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Swap Exposure to Cyclicals From Safety Stocks...NOW

It’s time for investors to position their portfolios for the change in leadership just beginning to take hold, and this means increasing exposure to the right sectors and groups in 2H19 and well into 2020. There is a burgeoning evidence of a market rotation away from safety stocks, such as utilities and staples, and toward cyclicals, which is likely to significantly impact portfolio performance through year end and well into 2020. As a starting point, I believe investors should have an opinion on where the current market cycle stands. And as regular readers know, I believe the S&P 500 index lows in December 2018 marked another multi-year cycle low at the rising 200-week moving average, similar to what developed in 2016 and 2011. In theory, the current cycle should continue higher over the coming two to three years and looks similar to the four-year market cycle accelerations that developed during the secular bull markets of the 1950-1960s and the 1980-1990s. With the S&P 500 currently tracking the roadmap of a normal four-year cycle, the next question is how best to position a portfolio for the emerging cycle? First, capitalize on changes in sector and group leadership. The most important technical development unfolding in Q3 is the nascent rotation from safety, such as utilities and staples, and towards more cyclical groups. The stock chart of Charles Schwab (SCHW) is particularly noteworthy as an example of a cycle low as it retests and bounces from important support at its rising 200-week moving average. (See below.) SCHW is in the early stages of completing a cycle low at its long-term uptrend (200-week sma)Source: FS Insight, Bloomberg As developed in July 2016, SCHW’s retest of its 200-week moving average appears to be part of a broader bottoming process that is developing for more cyclical groups from semiconductors to industrials to financials. Weekly momentum, which tracks one and two quarter shifts, is in the early stages of turning up from oversold levels and is consistent with a cycle low developing.

Watch for Cyclicals bottoming for sign of new up cycle

You have to be impressed by the persuasive power of price movement on sentiment and headlines. I’m obviously just a bit biased, but the sudden reversal from bearish to bullish headlines only reinforces the importance of including technical analysis in one’s investment process. Why? Well, despite the short-term wiggles that have developed through the summer, the longer-term technical backdrop has served as a very helpful steadying perspective through all the headline noise. Pull up a monthly chart of the S&P 500 on your favorite charting software for a longerterm perspective that steps back from the near-term wiggles that dominate headlines. What you’ll see is a market index that has traded in a very narrow range following a major rebound from its secular uptrend using the 200-week (4-year) moving average. In fact, as I’ve regularly highlighted here, 2019 looks very similar to 2016 which was another period when equity markets stalled in the shadow of pending global recession… that never happened. Now, of course, I can’t state for sure there won’t be a recession, but if you believe equities are reasonably good at discounting events 6-12 months ahead, then the S&P’s chart pattern is hardly bearish, at least not yet. If you been reading this space regularly, my view remains unchanged expecting a Q4 upside acceleration by stocks into yearand well into 2020-2021. Until I see otherwise, equity markets are tracking a very normal bullish 4-year cycle acceleration. For active traders, I’m expecting one more short-term pullback from current levels given daily momentum indicators are becoming overbought. Pending pullbacks are viewed as buying opportunities in anticipation of an upside surge through Q4. The focus of the three stock charts this week reinforce the broader market cycle commentary above. JPM, ITW and JPM are good proxies for companies moving money globally, manufacture ‘stuff’, and digging and building respectively. These monthly chart profiles are broad consolidations to important technical support at their rising secular uptrends defined by 48-month (200-week) moving averages. If the economic backdrop is truly deteriorating, as many forecasters are warning, why are these global cyclicals merely in relatively shallow consolidations and beginning to bottom at major support. In the interest of keeping these charts easy to read, I didn’t include monthly momentum indicators which are is a useful way to view the longer-term cycles. If you were to add them to each of these charts, you would see they are all in the very early stages of a cycle upturn after peaking in late 2017/early 2018. If you are interested seeing these indicators added to these charts feel free to contact us and I’ll forward them. The bottom line is that these cyclical stocks appears to be have simply consolidated for 12-18 months after a strong bull cycle between 2016-2018 and are showing technical evidence of bottoming as part of a new up-cycle. As part of a diversified portfolio, I would encourage investors to add some cyclicality back to your portfolio particularly if the current positioning is heavily over-weighted in bond proxies.

