19, the average price of oil was 15% lower than a year earlier; in other words,<i> </i>the energy sector became a headwind to overall sales and EPS growth. Oil has since recovered but it needs to hold those gains; <i>below $65, oil will remain a headwind in 2019</i>.<br />
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As we have seen, the direct impact of oil prices on the energy sector is far more important than any ancillary affects on other sectors. As an example, consider this: the price of oil fell from over $100 to under $50 between mid-2013 and mid-2016 but non-energy sector operating margins were 10% in both instances. In short, <i>lower oil prices are a net negative for sales and earnings</i>.<br />
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Fourth, corporate tax cuts were a major tailwind to earnings in 2018. Analysts estimate that these likely added 10 percentage points to growth, meaning baseline growth of 5% could have jumped to 15% by virtue of tax cuts alone.<br />
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But the <i>tax cut was a one-off adjustment, applicable only to 2018</i>, and there is not much reason to expect it to permanently raise growth rates. Why? US corporations are not capital constrained; they have abundant cash and access to low cost debt and equity. Moreover, corporations have been making fixed capital investments. Over the past 3 decades, rising corporate profitability (blue line) has had no positive affect on new investments (red line; from the FT).<br />
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Fifth: <i>the biggest risk to earnings in 2019 is margin contraction</i>. For earnings to grow as fast as sales, margins have to be maintained. But after trending higher over the past 7 years, margins jumped 140bp in 2018. This was a massive rise and sustaining that level (let alone expanding margins further) seems unlikely, especially given the fall in margins over the past 2 quarters.<br />
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<b><br /></b><b><br /></b>In fact, average margins in 2018 were 11.3%, the same as in 1Q19. If that level is maintained throughout 2019, <i>earnings growth will be 5% </i>(down from 22% in 2018)<i>.</i> If the dollar continues to appreciate, that growth could fall to 3%. If oil remains under $65/barrel, earnings will fall further.<br />
<b><br /></b><b><br /></b><b>Valuation</b><br />
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At the end of 2018, the combination of 22% earnings growth and a 6% fall in equity prices left valuations at 14.4x, the same level as in 2010 and well below their 25-year average. The rally since then has brought valuations right back to the average (from JPM).<br />
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Valuations are not cheap, but if investors once again become ebullient, <i>there is room for valuations to expand</i>. Why? When investors become bullish (blue line), valuations rise (red line). Investors had been pessimistic in early 2016 and then became far too optimistic at the market peak in January 2018. <i>Importantly, that was greatly reset by the end of December 2018</i> and while sentiment has since rebounded, it has not reached an extreme (from Yardeni).<br />
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It's hard to believe that investors have already reached peak bullishness. Fund flows into equity mutual funds and ETFs was strong before both the 2000-02 and 2007-09 bear markets, and even before the 2015-16 mini-bear market (blue circles). In comparison, fund flows have been negative for 4 of the past 6 quarters (red circle; from JPM).<br />
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Valuations are influenced by more than investor psychology. Part of the reason equities have become more expensive over time is rising corporate profitability. <i>Margins have reached successive new highs with each economic cycle over the past 3 decades</i>: they are now more 100bp higher than in 2007, and that peak was more than 100bp higher than in 2000. Higher profitability (and growth) is typically rewarded with higher valuation multiples (from JPM).<br />
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While it is objectively impossible to know when or at what level margins will peak for this cycle, it's a reasonable guess that the cycle peak was in 3Q18.<br />
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Importantly, valuations have almost no bearing on the market's 1-year forward return (left side). But over the <i>longer term, current valuations suggest that single digit annual returns are odds-on</i> (right side; from JP Morgan).<br />
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In summary, corporate results in the first quarter were good, but not great. Sales and earnings growth were 6% and 8%, respectively. Margins rebounded from the end of 2018 but are still below the cycle high made in 3Q18.<br />
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Looking ahead, analysts' expectations for 10% earnings growth in 2019 have been revised down to 3%. This estimate will be about right if margins can be maintained at the their 1Q19 level, but if the dollar continues to appreciate, earnings growth could be close to zero and another drop in oil prices could cause earnings to decline.<br />
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Valuations are now back to their 25-year average. If investors once again become ebullient, there is room for valuations to expand. With earnings growth likely to be negligible, the key for share price appreciation in 2019 is likely to hinge almost entirely on valuations expanding.<br />
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<i>If you find this post to be valuable, consider visiting a few of our sponsors who have offers that might be relevant to you.</i>Urban Carmelhttp://www.blogger.com/profile/11008222748707680522noreply@blogger.comtag:blogger.com,1999:blog-6302409656195627126.post-42306539272223508222019-05-14T17:59:00.001-07:002019-05-14T17:59:35.119-07:00Fund Managers' Current Asset Allocation - May<u>Summary</u>: Although fund managers are less bearish than they were at the start of 2019, they are far from being bullish. They are overweight cash. Their global equity allocations are almost a standard deviation below the mean. Their bond allocations are at a 7-year high. A slight majority expect profits to contract and economic growth to fall in the next year.<br />
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This is a far cry from 2018, when fund managers came into the year with cash levels at 4-year lows and allocations to global equities at 3-year highs. Global equities ended the year 15% lower.<br />
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US and European equity allocations remain low relative to levels seen at prior market peaks. Emerging markets are the consensus long. The US dollar is considered the most overvalued in 16 years, a possible tailwind for US multi-nationals and ex-US equities.<br />
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Among the various ways of measuring investor sentiment, the Bank of America Merrill Lynch (BAML) survey of global fund managers is one of the best, as the results reflect how managers are allocated in various asset classes. These managers oversee a combined $600b in assets.<br />
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Our sincere gratitude to BAML for the use of this data.<br />
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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 (<a href="http://fat-pitch.blogspot.com/2014/12/fund-managers-current-asset-allocation.html">post</a>).<br />
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Let's review the highlights from the past month.<br />
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<b>Overall</b>: Relative to history, fund managers are<i> overweight cash and underweight equities</i>. Enlarge any image by clicking on it.<br />
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Within equities, the emerging markets are overweight while Europe, in particular, is underweight. The US is close to neutral.</blockquote>
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A pure contrarian would overweight equities relative to cash and bonds, and European equities relative to emerging markets. </blockquote>
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<b>Cash</b>: Fund managers' <i>cash balance is high at 4.6%</i>, down just slightly from 4.8% in February. BAML considers cash levels above 4.5% to be a contrarian buy for equities, and below 3.5% to be a contrarian sell. This is supportive of further gains in global equities:<br />
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In October 2016, fund managers' cash levels rose to 5.8%, the highest cash level since November 2001. Global equities rose over 30% in the next year.</blockquote>
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By November 2017, cash levels had fallen to 4.4%, the lowest level since October 2013. Equities peaked in January 2018 and then fell 20% during the remainder of the year.</blockquote>
<blockquote class="tr_bq">
At 4.6%, current cash allocations are high enough to remain a tailwind for global equities.</blockquote>
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Likewise, fund managers are a net <i>+33% overweight cash</i> (+0.9 standard deviations above its long term mean). In the context of a bull market, cash should underperform a 60-30-10 basket (equity-bonds-cash).<br />
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<b>Global equities</b>: Fund managers' global equity allocations are <i>up just slightly to +11% overweight</i> from +6% overweight in January. This is supportive of further gains in global equities:<br />
<blockquote class="tr_bq">
At the market low in January 2019, fund managers were just +6% overweight equities. This equity allocation level was similar to that other market lows since 2009 (green arrows).</blockquote>
<blockquote class="tr_bq">
At the market peak in January 2018, by contrast, equity allocations were +55% overweight. Over 50% is a level at which equities have previously peaked, although the lag can be considerable (e.g., 2013-14; red arrows).</blockquote>
<blockquote class="tr_bq">
At just +11% overweight (-0.8 standard deviations below its long term mean), fund managers are far from being too bullish. This remains a tailwind for global equities.</blockquote>
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Fund managers are not bullish on profits, with a slight majority expecting a contraction in the next 12 months. But this is a marked improvement from January when 52% expected profits to deteriorate, their most bearish view in 10 years. Negative profit expectations marked equity lows in mid-2010, late-2011, mid-2012, early 2016 and January 2019 (green arrows).<br />
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Similarly, a net -5% expect a better economy in the next year, up from -60% in January, the lowest since equities crashed in November 2008. At the equity peak in January 2018, a net +47% expected a better economy. Investors are not bullish on the global economy.<br />
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<b>US equities</b>: Fund managers have only slightly increased their allocations to US equities, to <i>+2% overweight</i> from -3% underweight in February<i>. </i>There is room for US equities to rise further:<br />
<blockquote class="tr_bq">
When fund managers have been more than -20% underweight US equities (e.g., spring 2015 and autumn 2017), US equities have subsequently outperformed (green arrows). </blockquote>
<blockquote class="tr_bq">
When fund managers have been more than +15-20% overweight (e.g., December 2016 and November 2018), US equities have subsequently underperformed (red arrows). </blockquote>
<blockquote class="tr_bq">
At just +2% overweight (+0.3 standard deviations above its long term mean), fund managers are far from being too bullish. A contrarian would expect the region to outperform.</blockquote>
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<blockquote class="tr_bq">
(Note that the relationship between performance and weighting worked less well in the prior expansion cycle (2003-07) as emerging markets outperformed developed markets by about 5 times).</blockquote>
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<b>European equities</b>: Fund managers are now <i>+9% overweight</i> European equities, up considerably from -11% underweight in January (a 6-1/2 year low). Still, the region should outperform:<br />
<blockquote class="tr_bq">
When fund managers have been close to neutral (e.g., spring 2013, early-2015, mid-2016 and January 2019), European equities have subsequently outperformed (green arrows). </blockquote>
<blockquote class="tr_bq">
When fund managers have been more than +40-50% overweight (e.g., mid-2014, late-2015 and mid-2017), European equities have subsequently underperformed (red arrows). </blockquote>
<blockquote class="tr_bq">
At just +9% overweight (-0.3 standard deviations below its long term mean), fund managers are still leaning bearish. A contrarian would expect the region to outperform.</blockquote>
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<b>Emerging markets equities</b>: Fund managers are <i>+34% overweight</i> emerging market equities, largely unchanged from +37% overweight in February. EM remains the consensus long and is at risk of underperforming:<br />
<blockquote class="tr_bq">
When fund managers have been underweight (e.g., early-2016, early-2017 and autumn 2018), emerging market equities have subsequently outperformed (green arrows). </blockquote>
<blockquote class="tr_bq">
When fund managers have been more than +30-40% overweight (e.g., autumn 2016 and autumn 2018), emerging market equities have subsequently underperformed (red arrows). </blockquote>
<blockquote class="tr_bq">
At +34% overweight (+0.8 standard deviations above its long term mean), emerging markets remain the consensus long for fund managers. A contrarian would expect the region to underperform.</blockquote>
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<b>Global bonds</b>: Fund managers are -34% underweight bonds, <i>the highest allocation in 7 years</i>. Bonds are at risk of underperforming a 60-30-10 basket:<br />
<blockquote class="tr_bq">
