Industrials
Highlights Portfolio Strategy Internal dynamics warn that a broad market consolidation phase has begun. The jump in growth vs. value stocks has provided an opportunity to shift to a neutral style bias. Transports have sold off sharply, but downside risks have not yet been fully expunged, especially for the airline group. Recent Changes Growth Vs. Value - Shift to a neutral stance. Table 1Sector Performance Returns (%) Feature The perceived dovish Fed shift and doubts about the achievability of Trump's policy goals are causing equity market consternation. To the extent that the run up in stocks has largely reflected an improvement in sentiment and other 'soft' economic data, the lack of follow through in 'hard' data has created a validation void. While a weaker U.S. dollar, lower oil prices and less hawkish Fed imply easier monetary conditions, which are ultimately positive for growth, profits and the stock market, a digestion phase still looms. Financials, and banks in particular, had been market leaders, driven up by hopes for a meaningful upward shift in the yield curve and unleashing of animal spirits. But these assumptions are being challenged and there is limited fundamental support. Indeed, bank lending growth remains non-existent and there is no tailwind from improving credit quality. Our view remains that banks carry the most downside risk of all financial groups (please see the March 6 Weekly Report for more details). Regional banks are now down on a year-to-date relative performance basis (Chart 1). In fact, our newly constructed gauge of the equity market's internal dynamics suggests that additional tactical broad market turbulence lies ahead. A composite of relative bank stock, relative transport, small/large cap and industrials/utilities share prices has been a good coincident to leading market indicator in recent years (Chart 2). While no indicator is infallible, the message is that overall market risk is elevated and a choppy period lies ahead, reinforcing our defensive vs. cyclical bias. Nevertheless, it will be important to put any corrective action into a longer-term context. Over the years, we have kept an eye on several qualitative 'unconventional indicators' that have helped time major market turning points. They are meant to augment rather than replace fundamental factors. Chart 1Market Leaders Are Stumbling Chart 2A Yellow Flag From Internal Dynamics Below we highlight five critical variables to gauge whether a correction will devolve into a sustained sell-off. Each of the indicators measures either; profits; business confidence; investor confidence; and/or reflects how liquidity conditions are impacting market dynamics. Investor confidence can be measured through margin debt. While extremely elevated (Chart 3), there is no concrete sign that access to funds is being undermined by the modest backup in interest rates. When the cost of borrowing becomes too onerous, it will manifest in reduced margin debt and forced selling, which will be a serious threat to stocks given that leverage is challenging levels experienced at prior peaks, as a share of nominal income. M&A activity is losing momentum (Chart 4). A peak in merger activity typically coincides with a rising cost of capital. If corporate sector capital availability becomes a pressing issue, then M&A activity will decline further, signaling that the corporate sector is facing growth headwinds. Economic signals are mostly positive. Durable goods orders have tentatively perked back up (Chart 5), reinforcing that profits and confidence have improved after a soft patch. Temporary employment continues to rise (Chart 5). When temp workers shrink, it is often an early warning sign that companies are entering retrenchment mode, given the ease and low cost of reducing this source of labor costs. If temporary employment falls at the same time as share prices, that would be a red flag. The relative performance of consumer discretionary to consumer staples can provide a read on purchasing power and/or the marginal propensity to spend. This share price ratio does not suggest any consumption concerns exist (Chart 4, bottom panel). If consumer staples begin to outperform, then it would warn of a more daunting economic outlook. Chart 3Borrowing Costs Are Not Yet Restrictive Chart 4M&A Is Starting To Labor Chart 5Economic Signals Are Decent In all, these indicators suggest that any pullback will be corrective rather than a trend change. If the profit cycle continues to improve and the Fed has no inflationary need to become restrictive, then any broad market correction could provide an opportunity to selectively add cyclical exposure to portfolios in the coming weeks. In the meantime, we are revisiting our growth vs. value view and providing an update on transports. Growth Vs. Value: Shifting To Neutral Our last style bias update in the December 19 Weekly Report concluded that we would likely recommend moving to a neutral stance over the coming weeks/months from our current growth vs. value (G/V) stance, but expected to do after growth stocks had staged a comeback. That recovery is now well underway and so we are revisiting the outlook. Growth indexes have outperformed value since the depths of the Great Recession. The preference for growth reflected central bank interest rate suppression, which boosted the multiple investors were willing to pay for perceived growth at a time when growth was scarce. In addition, the composition of the growth index is much longer duration than that of the value space. The surge in long-term earnings growth expectations suggests that investors have increased conviction in the durability of the expansion, which has aided the G/V recovery (Chart 6). That monetary experiment has recently begun to pay off, as global economic growth has finally demonstrated evidence of self-reinforcing traction, led by developed countries. As a result, most central banks are well past the point of maximum thrust, which would mean the loss, albeit not a reversal, of the primary support for the secular advance in growth vs. value indexes. Keep in mind that growth benchmarks have a massive technology sector weight, at just over 1/3 of the total index capitalization. Value indices carry only a 7% weight. As shown in previous research, the technology sector underperforms when economic growth is fast enough to create inflationary pressure and therefore, the interest rate structure. Furthermore, value benchmarks have more than 25% of their weight in the financials sector vs. less than 5% for growth indexes. The upshot is that a meaningful interest rate increase would pad the profits of financials-rich value indices while having little to no impact on growth benchmarks by virtue of their tech-dependence. It is no surprise that the G/V ratio trends with technology/financials relative sector performance (Chart 7). The latter has clearly peaked, with an assist from the renormalization in Fed policy. Chart 6Time To Shift Chart 7Two Key Sector Influences These sector discrepancies mean that a critical question for the style decision is what is the path for government bond yields? The U.S. economy is exhibiting signs of self-reinforcing behavior. The small business sector's hiring plans have surged, and the ISM employment index remains solid (Chart 8). Chart 8Economy No Longer Favors Growth Chart 9A Mixed Bag While at least a modest employment slowdown is probable given that the corporate sector is feeling