Market Strategy Radar Screen Weekly May 07, 2018

And the Beat Goes On?

Last week ended with a broad rally in stocks across Europe and the US

Stocks caught a bid on Friday on news that Warren Buffet had added to his exposure in Apple (AAPL) stock and on jobs, unemployment, and wage data that added support for the view that the current rate of economic growth remains moderate, sustainable and at least not yet worrisome in terms of inflation.

With the S&P 500’s first quarter earnings season coming down the home stretch (410 of the benchmark’s 500 companies have reported thus far through last Friday) results added further support for stocks as earnings growth is up just under 25% on the back of 8.4% revenue (sales) growth.

While some investors still fret that Q1 results this good signal a “peak in earnings growth” for the cycle, a lessening of worries about inflation served to provide a positive offset as the jobs gain came in below expectations (164,000 versus 193,000 expected in a survey of economists), the average hourly wage year over year for April read 2.6% (also lower than expected) even as the headline unemployment rate fell to 3.9% (lowest level in 17 years) while the labor participation rate ticked slightly higher.

Friday’s stateside rally saw the Dow Jones Industrials, the S&P 500, the S&P 400 (mid-cap), the Russell 2000 (small cap) and the NASDAQ Composite rise respectively 1.4%, 1.3%, 1.3%, 1.2% and 1.7%. On a year to date basis those same indices have delivered mixed performance with the Dow Jones Industrials, the S&P 500 and the S&P 400 (mid-caps) relatively off 1.9%, -0.4%, and -0.16%.

The Dow Jones Industrials with just 30 names has shown vulnerability year to date via its exposure to weakness in the index’s member companies belonging to consumer staples, materials and telecommunications.

The Russell 2000 and the NASDAQ Composite (over 40% weighted in technology and technology related stocks) conversely have posted respective gains of 2% and 4.4% from the start of the year. The performance of those two benchmarks along with the positive gains of the information technology, consumer discretionary and energy sector in the S&P 500 point in our view to investors’ underlying belief that the recent market malaise from near the end of January through the start of this month may be a temporary interruption in the upside progress of the bull market.

In our discussions with clients and the press last week, we were asked some interesting questions. We’ve paraphrased the questions and our remarks and include them here:

Question: We hear much about volatility and the markets’ constant need to digest a wide range of news and information in the current political and economic environment. What’s the current disconnect in the markets, in your view?

Stoltzfus: I think there are several “disconnects” occurring simultaneously within the market at this time:

• The US economic expansion continues moving ahead at a moderate pace signaling a sustainable rate of growth of around 2.3% to 2.5% annualized with upside risk yet the stock market appears to churn and seems caught in a corrective phase partly on what we think are erroneous projections that interest rates are poised to move high enough to hurt corporate revenues and profits.
• Q1 earnings season (with some of 410 of the S&P 500’s 500 companies thus far reported) shows solid earnings growth (just under 25%) and plenty of positive surprises across the sectors. Yet only three of the S&P 500’s sectors are up on the year through the end of last week.
• As of Friday, ten of the benchmark’s eleven sectors have posted double digit earnings growth so far this earnings season. Among those sectors showing double digit earnings growth are six cyclicals: Energy, Materials, Information Technology, Financials, Industrials, Consumer discretionary, and two defensive sectors: Telecom Services and Health Care.
• Real Estate has thus far delivered single digit earnings growth with 31 of the sector’s 33 companies having reported.
• While 82% of the S&P 500 member companies have reported through last Friday things are looking in our opinion far better than one might think looking at the market’s performance thus far this year. With earnings better than they’ve been since around 2010 (when the economy and the markets were still early in the process of recovery from the Great Crisis and Recession) only three sectors are priced higher from where they started this year: Information Technology, Consumer Discretionary and Energy). The other eight sectors have lost ground so far this year.

Is the fear over rising Treasury yields overblown? And where would you put fair value for the 10-year right now?

