After a Meandering Summer, Resilient Market Breaks Out
Some of our readers might remember an old black and white TV commercial about a Timex watch in which the manufacturer attached the timepiece to a motorboat engine blade; shot it at a wall using a bow and arrow, and dropped it in a washing machine, among other tests of resilience. In the commercials, at least, it always passed with flying colors: “It takes a licking but keeps on ticking.”
That pretty well describes the U.S. stock market. The S&P 500 index (SPX) had every reason to break to downside in the past month, as the looming litany of bearish arguments grew larger seemingly by the week—the inverted yield curve; the U.S. Treasury 10-yr note yield below 1.5%; the ISM falling below 50 (which suggests contraction); the VIX (fear index) surging, and President Donald Trumps “threats” to close the Federal Reserve Board.
Instead, we are witnessing an upside breakout of S&P 500 from the August range (2,820-2,940). From conversations with clients in the past few days, it seems investors remain largely skeptical of the rally, mainly because so many spent the past few weeks getting defensive in positioning and now don’t want to be whipsawed again.
The S&P 500 finally broke out of its August range on the heels of de-escalation of U.S.China trade/tariff tensions. Investors need to respect this breakout, as it comes in the face of widespread skepticism and de-risking due to the movements of the yield curve.
I believe S&P 500 is poised for a year-end rally towards my 3,125 yearend target. This implies a 5% gain from current levels. Given the combination of Fed easing, likely cyclical acceleration in 2H19 (recall previous notes on the long-term yield curve) and investor de-risking, I see this as probably.
Granted, the world is a scary place but S&P 500 is de-coupling from it. Skepticism isn’t surprising—this is a challenging environment for active managers given presidential tweets are a crucial macro catalyst and the terrifying message from plunging global rates. Yet the S&P 500 has indeed de-coupled from global equities—my assessment since the beginning of 2019—with U.S. continuing its relentless outperformance against the world, topping the MSCI ACWI by 6,980 basis points since 2007) and 460 bps year to date.
The big picture drivers continue to be the following: a strong, high-margin or high value U.S. franchises (technology, healthcare, in particular) plus the lowest share of “deep cyclicals” like industrials, energy and materials. There’s also a supportive White House/ government policy, and supportive central bank policies (easing financial conditions).
The implication that is the S&P 500 isn’t “ignoring bad news” but is rather highlighting that we remain in a bull market. Nor is it the case that the S&P 500 is immune to a global slowdown. In fact, the only “real” sources of meaningful demand is the U.S. and China.
According to the Credit Suisse Global Report 2018, the U.S. and Chinese consumer controls $150 trillion of wealth, ~50% of the global total, with 2/3 being the U.S. Think of it this way, Alan Greenspan’s recent comment that “the stock market will determine whether there is a recession” implies that the U.S. ultimately dictates whether the world slips into a recession—European economic weakness is secondary.
This leads America to decouple. There are five structural reasons for this: (i) the U.S. five-year population growth is outpacing Europe, China and Japan by 1.5%, 1.3% and 4.4%, respectively; (ii) the U.S. has a greater share of “high-value” sectors (34%) vs Japan, Europe and China, 20%, 18%, and 10%; (iii) in the World Bank Competitive Index, America has improved to #1(or best) on regulatory burdens vs peers; (iv) the S&P 500 index’s “cash return” yield at 5.2% is higher than Europe, Japan and emerging markets, 4.4%, 4.3% and 2.8%; and (v) the U.S. equity market offers vastly greater liquidity.
For example, the median S&P 500 stock is a $22 billion market cap while that is only $610 billion outside U.S. Effectively, every stock outside U.S. is, on average, a mid-cap stock and among liquidity measures, the top 10 American stocks have ten to 20 times the volume of the top ten in other countries.
What could go wrong? Confidence, both business and consumer, remains key to sustainability of the expansion. The drumbeat of negativism could lead to contractionary behavior and the level of pessimism was near “hysteria” reaching recession-mania levels.
Bottom line: Our base case remains a 2H19 rally into year end and to S&P 500 3,125, led by cyclicals.
The following 20 stocks are worth a look based on (i) cyclical sector; (ii) dividend yield > U.S. 10-yr; and (iii) ranked in the first quintile of the Doctor Quant Model: KSS, TPR, GM, BBY, CAT, EMR, HPQ, QCOM, MXIM, LYB, EMN, NUE, HP, XOM, CVX, PBCT, KEY, MS, BLK and VIAB.
Per FS Insight
** Performance is calculated since strategy introduction, 1/10/2019
