We have started to deploy cash in our core Fishbone
portfolio. We understand that October (especially election year October’s) can
be quite volatile so we still have cash available in the portfolio and will use
a pullback (within market support levels) to build additional positions.
Now that the Fed decision and the first debate is out of the
way, we believe there exists several tail winds that could propel the market
higher from here.
Politics
The real clear politics average has Clinton gaining ground
in the national polls. While the results are too close to call by any means, it
is probably likely that the market is satisfied that Trump’s momentum from a
few weeks back has been halted, at least for now.
Clearly the market doesn’t care for the proposition of a
Trump presidency. This was seen during and after Trump’s lackluster debate
performance when market futures and forex moved in tandem with Clinton’s debate
success. According to the NYT,
“During the debate, the overnight futures
markets rallied, raising the value of broad stock market gauges like the
Standard & Poor’s 500-stock index by two-thirds to three-quarters of a
percentage point. This was a consequential move, and because it was driven by
the reduced chance of a Trump presidency, it reveals that the market believes
that stocks would be worth more if he were to lose the election…the rally
played out in virtual lock step with Mr. Trump’s debate performance. When Mrs.
Clinton pummeled him over his tax returns, stocks rose. And this pattern of
stocks rising in response to Mr. Trump’s miscues continued through the evening.”
“Finally, a particularly
large rise in the value of the Mexican peso paralleled the rise in S.&P.
500 stock futures. The peso move, which appears to be linked to the reduced
likelihood of Mr. Trump’s being able to put into effect his immigration and
trade proposals, also suggests that the financial markets’ reaction was a
judgment that Mr. Trump lost the debate.”
If we lay out the electoral map and give each candidate the
state where he or she is winning (even if it’s by an amount within the margin
for error) then Clinton clearly wins the presidency. Political beliefs aside,
that would be a good thing for the market in the very short-term.
We know the election is too close to call but we are also
assured that Trump will consistently do something dumb to make sure he caps his
momentum and doesn’t run away with it prior to election day. That
is good for stocks in our opinion.
The Fed & The
Economy
The market is placing a 60% chance of a rate hike in
December. In our opinion the rate hike is already reflected in prices and we
don’t think it will have an overwhelming effect on the market. A 25bp increase
with dovish language would most likely rally the market in our opinion. Only a surprise
rate increase of more than 25bp may spook equities.
The economy seems to be improving of late but not to the
extent that would push the Fed to get more hawkish in their position in our
opinion.
The Citigroup Economic Surprise Index has been improving.
Year-over-year industrial production has bottomed and has
started to turn higher.
Aggregate manufacturing readings have also started higher
signifying a second half rebound for this year.
The Chemical Activity Barometer (CAB) has also turned higher
recently. According to the American
Chemistry Council, “ACC's Chemical
Activity Barometer is a first-of-its-kind, leading economic indicator that
helps anticipate peaks and troughs in the overall U.S. economy and highlights
potential trends in other industries in the U.S. This barometer can be a
critical tool for predicting broader U.S. economic health.”
The Atlanta Fed’s GDPNow economic growth model has been
moving lower lately but is still showing 2.4% real GDP (seasonally adjusted
annualized) growth for 3Q16. According to the Atlanta Fed GPDNow
website, “The GDPNow model forecast
for real GDP growth (seasonally adjusted annual rate) in the third quarter of
2016 is 2.4 percent on September 30, down from 2.8 percent on September 28. The
forecast of third-quarter real consumer spending growth declined from 3.0
percent to 2.7 percent after this morning's personal income and outlays report
from the U.S. Bureau of Economic Analysis (BEA). Following yesterday's GDP
revision from the BEA and the Advance Economic Indicators release from the U.S.
Census Bureau, the forecast of the contribution of inventory investment to
third-quarter growth decreased from 0.60 percentage points to 0.26 percentage
points and the forecast of the contribution from net exports increased from
-0.13 percentage points to 0.13 percentage points.”
This economic growth isn’t strong enough for the Fed
to aggressively start to tighten but it is strong enough to assure the equity
markets that we are not headed for recession.
The New York Fed also compiles the data to produce an
economic forecast that is the FRBNY Nowcasting
Report. They are looking for 2.2% economic growth in 3Q16 and 1.3% for
4Q16. Once again, not strong enough to enter a tightening policy but not too
weak to threaten recession.
According to research done on XE
Blog by New Deal Democrat, “The
recent wobbling continues. While long leading indicators remain almost
universally positive, different short leading and coincident indicators have
been fluctuating from week to week. For example, this week oil broke its
long positive streak, and temp staffing turned negative, while rail and the
Regional Fed indexes improved enough to score neutral.