the profit margin pinch from higher wage costs, these gauges do not suggest a major crunch is imminent. The personal savings rate is drifting lower, supporting consumption growth (Chart 8). Value indexes have a higher economic beta than growth benchmarks, owing to their exposure to shorter duration sectors. The gap between growth and value operating margins tends to close when the economy enjoys a meaningful acceleration (Chart 8). Chart 10Volatility Is A Style Driver Other markers of global economic growth are more mixed. The global manufacturing PMI survey is very strong, but oil and other commodity prices have started to diverge negatively (Chart 9). That may soon change if the U.S. dollar has crested, which would provide a much needed fillip to emerging markets and remove a source of deflationary pressure. Real global bond yields are grinding higher, suggesting that in all, economic prospects have improved, and alleviating a major constraint on value stocks. Against this backdrop, it is timely to shift to a neutral style preference after the sharp rebound in the G/V ratio since late last year. Why not a full shift into value indexes? Developing countries are conspicuously lagging developed countries, which caps the outlook for commodities and their beneficiaries. EM capital spending is still very weak in real terms. Deep cyclical sectors are much more heavily-weighted in value benchmarks. A global recovery that has a greater thrust from consumption than investment, at least at the outset, argues against expecting value stocks to outperform. Moreover, the fallout from potentially protectionist U.S. trade policies remains unknown, which could restrain economic growth momentum and unleash volatility in the equity markets. The latter has been incredibly muted in recent months. In fact, BCA's VIX model, which incorporates corporate sector health and interest rate expectations, is heralding a higher VIX. Clearly, elevated volatility has supported the G/V ratio over meaningful periods of time (Chart 10). Bottom Line: Shift to a neutral style bias. A full shift to a value preference would require BCA to forecast a much weaker U.S. dollar and/or demand-driven inflationary pressure. Transports: Stuck In Neutral The S&P transports index peaked in mid-December versus the broad market, the first major sub-group to fizzle after the post-election sugar high (Chart 11). The recent setback has been broad-based. We had been overweight both the rails and air freight & logistics industry sub-groups, but booked gains in both prior to their respective pullbacks. Is it time to get back in? Transportation equities are ultra-sensitive to swings in global economic growth. Chart 12 shows that the relative share price ratio is an excellent leading indicator of both the ISM manufacturing survey and Citi's economic surprise index. The message is that at least a mild mean reversion in both of these indexes looms in the coming months, i.e. beware of some form of economic cooling. Chart 11Transports Have Cracked... Chart 12... Signaling Economic Cooling Ahead Against this backdrop, we are revisiting our last remaining underweight, the S&P airlines index. While rails and air freight & logistics stocks are directly linked to global trade, the same does not hold true for the S&P airlines index. Business and consumer travel budgets are the key drivers of industry demand. A revival in animal spirits and a healthy U.S. consumer could be clear positives for air travel. Moreover, the recent pullback in fuel costs should cushion profit margins for unhedged airline operators (Chart 13). Finally, renowned investor Warren Buffett has recently become a major shareholder in the U.S. airline industry, raising its profile. While betting against Buffett is always fraught with risk, our cautious take on the airline industry boils down to our view that excess capacity will continue to hold back profitability. If the overall transport index is accurately signaling that some loss of economic momentum looms, then a rapid expansion in business and travel spending may not be quick to materialize. A pricing war has already gripped the industry, as airlines are scrambling to fill up planes. Revenue-per-available-seat-mile and U.S. CPI airfare are contracting (Chart 14), reflecting a fight for market share. That is a serious impediment to profit margins. Chart 13Airlines Are Losing Altitude... Chart 14... As Price Wars Persist The headwinds extend beyond the U.S. Chart 15 shows that global airfare deflation also bodes ill for top line industry growth. The lags from previous U.S. dollar strength could compound this source of drag. Absent a decisive recovery in total travel spending, there does not appear to be any catalysts to reverse deflationary conditions. Carriers are still allocating an historically high portion of cash flow to capital spending. While upgrading aging fleets to become more fuel-efficient in an era of low interest rates is a long-term positive, the payback period may be extended. Revenue has failed to keep up with the increase in capital expenditures (Chart 16, bottom panel), suggesting that capacity growth continues to outpace industry demand, a recipe for ongoing pricing pressure. Chart 15Deflation Is Global Chart 16Too Much Capacity This difficult backdrop has begun to infect analyst earnings estimates. Net earnings revisions have nosedived. Relative performance momentum is tightly lined with the trend in earnings estimates (Chart 16). The message is that the breakdown in cyclical momentum has further to run. Indeed, the 52-week rate of change rarely troughs until it reaches much lower levels, warning of additional downside relative performance risks. Bottom Line: The S&P transports group is heralding a period of economic cooling, but the airline sub-component has not yet fully discounted such an outcome. Stay underweight. The ticker symbols for the stocks in the S&P airlines index are: UAL, AAL, DAL, LUV & ALK. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.
The large gap between the BCA Defense and BCA Aerospace indexes is likely to grow much larger. The U.S. is aiming to boost defense spending as part of its stimulus efforts, and is pressuring other NATO members to boost defense spending after a long contraction. While U.S. defense spending has been through a soft patch for the past several years, new orders for defense goods have been one of the strongest components of overall durable goods orders (second panel). Even global demand has boomed, even in the face of the strong U.S. dollar, as evidenced by surge in exports of military goods (bottom panel). On the flipside, aerospace new orders are on a downward trajectory, reflecting a downturn in the commercial aerospace cycle. While long lead times and lengthy delivery schedules offer some earnings protection, dwindling order backlogs will ultimately undermine confidence in the long-term outlook. Our global airline consumer price index, a composite of airline pricing power in a number of major countries, is in negative territory. A negative CPI reflects excess capacity, and warns of grim prospects for a recovery in new airplane orders. The bottom line is that earnings support remains intact for the defense index, but is rapidly dwindling for aerospace equities. Stay overweight the former and underweight the latter. The ticker symbols for the stocks in the BCA defense index are: LMT, GD, RTN, NOC, LLL and the BCA aerospace index are: BA, UTX, HON, TXT.
