Market Strategy Radar Screen Weekly May 16, 2016

Keeping Things in Perspective
Also means keeping expectations right-sized

Of the three major market capitalization indices, the S&P 500 reached its peak for the year so far on April 20th while the S&P 400 and the Russell 2000 ran higher a week further (to April 27) to arrive at their respective highs for the year to date.

A combination of a resurgence in dollar strength, volatility in the prices of oil and other commodities, declines in bond yields along with a Q1 earnings season that is poised to deliver negative earnings growth for a fourth consecutive quarter have curbed the market enthusiasm that drove a powerful equity rally from mid-February through most of April.

Typical of market retracements that we have witnessed over the last 7.5 years, since 2009, questions as to the longevity of the great recovery bull market in stocks are on the rise. This comes as no surprise to us.

Over the course of the economic and market recovery through the current expansion we have learned to practice discipline to avoid:

• mistaking reflation for worrisome inflation,
• mistaking stateside disinflation for deflation, and
• come to believe that a slowing in the economy from time to time may be just that and no more than interim slowing mid-economic cycle rather than the economy rolling over or an ominous sign of a  recession ahead.

It’s not about “late cycle slowing,” which in our opinion has too often been ascribed to periods of interim slowing over the last few years.

Instead periods of sluggishness that have emerged intermittently over the last 7-plus years seem in our view more illustrative of mid-cycle slowdown in an economy prone to slow growth.  This was caused initially by the magnitude of the financial and housing crisis and more recently challenged by slow wage growth (the latest reported at around 2.5% y-o-y) in large part driven by a major technological transition in the workplace that is driven by algorithms and robotics aligned with the process of secular globalization.

As a result of these trends the process of wage reflation that typically occurs in a post-recovery economic expansion is not taking place.

The upshot is a monetary policy that remains highly accommodative (some would say too much so) stateside and abroad to stimulate growth in lieu of more robust wage growth.

In such an environment it is hard to see official interest rates rising in such a way as to potentially risk a Fed rate hike mistake that would push the economy back toward recession. For now at least accommodative monetary policy remains the order of the day and the time line for the process of interest rate normalization appears extended.

For now we suggest investors stay focused on their objectives, remain patient, and keep observant while the economy and the markets seek out their next catalyst from which to garner direction and traction.

The adage to “know what you own and why you own it,” along with having an idea of how one’s portfolio is likely to perform in various scenarios applies well to the current environment.

Cyclical stocks with managements that foster dividend policies supported by strong cash flow appear the most attractive at this juncture. Improved performance this year in value stocks signals to us the attractiveness of a barbell approach that gains exposure to value stocks as well as to enough growth opportunities to provide current income with the potential for capital appreciation.

In the near term the economy and market are likely to produce sequences like those last week wherein progress remains mixed as some segments of the economy find tailwind and others face headwinds.

Consider that just last week:

• The price of oil (here we cite West Texas Intermediate data) rebounded 3.5% even as the S&P 500 Energy sector index shed 0.5%.
• While the price of oil has rebounded 72.2% from a mid-February low, it stands just under 57% below its June 20, 2014 high, likely indicating a rebound from earlier oversold conditions (see chart on next page).
• The US dollar (as measured by the DXY index) has jumped a little over 2% over the course of the last two weeks but remains off 4.1% year to date (see chart on this page).
• Retail sales reported last week showed a 3% y-o-y increase on the back of a better than expected 1.3% m-o-m increase expected in a survey of economists. In the same week, shares of a number of household names among traditional department stores fell sharply on disappointing first quarter results.  (see page 7 of this report for details).  

During previous periods of interim slowing that have occurred since the recovery process began stateside in the Spring of 2009 we have often found that after a growth scare appears on the landscape some piece of economic data (or an aggregate of data points that are decidedly positive) will cross the proverbial transom to overwhelm the angst and worry that grips the market. 

Turnaround sources have included an upward revision to economic data or a decidedly improved sequential data point that “turns the beat around” boosting sentiment from negative to positive in a relatively short period of time.

Volatility inherent in data is widely recognized in retrospect though not much remembered in the drama of the moment of a bad report.

A change for the better whether coming from the non-farm payroll number, initial jobless claims, auto sales, housing, ISM purchasing managers index or to a lesser extent durable goods and industrial production (likely because those gauges represents a smaller portion of the economy than that related to the consumer) can turn market sentiment pretty much on a dime.

Much like the posse that saves the besieged “good guys” in a classic western, a virtual “posse of positive economic data” has over the last few years none too infrequently chased fears off the investment landscape in fairly quick fashion.

Stay tuned.

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