Market Pullbacks Should Be Expected

There have been plenty of reasons to sell stocks since the end of the financial crisis in 2008. The drumbeat seems to be getting louder as the postwar market advance approaches one of the longest on record.

Source: The Leuthold Group

Also contributing to some angst about the market's advance is the fact the last pullback/correction of greater than 10% occurred in February 2016. In other words the market has gone more than 16 months without a >10% pullback. As the below chart shows, market pullbacks of nearly 10% are a fairly common occurrence. The market's average intra-year decline equals 14.9%.

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Dogs Of The Dow Underperformance Gap Widening

The first six months of the year are nearly behind us so I thought it appropriate to provide an update on the performance for the 2017 Dogs of the Dow. As noted in the past, the strategy is one where investors select the ten stocks that have the highest dividend yield from the stocks in the Dow Jones Industrial Average Index (DJIA) after the close of business on the last trading day of the year. Once the ten stocks are determined, an investor invests an equal dollar amount in each of the ten stocks and holds the basket for the entire next year. The popularity of the strategy is its singular focus on dividend yield. The strategy is somewhat mixed from year to year in terms of outperforming the Dow index though. Over the last ten years, the Dogs of the Dow strategy has outperformed the Dow index in six of those ten years.

Since my last update a few months ago, the Dow Dogs performance has fallen further behind the Dow Jones Industrial Average Index. As can be seen in the below table, the average return of the Dow Dogs through 6/16/2017 is 4.9% versus the DJIA return of 9.4%.

Full View (xls)

Interestingly, in the top ten performing stocks in the DJIA index this year, only two are Dow Dogs, Boeing (BA) and Caterpillar (CAT). Boeing is the best performing Dow stock, up 28.3%. So far this year, energy has been a drag on the both the DJIA index and the Dow Dogs, while at the same time, industrial stocks have been performing well. In short, the sole focus on dividends in the Dow Dog strategy has yet to pay off this year.

Amazon: Selling And Delivering Groceries Is Not A High Margin Endeavor

Of course the big news last week was Amazon (AMZN) announcing it was acquiring Whole Foods Market (WFM) in a deal valued at $13.7 billion. The deal is an all cash one, but with Amazon's stock trading at a trailing price earnings multiple of 185 times one might think funding the purchase with stock might make more sense. Nonetheless, this acquisition announcement had ripple effects on many other consumer product companies and not just grocery retailers. One question that arises is whether Amazon's purchasing leverage will put downward pressure on prices for products manufactured by the likes of Procter & Gamble (PG), McCormick & Company (MKC), Kellogg (K) and many other packaged consumer product companies. Friday's stock market reaction to this broad category of companies suggests the AMZN/WFM merger will be a significant headwind for other companies in this space or to those selling into the space.

Selling and delivering groceries is not the same as selling and delivering books and non-perishable products. As the picture at the beginning of this post shows, consumers have had home delivery options historically. Home delivery of milk, for instance, was a common practice years ago before the popularity of large grocery stores. Still today, consumers have home delivery of grocery options. One firm that has been delivering groceries since 1952 is Schwan's. Schwan's website notes the delivery options it provides to consumers,

• Personal Delivery: Our knowledgeable Route Sales Representative will deliver your food to your home at a time that is convenient for you.

• Drop-Off Delivery: No need to be home for delivery. We'll drop off your order at your scheduled delivery time in a reusable freezer bag that keeps your food frozen for hours.

• Mail Order: Mail Order delivery is available anywhere in the continental United States. It's a convenient option if our delivery service is not available in your area or if you want to send our food to family or friends.

More background on Schwan's can be found at this link.

At the end of the day, the success of any retail store is centered on the customer having a positive experience and the store or business executing on its business plan. And to this end, brick and mortar retailers need to make 'positive customer experience' an overriding aspect of their business model if they want to compete with the Amazon's of the world. I could, but won't in this post, list a number of procedures retailers have implemented that do not contribute to a customer having a positive experience.

