Consumer Discretionary

Overweight While housing-related data releases have been slightly weaker than anticipated lately, we deem that this softness is transitory as housing market fundamentals rest on solid foundations. True, affordability has taken a hit both as a result of rising home price inflation and mortgage rates but as long as job certainty remains intact and wage growth picks up steam as we expect, we doubt that the U.S. housing market will suffer a relapse. In that light, we recommend augmenting exposure to overweight in the S&P homebuilding index. While galloping lumber prices were previously a key reason for putting the S&P homebuilding index on our high-conviction underweight list, the recent liquidation, down $300/thousand board feet since the mid-May peak, in lumber prices represents a massive input cost relief for homebuilders (second panel). In addition, the latest Fed Senior Loan Officer survey showed that demand for residential real estate loans ticked higher, while simultaneously bankers remain willing extenders of mortgage credit. The implication is that new home sales will likely reaccelerate in the coming months (third & bottom panels). Bottom Line: A playable opportunity has surfaced to ride the S&P homebuilding index higher. Lift exposure to overweight and see Monday's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5HOME - DHI, LEN, PHM.

Highlights Portfolio Strategy The firming long-term housing demand backdrop, lumber price cost relief, steady new home prices and favorable new home sales expectations, all signal that it is time to buy homebuilders. On the flip side, we do not want to overstay our welcome in the S&P home improvement retail index as a number of leading industry profit indicators have started to wave a yellow flag. Recent Changes Boost the S&P Homebuilding index to overweight today. Trim the S&P Home Improvement Retail index to neutral and lock in gains of 13.3% today. Table 1 Feature Another week, another SPX all-time high. Investors have refocused their attention on the important macro drivers: solid profits, easing fiscal policy, and still-benign monetary policy with the real fed funds rate barely probing 0%. Trade-related rhetoric has taken the back seat as it has now become obvious that the rest of the world will bear the brunt of President Trump's trade escalation. Our EPS growth models are sniffing this out, with the SPX ticking higher, while our global profit model sinking close to nil (Chart 1). Chart 1Ex-U.S. EPS Will Bear The Brunt Of Trade Wars Importantly, we are impressed by how thick-skinned the market has become to negative trade-related news. Putting the looming Chinese tariffs into proper perspective is instructive. Assuming a 25% tariff rate on $250bn worth of Chinese manufactured goods and no relief from the renminbi's steep depreciation since April, results in a "tax" of $63bn. The net new "tax" is actually $53bn as an average 3.8%1 import tariff rate already exists on manufactured goods. The consumer and corporations will bear the brunt of this "tax", so it is worth examining the data on household net worth, consumer incomes, and corporate sales. Federal Reserve data show that household net worth increased by $8.1tn in the past year. BEA data reveal that total wage & salary disbursements increased by $400bn, and BCA's projections call for $600bn increase in SPX sales for 2019 (using IBES data for calendar 2019, Chart 2). In other words, it becomes clear that $53bn in a new tariff "tax" will barely eat into net worth, consumer incomes or corporate revenue flows. In addition, according to the IMF, fiscal easing in 2019 will surpass even this year's fiscal expansion in the U.S. The upshot is that over 1% of GDP in fiscal thrust in 2019 thwarts the specter of tariffs, before the fiscal impulse turns negative starting in 2020 (bottom panel, Chart 2). Meanwhile, following up from last week's report when we posited that the current macro backdrop resembles more the mid-2000s than the late-1990s, we are challenging ourselves and asking what if we are wrong in our assessment. Could we actually be replaying a late-1990s episode instead? Revisiting the late-1990s in more detail is in order, refreshing our memory on the sequence of events that led to the climactic LTCM bailout, and highlighting potential signposts that can be helpful in navigating today's macro and equity market maps. In March 1997 the Fed raised rates and pushed the fed funds rate to 5.5%. In hindsight that was a mistake as the Fed then paused the