Don't Panic Over Yield Inversion; US Stocks Attractive

The headlines and TV pundits have been screaming about the terrors of the inverted yield curve. After the yield on the 2-year U.S. Treasury note rose above the 10-year last Wednesday, a mini-panic ensued. Equity markets fell about 4% at one point after the 2-yr-10-yr US yield curve went negative, but have since recovered (see page 1). It’s the newest thing and bad news sells, of course, and it sells well. But what if the bad news is a head fake or just plain uninformed? A look at history often gives investors the context needed to make a knowledgeable decision. This is the third panic in markets as the US curve experienced various inversions, going back to the fall of 2018, just before the Christmas bear market. There was an inversion of the 1-year-5-year curve in November, when the market fell 16%, and then the 3mos.-10-yr inversion last March. The market lost 3%. Now you have the twos and tens inverting. The great market freak-outs over yield curve inversions are highlighted below. Inverting curves are not associated with normal circumstances. I get that this is a potential issue. Obviously, there is something troubling markets, evidenced by not only the widening inversions in the U.S. treasury yield curve but the widespread negative rates outside the U.S. (more than 27% of global sovereign bonds negative yield, or about $16 trillion). But here’s the history: previous 2-yr – 10-yr inversions going back to 1976 have predicted 22 of the 5 recessions. So you can see why I am not convinced that a recession automatically ensues or that stock selling is justified. Moreover, on the occasions when a contraction did follow the average time from inversion to recession was 20.5 months, with the shortest being 10 months lead time. Source: FS Insight, Bloomberg Secondly, a plunge in the 10-year note that drove an inversion has only happened once, in 1998, the only year out of five 2-10 inversions in which both yields were dropping— as now. The other four times were due to rising 2-yr rates. This should matter to investors because those other four inversions stemmed from Federal Reserve Board tightening and driving up front end. Sounds familiar, doesn’t it? This 2019 inversion is due to the collapse in 10-yr rates, and like 1998, stems from a global risk-off trade. Back then, it was the Long-term Capital and Russian debt crisis. Separately, I think there’s also juice in long term bonds, which have become a momentum trade. Multiple factors are strengthening the belief US interest rates could go to zero. If rates continue to drop, the 30-yr bond, for example, could rally 55%, the 10-yr 15%, but the 2-yr a mere 3%. Macro funds and momentum investors will be buying long-term bonds on this belief, further amplifying the inversion of the yield curve. Again, context is important. Investors should also note that in Germany and Japan, there has been this momentum bond trade but stocks have risen, too. Those countries with big gains in their 30-yr bonds also saw big gains in equities. Why interest rates are falling actually matters. This risks “over-simplifying” markets, but I’d like to provide a conceptual framework: Are falling interest rates due to deflation risk rising (i.e., business cycle slowdown), or this is a chase of lower rates/ momentum trade (add in “risk-off”). If the latter is this case, we should see lower “real” interest rates and this should be positive for equities. Zero interest rates are prevalent around the World, why not see it in the U.S.? Source: FS Insight, Bloomberg Here’s some more interesting history. Short term S&P 500 typically rallied after initial 10y-2-yr inversion. The S&P 500 index managed gains five of five times following the first inversion of the 2-yr-10-yr notes (the 2-yrs trade only since 1976), with an average further gain of 23%. In the last three occasions, stocks gained an average 33%, spanning 16-19 months before topping out. This doesn’t sound like a time to be selling stocks. The reason for the doom headlines is that recessions did follow five of the 2-yr-10-yr inversions. But what’s the predictive power of the 2-yr-10-yr inversion those five times when a recession followed? Weak is the answer. After each of the five inversions that were followed by a recession, it took at maximum 34 months and at minimum ten months for the recession to materialize. Ultimately, those who sell shares now could miss out on big gains, even if a recession arrives in late 2020. Mind you, after all of the sturm und drang last week, the 2-yr-10-yr curve returned to positive territory, albeit minimal, at a few basis points. In terms of strategy, note that cycle stocks led three of five times after the 2-yr-10-yr inversions (in 1998, cyclicals underperformed but technology outperformed in a big way) and cyclicals trailed in 1978 (stagflation period). What could go wrong? Global macroeconomic risks are elevated. Currently, the biggest concern is an escalation of trouble in Hong Kong and the threat of a mainland Chinese response. Bottom line: Inversion of the yield curve has caused markets to re-think their positions. The “zero rates” risk in the US creates a momentum trade to buy long-term bonds, potentially amplifying the inversion. We believe this mirrors 1998 and see this as a buying opportunity. Cyclicals worked 3 of 5 times we saw a 2-yr-10-yr inversion. 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