I am skeptical of how successful the delivery of groceries can be. As I stated earlier, home delivery of groceries is not the same as leaving a non perishable package on the doorstep. A benefit Amazon is getting with the Whole Foods acquisition is access to 400 plus brick and mortar locations. Is Amazon then saying brick and mortar is a necessity in order to continue its growth?

And finally, much of what Amazon has been able to do in its pursuit of growth is a direct result of the profitability of Amazon Web Services or AWS. AWS accounts for less the 10% of Amazon's revenue but accounts for 74% of Amazon's operating income. AWS is made up of many different cloud computing products and services. The division provides servers, storage, networking, remote computing, email, mobile development and security. AWS's two main products are Amazon’s virtual machine service and Amazon’s storage system. AWS is now at least ten times the size of its nearest competitor and hosts popular websites like Netflix Inc (NFLX) and Instagram (a subsidiary of Facebook Inc.(FB))

So long as the market continues to give Amazon a pass on generating a decent profit from its businesses outside of AWS, AMZN's retail competitors could continue to face challenges. However, I do believe that the AMZN/WFM acquisition may not work out as well as AMZN anticipates. Selling groceries and adding delivery cost on top of a low margin business, is not a recipe for fast growth in my view.

Growth Style Returns Dominating Value Style Returns

Over a long enough period of time, value stocks tend to outperform growth stocks and this fact is causing some pain for the value oriented investor during this market cycle. In a Fidelity article that compares value versus growth performance, this has indeed been the case when going back over 25 years. The Fidelity article shows, however, that on a risk adjusted basis the growth style wins out. The value style tends to have a large weighting in financial and economically sensitive sectors and most investors know these types of sector positions experienced headwinds in the 2008/2009 economic downturn.

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NIPA Earnings Weakness Leads IBES S&P 500 Earnings Weakness

The equity market seems to know only one direction and that is up. The result of this type of pattern has been a downward trend in volatility with the VIX trading at a near single digit level. One characteristic of a low VIX reading and a higher trending market has been the absence of any significant equity market pullback. As Urban Carmel, author of The Fat Pitch blog notes,

"SPX [S&P 500 Index] has now avoided a 5% drawdown since November 4, a period of 139 days. Since 2009, there have been only two uninterrupted uptrends that have lasted longer: 142 days (ending January 2014) and 158 days (ending September 2014). If past is prologue, then SPX appears likely to have a 5% correction before June 23 (158 days)."

I am not sure time in and of itself is a predictor of a 5% equity market correction, but the data is confirmation of the lower downside volatility recently experienced by the equity market as can be seen in the below chart.

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Equity Market Climbing The Proverbial Wall Of Worry

The individual investor continues to express concerns for stocks when looking at their sentiment response. Yesterday's Sentiment Survey report from the American Association of Individual Investors showed a nearly six percentage point decline in the bullish sentiment reading to 26.92%. This pushes the bullishness reading one standard deviation below the average bullishness reading.

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The Unfortunate Rise Of The Misleading 'Scary Chart' Comparisons Again

In early 2014 charts were circulating around the internet comparing the 2014 market to 1928-1929. One such chart is shown below. The below chart was taken from an article that highlighted the fallacy of these comparisons. In fact, this type of scare tactic infiltrated the main stream media where a MarketWatch.com article warned about the similarity of the '28/'29 market to that of 2014 and that “trouble lies directly ahead.” Since that 2014 article was written, the S&P 500 Index is up over 30%.

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Momentum Strategy Needs A Breather

One aspect of the S&P 500 Index return in 2017 is the fact a handful of stocks have generated a large portion of the return. Historical evidence suggests narrow market leadership is not an uncommon occurrence in bull markets. Interesting this year, however, is the fact this leadership has been centered in technology stocks. I discussed this in a post a few weeks ago when I looked at detail surrounding the Momentum Index (MTUM) strategy performance and its similarity to 2015. At the time of the prior post, the RSI of MTUM versus the S&P 500 Index was below 80. In the last few weeks though, the relative strength index (RSI) has pushed above the overbought level of 80, actually reaching above 85.