tightening cycle and watched as the Thai baht began to tumble in late-June 1997, eventually gripping all of the emerging world. True, the U.S. stock market modestly pulled back in October 1997 and the VIX spiked to 38. Then, as equities recovered in Q1/1998 and jumped to fresh all-time highs, suddenly the yield curve inverted in May 1998. Undeterred, the S&P 500 hit another peak in July of 1998 before falling roughly 20% in the subsequent month. Finally, once Russia defaulted and the Fed had to bail out the banks due to the LTCM fiasco, the FOMC, late in the game in September 1998, started to ease monetary policy, and engineered a steepening of the yield curve (Chart 3). Chart 2Trade "Tax" A Drop In The Bucket Chart 3Sequence Of Macro Events Matters The most important signpost from this trip down memory lane is the yield curve. In other words, heed the signal from the bond market: the yield curve inversion correctly predicted a reversal of Fed policy and naturally led the temporary peak in the stock market. Importantly, despite the peak-to-trough near-20% decline in the SPX between July and late-August 1998, if someone had bought the index on Jan 2, 1998 and held through the cathartic LTCM bailout, they remained in the black (bottom panel, Chart 3), and a buy the dip strategy was a winning one. As a last reminder, the SPX jumped another 65% from the August 1998 trough until the March 2000 peak that was preceded, once again, by another yield curve inversion. At the current juncture, were the yield curve to invert we would become overly cautious on the broad equity market as we highlighted in late-June2, and would begin to transition the portfolio away from cyclicals and toward defensives. But, we are not there yet. Thus, we sustain our sanguine broad equity market outlook on a 9-12 month horizon and our SPX target remains 10% higher with EPS doing all the heavy lifting as the multiple moves sideways (for more details, please refer to our April 30th, 2018 Weekly Report titled "Lifting SPX Target"). This week we are taking a deeper dive in housing and housing-related equities and making a subsurface portfolio shift. Look Through The Housing Soft Patch, And... While housing-related data releases have been slightly weaker than anticipated lately, we deem that this softness is transitory as housing market fundamentals rest on solid foundations. On the demand side, first-time home buyers still make only a third of total home sales and the homeownership rate is near generational lows, underscoring that pent up housing demand exists. In fact, the percentage of 18-34 year-olds that live with their parents remains close to 32% a multi-decade high and also represents another source of housing demand that has been dormant because of the Great Recession (Chart 4). Importantly, household formation is still running at a higher clip than housing starts and permits, signaling that the risk of a significant supply/demand imbalance is rising. Historically, this gets resolved via higher prices. Further on the supply side, inventories of existing and new homes for sale remain low and point toward a tight residential housing market (Chart 5). The 98.5% homeowner occupancy rate corroborates the apparent residential real estate market tightness. Chart 4Homeownership Still Well Within Reach Chart 5Positive Housing Demand/Supply Dynamics True, affordability has taken a hit both as a result of rising home price inflation and mortgage rates. But, putting affordability in historical context reveals that homeownership is still well within reach. Were we to exclude that aberration of the post 2007 surge in affordability owing to the collapse in house prices and all-time lows in mortgage rates, affordability is higher than the 1992-2007 range and only lower than the early 1970s. The reason is largely because of still generationally-low interest rates (Chart 5). While a rising interest rate backdrop and sustained house price inflation will continue to dent affordability, as long as job certainty remains intact and wage growth picks up steam as we expect (please see Chart 4 from last week's publication), we doubt that the U.S. housing market will suffer a relapse. ...Boost Homebuilders To Overweight, But... In that light, we recommend augmenting exposure to overweight in the S&P homebuilding index. With the labor market at full employment and unemployment insurance claims on the verge of breaking below the 200K mark, housing starts should regain their footing (Chart 6) and propel homebuilding profits. In