Let's Get Cyclical; Cyclicals Respond to Long Term Yield Curve Steepening

Those scary words “yield curve inversion” are being bandied about in the headlines by the press these days. Bad news sell papers, of course, but prudent investors should look beyond the headlines. The latter often don’t do justice to the phenomena supposedly being explained. What part of the Treasury yield curve is inverting seems to matter. And right now the U.S. Treasury 3- months bill to 10-year note is a negative 5 basis points. But, as I’ve noted here before, it’s the 10 year-30 year bond yield curve that gives the more accurate market signal historically. The front end is getting all the media attention and shouting but the back end is where investors should focus. The 10-30 yield spread has actually been widening, leading to a steepening yield curve, which is salutary for the economy in general and for cyclicals in particular, as we’ll see below. Today that spread is about 52bps compared to 10 bps about one year ago. Now the widening inversion of the front-end of the yield curve is a good news/bad news story. As I noted a few weeks ago, the first Federal Reserve rate cut, during a US expansion, sees explosive gains in equities (~18% over 9 months). However, an inverting curve also speaks to the growing global economic stresses from the trade war. Some of the global growth data is soft. Despite that, and more importantly, the long end of the yield curve has steepened sharply and is now the steepest in more than 3 years. That is a strong cyclical signal. A study done in 2017 by Fundstrat Global Advisors shows the long-term yield curve, as defined by the 30 yr-10 yr, leads the trends in the manufacturing survey from the Institute for Supply Management (ISM) by 16-18 months. Indeed, since that study was published, the long-term yield curve has done a good job forecasting inflection points in the ISM with about a 16-month lead. Why is that? That curve indicates the expected return of long-term capital investment; hence, a flattening signals slowing growth but a steepening creates investment incentives. The long-term curve is a more important business cycle indicator and is also a proxy for “return on long-term investment”—hence, a steepening spread signals economic growth set to re-accelerate. Currently, that yield curve suggests to me the ISM will fall towards 49-50 bps sometime in 3Q19 but then rise into 2020. As noted above, the spread saw a trough in June, 2018, which suggests to me that ISM will fall into 3Q19 and bottom perhaps in September or October at around 49-50. While this might trigger some investor anxiety about the business cycle, I expect the weakness to be transitory, assuming the global trade war does not further escalate. More importantly for investors, however, this signal points to a sharp rise in ISM throughout 2020. In particular, this move back up, in my view, is explaining the outperformance of cyclical stocks (see table below), which respond to both the steepening curve and to a rising ISM. If purchasing managers’ indexes are in fact bottoming and on the rebound, then cyclicals are the sectors to stick with. Given the front end yield curve inversion, investors might want to be defensively positioned, but the long term yield curve and an expected rise in ISM strongly argue for being overweight cyclical stocks. What could go wrong? The biggest risk to my view remains an external shock from political events, which is difficult to predict and not fundamental. Topping that list logically are: the China/US trade wars; the threat of a hard Brexit in October; potential military conflict in the Middle East, such as between Iran and the U.S., and the upcoming 2020 elections. President Trump remains at the focal point for three of the four points. Bottom line: My yearend Standard & Poor’s 500 index target remains 3,100, especially given the Fed is expected to cut in the second half of 2019. The following are 18 Cyclical stocks I expect to benefit from the upcoming ISM upturn in 3Q19. The tickers are BKNG, TPR, GM, LMT, NSC, MMM, CVX, XOM, PSX, COF, RE, BLK, MSFT, CSCO, ADP, NUE, FB and GOOG. 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

