The Big Four Indicators (12/7/18)

The Dshort website (part of Advisor Perspectives) hosts an incredible about of economic and market data.  Periodically I feature some of their work, specifically The Big Four Indicators update.  Taken together, these four indicators covering income, employment, retail sales and industrial production are thought to be an excellent monitor of the overall health and direction of the U.S. economy.

Advisor Perspectives, Jill Mislinski, December 7, 2018

The recovery from the Great Recession has been slow but positive.  The most encouraging development recently has been the strength coming from industrial production (purple line).

The Grind To Lower Valuations

Let’s think about the future for a moment.  After all, that is what the stock market is doing constantly.  Up to this point in 2018, the stock market has had a very positive view of the future.  Why wouldn’t it?  Corporate sales and earnings growth have delivered in the strongest economy since 2008.

In addition to an economy that is strengthening, we are also experiencing an innovation renaissance.  Quantum computing, space exploration, and organ replacement are just a few of the areas announcing major breakthroughs.  If you spend any time following science and technology news, rarely a week passes without a new scientific announcement.  Contrast that with the DotCom crash of 2000 where we were at the end of the personal computer revolution of the 1990.  The future did not look very bright.

The most important market to watch right now, in terms of what the near-term future may hold for stocks, may be high-yield (junk) bonds.  Many commentators point to the increase of debt by corporations as a major risk for the economy.  So far it is holding up remarkably well which is not what you would expect if the economy was about to fall in to a recession.

At some point in the future we will see another credit event like the sub-prime debacle of 2008.  That is the nature of a credit-based global economy and it will likely trigger a deep recession.  Perhaps we are on the verge of such an event but the high-yield market does not seem to think so.  It is holding up remarkably well considering how much corporate bond doom and gloom is being reported.

Stockcharts.com, Dightman Capital

If there were serous concerns in the high-yield bond market you would expect a bigger sell-off, but instead high-yield bonds appear to have decoupled from stocks.

I shutter to think what the global economic environment would be like without the corporate tax, personal tax and regulatory reform recently implemented in the U.S.  But I digress, that is the past.  What is more important is will these policies allow the U.S. economic expansion to continue?

In its totality this selloff has the character of a grind down to lower valuations; not a panic selloff with no bottom in sight.  I think the biggest surprise of this market could be the Dow, S&P 500 and Nasdaq reaching new all-time highs before we actually experience the next recession.  There are many things that could go wrong but I continue to believe we are experiencing an adjustment in valuations that will allow this market to resume the bull market rally; not the beginning of the end of the this cycle’s expansion.

Excellent Technical Analysis Example

There are a lot of technical indicators used by stock investors.  Some screens are so filled with colors, lines and data it tough to make heads or tails from what you are looking at.

It is helpful to remember there are only two data inputs.  Price and Volume.  Price determines the trade direction and volume establishes conviction.  Focusing on these two variables and adding a simple relative strength indicator can yield a great deal of information about the potential near-term price action.

Take the example below.  This is a high-growth tech stock that has delivered outstanding returns to investors over the last couple of years.  This stock when public in 2015.

Marketsmith, Dightman Capital

In weekly chart above we can see three different basing patters (identified by the green dots and curved line).  Two of these bases were consolidation types and the middle base was a cup w/handle type (the handle slopped upward which is a potential concern).  The most telling part of the current late stage base (also a warning) can be seen when comparing it to the prior consolidation base of about a year ago.

Notice how the current base is downward sloping (current price is near the bottom of the base range).  The base this stock produced over a year ago featured the price staying more in the middle and then upper range.   You should be able to see an upward sloping trend just looking at it.  The current consolidation is producing the opposite, a downward slope.

Below the price bars you see the blue relative strength (RS) line. The RS line measures the price performance of a stock with the price performance of the S&P 500.   If the line is trending higher it is outperforming the market.  For growth investors often a new high on the RS line is a bullish buy signal.  It is extra bullish if this line hits a new high ahead of the price.

In this example, the RS maintained an upward slope during the first two bases.  Now it is starting to exhibit a downward slope.  The red lines over the RS were drawn to show the change in slope.  Notice how in the first base the slope of the RS line initially weakened.  This is normal and to be expect as a stock rests.  It is possible the stock above will still move higher and the RS line will turn higher.  But, if the price of this stock moves below the bottom of the current base consolidation, that would increase the probability this stock is going to see weaker price performance in the near-term.

Should Investors Prepare For More Market Declines?