addition, the latest Fed Senior Loan Officer survey showed that demand for residential real estate loans ticked higher, while simultaneously bankers remain willing extenders of mortgage credit. The implication is that new home sales will likely reaccelerate in the coming months (third & bottom panels, Chart 7). Chart 6Homebuilders Rest On Solid Foundations Chart 7Lumber Input Cost Relief While galloping lumber prices were previously a key reason for putting the S&P homebuilding index on our high-conviction underweight list, the recent liquidation, down $300/thousand board feet since the mid-May peak, in lumber prices represents a massive input cost relief for homebuilders (second panel, Chart 7). With regard to the relative pricing power front, previous price concessions (new home prices compared with existing home prices) are paying off as new home sales are steadily gaining a larger slice of the overall home sales pie (second & third panels, Chart 8). As input cost relief is slated to kick in during the next few months, especially on the framing lumber front, at a time when new home prices have stabilized, homebuilding sales and profits will likely overwhelm (bottom panel, Chart 8). While the latest NAHB/Wells Fargo National Home Market survey showed some softness on the overall housing market index (HMI), keep in mind that both the HMI and the sales expectations subcomponents of the survey are squarely above the 50 boom/bust line and only slightly below the recent cyclical highs (top and second panels, Chart 9). This healthy housing backdrop is also evident in plentiful construction job openings and expanding national house prices (third & bottom panels, Chart 9). Nevertheless, there are two risks to our upbeat S&P homebuilding view. First, interest rates. At the margin, rising mortgage rates can be a source of deficient housing demand especially for first-time home buyers. However, as mentioned earlier, interest rates are generationally low (middle panel, Chart 10) and the job market remains vibrant which should continue to entice first-time home buyers to make one of the largest purchase decisions of their lifetime. Chart 8Price Hikes Should Stick Chart 9Big Gaps Set To Narrow Chart 10Two Risks: Interest Rates & Wages Second, industry wage inflation. Construction sector wages are climbing rapidly, as much as 150bps faster than overall average hourly earnings (bottom panel, Chart 10). This is another key input cost for homebuilders that could eat into profit margins, especially if new home price inflation does not stick. In sum, a firming long-term housing demand backdrop, lumber price cost relief, steady new home prices and favorable leading indicators of new home sales will more than offset rising interest rates and industry wage inflation. Bottom Line: A playable opportunity has surfaced to ride the S&P homebuilding index higher. Lift exposure to overweight. The ticker symbols for the stocks in this index are: BLBG: S5HOME - DHI, LEN, PHM. ...Don't Over Stay Your Welcome In Home Improvement Retailers Nevertheless, we do not want to overstay our welcome on the other residential real estate-levered consumer discretionary subgroup, the S&P home improvement retail (HIR) index. We recommend a downgrade to a benchmark allocation for a relative gain of 13.3% since the July 5, 2016 inception. Such a move does not reflect a worsening overall housing view; as we made clear in our analysis above, we remain housing market bulls. Instead, we are concerned that too much euphoria is already priced in HIR equities. Chart 11 shows that fixed residential investment as a percentage of GDP is up 50% from trough to the recent peak (similar to the advance in existing home sales), whereas relative HIR performance is up 170% in the same time frame. Our worry is that optimistic sell side analysts' relative profit forecasts will be hard to attain, let alone surpass (bottom panel, Chart 11). Three main reasons are behind our softening EPS backdrop for home improvement retailers. First, our HIR model has plunged on the back of the wholesale liquidation in lumber prices and rising interest rates (Chart 12). Lumber deflation in particular will prove a profit headwind as building supply Big Box retailers make a set margin on wood products. Chart 11Too Much Euphoria Chart 12Timberrrr! Second, household appliance and furniture & durable selling prices have tentatively crested, and represent another source of profit headaches for HIR (bottom panel, Chart 13). Finally, select industry operating metrics