Investors May Want to Look At Sectors That Worked In The 1980's

Subsequent to the election last month I published a post suggesting the equity market going forward was beginning to resemble the bull market of the 1950's and 1980's, A decade is a long time and market leadership will rotate in and out of sectors based on the business cycle. In that earlier post I noted the 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.

The chart below shows the sector return for the period following the early 1980's recession through 1989. For the entire time period, staples, health care and utilities outperformed with technology being the laggard. I include the Fed Funds target rate for reference since the current Fed is likley of the mind to continue its monetary tightening.

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Emerging Markets, The Dollar and Interest Rates

This morning I published a few tweets and charts on our Twitter site reviewing emerging market equity performance and the impact US Dollar strength has on emerging market equity performance. Additionally, interest rates influence US Dollar movement and rising interest rates tend to result in a stronger Dollar, all else being equal. Below are those tweets.

Ones view on the direction of the US Dollar critical to emerging market performance. pic.twitter.com/HlPPlJq4D4

— HORANCapitalAdvisors (@HORANCapitalAdv) December 10, 2016

@HORANCapitalAdv At least another year to run on US Dollar strength? pic.twitter.com/tiq4mlIaiH

— HORANCapitalAdvisors (@HORANCapitalAdv) December 10, 2016

@HORANCapitalAdv And higher interest rates lead to stronger US Dollar. pic.twitter.com/PDKZPAuF0m

— HORANCapitalAdvisors (@HORANCapitalAdv) December 10, 2016

@HORANCapitalAdv End of bond bull market? Interest rate curve steepening. Where to invest then? Equity market seems to be saying US stocks. pic.twitter.com/d3IA9cm503

— HORANCapitalAdvisors (@HORANCapitalAdv) December 10, 2016

@HORANCapitalAdv but we are long $HEDJ. Contrarian play? Chart courtesy of @InvstSideKick pic.twitter.com/2hgb8xD5NX

— HORANCapitalAdvisors (@HORANCapitalAdv) December 10, 2016

I frequently provide market relevant tweets throughout the week so feel free to follow our firm on Twitter @HORANCapitalAdv. At the same time, readers may want to follow our broader firm, HORAN on twitter as well @HORAN1948. For over 65 years HORAN has created plans to control health care costs, protect your wealth and insure your life. But the end game for all that we do at HORAN is more than a set of plans. We believe good health and true wealth create a better quality of life for our clients and their families.

Dow Dogs: The Pursuit Of Yield Coming To An End

With the passing of the election last month, expectations in place before the election seem to have been turned on its head. Dire forecast were anticipated if Trump were to somehow pull out a win. Fast forward to a month past election day and current market sentiment is far from what most expected and the equity market is reflecting this in its performance with the S&P 500 Index up 8.4% from the 11/4/2016 Friday close. The positive equity market performance is showing up in sentiment measures as well. Today's release of the University of Michigan's Consumer Sentiment Survey also reflected an improvement in sentiment. Econoday noted,

"Post-election confidence continues to build, lifting consumer sentiment by more than 4 points to a 98.0 level that hits the very outside of the Econoday range and is 1 tenth away from the index's recovery peak hit last year. Consumers specifically cite expectations of new economic policies as the biggest positive."

From a market perspective investors appear to be rotating out of the more defensive and income producing stocks (and bonds) into stocks that will participate in an environment of faster economic growth. Top performing sectors in the S&P 500 Index since the election are, financials (+21.9%), industrials (+13.3%), energy (+13.0%) with the laggards being utilities (0%), staples (+.8%) and REITs (+3.4%). 

This rotation out of the defensive equities is showing up in the lagging performance of the Dow Dogs. 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 Index 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. As can be seen in the below table, the average return of the Dow Dogs over the last month equals 1.9% versus 4.7% for the SPDR S&P 500 ETF and 6.6% for the S&P Dow Jones Industrials Index itself.

File (xls)

Whether or not we do or do not view favorably the outcome of the election, as investment managers, we continue to position our clients in sectors and market segments that might outperform under a Trump administration. This led to our positioning of client portfolios into stocks and sectors that might outperform under a faster economic growth environment.

Small Cap Stocks No Longer Cheap Relative To Large Caps

Subsequent to the election, the equity 'risk on' trade has been most evident in small company stocks with the S&P 600 Small Cap Index returning 13.0% since 11/4 versus a return of 5.4% for the S&P 500 Index.

In fact, small cap stocks have been outperforming large caps since the market pullback in February of this year. Benefiting the return of small cap stocks is the fact, based on their respective P/Es, they were cheaper than large caps on a relative basis as can be seen in the below chart. However, this spike in return over the last four weeks has put the relative valuation of small caps below the average relative value going back to 2004.