The stock market experienced swift and deep downward action last week. Part of the market selloff points to typical action by institutional investors and looks very similar to the February decline. This type of trade action includes Option Gamma Hedging strategies, where traders profit from increased sensitivity to an option’s price change measured by gamma. Much of this type of selling is believed to be behind us.

You also have the Trend Following crowd, once indexes made a strong move below the 50-day moving average selling and short exposure increased, which aggravates moves to the downside.

This week Volatility Sensitive Strategies (investment allocations that shift between cash and the S&P 500) and Risk Parity Strategies are expected to be active. Some trading desks suggest there’s around $355Bn allocated to this category of trading. Stock exposure for these strategies is believed to already be down to around 65% from 100%. Another 15% reduction is still expected.

Goldman Sachs reported good flows into their Corporate Buyback desk but as you can see in the chart below (Stockcharts.com & Dightman Capital), it was not enough to establish firm support. Trading volume on Friday was significantly below recovery rallies earlier in the year and selling volume for S&P 500 stocks was significantly higher.

The Tech Premium, the higher cost an investor is willing to pay for tech exposure versus other areas of the stock market has faded a bit and may have further to fall. One area contributing to the compression in tech stocks involves international growth. There is concern international market are going to fall into recession before they kick into a higher growth mode. Rising Costs are also weighing on tech. While top-line growth is steady, margins are being compressed as costs, like wages, are rising.

On the geopolitical front, Trade Talks with China should be quiet (but probably won’t be) leading up to the November G-20 meeting but Saudi trouble and the Price Of Oil is a new issue for the market to digest. Brexit talks are not progressing well with many obstacles remaining so that may be causing traders in Europe to sit on the sidelines.

Q3 Earnings ramp up this week, so we will know more about the health of corporate finance throughout the week. Disappointing results or poor guidance could send stocks lower.

A scenario is developing which could push stocks further into the red in the coming days and weeks, or at least mute any recovery.  More downside for the stock market would provide cover for The Fed to become more dovish and slow interest rate hikes. This would likely be a welcome development for stock investors but in the meantime, we may see a bit more pressure on stock prices. From a longer-term perspective this looks like it may end-up being a buying opportunity on the strength of the U.S. economy, a renaissance in innovation and low interest rates globally.

 

Will Higher Interest Rates Derail Stocks?

Continued economic growth has led the Federal Reserve to raise the Fed Funds rate to 2.25%.  This is the biggest issue facing asset markets right now even though the rate remains well below levels that led to recessions twice during the last 18 years.  For that reason, I believe the Fed is going to be cautious with moves above 3%.  Remember, one of their stated goals initially was to be able to “normalize” short-term rates.  I believe they will have accomplished that goal when they reach 3%.

Stockcharts.com, Dightman Capital

The 30-Year Treasury bond broke price support with the latest Fed announcement which pushed up interest rates at the long end of the curve.  The silver lining for the current rate environment is a steepening yield curve.  The interest rate spread (the difference between short-term and long-term rates) makes it possible for banks to borrow at low rates and lend at a higher rate.  A strengthening banking sector should benefit the broader economy.

Here is a look at the Treasury market yield curve and 30-Year Treasury Bond price chart.

Stockcharts.com

Real estate price appreciation should also slow as financing costs rise.  There is some evidence in certain markets that price increases have slowed or stalled.  Stocks too, will compete with higher bond yields as rates move higher (more on this below).

In terms of Inflation, globalization has kept most inflation measurements in check (aside from asset prices like real estate and stocks).  Low inflation should provide the cover the Fed needs to slow rate hikes in 2019-20.  On the operational side, companies do benefit from low and stable input costs, which helps drive earnings growth.  An increase in input costs could result in higher prices.

Trade disputes may influence inflation but it could be temporary in many cases.   There remains a lot of capacity in the world so moving production, for example, out of a country is an option for some.  Other products might require special machinery or expertise and those product markets might see higher prices, potentially much higher.  Those individuals in the market for new electronics might want to make a purchase now if higher prices is a concern.  It is possible we could see higher prices in a wide mix of products from trade negotiations; so far the effects have been negligible.  Early 2019 is when we might start to feel the pricing pressure from ongoing trade disputes.

The U.S. Economy remains healthy; October started with a trio of good news.

  • The ADP payrolls report hit 230,000 in September, beating estimates
  • The Purchasing Managers Index for Services in September came in at 53.5, above the 52.9 consensus
  • September’s Institute for Supply Management hit 61.6 for the service sector, ahead of the view at 58

The U.S. Stock Market continues to like the economic environment.  Three months remain in 2018 and if stocks can hold on to the gains they have generated, it will be a decent year.