suggest that the easy profits are behind HIR. Not only is our productivity growth proxy (sales per employee) on the verge of deflating, but also an inventory surge has sunk the HIR sales-to-inventories ratio into the contraction zone (second & third panels, Chart 13). But there are still some pockets of strength in the home improvement retailing industry that prevent us from turning outright bearish on the S&P HIR index. Despite the aforementioned easing in appliance and furniture wholesale prices, our HIR implicit price deflator has spiked on a short-term rate of change basis, likely owing to firm demand for remodeling activity. Indeed, the latest NAHB remodeling survey remains perched near record highs. The implication is that the recent lull in industry sales growth may reverse (middle and bottom panels, Chart 14). Importantly, a large driver of the previous cycle's remodeling activity was the availability of HELOCs and the stratospheric rise in Mortgage Equity Withdrawal (popularized by Fed economist Dr. James Kennedy). Now that home equity has nearly doubled to near 60% from the depths of the GFC, there are rising odds that homeowners may begin to tap their rebuilt equity and embark upon more renovations (top & middle panels, Chart 15). Tack on rising disposable incomes (bottom panel, Chart 15) and a buoyant labor market and the outlook for remodeling activity brightens further. Chart 13Operational Trouble Brewing... Chart 14...But Offsets... Chart 15...Exist Netting it out, is it prudent to lock in gains in the S&P HIR index as profit drivers have downshifted at the margin. Bottom Line: Crystalize gains of 13.3% in the S&P HIR index since inception, and downgrade exposure to neutral. The ticker symbols for the stocks in this index are: BLBG: S5HOMI - HD, LOW. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Source: The World Bank, https://data.worldbank.org/indicator/TM.TAX.MANF.SM.FN.ZS?locations=US&name_desc=true 2 Please see BCA U.S. Equity Strategy Weekly Report, "Has The Reward/Risk Tradeoff Changed?" dated June 25, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

The opposing sides of our market- and industry-neutral trade going long the S&P homebuilding index/short the S&P REITs index1 have both been on the receiving end of negative data in the last month. With respect to homebuilders, housing permits, a leading indicator of future starts, fell well short of expectations this week and took the S&P homebuilding index down with it. Meanwhile rising UST yields have been weighing heavily on REIT stocks. The end result is that our trade has given up its early gains. The macro environment tells us that it is too early to throw in the towel on this trade. We continue to believe prices in the residential real estate sector have the upper hand over their commercial real estate (CRE) peers. Existing home inventories have tightened and remain at historically low levels, which should support pricing. On the flip side, our CRE occupancy rate composite is still contracting, warning that already-slowing pricing has further to fall. The divergence in pricing should support homebuilders' returns at the expense of REITs. Bottom Line: We reiterate our long S&P homebuilding/short S&P REITs pair trade. The ticker symbols for the stocks in the S&P homebuilding and S&P REITs indexes are: BLBG: S5HOME - LEN, PHM, DHI and BLBG: S5REITS - IRM, MAA, AMT, BXP, PLD, ESS, CCI, PSA, O, VTR, VNO, WY, EQIX, DLR, EXR, DRE, FRT, WELL, SBAC, HCP, GGP, KIM, EQR, UDR, REG, MAC, HST, SPG, AVB, AIV, SLG, ARE, respectively. 1 Please see BCA U.S. Equity Strategy Special Report, "UnReal Estate Opportunity," dated July 9, 2018, available at uses.bcaresearch.com.

Overweight The S&P home improvement retail index (HIR) has historically benefitted from rebuilding efforts following costly hurricanes hitting the U.S. However, these spikes in relative performance largely track the earnings impact of the disasters; that is to say that they are one-off and do not provide much staying power. The impending arrival of Hurricane Florence today appears to have been priced into the index already as the stocks have already spiked. We would recommend against playing into this noise. Rather, we think investors should remain focused on the core profit profile of the index which has shown no sign of let up in its six-year run of earnings growth outpacing the S&P 500. Accordingly, we reiterate our overweight recommendation on the S&P HIR index. The ticker symbols for the stocks in this index are: BLBG: S5HOMI - HD, LOW.