Given small caps burst of outperformance over the last four weeks, a period of near term underperformance would not be surprising and would actually be healthy. One factor likely at play though is the anticipation that small cap earnings will begin to accelerate as occurring in the large cap space. The third quarter will market the end of the earnings recession with S&P 500 Q3 2016 earnings expected to be up 4.2% versus Q3 2015. Looking ahead, Thomson Reuters I/B/E/S is estimating earnings growth rates for the S&P 500 Index for Q4 2016 through Q3 2017 at 6.2%, 14.0%, 11.9%, and 9.8% respectively. This improvement in the earnings picture may serve as a floor against an extended equity market pullback.

Will The FANGs Lag During A Period Of Faster Economic Growth?

In the lead up to and after the November election a significant change in stock leadership has been underway. The better performing sectors are those that will benefit from faster economic growth and a steeper yield curve (like the banks.) Seemingly left behind, or at least underperforming, are the technology stocks as can be seen in the below sector performance chart.

One area of technology that generated out sized returns in 2015 was related to internet and social media companies. The favored group of stocks called the FANGs (Facebook (FB), Amazon.com (AMZN), Netflix (NFLX) and Google/Alphabet (GOOGL) were a beneficiary. The below chart shows the significance of the 2015 FANG returns.

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Black Friday For E-Commerce

E-commerce retailers are likely to continue their dominance and be the primary beneficiaries on Black Friday. As the below chart shows, e-commerce sales continue to garner a larger percentage of overall retail sales with traditional brick and mortar retailers stuck in a no growth environment. Further detail on third quarter e-commerce sales can be reviewed in the U.S. Census Bureau's recent e-commerce sales report.

Individual Investor Sentiment May Be Too Bullish

The American Association of Individual Investors released their Sentiment Survey today and bullish sentiment is reported at 49.9%. This is slightly above the +1 standard deviation level of 48.4%. As can be seen in the below chart, the bullish sentiment level has spiked higher subsequent to the U.S. presidential election from a few weeks ago. Although not shown on the chart, the bull/bear spread widened to +20.1 and is the widest level since November of last year.

Data Source: AAII

Individual investor sentiment measures are contrarian ones and at their extremes frequently coincide with market reversals or pullbacks. Given the strength of the market averages since the election, an equity market pullback or consolidation would not be surprising and actually healthy for a next move higher.

An Equity Market Finding Little Upside Resistance

Today the Dow Jones Industrial Average Index closed at another record high of 19,083.18, crossing another 1,000 point interval on Tuesday. It has taken nearly two years for the index to breach this 1,000 point interval after breaking 18,000 in December 2014. The market advance following the election is beginning to sound like a broken record as commentators announce the market's close at a "new all time high" at the end of each trading day.

Emotionally, it feels as though the market is due for a pullback, and for investors in cash, a pullback is being hoped for. A pullback will come just as night follows day; however, the market being a weighing machine as it is, a better investment environment continues to get more priced in based on potential policy changes in Washington.

Turning to the broader S&P 500 Index, the S&P is up 5.6% since the beginning of election week and up 20.4% since the February 11 taper tantrum low. Setting emotions aside and looking at the market technicals, the money flow index and the stochastic indicator appear to indicate the market is near overbought.

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Equity Market Beginning To Resemble Bull Market Of The 1950's And 1980's

In the early days following the presidential election, the equity market seems to be anticipating better economic growth in the years ahead. Knowing the economy is not the market though, investors believe a better economy will translate into stronger corporate profits as well. When the new administration takes office in 2017, Trump's campaign comments indicate the economy is in need of more government spending, specifically on infrastructure and the military. Additionally, a Trump administration has promised tax reform, and specifically tax cuts.

History does not necessarily repeat itself perfectly; however, it does tend to rhyme. The below chart overlays the S&P 500 Index from September, 2013 compared to the bull markets of the 1950's and 1980's. Trump's anticipated policies do have similarities to policies pursued in the 1950's and 1980's and those two decades were periods of a strong bull market.

h/t: Fidelity Investments

The decade of the 1950's followed World War II and pent up demand saw 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. A Trump administration is indicating a stimulus program would focus on infrastructure and the military.

The decade of the 1980's was know as the Reagan Revolution. A focus of President Reagan's policies was reducing the tax burden on Americans, lowering government regulation and shrinking government itself. During Reagan's years in office, he cut the top tax rate from 70% to 28%. President Elect Donald Trump also projects to implement similar policies as Reagan, i.e., reduce regulation, shrink the government and lower taxes.

The 1950's and 1980's were good decades for equity investors. President Elect Donald Trump is projecting he will pursue policies that look similar to those implemented by presidential administrations of the 50's and 80's. If Trump's policies have a similar impact as those in the 50's and 80's, the coming years could be rewarding for equity investors.

