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Even as market seems to go from the pillar of rising coronavirus (COVID-19) infections in the US to the post of a potential vaccine, each with differing impact on the economy, equities continue to rise. As I and my colleagues have noted, the market is a discounting machine and right now it appears to be looking to a 2021 that could be better for humans and markets. Clearly, the talk of a vaccine from Moderna (MRNA) raised expectations and stock prices, on the one hand, but the heavy rise in U.S. COVID-19 cases—but not hospitalizations or deaths, see Tom Lee’s piece below—turned investors cold and sank prices. So there were many cross currents in a week that saw the Standard & Poor’s 500 index rise 1.3% to 3225. That’s about where it was when it hit a post-Covid19 panic high June 8, 3232.39, so stocks effectively have been marking time. For the year of 2020, the market’s total return eased into positive territory, up 1%. It was a week of reversals. Monday in particular was an unusual day, which saw the market jump out to a big rise, then only to fall after California rolled back its reopening plans, putting a damper on the economic recovery. Much is being made of the NASDAQ’s move up 2% that day to a new high and a 2% lower close, the only other time that happened was in March of 2000. A sample size of two doesn’t really do it for me in terms of scariness. As noted, stocks were pushed up on talk of a Moderna COVID-19 vaccine progressing through trials, but pushed down by the increasing number of coronavirus cases in the U.S. Again, as Tom Lee points out beginning page 3, serious hospitalizations and deaths are generally going in the opposite direction as cases, which is a good sign. Among sectors, cyclicals and value stocks are rebounding, something that colleague Rob Sluymer has been writing about. See page 7. Last week, value and cyclical stocks like financials, industrials and materials were among the leading sectors, up about 2%,6%, and 5%, respectively, while the info tech sector had a rare down week, off over 1%. And all that leaves out the beginning of the second quarter earnings reporting season. We’ve been saying that investors will look through what is sure to be a poor profits quarter. And there are more crosscurrents to parse. U.S. jobless claims showed 1.3 million filed for unemployment in the week ended July 11, not much changed. Yet U.S. retail sales for June rose 7.5%, more than economists expected. Industrial production—a measure of output at factories, mines and utilities—rose a seasonally adjusted 5.4% in June from May, the Fed said, higher than the 4% rise anticipated by economists. For 2Q20 as a whole, the index fell at an annual rate of 42.6%, the largest quarterly decrease since World War II. Despite some good data, there is worry about a double dip recession given some of the reversals in state re-openings. For example, job openings in July are down from last month across the U.S., and Google searches for “file for unemployment” are creeping up. Meanwhile, the major U.S. banks’, JPMorgan Chase (JPM) and Citigroup’s (C)—though beating analysts’ 2Q estimates—also reported setting aside reserves of billions of dollars as loan loss provisions. That’s rarely a good sign. Overall, investors are expecting corporate earnings among companies in the S&P 500 to have fallen 45% in the second quarter from the year-earlier period, according to FactSet. Financial companies within the S&P 500 are expected to take an even bigger hit—a roughly 57% drop. Chinese stocks had a tough week, down nearly 7%, on rising coronavirus infections and worries about the global economy. Data on China’s retail sector showed it is recovering more slowly than expected, with sales falling 1.8% in June from a year earlier. Economists had projected 0.3% growth. Still, the stock market remains resilient, despite the numerous negatives, supported by a basic expectation of an eventual recovery and stimulus from the Federal Reserve and the Federal government. As the market rose, the VIX (or so-called Fear Index) fell to 26 from about 32 one week ago. Quote of the Week: The Wall Street Journal: “The markets are looking out six months from now, and saying that things will be a whole lot better by then,” said Randy Frederick, vice president of trading and derivatives at Charles Schwab. He cautioned that uncertainty about the pandemic or the upcoming U.S. election could still sour the market’s rally in the coming months. Questions? Contact Vito J. Racanelli at vito. racanelli@fundstrat. com or 212 293 7137. Or go to