Neutral Despite rising rates, homebuilders remain highly optimistic about the prospects for the domestic housing market, with the homebuilder survey persistently pushing near decade-highs (second panel). The message from Q2 earnings calls echoed this positivity, with the public homebuilders indicating demand was resilient even in a rising price environment. Still, the niche S&P homebuilding index has been moving sideways since our late-May upgrade to neutral. The cue from lumber prices is equally mixed; while the fall from the stratospheric levels of late-2017 is certainly a boon to profits, such a fall may be indicative of declining demand (third panel). At the same time, the tight labor market has seen wages in construction accelerating at the fastest rate since the rebound coming out of the financial crisis (bottom panel). The margin implication is thus unclear; we remain comfortable on the fence and reiterate our benchmark allocation. The ticker symbols for the stocks in this index are: BLBG: S5HOME - DHI, LEN, PHM.

Special Report

Following up from our inaugural U.S. Equity Market Indicators Report in early-August 2017, this week we introduce the second part in our Indicators series. In this Special Report we have drilled down to the ten GICS1 S&P 500 sectors (excluding the real estate sector) and have compiled the most important Indicators in four broad categories: earnings, financial statement reported, valuations and technicals. Once again this is by no means exhaustive, but contains a plethora of Indicators - roughly thirty Indicators per sector condensed in seven charts per sector - we deem significant in aiding us in our decision making process of setting/changing a view on a certain sector. The way we have structured this Special Report is by sector and we start with the early cyclicals continue with the deep cyclicals and finish with the defensives. Within each sector we then show the four broad categories. In more detail, the first three charts depict earnings Indicators including our EPS growth model, EPS breadth, profit margins, relative forward EPS and EBITDA growth forecasts and ROE and its deconstruction into its components. The following two charts relate to financial statement Indicators including indebtedness, cash flow growth and capital expenditures. And conclude with one valuation and one technical chart. As a reminder, the charts in this Special Report are also made available through BCA's Analytics platform for seamless continual updates. Due to length constraints, Part III of our Indicators series, expected in mid-October, will introduce a style and size flavor along with cyclicals versus defensives and end with the S&P 500, again highlighting Indicators in these four broad categories. Finally, likely before the end of 2018, we aim to conclude our Indicators series with Part IV that would feature our most sought after Macro Indicators per the ten GICS1 S&P 500 sectors, along with value/growth, small/large and cyclicals/defensives. We trust you will find this comprehensive Indicator chartbook useful and insightful. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Dulce Cruz, Senior Analyst dulce@bcaresearch.com Consumer Discretionary Chart 1Consumer Discretionary: Earnings Indicators Chart 2Consumer Discretionary: Earnings Indicators Chart 3Consumer Discretionary: ROE And Its Components Chart 4Consumer Discretionary: Financial Statement Indicators Chart 5Consumer Discretionary: Financial Statement Indicators Chart 6Consumer Discretionary: Valuation Indicators Chart 7Consumer Discretionary: Technical Indicators Financials Chart 8Financials: Earnings Indicators Chart 9Financials: Earnings Indicators Chart 10Financials: ROE And Its Components Chart 11Financials: Financial Statement Indicators Chart 12Financials: Financial Statement Indicators Chart 13Financials: Valuation Indicators Chart 14Financials: Technical Indicators Energy Chart 15Energy: Earnings Indicators Chart 16Energy: Earnings Indicators Chart 17Energy: ROE And Its Components Chart 18Energy: Financial Statement Indicators Chart 19Energy: Financial Statement Indicators Chart 20Energy: Valuation Indicators Chart 21Energy: Technical Indicators Industrials Chart 22Industrials: Earnings Indicators Chart 23Industrials: Earnings Indicators Chart 24Industrials: ROE And Its Components Chart 25Industrials: Financial Statement Indicators Chart 26Industrials: Financial Statement Indicators Chart 27S&P