Highlights Portfolio Strategy The market has quietly adopted a less cyclical sectoral tone since yearend, a trend that could amplify over the coming months, even if overall appreciation persists. Defense stocks have grown into previously extended valuations, warranting ongoing above-benchmark exposure. The opposite is true for aerospace equities. Data processing shares are more likely to roll over than break out and we recommend paring positions to underweight. Recent Changes S&P Data Processing - Downgrade to underweight from overweight. Table 1 Feature The stock market has cheered the broad-based rebound in earnings and improvement in corporate sector pricing power (Chart 1). Unbridled optimism about growth friendly policy tilts including potential tax reform and select regulatory relief combined with an easing in financial conditions have encouraged investors to make large down payments against expected future profit gains. Indeed, extreme economic and earnings bullishness is evident in record setting price/sales (P/S) multiples: Chart 1 shows that on a median basis, the industry group (P/S) ratio is far above the 2000 peak, providing yet another metric in a long list of yardsticks signaling that greed is the overriding market emotion. Nosebleed valuation levels are cause for significant cyclical concern, but as discussed last week, momentum and a valuation-agnostic transition from fixed income to equities are the dominant tactical forces at the moment. Since it is difficult to reconcile valuations at odds with realistic expectations about future earnings growth, we remain focused on sub-surface positioning to indemnify against disappointment. Since late last year, the market has adopted a more defensive than cyclically-oriented tenor. Defensive sectors have troughed at extremely attractive relative valuation levels, based on our models (Chart 2). Conversely, cyclical sectors have rolled over, meeting resistance at very demanding valuation levels of more than two standard deviations above normal (Chart 2). Chart 1Future Growth Has Been Paid For Already Chart 2The Market Tone Is Changing Contrarians should take note. These nascent trend changes have developed even though economic data have generally surprised on the upside, which may be an indication that a more forceful response will occur once the string of upside surprises loses momentum. The global PMI has been very strong, but any hint of a reversal would provide a catalyst for a full-fledged recovery in defensive vs. cyclical stocks (Chart 3). The contraction in U.S. bank lending growth may be heralding slippage in hard economic data (Chart 3), to the benefit of defensive vs. cyclical sectors. Keep in mind that the market is priced for non-inflationary growth nirvana, such that even modest economic disappointment could short circuit the buying binge. The yield curve has stopped widening and financial conditions are no longer easing (Chart 3), providing additional confirmation that the defensive vs. cyclical equity sector trough is more likely a budding trend change than a pause in a downtrend. A trend change is also consistent with the relentless downgrading in emerging market vs. developed country GDP growth expectations (Chart 4). Chart 3Forward Looking Yellow Flags Chart 4No EM Confirmation For Cyclicals The lack of a durable and credible growth thrust in EM is confirmed by regional share price performance, as EM equities have significantly lagged their developed country counterparts (Chart 4). Now that China's fiscal stimulus impulse has rolled over amidst ongoing currency depreciation, EM lacks a catalyst for incremental growth outperformance vs. developed markets. Adding it up, evidence of a sub-surface trend change continues to materialize, even in the face of upward momentum in the broad market. We expect a mostly defensive along with select interest rate-sensitive exposure to provide optimal portfolio performance in the next 3-6 months. Defense Stocks Will Continue To Protect Portfolios... A Special Report sent to clients on October 31 outlined the long-term appeal of defense stocks, prior to the installment of a new, bellicose U.S. Administration. If anything, the latter threatens to exacerbate the decline in globalization that was already in progress (as discussed since 2014 by BCA's Geopolitical Strategy Service), potentially creating a leadership vacuum that will raise the specter of open military conflict. More nationalistic foreign policies in a number of countries, i.e. moving away from collaboration and cooperation and toward isolationism and self-sufficiency, is a recipe for increased geopolitical instability. China's challenge to the status quo is also likely to motivate a boost to defense spending globally. The recent World Economic Forum estimates of global military spending by 2030 cite both China and India planning to quadruple military outlays over this time frame (Table 2). The U.S. Administration is already pressuring other NATO members to boost defense spending after a long contraction (Chart 5), which should eventually spillover into rising defense contractor sales. Reportedly, only 5 out of 28 NATO members reached the targeted goal of spending 2% of GDP on defense. Ergo, there is room for an increase, especially in some larger countries with fiscal room to maneuver. More imminently, the conditions that have created the gap between aerospace and defense relative performance are growing even stronger (Chart 6). Table 2A New Arms Race Underway Chart 5Lots Of Upside Chart 6A Growing Gap While U.S. defense spending has been through a soft patch for the past several years, new orders for defense goods have been one of the strongest components of overall durable goods orders (Chart 6). The unfortunate reality is that the incentive to boost defense and security spending has never been higher. Terrorist activity continues to proliferate around the world (Chart 7), raising a sense of geopolitical uncertainty and mistrust. With defense new orders continuing to make new cyclical highs, factory output should run at levels flattering operating margins. Shipments of defense goods are outpacing inventories by a wide margin, which is consistent with solid pricing power. Even exports of military goods are booming (Chart 7), despite the strong U.S. dollar, reflecting a strong undercurrent of global demand. Domestic defense spending has room to expand. Real defense outlays are only just starting to recover (Chart 8). President Trump ran on a campaign to protect the U.S. from terrorism. That should make it comparatively easy to increase defense spending in the years to come. It is normal for defense stocks to retain momentum as defense spending growth accelerates (Chart 8, top panel). Increased staffing at the U.S. Department of Defense (DOD) implies that purse strings may already be loosening in anticipation of heightened activity. DOD employment