Overweight Value, Cyclicals; Favor Tech, Energy, Industrials

In my previous missives about 2020, I outlined our market view from 30,000 feet, so to speak, that our base case outlook is U.S. stocks rise 10% plus—to about 3450 on the Standard & Poor’s 500 index. This is predicated on index earnings growth of about the same amount or better this year. Let’s dive deeper now and see what styles, sectors and stocks I believe might work in this new year. My basic longer term-premise is that investors should overweight value and cyclical stocks, for reasons I’ll enumerate below. In particular, I favor technology, industrials, energy and basic materials sectors. In general, my themes for 2020 include the following: Overweight American stocks, as the U.S. decouples from the rest of the world Overweight technology, as technology/industrial companies will supply “nonhuman” labor and increase productivity Overweight asset heavy companies, as coming reflation will hurt those “subscription” asset light models and boost asset heavy models. Overweight companies exposed to the Millennial generation, as this bulging demographic cohort will be the primary driver of credit expansion in the future. And, in general, overweight value stocks versus growth, because we expect that as economic growth improves it will become a rising rate world, and history suggests that value beats growth in that environment. The base case for our “EPS is key” outlook is a recovery in 2020 EPS growth towards double-digits, as I noted in last week’s piece. The deep cyclical sectors are driving this recovery, led by technology, industrials, energy and basic materials. Collectively, these sectors are forecast to be more than 45% of the SPX’s EPS gains in 2020, so it’s pretty crucial to the thesis. Let’s look at history. Since 1949, whenever Purchasing Manager Indexes recover to above 50 level, as we expect, cyclical and value stocks have done well. More interesting, in the last 25 years, 3 groups consistently outperform in that scenario: technology, energy, among sectors, and value, in style. Why does value tend to outperform when the PMIs recovers above 50? The composition of the Russell 1000 Value Index, for example, could explain this. The “deep cyclical” sectors that are most sensitive to change in economic condition – the aforementioned industrials, materials and energy—represent some 21% of that Value index. Additionally, technology (including communication services) and financials represent more than one third of the Value index. They are the best performing sectors when PMIs rise above 50. The U.S. manufacturing sector contracted in December, thanks mainly to trade tensions. The Institute for Supply Management said on Friday its manufacturing index fell to 47.2 in December from 48.1 in November. The PMI is still in the process of bottoming and, as I’ve noted in the past, the UST 10-year-30-year bond spread suggests PMIs will recover later this year. On the other hand, the S&P 500 index has a higher mix of ‘high margin” or “high value” sectors such as technology and healthcare and has the lowest share of “deep cyclicals” like industrials, energy and basic materials. As a sidelight, I’d add that the inventory cycle is adding a little “oomph” to the PMI recovery. A factor supporting the bottoming of the industrial cycle (and hence, upside to 2020 growth) is this potential reversal of the previous inventory destocking. Another positive supporting stronger EPS growth in 2020 is that financial conditions continue to ease and markets stand at the best financial conditions since March 2018. The Goldman Sachs Financial Conditions index shows that financial conditions have eased in the past few weeks. (See chart below.) One thing not generally considered by investors is the turnover inside the S&P 500 index and what it means. Newly added companies will drive 23% of gains in S&P 500. Notably, my confidence in the future gains in the S&P 500 is driven by the realization that new companies will produce a meaningful share of gains. More than 23% of the return of the S&P 500 within any 10-year period is derived from companies added within the prior 10-year period. For example, in the last decade this has included new profits from Google (GOOGL), Facebook (FB), and Twitter (TWTR). Bottom line: Given that, my forecast is for the SPX to reach about 3,450 (from about 3235 currently) in our base case, or a bit less than 18 times price/earnings ratio on that $178 EPS. My best case scenario is for $184 EPS, to which we apply an 18 multiple for a level of nearly 3600 on the SPX.