Industrials: Valuation Indicators Chart 28S&P Industrials: Technical Indicators Materials Chart 29Materials: Earnings Indicators Chart 30Materials: Earnings Indicators Chart 31Materials: ROE And Its Components Chart 32Materials: Financial Statement Indicators Chart 33Materials: Financial Statement Indicators Chart 34Materials: Valuation Indicators Chart 35Materials: Technical Indicators Tech Chart 36Technology: Earnings Indicators Chart 37Technology: Earnings Indicators Chart 38ROE And Its Components Chart 39Technology: Financial Statement Indicators Chart 40Technology: Financial Statement Indicators Chart 41Technology: Valuation Indicators Chart 42Technology: Technical Indicators Health Care Chart 43Health Care: Earnings Indicators Chart 44Health Care: Earnings Indicators Chart 45Health Care: ROE And Its Components Chart 46Health Care: Financial Statement Indicators Chart 47Health Care: Financial Statement Indicators Chart 48Health Care: Valuation Indicators Chart 49Health Care: Technical Indicators Consumer Staples Chart 50Consumer Staples: Earnings Indicators Chart 51Consumer Staples: Earnings Indicators Chart 52Consumer Staples: ROE And Its Components Chart 53Consumer Staples: Financial Statement Indicators Chart 54Consumer Staples: Financial Statement Indicators Chart 55Consumer Staples: Valuation Indicators Chart 56Consumer Staples: Technical Indicators Telecom Services Chart 57Telecom Services: Earnings Indicators Chart 58Telecom Services: Earnings Indicators Chart 59Telecom Services: ROE And Its Components Chart 60Telecom Services: Financial Statement Indicators Chart 61Telecom Services: Financial Statement Indicators Chart 62Telecom Services: Valuation Indicators Chart 63Telecom Services: Technical Indicators Utilities Chart 64Utilities: Earnings Indicators Chart 65Utilities: Earnings Indicators Chart 66Utilities: ROE And Its Components Chart 67Utilities: Financial Statement Indicators Chart 68Utilities: Financial Statement Indicators Chart 69Utilities: Valuation Indicator Chart 70Utilities: Technical Indicator

  Underweight (Upgrade Alert) Auto components stocks found a rare bit of relief this week on the back of news of a trade deal with Mexico and hopes that a similar deal can be made with Canada. Importantly, the scant details gleaned about Mexico are better than had been feared. Of particular note are the increase in regional value content from 62.5% previously to 75% and a 40-45% auto content made by workers earning at least $16 per hour requirement. Both of these should see a diversion of supply chain from overseas to domestic auto parts companies. This makes us reasonably optimistic on the industry's medium-term growth outlook. However, we caution that the situation is highly fluid and the details of final trade deal may be vastly different from the ones thus far released. Further, industry-operating metrics have been deteriorating; light vehicle sales have flat lined, consumer confidence (at least with respect to making a purchase of a new vehicle) has declined and vehicle pricing has fallen back into deflation. Bottom Line: we remain bearish on the S&P auto components index but are cognizant that NAFTA renegotiations could offer a solid tailwind to a beaten-up sector. Accordingly, we are putting this niche index on upgrade alert. The ticker symbols for the stocks in the S&P auto components index are: BLBG: S5AUTC - APTV, BWA, GT.

Overweight Consumer discretionary giant Home Depot has put together a string of solid earnings reports and outlook improvements that have served to keep the S&P home improvement retail index at its lofty levels for the past several years. We think more is to come. Lumber prices, though off the stratospheric levels they reached earlier this year, remain exceptionally high (second panel). Further, pricing power of household appliances continues to expand, thanks to more expensive imports resulting from tariffs put in place earlier this year (third panel). As home improvement retailers earn a spread on these key products, both sales and earnings should continue to expand; Home Depot's Q2 same store sales growth of 8% certainly underscores this point. While home improvement retail sales growth is likely to trail industry retail sales, we think as long as the six year run of earnings growth beating the S&P 500 continues (as we expect it will, bottom panel) investors should stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5HOMI - HD, LOW.