growth often provides a good leading indication for real defensive spending trends (Chart 8, bottom panel). Thus, while share prices have been on a tear and valuations are not cheap, rapid earnings growth has pushed down forward multiples to manageable, below-market, levels (Chart 9, shown as an average of the companies in the BCA Defense Index). Chart 7Powerful Momentum... Chart 8... With Long-Term Durability Chart 9Growing Into Valuations Prospects for strong multiyear growth should support a move to a premium valuation as margins expand (Chart 9), similar to what occurred during past defense spending booms, as chronicled in our October 31 Special Report. ...But Aerospace Stocks Are Out Of Fuel In terms of aerospace equities, the outlook is more challenging. New orders have been sinking steadily, reflecting a downturn in the commercial aerospace cycle. While long lead times and lengthy delivery schedules offer some earnings protection, dwindling order backlogs will ultimately undermine confidence in the long-term outlook. Chart 10 shows that aerospace unfilled orders are contracting, an environment typically associated with share price underperformance, or at least elevated volatility. Shipments of aerospace goods are falling, a rare occurrence (Chart 10). The implication is that aerospace industrial production is also shrinking (Chart 10). With a heavily unionized labor force, it will be difficult to maintain profitability. Will increased global growth translate into a recovery in aerospace new orders? Doubtful. Aerospace cycles tend to be long and are not always correlated with the business cycle. Aerospace new order growth has little correlation with the global leading economic indicator. In fact, if anything, it is more countercyclical. Ominously, there are signs of excess capacity. Our global airline consumer price index, a composite of airline pricing power in a number of major countries, is in negative territory. A negative CPI reflects excess capacity, and warns of grim prospects for a recovery in new airplane orders (Chart 11). Chart 10Running On Empty Chart 11Too Much Capacity Against this backdrop, aerospace profits will become increasingly reliant on maintenance, repair and consumables activity. However, weak pricing power suggests that this source of revenue is soft (Chart 11). Aerospace valuations are close to a par with those of defense stocks. Divergent profit outlooks imply that the latter should expand while the former get squeezed. Bottom Line: We remain confident that the BCA defense index (LMT, GD, RTN, NOC, LLL) will continue to generate above market returns, whereas the BCA aerospace index (BA, UTX, HON, TXT) exhibits asymmetric downside risk. Data Processors Are Losing Their Allure After a consolidation phase that restored value to a more neutral level, we upgraded the S&P data processing index to overweight in late-September, because it fit into our consumption vs. capital spending theme, outperforms in disinflationary environments and would benefit from a recovery in industry sales growth. While several of those factors still exist, the share price ratio has been unable to gain traction and the window for outperformance may be closing. The economic backdrop is no longer conducive to capital inflows. Data processing companies enjoy hefty recurring revenue and high returns on equity, warranting persistent above market valuations (Chart 12). However, the flipside of predictability is lower operating leverage than many other industries and a pattern of underperformance during periods of rising inflation expectations. Indeed, cyclical share price momentum tends to take its cue, inversely, from inflation expectations (inflation expectations shown inverted, middle panel, Chart 12). Renewed traction in global economic growth, as evidenced by the upturn in the global leading economic indicator (GLEI, shown inverted, top panel, Chart 13), represents a headwind to capital inflows and relative multiple expansion. The improvement in business sentiment has also boosted our capital spending model, albeit we are doubtful as to whether increased animal spirits will translate into much of a capital spending cycle in a world of deficient final demand and soft free cash flow. Still, any rise in capital spending would put the services-based data processing group at a disadvantage, in relative terms. The downturn in the ISM services index compared with the ISM manufacturing index reinforces that the external environment has become more challenging (Chart 13). All of these factors could be overcome if operating trends were set to improve. Data processing revenue trends are tightly linked with consumer spending (Chart 14). The personal savings rate has room to fall, facilitating an increase in outlays, particularly now that the labor market has tightened. Rising job security has buoyed consumer confidence, which has historically augured well for data processing sales growth. Chart 12The Window Has Closed Chart 13Sell Signals Chart 14Margin Squeeze But top-line growth has been in a funk of late, even with firming pricing power (second panel, Chart 14). Companies have made a significant investment to boost marketing, as evidenced by the surge in SG&A, but so far, this has sapped margins more than stoked revenue. Importantly, Visa has recently provided a fee break to retailers, who are increasingly banding together to put pressure on the industry to lower fees. Amidst increased competition on the payments processing side, this trend is likely to be structural and put downward pressure on profit margins. Thus, we are reluctant to embrace the jump in the producer price index, as future readings could be much weaker. The implication is that operating performance will not overcome macro hurdles. Bottom Line: Reduce the S&P data processing index (V, MA, PYPL, ADP, FIS, FISV, PAYX, ADS, GPN, WU, TSS) from overweight to underweight. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).
Our Industrials sector Cyclical Macro Indicator has edged lower after a modest recovery in recent months. The strong U.S. dollar, relapse in short-term pricing power measures and sector productivity contraction are offsetting improvement in global PMI surveys. The lack of confirmation of an industrial sector revival from emerging markets is also holding back the CMI. The post-election surge in share prices is slowly being unwound, as the sector was quick to discount expectations for massive domestic fiscal stimulus. Participation is beginning to fray around the edges, as our relative advance/decline line has rolled over, as has breadth. Our TI is pulling back from overbought levels, warning that a further correction in the share price ratio looms. It would be nearly unprecedented for the share price ratio to trough before our TI hits oversold levels. We retain our high conviction underweight position in the S&P industrials sector.
