Dogs Of The Dow Update: As Of June 21, 2019

With the first half of 2019 nearing an end, the Dogs of the Dow strategy is keeping pace with the Dow Jones Industrial Average Index. However, the Dow Dogs for 2019 trail the return of the broader S&P 500 Index. 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 that portfolio for the entire next year. The popularity of the strategy is its singular focus on dividend yield.

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Understanding The Purchasing Managers Index

No one variable provides the key to the future direction of the economy or market. However, one economic data point that tends to get a lot of attention is the Purchasing Mangers Index for both manufacturing and non-manufacturing parts of the economy. In fact in an article I wrote earlier this week I highlighted the optimism being expressed by manufacturers and small businesses. Many of my articles get republished on Seeking Alpha as did this one. One reader comment to the article stated I must not be "paying much attention to the manufacturing PMIs, which are showing a severe turn to pessimism." PMIs are important variables we do review; however, we believe many misinterpret the meaning behind the PMI's.

A key misinterpretation revolves around contracting manufacturing versus a recession level PMI reading. PMI readings below 50 do indicate manufacturing is generally contracting but it does not mean with certainty that the economy is headed for a recession. According to the Institute for Supply Management that reports PMI data, they note,

• "A reading above 50 percent indicates that the manufacturing economy is generally expanding; below 50 percent indicates that it is generally contracting."

As it relates to economic expansions though, ISM states,

• "PMI^® above 42.9 percent, over a period of time, generally indicates an expansion of the overall economy [emphasis added]. Therefore, the May PMI^® indicates growth for the 121st consecutive month in the overall economy and the 33rd straight month of growth in the manufacturing sector. 'The past relationship between the PMI^® and the overall economy indicates that the PMI^® for May (52.1 percent) corresponds to a 2.7-percent increase in real gross domestic product (GDP) on an annualized basis,' says Timothy R. Fiore, CPSM, C.P.M., Chair of the Institute for Supply Management^® (ISM^®) Manufacturing Business Survey Committe."

As the below chart of the PMI data shows, PMI readings below 50 occur frequently and a recession does not always follow. 

Last week several additional manufacturing reports exhibit weakness. The Empire State Manufacturing Survey's General Business Conditions Survey Index was reported at -8.6, below  the consensus expectations of 10.0. The drop from the prior month reading was 26.4 points, the largest drop in the index's history which dates back to 2001.

Thursday's Philadelphia Fed business Outlook Survey missed expectations at .3 versus consensus of 11.0. Econoday noted though,

"Yet outside of the headline which is not a composite but a general sentiment reading based on a single question, details in today's report are less alarming. New orders did slow but not very much and remain respectable and solid at 8.3. And unfilled orders are building nicely so far this month, at 10.2 for a more than 8 point gain which is very strong for this reading. Shipments continue to move out the door at 16.6 and hiring remains solid at 9.4."

In  conclusion, the manufacturing data is indicating a slowdown, but it is not at recessionary levels. Globally, PMI's have improved with the Eurozone PMI trending higher for most of this year. Also, the emerging market and China PMIs have improved to above 50 after dipping below 50 earlier this year. So PMIs in the low 40's would be more of a concern versus brief periods falling below 50.

Manufacturers And Small Businesses: Widespread Optimism

It seems one topic of interest continues to be talk of a recession as a result of the trade and tariff situation. A recent CNN Business article noted, "America's business leaders are growing more worried that the United States will enter a recession by the end of 2020. Their primary fear: protectionist trade policy." Who are these business leaders? "The survey, based on 53 economists, is a leading barometer of where the US business community thinks [emphasis added] the economy is headed." I do not want to minimize the importance of economists; however, recent surveys of the small business and the manufacturing community suggest anything but a recession.

