Investors who look more deeply into what the market is saying will always do better. The consensus market mantra is that we are “late cycle” and that a recession is coming soon. Cue the bear market soundtrack.
As regular readers know, I don’t agree, and there’s data to back me up. Not every cyclical is telling us that we are “late cycle.” It will pay to heed that counsel. This upcoming week, global purchasing manager indexes for September will be released. It’s likely they won’t be so hot. The mantra will be repeated.
But here’s what you need to look at, and I’ve written about this in the past few months, even as that bear mantra has been repeated over and over. I don’t expect the US PMIs to bottom until the fall (October-ish) with a print ~46-48, as the 2018 downturn in oil, government shutdown, lingering damage from Fed over-tightening and global trade war work their way through the global economy.
Moreover, my favorite leading indicator for the US Institute of Supply Management’s Purchasing Manager’s Index is the 200-day change in long-term yield curve, which previously pointed to 2019 as seeing continuously weakening PMIs until the fall. See nearby chart.
Wait, you say, Tom, then how can you be optimistic?
Arguably, the global economy is weaker than the U.S., but that is because it has greater exposure to China. However, I do not believe the US economy is late cycle. Since the April 2017 study on the ISM that my team did, the long-term U.S. Treasury yield curve— the 10 month change of the 30-yr yield minus the 10-yr yield—seems to be doing a pretty consistent job of predicting ISM moves. Here’s what’s important: The latter signaled 16 months ago that a downturn in ISM PMIs was coming.
The data currently suggests the ISM will fall towards 50 by 3Q19 but then soar to new highs in 2020. This is my key response to the doomsayers. This move upwards in the yield curve, in my view, explains cyclical stock outperformance. Note that many global cyclicals are showing solid relative strength, consistent with our view PMIs could be bottoming this Fall. Groups sensitive to global cyclicality such as aerospace, construction materials, agricultural machinery, industrial gases and specialty chemicals are showing decent leadership and outperformance. See chart.
Even US groups like railroads, trucking and construction & engineering are not rolling over. The contra signal to the bear mantra is waste services. Generally, this group should be surging in a weakening environment, but it has actually seen a sharp downturn in past few months.
This action reflects two things: first, global central bank easing is working through the economy. And second, the global bear market of late 2018 is running its course. There are signs of bottoming in many of the hardest hit markets like emerging markets and Europe. Meanwhile, groups tied to global trade are understandably weak, such as conglomerates, industrial and construction machinery, among others, which have tanked. This confirms that economic momentum has slowed, but these groups are not necessarily a leading indicator of recession. An inventory correction is underway, affected by Brexit and the US/China trade war.
US housing related equities have come to life. Homebuilders, building products and construction materials, are surging. Appliances, home improvement retail, and home entertainment software are inflecting. This housing upturn is a particularly important signal. It shows that the Federal Reserve’s easing and global central bank liquidity is helping consumers.
Second, US residential private investment is 40% of overall US private sector spending (greater than corporate capex) and this is the area of the economy that has been dormant. Finally, this lines up with my thesis that millennials are entering their prime income years, pointing to a multi-decade rise in housing. Axios wrote recently that “Millennials are discovering the suburbs.”
What could go wrong? The drumbeat of headwinds from trade war, impeachment, Senator Warren surge, and tanking PMIs is scary.
Bottom line: We are still seeing signs of mid-cycle and not late cycle. We have identified 14 stocks in the 14 groups that are housing and cyclical momentum related. The tickers are ATVI, TTWO, LEN, NVR, PHM, NEU, ARNC, LHX, LMT, TDY, AGCO, DE, JEC, NSC.
Per FS Insight
** Performance is calculated since strategy introduction, 1/10/2019