Highlights Key Portfolio Highlights Improved world economic growth and rising inflation expectations have buoyed global equities (Chart 1). The downside is that financial conditions are tightening and U.S. dollar-based liquidity is contracting, which is growth restrictive (Chart 2). The massive outperformance of the financials and industrials sectors since the U.S. election implies that U.S. markets have been largely politically-motivated. Positive economic surprises remain mostly sentiment/confidence driven, rather than from upside in hard economic data (Chart 3). That unusually large gap implies that a big jump in 'hard data' surprises is already discounted and represents a latent risk, as it did in the spring of 2011 just before the summertime equity market swoon. Federal income tax receipts are contracting, suggesting that an economic boom is not forthcoming (Chart 4). In fact, there has never been a contraction in tax receipts without a corresponding slump in employment growth. Corporate sector pricing power gains have not been evenly distributed. Deep cyclicals gains came off a low base and may already be experiencing a relapse. Conversely, defensive and interest rate-sensitive sectors are demonstrating the most strength (Chart 5). Our macro models are not signaling that investors should position as if robust and self-reinforcing economic growth lies ahead. Our Deep Cyclical indicators are the weakest, while defensive and interest rate-sensitive models are grinding higher (Chart 6). Deep cyclical sectors are very overvalued and overbought, while defensives are deeply undervalued and oversold (Charts 7 and 8). Mean reversion is an apt theme for the next few months. The most attractive combination of macro, valuation and technical readings are in the consumer staples, health care sectors. The financials sector is a close second, but it is overbought. The least attractive combinations are in energy, materials and industrials. Prospects for elevated market volatility, stronger economic growth in developed vs developing economies, a tighter Fed and expensive U.S. dollar are consistent with maintaining a largely defensive portfolio structure (Charts 9-12). Chart 1Pricing Power Revival... Chart 2... But A Liquidity Drain Chart 3Show Me The Money Chart 4Yellow Flag Chart 5Pricing Recovery Is Not Broad Based Chart 6Indicator Snapshot Chart 7Focus On Value Chart 8Mean Reversion Ahead Chart 9Fundamentals Favor Defensives... Chart 10... As Do Market Signals Chart 1112-Month Performance After Fed Hikes Chart 1224-Month Performance After Fed Hikes Chart 13Staples Will Cushion A Volatility Resurgence Chart 14Media Stocks Like A Strong Currency Chart 15Unduly Punished Chart 16Strong Fundamental Support Chart 17Less Production... Chart 18... Means More Rigs Chart 19End Of Sugar High Chart 20A Toxic Mix Chart 21Tech Stocks Don't Like Inflation Chart 22Time To Disconnect Feature S&P Consumer Staples (Overweight - High Conviction) The Cyclical Macro Indicator (CMI) has been grinding higher for several months, even climbing through last year's share price shellacking. The CMI has been supported by the uptrend in relative consumer spending on essential items and consumer preference for saving vs. spending. More recently, a pricing power recovery in a number of groups has provided an assist as has a rebound in staples export growth. Booming consumer confidence and business confidence have held the CMI in check. The strong U.S. currency, particularly bilaterally against China, also implies a reduction in the cost of imported goods sold, and has also been an indication of relative valuation expansion because it often signals increased financial market volatility (Chart 13 on page 6). The attractive valuation starting point this cycle, and historic outperformance when the Fed raises interest rates (Chart 13 on page 6), were key factors behind our upgrade to high conviction status in January. Technical conditions are completely washed out. Sector breadth and momentum have reached oversold extremes. That signals widespread bearishness, which is positive from a contrary perspective. Chart 23 S&P Consumer Discretionary (Overweight) Our CMI is forming a tentative trough, supported by rebounding relative outlays on media services, low prices at the pump, a budding recovery in mortgage equity withdrawal and firming wage growth. The biggest drags over the past few months have come from higher Treasury yields and consumers increased propensity to save. However, rising job certainty and a vibrant residential real estate market suggest that consumers should loosen their purse strings. The VI has deflated toward the neutral zone, although remains moderately expensive from a long-term perspective. Our TI started to rebound from oversold levels. History shows that a recovery in the TI from one standard deviation below the mean has heralded a playable relative performance rally. Overweight positions should remain concentrated in housing-related equities and the media space, both of which benefit from U.S. dollar appreciation (Chart 14 on page 6). Chart 24 S&P REITs (Overweight - High Conviction) Our new REIT CMI has ticked lower, but the share price ratio has over-exaggerated this small move down. REITs have traded as if the back up in global bond yields will persist indefinitely, and that they are the only factor that drives relative performance. Improving cash flows and cheap valuations suggest that REITs can decouple from bond yields. Banks have tightened standards on commercial real estate loans, but this appears more likely to limit supply growth than create a slowdown. Commercial property prices are hitting new highs and our REIT Demand Indicator (RDI) has climbed into positive territory, signaling higher rental inflation. The latter is already outpacing overall CPI by a wide margin (Chart 15 on page 7). While REITs are back to fair value from a long-term perspective, on a shorter term basis the sector is very undervalued (Chart 15 on page 7), particularly with Treasury yields now in undervalued territory. Our REIT TI is extremely oversold, at a point which forward relative returns typically shine on a 12 and 24 month basis, even excluding the dividend yield kicker. Chart 25 S&P Health Care (Overweight) Our CMI continues to grind higher, opening a massive divergence with relative performance. This gap can be explained by the political attack on the pharmaceutical industry, the sector's heavyweight, rather than by a downturn in relative earnings drivers. Pharmaceutical shipments are hitting new highs and pricing power continues to grow at a robust mid-single digit rate. Future pricing gains may slow if government gets more heavily involved in setting prices, but this is already discounted. Pricing power in the rest of the sector remains strong, while wage inflation is tame. Health care spending is still growing as a share of total spending, but the pace is decelerating. Typically, this backdrop signals outperformance for health care insurers, who may also receive a risk premium reduction from a potential revamp of the Affordable Care Act, albeit the timing will likely be drawn out. Relative valuations are very attractive. The sector has been used as a source of capital to fund purchases in areas expected to benefit from increased fiscal stimulus. That is an overreaction, and flows should be restored to reflect the sector's appealing investment profile, particularly given the sector's track record during Fed tightening cycles (Chart 16 on page 7). The TI is deeply oversold. Breadth measures are beginning to recover from completely washed out levels. These conditions reinforce that an exploitable undershoot has occurred. Chart 26 S&P Financials (Neutral) Our Financial CMI has surged, underscoring that the advance in relative performance reflects more than just a reaction to anticipated sector deregulation by the Trump Administration. Leading indicators of capital formation, such as the stock-to-bond ratio, have jumped sharply. Moreover, the yield curve has steepened in recent months, bolstering the CMI. An improvement