Fund managers' bond allocation has been a less helpful indicator of performance. For one, fund managers are almost always underweight. </blockquote>
<blockquote class="tr_bq">
Still, when fund managers have been more than -60% underweight (e.g., mid-2015, early-2018 and late-2018), bonds have subsequently outperformed (green arrows). </blockquote>
<blockquote class="tr_bq">
When fund managers have been less than -35% underweight (e.g., mid-2016 and early-2019), bonds have subsequently underperformed (red arrows). </blockquote>
<blockquote class="tr_bq">
At -34% underweight (+0.4 standard deviations above its long term mean) and at a 7 year high, a contrarian would expect bonds to underperform equities.</blockquote>
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In November, 70% of fund managers expected higher inflation over the next 12 months; this was near a 14 year high. Since then, inflation expectations have collapsed by the largest amount since the depths of the financial crisis (first chart). As in the past, a strong consensus view on inflation preceded a drop in US 10-year yields in the following months (second chart).<br />
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Lower inflation expectations often goes in hand with lower commodity allocations: in May, fund managers' dropped exposure to a net -8% underweight (-0.3 standard deviations below its long term mean).<br />
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<b>Dollar</b>: The US Dollar is considered the <i>most overvalued in 16 years </i>(+1.6 standard deviations above its long term mean), a possible tailwind for US multi-nationals and ex-US equities:<br />
<blockquote class="tr_bq">
Since 2004, fund managers surveyed by BAML have been very good at determining when the dollar is overvalued (red arrows).</blockquote>
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In March 2015, they viewed it as overvalued for the first time since 2009; the dollar index fell 7% in the next two months.</blockquote>
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In late-2015, they viewed the dollar as overvalued and the index lost 8%.</blockquote>
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In late-2016, they viewed the dollar as overvalued and the index lost 7%.</blockquote>
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The dollar is now considered the <i>most overvalued since 2002</i>. Risk is to the downside. A weaker dollar benefits US multi-nationals as well as European and emerging markets equities. </blockquote>
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Survey parameters are below.<br />
<ol>
<li><b>Cash</b>: The typical range is 3.5-5.0%. BAML has a 4.5% contrarian buy level but we consider over 5% to be a better signal. More on this indicator <a href="http://fat-pitch.blogspot.com/2013/01/fund-manager-cash-balance-at-extremes.html">here</a>. </li>
<li><b>Equities</b>: Over +50% overweight is bearish. A washout low (bullish) is under +15% overweight. More on this indicator <a href="http://fat-pitch.blogspot.com/2013/01/fund-manager-equity-exposure-at-extremes.html">here</a>. </li>
<li><b>Bonds</b>: Global bonds started to underperform in mid-2010, 2011 and 2012 when they reached -20% underweight. -60% underweight is often a bearish extreme.</li>
<li><b>Commodities</b>: Higher commodity exposure goes in hand with improved sentiment towards global macro and/or inflation.</li>
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Urban Carmelhttp://www.blogger.com/profile/11008222748707680522noreply@blogger.comtag:blogger.com,1999:blog-6302409656195627126.post-54143039812235226292019-05-05T11:32:00.000-07:002019-05-29T06:13:02.289-07:00Weekly Market Summary<u>Summary</u>: SPX, NDX and COMPQ are now all at new all-time highs (ATH). The Russell 3000 and Wilshire 5000, which represent essentially all of US equities, are also at their prior highs. The trend remains higher. Moreover, strong starts to the year and multi-month gains have a very high propensity to lead to further gains in the months ahead and by year end. There are precedents for the index to top now, but those are the exception.<br />
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Sentiment has become more bullish. This can certainly mark a top, but the historical record is inconsistent. It's a warning, not a red light.<br />
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In the most important respects, breadth is fine.<br />
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On balance, all of this leans bullish, but it would be a mistake to assume the indices will just sail higher in the remainder of the year. That can happen, but most often a drawdown much more than the barely 2% seen so far in 2019 will occur, even after a start like the current year.<br />
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US equities continue to grind higher. SPX, NDX and COMPQ ended the week at new ATHs. They have risen in each of the first 4 months of the year. The leader is NDX, which has risen 18 of the last 19 weeks since Christmas Eve (table from <a href="https://alphatrends.net/">alphatrends.net</a>). Enlarge any chart by clicking on it.<br />
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Since January, we have said that SPX was likely to grind its way higher as the volatility index, VIX (lower panel), sunk under 16, just as it had in 2018. And in fact that has been the case, and remains so even as SPX exceeds its September high.<br />
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It might feel like the rise has been too much and too fast, but in fact the average recovery to new highs after a steep plunge has been almost identical to that seen in the past half year (from <a href="https://www.indexologyblog.com/category/equities/">Indexology</a>).<br />
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Our perspective on US equities so far in 2019 has been the following:<br />
<blockquote class="tr_bq">
Since the start of the year, the overwhelming evidence has indicated that <i>the bull market remains intact</i>, meaning new ATHs were still ahead this year. That has now been achieved.</blockquote>
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With SPX, NDX and COMPQ at new ATHs, what lies ahead?<br />
<blockquote class="tr_bq">
The persistence of the trend so far this year <i>strongly suggests further gains</i> in the months ahead.</blockquote>
<blockquote class="tr_bq">
The prolonged government shutdown coincided with a spate of ugly economic reports this winter, but data from the past month points to renewed growth. A <i>recession starting in 2019 is unlikely</i>, also supporting continued equity gains (a new post on this <a href="http://fat-pitch.blogspot.com/2019/04/april-macro-update-employment-and.html">here</a>). </blockquote>
<blockquote class="tr_bq">
This is one of the least volatile starts to a year in the past 90 years. The largest reaction so far this year has barely been more than 2%. A <i>meatier reaction is odds on</i> in the weeks and months ahead (a recent post on this is <a href="http://fat-pitch.blogspot.com/2019/04/summary-ndx-is-now-at-new-all-time-high.html">here</a>).</blockquote>
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The evidence:<br />
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SPX has now made a new ATH after having not done so for at least a half year. In the past 100 years, the index has been higher 3 months later, by an average of 2%, in 75% of the cases. In 100% of cases, the index has been higher at some point between 2 weeks and 6 months later and in <i>96% of cases it has been higher between 1 and 6 months later</i>. With SPX not much higher than it was when it first made a new ATH on April 23, more gains a very likely ahead (from <a href="https://twitter.com/bullmarketsco">Troy Bombardia</a>).<br />
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<a href="https://2.bp.blogspot.com/-v0W_QJeVrAo/XM4VvSA1ccI/AAAAAAAAuFQ/VDe05YX6f8YuhQBfMPHXJEsxwbr6qdSNwCLcBGAs/s1600/first%2Bnew%2Bhigh%2Bin%2B6%2Bmo.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="662" data-original-width="832" height="508" src="https://2.bp.blogspot.com/-v0W_QJeVrAo/XM4VvSA1ccI/AAAAAAAAuFQ/VDe05YX6f8YuhQBfMPHXJEsxwbr6qdSNwCLcBGAs/s640/first%2Bnew%2Bhigh%2Bin%2B6%2Bmo.png" width="640" /></a></div>
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That's the good news (and there will be more examples of this below). But in the table above, note that within the next 3 months, <i>only 12 of 28 instances (43%) just sailed higher</i>. That's even more true over the next 6 months, as <i>just 32% avoided any drawdown</i>. In other words, the odds strongly favor either consolidation now or if there are interim gains, a period where those gains are given back.<br />
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Let's look at the past 40 years to illustrate that point, starting with the 2015-16 plunge. After regaining the prior high in June, SPX immediately dropped nearly 6%, then made a new ATH but essentially chopped sideways until December (4 months) before moving much higher.<br />
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After the 2011 plunge, SPX first moved 4% above its prior ATH but then gave all those gains (and more) back. Net, it went sideways over the next 5 months.<br />
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After the 2010 plunge, SPX immediately fell 4%, bounced back quickly and then marched to new highs (chart above).<br />
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The recovery from the 1998 plunge was like that in 2010: SPX immediately fell 4%, quickly bounced back and then marched much higher.<br />
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After the 1991 bear market, SPX first exceeded the prior high by 6% but then gave all those gains back. Net, it went sideways over the next 5 months, a pattern similar to 2011.<br />
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<a href="https://2.bp.blogspot.com/-TN8fO06SMwE/XM4gs00D5HI/AAAAAAAAuF4/HJlae4n5X90OjtuFkW8U-v66cVNiJ470wCLcBGAs/s1600/High%2Bretest%2B1991.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="376" data-original-width="1325" height="180" src="https://2.bp.blogspot.com/-TN8fO06SMwE/XM4gs00D5HI/AAAAAAAAuF4/HJlae4n5X90OjtuFkW8U-v66cVNiJ470wCLcBGAs/s640/High%2Bretest%2B1991.png" width="640" /></a></div>
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After the 1987 bear market, SPX first exceed the prior high by 7% but then gave all those gains (and more) back. Net, it went sideways over the next 9 months, a pattern similar to 2011 and 1991.<br />
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Finally, after regaining the losses from the 1982 bear market, SPX immediately lost 6%, then made a new ATH by 4%, then lost all those gains. Net, it went sideways over the next 3 months, a pattern similar to 2010 and 1998.<br />
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<a href="https://1.bp.blogspot.com/-9UBm22CH9A4/XM4isB9_ONI/AAAAAAAAuGM/9YoaSk8cOOoS-shrxquzjOqHB1fLgF0HwCLcBGAs/s1600/High%2Bretest%2B1982.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="377" data-original-width="1324" height="182" src="https://1.bp.blogspot.com/-9UBm22CH9A4/XM4isB9_ONI/AAAAAAAAuGM/9YoaSk8cOOoS-shrxquzjOqHB1fLgF0HwCLcBGAs/s640/High%2Bretest%2B1982.png" width="640" /></a></div>
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In summary, SPX is very likely to see more gains in the months ahead. It is also likely to see gains given back, a drawdown or a period consolidation that could last several months. It is, objectively, impossible to know with certainty in which order these will occur. The examples above are evenly split.<br />
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Other data gives a similar result.<br />
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SPX rose every month to start this year, something that has happened 14 other times in the past 65 years. At the end of the year, <i>all but one (93%) closed higher by a median of 10%</i>. But within the next 4 months, <i>just 29% sailed higher</i> without any end of month drawdown. In most cases, a period chop, consolidation or retracement ensued, which ultimately resolved higher (the next two tables from <a href="https://twitter.com/SJD10304?lang=en">Steve Deppe</a>).<br />
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<a href="https://4.bp.blogspot.com/-yBAB4OVy0Vk/XM8N0gUEzQI/AAAAAAAAuHE/nfIT2kTk4VkKsrgQlu5vnKvDoxdavl5IgCLcBGAs/s1600/SPX%2Bup%2BJan-Apr.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="422" data-original-width="1024" height="262" src="https://4.bp.blogspot.com/-yBAB4OVy0Vk/XM8N0gUEzQI/AAAAAAAAuHE/nfIT2kTk4VkKsrgQlu5vnKvDoxdavl5IgCLcBGAs/s640/SPX%2Bup%2BJan-Apr.png" width="640" /></a></div>
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Likewise, SPX rose more than 15% in the past 4 months, something that has happened 21 other times in the past 50 years. 8 months later (by year end, in the current case), SPX has closed higher 81% of the time by a median of 9%. SPX has closed higher between 1 and 8 months later in all but one instance (95%). Only 1980 was a complete failure. Interestingly, in half of these instances, SPX sailed higher without any drawdown by end of month.<br />
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SPX is off to its 3rd best start to the year in the past 70 years. The index has then gone on to close the year <i>higher 85% of the time</i>. April was the high for the rest of the year in both 1971 and 2011, so there are precedents for this to be as good as it gets. The other failure was 1987, which had the worst performance of any year by year end, losing 14%, but there's an important caveat: between May and August 1987, SPX gained another 17% (from <a href="http://jeffhirsch.tumblr.com/">Jeff Hirsch</a>).<br />
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For what it's worth, 1971 is not very analogous to today. The year was closely sandwiched between two recessions and bear markets. In comparison, the US is now in a 10 year expansion (from Stooq).<br />
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<a href="https://4.bp.blogspot.com/-vAP7yBo-kng/XM8VX8taJ8I/AAAAAAAAuHk/Kc1U4B0QoIAFeWVmrbA8qaUw0dQqEyrMgCLcBGAs/s1600/1971.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="869" data-original-width="1600" height="346" src="https://4.bp.blogspot.com/-vAP7yBo-kng/XM8VX8taJ8I/AAAAAAAAuHk/Kc1U4B0QoIAFeWVmrbA8qaUw0dQqEyrMgCLcBGAs/s640/1971.png" width="640" /></a></div>
