Sectors

The Brexit vote has ended the reflation trade, but does not represent a "Lehman moment" either. Stick close to benchmark in terms of broad asset allocation, and watch European bank CDS for signs that another financial crisis is brewing.

The S&P media sector has been in a consolidation phase for over two years, in relative performance terms. That is consistent with cash flow trends, which flat-lined alongside a slump in sales growth and rising costs. However, we expect both relative performance and cash flow to turn higher. Sales growth has hooked back, because the industry has been able to introduce new services and raise selling prices by enough to drive up consumers' share of spending on media services (second panel). Pricing power has surged in both the cable and entertainment industry. If cash flow grows again, as we expect, then an increasing scarcity of media shares outstanding should ultimately act as an upward force on share prices as investors boost allocations to the space. We reiterate our recent moves to overweight in both the S&P cable & satellite and S&P movies & entertainment sub-components. The ticker symbols for the stocks in this index are: BLBG: S5MEDA - DIS, CMCSA, TWX, FOXA, CBS, OMC, VIAB, IPG, SNI, DISCA, NWSA, TGNA, DISCK, FOX, NWS.

The combination of biotech stabilization and a health care facilities plateau argues for profit taking in our long/short trade between the two groups. We had exploited the valuation mismatch because hospital profit prospects were far superior to those of the biotech group, especially within the context of a soaring U.S. dollar. Now that the primary upward thrust in the currency has played out, the revenue playing field will shift to a more neutral setting, on the margin. Indeed, while hospital spending is still growing much faster than pharmaceutical exports, a proxy for relative top-line trends, pricing power has not followed suit. Against a backdrop of soaring hospital wage bills, especially relative to pharmaceutical wages, we are closing this pair trade for a profit of 10%. The ticker symbols for the stocks in both indexes are: BLBG: S15HCFA - HCA, UHS, WOOF, AMSG, LPNT, THC, CYH, SCAI, SEM, KND, ENSG, USPH, QHC and BLBG: S5BIOT - AMGN, GILD, ABBV, CELG, BIIB, REGN, ALXN, VRTX.

Health care facilities equities may become the odd man out in the overall health care sector bull market. While we are not concerned that hospitals will see a drop off in activity levels, slowing revenue growth may constrain incremental valuation expansion. Hospital procedures are labor-intensive, underscoring that business models are not scalable. Hospitals have hired at the most aggressive pace in the entire history of the BLS data. Other costs are also inflating. Hospitals are one of the largest buying groups for pharmaceuticals, and the relentless advance in drug prices is profit margin sapping. The producer price indexes for physician services and medical equipment, while still low in absolute terms, are beginning to accelerate. These forces will limit earnings growth potential, especially given that they appear to have been strong enough to offset the benefit from falling bad debt expenses and low capital spending. If operating margins and ROE cannot expand in the current environment, both are unlikely to improve much if overall employment growth continues to cool, as we expect, causing a second derivative slowdown in bad debt recoveries and surgical procedures. Downshift to neutral. The ticker symbols for the stocks in this index are: BLBG: S15HCFA - HCA, UHS, WOOF, AMSG, LPNT, THC, CYH, SCAI, SEM, KND, ENSG, USPH, QHC.

A gap has opened between the Nasdaq and S&P biotech indices, suggesting broad-based selling has reached a stage where discrimination is occurring. The former is infused with concept stage companies with no revenue or earnings, while the latter comprises more mature, pharmaceutical-type firms. We are becoming more favorable toward the S&P biotech index. Using the tech bubble as a guide, on a relative price/sales basis, the S&P biotech group has deviated from fair value by more than the tech sector did after the turn of the century. With value fully restored and robust pharmaceutical industry fundamentals, buying interest should ensue. At least one potential threat to pricing power has been deferred, as the U.S. governments' drug pricing control measures have reportedly been delayed. Consequently, the risk premium associated with doubts about pricing power sustainability should lift. We recommended shifting from underweight to overweight in yesterday's Weekly. Please refer to that report for more details. The ticker symbols for the stocks in this index are: BLBG: S5BIOT - AMGN, GILD, ABBV, CELG, BIIB, REGN, ALXN, VRTX.

The health care sector is poised to resume its bull market, but the character of the rally will change. Sell hospitals and buy biotech.

The health care sector is slowly reclaiming ground lost on the back of the dip in the U.S. dollar and temporary rebound in inflation expectations (second panel). We expect this rebound to gather pace. Now that both the currency and inflation expectations are headed in a direction that suggests disinflation/deflation have not been overwhelmed by policy efforts and/or stronger global final demand, flows into the non-cyclical health care sector are likely to resume. Technically, the sector is improving. Participation is broadening following last year's wholesale flight out, as the number of groups trading above their 40-week moving average has climbed decisively above 50%. Our sector advance/decline (A/D) line, shown compared with our overall S&P 500 A/D line, is flirting with new cyclical highs. Strong breadth is essential to revitalizing the bull phase. Importantly, our Technical Indicator is rebounding, but remains in deeply oversold territory, underscoring that there is plenty of room for momentum to accelerate. Stick with a high conviction overweight. The ticker symbols for the stocks in this index are: BLBG: S5HLTH.

Transportation stocks are weak, reflecting profit warnings in both the trucking and rail industries. Air freight equities have been slightly more resilient, but the outlook for profits remains bearish. Global revenue ton miles are contracting, with weakness spread across all the major regions. High inventory-to-sales ratios in both developed and developing markets warn that demand for rapid delivery services will stay soft. The implication is that deflationary pricing power will persist, just as fuel costs have climbed anew. To make matters worse, FedEx stated that it was raising its capital spending outlook to better compete, continuing a trend of rising investment and growing capacity. Consequently, it will take a major resurgence in top-line growth to reverse deflationary tendencies and pressure on operating margins. Despite increasingly low valuations, we recommend staying underweight. The ticker symbols for the stocks in this index are: BLBG: S5AIRF - UPS, FDX, CHRW, EXPD.

The previous Insight showed that mortgage demand was rising steadily, courtesy of the decline in mortgage rates and willingness of banks to extend mortgage credit. We expect this to translate into steady sales increases for the homebuilding industry. New home sales are gaining as a share of total home sales, flirting with their highest level in the post-crisis era. Importantly, the supply of new homes is now falling relative to total supply, underscoring that meeting this new demand will require faster new home construction. Single family housing starts are rising relative to total starts, a significant change since the financial crisis ended when multifamily dwellings dominated construction activity, as commercial/financial developers were the only ones with easy access to financing. The upshot is that good value in the S&P homebuilding index should be realized. Stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5HOME - DHI, LEN, PHM.

The decline in global bond yields and negative interest rates abroad represents a windfall for U.S. housing, to the extent that U.S. mortgage rates are lower than they otherwise would be. The latest plunge in yields is translating into a clear acceleration in mortgage demand, as proxied by the advance in mortgage purchase applications. That is a leading indicator for home sales, the lifeblood of the homebuilding industry. Importantly, the financial incentive to buy a home is high and rising, given the attractiveness of owning vs. renting, and the growing gap between house price inflation and mortgage rates. It is no wonder that the latest National Homebuilder's Survey recorded a sharp jump in sales expectations, heralding faster top-line growth ahead. That should be sustainable, as discussed in the next Insight. The ticker symbols for the stocks in this index are: BLBG: S5HOME - DHI, LEN, PHM.