in overall profit growth and the tight labor market suggest that the credit cycle may not become a profit drag until the economy begins to cool. While not yet evident, the restrictive move in oil, the dollar and bond yields warn that disappoint may emerge in the coming months. It is notable that bank loan growth has dropped to nil over the last 3 months. C&I loan growth is contracting over that time period. Banks are hiring more aggressively, yet are tightening lending standards, suggesting productivity disappointment ahead. Despite the share price jump, value remains attractive after 8 years of financial repression. Our TI is overbought and breadth is beginning to recede, which is often a precursor to a consolidation phase. We are not willing to move beyond a market weight allocation at this juncture. Chart 27 S&P Energy (Neutral) Our CMI has plunged, probing all-time lows. Rising oil inventories and spiking wage inflation are exerting severe gravitational pull on the CMI, more than offsetting the budding recovery in domestic production. Refining margins are probing six year lows as the Brent/WTI spread has evaporated. Nevertheless, OPEC is finally curtailing production, joining non-OPEC producers (Chart 17 on page 8), which should ultimately help eat into excess global oil supply. History shows that once supply growth peaks, the rig count typically firms. That is a plus for energy services (Chart 18 on page 8), even though rising oil production will prove self-limiting for oil prices. High yield spreads have narrowed significantly from nosebleed levels, but industry balance sheets remain bruised. Net debt is historically elevated, EBITDA has yet to return to its glory days, and interest coverage remains anemic and vulnerable to any downside energy price surprises. The surge in our VI reflects depressed cash flow, and is overstating the degree of overvaluation. The TI has returned to the neutral zone, and will need to hold at current levels otherwise a relapse in the share price ratio toward previous lows is probable. Selectivity is still warranted in the energy complex. We remain underweight refiners and overweight the energy services index. Chart 28 S&P Utilities (Neutral) Our utilities sector CMI is stabilizing. That is a surprise, given the rebound in inflation expectations and firming global leading economic indicators, which are typically bearish for this defensive, fixed-income proxy. The latter negative exogenous factors are being offset by falling wage inflation, better pricing power and rising electricity output growth. Power demand is linked with manufacturing activity, underscoring that there is an element of cyclicality to sector profits. The share price ratio has held up better than most other defensive sectors since the U.S. election, perhaps on the hope that an overhaul of the tax code will benefit this domestic sector. Regardless, valuations have retreated from the extremely expensive zone where we took profits and downgraded to neutral last summer, but are not yet at a level that warrants re-establishing overweight positions. An upgrade could occur once our TI becomes fully washed out, provided that occurs within the context of additional CMI strength and a peak in global growth and inflation momentum. Chart 29 S&P Industrials (Underweight - High Conviction) The CMI has edged lower after a modest recovery in recent months. The strong U.S. dollar, relapse in short-term pricing power measures and sector productivity contraction are offsetting improvement in global PMI surveys. The lack of confirmation of an industrial sector revival from emerging markets is also holding back the CMI. There continues to be a deflationary undercurrent in the form of more rapid capacity than industrial sector output growth, suggesting that durable pricing power gains may remain elusive (Chart 19 on page 9). The post-election surge in share prices is slowly being unwound, as the sector was quick to discount expectations for massive domestic fiscal stimulus. Our valuation gauge is not at an extreme, although a number of individual groups are trading at historically rich multiples, such as machinery and railroads. Participation is beginning to fray around the edges, as our relative advance/decline line has rolled over, as has breadth. Our TI is pulling back from overbought levels, warning that a further correction in the share price ratio looms. It would be nearly unprecedented for the share price ratio to trough before our TI hits oversold levels. Industrials fare poorly when the Fed tightens. Chart 30 S&P Materials (Underweight) The CMI has nosedived, reflecting China's diminishing fiscal thrust and the recent tightening in monetary policy. Commodity price inflation peaked in mid-December concurrent with the Fed raising rates, signaling that emerging markets end-demand, in general and Chinese in particular, is likely past its prime. The nascent rebound in EM currencies represents a positive offset, but not by enough to turn around the CMI. Select heavyweight EM manufacturing PMIs are still below the boom/bust line. Relative valuations are becoming extended according to our VI, and stretched technical conditions are waving a red flag. Keep in mind the materials sector has an abysmal performance history after the Fed starts tightening (Chart 20 on page 9). The heavyweight chemical index (75% of the sector) bears the brunt of the downside risks owing to excess capacity (Chart 20 on page 9). On the flipside, overweight exposure in gold mining (via the GDX:US ETF) and the niche containers & packaging sub-indexes is recommended. Chart 31 S&P Technology (Underweight) The CMI has rolled over, driven lower by contracting relative pricing power, decelerating new orders-to-inventories growth, lack of capital expenditure traction and the appreciating greenback. Tech stocks thrive in a disinflationary/deflationary environment and suffer during inflationary periods (Chart 21 on page 10). Inflation is making a comeback, so it will be an uphill battle for tech companies to successfully raise selling prices at a fast enough pace to keep profits on a par with the broad corporate sector. While a capital spending cycle would be a welcome development, the narrowing gap between the return on and cost of capital warns against extrapolating improvement in business sentiment just yet. Our S&P technology operating profit model warns that tech profits are likely to trail the broad market as the year progresses, a far cry from what is embedded in analysts' forecasts. The good news is that valuations are not demanding nor are technical conditions overbought, which should cushion the magnitude and sharpness of downside risks. Chart 32 S&P Telecom Services (Underweight) Our CMI for telecom services has gained ground of late, primarily on the back of a sharp decline in wage inflation. However, we recently downgraded exposure to underweight, because of a frail spending backdrop. Our telecom services sales model is extremely weak (Chart 22 on page 10). Softening outlays on telecom services have reinvigorated the industry price war, and our pricing power gauge is sinking like a stone (Chart 22 on page 10). Telecom carrier capital expenditures have been running at a healthy clip, which could further pressure profit margins. Undervaluation exists, but this has been a chronic feature for the sector over the past decade, and does not foretell of cyclical upside or downside risks. Our TI has plunged into the sell zone, but remains above levels that would signal that a countertrend rally is imminent. Chart 33 Size Indicator (Overweight Small Vs. Large Caps) The small/large cap ratio is correcting short-term overbought conditions. The dip in the U.S. dollar has provided a fundamental reason for corrective action in this domestically-oriented asset class. However, we doubt a trend change is at hand. Our style CMI is climbing steadily. Small company business optimism has soared, partly because of an increase in planned price hikes, but also from an anticipated reduction in the regulatory burden. If small company price hikes persist, then rising labor costs will be more easily absorbed. That is critical to narrowing the profit margin gap between small and large firms. A stronger domestic vs. global economy and the potential for trade barriers is also unambiguously positive for small firms that do the bulk of their business at home. Despite the surge in the share price ratio post-U.S. election, our valuation gauge is not yet at an overvalued extreme. The lack of extreme overvaluation suggests that positive momentum will persist, perhaps similar to the 2004-2006 period, when the share price ratio stayed in overbought territory for years. Chart 34