It is important to remember a diversified portfolio will have a mix of investment returns.  While certain parts of the stock market are delivering nice returns, some categories are under performing.  Many dividend stocks have not had a particularly strong year.  Bond yields are part of the reason.  The relative safety of bonds, combined with their now higher yields, compete with stock dividend yields.  Also, value stocks are not favored in the current environment; both of those factors should eventually become attractive as market character shifts.

Earnings-Growth Expectations for Q3 remain strong.  The view from FactSet  suggest earnings growth between 20-25% for the period.

So no, I don’t believe stocks are going to be derailed by higher interest rates in 2018.  We remain in a very constructive economic environment despite ongoing trade negotiations.  As we start Q4 stocks have pulled back; expect more selling in the days and weeks ahead.  This is a normal and healthy process which should eventually allow stocks to rally as 2018 comes to a close.  Don’t be surprised if this pullback ends up being 5-10% deep.  Primarily due to interest rates and trade talks.  As of the close on October 8th, the S&P 500 was down less than 2%.

Are Tech Stocks Going On Sale?

The U.S. stock market has come under pressure despite good Q2 earnings and the continuation of strong economic numbers.  The price declines are especially prevalent in tech industries while other sectors of the stock market have held up over the last week.  What is the market telling us?

In simple terms, technology stocks may be going on sale.

It is clear Facebook and Twitter face unique and systemic business challenges, but the massive declines they have experienced in the last few days seem to be taking down other tech related stocks.  The software industry, for example, is down nearly 5% from highs reached just 5 days ago.  More specifically, Cyber Security is down nearly 6% from highs it reached on July 18th.  Biotech is another example, down 6% since July 12th.

Company valuations are also a concern.  Technology stocks have become expensive and those companies with strong growth fundamentals, primarily sales and earnings growth, generally trade at a premium to the market, during rising markets.  There’s little evidence business conditions for tech companies are contracting so the decline in price appears to be a typical correction bringing tech valuations closer to the broad market.

Other sectors of the stock market do not appear to be impacted by the tech selling, at least so far.  How can we tell?  For one thing, other stock market sectors have been able to avoid the selling:  Materials (XLB), Industrial (XLI), Consumer Staples (XLP), Energy (XLE), Healthcare (XLV) Utilities (XLU), Financial (XLF) have all generated positive returns over the last 5 trading days.  7 out of 11 sectors delivering positive returns.  These are not just defensive sectors either.  The Financial Sector participation is a bonus, suggesting these financial companies have not been impacted significantly by problems in the tech space and valuations in this sector are actually quite reasonable.

Other groups have also been able to side-step the selling over the last 5 days.  Transportation, Healthcare, and Consumer Staples, just to name a few.

Below is a look at the price performance over the last two months of the 11 SPDR Sectors, considered a good proxy for the entire U.S. stock market.  Recent selling appears to be focused on technology related companies;  However, talk of a government shutdown has the potential to aggravate the situation; it would be wise to proceed cautiously with any new investment.

(NOTE: The recently introduced eleventh “Communications Services Sector” (XLC), has an 18.5% allocation to Facebook, and 26% to Google.  The largest traditional “Telecommunications” holding is Verizon, which only represents 4.8% of the sector ETF.  A good example of why it is important to know the actual holdings of any mutual or exchange traded fund.)

As of July 30, 2018. StockCharts.com

2018 Investment Strategy Review

Stock and bond market performance has been more volatile in 2018.  After an amazing run in 2017 stocks have become more sensitive to interest rate hikes and potential disruptions in global trade because of ongoing trade negotiations by the Trump administration.

Bonds too have seen an increase in volatility as the Federal Reserve increases the Fed Funds rate and sell bonds from their balance sheet.

The start of the year was extremely volatile for both asset classes but over the last month U.S. stocks and bonds have settled down.  Other asset classes are still struggling.  Emerging market bonds are down over 4% and emerging market stocks have declined nearly 10% according to statistics from ETFReplay.com.

Over the years I have tracked the performance of 4 classical investment strategies from pillars in the industry. Here is a quick look at how they are doing so far in 2018.

Note:  This data is historical and does not reflect actual account performance.  Please see the performance disclosure below for additional detail.  The benchmark for each strategy is the iShares Moderate Growth ETF (AOM).  It is important to remember the CAGR (Compound Annual Growth Rate) for all these strategies are only  using approximately 6 months of data.  Year-To-Date (YTD) performance and volatility is provide below each summary.