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Finally, in the past 70 years, SPX has gained an average of 14% in the year after mid-term elections. While SPX has rallied, it is up only 7% since the election last year. Of course, it may outperform or underperform this average but, on this basis at least, it would be 'normal' for the index to rise further into November (from <a href="https://twitter.com/RyanDetrick">Ryan Detrick</a>).<br />
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Again, the evidence presented above suggests SPX is very likely to see more gains by year end, but it is also likely to see gains given back or a period of consolidation.<br />
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Sentiment data is mixed, but there is certainly less of tailwind now than in the past 4 months.<br />
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The most bearish data is from Investors Intelligence (newsletter writers). This week, bulls minus bears equaled 38%. When this has exceeded 40%, SPX soon peaked in 2007, 2011 and last September (red lines). But extremes in bullish sentiment are not the same bearish sentiment extremes (which often mark lows). As the chart below shows, bullish sentiment has often been followed by more gains (green lines) or just a period of consolidation and then more gains (yellow lines). It's a warning, but not conclusive on its own (from <a href="https://twitter.com/vixsquared">Vix Squared</a>).<br />
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Likewise, sentiment amongst analysts finally climbed back to 66% this week. That marked the high in late-2015. But bulls exceeded 70% before peaks last September and in mid-2015, and bulls exceeded 75% before peaks in 2010, 2011, 2012 and in January 2018. Could SPX peak here? Yes, but it could just as well grind higher until sentiment is more clearly at an extreme (from <a href="https://twitter.com/hmeisler">Helene Meisler</a>).</div>
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AAII (retail investors) have been more 'neutral' than bullish. In the past 32 years, when SPX has rallied more than 10% but investors remain mostly neutral, SPX has closed higher 2, 6 and 9 months later in all instances but one (94%; (from <a href="https://twitter.com/bullmarketsco">Troy Bombardia</a>).<br />
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Fund flows, which reflect how investors are actually deploying their money, runs contrary to the survey data presented above. Investors have been putting their money into the safety of fixed income throughout the current rally. <i>Equity funds flows have been weak</i>, unlike the lead into peaks in 2000, 2007 and even 2015 (from <a href="https://am.jpmorgan.com/us/en/asset-management/gim/adv/insights/guide-to-the-markets/viewer">JPM</a>).<br />
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It's true that investors have been shorting the volatility index, Vix, leading to worries that the opposite is likely to happen: an explosion in volatility, usually coinciding with a decline in SPX. But that has historically not been the case. SPX has normally continued to rise (the next two charts are from <a href="https://www.sentimentrader.com/">Sentimentrader</a>; to become a subscriber and support the Fat Pitch, click <a href="https://partners.sentimentrader.com/idevaffiliate.php?id=101">here</a>).<br />
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Hedge funds have a low exposure to equities. This would seem to be an indication that sophisticated investors are betting against the rally - a warning. But that has not been the case, historically. In fact, the best performance for SPX has occurred in precisely these circumstances, with annualized gains of more than 10%.<br />
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The IPO market is also heating up. This past week, Beyond Meat rose over 160% on its first day of trading, leading to worries that this is just like the lead in to the dot com bubble. But there haven't been anywhere near that many IPOs this year (first chart) and while gains on the first day are on the rise, they are a far cry from levels seen 20 years ago (both charts from <a href="https://www.bespokepremium.com/interactive/">Bespoke</a>).<br />
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Breadth does not appear to be an impediment to further equity gains.<br />
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First, the rally has been broadly-based. The equal-weight versions of SPX and NDX made new ATHs ahead of the traditional market-weight indices. That means that the larger market cap stocks were not solely responsible for the advance. In fact, the FAANG stocks have been lagging.<br />
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Moreover, this week, both the Wilshire 5000 and the Russell 3000, which represent 98% of US equities, returned to their ATHs.<br />
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Second, after a breadth washout in December, the percent of stocks on the NYSE above their 200-dma is now back above 50%. This is analogous to the recoveries in 1991, 1995, 2012 and 2016, among others, after which SPX continued to rise (from <a href="https://twitter.com/mark_ungewitter">Mark Ungewitter</a>).<br />
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Seasonality, which can be inconsistent, favors some interim weakness in May and/or June. In pre-election years (like now), the second half of May has been weak, on average. The late summer and autumn is also a period with few net gains (from <a href="http://jeffhirsch.tumblr.com/">Jeff Hirsch</a>).<br />
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There is probably more short-term upside, however. That the COMPQ gained 1% to a new ATH on Friday, following the good employment report, has historically led to further gains over the next week 89% of the time, with risk/reward 3:1 positive (from <a href="http://quantifiableedges.com/blog/">Quantifiable Edges</a>).<br />
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NDX was the first index to make a new ATH. It leads, but momentum has started to wane over the past 2 weeks (top panel). It might just be consolidating gains while holding above prior resistance. At this point there is no foul until this week's low is breached.<br />
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There are no important macro reports this week. The following week, however, has retail sales, industrial production and new home sales (from IBD Investors; for a trial subscription, <a href="https://shop.investors.com/offer/splashresponsive.aspx?id=mssharpenpopup&src=A00452A&refcode=UC_Links">please use this link</a>).<br />
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Urban Carmelhttp://www.blogger.com/profile/11008222748707680522noreply@blogger.comtag:blogger.com,1999:blog-6302409656195627126.post-4439088181897884882019-04-24T10:16:00.000-07:002019-05-03T08:57:47.566-07:00April Macro Update: Employment and Housing Rebound<u>Summary</u>: It's been a noisy few months for macro. The prolonged government shutdown in December significantly delayed many data reports. Into this mess, several reports were ugly:<br />
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Retail sales in December fell into yoy contraction for the first time since 2009. </blockquote>
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New employment in February fell to the lowest level since 2010. </blockquote>
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New home sales growth in November dropped 14% yoy, the lowest rate since 2011.</blockquote>
<span style="font-weight: normal;"><br /></span><span style="font-weight: normal;">That weakness now looks anomalous: the </span>data from the past month mostly point to positive growth<span style="font-weight: normal;">.</span><span style="font-weight: normal;"> <i>A recession starting in 2019 is unlikely.</i></span><br />
<span style="font-weight: normal;"><br /></span>The bond market sees continued growth. The yield curve has 'inverted' (10 year yields less than 2-year yields) ahead of <i>every</i> recession in the past 40 years (dots). The lag between inversion and the start of the next recession has been long: at least 7 months and in several instances as long as 2-3 years. On this basis, the current expansion will <i>likely last through 2019</i> at a minimum (from JPM). Enlarge any image by clicking on it.<br />
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Likewise, high yield <i>spreads never blew out during the market correction and have since declined/normalized.</i> Default rates remain well below average. This part of the bond market is not signaling trouble (from JPM).<br />
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Unemployment claims are back in a declining trend. Historically, claims have started to rise at least 7 months ahead of the next recession: <i>claims reached a 49 year low this month</i>, a big positive.<br />
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Less positive is recent consumption data. Real retail sales declined on a yoy basis in December, but rebounded to <i>1.7% growth in March</i>. The trend flattened in the period prior to the past two recessions and there is some risk that the same is beginning to happen now. Continued improvement in the months ahead is needed.</div>
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<span style="font-weight: normal;">Housing has been the primary macro concern. In March, housing starts fell 14% yoy and building permits fell 8%. But new home sales in March showed a strong rebound, growing 3% yoy and notching <i>the second highest sales level of the 10 year old expansion</i>. A continuation higher will be a major positive: in the past 50 years, a median of 28 months has lapsed between </span>new home sales'<span style="font-weight: normal;"> expansion high (arrows) and the start of the next recession; so far, the cycle high was </span>in November 2017, 17 months ago.<br />
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<span style="font-weight: normal;">New home sales have rebounded 23% in the first three months of the year. The peak in home sales came after mortgage rates troughed in late 2017, and sales seem to be rebounding as mortgage rates have fallen from 5% in November to 4% this month.</span><br />
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<span style="font-weight: normal;"></span><span style="font-weight: normal;"><br /></span><span style="font-weight: normal;">The Conference Board's Leading Economic Indicator (LEI) Index reached a <i>new uptrend high</i> in March. This index includes the indicators above plus equity prices, ISM new orders, manufacturing hours and consumer confidence. This index can fluctuate during an expansion but the final peak has been <i>at least 7 months</i> before the next recession in the past 50 years (from Doug Short).</span><br />
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<span style="font-weight: normal;"><br /></span><span style="font-weight: normal;"><br /></span>Why does any of this matter for the stock market?<br />
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Equity prices typically fall ahead of the next recession, but the macro indictors highlighted above weaken <i>even earlier</i> and help distinguish a 10% correction from an oncoming prolonged bear market. On balance, these <i>indicators are not hinting at an imminent recession</i> (a recent post on this is <a href="http://fat-pitch.blogspot.com/2018/05/when-innocuous-correction-is-start-of.html">here</a>).<br />
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Here are the main macro data headlines from the past month:<br />
<blockquote class="tr_bq">
<b>Employment</b>: Monthly employment gains have averaged 218,000 in the past 12 months, with an annual growth of 1.8% yoy. Employment has been been driven by full-time jobs, which rose to a new all-time high in February. </blockquote>
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<b>Compensation</b>: Compensation growth is on an improving trend. Hourly wage growth was 3.2% yoy in April, while the 1Q19 employment cost index grew 3.0% yoy, nearly the highest growth in the past 10 years. </blockquote>
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<b>Demand</b>: Real demand growth has been 2-3%. In 1Q19, real GDP grew 3.2% and real personal consumption grew 2.7%. Real retail sales grew 1.7% yoy in March, just below a new all-time high. March PCE made a new all-time high.</blockquote>
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<b>Housing</b>: Macro weakness has been most apparent in housing. New home sales rose 3% yoy in March, but housing starts fell 14% yoy and permits fell 8% yoy in March. Multi-family units remain a drag on overall development. </blockquote>
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<b>Manufacturing</b>: Core durable goods rose 0.4% yoy in March. The manufacturing component of industrial production grew 1.3% yoy in March and is just below a 10-year high. </blockquote>
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<b>Inflation: </b>The core inflation rate remains near the Fed's 2% target. </blockquote>
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Our key message over the past 6 years has been that (a) growth is positive but slow, in the range of ~2-3% (real), 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.<br />
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This is germane to equity markets in that <i>macro growth drives corporate revenue, profit expansion and valuation levels</i>. The simple fact is that when the economy is expanding, the historical risk of a greater than 10% annual (not intra-year) decline in the stock market is just 4% (from Goldman Sachs).<br />
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The highly misleading saying that <i>"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</i>. When they diverge, it is normally a function of emotion, whether measured in valuation premiums/discounts or sentiment extremes.<br />
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A valuable post on using macro data to improve trend following investment strategies can be found <a href="http://www.philosophicaleconomics.com/2016/02/uetrend/">here</a>.<br />
