Shifting Investor Sentiment

It seems the market's consistent bid to move higher this year might be confusing the individual investor. That is, the fact the market has escaped any material pullback this year may be weighing on consumers in that they are prepared for or expect a pullback. As the below chart shows, the market has avoided such a pullback of more than 3% so far this year.

This lack of volatility has not translated into a bullish individual investors though if the American Association of Individual Investors Sentiment Survey is a guide. This week's sentiment report shows bullish sentiment declined almost seven percentage points to 33.3%. Most of this decline showed up in an increase in the neutral reading with a 5.3 percentage point increase to 37.9%.

With the strength of this year's market return that actually began in February of last year, one would expect the individual investor to be bullish on equities. Remembering the sentiment reading is a contrarian one, high bullishness readings can be a negative for future equity prices. Excessive individual investor bullish is certainly not the case at the moment if the survey readings are to be believed.

A Recession And Equity Market Bubble Five Years Ago Did Not Materialize, Now What

I was communicating with a client today who reminded me of a conversation we had five years ago almost to the day about whether or not the U.S. equity market was in a bubble. The discussion was prompted by the USA Today article, Consumer Sentiment Stat Hints that Bull Market May be Stalling Out, that highlighted a data point from the recent University of Michigan Sentiment Survey. In the survey it was noted that 65% of individuals surveyed believe stock prices rise over the next twelve months. This is a high level for the survey and a contrarian data point for stocks. The conclusion from that 2012 conversation was equities were attractive and our firm wrote as much in our third quarter 2012 newsletter. Additionally, I shared a Fidelity white paper, U.S. Equities: Light At The End Of The Tunnel. An interesting read in retrospect.

Much was occurring in 2012 with the 10-year Treasury yield below 2% and the Federal Reserve providing massive monetary support (QE) to the economy, i.e., buying $40 billion of mortgage bonds each month. This was occurring on the back of an equity market that was up 100% from the March 2009 low to June 2012. Both print and television financial commentary at the time was intimating concern for the markets.

A CNN Money article from September 2012 was titled, Stocks End Week At Multi Year Highs. In the article a link was provide to, Are Investors Getting Too Greedy which referenced CNN Money's Fear & Greed Index that was flashing an extreme Greed level of 93. Several weeks later and into the first week of October 2012, Sam Zell, Chairman of Equity Group Investments, stated in an interview on CNBC, "We're heading for a recession and that's exactly what you're looking at now."

Five years after 2012 to today and following all the consternation about bubbles, corrections and recessions, the U.S. equity market (S&P 500 Index) is up an additional 87% and the economy has avoided a recession. Certainly the period from 2015 through the third quarter of 2016 was a choppy one with the S&P 500 Index trading mostly sideways for almost two years. But so far in 2017, U.S. stocks seem to know only one direction and that is up, with the S&P 500 Index returning just under 13% on a price only basis with very little downside volatility

Raising the bubble question now is even more appropriate today then it was five years ago given how far the equity markets have risen over the last five years. Also, market data is decidedly different and is summarized below. Some of the data was taken from the earlier cited Fidelity white paper. If any variable in the below table jumps out at readers, it should be the higher valuation of the S&P 500 Index based on the price earnings ratio or P/E, 56.5% higher, while earnings are higher by only 17.5% during the same time period. In other words, the market advance over the last five years has largely been supported by multiple or P/E expansion. Sentiment data is also more bullish at the moment, but not at a level that has historically been associated with a bear market type downturn.

Certainly given current market valuation levels, earnings growth will be important for strong S&P 500 Index returns as we look ahead. Twelve month trailing earnings as of June 2017 does capture the energy weakness in 2012; however, when evaluating the year over year June 2017 to June 2018 estimated operating earnings growth rate for the S&P 500 Index, earnings growth is expected to equal about 18% and in line with the forward P/E. On a calendar year basis, comparing 2018 to 2017, earnings growth is expected at a respectable low double digit growth rate.

In a couple of recent posts I have noted the Fed's desire to actually begin withdrawing liquidity from the market and they announced as much in last week's Fed statement with a start date beginning next month. An old adage that gets repeated around Fed accommodation changes is, 'don't fight the Fed'. Just as the Fed has been supply liquidity since the onset of the financial crisis, and this has likely had some positive impact on asset prices, withdrawing liquidity can be disrupting on the way out. We will be on guard for potential asset price volatility, but will note, historically, stocks have been positively correlated to the rate moves when they occur below 5%.

