Stock Buybacks Up 57.8% In Third Quarter

S&P Dow Jones Indices recently reported preliminary dividend and buyback information for the third quarter ending 9/30/2018. On a year over year basis stock buybacks for S&P 500 companies are collectively up 57.8% for Q3 2018. For the 12-months ending 9/30/2018 total buybacks increased 39.1%. Relative to buybacks, dividends increased a much smaller 9.7% resulting in combined dividends plus buybacks increasing by 36.2% for the third quarter. Year over year operating earnings were reported up 25.8%.

The three largest buybacks were initiated by companies in the information technology sector:

• Qualcomm (QCOM): $21.2 billion
• Apple (AAPL): $19.4 billion
• Oracle (ORCL): $10.3 billion

For the quarter the top 20 companies initiating buybacks in the quarter accounted for more than half, or 54.3%, of the total buybacks of all S&P 500 firms.

In conclusion, I would prefer to see larger dividend increases which would be more of an indication that companies expect to see improved cash flow/earnings over an extended time frame. The recent tax cut is not permanent though; thus firms are likely hesitant to commit to higher dividend payments on an ongoing basis. The most significant tax cut expiration impacting businesses might be the phase out of the full expensing of equipment purchases beginning at the end of 2022. At the moment though, companies seem committed to returning to shareholders some of the cash flow benefits resulting from the tax cut.

With Abysmal Investor Sentiment A Market Bottom Might Be Near

Simply noting that the S&P 500 Index is down 12.45% month to date through the close on 12/21/2018, this pretty much sums up the damage inflicted on investors by the market. After a strong start to the year, and following a rewarding 2017, the S&P 500 index had a return of 9.62% through late September. In nearly three short months thereafter, the S&P 500 Index has declined 19.23% from its high, leaving the index down 9.61% for the year through 12/21/2018. This type of market reversal has resulted in investor sentiment turning extremely bearish.

The equity only put call ratio reached 1.13 at Friday's close. Readings above 1.0 represent an extreme bearish reading. The equity market has a tendency to reverse itself when the P/C ratio is above 1.0.

Trading volume on Friday reached a high level last seen in the market pullback in 2011. This high volume level on a down day in the market could signal a capitulation trading day. These capitulation days do not necessarily wash out on a single day; however, it is a sign a market bottom might be near.

The Fear & Greed Index reported by CNN Business is about as low as it can get at '3'. All seven of the components that comprise the Fear/Greed Index calculation are at extreme fear levels.

The NAAIM Exposure Index was reported at 31.96% this week. The NAAIM Exposure Index consists of a weekly survey of NAAIM member firms who are active money managers and provide a number which represents their overall equity exposure at the market close on a specific day of the week, currently Wednesday. Responses are tallied and averaged to provide the average long (or short) position or all NAAIM managers as a group. Institutional money managers have equity allocations at a level approaching those reached during the market pullback experienced in 2015.

Lastly, as this is written, it appears a government shutdown will take place. Charles Schwab notes prior government shutdowns have not had a long lasting negative impact on equity markets as seen below.

This year has been difficult for investors long the market. In a research report I received today it was noted that of 102 Morningstar fund categories, only short term bonds/loans, municipals and one economic sector – utilities – have positive returns this year. We believe recent market action is a correction in a longer-term bull market and continued strong fundamental data will result in a recovery and resumption of this long-term trend, all else being equal, but not without continued market volatility.

Trend In Index Earnings More Important Then A Slowing Rate Of Earnings Growth

One issue strategists are highlighting of late is the fact the earnings growth rate for the S&P 500 Index in 2019 is expected to decelerate from the mid to high 20+% level this year to the mid single digit percentage level in 2019. Some have indicated this slowing earnings growth rate may negatively impact U.S. equity returns next year. Of course the strong rate of earnings growth this year is due in part to the benefit companies have received from the tax cut. In addition to the tax cut benefit though, companies are seeing top line revenue growth in the high single digit percentage level. Although earnings will remain at a higher level due to the lower tax rate, the year over year growth rate in earnings will fall back to a more normalized level next year as the earlier year comparison is a higher number.

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Steep Decline In Bullish Investor Sentiment

The American Association of Individual Investors reported sentiment data for the week ending December 12, 2018. The sentiment survey reported the largest change in the difference between bullish and bearish sentiment since April 11, 2013. The swing in the current week equaled -35.4 percentage points.

