Sunday, May 20, 2018

Dollar Strength Leads To Large Cap Stock Outperformance

A recent strengthening of the US Dollar has some investment commentary now favoring small cap stocks over large cap stocks. This is partly due to the earnings headwind that can negatively impact multinational companies as they convert foreign earnings back into the Dollar. One recent report titled, Rising Treasury Yields And Dollar Completely Change Investment Themes, noted:
"The resumption of the bull market has taken shape in the form of small caps. I fully expect that the rest of the market will follow suit eventually, but rising treasury yields and the surging dollar have money rotating feverishly into smaller companies and that relative strength is likely to continue."
In the below chart, a downward trending red line indicates small cap stocks are outperforming large cap ones. In 2018 small cap stocks have outperformed large cap stocks while the US Dollar Index (DXY) has risen from below 90 to almost 94.

However, as can be seen in the above chart, from mid 2014 into 2015, as the Dollar index rose from 80 to over 100, large cap stocks outperformed.

In a research report published a few years ago by S&P Dow Jones Indices, it is noted large cap stocks outperform small cap stocks when the Dollar Index rises above 95 and currently, the Index is near 94.

The report notes,
" is misdirected reasoning that causes investors to believe that small-cap stocks outperform large caps during a rising dollar. Yes, small-cap stocks have less foreign exposure, so their earnings will not be whittled down during the translation process. Yet many companies hedge their foreign currency exposure, so this becomes less of an issue. More important, in my view, is that international investors are looking to the U.S. and pushing up the value of the dollar."
A longer term view of the Dollar and large cap stock versus small cap stock performance can be seen in the below chart. Clearly, a strengthening Dollar has mostly favored large caps over small caps and vice versa. For investors then, Dollar strength alone should not be sufficient reason for allocating funds to small cap stock investments. 

Thursday, May 03, 2018

Investor Sentiment Continues To Be Less Bullish

This week's Sentiment Survey report from the American Association of Individual Investors continues to show a falling trend in the level of bullishness of individual investors. This week's bullishness reading was reported at 28.4% and down from 36.9% in the prior week. The current bullishness reading is near the minus 1 standard deviation level and these sentiment measures are most useful as a contrarian indicator at extremes. In January of this year the bullishness reading reached near 70% and subsequent market returns have trended lower since then. AAII published an article, Is the AAII Sentiment Survey a Contrarian Indicator?, that provides insight into the market's return at various sentiment levels.

Active managers are indicating less bullishness as well when one evaluates the NAAIM Exposure Index. In December of last year, the NAAIM Index average was 120% which means, on average, active managers were slightly leveraged long. The most bearish managers at that time averaged 75% long. Today the Exposure Index is 52.6%. The most bearish is fully short at -100%, however, not fully leveraged short, which would be -200%.

Lastly, newsletter writers continue to trend more bearish as well. The Investor Intelligence Advisors' Sentiment bull/bear ratio has fallen to 2:1 versus over 5:1 at the beginning of the year. The II Advisors' Sentiment Survey studies in excess of one hundred independent market newsletters and assesses each author’s current stance on the market: bullish, bearish or correction.

As noted earlier, and detailed in the AAII contrarian article linked to above, these indicators are most useful at their extremes. And, although the sentiment measures are trending decidedly bearish, the levels can become more bearish. Also noteworthy is the fact the market is in the second year of the Presidential Cycle and this part of that cycle tends to be the most volatile. However, a recent article by Urban Carmel notes the prior three mid term election years had the S&P 500 Index return low double digits. In spite of year two of the cycle generating the lowest return historically, the return has averaged a positive one at 4.5%.

Source: The Fat Pitch

From a positive perspective then, underlying earnings and economic fundamentals remain favorable, thus, the market has a reason to find a firm footing at these levels and begin a more favorable upward trend. The level of volatility being experienced over the last several months is actually the type that occurs in a more normal market environment. The low level of volatility in the several years leading up to 2018 were the abnormal ones.

Heightened Volatility A Result Of The Change In The Earnings Growth Rate

Investors are experiencing a market exhibiting a higher level of volatility. This heightened volatility is more normal than the lack of volatility experienced in the few years leading up to 2018 and yet the S&P 500 Index is down less than 2% this year.

Including the last two months of 2017 (November and December) the S&P 500 Index is up just less than 2%. Given some of the financial commentary one would think the market is down significantly.