In summary, we were strongly bullish in 2012 given equity valuations and a high equity risk premium. We do not expect a recession near term, but believe today that more pressure falls on companies to generate earnings growth, which we do think is likely, but probably not a market where a rising tide raises all boats.

In client accounts we have reduced some equity investments where we believe earnings growth is more challenged  and taken profits in some stocks that have moved higher and gotten ahead of valuations. At the same time, we have allocated equity investments to developed and emerging international markets over the last 18-months or so. This allocation adjustment has been a positive for clients and we continue to find valuations outside the U.S attractive.

Higher Bond Yields A Headwind For Technology Stocks

In a recent note from the John Murphy of the stockcharts.com website ($$) he notes technology stocks tend to have an inverse relationship to bond yields. In his commentary he noted,

• "One of the lesser known intermarket principles is the inverse link between bond yields and technology stocks' relative performance...Growth stocks like technology...do better in a slower economy which is usually associated with low interest rates."

• "Value stocks (like banks) do better in a stronger economy with rising bond yields...Rising global bond yields could make the going tougher for technology stocks."

The below chart was included with his comment and shows the inverse relationship between the 10-Year Treasury yield (red line) to a ratio of the Technology SPDR (XLK) divided by the S&P 500 Index. Jon Murphy notes, "Rising rates this past month may again be contributing to tech selling, especially with a more hawkish sounding Fed. The inflationary impact of rising energy prices may also give the Fed more cover for a December rate hike."

Weakness is beginning to show in some of the large cap technology stocks. Below is a chart of the average return of Apple, Alphabet and Amazon for month to date in September. This time period is a short three weeks, but the performance of large cap technology stocks is something investors will want to follow as the last three months of the year unfold.

Disclosure: Firm/family long AAPL, GOOGL

Market Is In An Uptrend And Trends Tend To Persist

One strategist I read regularly and who prepares weekly technical commentary, Charles Kirk at The Kirk Report, had a reference in this week's report relative to the strength of the current market. Kirk highlighted the below quote from James DePorre,

"If you simply focus on what the pricing action is saying, then your job of profitably navigating the market becomes a lot less complex. The simple fact is that we are in a very long-term uptrend, and trends tend to persist. The media might have all sorts of headlines to create their narrative, but all we really need to know is that the odds favor the bulls in an uptrend and vice versa. At some point, that pattern (and trend) will change, but trying to predict it ahead of time is a hard way to make a living."

The quote is certainly applicable in the equity market environment investors are currently experiencing as corrections and pullbacks seem to be nearly few and far between. I noted this lack of volatility in a post late last week, The Risk Of De-Risking The Equity Portfolio. And as it relates to trends, over the long term, the market trend is one that moves higher as can be seen in the below chart. An important observation from the below chart is the fact the line mapping the current market advance falls between long term support (green line) and resistance (red line.) So one might say the market is neither oversold or overbought from a technical perspective when only evaluating the below chart.

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Stocks Need Some Healthy Competition

It seems a day does not go by where various strategists lament the market's valuation and lack of any significant pullback in over a year and a half. Not only are the valuations of a number of equity indices above their long term average, some might say the valuations are indicative of the speculative froth in the market. One data point highlighted is the margin debt level. Certainly margin debt has increased as can be seen in the first chart below. However, the second chart shows that margin debt as a percentage of total equity market capitalization has remained fairly stable since 2010. A good article on evaluating margin debt can be found in a MarketWatch article from a few years back, Cash vs. margin debt is the real problem for this market.

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The Risk Of De-risking The Equity Portfolio

The unique aspect of the current U.S equity market has been the market's desire to move higher without any significant pullback. As the below chart shows, the last correction (double digit decline) occurred in early 2016 and culminated with a 13.3% decline ending February 11, 2016. Since the February correction, two other pullbacks of around 5% occurred around June 2016 and November 2016.

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Spike Higher In Bullish Sentiment

In today's Sentiment Survey release by the American Association of Individual Investors, bullish sentiment jump twelve percentage points to 41.3%. All of the increase in bullish investor sentiment come from a 13.8 percentage point drop in bearish sentiment as can be seen in the second chart below.

