Cyclical Stocks Outperforming Defensive Stocks An Indication Of A Strengthening Economy?

Since the beginning of 2018, investors have encountered a stock market that is more volatile, yet at a level of volatility that is more normal. The below chart shows the return pattern for the S&P 500 Index since 1/2/2018 and the steep decline that began at the end of last September has been followed by a sharp recovery in 2019.

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Investor Sentiment Has Improved But Not To An Extreme Level

Several recent releases of various investor sentiment reports show an improvement in overall investor sentiment. In late December I noted a number of the sentiment measures were indicating extreme fear on the part of investors. Since my December post both sentiment and the equity market have experienced a marked improvement. One example is this week's release of the AAII Sentiment Survey. Individual investor bullish sentiment improved 8.1 percentage points week over week to 39.9%. In mid December the bullish sentiment fell to 20.9%. Although the bullish sentiment level of 39.9% is an improved level, it is just above the long term average of 38.5%.

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Higher U.S. Stock Prices Not Driven By Higher Domestic Equity Inflows

The end of 2018 saw the S&P 500 Index return decline over 13% as seen in the first chart below. The second chart shows the snap back in the market that has rewarded investors at the start of 2019 with the price only return of the S&P 500 Index up nearly 9%.

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Winter 2018 Investor Letter: A Tough Year For Most Asset Classes

As noted in our Winter 2018 Investor Letter, following passage of the Tax Cut and Jobs Act, the reduction in corporate tax rates caused analysts to revise their earnings growth expectations higher to nearly 24% for 2018. Given a number of positives, further upside in equity markets was anticipated in 2018. As fate would have it, not only were equity returns weak, most asset class returns were negative. Data from Lipper showed the Money Market Fund average return was 1.52% in 2018. In other words, cash turned out to be king in 2018 as can be seen in the below table.

Despite solid fundamentals heading into the year, 2018 was extremely difficult. The uncertainties faced in 2018 will likely continue to overhang the markets in 2019. However, the events that drove markets lower last year proved to alleviate some of the concerns plaguing investors at the year’s start. For example, equity valuations have declined to a more attractive level. In January 2018, the S&P 500 had become the most expensive since 2004 on a forward P/E basis. The S&P 500 Index now trades at a price to earnings ratio of about 15 times which is in-line with its historical average. Growth and inflation have moderated while staying positive, alleviating concerns of an overheating economy and aggressive interest rate increases from a Hawkish Fed. Fed chair Jerome Powell recently remarked the Fed “will be patient” as they assess the prospects of further rate hikes in 2019.

For additional insight into our views for the market and economy as 2019 begins, see our Investor Letter accessible at the below link.

• Winter 2018 Investor Letter

Dogs Of The Dow A Winning Strategy In 2018

With the 2018 investing year now closed, one strategy that turned out to be a winning one was the Dogs of the Dow strategy. The Dogs of the Dow 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 them for the entire next year. The popularity of the strategy is its singular focus on dividend yield.

I have written about this from time to time and early in 2018 the Dow Dogs were underperforming both the S&P 500 Index and the Dow Jones Industrial Average Index. This was on top of the fact the Dow Dogs underperformed the market in 2017. Through the first half of 2018 the Dow Dogs continued their lagging ways; however, a more volatile market in the second half of last year benefited the strategy and the Dogs of the Dow ended up generating a slight positive total return of .02% for 2018. This compares to a loss of 3.74% for the SPDR Dow Jones Industrial Average ETF (DIA) and a loss of 4.56% for the SPDR S&P 500 Index ETF (SPY) as displayed in the below table.

Data File (xls)

Both Merck (MRK) and Pfizer (PFE) were the top performing Dow Dogs and the top performing stocks in the broader Dow Jones Industrial Average Index for 2018 as well.

As the new year begins, one new member joins the Dogs of the Dow for 2019. Entering the Dow Dogs in the coming year is JP Morgan (JPM) with a dividend yield of 3.28%. Dropping out of the Dogs is General Electric (GE) not only because of its lower yield, but GE was removed from the Dow Jones Index last year.

Long MRK, VZ, JPM

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.