As the below graph shows, the top ten holdings of the iShares MSCI Momentum Factor ETF (MTUM) is comprised largely of technology stocks. The weighting of these top 10 positions equals nearly 40% of the overall index itself. The performance begins at the first of December, the time when momentum began its outperformance.

In spite of the fact the momentum strategy may continue to lead in 2017, the leadership does not produce higher returns in a straight line. Given the overbought level of the RSI and the strength of the move since December, a near term pullback in these larger technology positions, and the momentum strategy itself, would not be a surprise.

Investors Skeptical Of Stocks

Much of the sentiment data seems to indicate investors are a bit nervous about stock ownership. This morning's sentiment survey report by the American Association of Individual Investors did show a nine percentage point improvement in the weekly bullish sentiment reading, increasing to 32.9% from last week's 23.9% reading. However, the less volatile 8-period moving average of the bullishness reading remains at a low 31.1%, improving only .4% on the week.

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Results of the "Trump Trade"

Now that the Wall Street Journal and others have declared it dead, it is interesting to consider what exactly the Trump trade was.  As Josh Brown put it, the election provided finality, but the “Trump Trade” never really existed.  A decisive victory either way could have been bullish for the markets.  In our Q4 2016 investor letter, we said that the election conclusion was simply a catalyst for a much needed rotation.  The catalyst was difficult to predict, but the eventual rotation seemed likely.  So, now that it is dead, where does that leave us? 

The below chart shows the S&P 500 P/E and PEG as of 11/4/2016 (prior to the election).

Pre-Trump Rally, defensive sectors like Consumer Staples, Utilities, and Telecommunications all looked relatively expensive based on PEG ratios while some (not all) cyclical sectors appeared relatively cheaper.  The post-election performance (yellow bar below) reflected a reversion to the mean for each of these sectors with the most expensive underperforming while the least expensive outperformed.

So, where does that leave us today with the recent “death” of the Trump rally?  Relative sector valuations look more similar.  Utilities still appear moderately expensive, but Telecom has taken its place as the clear outlier (due to lower growth expectations).  Everything else is hovering around a PEG of 1.  We are back to “normal”.

The election served as the catalyst for this rotation, but it may have come regardless of the ultimate victor.  With earnings growth looking very strong for Q1, most sector valuations now appear reasonable.  The slight bias towards defensive sectors (Utilities, Staples, and especially Telecom) makes sense given the widespread caution throughout much of the last few years of this bull market.  The overall market is not cheap, but if earnings come in as expected, only a few sectors look particularly expensive.

Momentum Strategy Leading Again

It is back to the future for the market as momentum is once again a leading investment strategy just as it was in 2015. Momentum fell out of favor in the run up to the election and into year-end 2016; however, momentum is once again leading the S&P 500 Index this year. The momentum strategy may be overbought near term with the RSI near 80.

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Brick And Mortar Retail Is A Mess At The Moment

It seems anything associated with brick and mortar retailing is an investment that will do anything but go up. The brick and mortar retailers themselves are struggling to figure out how to compete in the internet age. Macy's (M) reported disappointing earnings today and the stock closed down 17%. After the market close, Nordstrom (JWN) reported results with earnings up 37%, yet same store sales were down a worse than expected .8%. After hours Nordstrom's stock is trading down 3.5%. The green line in the below chart represents the FTSE NAREIT Equity Regional Mall Index (FN22). This index is struggling along with the brick and mortar retailers as well.

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Indexing Investment Strategy Becoming Increasingly More Risky?

Indexing ones investments has turned into the investment strategy of choice for a number of investors. According to a recent Wall Street Journal article, in 2016 82% of new investments coming through financial advisers (more than $400 billion) went into index funds and ETFs. This statistic was highlighted by Consuelo Mack on a recent WealthTrack segment where she interviewed David Winters of the Wintergreen Funds. Winters addresses several points about the potential risks and factors surrounding index funds, one risk called look through expenses and the other about index investing ignoring company fundamentals. I did not necessarily buy into the look through expense argument; however, the issue with indexing 'ignoring company fundamentals' is a very valid one. The WealthTrach video is provided at the end of the post.