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Let's review the most recent data, focusing on four macro categories: labor market, end-demand, housing, and inflation.<br />
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<b>Employment and Wages</b><br />
<b><br /></b>The April non-farm payroll was <i>263,000 new employees </i>plus 16,000 in net revisions for the prior two months.<br />
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<i>Employment growth has accelerated in the last year</i>. The average monthly gain in employment was 240,000 in 2015, 211,000 in 2016 and189,000 in 2017 but it increased to 204,000 in 2018. In the past 12 months, the monthly average has further improved to 218,000.<br />
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Monthly <i>NFP prints are volatile</i>. Since the 1990s, NFP prints near 300,000 (like in January) have been followed by ones near or under 100,000 (like in February). That has been a pattern during every bull market; NFP was negative at times during 1993, 1995, 1996 and 1997. This is normal, not unusual or unexpected.<br />
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Why is there so much volatility? Leave aside the data collection, seasonal adjustment and weather issues; appreciate that a "beat" or a "miss" of 120,000 workers in a monthly NFP report is within the 90% confidence interval (explained <a href="https://projects.fivethirtyeight.com/jobs-report-growth-unemployment/">here</a>).<br />
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For this reason, it's better to look at the trend; in April, trend <i>employment growth was 1.8% yoy</i>. Until spring 2016, annual growth had been over 2%, the highest since the 1990s. Ahead of a recession, employment growth normally falls (arrows).<br />
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<i>Employment has been been driven by full-time jobs</i>, which rose to a new all-time high in February (blue line), not part-time jobs (red line).<br />
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The labor force participation rate (the percentage of the population over 16 that is either working or looking for work) has <i>stabilized over the past 5 years</i>. The participation rate had been falling since 2001 as baby boomers retire, exactly as participation started to rise in the mid-1960s as this demographic group entered the workforce. Another driver is women, whose participation rate increased from about 30% in the 1950s to a peak of 60% in 1999, and younger adults staying in school (and thus out of the work force) longer.<br />
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A better measure is the prime working age (25 to 54 year olds) labor force participation rate; it stands at 82.3%, <i>down only slightly from its peak in 2000</i> at 84%, and much higher than anytime prior to the 1980s.<br />
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Average hourly <i>earnings growth was 3.2% yoy</i> in April; February's rate of 3.4% was the highest in 10 years. This is a positive trend, showing demand for more workers. Sustained acceleration in wages would be a big positive for consumption and investment that would further fuel employment.<br />
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Similarly, 1Q19 employment cost index shows total <i>compensation growth was 3.0% yoy</i>, nearly the highest in the past 10 years.<br />
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For those who doubt the accuracy of the BLS employment data, federal individual income tax receipts have also been rising<b> </b>to new highs<b> </b>(red line), a sign of better employment and wages (from Yardeni).<br />
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<b>Demand</b><br />
<b><br /></b>Regardless of which data is used, real demand has been growing at about 2-3%, equal to about 4-5% nominal.<br />
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Real (inflation adjusted) <i>GDP growth through 1Q19 was 3.2% yoy</i>, the best growth rate in nearly 4 years.<br />
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Stripping out the changes in GDP due to inventory produces "real final sales". This is a better measure of consumption growth than total GDP. In 1Q19, this <i>grew 2.7% yoy</i>. A sustained break above 3% would be noteworthy.<br />
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The "real personal consumption expenditures" component of GDP (<a href="http://mic.com/articles/15097/us-gdp-is-70-percent-personal-consumption-inside-the-numbers">defined</a>), which accounts for about 70% of GDP, <i>grew 2.7% yoy</i> in 1Q19.<br />
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On a monthly basis, <i>real personal consumption expenditures grew 2.9% yoy</i> in March, notching a new ATH.<br />
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GDP measures the total expenditures in the economy. An alternative measure is GDI (gross domestic income), which measures the total income in the economy. Since every expenditure produces income, these are equivalent measurements of the economy. Some research suggests that GDI might be more accurate than GDP (<a href="http://www.nytimes.com/2014/09/27/upshot/gdp-report-emphasizes-the-problem-of-conflicting-economic-signals.html?abt=0002&abg=0">here</a>).<br />
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Real GDI growth in 4Q18 was 2.7% yoy.<br />
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Real retail sales grew 1.7% yoy in March. Sales declined yoy in December but last month's sales are just below the ATH set in November. Sales fell yoy more than a year ahead of the last recession.<br />
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Retail sales in the past three years have been strongly affected by the large fall and rebound in the price of gasoline. In March, real retail sales at gasoline stations grew by 1.2% yoy after having fallen more than 20% yoy during 2016. <i>Real retail sales excluding gas stations grew 1.8% </i>in March, making a new ATH.<br />
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This expansionary cycle is not like others in the past 50 years. Households' savings rate typically falls as the expansion progresses; this time, savings has risen and remains at an elevated level.<br />
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The next several slides look at manufacturing. It's important to note that manufacturing accounts for less than 10% of US employment, so these measures are of lesser importance.<br />
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Core durable goods orders (excluding military, so that it measures consumption, and transportation, which is highly volatile) <i>rose 0.4% yoy</i> (nominal) in March. Weakness in durable goods has not been a useful predictor of broader economic weakness in the past (arrows).<br />
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Industrial production (real manufacturing, mining and utility output) <i>growth was 2.8% yoy</i> in March. The more important manufacturing component (excluding mining and oil/gas extraction; red line) rose 1.3% yoy. Growth has moderated for both, with the cycle peak (so far) in December 2018. Industrial production is a volatile series, with negative annual growth during parts of 2014 and 2016.<br />
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Importantly, 57% of industrial production groups are expanding. A drop below 40% will imply widespread weakness that typically precedes a recession (from <a href="https://blogs.uoregon.edu/timduyfedwatch/">Tim Duy</a>).</div>
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Weakness in total industrial production in 2015-16 was concentrated in the mining sector, with the worst annual fall in more than 40 years. It is not unusual for this part of industrial production to plummet outside of recessions. With the recovery in oil/gas extraction, mining rose 11% yoy in March. </div>
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Companies are often wrongly accused of underinvesting in lieu of greater share repurchases (buybacks). But capacity utilization is still under 80%, so there is plenty of room for production to expand within existing capacity. </div>
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<br />
<b>Housing</b><br />
<b><br /></b>Macro weakness has been most apparent in housing. Both new sales and starts peaked more than a year ago.<br />
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First, new single family houses sold was 692,000 in March - the second highest level of the current expansion - with growth of +3% yoy. The cycle high was in November 2017, 17 months ago. Overall levels of construction and sales are small relative to prior bull markets.<br />
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Second, housing s<i>tarts fell 14% yoy in March. </i>The cycle high was in January 2018, 14 months ago; the cycle high has typically been well over a year before the next recession (arrows).<br />
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Building permits (red line) <i>fell 8% yoy in </i><i>March</i> after rising 8% yoy in March 2018.<br />
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Single family housing starts (blue line) fell 11% yoy in March; multi-unit housing starts (red line) fell 22% yoy and have been a drag on overall starts for more than 4 years.<br />
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<b>Inflation</b><br />
<b><br /></b>Despite steady employment, demand and housing growth, core <i>inflation remains near the Fed's target of 2%</i>.<br />
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CPI (blue line) was 1.9% last month. The more important core CPI (excluding volatile food and energy; red line) <i>grew 2.0%</i>.<br />
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The Fed prefers to use personal consumption expenditures (PCE) to measure inflation; total and core <i>PCE were 1.5% and 1.6% yoy</i>, respectively, in March.<br />
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Some mistrust CPI and PCE. MIT publishes an independent price index (called the billion prices index; blue line). It has tracked both CPI (red line) and PCE closely.<br />
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<b>Summary</b><br />
<b><br /></b>On balance, the major macro data so far suggest continued positive, but modest, growth. This is consistent with corporate sales growth. SPX sales growth in 2019 is expected to be about 5% (nominal).<br />
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Valuations are slightly above their 25 year average. The consensus expects earnings to only grow about 3% in 2019 but there is room for faster equity appreciation through valuation expansion (chart from JPM).<br />
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Urban Carmelhttp://www.blogger.com/profile/11008222748707680522noreply@blogger.comtag:blogger.com,1999:blog-6302409656195627126.post-57979887044690550632019-04-21T17:04:00.000-07:002019-05-29T06:13:14.474-07:00Weekly Market Summary<u>Summary</u>: NDX is now at a new all-time high (ATH). Leadership by NDX is a positive for SPX: historically, the risk/reward over the coming weeks and months for SPX has been excellent.<br />
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On an equal-weigh basis, both SPX and NDX are also at new ATHs. Any weakness in breadth is almost exclusively explained by the healthcare sector. The other sectors, aside from utilities, have all reached new YTD highs in the past week.<br />
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Volatility has been unusually low so far this year. By one measure, this is one of the least volatile starts to a year in the past 90 years. That's unlikely to last. The largest reaction so far this year has barely been more than 2%. Going back 40 years, no year has seen a lower drawdown and all but two (95%) have seen a drawdown of at least 5%. With SPX now within 1% of its prior ATH, a meatier reaction is odds on in the weeks and months ahead.<br />
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US equities continues to grind higher. With about a week to go in April, SPX, NDX and DJIA are on pace to rise in each of the first 4 months of the year. The leader is NDX, which has risen 6 weeks in a row and 16 of the last 17 weeks since Christmas Eve (table from <a href="https://alphatrends.net/">alphatrends.net</a>). Enlarge any chart by clicking on it.<br />
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In January, we noted that SPX was likely to grind its way higher as the volatility index, VIX (lower panel), sunk under 16, just as it had in 2018. That remains the case, and SPX is now less than 1% from its all-time high (ATH) of 2930 set in September.<br />
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On a total return basis (including dividends), SPX has closed above its prior ATH the last 5 days in a row.<br />
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This week, NDX made a new ATH. It leads. Momentum remains strong; there's no apparent divergence, yet.<br />
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This bodes well for SPX. When NDX makes a new high after not doing so for more than 100 days, SPX has continued to rise in each of the 14 prior instances since 1985. Risk/reward over the coming weeks and months has been excellent (from <a href="https://www.sentimentrader.com/">Sentimentrader</a>; to become a subscriber and support the Fat Pitch, click <a href="https://partners.sentimentrader.com/idevaffiliate.php?id=101">here</a>).<br />
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Breadth is healthy. To the extent their has been any weakness, it is almost exclusively explained by the healthcare sector. The others, aside from utilities, have all reached new YTD highs in the past week.<br />
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Similarly, the SPX on an equal-weight basis has now regained all of its losses since last September and is back at its prior ATH. It has led the market-cap weighted index.<br />
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Nasdaq breadth is even better. The equal-weight NDX made a new ATH a month ago and has since added another 3.5%. Put another way, FAANG stocks are holding the indices back; given their heavy weighting, if they kick into gear, the traditional market capitalization-based indices will likewise move well above their prior ATHs.<br />