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Seems All About The Fed At The Moment

Since the Federal Reserve began raising the Fed Funds rate in December 2015, there have been nine rate increases. Now that the Fed is in a pause mode, strategists and investors have turned their focus on rate cuts. It seems as though strategists believe the equity market and economy can not move ahead unless the Fed cuts interest rates. By now many have heard that every recession since World War II has been preceded by an inverted yield curve, i.e. short term interest rates are higher than long term interest rate. And therein lies the issue with the focus on the Fed's interest rate decisions.

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Passion

I recently ran across an article on the blog of Better Investing written by Vitaliy Katsenelsom, CFA and CEO of Investment Management Associates. When I first began publishing articles on our blog in 2006, Vitaliy was an individual who early on connected to some of my content from his blog, ContrarianEdge. Over time our careers paths varied but were driven by our passions. Vitaliy's writings continue to be worthwhile readings.

His recent article caught my attention as I have had an opportunity to have conversations with a few younger colleagues in our firm and we discussed the importance of having a passion for one's career aspirations. Passion for what one does can supply the drive and lead to the success one desires over time. The importance of passion is the fact a key component is it is a strength developed by oneself and that it can't be taught and it is doing something one loves and is developed from within.

In Vitaliy's recent article he writes about his firm's effort to hire an intern. In the past his firm would advertise for the openings and then receive hundreds of resumes. What his firm found was, "We have learned from experience that educational background, prior experience, and even working toward the CFA designation had very little predictive power as to whether a person would end up doing great or just mediocre research." So what change did they make. The firm's approach was focused on finding an individual that had "passion" for investments, the position and learning. Passion can be hard to measure so the application process required:

1. List the books you’ve read over last 12 months (not limited to just investment books)
2. Provide a sample of a stock idea analysis
3. Write a few paragraphs about two people (dead or alive) who impacted you the most and tell us why
4. Tell us about three books that have impacted you the most and why; and finally, 
5. Write us a cover letter to tell us why we’d be making the biggest mistake of our professional lives by not hiring you

Instead of receiving hundreds of resume's they received four dozen and most were simply resumes with a standard cover letter. A dozen met the above noted requirement. The entire blog Vitaliy wrote is a worthwhile read and contains a final "Letter to a Young Investor (or my younger self)"

Recently, I have had the opportunity talk with a couple of graduates looking for jobs and we have talked about the importance of doing something one is passionate about and how important this is in one's long term success. In short, if you love what you do, you have a high likelihood of being successful and the monetary rewards will follow. Conversely, if one is doing something just for the money, life will likely be filled with more disappointments as monetary success does not occur in a straight line.

Whether one is getting started in a career or looking at a career change, pursue your passion.

There Are Some Positive Data Points

It seems much of the news being reported on the market and the economy lately is falling in the negative category. With both the S&P 500 Index and the Dow Jones Industrial Average Index down a little over 5% in the month of May and with only one trading day remaining, highlighting the negative news might be somewhat attributable to confirmation bias. Nonetheless all the news is not negative.

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Investors Increasingly Bullish On Stocks, But Outflows Continue From Equity Funds

This past week saw the AAII individual investor bullish sentiment move higher to 43.1%. This pushed the bullish reading above its average reading of 38.5% but still below the overly bullish +1 standard deviation level of 48.3%. The bullishness reading has been somewhat volatile of late resulting in the 8-period moving average remaining below 40% at 36.9%.

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Hiring Continues To Lag Growth In Job Openings

In the recent Job Openings and Labor Turnover Survey, the level of openings increased by 346,000, while job hires feel 35,000. Openings remain at a high level but began to decline starting in December last year. The fact hiring level is lagging the growth in openings is a sign companies are having a difficult time finding qualified individuals to fill open positions. This hiring difficulty is showing up in the NFIB Small Business Optimism Index survey. The most recent NFIB report noted, "22% of owners cited the difficulty of finding qualified workers as their Single Most Important Business Problem, only 4 percentage points below the record high." This strength in the employment area is one sign of a healthy business environment.