Admittedly, I do not have the so-called magic eight ball that provides all the answers; however, some aspects of the market and economy seem to support higher prices ahead. Our firm believes one factor that might be taking place at the moment is the market adjusting to a lower level of earnings growth versus the 20+% growth expected now. The equity market does a pretty darn good job of anticipating and adjusting to earnings growth expectations. As a result, we sometimes tell our clients stock prices tend to follow earnings expectations. As the below chart shows, after the passage of the Tax Cuts and Jobs Act, which largely benefited businesses via lower corporate taxes, the forward or expected earnings growth rate for the S&P 500 Index increased from 9.2% to 20.5% in a few short months.

With this spike in the growth rate at the end of 2017, the S&P 500 Index was up nearly 8% at its high in late January. As this earnings excitement wears off, the market is seems to be adjusting to a more normal low double digit earnings or high single digit growth rate. As the shaded area on the above chart shows, when the change in the earnings growth rate is negative, i.e., decreasing from 20.5% to 9.5%, the equity market tends to struggle. Below is the anticipated quarterly earnings growth rates along with the calendar years 2018 and 2019. The market tends to look out one year and that puts us at the first quarter of 2019 and earnings growth is expected to equal 6.9% in that quarter.

The one positive today is the fact companies will benefit from a higher earnings level as a result of the cut in the corporate tax rate. It is the higher rate of change that is a one time event. At least a portion of the excess earnings resulting from the lower tax payments is likely to finds its way into the economy via increased capital expenditures over a multi year period. This higher level of activity, along with a reasonably strong consumer, should benefit stocks in the balance of this year.

Wednesday, April 25, 2018

Consumer In Decent Shape, A Positive For Continued Economic Growth

In spite of the market's negative reaction to some of the recent earnings reports issued by credit card companies, one might think the individual consumer is in pretty bad shape. To the contrary though. About a year ago I evaluated the consumer as a result of issues surrounding some of the credit card firms. As was the case in the earlier blog post, the consumer data today is indicative of a consumer that is not overly burdened with debt repayment.

The following three charts provide a visual picture of the debt service burden on consumers along with various charge-off and loan delinquency rates. The first chart represents the Household Debt Service Ratio which is debt payments as a percentage of disposable income. The current ratio of 10.3% is just slightly above the year ago level of 10% and remains below levels seen at the beginning of prior recessions.

Sunday, April 15, 2018

Dividend And Stock Buyback Growth Potentially Accelerate In 2018

Near the end of last month S&P Dow Jones Indices reported preliminary dividend and buyback activity for the S&P 500 Index for the fourth quarter of last year. For the quarter the dollar amount of dividends paid increased 5.4% versus the same quarter in the prior year. Additionally, for the quarter, dividends combined with buybacks increased 3.1% year over year. It is not uncommon for the combined dividends with buybacks to exceed as reported earnings in the quarter and that was the case for Q4 2017 as seen in the below chart.

Thursday, April 12, 2018

Sentiment Now Broadly Bearish

In prior posts highlighting investor sentiment data it has been noted that sentiment data is more actionable at market bottoms than at market tops. Knowing this, the American Association of Individual Investors reported bullish investors sentiment at 26.1%, which is below the minus 1 standard deviation level of the average bullish sentiment level.

Additionally, bearish sentiment jumped 6.1 percentage points to 42.8% resulting in the bull/bear spread being reported at a negative 16.7 percentage points, the widest negative spread in more than a year.

Also, newsletter writers are far less bullish with the bullish sentiment falling to 42.2% from nearly 70% at the beginning of this year. The Investor Intelligence Advisors' Sentiment bull/bear ratio has fallen to nearly 2:1 versus over 5:1 at the beginning of the year as well. The II Advisors' Sentiment Survey studies over a hundred independent market newsletters and assesses each author’s current stance on the market: bullish, bearish or correction.

With much of the sentiment now decidedly bearish, just possibly the market is nearing a bottom.

Wednesday, April 11, 2018

US Dollar Influencing Oil Prices

Nearly two years ago four factors were influencing the energy market and specifically the price of oil. 
  • Oil inventory in the U.S. hit a record high
  • The price of crude (West Texas Intermediate or WTI) reached a post financial crisis low
  • Rotary oil rig count hit a record low of 404
  • The trade weighted value US Dollar hit a post financial crisis high
The fact oil inventory spiked is partially attributable to technological advancement in drilling and specifically, increased supply from fracking activity. The subsequent low level of drilling activity that began a few years ago contributed to the supply decline. Today, the rig count has once again moved higher and the oil market may be seeing a potential bottoming of the supply decline, yet oil prices continue to move higher as seen in second chart below.