Powerful Sector Rotation May Need A Breather

The market action following last week's election has seen powerful rotation among stock market sectors and industries. In my last post I highlighted this movement along with stocks and industries that are benefiting from this rotation and industries that are not benefiting. I noted a potential caution due to the fact the targeted sectors seems to be a consensus trade by investors and the moves may be occurring too quickly. One area benefiting from the rotation is the financial sector at the expense of the technology sector as seen in the below chart.

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Investors Adjusting Investments As A Result Of The Election Outcome

This post is more of a chartfest to feature information I ran across over the weekend from various sources but related to investment topics relevant to potential policy changes under a President-Elect Trump administration. Investors know the equity market reacted favorably to the election outcome last week; however, some market segments did far better than others. Although the night is long, the futures market tonight is indicating a positive open for Monday. The Dow and S&P futures are higher by about .40% to .50% (this is 95 points on the Dow.)

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Toss Aside Your Political Leanings, The Equity Market Is

Tossing aside ones political leanings, the stock and bond market are telegraphing positive results from a Trump presidency as it relates to the economy. I briefly touched on the bond market in yesterday's post and below is another chart of the 10-year Treasury yield-the yield continues to move higher.

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The Market The Day After The Election: Emotion Versus Fundamentals

In Monday's post I highlighted the importance of separating ones politics from their portfolio. The market's reaction to yesterday's election outcome is a perfect example why this is important. As election results trickled in last night and it became apparent Donald Trump would be the 45th President of the United States, equity futures sold off sharply. The day after election sell offs are not unique. The market sold off 2.4% after the 2012 election and sold off 5.3% after the 2008 election.

The Dow futures were down over 860 points at one point early this morning. In spite of this initial negative reaction, today the Dow Jones Industrial Average closed up 256 points at 18,589 after reaching an intraday all time high of 18,650. At the end of the day, stocks will trade on fundamentals and whether or not one is a Trump supporter, his policy proposals could be very bullish for the economy and stocks. Today's market action is a reflection of this potential positive. Additionally, stock prices follow earnings and it looks highly likely third quarter S&P 500 earnings growth will be positive for the first time since Q1 2015. Q3 2016 earnings growth is tracking to be up 3.9% and 7.5% ex-energy.

The bond market sold off rather sharply in a potential sign investors anticipate a faster pace of economic growth. The 10-year Treasury yield closed at 2.07% and is the highest yield since reaching 2.1% in January of this year.

The market will certainly not move higher in a straight line. Also, the Fed rate decision in December may also create some equity market volatility. However, the election outcome in and of itself may not be bad for the economy and thus could be good for stocks. Separating emotion from fundamentals remains an important characteristic for investors.

Election Day Is Finally Upon Us

In one day the S&P 500 Index recovered six of the nine days of losses incurred over the last two weeks. Today the S&P 500 Index recovered 46.34 points or 2.22% versus the 66.15 point loss (-3.07%) incurred from 10/25 through 11/4. Today's rally did not occur on exceptionally high volume, but the stochastic indicator has turned positive.

Charles Kirk of The Kirk Report made a couple of observations in his strategy note over the weekend.

• Separate your politics from your portfolio as the combination of the two frequently proves unproductive and unprofitable.

• If the market continues to decline after the election, it would do something we haven't seen in some time – namely that those selling into weakness have made the correct decision to do so. This market has consistently punished selling into weakness like we've seen of late so, if the market punishes those who haven't hedged, raised cash, and position more defensively, it would be the first sign that a top has been made for the market.

• Kirk states, "My personal view is that the market will rally significantly no matter who wins the election. The way I think it will continue to go consistently down is in a contested type situation (like a Gore/Bush) which would continue this period of tremendous angst and uncertainty for markets worldwide. I could be wrong as I am often about such matters, but that’s my two cents worth"

Tomorrow is the election and recent market activity is suggesting continued volatility. LPL Research publish a post, What Happens Historically After Elections?, that is a worthwhile read for investors as election day is finally upon us.

Defensive Market Sectors Not So Defensive During Equity Market Pullback

With today's market close the S&P 500 Index has been down for nine consecutive trading days. The index is down 4.2% from the August 15 high, but remains up 4.1% year to date. However, during the pullback from the August high, most of the traditionally defensive sectors have been the worst performing ones. As can been seen in the below bar chart, REITs are down 11.1%, health care is down 10.9%, telecoms down 10.8% and consumer staples are down 5.5%.

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Investors Positioning For The Worst In U.S. Election Outcome

In five days the U.S. election will be behind us, absent a contested outcome. Through yesterday's close, the S&P 500 Index has been down seven consecutive days putting the Index down 4.2% from its August 15 close. This weakness in the markets is now showing up in technical indicators like the CBOE Equity Put/Call ratio. At the close Wednesday, the equity put/call ratio was reported at .99 which is an indication of extreme equity market bearishness from which rallies tend to occur.