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Higher Oil Prices Contend With Too Much Supply And Higher Energy Efficiency

Almost to the day one month ago, when oil was trading at $52.25/bbl, I noted higher oil prices faced strong headwinds. I mentioned several factors that would likely result in lower oil prices, with the largest being the oversupply of oil in an environment where drilling activity was picking up. Fast forward to today and the price of spot WTI has fallen 12.8% to $45.55/bbl. Additionally, supply does not seem to want to abate as the rig count has increased to 870 rigs this week versus 839 in the month ago article.

A faster pace of supply growth continues to be the overriding issue although demand continues to increase as well, but yet to reach pre-recession levels. Certainly, the below trend rate of economic growth is playing some role in the lower overall demand for petroleum products.

Another factor in the slowing rate of demand growth is energy efficiency improvements made to a number of petroleum consuming parts of the economy. One significant area of improvement is in the area of vehicle gas mileage. This is important as gasoline is the main petroleum product consumed in the U.S. and accounts for nearly 47% of petroleum consumption.

As the first chart below shows, since 2014, consumers have consistently driven more miles, year over year. This has translated into continued growth in total vehicle miles driven on a rolling 12-month basis and finally surpassing the pre-recession peak in 2015.

The efficiency is most evident in the below chart the shows miles per gallon for all vehicles (red line) along with gallons consumed per vehicle in a given year (blue line.) Improvement in both of these areas has slowed the growth in the demand for petroleum products.

In conclusion, a below trend pace of economic growth and efficiency improvements have served as a headwind to higher oil prices, especially in an environment were drilling activity is increasing. The article from a month ago also discussed the potential oil price headwind resulting from a stronger U.S. Dollar, vis-à-vis, a potentially higher interest rates. This may become a more significant factor next month as the odds of a Fed interest rate hike in June are now around 75%. 

Credit Card Firms' Earnings Reports A Sign Of Potential Weakness With The Consumer

The first reading for Q1 2017 GDP came in at a weak .7% at an annualized rate. A particularly weak component of the report was consumer spending which rose only .3% and is the weakest level for spending since the fourth quarter of 2009. The blue portion of the bars in the below chart represent the consumer contribution to GDP and the weak report in Q1 2017 is evident.

Over the past few years, first quarter GDP numbers have been weak for a number of reason. However, many believe there are issues with the government's seasonal adjustment factor. Nonetheless, is there something else impacting the consumer which could indicate potential headwinds lie ahead for the economy and is being reflected in recent credit card data?

This past week, several financial firms reported earnings, Synchrony Financial (SYF), Capital One Financial (COF) and Discover Financial Services (DFS) and each company has a sizable portion of their business in consumer credit cards. Earnings for both SYF and COF were anything but positive relative to expectations. DFS earnings were not too weak and the company reported only a small earnings miss. Below are some comments from the company conference calls and/or earnings press releases.

Capital One Financial:

• Net income fell 22% to $752 million while its earnings per share of $1.54 came in 39 cents below the average estimates of analysts. The company increased its loan loss provision by 30% year over year to $1.9 billion, as the 30-day plus delinquency rate climbed 28 basis points, to 2.92%. Meanwhile, net charge-offs rose 28% to $1.5 billion and its rate of net charge-offs to total loans increased 42 basis points to 2.5%. Most of the delinquencies and charge-offs were in the bank's credit card and auto loan portfolios (emphasis added).

Synchrony Financial:

• First quarter net earnings totaled $499 million or 61 cents per diluted share versus average analysts' estimates of 73 cents. Our results were impacted by the 45% increase in the provision for loan losses we experienced this quarter. The reserve build from the fourth quarter equalled $322 million. The reserve builds for the next couple of quarters are likely to be in a similar range on a dollar basis to what we saw this quarter.While most of the build continues to be driven by growth and the normalization we are seeing in the portfolio, lower recovery pricing in the quarter also drove approximately $50 million of additional reserves or 7 basis points of coverage. The net charge-off rate was 5.33% compared to 4.74% last year. we now expect NCOs to be in the 5% to low-5% range this year (emphasis added.)