Highlights Portfolio Strategy Pricing power has improved across a number of industries, with the exception of technology, a necessary development to sustain an overall profit recovery. The S&P railroads index has surged to the point where it will take massive upside earnings surprises to drive additional gains. Profit-taking is appropriate. Telecom services profit drivers have deteriorated significantly of late, and a full shift to underweight is recommended. Recent Changes S&P Railroads Index - Take profits of 22% and downgrade to neutral. S&P Telecom Services Index - Take profits of 6% and downgrade to underweight from overweight. Table 1 Feature Chart 1Pricing Power Is Profit Positive... Momentum remains the dominant market force. Fear of missing out is pulling sidelined cash into the market, supported by a decent earnings season to date and rising economic confidence. While consumer inflation expectations remain very low, market-derived inflation expectations have moved up markedly since the U.S. election (Chart 1), a surprising development given the surge in the U.S. dollar. Inflation expectations are back to levels that existed prior to the 2014 kickoff to the U.S. dollar rally. A shift away from deflation worries is supporting a re-pricing of stocks vs. bonds. That trend could continue until the U.S. economy begins to disappoint, potentially causing inflation expectations to retreat. Our pricing power update shows that while deflation remains prevalent, its intensity is fading. We have updated our industry group pricing power (Table 2), which compiles the relevant CPI, PPI, PCE or commodity-data for 60 S&P 500 industry groups. The table also compares those pricing power trends with overall inflation rates to help determine which areas are at a profit advantage or disadvantage. Based on our analysis, the number of groups suffering deflation in selling prices has shrunk to 19 from 23 in our update last September, and 32 last March. In all, 34 out of 60 groups are still unable to raise prices by more than 1%, but that is also an improvement from the 40 out of 60 industries that couldn't keep a 1% price hike pace last September. The bad news is that less than 1/3 have a rising selling price trend, even if the absolute level is negative, down from 50%, and another third has a flat trend. The implication is that upward momentum in pricing power may already be fading. Where is the pricing power improvement? Deep cyclical sectors such as energy and materials account for the lion's share, reflecting higher commodity prices. However, as discussed previously, 6-month growth rates have rolled over (Chart 2), signaling that the unwinding of the negative rate of change shock has run its course. The technology sector is also notable, as several groups are cutting selling prices at a faster clip. Table 2Industry Group Pricing Power Defensive sectors such as consumer staples, health care and utilities remain well represented in the positive category, while a reacceleration in consumer discretionary and financials sector selling price increases has boosted interest rate-sensitive sector pricing power (Chart 2). This would suggest that profit advantages continue to reside in these areas, rather than in cyclical sectors. That is confirmed by the uptrend in developed vs. developing market PMIs. This manufacturing gap would presumably widen further if the U.S. ever imposes import taxes. The latter would weaken developing country exports, thereby forcing currency devaluation and hurting capital inflows. Regardless, the PMI divergence reinforces that, in aggregate, cyclical sectors are not as fundamentally well supported as other sectors, and that a highly targeted and selective approach is still the right strategy (the PMI ratio is shown advanced, Chart 3). Even external factors warn against chasing lingering cyclical sector strength. Using the options market, the SKEW index provides a good read on perceived tail risk for the S&P 500. A rise toward 150 indicates significant worries about potential outlier returns. The SKEW has soared in recent weeks, which is often a harbinger of increased equity volatility and defensive vs. cyclical sector strength (Chart 4). Chart 2... But Is Not Broad-Based Chart 3Global PMIs Are Signaling Defense First... Chart 4... As Are Market-Based Indicators In sum, the broad market has a powerful head of steam and it could be dangerous to stand in its way, but the rally continues to exhibit signs of a late stage blow-off, vulnerable to sudden and sharp corrections. Maintain a healthy dose of non-cyclical exposure to protect against building and potentially sudden downside overall market risks, while being careful in terms of cyclical industry coverage. This week, we are taking advantage of exuberance in the rail space, and reversing our call on the telecom services sector in response to broad-based erosion in profit indicators. Rails Are Now Priced For Perfection For such a mundane and staid industry, railroad stocks have garnered considerable attention of late. Most recently, rumors that railroad maven Hunter Harrison will be installed at CSX to engineer yet another corporate turnaround have spurred a massive buying frenzy. We upgraded the S&P railroads index to overweight on August 1, 2016. Our analysis suggested that analysts and investors had made a full bearish capitulation, slashing long-term growth estimates to deeply negative territory and pushing valuations decisively into the undervalued zone. That pessimism overlooked efforts to cut costs and stabilize profit margins in the face of waning freight growth, setting the stage for a re-rating. While that thesis has worked out, we are concerned that the needle has now swung too far in the other direction, much like what occurred in the air freight industry. The latter had a steep run up only to disappoint newly buoyant expectations. We took air freight profits in late-November, as the soaring U.S. dollar was an anti-reflationary threat to the anticipated recovery in global trade that both investors and the industry had positioned for. Indeed, industry hiring has expanded rapidly (Chart 5). However, hours worked are contracting (Chart 5). Ergo, the hoped for increase global revenue ton miles has not materialized to the extent that was expected (Chart 5). Over-employment is a productivity and profit margin drag, and we were fortunate to take profits before the payback period. We can envision a similar scenario for railroads. There has no doubt been an improvement in freight activity, and there is more in the pipeline. The question is one of degree. Total rail shipment growth has climbed back into positive territory, and our rail shipment diffusion index, which measures the number of freight categories experiencing rising vs. falling growth, is near the 80% level (Chart 6). The key consumer-driven intermodal segment, which accounts for over half of total freight volumes, has finally begun to recover. Rising personal incomes should underpin credit availability and demand, and therefore, spending. The increase in business sales-to-inventories and growth in Los Angeles port traffic also augur well for intermodal shipments (Chart 6). One caveat is that autos represent a large portion of this segment, and pent-up demand has been fully realized at the same time that auto credit quality is beginning to crack. That could keep a lid on the magnitude of the intermodal shipment recovery. Coal volumes have also shown signs