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Investors have reluctantly embraced the rise in equities. Through mid-April, US equity ETF and mutual fund flows have been net negative. While anything is possible, it's hard to imagine this being the context of an important top (from ICI).<br />
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Likewise, despite a strong 4 month rally, sentiment amongst analysts has not rebounded that strongly (blue line). Bulls climbed back to just 64% this week; rallies in the past 8 years have not fizzled out until bulls were at least 65% (like late-2015) and more often when bulls were at least 70% (like July 2015 and both January and September 2018). Could SPX peak here? Yes, but it could just as well grind higher until sentiment is more clearly at an extreme (from <a href="https://twitter.com/hmeisler">Helene Meisler</a>).<br />
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One of the more remarkable aspects of the current market is the persistence of the rally. Through the first 75 days of the year, SPX has closed below its 10-dma on only 10 days. In the past 90 years, this has only happened 9 other times. The last three times - 1995, 1998 and 2013 - all added 9% or more through year-end. That has been the general pattern for these types of years and you'd have to go back to the start of the Great Depression to find an instance where the equity markets fell into a bear market in the months ahead (from <a href="https://twitter.com/QuantEdges">Quantifiable Edges</a>).<br />
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VIX remains subdued. These periods can last for months, even years (yellow shading). Two of the years mentioned above - 1995 and 2013 - were similar. There is nothing inherently unstable or unsustainable about these low volatility periods<br />
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That obviously doesn't preclude periodic jumps in volatility. In 2013-14, VIX jumped from around 12 to 16-20 on 10 different occasions.<br />
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In fact, that is an odds-on event. There have been just three notable drops in SPX since January, each spaced about a month apart and the last one was a month ago (yellow shading). Each occurred near an area of resistance, which is notable now as SPX is within 1% of prior resistance at 2930. A reaction seems likely.<br />
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The largest reaction so far this year has barely been more than 2%. Going back 40 years, no year has seen a lower drawdown and all but two (95%) have seen a drawdown of at least 5%. A meatier reaction is odds-on in the weeks and months ahead (from <a href="https://am.jpmorgan.com/us/en/asset-management/gim/adv/insights/guide-to-the-markets/viewer">JPM</a>).<br />
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Between April 2013 and September 2014, VIX mostly stayed under 18 yet SPX dropped at least 3% on 7 different occasions. It was a persistently low volatility period but temporary setbacks were normal about every other month. This should be expected in 2019 as well.<br />
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May and June are just ahead. Historically, these are not great months for SPX. Anything can happen, but this wouldn't be an unusual time period for the uptrend to weaken a bit, as it did in both 2013 and 2014 (from (from <a href="https://twitter.com/RyanDetrick">Ryan Detrick</a>).<br />
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On the calendar this week: new home sales on Tuesday, durable goods on Thursday and GDP for 1Q on Friday. Of more consequence, the following week includes an FOMC meeting on Wednesday and the employment report on Friday (from IBD Investors; for a trial subscription, <a href="https://shop.investors.com/offer/splashresponsive.aspx?id=mssharpenpopup&src=A00452A&refcode=UC_Links">please use this link</a>).<br />
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Urban Carmelhttp://www.blogger.com/profile/11008222748707680522noreply@blogger.comtag:blogger.com,1999:blog-6302409656195627126.post-3461615841692115452019-04-16T12:31:00.001-07:002019-04-16T12:31:53.167-07:00Advisors Perspectives: The Top 25 Venerated Voices for 1Q 2019Many thanks to Advisor Perspectives for including the Fat Pitch in its list of the Top 25 Venerated Voices for 1Q 2019, placing ahead of much larger firms such as Invesco, Raymond James, BlackRock, Northern Trust, Pimco and AllianceBernstein. <div>
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Advisor Perspectives’ website currently attracts over 150,000 unique visitors per month, virtually all of them financial advisors serving high- and ultra-high net worth individuals. The full list is <a href="https://www.advisorperspectives.com/articles/2019/04/15/venerated-voicestm-q1-2019-rankings">here</a>.<br />
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Urban Carmelhttp://www.blogger.com/profile/11008222748707680522noreply@blogger.comtag:blogger.com,1999:blog-6302409656195627126.post-76624618699187766372019-03-30T10:50:00.000-07:002019-03-30T12:03:45.828-07:00Weekly Market Summary<u>Summary</u>: SPX and NDX are now just 3-4% from their September all-time high (ATH). On an equal-weigh basis, NDX has already made a new ATH.<br />
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This has been one of the 10 best ever starts to a year; over the past 60 years, similar fast starts have consistently led to continued gains in the months ahead. That doesn't mean stocks will not have an interim setback. But if past is prologue, SPX is likely to gain enough to make a new ATH in 2019.<br />
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Macro data weakened in the past half year. A conservative investor with a shorter time horizon wouldn't be wrong to reduce their equity holdings into strength. But the panic over weakening macro is likely to abate and, with fund managers' risk exposure falling to a 2-1/2 year low this month, sentiment supports a continued rise in equities.<br />
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Since Christmas Eve, SPX is up 21%, NDX 24% and RUT 23%. Europe and emerging markets are each up 14% (table from <a href="https://alphatrends.net/">alphatrends.net</a>). Enlarge any chart by clicking on it.<br />
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In early March, SPX reached the top of its trading range from October to early December (upper panel). It then corrected less than 3% and closed the month at 6 month high. The next resistance area is 2860-70, which it has already reached once, 6 days ago. All-time highs (ATH) from September are now just 3% higher. The index is grinding upwards as Vix stays under 16 (lower panel). It would take a close under 2600 to trigger a bearish failure.<br />
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Breadth is healthy. The SPX on an equal-weight basis closed above the top of its prior range in mid-February. It's now less than 2.5% from its September ATH. It has led.<br />
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Nasdaq breadth is even better. The equal-weight NDX made a <i>new ATH</i> two weeks ago. Put another way, FAANG stocks are holding the indices back; given their heavy weighting, if they kick into gear, the traditional market capitalization-based indices will likewise move back to their ATHs.<br />
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There has been some consternation over small caps, which have lagged in the past month. These worries are misplaced.<br />
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First, RUT has outperformed SPX since Christmas and so far in 2019: it's not lagging. Second, the total market capitalization of RUT is less than the 6 largest companies in SPX; it represents a minor part of the stock market.<br />
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Consequently, RUT has rarely been a valuable tell for SPX: it lagged throughout most of the 1990s, outperformed during the 2000s and has been an equal performer to SPX the past 10 years (top panel). Whether it leads or lags hasn't made a difference.<br />
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The situation in Europe has improved. Stoxx has exceeded its October-early December range and, for what it's worth, broken above a downtrend (dashed line). But Europe peaked way back in January 2018 and ATHs are still 7% higher. The situation is better, but it's still not great.<br />
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On Monday, the SPX will have a "golden cross", whereby the 50-d crosses above the 200-d (arrows). This means the long term trend is improving. Over the past 40 years, a golden cross has only taken place within the context of a bull market when the low is already in place.<br />
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The red arrow above occurred in December 2015. From that point, SPX gained 13% over the next 12 months but it corrected 12% first. A 12% correction is normal within any 12 month period but the timing, in this case, was tough.<br />
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What does the good start to the year imply for 2019? More gains are very likely, but corrections along the way are also odds-on.<br />
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In the past 60 years, when SPX has gained more than 10% during 1Q, it has added to those gains into year-end 9 out of 10 times by a <i>median of 8%</i>. The one outlier was the infamous year of 1987. Still, maximum gains over the next 9 months were a <i>minimum of 9%</i> (from <a href="https://twitter.com/RyanDetrick">Ryan Detrick</a>).<br />
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In the far right column, note that pullbacks in the next 9 months have been a median of 9%. This is normal for any year, and the strong start doesn't reduce forward volatility. Risk/reward over the next 9 months is a bit less than 2:1.<br />
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SPX has started the year by rising all 3 months. In the past 65 years, SPX closed higher either 6 or 12 months later <i>every time</i>. Its maximum gain over the next year was a <i>minimum of 7%</i>. Pullbacks in the next year were a median of 4%. Risk/reward during this period was better than 3:1 (from <a href="https://twitter.com/SJD10304?lang=en">Steve Deppe</a>).<br />
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Will SPX continue to sail higher unabated? It's not likely: in the table above, note that within the next 3 months, SPX closed lower than at the end of March in 67% of instances.<br />
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Instead of focusing on the first 3 months of the year, let's look at any 3 month period where SPX gained at least 20%. In the past 70 years, SPX has closed higher either 6 or 9 months later <i>every time</i> by a <i>median of another 6% or 12%</i>, respectively (from <a href="https://twitter.com/fundstrat">Thomas Lee</a>).<br />
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If past is prologue, SPX is likely to gain enough in the months ahead to make a new ATH. With the unfolding macro, corporate profitability, valuation and IPO environment, that will create a very exciting set up for the second half of 2019 and 2020. More on that when the time comes.<br />
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Will the interim pullback in SPX occur in April? Anything is possible, but it's not especially likely.<br />
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April is usually an exceptionally strong month. Over the past 30 years, April has been <i>the strongest month</i> of the year (from Sentimentrader; to become a subscriber and support the Fat Pitch, click <a href="https://partners.sentimentrader.com/idevaffiliate.php?id=101">here</a>).<br />
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In the past 70 years, April has been especially strong in the year before the next general election, gaining 95% of the time by an average of 3.5% (from <a href="http://jeffhirsch.tumblr.com/">Jeff Hirsch</a>).<br />
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On balance, investor sentiment is not an impediment to further equity gains.<br />
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Fund managers' allocation to equities sank to their <i>lowest level in 2-1/2 years</i> in March. Their equity exposure is concentrated on defensives, like utilities. Their cash allocations are unusually high. This is not the profile of greed (the next two charts are from BAML).<br />
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Fund managers' equity allocations are now similar to those at equity lows in 2011, 2012 and 2016, and also at the bear market low in 2002-03. Of course, the bottom fell out in 2008.<br />
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Domestic (US) equity fund flows (both mutual and ETFs) have been persistently negative the past year (from ICI).<br />
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The same is true globally (from <a href="https://twitter.com/SBarlow_ROB">Scott Barlow</a>).<br />
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Money has instead flowed partly to the safety of money markets; balances have soared 10% in the past 4 months to their <i>highest levels in 9 years</i> (from <a href="https://twitter.com/fundstrat">Thomas Lee</a>).<br />
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But the biggest inflows have been to bonds as investors have sought to lower risk. A reversal in these flows, from bonds and cash to equities, represents a significant potential tailwind in the months ahead (from <a href="https://twitter.com/lisaabramowicz1">Lisa Abramowicz</a>).<br />
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Part of the move to defense is rational. Unemployment remains low, but the trough in claims was probably 6 months ago. New home sales may have peaked 15 months ago. Retail sales in January grew a scant 1% yoy.<br />
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Many of these things lead recessions, and recessions and bear markets go hand in hand as our monthly macro summary table shows.<br />