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Tight Labor Market A Headwind For Business Sentiment

Although the November NFIB Small Business Optimism Index remains at a high level of 104.8, today's report is the third consecutive decline in the optimism index. The index high of 108.8 was reached in August of this year.

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Investment Fund Outflows Dominate

The most recent flow data for ETF's and mutual funds reported by ICI last week notes outflows occurred in nearly all of the broad asset categories. One exception was a small positive flow into commodity oriented investments.

 Source: ICI

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Trying To Make Sense Of China/US Trade Issues

What seems to be influencing the market the most at the moment is the trade issues with China and the U.S. Jeff Miller who writes at the Dash of Insight blog published a short article yesterday that seems to get to some of the main issues surrounding trade and the equity markets. A couple of highlights from the article follow, but the entire post is a worthwhile read. Jeff notes the market's reaction is,

"a typical example of the trading community’s failure to understand politics, negotiation, and compromise. I have highlighted this before on issues like Greece and the asserted collapse of Europe and concerning various US policy debates."

He notes further,

Here is what to expect:

• Decades of history will not be reversed in a few months. Be happy for some progress.

• The outcome will be a compromise. It will not be a complete success for either side, but each will trumpet what they have accomplished.

• Nothing big will happen until the last minute. This is the way that partisans demonstrate they have accomplished as much as possible.

• Eventual relief on the most important reciprocal tariffs.

• Some progress on the intellectual property issues.

• Some immediate relief on existing boycotts, e.g. soybeans.

The entire post can be read here: China/US Trade – Finding a Signal Amidst the Noise

GM Restructuring News Not A Sign Of A Slowing Economy

Today General Motors (GM) announced a restructuring that will cut 14,000 positions and the possibility of closing five auto manufacturing plants. Some headlines attributed the restructuring to an economy that may be slowing. However, when one reviews the data that comprise new sales of automobiles and light trucks, the exact opposite conclusion is drawn. A divergence has developed in the sale of cars versus light trucks that is clearly evident when one looks at unit sales volume in the below chart. Since 2014 a noticeable turn in interest has occurred toward the light truck category and away from the automobile category. In other words, it appears GM is responding to market forces and focusing the future of the company on the light truck market.

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Low Level Of Bullishness Means Equity Market Bottom Maybe Near

Investor sentiment continues a trend of turning less bullish. Today's Sentiment Survey report from the American Association of Individual Investors noted individual investor bullish sentiment decline 9.8 percentage points to 25.3%. Neutral sentiment declined 1.3 percentage points with the result that bearish sentiment rose 11.2 percentage points. The net result is the bull/bear spread of -21.8 pp is the widest since the spread reached -29 pp in February 2016.

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Institutional And Individual Investors More Bearish On Equities

At the end of October the American Association of Individual Investors reported individual investor bullish sentiment was 28.0%, one standard deviation below the bullishness average. Sentiment measures are contrarian ones and are most actionable at their extremes. October's reading was certainly not an extreme level; however, the reading was at a low level of bullishness for the individual investor sentiment measure. Since the January market high, the bullishness reading has vacillated between +26% to +45%, with a level in the mid teens being an extreme.  Today's reading of 35.1% bullishness falls within this range, as does the 36.2% 8-period moving average.

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Small Business Continues To Be Highly Optimistic

Today's NFIB Small Business Optimism Index was reported at a strong 107.4, down only 1.4 points from the Index's 45-year August high. According to the NFIB report for October,

"Small business optimism continued its two-year streak of record highs. Overall, small businesses continue to support the 3%+ growth of the economy and add significant numbers of new workers to the employment pool. Owners believe the current period is a good time to expand substantially, are planning to invest in more inventory, and are reporting high sales figures. Seasonally adjusted, 30 percent of owners think the current period is a good time to expand substantially, citing the economy (72%) and strong sales (14%)."

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Dollar Defies The 7-Year Cycle

Historically the U.S. Dollar has had a tendency to exhibit strength over a 7-year cycle. In July of this year the Dollar strength cycle crossed into its eighth year though, as seen in the below chart.

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Emerging Markets: An Opportunity?