We start with our baseline “Classic” Strategy Year-To-Date (YTD) performance.  This strategy is considered a blue-chip approach to investing by several well respected investors.  This mix of investments represents 60% U.S. stocks and 40% U.S. Bonds.

YTD:  Classic Return:  2.8% vs. AOM Return 0.0%     Volatility:  9.7% vs. AOM Volatility 6.0%

Next, we will look at the YTD performance 3-asset class strategy we call the “Cycle” strategy.  This strategy holds 5 investments from 3 asset classes.  It is the lowest volatility strategy I manage.  The benchmark for this portfolio is the iShares Moderate Growth ETF, AOM.

YTD:  Cycle Return:  0.6% vs. AOM Return 0.0%    Volatility:  5.5% vs. AOM Volatility 6.0%

Adding more asset class, next we feature a “risk parity” strategy YTD performance.  In this approach 7 asset classes are weighted based on their volatility (or risk) with lower volatility investments receiving a higher weight.  The benchmark for this portfolio is the iShares Moderate Growth ETF, AOM.

YTD:  Risk-Parity Return:  -1.7% vs. AOM Return 0.0%    Volatility:  4.1% vs. AOM Volatility 6.0%

Finally, the most diversified of the bunch, the 10-asset strategy YTD performance.  This approach invests equally in 10 asset classes.  The benchmark for this portfolio is the iShares Moderate Growth ETF, AOM.

YTD:  Ten Asset Return:  -0.4% vs. AOM Return 0.0%    Volatility:  5.8% vs. AOM Volatility 6.0%

It is clear 2018 has not favored highly diversified strategies.  Those strategies that focus on U.S. stocks have performed better.

For a real shocker, here is how 10 select industry groups I incorporate into my strategies have performed YTD.  This is an all stock selection, so the benchmark has been changed to the S&P 500 (SPY).

YTD:  Industry Group Stocks Return:  16.3% vs. SPY Return 5.6%    Volatility*:  19.5% vs. SPY Volatility 16.1%

*Note the significant increase in volatility associated with the portfolio of Industry Groups.  That is the trade-off for exposure to high-growth areas of the economy.

We don’t know what the future holds but as we embark on a new generation of product and service innovation, along with stronger economic performance in the U.S., I have been guiding clients to overweight U.S. stocks and incorporate industry groups from areas of the economy expected to grow faster than the general economy.  It has been working well and has the potential to add value for years to come.  In addition, I can include industry group exposure to any of the strategies above where risk-management characteristics should generally reduce volatility.

All the statistics provided by ETFReplay.com.

Past performance does not guarantee future results.  Investments and the income derived from them fluctuate both up and down.  Investments at Dightman Capital are subject to risks including loss of principal.  No specific investment recommendations have been made to any person or entity in this written material.  This presentation is for informational purposes only and is neither an offer to sell or buy any securities.  Benchmarks or other measures of relative market performance over a specified time period are provided for informational purposes only.  Dightman Capital does not manage any strategy toward a specific benchmark index.   A variety of sources we consider reliable have provided information for this presentation, but we do not represent that the information is accurate or complete.  Dightman Capital Group does not provide tax advice to its clients.  Conduct your own research or engage an investment professional before making any investment decision.  Investors are encouraged to discuss any potential investment with their tax advisors.  The material provided herein is for informational purposes only.  Data Sources:  IDC, Dightman Capital.

Trade Negotiations & LIBOR Spike

Another round of volatility hit stocks this week, but current support levels remain, and volume has been tamer. The Nasdaq 100’s outperformance YTD remains intact suggesting tech investors are still committed to the sector.

It’s one thing to see stocks under pressure but the recent spike in LIBOR (the rate banks lend to each other overnight) was my focus this week. Fortunately, the banking system remains stable and the rise in LIBOR appears to be the result of an increase in demand from short-term U.S. government funding needs for deficit spending and U.S. corporations pulling offshore money from corporate bonds and putting it into cash for spending. While the spike in LIBOR signals caution, banks impacted by the higher rate are not flashing other warning signs.

For those familiar with the TED Spread, the difference between interest rates on Eurodollar Contracts and T-bills, we are still well below levels that signaled problems in the banking sector back in 2008.