We’d think the fear over rising Treasury yields is indeed overblown. Inflation remains moderate indicating a greater propensity for reflation of the economy (a good thing) rather than for rapid price advances that could lead to economic overheating and force the Fed to raise interest rates aggressively.

Wage growth remains modest as technology (robotics on the factory floor and algorithms in the workplace) reduces the relative number of employees that once might have been needed in offices and manufacturing facilities compared with past upswings or prior expansions. In addition, globalization has lowered barriers of entry to competition in a myriad of businesses. This increased competition among firms has been keeping inflation moderate as well.

What’s the worst that could happen to equities?

Lots of things could go wrong including: an unexpected deterioration of fundamentals, an unexpected surge in inflation that lingers, a protracted trade war, a mistake by the Fed in judging growth and inflation, or a period of unfounded negative sentiment overtaking the market for an extended period. We don’t expect that any of these will be realized but there’s never been “an all clear signal” sounded around the markets in our experience which spans over three decades.

Should investors be worried about stagflation?

Not at this time. Stagflation by definition is “persistent high inflation combined with high unemployment and stagnant demand” in a country’s economy. With inflation still low and rising only modestly, the unemployment rate at its lowest level since 2000, and economic growth steady in the 2% to 2.5% range, the reemergence of stagflation is pretty far down the list of worries at this time.

Where are we in the business cycle and the credit default cycle?

We’d say the US is in the late mid- to early late-cycle in terms of the business cycle. Technology and globalization in our view have contributed to a lengthening of economic and business cycles over the past 30 years just as they have contributed to the taming of inflation.

As to the “default cycle?” It’s likely been pushed out as a result of improved regulation in lending and broadly by more vigilant business practices in response to tougher lending regimens.

What are your expectations for the Fed next month?

Since the Fed has made its commitment to interest rate normalization very clear we expect it will raise its benchmark rate 25 bps in June, followed by another 25 bps in December. We expect three hikes total in 2018. That said, should the economy deliver a higher-thanexpected surprise in growth that would bump inflation high enough to concern the Fed, we believe monetary officials would respond accordingly.

What are your earnings expectations? And what will it take for earnings to push broader markets higher?

Our target price for the S&P 500 in 2018, which we initiated last December and have recently reiterated, calls for the benchmark to reach 3,000 by year end bolstered by earnings which we expect to reach $146 per share this year.

Are companies fairly valued right now?

The market appears to be seeking from day to day a clearer determination of fair value in light of concerns it currently embraces that range from inflation worries, interest rate risk, geopolitical risk, domestic political risk, deficit growth, and risks to revenue and earnings growth after some seven consecutive quarters of positive earnings growth through the current earnings season.

Does anything scare you about this market?

Should the market be overtaken by “FEAR” (defined as “false evidence appearing real”), that would worry us. FEAR and the market’s ability from time to time to erroneously project negative outcomes particularly on conflicting or volatile pieces of data. Remember when the yield on the 10-year US Treasury in 2013 rose from 1.63% on May 2 of that year to 3.02% on December 31 of that year based on concerns that the Fed’s consideration of tapering of its then monthly bond buying program was indication of worrisome levels of inflation ahead? At the start of 2014 the forces in the bond market realized that there wasn’t enough inflation at the time to warrant a 3% yield on the 10-year and bonds rallied and yields fell. Ironically the stock market in 2013 moved up over 29% that year counter to what many might have expected.

Where do the best investment opportunities currently lie?

Global equities (US and International) remain our favorite asset class for investable funds. We are overweight US equities, but are well exposed to developed, emerging and frontier international equities. (See our global asset allocation on page 11 of this report).

We remain market cap agnostic (prefer owning large, mid and small cap equities) as markets remain prone to rotation and rebalancing.

We favor cyclicals over defensive stocks and suggest exposure to both growth and value stocks.

The Week Ahead:

A busy week awaits investors returning from the weekend with a large list of items on the calendar to follow and ponder including US inflation, business sentiment, job openings, housing, wages, consumer, import/export gauges among this week’s data releases.

For the complete report, please contact your Oppenheimer Financial Advisor.

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