of life after a brutal contraction. Coal is a high margin product and another large freight category, and any sustained recovery would provide a meaningful profit boost. Rising natural gas prices typically bode well for coal volumes (Chart 7), via increasing the cost of competing fuels to burn for power generation. However, it is premature to celebrate, because the abnormally warm North American winter may mean that the rebound in electricity production is passed its peak. That would slow the burn rate and keep coal (and natural gas) supplies higher than otherwise would be the case. Chart 5Stay Grounded Chart 6Broad-Based Freight Recovery Chart 7Coal Is Critical History shows that pricing power and coal shipment growth are tightly linked. Selling prices have firmed in recent months, but are not at a level that heralds meaningful improvement in return on equity (Chart 8, third panel). True, rising oil prices typically lead to rail companies reinstituting fuel surcharges. But that is profit margin protective, not expansionary, as true pricing power gains come on the back of increased demand and the creation of bottlenecks. It is not clear that such a point has been reached. The Cass Freight Expenditures Index has been flat for several months, signaling that companies do not intend to raise transportation outlays. This series correlates positively with relative forward earnings estimates (Chart 8). That will make it difficult for rail freight to grow faster than GDP (Chart 9), a necessary development to drive earnings outperformance. Meanwhile, productivity gains may be slow to accrue if freight only grows modestly. Weekly train speeds have been stuck in neutral (Chart 8), and the industry may be in the early stages of a capital spending reacceleration. Rail employment growth has jumped in recent months, which is often a leading indicator of investment (Chart 9). If capital spending begins to take a larger share of sales in the coming quarters, then recent investor excitement may ease, leading to a prolonged consolidation phase. After all, valuations are stretched. Over the past two decades, whenever the relative forward P/E has crossed above a 10% premium, relative forward 12-month returns have averaged -4%, and been negative in 4 out of 5 cases. Overheated technical momentum also warns against extrapolating the latest price gains (Chart 10). Chart 8Earnings Will Only Improve Slowly... Chart 9... If Capital Spending Re-Accelerated Chart 10A Profit Recovery Is Discounted Bottom Line: Take profits of 22% and downgrade the S&P rails index (BLBG: S5RAIL - UNP, CSX, NSCX, KSU) to neutral, as the index appears to be setting up for a 'buy the rumor, sell the news' scenario. Stay neutral on the S&P air freight index (BLBG: S5AIRF - UPS, FDX, CHRW, EXPD). Telecom Services: Can You Hear Me Now? The niche S&P telecom services sector (comprising 3% of the S&P 500) has served our portfolio well, up 6% since inception. However, operating conditions have downshifted and we recommend lightening up a notch and reducing weightings to underweight. There are five factors driving this downgrade: the relative spending profile, sales outlook, margins pressure, interest rates and capital spending trends. First, telecom services personal consumption expenditures (PCE) have sunk anew after a brief attempt to stabilize last year. While consumer spending on telecom services has increasingly become a discretionary item, the improvement in consumer finances and vibrant labor market appear to be generating even more outlays on non-telecom goods and services (top panel, Chart 11). Second, this spending backdrop has undermined the sector sales outlook. Top line growth has retreated to nil, and BCA's telecom services sales-per-share model is signaling that a contraction phase looms (middle panel, Chart 11). Worrisomely, the latest producer price index release revealed that industry pricing power has taken a turn for the worse, which will sustain downward pressure on revenue growth. Third, profit margins are under stress. Selling prices are deflating at a time when the wage bill is still expanding at a mid-single digit rate. The implication is that margins, and thus earnings, are unlikely to improve much in the coming quarters (Chart 12). Chart 11Sales Prospects Have Dimmed Chart 12Ditto For Profit Fourth, telecom services is a high yielding sector and the recent sell-off in 10-year Treasurys (UST) is an unwelcome development. When competing investments rise in yield, the allure of telecom carriers diminishes, and vice versa. Chart 13 shows that relative performance momentum and the change in UST yields are inversely correlated, underscoring that as long as the bond market selloff persists relative share price pressures will remain intact. Finally, industry capital expenditures are reaccelerating, which is a short-term negative for profitability. This message is corroborated by the government's construction spending release, which shows a pickup in telecom facilities construction (bottom panel, Chart 13). Taken together with the deteriorating sales backdrop, higher capital spending would be negative for profit margins. While we would normally be reluctant to move an attractively valued sector all the way to underweight (Chart 14), the marked deterioration in these five drivers of relative profitability warrants such an extreme move, regardless of our reticence about the sustainability of the broad market's recent gains. Chart 13Higher Bond Yields Aren't Helping Chart 14Technical Breakdown Our Technical Indicator has crossed decisively into the sell zone, and the share price ratio has failed to break back above its 40-week moving average, providing technical confirmation of a breakdown (Chart 14). Bottom Line: Lock in profits of 6% in the S&P telecom services sector since the Nov 9th, 2015 inception and downgrade exposure all the way to underweight. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).
After the election, machinery stocks jumped sharply on the hope that only Trump's growth-oriented policies will be successful while growth-restrictive proposals will be watered down, supporting commodity prices and ultimately reinvigorating machinery demand. However, the risk is that the waiting period will prove longer than expected, testing investor patience. While global manufacturing surveys have perked up on the back of inventory restocking, global machinery orders are still sinking, and U.S. machinery new orders are contracting. The strong U.S. dollar makes it dangerous to extrapolate firming global surveys into strong U.S. corporate performance. The chart shows that relative machinery EPS estimates have moved in the opposite direction of relative share prices. As a result, the bottom panel of the chart shows that relative valuations have skyrocketed. The S&P machinery sector's forward P/E is now trading at a 20% premium to the broad market (over a two decade high, excluding the Great Recession) spiking 6% since November. If earnings fail to live up to extremely optimistic expectations, as we expect, then relative share prices are at risk of a retracement. Bottom Line: Continue to underweight the S&P machinery index.
In early 2016, our sister publication Global Alpha Sector Strategy did a cycle-on-cycle analysis on the ISM manufacturing index and relative industrials performance in the following twelve months every time the ISM sank below the boom/bust line for 5 or more consecutive months. The conclusion was that it did not pay to underweight industrials stocks, as too much bearishness was already baked in the cake. The opposite is also true. We analyzed relative industrials performance since the early 1990s every time the ISM manufacturing new orders sub-index hit 60. The bottom panel of the chart shows median relative performance in the ensuing twelve months. The implication is that industrials stocks will suffer in the coming quarters as too much optimism is already discounted since the post-election reflex advance. Bottom Line: We reiterate our recent high-conviction underweight stance on the S&P industrials sector.