For a period of time this year, the U.S. equity market avoided the weakness that was occurring in many other equity markets around the world. October has certainly changed this though. As can be seen below, the S&P 500 Index is in correction territory now, i.e., down greater than 10% from its high at the end of September.

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Much To Like About The Economy

Recent equity market volatility has raised the question about the health of the current economic expansion. I must confess it is difficult to find too much in the way of negative news. What is important about this is the fact that a recession does not seem to be around the corner in our view. William Delwiche, CMT, CFA of R.W. Baird noted in a recent commentary, "Bear markets are almost always associated with a recession. Given the latest economic data and the leading indicators that point to further growth, the odds of recession are low." We would agree.

Following are just some of the favorable data points and charts.

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VIX Curve Moving Back Towards Contango A Positive For Stocks

The level of the VIX is one measure to gauge fear in the equity markets. When the near term VIX index is trading at a higher level than the VIX further in the future, for example, the 3 month VIX (or ticker VXV), then the VIX curve is said to be in backwardation. This is not the normal structure for the VIX curve as the VIX curve is usually in contango, meaning prices in the distant future are higher than those nearer term. For equity market volatility, i.e. the VIX, this makes sense as volatility inducing events are less predictable in the distant future versus today thus, the future VIX should be at a higher level than the near term VIX. As the below chart shows, in instances where the near term VIX is higher or significantly greater than one, this tends to occur near equity market bottoms.

As the near term VIX begins to decline or fall below the future VIX or VXV, the equity market tends to move higher. This process can take place over a several week period, but nonetheless, the equity market does tend to bottom 'near' spikes in backwardation. The recent spread between the VIX and VXV of 3.4 may have marked a near term peak in backwardation. If this is the case, the equity market may be setting the stage for a rally into year end.

Many Individual Stock Returns Are In Correction Territory

On a price only basis the S&P 500 Index remains up 3.08% year to date and up 4.66% on a total return basis. As the following chart does show, the S&P is off its late September high by 6.54%.

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Fall 2018 Investor Letter: A Midterm Election Year

There are many indicators pointing to continued strength in the U.S. economy including increased manufacturing activity, robust readings from the service sector and low unemployment levels last seen 49 years ago. Employee wages are rising, and the labor market is benefiting from the current growth in the economy. We view the low levels of unemployment and continued wage growth as a positive signal for the economy.

As we discuss in the Fall 2018 Investor Letter, history shows the fourth quarter of a midterm election year combined with the first quarter of the following year are the two strongest returning quarters for the market over the four-year presidential cycle. The start of the fourth quarter may lead investors to believe something other than the historical data though. Days into the quarter, markets have turned lower and volatility has increased to a more normal level. Although this is unsettling, the underlying economic and market fundamentals are still supportive of favorable equity returns looking ahead. As the above chart shows, the performance of the S&P 500 occurs late in a mid term year.

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

• Fall 2018 Investor Letter

Hiring Pace Continues To Lag Job Openings Growth

If job openings are an indication of the economy's strength, yesterday's Job Openings and Labor Turnover (JOLTs) report is confirmation of economic strength. Job openings reached another record high of 7.136 million. Compared to last August's openings of 6.044 million, openings are up 18.1% on a year over year basis.

The timing of the unemployment data is one month ahead of the JOLTs data, however, the number of unemployed looking for work is 1.172 million lower than job openings. This is hard evidence that labor is a scare resource at the moment. This is not the type of data output that occurs in a recessionary environment. 

Pullbacks, Fear And Opportunity

From early 2016 to early 2018 the S&P 500 Index moved higher with very little downside volatility. As the below chart shows, that stretch of time was an abnormally long one in terms of very little downside market move. One consequence of this low volatility period is many investors' began to believe the equity market does not go down. In reality, a low volatility market is not normal though. Having the market pullback between 5-10% once or twice a year should be expected by equity investors. The current decline from peak to current level is only 6.9%.

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Large Decline In Bullish Sentiment

Today's Sentiment Survey release by the American Association of Individual Investors reported a  15.1 percentage point decline in bullish sentiment. Of course this report comes one day after the 800+ drop in the Dow Jones Industrial Average Index. Two-thirds of the decline moved to the bearish camp with the other one-third moving to the neutral category. When all is said and done, the three categories of sentiment, bullish, neutral and bearish, fall in the 30-35% range.

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