In regards to lower cost recovery, this refers to credit card companies selling troubled credit card debt to third party collection firms. As noted in the Synchrony conference call,

• Company saw an incremental decline in recovery pricing this quarter. We believe it's driven by a combination of factors, including just the fact that you've got increased supply in the market. As charge-offs start to normalize across the industry, which we've seen, you've got that dynamic. So you've got just increased supply in the market, which we think is impacting the price.

Bank of America:

• Total net charge-offs of $934MM increased $54MM from 4Q16. Increase driven by consumer due to seasonally higher credit card losses, while commercial charge-offs were relatively flat. Net charge-off ratio increased modestly from 4Q16 to 0.42%, but declined from 1Q16. Provision expense of $835MM increased $61MM from 4Q16, driven primarily by consumer (emphasis added.)

Discover Financial (DFS) also reported weaker earnings of $1.43, but the miss was only 3 cents. DFS also cited caution on credit and indicated credit card portfolios are normalizing to a higher more historical loss rate. DFS also increased the company's provision expense.

The below chart compares the performance of the credit card firms to each other and the S&P 500 Index. The lower than expected earnings results had a negative impact on the prices of the stocks as can be seen below.

As the below table shows, credit card delinquency rates are below historical levels. On the other hand charge-off rates are trending higher and near economic late cycle levels.

Supporting a leveling off for charge offs and delinquencies is the fact the household debt service ratio remains at a very low level.

With charge-offs and delinquencies normalizing to higher and more so-called normal levels, maybe some stability is near. The fact companies are reporting lower loss recovery rates is also an indication of broader weakness in the credit card sector of the consumer economy. Recovery rate weakness occurs as the supply of delinquent credit card receivables increases and third party collection firms can pay credit card companies less for this type of loan paper.

Given the much weaker GDP report in the most recent quarter and the weakness beginning to show up in credit card portfolios, these are yellow flags that investors should monitor for signs of further economic weakness. The current expansion is now the third longest since World War II and the economy will not expand forever. At this point though, based on other recession variables we review, we do not foresee a recession looking out the next 18 months or so.

Investor Sentiment Turns More Bullish

Since my post published nearly two weeks ago on widespread market bearishness and a potential indication of a market turning point, the S&P 500 Index has bounced higher by 2.6%. True to form, this overly bearish sentiment was followed by higher equity prices. Also, sentiment has improved with the AAII bullish sentiment reading reported at 38.05% today, a 12 percentage point increase. This improvement in sentiment has also seen the bull/bear spread flip to more bulls than bears at +6 percentage points versus last week's -13 percentage points. Although bullish investor sentiment has improved, the reading is not at a level suggestive of 'irrational exuberance."

Dogs Of The Dow Falling Further Behind

It has been several months since updating the performance of the Dogs of the Dow investment strategy. The strategy is one where investors select the ten stocks that have the highest dividend yield from the stocks in the Dow Jones Industrial Index (DJIA) after the close of business on the last trading day of the year. Once the ten stocks are determined, an investor invests an equal dollar amount in each of the ten stocks and holds the basket for the entire next year. The popularity of the strategy is its singular focus on dividend yield. The strategy is somewhat mixed from year to year in terms of outperforming the Dow index though. Over the last ten years, the Dogs of the Dow strategy has outperformed the Dow index in six of those ten years.

 

As we noted in our early February post, it is important for investors utilizing the strategy to be aware of the strategy's bets in terms of stock and sector exposure. Through Friday's close, the 2017 Dow Dogs return of 2.0% trails the return for both the Dow Jones Industrial Average Index and the S&P 500 Index, 4.6% and 5.4%, respectively. Relative to the Dow Jones Industrial Average, the 2017 Dow Dogs are significantly over weight energy (19% versus 6.2%) and energy has been weak this year as can be seen in the energy holdings in the below table. Additionally, the strategy is overweight in telecom through its holding of Verizon. Other differences can be seen in the earlier post.

At least during the first four months of 2017, the pursuit of higher yielding stocks via this strategy has yet to be an outperforming one.