Other technical market indicators are also indicating a market that is oversold or at least near oversold. As can be seen in the below market chart, the stochastic and money flow indicators are at levels that have coincided with an oversold market.

And lastly, the percentage of S&P 500 stocks trading above their 50 day moving average stands at 27%.

In summary, investors seem to be positioned for a market that reacts negatively to the election outcome. As the second chart above shows, the market's reaction to the BREXIT vote was certainly negative; however, the sharp decline was fully recovered within a week of the BREXIT results. And from a fundamental perspective, the earnings recession seems to be coming to an end with third quarter earnings now tracking to be up 2.9% with 76% of S&P 500 companies already having reported results. With company fundamentals/earnings turning more favorable and equity shocks like investors are anticipating with the election outcome, the current pullback is more likely to be only temporary as we noted in our BREXIT commentary in June.

Bonds And Bond-Like Equities Adjusting To Higher Interest Rate Environment

The Federal Reserve meets during the first week of November to decide whether or not to increase interest rates. The probability of a rate hike in November stands at only 8.8% while increasing to 63.3% at the December meeting. With the elevated likelihood of an interest rate hike before year end, income focused investments, both fixed income and bond like equities, are adjusting to this potential outcome.

As can be seen in the above chart, over the last three months, the yield on the 10-year Treasury has increased over 30 basis points while a few selected income focused ETFs are down five percent or more, with REITs (IYR) down 10%.

The same return outcome is occurring with some fixed income investments. As the below chart also shows, bond investments are adjusting to a potentially higher interest rate environment as well. Longer term bonds, as represented by the iShares 20+ Year Treasury ETF (TLT), have fared worse than bonds of a shorter maturity and is down over 7%.

A Fed rate increase before year end is not a certainty; however, with market rates adjusting to a higher level, bond like equities and longer term bonds remain under pressure.

U.S. Government Has A Spending Problem

As of the end of the second quarter the U.S. government's budget deficit is once again widening and stands at $664 billion compared to $543 billion at the end of 2015. As can be seen in the below chart, government outlays as a percentage of GDP equals 22.4% and above the long run average of 20.3%. Additionally, government revenue as a percentage of GDP equals 18.8% versus the long run average of 17.7%. The gap is real but the percentages are elevated due to the continued weak growth of the economy in this recent expansion and hence the below trend GDP level.

In absolute dollar terms, the deficit has widened in spite of record tax receipts/revenue collected by the government. The below chart shows revenue is up 30% since just before the the start of the last recession. Government receipts have increased from $2.669 trillion to $3.472 trillion. At the same time, government expenses have increased at a far faster pace, up 39% over the same time period to $4.137 trillion from $2.979 trillion.

A significant issue with government expenditures is the high level of non-discretionary items. Additionally, net interest expense stands at $248 billion, 6% of the budget. If the recent move in interest rates is any indication of future interest expense on the government's debt, the budget deficit will likely continue to widen without implementation of policies that are pro-economic growth. Since July 6, the yield on the 10-year Treasury has increased 53 basis points from 1.32% to 1.85%. As new debt is issued to fund the deficit, these higher interest rates will be problematic for the government's budget.

Aside from interest on the government debt, explosive growth in entitlement spending will need to be addressed in order to bring discipline to the government's budget as well. Rhetoric that the middle class will not be impacted by tax hikes is just that, rhetoric. It was recently announced that wages subject to the social security tax will increase from $118,500 this year to $127,200 in 2017, a 7.3% increase and thus directly impacting the middle class tax payer. There are no easy solutions to addressing the government's budget deficit, but addressing this sooner versus later can ease any potential pain.

Fall 2016 Investor Letter: Time In The Market

In our recent published Fall 2016 Investor Letter, our commentary covers recent market related events, U.S. earnings, interest rates and the pending election. Emotions tend to run high during these times creating an environment that can drive investors to reduce their stock market exposure. The newsletter discusses the consequences these decisions can have on long-term returns. 

In our Summer 2016 Investor Letter, we highlighted our positive view on U.S. equities, supported by an anticipated resumption in earnings growth for the second half of 2016 and into 2017. Although analysts expect companies in the S&P 500 Index to report a slight drop in quarterly earnings for the third quarter, we believe reported earnings will turn positive in the quarter and discuss this in the Investor Letter.

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

• Fall 2016 Investor Letter

Slow Economic Growth Has Led To Weak Job Growth

One factor that has turned into 'normal' for this economic recovery is its slow rate of growth. Out of the eleven recoveries since 1949, the current one is the slowest, barely averaging above 2%.

Source: The Wall Street Journal

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