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It would be typical for employment and housing to have their cyclical high farther in advance of a top in SPX than what may have already occurred, but it is not unprecedented. The LEI also, on average, peaks 3-5 months ahead of SPX. It has never peaked more than 5 months after SPX, as might be the case now. LEI was at an ATH in February.<br />
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The Fed, responding to this data, has paused its cycle of tightening and seems likely to end QT, at least for now. Given this macro data, and corporate profit margins that may well have peaked for this cycle (read <a href="http://fat-pitch.blogspot.com/2019/02/4q-corporate-results-margins-fall-watch.html">here</a>), a conservative investor with a shorter time horizon wouldn't be wrong to reduce their equity holdings into strength.<br />
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But it seems more likely that investors have panicked.<br />
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In December, the implied probability of a rate cut in 2019 was zero. This week, it rocketed to 76% as expectations grow that the Fed will have to fend off a recession (from <a href="https://twitter.com/SoberLook">Daily Shot</a>).<br />
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In November, we warned that investors' inflation expectations were at an extreme (near a 14 year high) and that that has consistently led to a drop in treasury yields in the months ahead. In the event, the US 10-year has fallen from 3.2% to 2.4%.<br />
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The drop in treasury yields is not, on its own, bearish for equities. Treasury yields have been falling for close to 40 years, during which equities have been mostly rising. In the chart below, the green highlights are periods when yields fell and SPX rose; this has just as often been the case as yields falling with SPX (yellow highlights). Contrary to what is often believed, the bond market doesn't always know something before equities.<br />
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The pause in the Fed's tightening is likewise neither bearish nor unusual. There have been 5 prior tightening cycles in the past 35 years (top panel) and the peak in SPX has come <i>after</i> the final rate hike each time. When the Fed has paused, stocks have continued to rise (bottom panel).<br />
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In the past week, the 10-year/3-month yield curve briefly inverted. Economists like to use this measure as a recession warning, but stock market investors should prefer to use the 10-year/2-year yield curve. Why? Because in the past 50 years it has inverted an average of 12 months <i>before</i> SPX has peaked, and it has always inverted before the 10-year/3-month curve (by an average of 9 months). Importantly, the 10-year/2-year curve has not inverted.</div>
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More to the point, the inversion using the 3-month rate occurred because the Fed signaled a pause in tightening. That dropped very short term rates into inversion (circle). The curve from 2-years on out remains positive. This is not signaling sustained growth anxiety (the next two charts from <a href="https://twitter.com/DailyYieldCurve">Daily Yield Curve</a>).</div>
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In comparison, the yield curve was inverted all the way out a half year before the SPX peaked in October 2007. This is a signal of sustained growth anxiety.</div>
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In the past 40 years, SPX has continued to gain even after the 10-year/2-year curve inverted, most often by double digits (from <a href="https://twitter.com/RyanDetrick">Ryan Detrick</a>). </div>
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Finally, it seems likely that some of the macro data will rebound in the months ahead. Housing, for example, peaked in late 2007 just as mortgage rates troughed, and then softened as rates rose during 2018. Rates have fallen from 5% in November to 4% this week, and purchase applications have soared (first chart, from <a href="https://www.marketwatch.com/story/mortgage-rates-stay-subdued-bringing-relief-to-slumping-housing-market-2019-01-17">MarketWatch</a>). New home sales popped to their third highest level in 11 years last month, and have risen 11% in the past 6 months (second chart).</div>
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The employment cycle may peaked but there has been no serious deterioration. This week's claims are less than 3% higher than the low in September. Into a recession, employment has had a sustained and pronounced period of weakening, something to watch out for in the weeks/months ahead.</div>
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Equities are off to one of their best ever starts to a year, something that has consistently led to continued gains. If past is prologue, SPX is likely to gain enough to make a new ATH in 2019. The panic over weakening macro is likely to abate and, with fund managers' risk exposure falling to a 2-1/2 year low this month, sentiment supports a continued rise in equities.<br />
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On the calendar this week: retail sales on Monday, durable goods on Tuesday and employment on Friday (from IBD Investors; for a trial subscription, <a href="https://shop.investors.com/offer/splashresponsive.aspx?id=mssharpenpopup&src=A00452A&refcode=UC_Links">please use this link</a>).<br />
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Urban Carmelhttp://www.blogger.com/profile/11008222748707680522noreply@blogger.comtag:blogger.com,1999:blog-6302409656195627126.post-88157884818913597902019-02-24T15:14:00.000-08:002019-02-25T17:52:25.707-08:00Weekly Market Summary<u>Summary</u>: NDX, RUT and DJIA have all risen 9 weeks in a row. Long win streaks like these have a very strong propensity to continue higher over the next several months, although an interim period of consolidation and retracement is frequent. That SPX is now back at the top of its trading range from October to early December perhaps makes that outcome likely now as well. But years that start as strongly as 2019 have almost always (more than 90% of the time) added sizable gains the rest of the year.<br />
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Since Christmas Eve, SPX is up 19%, NDX 20% and RUT 25%. NDX, RUT and DJIA have each risen the past 9 weeks in a row (table from <a href="https://alphatrends.net/">alphatrends.net</a>). Enlarge any chart by clicking on it.<br />
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SPX is now back to within 0.5% of the top of its trading range from October to early December (upper panel). The index is grinding higher as Vix sinks further under 16 (lower panel). It would take a close under 2600 to trigger a bearish failure. There are a lot of eyes on this chart and it would be very surprising if SPX did not encounter some resistance around 2810.<br />
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<a href="https://3.bp.blogspot.com/-KA1TpZegI3g/XHMBlkITAuI/AAAAAAAAtAk/Npn2gSrGNlEcs2Lcme6aejhfcfYRcgPqwCLcBGAs/s1600/vix%2Bspike.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="775" data-original-width="1368" height="362" src="https://3.bp.blogspot.com/-KA1TpZegI3g/XHMBlkITAuI/AAAAAAAAtAk/Npn2gSrGNlEcs2Lcme6aejhfcfYRcgPqwCLcBGAs/s640/vix%2Bspike.png" width="640" /></a></div>
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The very broad NYSE index closed above the top of this range on Friday, but not by much. A decisive move higher in the coming week would be consequential, setting up a retest of the September all-time high (ATH).<br />
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<a href="https://2.bp.blogspot.com/-cmaQkyvICH8/XHMC8IMML8I/AAAAAAAAtAw/42N6DqnThPUTsZZkjVFHFy_qGnNOwZPPwCLcBGAs/s1600/nyse.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="503" data-original-width="1354" height="236" src="https://2.bp.blogspot.com/-cmaQkyvICH8/XHMC8IMML8I/AAAAAAAAtAw/42N6DqnThPUTsZZkjVFHFy_qGnNOwZPPwCLcBGAs/s640/nyse.png" width="640" /></a></div>
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Likewise, the SPX on an equal-weight basis closed above the top of its prior range this week. It's now less than 3% from its September ATH.<br />
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<a href="https://4.bp.blogspot.com/-DoSnmp1W5Oc/XHME1d_UYdI/AAAAAAAAtA8/Q5JmFIBbrMUhJIbuN0DoCAjurJsPKe4EACLcBGAs/s1600/RSP.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="511" data-original-width="1338" height="244" src="https://4.bp.blogspot.com/-DoSnmp1W5Oc/XHME1d_UYdI/AAAAAAAAtA8/Q5JmFIBbrMUhJIbuN0DoCAjurJsPKe4EACLcBGAs/s640/RSP.png" width="640" /></a></div>
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The same is true for the equal-weight NDX, which is less than 1.5% from its ATH. Put another way, FAANG stocks are holding the indices back; given their heavy weighting, if they kick into gear, the traditional market capitalization-based indices will likewise move back to their ATHs.<br />
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That NYSE and the equal-weight indices are leading says that breadth has been strong. This is a net positive. More than 90% of the SPX is now back above their respective 50-dma. In the past 30 years, SPX has closed the month higher within the next 3 months <i>every time</i>. If returns 3 months from now meet the historical average (4.7%), SPX will essentially be back at its September ATH (the next two charts are from <a href="https://twitter.com/RyanDetrick">Ryan Detrick</a>).<br />
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<a href="https://4.bp.blogspot.com/-Wm969A6gZYI/XHMIrjJ-S-I/AAAAAAAAtBc/N4Ab7Z_Q2bUy1cyNXWLT81y3pMnkaSF6wCLcBGAs/s1600/%2525%2B%253E%2B50-dma.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="637" data-original-width="1023" height="398" src="https://4.bp.blogspot.com/-Wm969A6gZYI/XHMIrjJ-S-I/AAAAAAAAtBc/N4Ab7Z_Q2bUy1cyNXWLT81y3pMnkaSF6wCLcBGAs/s640/%2525%2B%253E%2B50-dma.png" width="640" /></a></div>
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That the DJIA, NDX and RUT have all closed higher the past 9 weeks in a row is also an intermediate-term positive. For the DJIA, this has happened at least 15 times in the past 120 years, and <i>none</i> marked a major top. The instance from 1965 looks close but the reality is the DJIA closed higher 14 weeks in a row and then rose another 4% after that.<br />
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<a href="https://3.bp.blogspot.com/-cvaZftZ7Pfo/XHMJ1gkpl3I/AAAAAAAAtBk/n2hbEQoi_mYCRJe4HED6rfpqZRG8NCrtgCLcBGAs/s1600/djia%2B9%2Bweeks%2Bhigher.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="476" data-original-width="1017" height="298" src="https://3.bp.blogspot.com/-cvaZftZ7Pfo/XHMJ1gkpl3I/AAAAAAAAtBk/n2hbEQoi_mYCRJe4HED6rfpqZRG8NCrtgCLcBGAs/s640/djia%2B9%2Bweeks%2Bhigher.png" width="640" /></a></div>
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Likewise, when COMPQ has gained 9 weeks in a row, it has continued higher: <i>all</i> instances closed higher after either 6 or 12 weeks. Risk/reward was extremely biased positive during the next 3 months. If returns 3 months from now meet the historical average (10.5%), COMPQ will be well above its September ATH (7.5% above Friday's close; table from <a href="https://twitter.com/SJD10304?lang=en">Steve Deppe</a>).<br />
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The rise in the indices has been unrelenting in another way: SPX has not closed below even its 10-dma in more than 32 days. There have been only 4 other instances like this in the past 46 years. In the past 70 years, SPX has continued higher over the next month 88% of the time. This streak might end soon, but the uptrend in SPX is likely to continue (table from <a href="https://twitter.com/bullmarketsco">Troy Bombardia</a>).<br />
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The rally since Christmas continues to look more like an uptrend to new highs than a bear market bounce. This week, the volatility index dropped under 15. Volatility tends to remain elevated during a bear market bounce, but this market has relentlessly ground higher. It's a limited sample size, but no ongoing bear market in the past 30+ years (yellow vertical shading) has had equally low volatility as now.<br />
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The month of February ends Thursday. So far this month, SPX is up 3.3% after rising 7.9% in January. Years when SPX has gained in both January and February have had a very strong tendency to continue higher into year end: since the end of WWII, equities have risen 25 of 27 times (93%) by a median of another 11% (table from <a href="https://twitter.com/oddstats">Odd Stats</a>).<br />
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Despite a strong 9-week rally, sentiment amongst analysts has not rebounded very strongly, yet (blue line). Bulls climbed back to just 58% this week; rallies in the past 8 years have not fizzled out until bulls were at least 65% (like late-2015 before the second swoon in early 2016). It would be unusual for there to be much downside until sentiment improves further (from <a href="https://twitter.com/hmeisler">Helene Meisler</a>).<br />
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It's true that sentiment among newsletter writers (Investors Intelligence) has rebounded more strongly (to 31% net bulls) but this has not been a very useful indicator on its own: SPX has topped, or chopped sideways or just continued higher in the past (yellow shading in the first chart). A rise to 40% net bulls, on the other hand, would be a notable extreme (second chart; from <a href="https://twitter.com/vixsquared">VixSquared</a>).<br />
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As stated at the top of this post, it would be very surprising if SPX did not encounter some resistance near 2810. Even strong rallies like this one usually consolidate and retrace gains before moving higher. Two bits of evidence support that conclusion.<br />
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First, 6 of the last 8 times that Investors Intelligence net bulls exceeded 31%, SPX was lower 2 weeks later (75% loss rate; data since 1981, from Sentimentrader; to become a subscriber and support the Fat Pitch, click <a href="https://partners.sentimentrader.com/idevaffiliate.php?id=101">here</a>).<br />