Emerging Markets Poised To Outperform

In our Spring 2017 Investor Letter we briefly commented on first quarter investment changes we initiated in client accounts, specifically, adding exposure to emerging markets. Expanded commentary follows on some of the rational for this change. Simply because an asset class or stock is cheap does not necessarily suggest the asset should be purchased; however, valuation does tend to matter in the long run. The below chart was referenced in our Spring Investor Letter and the top pane of the chart shows the relative valuation of the MSCI Emerging Market Index versus the S&P 500 Index favors emerging markets.

Additionally, when comparing the forward earnings growth expectations for emerging market equities and S&P 500 equities, emerging market companies that comprise the MSCI Emerging Market Index are expected to grow earnings nearly three times faster then S&P 500 companies.

With respect to emerging markets, their prices seemed to be discounting the improvement taking place in global economies and the consequent benefit that should accrue to emerging market economies and thus emerging market stock prices themselves. Certainly, if global trade slows significantly, emerging market economies will be negatively impacted. However, our firm's view is developed economies will continue to grow over the next several years, even if at a below trend pace, and emerging economies will benefit. As the below chart shows, GDP growth in the emerging and developing economies has started to turn higher indicating a faster pace of economic growth than advanced or developed economies.

This faster pace of economic growth tends to persist over multiple years. As a result, some investors are beginning to recognize this as emerging market equity performance on a year to date basis is outperforming a number of developed markets as can be seen in the below chart.

This recent outperformance is occurring at a time when emerging markets have underperformed the U.S. market on a rolling 3-year annualized basis for the past five years. The second chart below shows the rolling 1-year returns versus the S&P 500 Index and the rolling 1-year returns have begun to favor emerging markets in 2017.

In investing, there are no certainties; however, with global economies seeming to become more synchronized with respect to economic growth, emerging markets could have a performance advantage over developed markets over the course of the next several years.

Brick & Mortar Retail Struggles Attributable to Growth In E-Commerce

Today another retailer announced it will be closing up shop, Bebe Stores, Inc. (BEBE), making it the 15th retailer to go under this year. By the end of May BEBE plans to liquidate its approximately 180 stores. This nearly matches the 18 retail bankruptcies for all of 2016.

Source: S&P Global: Market Intelligence

With the consumer accounting for nearly 70% of economic growth in the U.S., are the struggles of brick and mortar retailers a sign of a weakening consumer? What the data seems to be suggesting is overall retail sales are growing at a decent pace. According to the U.S. Department of Commerce's most recent report on retail sales, it is noted, "Total sales for the January 2017 through March 2017 period were up 5.4 percent [versus] the same period a year ago. What is occurring though is consumer buying habits have transitioned to online or e-commerce sales versus a trip to the brick & mortar sores/malls.

The two below charts show the break down of e-commerce sales and brick & mortar sales on both a dollar basis as well as a percentage basis.

As the blue line in the above chart shows, brick & mortar retail sales are growing at a greater than 2% YOY pace. Certainly this is a slower rate of growth versus a few years ago; however, it is growth nonetheless. On the other hand, the growth in e-commerce sales is moving forward at a mid-teens pace and has done so for over five years. Consequently, the brick & mortar retail headwinds are mostly attributable to the changing buying habits of consumers and their preference for the convenience online shopping provides.

This shift in buying habits, and now driven by Amazon, is covered in the below video presentation. The video covers Amazon and its destruction of retail and highlights the destruction of “brands’ that is occurring as a result of the growth in the preference of e-commerce buying.

Widespread Bearishness Indicating Market Nearing A Turning Point?

Bearish sentiment has over taken what was a bullish environment that unfolded after last year's election. The sentiment change can be attributed to a number of factors, such as continued gridlock in Washington, U.S. bombing campaigns in several countries overseas, etc. Most of the return generated by the equity market over the past two years has occurred since the election in November of last year. In spite of what seems like pervasive investor bearishness​ in stocks, the S&P 500 Index is down only 3.0% from its high at the beginning of March as can be seen in the below chart.

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