Sectors
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
The downside of a transitioning to a self-reinforcing economic dynamic is tighter financial conditions. This backdrop poses a challenge for the high-beta biotech group. The top panel of the chart shows that more restrictive monetary settings tend to coincide with biotech underperformance (the shadow Fed funds rate is shown inverted). Higher interest rates boost the discount rate, undermining valuations in the highest multiple market sectors. Similarly, U.S. dollar liquidity drainage - which represents a tightening in global monetary conditions - has historically been an excellent indicator of biotech stock momentum: the current message is also bearish (second panel). On the back of Gilead's recent revenue warning, we expect the biotech bubble to continue to deflate. Bottom Line: We reiterate our high-conviction underweight status on the Nasdaq biotech index (ETF ticker: IBB:US).
We took profits on our underweight S&P hotel index position and upgraded to neutral in November, because a number of companies reduced 2017 guidance and revenue per room (REVPAR) expectations at the same time that value had improved. Since then, hotel stocks have outperformed significantly, as the improvement in consumer and business sentiment is expected to boost lodging spending. That is necessary to counter the surge in wage inflation, as measured by the acceleration in the lodging industry employment cost index (bottom panel). Perhaps the most appealing development of late has been the downturn in lodging industry construction outlays. If sustained, that will reverse a long-term increase in capacity. The latter is critical to fostering more robust pricing power gains in line with past cyclical upswings. The bottom line is that the outlook for hotel profits has improved, but staying patient for a more attractive entry point is recommended given that the share price ratio is extremely overbought in the short run. Stay neutral, but put this group on upgrade alert. The ticker symbols for the stocks in this index are: BLBG: S5HOTL - MAR, CCL, RCL, WYN.
While bank stocks are quick to react positively to any indication that the regulatory burden may eventually be diminished, beneath the surface, there are mounting signs of profit headwinds. The latest Fed Senior Bank Loan Officer Survey revealed that banks are tightening lending standards on most loan categories. Worrisomely, demand for commercial, consumer, mortgage and C&I loans is also waning. In fact, C&I loan growth is now contracting on a 3-month rate of change basis. A cooling in bank balance sheet expansion may expose a heavier cost structure than desired in the coming quarters, given that bank employment has been on the upswing. Absent any renewed steepening in the yield curve, the surprise could be that bank stocks underperform in the coming months after overshooting since the election. The ticker symbols for the stocks in this index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT.
The S&P containers & packaging group offers a more attractively valued alternative to play a transportation recovery than either rails or air freight. Global export volumes have begun to rebound, consistent with the increase in U.S. port traffic and intermodal (consumer) goods shipments. Any increase in global trade would bolster sentiment toward this high volume industry. Companies in this index are also highly exposed to the food and beverage business since the bulk of consumable non-durable goods products require packaging materials. As such, its fortunes rise and fall with swings in food prices. The current contraction in the food CPI has spawned a boom in food consumption, as measured by the surge in real (volumes) personal outlays on food & beverage products. This phenomenon is also true on a global basis, as food exports are booming, a remarkable development given U.S. dollar appreciation. If food and beverage consumption stays robust, then the relative valuation expansion in packaging stocks will persist. In sum, packaging stocks offer attractive exposure within an otherwise unattractive S&P materials sector. Please see yesterday's Weekly Report for more details on our upgrade to overweight. The ticker symbols for the stocks in this index are: BLBG: S5CONP - IP, WRK, BLL, SEE, AVY.
Highlights Portfolio Strategy Food price deflation bodes well for increased volumes, and by extension, packaging stocks. Upgrade to overweight. Prospects for intensifying market and economic volatility argue for reestablishing a portfolio hedge in gold shares. The tech sector underperforms when there is upward pressure on inflation, and the next twelve months is unlikely to prove an exception. Stay clear. Recent Changes S&P Containers & Packaging - Upgrade to overweight from neutral. Gold Mining Shares - Upgrade to overweight from neutral. Table 1 Feature Equity markets finally took a breather last week, as investors digested spotty earnings and began to discount the possible economic downside of U.S. isolationism. While profits should dictate the trend in stocks over the long haul, equity valuations have soared since the election, it is critical to consider the durability of this trend and other influences at this juncture. The recent string of positive economic surprises raises the risk that monetary conditions will tighten further, especially amidst rising inflation pressures and a tight labor market. As such, the broad market remains in a dangerous overshoot phase, predicated on hopes for a sustained non-inflationary global economic mini-boom. The risk is that these hopes are dashed by nationalistic policy blunders (i.e. protectionism and trade barriers) or a more muted and drawn out improvement in global economic growth than double-digit earnings growth forecasts would imply. There appears to be full buy-in to a durable bullish economic/profit outcome. We have constructed a 'Complacency-Anxiety' Indicator (CAI), using a number of variables that gauge investor positioning, sentiment and risk on/off biases (Chart 1). The CAI is at its highest level ever, signaling extreme