Sectors

In recent months we have outlined and acted on the bull case for media by upgrading both the S&P cable & satellite and S&P movies & entertainment indexes. This week we added another sub-component to the overweight column. The S&P advertising index has an opportunity to positively surprise in the coming quarters. Expectations are subdued, as measured by both long-term and cyclical relative forward earnings growth estimates, as well as elevated short interest (third panel). On this front, accelerating outlays on media services are a positive omen for marketing budgets, as well as advertising stocks, particularly if consumers begin to loosen their purse strings. Already, advertisers have enjoyed solid revenue growth, in contrast with the contraction in overall S&P 500 sales. As a result, ad rates have gone up, as proxied by the producer price indexes for radio, broadcasting and network TV (second panel). A demand-driven increase in pricing power should be viewed as sustainable, and has higher odds of translating into premium share price valuations given the positive impact on industry productivity (bottom panel). True, the leveling off in auto sales is a risk given the industry’s massive marketing budget, but there are offsets, including the boom in electronics spending, which has positive implications for content demand and potential digital media spending. Netting it out, the reward/risk tradeoff is favorable for an upshift to overweight. The ticker symbols for the stocks in this index are: BLBG: S5COND - OMC and IPG.

In order to harvest a tactical continuation of the high-risk, momentum-driven broad market advance, we have made a few tweaks to our portfolio, while maintaining a core non-cyclical emphasis given that the global growth outlook remains sketchy. This week, we added the cyclical interest rate-sensitive consumer discretionary sector to the fold after recently upgrading the S&P home improvement retail index back to overweight. Relative performance has dropped to a four year low, once heavyweight Amazon is excluded, but a recovery window has opened if the Fed stays lax while wage growth continues to firm and the U.S dollar regains strength. The consumer is the strongest engine in the U.S. economy, and is benefiting from lower oil prices and plunging mortgage rates. Our Consumer Drag Indicator (CDI), comprising mortgage rates and gasoline prices, has climbed significantly, heralding ongoing consumption resilience. Importantly, the CDI has a good track record in leading relative performance (second panel). Money growth is sending a similar message, particularly given a healthy clip in consumer lending growth (top panel). After deleveraging for several years, financial obligations are not onerous, even if interest rates rise modestly. Any upgrade in consumer confidence as a consequence of income growth could unleash pent up dry powder for consumption. As a result, we recommend buying into relative performance weakness and upgrading to overweight, including a boost to the advertising group, please see the next Insight. BLBG: S5COND.

The major banks are more willing to lend to the consumer and less willing to lend to the corporate sector.

Expectations of a prolonged period of abundant liquidity and rising confidence that recession is not imminent have created the conditions for a potential blow-off phase. This week we are fine-tuning our portfolio for peak performance.

The previous Insight showed that the capital markets group required a reversal in currently bearish relative forward earnings momentum in order to break out of its funk. Trading profits are volatile, and markets typically only reward the group with a higher multiple when capital formation is on the upswing. On this front, leading indicators remain grim. New stock issuance is in the dumps, and the global credit impulse is negative (second panel). Corporate balance sheet health has deteriorated, which is a leading signal for future M&A activity (third panel). Businesses are in retrenchment mode, and the corporate sector financing gap, defined as the amount companies are spending in excess of internally generated funds, has rolled over, underscoring that the need for external financing is diminishing. All of this cautions against expecting a sustained upturn in fee generation. Ergo, the relative performance bear market is likely to stay intact, despite the appearance of good value and recent better-than-expected earnings results. The ticker symbols for the stocks in this index are: BLBG: S5CAPM - GS, BLK, BK, MS, SCHW, STT, TROW, AMP, BEN, NTRS, IVZ, AMG, ETFC, LM.

Several large capital markets firms have produced better-than-expected profits in the latest quarter, driven largely by a flurry of fixed income trading following the Brexit vote, subsequently triggering a short covering rally in related shares. Is the bear market in capital markets stocks finally over? We doubt it. The top panel of the chart shows that relative stock price performance is tightly linked with relative forward earnings momentum. The latter is negative, and unlikely to receive a boost from higher trading profits, as this source of income is unreliable and lumpy, i.e. here today but gone tomorrow. Instead, a sustained upturn in capital formation is required to reverse the profit downtrend. However, that is unlikely when deflation remains the dominant force, the U.S. dollar is regaining strength and the yield curve is narrowing. Previous relative performance troughs have occurred within the context of rising inflation expectations and a steeper yield curve, both of which signal increased corporate sector capital requirements. At the moment, the latter are on the wane, please see the next Insight. The ticker symbols for the stocks in this index are: BLBG: S5CAPM - GS, BLK, BK, MS, SCHW, STT, TROW, AMP, BEN, NTRS, IVZ, AMG, ETFC, LM.

In successful investment analysis "less is more, and usually much more effective."

There has not been much of an improvement/recovery in the Chinese economy. Credit growth is weakening anew, which warrants a downbeat cyclical outlook for China's industrial sectors. Malaysia is heading into a classic credit/banking downturn. Go short Malaysian banks stocks and short the ringgit versus the U.S. dollar. In South Africa, take profits on the yield curve flattening trade. Continue shorting the rand versus the U.S. dollar.

The S&P health care sector's diagnosis is encouraging, as there has been improvement on a number of fronts. Recent profit reports signal that top line growth is recovering smartly at a time when industry selling prices remain resilient. Bellwether JNJ's robust guidance may foretell of a broader trend for the sector. Thus, the valuation discount weighing on this laggard defensive sector is no longer warranted and this earnings season may serve as a catalyst for a re-rating in historically depressed relative valuations (bottom panel). Importantly, the brightening profit backdrop is signaling that industry dividend growth will remain sold, in marked contrast with that of the broad market (second panel). Persistent dividend growth will be increasingly appealing in a world where investors are starved for sources of stable income. Meanwhile, generationally low fixed income yields are sustaining the appeal of share buybacks and the sector's share count will continue to drift lower. That should underpin both EPS and relative performance (third panel). Bottom Line: We are reiterating our high-conviction overweight stance in the S&P health care sector. BLBG: S5HLTH

With Treasury yields backing up from extremely depressed levels, many clients are asking if an overweight allocation to the REIT space remains appropriate. While a sharp spike in yields would clearly be problematic in the short run, we have shown that REITs have often outperformed during periods of strong economic growth and Fed tightening cycles. The key is for REITs to generate above-market cash flow. At the moment, our composite REIT rental rate inflation is running comfortably above overall inflation, led by the CPI for homeowner's equivalent rent (top panel). New supply has been coming on stream for years, but so far has been absorbed with little adverse pricing power impact. Vacancy rates are still historically low. Consequently, operating performance should stay robust. Importantly, relative valuations are not overly demanding, and technical conditions are not overbought, and there have been no negative momentum divergences. We continue to recommend an overweight stance. BLBG: S5REITS