Economic And Company Data More Positive, But Headwinds Exist

One area of the economy in both the U.S. and abroad that has garnered heightened attention of late is the manufacturing sector. Based on business surveys it is clear trade and tariff issues are having a more significant impact on the manufacturing sector. As the below chart shows the Purchasing Managers Index for manufacturing has dipped below 50 in the Eurozone yet remains above 50 in the U.S. A reading below 50 indicates the manufacturing sector is contracting, but not necessarily a recessionary level reading. Recessionary readings generally are in the low 40's area. Although the U.S. manufacturing PMI is above 50, the sector has slowed since its mid 2018 level.

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Low Bullish Investor Sentiment And Equity Fund/ETF Outflows

In the most recent report on investor sentiment by the American Association of Individual Investors, individual investors continue to express a low level of bullish sentiment. As the sentiment indicators are contrarian ones, a low bullish sentiment reading is viewed as one positive for higher equity prices. No one indicator works in a vacuum, but it does seem the individual investor remains cautious on the current equity market. The sentiment readings tend to be volatile from week to week, as a result evaluating the 8-period moving average smooths this volatility. For the week, the 8-period moving average did tick slightly higher to 30.5% from the prior week but remains at a lower level.

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Buybacks Down In First Quarter 2019, But Remain Near A High

Late last month S&P Dow Jones Indices reported preliminary dividend and buyback results for the S&P 500 Index for first quarter of 2019. On a quarter over quarter basis dividends declined by $2.48 billion. This sequential decline in the first quarter versus the fourth quarter is not an uncommon occurrence. On a YoY basis dividends were up 7.46% and this was down from the fourth quarter YoY growth rate of 9.46%. Buybacks declined by $17.17 billion on a QoQ basis. As reported operating earnings were up significantly on a QoQ basis, +$48.32 billion or 19.9%, but only up 3.54% on a YoY basis.

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Summer 2019 Investor Letter: A Rate Cut Seems Near

The headwind created by the trade and tariff issues formed a heightened level of uncertainty facing the economy and the market; however, the stock market, yet again, scaled the proverbial “wall of worry” over the first six months of this year. The June total return for the Dow Jones Industrial Average of 7.3% was the best June monthly return since 1938. Further, for the first half of 2019, the S&P 500 Index recorded its best six-month total return in twenty-two years increasing 18.5%. As of July 2019, the U.S. economic expansion that followed the Great Recession becomes the longest on record at 121 months. The second longest expansion was from 1991 to 2001 with a length of 120 months. In our Summer 2019 Investor Letter we discuss how some of today’s policy decisions are beginning to rhyme with the 1991 to 2001 period. One of those policy decisions centers around a likely Fed Funds interest rate reduction by the Fed at the end of July. What may seem unusual is the fact an interest rate reduction seems likely at a time where the stock market is near an all-time high and the economy continues to expand. This is discussed in more detail in the Investor Letter.

Economic data is suggesting a slowing global environment, but a recession seems further out than near. Furthermore, it appears the Federal Reserve will reduce rates by 25 basis points at its July meeting, if for no other reason than to provide an “insurance cut” to push out a potential recession. More insight on our views for the balance of the year are covered in the Investor Letter accessible at the below link.

• Summer 2019 Investor Letter

Dividend Payers Return Lags The Return Of The Non Dividend Payers

S&P Dow Jones Indices recently reported the return for the dividend payers and non-dividend payers in the S&P 500 Index for the period ending June 28, 2019. Given the underperformance of the value style over the past several years then it is not surprising the dividend payers are underperforming the non-payers on an average return basis year to date and over the trailing twelve months. The dividend paying stocks tend to be more defensive and have a value tilt. 

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Earnings Growth Expected To Increase From Here

Second quarter earning season kicks into gear in the coming week and a lower bar seems set by a number of firms. Downward estimate revisions are occurring in twice the number as upward estimate revisions. As it stand now, second quarter earnings are estimated to be lower than the same quarter last year by 1.9%, yet I expect earnings growth in the quarter to be positive when the reporting season comes to a close.

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Investors Are Selling Equities: Not A Typical Behavior At Market Tops

After a brief summer vacation and now catching up on some market research, recent fund flow data caught my eye. In this week's ICI fund and ETF flow/issuance report, equity out flows totaled a sizable $28.8 billion. Of this amount $25.2 billion represents outflows from U.S. domestic funds and ETFs. This is the second week in a row that equity flows have been negative. On the receiving end, bond funds and ETFs had inflows of $10.4 billion for the six day period ending July 2 and inflows of $10.5 billion in the prior week. ICI data is reported with a weekly lag. More current Lipper flow data is showing equity outflows continuing for the week ending July 10. This flow data makes it difficult for me to believe the equity market has reached a top. That does not mean one will not see equity market pullbacks, but investors seem far from 'all-in' as they say.

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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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