confidence/conviction in the outlook for equities. While timing market peaks is difficult, because momentum can persist for longer than seems rational, the level of investor complacency is disturbingly high given that policy uncertainty is such a large economic threat. Global economic growth has never accelerated when global economic policy uncertainty has been this high (Chart 2, shown inverted). Chart 1Complacency Reigns Chart 2Uncertainty Is A Growth Impediment If rhetoric about anti-globalization measures turns into reality, that will deal a serious blow to burgeoning economic confidence before it translates into actual economic growth. Thus, the risk of sudden market downdrafts has risen to its highest level of this bull market. Chart 3 shows that positive economic surprises remain primarily sentiment/confidence driven, rather than from upside in hard economic data. To be sure, the stock market trades off of 'soft data' given its leading properties, but the size of the current gap is unusually large and reinforces that a big jump in 'hard data' surprises is already discounted. This gap represents a latent risk, as it did in the spring of 2011 just before the summertime equity market swoon. Chart 3A Big Gap Means Big Shoes To Fill Worryingly, the behavior of corporate insiders suggests that their confidence does not match their share price valuations. According to Barron's1, the insider sell/buy ratio has soared to an extremely bearish level for markets. For context, their gauge is close to 60; anything over 20 is deemed bearish while less than 12 falls into the bullish zone. Chart 4An Increasing Supply Of Stock The spike in secondary issuance corroborates insider selling (Chart 4). Insiders would not be unloading their shares if they felt earnings prospects would outperform what is discounted in current valuations. Even the pace of share buybacks has slowed considerably, to the point where the number of shares outstanding (excluding financials) has moved higher for the first time in 6 years (Chart 4). An increase in the supply of shares, from sources that have incentive to sell when the reward/risk tradeoff is unattractive, is a yellow flag. All of this argues for maintaining a capital preservation mindset rather than chasing market euphoria in the near run. Elevated complacency suggests that the consensus is focused solely on return rather than risk. It will be more constructive to put money to work when anxiety levels are higher than at present. This week we recommend adding a defensive materials sector gem, buying some portfolio insurance and we update our tech sector views. Packaging Stocks Are Gift Wrapped While our materials sector Cyclical Macro Indicator is hitting new lows, this is often a sign that the countercyclical S&P containers & packaging index deserves a second look. We have shown in past research that its strongest relative performance phases often occur when the overall materials sector is struggling. This group offers a more attractively valued alternative to play a transportation recovery than either rails or air freight, as discussed in last week's Report. From a macro perspective, deflation in global export prices should provide a strong tailwind. Why? Low prices spur volume growth. Global export volumes have begun to rebound, consistent with the increase in U.S. port traffic and intermodal (consumer) goods shipments (Chart 5). Any increase in global trade would bolster sentiment toward this high volume industry. Companies in this index are also highly exposed to the food and beverage business since the bulk of consumable non-durable goods products require packaging materials. As such, its fortunes rise and fall with swings in food prices. When food inflation is rising, consumers spend less in real terms, undermining the volume of food packaging demand. The opposite is also true. The current contraction in the food CPI has spawned a boom in food consumption, as measured by the surge in real (volumes) personal outlays on food & beverage products (Chart 6). This phenomenon is also true on a global basis, as food exports are booming (Chart 6, bottom panel), a remarkable development given U.S. dollar appreciation. Chart 5Stealth Play On Volume Growth Chart 6Booming Food Demand... Chart 7... Should Drive Up Multiples If food and beverage consumption stays robust, then the relative valuation expansion in packaging stocks will persist (food demand shown advanced, Chart 7). Increased demand for packaging products has become evident in the budding rebound in pricing power (Chart 8). The producer price index for containers has picked up nicely on a 6-month rate of change basis, albeit it is still low in annual growth terms. Nevertheless, any increase in pricing power would support profit margins if volume expansion persists, given the industry's disciplined productivity focus. Headcount remains in check, likely reflecting automation and investment, and is falling decisively relative to overall employment (Chart 8). The implication is that profit margins have a chance to outperform, particularly if energy prices stay range-bound (Chart 8). U.S. protectionism, and/or a continued rise in bond yields on the back of improving global economic momentum constitute relative performance risks to this position. Chart 9 shows that relative performance is mostly inversely correlated with global bond yields, given that it is a disinflationary winner. Chart 8Productivity Gains Chart 9A Risk Factor However, the global economy has already been through a phase of upside surprises. Moreover, now that China has moved to cool housing, investors should temper expectations for more stimulus to cause Chinese growth to accelerate. Conversely, economic disappointment could materialize before midyear if financial conditions tighten further. In sum, packaging stocks offer attractive exposure within an otherwise unattractive S&P materials sector. Bottom Line: Raise the S&P containers & packaging index to overweight. Gold: Back To Overweight As A Portfolio Hedge Gold mining shares look increasingly attractive, at least as a portfolio hedge. We