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Second, while the 9-week win streak in DJIA is a longer term positive, it has historically been most often followed by near-term weakness: the index was lower 2 weeks later 75% of the time, although the losses were minor (table from <a href="https://twitter.com/bullmarketsco">Troy Bombardia</a>).<br />
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The case from 1989 is worth highlighting. DJIA rose 9 weeks in a row and then went into a 10% trading range lasting the next 8 months. It eventually broke out of this range and made a new ATH another 8% higher. The lesson: a set up for a longer term continuation higher can sometimes take a frustrating long time to unfold.<br />
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Looking ahead for the year, the fundamental picture for US equities is less positive.<br />
<blockquote class="tr_bq">
In the corporate results released for the fourth quarter, profit <i>margins fell</i> by the most since the "profit recession" in 2015. </blockquote>
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Expectations for 10% earnings growth in 2019 have already been revised down to 5% but this still looks too optimistic: if margins in 2019 remain at the same level as in 4Q18, then earnings <i>growth will be 0%</i>. </blockquote>
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Valuations are not cheap, but the excesses from early 2018 have been worked off: if investors once again become ebullient, there is room for valuations to expand. However, with earnings growth likely to negligible, the key for share price appreciation in 2019 is likely to <i>hinge entirely on valuations</i> expanding. </blockquote>
A new post on this is <a href="http://fat-pitch.blogspot.com/2019/02/4q-corporate-results-margins-fall-watch.html">here</a>.<br />
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On the calendar this week: housing starts on Tuesday, GDP on Thursday and PCE on Friday. Due to the government shutdown, delayed data will be released over the coming weeks (from IBD Investors; for a trial subscription, <a href="https://shop.investors.com/offer/splashresponsive.aspx?id=mssharpenpopup&src=A00452A&refcode=UC_Links">please use this link</a>).<br />
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Urban Carmelhttp://www.blogger.com/profile/11008222748707680522noreply@blogger.comtag:blogger.com,1999:blog-6302409656195627126.post-40759537952965043872019-02-19T18:59:00.001-08:002019-02-19T21:18:12.947-08:004Q Corporate Results: Margins Fall. A Watch Out for 2019<u>Summary</u>: Overall, corporate results in the fourth quarter of 2018 were good, but not great. S&P sales grew 6% and earnings rose 32%, but <i>profit margins fell</i> to 10.9% from a high of 12.1% in the third quarter. This was the first substantial fall in margins since the "profit recession" in 2015.<br />
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Fundamentals have been driving the stock market higher, not valuations: earnings during the past 1 year and 2 years have risen <i>faster</i> than the S&P index itself (meaning, valuations contracted). The strong growth in company profits is not due to a net share reduction (e.g., buybacks) either.<br />
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Looking ahead, expectations for 10% earnings growth in 2019 have already been revised down to 5%. This still looks too optimistic: if margins in 2019 remain at the same level as in 4Q18, then earnings growth will be 0%. Dollar appreciation and declining oil prices are additional headwinds that could cause earnings to fall this year.<br />
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Valuations are now back to their 25-year average. They are not cheap, but the excesses from early 2018 have been worked off: if investors once again become ebullient, there is room for valuations to expand. However, with earnings growth likely to negligible, the key for share price appreciation in 2019 is likely to hinge entirely on valuations expanding.<br />
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85% of the companies in the S&P 500 have released their fourth quarter (4Q18) financial reports. The headline numbers were good, but not great. Here are the details:<br />
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<b>Sales</b><br />
<i><br /></i><i>Quarterly sales reached a new all-time high, growing 6% over the past year</i>. On a trailing 12-month basis (TTM), sales are 9% higher yoy, among the best growth in 12 years (all financial data in this post is from <a href="https://us.spindices.com/indices/equity/sp-500">S&P</a>). Enlarge any image by clicking on it.<br />
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The arrows in the chart above and those that follow indicate the period from 2Q14 to 1Q16 when oil prices fell 70%. The negative affect on overall S&P sales (above) and the energy sector alone (below) is easy to spot.<br />
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<a href="https://1.bp.blogspot.com/-HpwSw0oAprw/XGw04cv6lgI/AAAAAAAAs6c/MTJWpvP29zIQAbz4DOrtG6ajEVRbsVYZwCLcBGAs/s1600/energy%2Bsales.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="449" data-original-width="953" height="300" src="https://1.bp.blogspot.com/-HpwSw0oAprw/XGw04cv6lgI/AAAAAAAAs6c/MTJWpvP29zIQAbz4DOrtG6ajEVRbsVYZwCLcBGAs/s640/energy%2Bsales.png" width="640" /></a></div>
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The six sectors with the highest weighting in the S&P have grown an average of 8% in the past year (box in middle column) and, since the peak in oil in 2Q14, their sales have grown an average of 38%. In contrast, energy sector sales have declined 25% (far right column).<br />
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Excluding the volatile energy sector, sales for the remainder of the S&P have continued to trend higher at about the same rate over the past 8 years, with some acceleration in the past 2 years (blue line; from Yardeni).</div>
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The dollar has become a minor headwind for sales: in the past year (thru 4Q18), <i>the dollar appreciated by 6%; this accounts for about a 3 percentage point decline in growth in corporate sales.</i> For the current quarter (1Q19), the dollar is pacing an 8% yoy appreciation.</div>
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How does the dollar impact sales growth? Companies in the S&P derive about half of their sales from outside of the US. When the dollar rises in value, the value of sales earned abroad (in foreign currency) falls. If foreign sales grow 5% but the dollar gains 5% against other currencies, then sales growth will be zero in dollar terms. The chart below compares changes in the dollar (blue line; inverted) with growth in S&P sales (red line): a higher dollar corresponds with lower sales (from Yardeni).</div>
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<b>Earnings and Margins</b></div>
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<i>Operating EPS grew 13% over the past year</i> on a quarterly-basis and 24% on a trailing 12-month basis (TTM). GAAP EPS was better: 32% quarterly growth yoy and 26% growth TTM. More on these differences below.</div>
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Importantly, EPS <i>fell this quarter from its all-time high in 3Q18, </i>the first substantial fall<i> </i>since the "profit recession" in 2015<i>.</i></div>
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The arrows in the next chart again indicate the period when oil prices fell 70% between 2014 and 2016. The improvement in total EPS since then comes with energy sector EPS at two-thirds of its level in mid-2014.<br />
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Likewise, overall S&P profit margins peaked at 10.1% in early 2014, fell to 8% at the end of 2015 and have since rebounded to 10.9% in 4Q18. <i>However, margins fell this quarter from a high of 12.1% in 3Q18.</i><br />
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Similarly, <i>non-energy margins have dropped to 11.2% in 4Q18 from 12.6% in 3Q18</i>.<br />
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Most of the largest sectors have done well, increasing their margins 1-2 percentage points in the past 1 year and 2 years. </div>
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An important exception is the technology sector, where margins shot up from 19% in 2016 to 23% in 2017 but have since fallen back to 21%. This is weighing on overall margins for the S&P.</div>
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<b>Misconceptions and Bad Memes</b><br />
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There are some common misconceptions that are regularly cited with respect to corporate earnings.<br />
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First, companies have been accused of inflating their financial reports through a net reduction in shares through, for example, corporate buybacks. In reality, however,<i> over 90% of the growth in earnings in the S&P over the past 9 years has come from better profits, not a net reduction in shares</i>. Better profits have driven growth, not "financial engineering."<br />
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That has been true over the past 17 years, during which the net change in corporate shares has accounted for just 3% of EPS growth (from JPM).<br />
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In fact, despite record buybacks, the difference between EPS and profits has been consistently narrow.<br />
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Second, equity prices are said to have far outpaced earnings during this bull market. In fact, <i>better profits accounts for about 85% of the appreciation in the S&P over the past 9 years</i>. Of course valuations have also risen - that is a feature of every bull market, as investors transition from pessimism to optimism - but this has been a much smaller contributor. In comparison, 75% of the gain in the S&P between 1982-2000 was derived from a valuation increase (that data from <a href="https://www.bloomberg.com/view/articles/2017-10-27/how-to-tell-the-bulls-from-the-bears">Barry Ritholtz</a>).<br />
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Over the past 2 years (since 4Q16), during which time the S&P has risen about 24%, earnings have risen 47%, i.e., faster than the S&P index itself thereby accounting for more than 100% of price appreciation. The same is true over the past 1 year (from JPM).<br />
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Third, financial reports based on "operating earnings" are said to be fake. This complaint has been a feature of every bull market since at least the 1990s. In truth, the <i>trend in GAAP earnings (red line) is the same as "operating earnings" </i>(blue line).<br />
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It's accurate to say that operating earnings somewhat overstate and smooth profits compared earnings based on GAAP, but that is not new. In fact, the difference between operating and GAAP earnings in the past 25 years has been a median of 10% and the recent history has been no different (it was 8% in the most recent quarter). Operating earnings overstated profits by much more in the 1990s and earlier in the current bull market. The biggest differences have always been during bear markets.<br />
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<b>Outlook for 2019</b></div>
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Looking ahead, <i>expectations for 10% earnings growth in 2019 have already been revised down to 5%</i>. Sales growth is expected to also be 5%, rising to 6% in 2020 (from FactSet).<br />
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There are 5 considerations with a strong bearing on forward sales and earnings. Most of these appear likely to be a headwind in 2019.<br />
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First, as a baseline, it is reasonable to assume that corporate (non-energy) sales growth will be largely similar to the <i>nominal economic growth rate of 4-5%</i>, excluding currency effects. Right now, this seems achievable (from the OECD).<br />
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Second, the dollar weakened from the end of 2016 to early-2018 (a tailwind to growth) but has since appreciated 6%. That means that <i>currency effects are now a headwind</i> to growth<i>.</i> With half of corporate sales coming from abroad, even a small 4% appreciation in the dollar could cut 2 percentage points to sales growth this year (second chart from JPM).<br />
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Third, the price of oil was tracking more than a 30% yoy gain until October; the price has since fallen 30%.<i> </i>In other words,<i> </i>the energy sector had been a tailwind to overall sales and EPS growth; <i>below $65, oil becomes a headwind in 2019</i>.<br />
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As we have seen, the direct impact of oil prices on the energy sector is far more important than any ancillary affects on other sectors. As an example, consider this: the price of oil fell from over $100 to under $50 between mid-2013 and mid-2016 but non-energy sector operating margins were 10% in both instances. In short, <i>lower oil prices are a net negative for sales and earnings</i>.<br />
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Fourth, corporate tax cuts were a major tailwind to earnings in 2018. Analysts estimate that these likely added 10 percentage points to growth, meaning baseline growth of 5% could have jumped to 15% by virtue of tax cuts alone.<br />
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But the <i>tax cut was a one-off adjustment, applicable only to 2018</i>, and there is not much reason to expect it to permanently raise growth rates. Why? US corporations are not capital constrained; they have abundant cash and access to low cost debt and equity. Moreover, corporations have been making fixed capital investments. Over the past 3 decades, rising corporate profitability (blue line) has had no positive affect on new investments (red line; from the FT).<br />
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Fifth: <i>the biggest risk to earnings in 2019 is margin contraction</i>. For earnings to grow as fast as sales, margins have to be maintained. But after trending higher over the past 7 years, margins jumped 140bp in 2018. This was a massive rise and sustaining that level (let alone expanding margins further) seems highly unlikely.<br />