The bull/bear spread of 19.3 is the second highest of the year following early January's 20.97 bull/bear spread.

S&P And MSCI May Change The Composition Of The Telecommunications Sector

In July of this year S&P Dow Jones Indices and MSCI announced they were considering making changes to the current GICS Telecommunications Sector. Any changes would be announced in November and go into effect in 2018. Currently, the telecommunications sector represents about 2% of the S&P 500 Index. S&P's and MSCI's intent is to broaden the composition of the sector and rename it Communications Services with the sector weight increasing to approximately 10% of the S&P 500 Index. As noted in the release,

"The main proposal set out in the consultation paper is the creation of a Communication Services Sector, comprised of the current Telecommunication Services Sector, Media Industry Group, and specific companies from the Software & Services Industry Group."

Sector weights in other indexes would be impacted as well with a couple of those noted below. As an example, Communications Services would increase to 13.7% from 1% in the Russell 1000 Growth Index. In the S&P 500 Index, the Information Technology sector would decline to 18.4% from the current 23.3% weighting.

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Growth Outperforming Value And The Economic Cycle

One style of the market that has outperformed, except in 2016, has been growth type equities. In 2016 value outperformed growth with a value outperformance burst subsequent to the election. Value's outperformance essentially ended at the beginning of this year though.

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Equity Market Nears Record High And Investors Become Less Bullish

As the equity market nears a record high, both institutional and individual investors continue to indicate they are less bullish. The NAAIM Exposure Index continues to decline with long equity exposure down to 77%.

Yesterday's AAII Sentiment Survey report showed bullish sentiment fell another 3.1 percentage points to 25% and now is below the minus one standard deviation level for bullish sentiment. 

The market rarely rewards investors for being properly positioned for a market pullback. Sentiment measures are contrarian ones and by these measures only, this widespread skepticism would suggest the market might continue to move higher.

DowDupont Will Be Included In Dow Jones Industrial Average Index

As many readers know, effective September 1, Dow Chemical (DOW) and DuPont (DD) will merge into one company, DowDupont (DWDP). Effective that same day, S&P Dow Jones Indices will replace DuPont, a component of the Dow Jones Industrial Average Index, with DowDuPont. S&P notes,

"Replacing du Pont with the new DowDuPont allows the Dow Jones Industrial Average to maintain its exposure to the Materials sector....The change won’t cause any disruption in the level of the index. The divisor used to calculate the index from the component’s prices on their respective home exchanges will be changed prior to the opening on September 1. This procedure prevents any distortion in the index’s reflection of the portion of the U.S. stock market it is designed to measure."

Large Decline In Bullish Investor Sentiment

This week's AAII Sentiment Survey reported a 6.1% decline in bullish investor sentiment to 28.1%. The bullish sentiment level is now near one standard deviation below the long term average. Nearly all of the decline in the bullish sentiment showed up in the bearish number which increased 5.5%. The bull/bear spread is now -10.4 percentage points.

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Dr. KOSPI's Protocol For Global Growth Diagnosis

It has been about two weeks and market sentiment seems to have quickly turned decidedly bearish and the S&P 500 Index is down only 2.2% from its high. I will not list all the bearish commentary over the last few days, but we even pushed out some thoughts this weekend on our Twitter account (@HORANCapitalAdv) that leaned a little bearish. A couple of reasons for the increased bearishness might be the fact the market has gone over a year without a pullback of more than 5% and stock valuations do appear elevated on an absolute basis. Lastly, with the increase in technical and computerized trading, readers should know the S&P 500 Index acquired a significant target price that was triggered over four years ago and was formed out of a 16 year trading range for the market. Once significant levels like this are reached, it is not uncommon for the market to at least consolidate gains.

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No Slowdown In Growth Of e-Commerce Sales

It seems nearly every company reporting earnings now references a strategy to deal with Amazon (AMZN) due to Amazon's command of e-commerce sales. Beyond the simple delivery of packages and hard goods, AMZN is moving into many other areas like grocery, air transportation, etc. I discussed this in a post a few months ago. In that post I highlighted the profitability of Amazon's cloud business (AWS) and the company using AWS profits to fund growth in other industries.