Tuesday, April 10, 2018

Spring 2018 Investor Letter: Noise Versus Fundamentals

In one brief quarter, the equity market goes from experiencing virtually no volatility to seemingly +/- 2% swings on a daily basis. Last year was a bit abnormal and more a year of consistent returns and minimal drawdowns. In fact, the largest drawdown was just 3%. The market has already experienced a 10% drawdown in 2018. In our Spring 2018 Investor Letter we note the fact the first quarter broke a string of nine consecutive positive quarters for the S&P 500 Index. Investors have been fortunate by the length of this positive cycle, however, recent experience can often lead one to expect “more of the same.” This expectation or behavior is referred to 'recency bias' and we discuss its implication for investors in our Spring Investor Letter along with our firm's thoughts for the coming year.

For additional insight into our views for the market and economy in the coming year, see our Investor Letter accessible at the below link.

Monday, April 09, 2018

Tariffs, Stocks And Recessions

One truism investors know well is the fact the stock market does not perform well in a recession. The recent focus on implementation of tariffs on the U.S.'s largest trading country, China, have some concerned about escalation into an all out trade war and leading to an economic slowdown or recession. Google web search on the term 'Tariffs' has moved higher with the March 1 peak coinciding with the  rebound peak for the S&P 500 Index around the same time.

Thursday, April 05, 2018

Not A Unique Equity Market: Higher Prices Ahead?

About a year and a half ago I wrote a post on the current equity market that broke out of a thirteen year trading range in 2013 and compared it to the bull markets of the 1950s and 1980s. A number of policy issues being pursued today have similarities to ones in those two decades and below is a brief summary of what I wrote then:
"...potential commonality to the current market compared to those prior decades related to policy decisions coming out of Washington, D.C. In the 1950's the Gross National Product in the U.S. more than double from 1945 to 1960. Government spending in the 1950's was targeted at construction of the interstate highway system, building of schools and an increase in military spending. In the 1980's President Reagan's policies focused on reducing the tax burden on Americans, lowering government regulation and shrinking government itself. President Elect Donald Trump also projects to implement similar policies, i.e., reduce regulation, shrink the government, increase spending on infrastructure and lower taxes. For investors the question to answer is what market segments worked then and might these same sectors outperform early in a Trump administration."
An update to a chart in that earlier post is shown below and in spite of the size of the 'point' swings in the market today, the path of this current bull market is not unique. If history is any guide, and given similar policies out of Washington as in the 1950's and 1980's, the S&P 500 Index certainly appears to have more room to the upside. In fact, the market maybe nearing a point of a sustained upside move.

One thing investors experienced in the first quarter was a return of volatility to the equity markets, and the bond market for that matter. Wednesday's market action was a perfect case in point as the Dow Jones Industrial Average traded down over 500 points near the open yet closed up 230 points, a trading range of more than 700 points. The catalyst for the market swing seems to be connected to the discussion around tariffs and the potential negative implications resulting from the tariff negotiations. I stress 'negative' as most of the tariffs have not been instituted, yet it is the unknown that can cause difficulty for the equity markets.

I can list a number of additional potential negative issues with any single one being a headwind for the equity market: rising interest rates and consequent flattening yield curve, growth in deficit spending out of Washington and more. All but the interest rate factor are mainly political events and I would say business fundamentals and economic fundamentals remain more important variables for the market right now. Given some of the negative factors cited, just maybe the market will climb the proverbial wall of worry.

I am not recommending burying one's head in the sand regarding some of these potential headwinds. What is important though is not to place out sized weight on the 'noise' at the expense of underlying fundamentals. Importantly, policies being pursued today have similarities to policies implemented in earlier decades and those policies were bullish for stocks then.

Monday, April 02, 2018

A More Challenging But Normal Equity Market

Before I left for a week of vacation at the end of March, the equity markets had begun to exhibit a higher level of volatility. This seems to occur more often than not around this time period each year. This heightened volatility was to the downside and I wrote a post before leaving town noting this was more typical market action. What has been so abnormal about the equity market over the past five years is the fact nearly every calendar quarter since 2013 has generated a positive return. As the below chart shows, prior to 2013, this was certainly not the case.