Only The Good News

As seems often the case, it is the bad news that leads headlines and garners the attention of those interested in digesting news reports. In the current economic environment though it seems somewhat difficult to promote the bad news when there seems little of it. I am not saying there is no bad news, but much of the news today that is related to the market and the economy is decidedly positive, however, from my perspective this good news does not seem to get much press. So, below are highlights of some of the positive news that may be of interest to investors.

The Consumer:

The consumer segment accounts for 70% of economic growth and post the financial crisis in 2009, the consumer seems in very good shape.

• debt payments as a percentage of disposable personal income is lower than the pre-financial crisis level and below the level at the beginning of 1980.

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Potential For A Stronger Second Half In Stocks

Seems as though much has taken place in the first five months of this year that is newsworthy and impactful to the markets, i.e. Iran, North Korea, tariffs, an increasing 10-year yield, and I could go on. With the volume of news flow though, the equity market has essentially traded sideways this year with the S&P 500 Index price return equaling just 1.78%.

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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.

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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.

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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.

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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.

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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.

Source: S&P Dow Jones Indices

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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.

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.

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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.

• Spring 2018 Investor Letter

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.

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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.

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.

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Recent Equity Market Weakness A Symptom Of A More Normal Market

This past week was certainly a difficult one for the market and by default, a difficult one for investors. Most of the weakness occurred on the last two days of the week, which resulted in the week's return for the S&P 500 Index ending at a negative 5.98%.

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Improved Earnings Growth Expectations Broadly Reduce PEG Ratios

Before passage of The Tax Cuts and Jobs Act in December, earnings growth for the S&P 500 was expected to be low double digits in calendar year 2018. Since passage of tax reform, a significant improvement in earnings growth expectations has occurred. The below table shows I/B/E/S earnings growth expectations in October by sector and for the S&P 500 Index compared to expectations as of the end of last week.

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Near Record Small Business Optimism

Today the National Federation of Independent Business (NFIB) reported small businesses are showing unprecedented optimism. The NFIB Small Business Optimism Index was reported at 107.6, the second highest reading in the 45-year history of the Index. The highest reading recorded was 108.0 in 1983.

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Bond Yield To Stock Yield Spread Sufficiently Wide To Challenge Stock Returns

A little over a year ago I noted the yield on the 10-year Treasury surpassed the dividend yield of the S&P 500 Index. With rising bond yields, there becomes a point when the bond yield is sufficiently high relative to the yield on stocks that bonds can challenge stock returns. In that earlier article I referenced a research article written by CFRA Research's Sam Stovall and titled, Rising Prices, Shrinking Yields. In the research article it was noted prospective stock returns became most challenged when the yield on the 10-year U.S. Treasury exceeded the dividend yield of the S&P 500 Index by at least one full percentage point, i.e. 100 basis points. The forward return at varying spreads is detailed below.

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Individual Investors Favoring Technology Stocks

Periodically I review the most active stocks individual members of Better Investing indicate they are purchasing. A notable feature on the current list is the fact technology related stocks are dominating member purchases.

Full File (xls)

Additionally, after the market's close on Friday, I posted a tweet noting Fidelity customers' top purchases. Again, technology stocks are gaining the interest of Fidelity's individual investors.

With both the technology sector SPDR (XLK) and the Nasdaq Index both achieving record highs on Friday, one might believe the technology sector is getting over heated. The interest in technology has led to acronyms for various groups of stocks, with the most familiar being the FAANGs, representing Facebook (FB), Amazon (AMZN), Apple (AAPL), Netflix (NFLX) and Google (GOOGL), now known as Alphabet. As the below chart shows, the technology sector in the S&P 500 Index accounts for 25.2% of the index weighting and is approaching the technology bubble peak of 32.9%. One major difference today though is the fact the valuation of the technology sector holdings is not even close to the bubble peak valuation. At the height of the technology bubble in 2000, the technology sector P/E equaled 82 times trailing earnings. Today, the trailing technology sector P/E is 23 times earnings.

In spite of the fact a few technology or technology related stocks trade at higher P/E multiples, the valuations are far from bubble levels seen in 2000.

Sentiment And Economic Data Laying The Foundation For Higher Stock Prices

The headline number of an increase of 313,000 in February's non-farm payrolls this morning was big. This is the largest monthly increase since July 2016. The high end of consensus estimates was for a 230,000 increase in payrolls. December and January reports were also revised higher.

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Trade Deficit And Tariffs: It Is Complicated

President Donald Trump's announcement that he is instituting tariffs on imported steel and aluminum came as a surprise to some although reducing the trade deficit was one of his campaign promises. Dealing with the trade deficit issue is a complicated one since no one factor impacts trade. What is complicating a necessary discussion at the moment is the vitriol in which President Trump's tariff proposal is being discussed. For example, the media repeated commentary that the market would collapse once President Trump signed the tariff executive order; yet the S&P 500 Index closed almost .50% higher today.

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