Non-Consensus View: Cyclical Stocks Should Come Alive

The market consensus is sometimes correct but sometimes wrong. I like to push against the consensus. Not only is it intellectually stimulating, but when the consensus is wrong investors can do well by using a contrarian approach. Currently, for example, the central thesis of market skeptics is that numerous political risks—such as the ongoing U.S.-China trade spat, a looming hard Brexit later this year, and President Donald Trump’s regular shoot from the hip tweets—will undermine corporate and financial market’s confidence sufficiently enough to lead to a selfsustaining economic contraction. That’s otherwise more commonly known as a recession. This is a consensus view and as such, investors are defensively positioned. Yet there’s some cognitive dissonance here: Why then are cyclical stocks—such as consumer discretionary and industrials—doing well this year and also leading in the rally from the June 3? (See nearby chart.) Secondly, why is the real estate sector second best? I believe that cyclical stocks are responding to, among other factors, the steepening long term yield curve and to rising inflation expectations. Cyclicals are leading year to date, and do so despite the 7% correction in May. The interesting sector anomaly is real estate, which reflects a rising inflation risk. Historically, the only time the market generally sees strong cyclical relative performance is when the long-term yield curve is steepening. This is the case currently, and I think owning cyclical stocks is the appropriate investment stance as well. This is analogous to the 2009 2010 period, which is fitting because I believe a new bull market started in December 2018, when stocks fell 20%–a bear market—from the September’s all-time high, on an intraday basis. The inflation risk is perceived to be rising because the Fed’s forward 5-year breakeven inflation rate less the consumer price index—a measure of that risk—has risen this year. (The breakeven rate is derived from the nominal 5-year Treasury yield minus the 5-year TIPS yield.) The gap between expected and actual inflation has widened, suggesting financial markets are pricing in a rise in inflation risk. Investors shouldn’t misread the drop this year in the US Treasury 10-year yield, which as I have argued several times earlier, is more due to zero interest rates in much of the rest of the world’s major bond markets than to a potential economic slowdown. Meanwhile, even as bears fret about the inversion of the 3 months-10-year Treasury yield spread and as the front end of curve is pricing in a Federal Reserve easing of the Fed funds rate quite soon, the more important long-term yield curve has moved counter to that and is steepening. Indeed, the best indicator of business cycle health is the long term yield curve, notably the 30 year-10 year spread. And its steepening suggests long-term growth outlook is accelerating and there is stronger growth ahead. The spread, now about 40 basis points, was just 12 bps one year ago. That’s bullish for cyclical outperformance, and similar to 2009-2010. The inversion in the front end reflects the need for the Fed to cut rates to correct for having tightened financial conditions in 2018, which aren’t hurting the long-term growth outlook. Additionally, as all the world knows by now, the Fed has made a very quick about face in the last month and is now expected to cut interest rates in 2019 instead of hike. Fed futures are pricing a rate cut potentially as early as next month. A rate reduction often leads an expansion in the market’s price/earnings (P/E) ratio. When the economy is not in a recession, as now, such Fed cuts lead to an average P/E expansion of 1.7 times over the next six months. This implies the forward P/E (2020) should rise to about 17 times, which would put the S&P 500 index comfortably at 3,100 or higher by year. My yearend target of 3125 is based on 17 times my S&P 500 Index EPS estimate of $184 in 2020. What could go wrong? With purchasing managers index surveys weakening, the current stall in economic momentum could lead to an economic downturn. However, this isn’t my base case and the US economy remains fairly resilient. Bottom line: I’m constructive on equities and see tailwinds for cyclicals. The following are the ticker symbols for 21 highly-ranked cyclical stocks: TRP, GM, BKNG, LMT, MMM, NSC, CSCO, ADP, MSFT, LYB, APD, NUE, CVX, XOM, PSX, BLK, NTRS, COF, FB, GOOGL and DIS.

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