Equity Fund And ETF Flows Remain Negative

Year to date combined mutual fund and ETF fund flows show investor continue to be net redeemers of equity funds, both international and U.S. domestic equities in the amount of $30.5 billion. Conversely, investors have been net purchasers of bond or fixed income investments. The flow data shown below is reported by the Investment Company Institute with a one week lag with last week's report representing data for the week ending April 24, 2019. Lipper reports fund data as well and they show continued equity fund redemption for the week ending May 1, 2019 in the amount of -$1.8 billion.

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Economic Expansion To Continue

Consuelo Mack interviews Nancy Lazar on a recent episode of Wealthtrack. Nancy Lazar is Co Founder, Partner & Head of Economic Research at Cornerstone Macro. Nancy Lazar is consistently ranked as one of the top economist by Institutional Investor.

As covered in the interview, Nancy remains bullish on the U.S. economy and sees improvement in productivity and improvement in the labor force participation rate supporting low inflationary growth. A similar environment was in place in the 1990's. The resurgence in manufacturing and capital spending in both the manufacturing and service sectors of the economy are contributing to faster wage growth of around 5% in lower income wage levels. She calls the U.S. the "tug boat of the world that is driving global growth." All else being equal she is not seeing a recession until at least the back half of 2021.

A worthwhile interview to watch.

Dogs Of The Dow Lag Broader Market

With nearly a third of the year behind investors, following is an update on the performance of 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 that portfolio for the entire next year. The popularity of the strategy is its singular focus on dividend yield.

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A High Neutral Sentiment Level Indicative Of An Indecisive Investor

Earlier this week the American Association of Individual Investors (AAII) reported the results from their weekly Sentiment Survey. The report noted the bullish sentiment level was 33.5% which certainly indicates individual investors are not overly bullish. Sentiment readings are contrarian in nature so a high bullishness reading would be one cautionary factor for investors to take into account regarding the market's future direction. Even the 8-period moving average (red line below) is at a subdued level.

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The Tax Cut And Jobs Act Is Distorting 2019 Estimated Earnings Growth

With first quarter earnings season shifting into high gear (50 companies reporting the week of April 15), investors will contend with a slower pace of earnings growth in 2019 versus 2018. The difficulty is the fact 2018 earnings saw a significantly higher pace of growth due to the passage of the Tax Cuts and Jobs Act (TCJA) that lowered the corporate tax rate; thus, providing an earnings tailwind for companies. Analyst accounted for this tax cut benefit by revising company earnings higher as 2018 unfolded.

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Negative Equity Flows Reflective Of A Cautious Investor

A little less than a month ago I wrote a post noting weekly flows into equity mutual funds and ETF's had turned decidedly positive, and in fact were the largest inflows looking back an entire year. I rhetorically pondered if the increase in equity flows was a sign equity markets were topping, especially after such a strong start to the year. From a contrarian perspective, had investors jumped into equities near a market top, even if just an intermediate one? On the contrary, as the below chart panel shows, domestic equity flows have once again turned negative over the course of the last two weeks. If world equity flows are included, equity flows are negative for the last three weeks according to ICI data. Fixed inflows have been positive for thirteen consecutive weeks.

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Spring 2019 Investor Letter: Markets Rebound To Begin The Year

Stocks bounced back in the first quarter with the best quarterly start for the S&P 500 Index since 2009, up 13.5%, after a weak showing at the end of last year. We have said in the past that strength tends to beget more strength. LPL Research noted in a recent report that there have been ten other times since 1950 where the S&P 500 Index was up greater than 10% in the first quarter. In 9 out of 10 of those periods, the final three quarters were positive and in all 10 periods returns were positive for the year. The average gain in those final three quarters was 16.1%; however, the path was not straight and the average pullback was 11.7%.

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JOLTS Weakness, But A Month Is Not A Trend

The February Job Openings and Labor Turnover Survey showed a drop in openings of 538,000. Commentary on the February report used terms like plunged and disaster. Admittedly, the decline in openings should not be dismissed out of hand; however, it has not been an unusual occurrence for openings to fall as seen in the below chart.