took profits on our overweight position in the middle of last summer, just prior to the share price crunch, because tactical sentiment and positioning had gotten too stretched. Thereafter, the equity risk premium melted, dimming appetite for portfolio insurance (Chart 10). Moreover, bond yields rose in response to firming economic expectations, increasing the opportunity cost of holding an income-free asset like gold. However, in the absence of a global economic boom, which seems unlikely, and if trade barriers are erected and policy uncertainty continues to escalate, there is a limit to how high real rates can rise. Potential GDP growth remains low throughout the world, weighed down by excessive debt, weak productivity and deflationary demographics (Chart 11, second panel). Chart 10End Of Correction? Chart 11Structurally Bullish A revival in market volatility and an unwinding of previously frothy technical conditions have created an attractive re-entry point in gold shares. The yield curve stopped steepening when the Fed raised interest rates last month (Chart 12). The last playable rally began when the yield curve started to flatten, signaling doubts about the longevity of the business cycle. If the yield curve does not steepen anew, and interest rate expectations move laterally, then the U.S. dollar is less likely to be a barrier to gold price gains. Sentiment toward the yellow metal is no longer overheated, as evidenced by both surveys and investor behavior. Flows into gold ETFs have been trending lower in recent months, reversing last summer's buying frenzy (Chart 12). Speculative positions have also been unwound (Chart 12). Netting it out, the surge in U.S. policy uncertainty, prospects for economic disappointment relative to increasingly elevated expectations and any pause in the U.S. dollar rally support reestablishing overweight positions in gold mining stocks as a portfolio hedge, especially now that overbought conditions have been unwound (Chart 13). Chart 12No Longer Frothy Chart 13Time To Buy Hedges Bottom Line: Return to an overweight position in gold mining shares, using the GDX as a proxy. A Tec(h)tonic Shift Our Special Report published in early-December showed that the tech sector underperforms when inflation pressures accelerate. Companies in the S&P technology sector are typically mature and have shifted from reinvesting for growth to paying dividends and buying back stock. Thus, the rise in bond yields and headline inflation imply higher discount rates and by extension, lower valuations, all other things equal, for the long duration tech sector (Chart 14). Tech companies exist in a deflationary business model mindset. While relative pricing power had been in an uptrend since 2011, it has recently relapsed into the deflationary zone (Chart 15, middle panel). As shown in last Monday's Weekly Report, the tech sector is one of the few suffering from deteriorating pricing power. Chart 14Stiff Headwinds Chart 15Pricing Power Disadvantage Among the broad eleven sectors, tech stocks have the highest international sales exposure, so a higher dollar is also a net negative for exports, revenues and by extension profit growth, relative to the broad market. Industry sales growth is nil, significantly trailing the S&P 500's recent pick up in top line growth rate. History shows that tech relative performance is negatively correlated with the U.S. dollar in the latter stages of a currency bull market. While the temptation to position for an increase in capital spending via the tech sector is high, data do not show any demand improvement. Tech new order growth is decelerating. The tech new orders-to-inventories ratio is on the verge of contracting, and further weakness would herald downward pressure on forward earnings estimates (Chart 16). Net earnings revisions have swung violently downward recently. Any prolonged de-rating would warn of negative share price momentum given the tight correlation between the two (Chart 16). Meanwhile, the loss of tech sector competitiveness and a retreat from globalization via protectionism de-globalization pose serious headwinds to the industry's longer-term prospects. Return on equity is already ebbing, reflecting more intense profit margin pressure from the surge in wage growth and a lack of revenue gains. As a result, EBITDA growth has been non-existent (Chart 17). Chart 16Momentum Is Fading Chart 17Growth Remains Elusive Chart 18Profits Set To Underperform All of these factors are encapsulated in our S&P technology operating profit model, which has an excellent record in forecasting tech earnings. Chart 18 shows that tech profits are likely to contract as the year progresses, a far cry from what is expected for the broad market and the 450bps of profit outperformance embedded in analyst forecasts in the coming 12 months. Bottom Line: Reducing tech exposure on price strength is a prudent strategy. Stay underweight. 1 http://www.barrons.com/public/page/9_0210-instrans.html Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).
The Treasury bond sell has undermined the REIT sector, but that has created excellent value. Our REIT valuation gauge is one standard deviation below the mean, an excellent starting point for forward relative returns. Now that Treasury yields are also in undervalued territory, the drag from this source is likely to diminish. Importantly, payouts remain well supported by rising pricing power, as proxied by new cyclical highs in the CPI component for homeowners equivalent rent. Importantly, multifamily housing starts continue to trend lower as a share of total housing starts, underscoring the future residential supply growth should subside. While banks have tightened standards on commercial real estate loans, this appears more likely to limit supply growth than create a slowdown, given that commercial property prices are hitting new highs. The bottom line is that both Net Asset Values and payouts remain well supported, setting the stage for a playable outperformance phase. We reiterate our high conviction overweight.
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).