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<b><br /></b><b><br /></b>In fact, average margins in 2018 were 11.5% but fell to 10.9% in 4Q18. If that level is maintained throughout 2019, <i>earnings growth will be 0%.</i> If the dollar continues to appreciate, that growth could to -2%. If oil remains under $65/barrel, earnings will fall further.<br />
<b><br /></b><b><br /></b><b>Valuation</b><br />
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At the end of 2018, the combination of ~25% earnings growth and a 6% fall in equity prices left valuations at 14.4x, the same level as in 2010 and well below their 25-year average. The continued rally since then has brought valuations right back to the average (from JPM).<br />
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Valuations are not cheap, but if investors once again become ebullient, <i>there is room for valuations to expand</i>. Why? When investors become bullish (blue line), valuations rise (red line). Investors had been pessimistic in early 2016 and then became far too optimistic at the market peak in January 2018. <i>Importantly, that was greatly reset by the end of December 2018</i> (from Yardeni).<br />
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It's hard to believe that investors have already reached peak bullishness. Fund flows into equity mutual funds and ETFs was strong before both the 2000-02 and 2007-09 bear markets, and even before the 2015-16 mini-bear market (blue circles). In comparison, fund flows have been negative for 4 of the past 6 quarters (red circle; from JPM).<br />
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Valuations are influenced by more than investor psychology. Part of the reason equities have become more expensive over time is rising corporate profitability. <i>Margins have reached successive new highs with each economic cycle over the past 3 decades</i>: they are now more 100bp higher than in 2007, and that peak was more than 100bp higher than in 2000. Higher profitability (and growth) is typically rewarded with higher valuation multiples (from JPM).<br />
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While it is objectively impossible to know when or at what level margins will peak for this cycle, it's a reasonable guess that the cycle peak was last quarter (3Q18).<br />
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Importantly, valuations have almost no bearing on the market's 1-year forward return (left side). But over the <i>longer term, current valuations suggest that single digit annual returns are odds-on</i> (right side; from JP Morgan).<br />
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In summary, corporate results in the fourth quarter were good, but not great. Sales and earnings growth were strong, but margins severely contracted. This was the first substantial fall in margins since the "profit recession" in 2015.<br />
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Looking ahead, expectations for 10% earnings growth in 2019 have already been revised down to 5%. This still looks too optimistic: if margins in 2019 remain at the same level as in 4Q18, then earnings growth will be 0%. Dollar appreciation and declining oil prices are additional headwinds that could cause earnings to fall.<br />
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Valuations are now back to their 25-year average. If investors once again become ebullient, there is room for valuations to expand. With earnings growth likely to negligible, the key for share price appreciation in 2019 is likely to hinge entirely on valuations expanding.<br />
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<i>If you find this post to be valuable, consider visiting a few of our sponsors who have offers that might be relevant to you.</i>Urban Carmelhttp://www.blogger.com/profile/11008222748707680522noreply@blogger.comtag:blogger.com,1999:blog-6302409656195627126.post-25800384584978449622019-02-17T15:04:00.000-08:002019-02-18T13:04:22.985-08:00Weekly Market Summary<u>Summary</u>: SPX has now gained 19% since Christmas Eve, while the Nasdaq is up 20% and RUT is up 23%. NDX, RUT and DJIA have all risen 8 weeks in a row.<br />
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SPX is now back to within 1% of the top of its trading range from October to early December. It would be very surprising if SPX did not encounter some resistance as it nears 2790-2810. That is made more likely by the fact that consecutive weeks of gains, while bullish longer term, have most often been followed by a period of consolidation and retracement.<br />
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The longer term outlook continues improve. Equal weighted indices, which remove the influence of a few, large companies, are outperforming their traditional market capitalization weighted peers. The Nasdaq index, normalized to reduce the influence of FAANG, is just 1.5% from a new all time high (ATH). If those big companies kick into gear, the traditional indices will likewise move back to their ATHs.<br />
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The primary characteristic of this rally has been broad participation. This week, the cumulative advance/decline line for the very broad NYSE made a new ATH . This did not happen during any bear market rally over the past 40 years.<br />
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Since Christmas Eve, SPX is up 19%, NDX 20% and RUT 23%. NDX, RUT and DJIA have each risen the past 8 weeks in a row (table from <a href="https://alphatrends.net/">alphatrends.net</a>). Enlarge any chart by clicking on it.<br />
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<a name='more'></a>SPX is now back to within 1% of the top of its trading range from October to early December (upper panel). The index is grinding higher as Vix sinks under 16 (lower panel). It would take a close under 2600 to trigger a bearish failure. There are a lot of eyes on this chart and it would be very surprising if SPX did not encounter some resistance as it nears 2790-2810.<br />
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Notice how SPX hesitated after entering the bottom of the range (at 2600) in January. That would be a bullish scenario now as SPX approaches the top of this range: a "handle" to put on the "cup" formed during the December plunge and subsequent v-shaped recovery.<br />
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The primary characteristic of this rally has been broad participation. This rally is not being led by a few large companies. SPX (market cap weighted) has not broken out of its prior range, but the equal-weight index has.<br />
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Likewise, the equal weight Nasdaq broke out two weeks ago. It is now within 1.5% of its all-time high (ATH). Put another way, FAANG stocks are holding the index back; given their heavy weighting, if they kick into gear, the traditional indices will likewise move back to their ATHs.<br />
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Transportation indices have been strong. Railroads made new ATHs this week.<br />
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The trucking index closed above its range from October to early December on Friday.<br />
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In an early January post we wrote that this "does not look a bear market" (<a href="http://fat-pitch.blogspot.com/2019/01/weekly-market-summary_12.html">here</a>). Part of our rationale was that early momentum was unusually strong: in the past 70 years, this had <i>never</i> taken place within the context of a bear market. In fact, momentum like this has often been associated with the <i>start</i> of new bull markets. An example of the strong forward returns is presented below. A month after "breakaway momentum" had triggered, SPX was up almost 5%, a condition that has <i>always</i> lead to continued gains 3, 6 and 12 months later (from <a href="https://twitter.com/WalterDeemer">Walter Deemer</a> and <a href="https://twitter.com/coynefucius">Coynefucius</a>).<br />
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Likewise, the McClellan Summation index (another measure of breadth momentum) rose to +1000 this week (discussed <a href="http://fat-pitch.blogspot.com/2019/02/weekly-market-summary.html">here</a> last week). This did not occur during either the 2000-02 or 2007-09 bear markets. According to Sentimentrader, reaching +1000 has led to positive returns in SPX over the next year 27 out of 28 times (<i>a 96% win rate</i>; to become a Sentimentrader subscriber and support the Fat Pitch, click <a href="https://partners.sentimentrader.com/idevaffiliate.php?id=101">here</a>).<br />
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In the past 20 years, there have been 12 instances in which NYSI has exceeded +1000. SPX closed higher at least once within the next 4 months <i>every</i> time. A year later, SPX was higher <i>every</i> time by a median of 13% and by a minimum of 5%. A 5% gain from Friday's close would put SPX back at its ATH from September (table from <a href="https://twitter.com/SJD10304?lang=en">Steve Deppe</a>).<br />
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Also on Friday, the cumulative advance/decline line for the very broad NYSE made a new ATH (top panel). This did not happen during <i>any</i> bear market rally over the past 40 years, including during the ultra-outlier 1987 bear market (vertical red lines). For those who see the current rally as similar to the one at the end of 2015 before the early 2016 plunge, note that the A/D line came nowhere near an ATH during that period, even though SPX came within 1% of an ATH. All instances since 1980 are shown below.<br />
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The rally since Christmas has been almost entirely uncorrected. There have been only two days with more than a 1% fall. This has happened only 6 other times in the past 65 years. It's a small sample, but the index was higher 2 months and 6 months later <i>every</i> time. Only 1987 showed a negative return after a year but that came after the index had already gained more than another 15% (table from <a href="https://twitter.com/bullmarketsco">Troy Bombardia</a>).<br />
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But in other respects, the current rally seems most likely to take at least an interim pause, during which gains are consolidated or partially given back.<br />
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First, there have been 10 other instances in which SPX fell 20% in 3 months. The current rally off that low is not only tracking above the median but at the top of the range for all 10. If past is prologue, SPX could chop sideways well into spring (yellow highlights) before resuming its upward recovery). This consolidation might coincide with SPX encountering some resistance at the top of its October to early December range (from Goldman Sachs).<br />
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Second, SPX has closed every week higher than it opened for 8 weeks in a row. In the past, the index was higher 6 weeks later in all but 1 instance (a 93% win rate). But in the interim 6 weeks, it has closed lower at least once in all but 3 instances (an 80% lose rate); in the past 50 years, only 1985 continued to sail higher (a 91% lose rate). In other words, a period of consolidation/retracement ahead is high odds (next two tables from <a href="https://twitter.com/SJD10304?lang=en">Steve Deppe</a>).<br />
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Likewise, NDX has closed higher 8 weeks in a row. In the past 50 years, it has closed higher again within the next 3 months in 86% of all instances. But during those next 3 months, a period of some consolidation/retracement occurred in 68% of instances (weekly closing basis).<br />
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Want to short this rally? Your best set up would be a pop in SPX above 2800 with, preferably, a drop in volatility so the term structure is near 80% or less.<br />
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Despite a strong 8 week rally, sentiment amongst analysts has not rebounded very strongly, yet (blue line). Bulls climbed back to just 56% this week; rallies in the past 8 years have not fizzled out until bulls were at least 65% (like late-2015 before the second swoon in early 2016). It would be unusual for there to be much downside until sentiment improves further (from <a href="https://twitter.com/hmeisler">Helene Meisler</a>).<br />
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Similarly, fund managers' are not bullish. This month, BAML reports that they are overweight cash by the most in 10 years, their global equity allocation is at a 2-1/2 year low and their profit and macro expectations are the most pessimistic in 10 years. A new post on all of this is <a href="http://fat-pitch.blogspot.com/2019/02/fund-managers-current-asset-allocation.html">here</a>.<br />
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It's true that US macro data has become decidedly ambiguous in the past few months. Real retail sales in December grew just 0.3% yoy. Industrial production fell 0.6% mom in January. This looks weak until you remember that industrial production was at an ATH in December, real retail sales were at an ATH in November and 2018 was the 2nd best year for new employment since 2000. An excellent, balanced take on the state of US macro from <a href="https://twitter.com/TimDuy">Tim Duy</a> is <a href="https://blogs.uoregon.edu/timduyfedwatch/2019/02/14/beware-of-a-recessionary-bias-among-analysis/">here</a>.<br />
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On the calendar this week: the Presidents Day holiday on Monday; housing starts and FOMC minutes on Wednesday; durable goods on Thursday. Due to the government shutdown, delayed data will be released over the coming weeks (from IBD Investors; for a trial subscription, <a href="https://shop.investors.com/offer/splashresponsive.aspx?id=mssharpenpopup&src=A00452A&refcode=UC_Links">please use this link</a>).<br />
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Urban Carmelhttp://www.blogger.com/profile/11008222748707680522noreply@blogger.com