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Tactical Asset Allocation Can Add Value To Portfolio Return

A potential downside for investors employing a strict longer term strategic investment allocation based on a specific benchmark or index is that the strategy fails to incorporate shorter term tactical changes. It certainly can go without saying but indexing strategies are popular ones for investors. In fact we utilize some index products in our investment approach with our clients. The downside for investors is many investment approaches may only utilize an index approach and construct an investment portfolio based on a longer term strategic asset allocation. In other words, a benchmark is selected and the client portfolio is allocated or invested in the same weightings that comprise that benchmark.

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Economic Expansions Don't Die Of Old Age

As the end of March neared, the 3-month Treasury interest rate surpassed the 10-year Treasury interest rate and this resulted in a 3-month/10-year inversion of the yield curve, the first since 2007. This inversion has unwound as the curve has started to steepen with a move higher in the 10-year yield. At HORAN we focus more on the 2-year rate versus 10-year rate and this portion of the curve has yet to invert. Investor focus on the yield curve is due to the fact when spreads between short- and long-term rates narrow it is an indication that economic growth will fall in the future.

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Stock Buyback Boom In 2018

Yesterday S&P Dow Jones Indices reported stock buyback activity for the S&P 500 Index as of the end of the fourth quarter 2018. Highlights from S&P DJI report:

• Q4 share repurchases increased 62.8% year-over-year to a record $223.0 billion

• Total 2018 buybacks set record $806.4 billion, up 55.3% year-over-year, and up 36.9% from the record $589.1 billion set in 2007

• Almost every S&P 500 constituent – 444 – repurchased shares in 2018, up from 424 in 2017

• Apple spent the most in 2018 buybacks at $74.2 billion

The level of buybacks provided a tailwind for earnings growth in the fourth quarter as well as the entire calendar year 2018. S&P DJI notes, "the percentage of companies that substantially reduced share counts of at least 4% year-over-year rose to 18.8% (90 total issues), up from the prior quarter’s 17.7% (88 total issues) and Q4 2017’s 15.1% (70 total issues.)" The four quarter buyback plus dividend yield equaled 6.0% in Q4 2018 and up from 4.75% in Q3 2018.

Lastly, S&P DJI listed the below five companies as having the largest total buybacks in the fourth quarter,

• Apple (AAPL) led in buybacks, spending $10.1 billion in Q4 2018, down from $19.4 billion spent for Q3 2018. Its Q4 2018 expenditure ranked 19th highest historically; for the year, Apple spent $74.2 billion on buybacks, up from 2017’s $34.4 billion; over the five-year period the company spent $229.0 billion, and $260.4 billion over the 10-year period.

• Oracle (ORCL): $10.0 billion for Q4 2018, down from $10.3 billion for Q3 2018; 2018 was $29.3 billion, up $4.0 billion in 2017.

• Wells Fargo (WFC): $7.3 billion for Q4 2018, slightly down from the $7.4 billion spent in Q3 2018; 2018 was $21.0 billion, up from $10.3 billion in 2017.

• Microsoft (MSFT): $6.4 billion for Q4 2018, up from $3.7 billion for Q3 2018; 2018 was $16.3 billion, up from $8.4 billion in 2017.

• Merck (MRK): $5.9 billion for Q4 2018, up from $1.0 billion for Q3 2018; 2018 was $9.1 billion, up from $4.0 billion in 2017.

Equity Inflows Now Turning More Positive As Equity Returns Near A Peak?

The Investment Company Institute releases fund flow and ETF net issuance data on Wednesday's with a one week lag. In Wednesday's report for the week ending March 13, 2019, ICI reports domestic equity inflows spiked to $12.8 billion. This represents the largest weekly inflow since March 20, 2018 when domestic equity inflows totaled $19.1 billion.

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