Deep Drill into Data Shows Re-Accelerating Economy in 2020

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. Source: FS Insight, Bloomberg 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. Source: FS Insight, Bloomberg 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. Figure: Comparative matrix of risk/reward drivers in 2019 Per FS Insight Figure: FS Insight Portfolio Strategy Summary – Relative to S&P 500 ** Performance is calculated since strategy introduction, 1/10/2019

Don't Fight the Fed: Go for Growth and Cyclical Sectors

What’s a Federal Reserve Board interest rate cut worth to the stock market? We’ll soon find out, but history suggest it’s quite valuable to investors when the Fed reduces rates during an expansionary period rather than ahead of or during a recession. As you’ll see below, such a move will boost U.S. cyclical, growth and large cap stocks, among other asset classes. As the second quarter earnings reporting season gets underway, I’ve heard a growing chorus of strategists and investors call for a pullback in equities. Such bearishness is perhaps no surprise given the S&P 500 index is already up ~20% YTD, and given an earnings recession is underway, the third one since 2009. (For more on this see page 1.) Two weeks from now, the U.S. central bank is likely to make its first interest rate cut in almost 5 years and, as I’ve pointed out previously, such a move has dramatic impacts on markets. Moreover, given the paucity of investor conviction, one could argue there is a lot of cash on the sidelines, especially considering the substantial retail outflows from equity mutual funds in 2019 YTD. Equities are likely to see a strong boost from a cut. Since 1971, when the Fed makes its first cut and Leading Economic Indicators (LEIs) are still positive (as is the case currently, hence, we are not in recession), stocks have risen 100% of the time three, six, nine and 12 months later. In other words, don’t fight the Fed. The timing is key. When the Fed cuts and the U.S. economy is in expansion, the move drives positive equity returns. 100% of the time. (See nearby table.) The median nine months gain is ~18%, hence, we expect stocks to rise strongly into YE and believe our current 3,125 target is low. Cyclicals, which are outperforming the market by 280 basis points and defensives groups by 690 bp, is a group that should be positively affected. Multiple factors are behind this but I think the rally in high-yield and easing financial conditions are supportive. Moreover, the steepening of the U.S. Treasury 30 year – 10 year yield curve spread historically is coincident with cyclical outperformance. The rate reduction is also likely to favor growth stocks over value stocks, a continuation of the dominant theme for roughly the last decade. I have written extensively on the thesis that rising interest rates favor asset intensive businesses, such as value stocks, so the cut is likely a headwind for value. Similarly, the Fed’s anticipated move will probably help boost large market capitalization stocks over small. While this may sound counterintuitive, I see large-caps benefitting. Why? This further amplifies the equity “there is no alternative” (TINA) to stocks thesis, and US TINA in particular. I believe investor equity flows will more likely accrue to the big guys over the small fry. Additionally, I am beginning to wonder if a long-term mean reversion is underway. Since 1999, small-caps massively outperformed large-caps, but in the past eight years performance has really flattened. Further back, from 1990-1999, there was massive small-cap underperformance—is this a repeat? I’ve favored U.S. equities over the rest of the world (ROW) for some time now, but I expect the likely impact of a cut is for the S&P 500 to further pull away from the ROW. I base this on three cornerstone arguments: (i) US corporates have strong franchises; (ii) supportive White House/gov’t policy and (iii) accommodative financial conditions in US. A Fed cut is icing on the cake. My assessment since the start of the year is that the U.S. continues its relentless outperformance versus ROW. (See chart below.) Source: FS Insight, Bloomberg, FactSet Finally, I think gold will gain traction as a “hedge” around negative rates, but it will likely also be good for emerging markets. Gold outperformance is supported by Fed cuts (weaker USD, more zero rate bonds). But there is a curious positive relationship between rising gold and rising EM equities. While weaker USD is the likely link, I wonder if this means EM could lift-off on a Fed cut. Bottom line: While consensus may be right on a pullback, Fed cuts matter more. We see a 2H19 rally and recommend the following stocks: The tickers are GOOG, MNST, NKE, TSLA, AAPL, AMGN, AMP, AMZN, AXP, BF/B, BKNG, CSCO, FB, GRMN, NVDA, PM, PYPL, ROK, XLNX, ADP, CLX, MA, PG, V. Figure: Comparative matrix of risk/reward drivers in 2019 Per FS insight Figure: FS Insight Portfolio Strategy Summary – Relative to S&P 500 ** Performance is calculated since strategy introduction, 1/10/2019

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