Market Strategy Radar Screen Weekly May 31, 2016

Fed Speaks versus Fed Action

There's a considerable difference between what the FOMC members say and what the FOMC does.

We think it best for investors of bullish persuasion to remain committed to their cause, “stick to their guns” and “not race from one side of the boat to the other” in trying to stay in fashion with the latest whims or worries pumped through digitalized channels of information that can be influenced too easily in the moment by vested interests and un-vetted “tweets”.

We continue to hold the mantra of “don’t fight the Fed” in high regard.

That said,we believe it’s important to recognize the key risks facing the markets at this time. 

We believe they include:

• Fed policy transitioning towards normalization of rates
• Concern that the Fed might “get ahead of the curve” or “fall behind the curve”
• Risks in dollar strength vs. global currencies to regional and global growth
• Commodity price volatility tied to globalization and technology
• Near-term prospects for revenues and earnings in the quarters ahead for U.S. multinationals
• Brexit risk for the U.K., Europe and the U.S.
• U.S. Presidential election year risk ahead of the conventions in August
• Wage reflation while improving of late remains challenged by robotics on the factory floor and algorithms in the office place
• Lower barriers to competition driven by technology and globalization have caused businesses to remain hesitant to hire and expand capacity

Not exactly a short list of risks even when outlined in bullet points.

Near term the market has to work its way through these issues: 

• The next move by the Fed in the process of rate normalization: When? If? And by how much? As soon as June? (we think not) We expect the Fed to raise rates no later than December (by 0.25bps) and as early as July or September. Stateside data along with the health of the world economy ex-U.S. are key to their decision. 
• Some investors wonder just how hawkish is the Fed? We think there is a difference between “Fed speak” and Fed action
• In normalizing rates thus far (admittedly still early in the process) we think the Fed’s done a pretty good job. We think it will prove ultimately to be effective in delivering a process of normalization as well. Mistakes are always a possibility but this Fed would likely adjust course if it went too far in any one direction and adjust quite quickly at that.
• The dollar’s recent strengthening (after having weakened from the start of the year) could have negative implications for  U.S., multi-national revenues and earnings---particularly if the dollar would strengthen much further than it recently has should the Fed hike as soon as June or even July. We think the Fed is very aware of this risk and will act accordingly.
• Oil prices – appear to have stabilized (see figure below). The question is will they stay at these levels or will too much supply erode the recent price gains?
• We believe robotics on the factory floor and algorithms in the office are keeping labor pool inflation in check globally.
• Globalization and lower barriers of entry across a wide range of industries and lines of business worldwide heighten competition and are reflected in slower economic growth worldwide.

We believe the Federal Reserve as well as many of the central banks around the world recognize this and are acting accordingly to foster growth (even if at a relatively moderate pace) via monetary policy.

Our investment strategy reflected in our sector weightings favors select cyclical (economically sensitive) sectors over defensive (counter cyclical) sectors. We remain:

• Overweight four of the cyclicals: Consumer Discretionary, Information Technology, Industrials and Materials
• Neutral or market weight two defensives: Consumer Staples and  Health care along with one cyclical sector: Financials
• Underweight: Utilities,  Energy and Telecommunications

Market Activity:

So far this year with Fed and investors highly data dependent it’s not been easy being a bull but from our perspective it’s been even tougher to be bearish in our opinion.

Since February 11^th it appears to us that a combination of improving fundamentals via economic data along with expectations of improvements in revenue and earnings growth for corporations in the quarters ahead have provided the equity market with a degree of resilience that has so far been difficult for bears to overwhelm.

As of market close last Friday, the S&P 500, the S&P 400 (mid-caps) and the Russell 2000 (small caps) were 2.7%, 6.7% and 1.3% respectively higher on a year to date basis. In the week ended last Friday the same indices advanced respectively 2.3%, 2.9% and 3.4% (see pages 9 and 10).

Gold took a hit last week

While stocks have “shown brightly” so far in May (with only one trading day remaining in the month), gold’s luster has faded as expectations of a Fed rate hike sooner than later provided an earlier in the year weakened dollar with a second wind.

As stocks and the dollar advanced last week, the price of gold fell 3.1% as the shiny metal lost a degree of its luster with investors on prospects of the Fed raising rates higher and more than once this year.

Included among items that threw cold water on the bear case for equities and the economy last week was a packet of economic data that included:

• Better than expected existing home sales
• Substantially better new home sales (up 16.6% month over month)
• Better than expected improvement in the FHFA House Price Index
• A greater than expected drop in initial jobless claims to 268,000 last week
• Durable goods orders for April that broadly exceeded expectations (up 3.4% vs. 0.5% expected)
• U.S. March factory orders which were revised upward from a rise of 1.5% to 1.8%
• Pending home sales up 2.9% y-o-y vs expectations of a 0.2% gain
• An upward revision of annualized GDP from 0.5% to 0.8%

What’s gold telling us?

Gold is off 6.8% from its recent peak at the end of April.  Even with last week’s decline, the price of gold is still up 13.6% since the start of the year (see figure above).

The current decline tells us that perhaps too many investors had crowded into gold as it advanced sharply from the start of the year. The change in status of the metal has contributed to the recent rally in the dollar and has pushed the shiny metal from its perch of $1,292.99 per oz. (just reached at the end of last month) as expectations of higher rates stateside caused the metal to lose its favor with investors.

To us this should serve investors as a reminder that “follow-the-pack" trades too often end badly.

Most recently this has been illustrated by crowding in a long dollar trade at the beginning of the year just before the dollar began to weaken. That was followed by crowding to a “short the dollar" trade just as the dollar was about to rally having reached oversold conditions.

Crowded trades are akin to investors racing from “one side of the boat to the other” chasing the latest broadly identified short-term trend. Such action has caused more pain this year to impatient and nervous investors than many would care to admit.

It’s not hip to be square in numerous venues but in the market sometime the contrarian out of fashion viewpoint can have its advantage.

“What, me worry”?

Here’s a partial list of what we see as legitimate concerns that may prove less detrimental to stock prices if unrealized:

• Dollar rally risk (could go too far and hurt nascent recovery in U.S. multinational revenues and earnings
• Brexit risk (the effect of a Brexit would be broadly negative for UK and Europe
• U.S. Presidential election risk from now through the conventions with lead candidates’ platforms still uncertain
• Potential for a Fed policy error in raising or not raising rates
• China – economic and currency risk (should its currency decline further)
• Eurozone recovery risks
• Japan recovery risks
• Negative interest rates’ worldwide effect along with upward pressure on the dollar and downward pressure on U.S. interest rates
• Rising U.S. wages  could be misinterpreted as inflationary rather than reflationary

From “Don’t Fear the Fed” last week possibly to “Fear the Fed” this week

As we went press on Memorial Day 2016 headlines crossing the tape signal emerging market currencies moving lower against the dollar and in a process of extending their “worst monthly decline since August.”

It would seem that at least some investors are having second thoughts on last week’s broadly positive market reaction to Fed Chair Janet Yellen’s remarks last week.

We recall that the process of markets’ digesting comments of Fed chairs or the reading of FOMC minutes is seldom without second thoughts or questioning. 

We find ourselves not unsettled by the Fed Chair’s remarks and FOMC meeting minutes and find that they point towards an economy strong enough stateside and a recovery abroad sufficiently underway for the Fed to raise rates “in the coming months.”

The recent history of the Fed's actions throughout the Financial Crisis and Great Recession, through the recovery process, and now within an economic expansion causes us to remain positive on the future outcome of its actions ahead notwithstanding the possibility of some speed bumps along the way.

Stay tuned.

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