Yesterday, the U.S. Census Bureau reported quarterly retail e-commerce sales for the second quarter of 2017. Not a surprise to many now, e-commerce sales continue to grow at a high rate, i.e., up 16.2% on a year over year basis for Q2. Traditional brick and mortar sales were up a small 2.9% year over year. The other notable highlight from the Census Bureau report, e-commerce sales now account for 8.9% of total retail sales. This is nearly three times larger than ten years ago.

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The Economy May Not Be At Full Employment

One economic conundrum has been the sub-par growth rate in average hourly earnings in spite of what appears to be an economy operating at full employment. In a fully employed economic environment, wages generally see fairly strong upside pressure and this becomes a concern with the Federal Reserve due to the upward pressure placed on the inflation rate. As the below chart does show, average hourly wages have grown at about a 2% annual rate since the end of the financial crisis. Prior to the onset of the last recession, wage growth was in the range of 3% to 4%. From a positive perspective though, wages have been growing faster than the rate of inflation for most of the last four years. Additionally, the differential wage growth and inflation in this cycle is on par with prior economic expansions.

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Investor Fund Flows Favoring Bonds And Not Equities

The equity market has gone over a year without a pullback of at least 5% or more. The last 5% decline occurred in mid-June 2016 when, over a two week period, the market fell 5.5%. Even in the run up to the election last year, the equity market did not close down over 5%. This lack of volatility is showing up in popular volatility measures like the VIX, but the VIX may not be a good measure of expected future volatility.  Also, this lower level of volatility has some strategists suggesting investor's have become to complacent about the equity market and have willingly taken on more equity exposure as a result.

A recent post by Dr. Ed Yardeni, Ph.D., and he puts out some great research, noted individual investors may have become too optimistic as well. In that post, Investors Hearing Call of the Wild, he included the below chart of U.S. equity ETF flows.

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The S&P 500 Index Is Expensive And Has Mostly Been So Since The Early 1990's

One can cite any number of stock valuation measures and conclude U.S. equities look expensive or are at least trading above their long term average valuation measures. In this environment one might conclude stocks are priced for perfection with little margin for error. Of course this might certainly be the case, but is this an uncommon position for the equity market? As the shaded areas in the below chart show, investors would have had a difficult time buying or holding onto stocks at valuation levels that were below their long term average valuation since the early 1990s.

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Dividend Payers Are Underperforming

A year ago dividend paying stocks were significantly outperforming the non payers in the S&P 500 Index and the S&P 500 Index itself. If investors were chasing performance back then and loading up on the payers, today they would be disappointed. Below is a chart of the year to date performance of two dividend paying exchange traded funds, SPDR Dividend ETF (SDY) and iShares Select Dividend ETF (DVY). The return of the dividend focused ETFs is nearly half that of the S&P 500 Index.  The return difference is similar for one year. My year ago post contains some details on both ETFs.

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Equity Valuations No Longer Matter?

One benefit to writing blog content is it serves as a record of ones past thinking and the results of any decisions made from the prior analysis. With that in mind I reviewed some of the topics written over a year ago, that is, in June/July of 2016. A few of the topics at that time had to do with valuations, PEG ratios and the fact the market was trading at an all time record high. In fact one article was titled, Is It Right To Be Bullish Near A Record Market High? The conclusion at that time was to stay invested in equities as I wrote then,

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Strong Earnings Growth And Favorable Valuations Lead To Weak Stock Returns

One factor utilized in uncovering potential investment opportunities is to evaluate companies and sectors that are projected to generate strong earnings and cash flow growth over the course of the next year or more. The risk associated with simply reviewing earnings growth rates is the fact other variables often influence the future price performance of a company's stock. A good case in point at the moment can be found in evaluating energy companies and the associated sector. For calendar year 2017 and 2018, the energy sector is expected to exhibit the highest earnings growth rate among all the S&P 500 sectors. For 2017 the year over year earnings growth rate for the energy sector is estimated to equal over 300%. In 2018 the YOY growth rate is projected to equal 41.3%.

Even reviewing the sector PEG ratios (P/E to earnings growth rate), the energy sector looks very attractive and is the only sector that has a PEG below 1.0.

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