On balance the market is evaluating several concurrent events; higher interest rates, chronic deficit spending and trade policy adjustments are center stage. The economy and corporate sales/earnings are in good shape, so the bias remains to the upside. If a nasty trade war does break out, then we could see more downside pressure on stocks and the economy; we are a long way from that environment and it will be interesting to see how far President Trump will push the Chinese. They have far more to lose then we do in a trade war, but I don’t think the president wants to derail the overall growth environment in the U.S.

There is no such thing as “free trade”. What President Trump is trying to do with trade overall is reduce the concessions we provide our global partners (and reduce outright theft). The goal of spreading wealth via trade rules is a noble one, but the principles that make our country the success it is are free for the adopting too.

You may have heard, today the Dropbox IPO started trading and delivered a gained of 35%. An active IPO market is a sign this market may have more upside. Leading stocks are also holding up well, which is promising.

So far markets are correcting for trade uncertainties following interest rate concerns earlier this year. As uncomfortable as it can be, it’s a healthy process and should allow stocks to resume their uptrend once trade matters are resolved.

Stocks Finally Correct, What’s Next?

After an outstanding 15-month stock market advance, last week stocks experienced a significant pullback.  The S&P 500 declined 3.9% but all three major U.S. stock indexes remain in positive territory so far in 2018.  After outstanding performance in 2017, U.S. stocks started 2018 on an even more accelerated run with the Dow Jones Industrial Average gaining 7.6% during January, before last week’s pullback.  The stock market rally needed to slow down.

In terms of earnings, Factset reports as of February 2nd approximately 50% of the companies in the S&P 500 have reported actual results for Q4-2017.  Of those, 75% are reporting actual earnings-per-share above estimates compared to the five-year average.  In terms of sales, 80% are reporting actual sales above estimates; the sales and earnings health of U.S. publicly traded companies appears to be good.

The likelihood of additional interest rate hikes in 2018 may have been the trigger for last week’s stock market correction.  Jerome Powell is the new Fed Chair and futures markets are expecting another 75-basis point increase in Fed Funds in 2018, which would bring the rate to around 2%, still below the historical average.  Investors also saw declines in bond prices last week as the 10-year Treasury yield shot up to 2.92%.

The continued improvement in economic numbers along with the overall optimism and rapid pace of innovation currently underway could suggest we are a long way from interest rates causing a sustained decline in the stock market.

Don’t be surprised if stocks are up big on Monday.  We could see more selling but a lot of cash remains on the sidelines and some investors have been looking for an opportunity to enter this market; one of the reasons stocks have not given much ground since President Trump ushered in a new set of economic policies aimed at broad sustained economic growth.

I have said this before and I will repeat it here.  We could very well see the the Dow at 30,000, the Nasdaq at 10,000 and the S&P 500 at 5,000 before we see the next bear market.  For those that do not understand how this could be, let me remind you; stocks went nowhere for 14 years from 2000 – 2013.  In the four or so years since the S&P finally regained a new all-time high in 2013, the stock market spent 18 months in a trading range between 2015-16, as the U.S. teetered on the verge of falling into a recession.

We have a combination of conditions that are conducive to a continued market rally:

  • Low Interest Rates
  • Positive Economic Policy
  • An Innovation Renaissance

Unlike prior market cycles, this one may not last as long as those previously for a couple reasons.  First, this expansion comes on the heels of a recovery that started 8 years earlier.  Second, a tremendous amount of debt was created in the U.S. and globally as the primary policy for recovering from a debt crisis.  If you are shaking your head, you should be.  Eventually we will pay a price for policy mistakes used to address the 2008 financial crisis.  Until then it is a race between economic growth and debt growth.  The next crisis could very well come from a country needing to restructure their debt.

In terms of interest rates, it appears we have some breathing room.  The 10-year Treasury yield remains well below levels of the last 20+ years.

In terms of short-term rates, if the Fed Funds rate were to rise above 3% the economy should be doing exceedingly well.  However, government debt funding is more sensitive to short-term rates, so policy makers are likely to take funding costs into consideration as they move rates higher.  Fortunately, other broad economic factors appear to be holding inflation in check which should allow The Fed to keep short-term funding rates at or below normal levels.

Until The Fed has turn up interest rates to a point of slowing the economy, the stock market is likely to continue rallying…there are amazing investment opportunities in the next generation of biotechnology, materials, software, and much, much more.  It is truly an exciting time to be an investor which is another reason I believe more money will find its way into the stock market over the coming years.

Please let me know if you are interested in learning more about investment opportunities from innovations in finance, travel, technology and more in a risk-managed, proactive approach.

Stock Index Performance Calculations, Stockcharts.com

Yield data from Stockcharts.com, Investors Business Daily.