Among long leading
indicators, interest rates for corporate bonds, treasuries, the yield curve,
real money supply, real estate loans, mortgage rates, and mortgage applications
are positive. A significant negative, however, is that mortgage rates have not
made new lows for over 3 years.
Among short
leading indicators, stock prices, jobless claims, gas prices, gas
usage, and industrial commodities, are all positive. Oil prices, however,
have turned neutral from being positive for over 2 years. Both readings of the
US$ are now neutral. The volatile regional Fed average have improved
enough to score as neutral.
The coincident
indicators remain mixed. Rail has improved enough again this week to score
neutral. Consumer spending remains neutral to negative. The BDI is now
positive. Steel, the Harpex shipping index, and bank rates remain negative. Tax
withholding is positive. Temp staffing turned from neutral to negative.”
Additionally, there seems to be a dire fear of the markets
correcting in any reasonable measure by policy makers across the globe. The markets
hit a weak patch largely due to the Deutsche Bank fall-out and suddenly we get
leaks of a much more subdued
banking fine and news that Chair Yellen would consider buying
equities as part of her monetary policy toolbox. The market recovers.
A weak but growing economic picture with policy makers
desire to keep the stock market stable ahead of elections will keep the
goldilocks stock market scenario in place for a reasonable period of time in
our view. That is good for stocks in our opinion.
Corporate Earnings
Earnings season is upon us and we believe it could provide a
boost to equity prices. According to FactSet,
“The Q3 bottom-up EPS estimate (which is
an aggregation of the EPS estimates for all the companies in the index) dropped
by 2.9% (to $29.76 from $30.65) during the quarter…Thus, the decline in the
bottom-up EPS estimate recorded during the third quarter was smaller than the
1-year, 5-year, and 10-year averages.”
A slowing in earnings deterioration should be considered a
good thing for equities.
They go on to note, “After
several quarters of year-over-year declines, analysts currently expect revenue
growth to return in Q3 2016 and earnings growth to return in Q4 2016. In terms
of earnings, the estimated growth rates for Q3 2016 and Q4 2016 are -2.1% and 5.6%. In terms of revenues, the
estimated growth rates for Q3 2016 and Q4 2016 are 2.6% and 5.2%. For all of
2016, analysts are projecting earnings to decline year-over-year (-0.2%), but
revenues to increase year-over-year (2.0%).”
It would appear that the profits recession is ending.
We could argue that the market is overvalued based on historical
valuation measurements, but only a damn fool would short this market based on
historical valuation in light of skewed equity risk premiums exacerbated by
aggressive monetary policy easing since the great recession.
The S&P 500 is expected to produce $127.18 in EPS over
the coming twelve months. Using Friday’s price of $2168.27 we get an earnings
yield of 5.9% compared to 1.59% on the ten-year. Risk premium comparisons
between the two are useless at this point. Given historical, five year and ten
year average P/E ratios for the S&P 500 one could make the case that the market
is 15% to 20% overvalued.
That said, shorter term earnings trends are looking
encouraging. The slope of the twelve month forward EPS for the SPX are recovering.
The slope of the earnings trend is a key variable to support higher equity
prices.
SPX book value and free cash flow have also resumed an
uptrend.
The same can be said for the Nasdaq Comp…
…and the Russell 2000
The end of the corporate profits recession and the return of
an upward sloping trajectory of fundamentals should provide fuel to advance
equities. A strong earnings season approaching can act as a catalyst for this
to transpire. That is good for stocks in our opinion.
Technical Picture
The SPX on a daily picture seems to be holding steady. The
solid support between 2120 and 2130 held up well last month and the index has
regained its 20DMA. It’s now bumping against the 50DMA. A break through that on
strong volume will entice us to deploy the remainder of our cash through 4Q16.
On the SPX weekly, We’re seeing a pick-up in volume and all the proper support
levels are intact. RSI (14) remains above 50 and the rally has been broad based
as seen by the action in the equal weighted SPX equivalent. We would like to
see a bullish MACD cross sometime soon to confirm the resumption of the
uptrend.
On the daily Nasdaq chart all signals are confirming an
uptrend. What we don’t like to see is the waning momentum seen in the MACD and
the various oscillators. As volume picks up we will be comforted in knowing
momentum has returned in a strong fashion. The weekly Nasdaq chart confirms our
bullish stance and has yet to show signs of cracking.
The daily Russell 2000 chart is very interesting. This index
has seen the greatest improvement in the slope of earnings (as seen in the
models above) and appears to be coiling for a nice breakout. A close above the
1260-1265 range with strong volume could launch this index. The uptrend remains
intact. We have taken a small position in ProShares UltraPro Russell2000
(URTY). We are waiting for confirmation before increasing our position. The
weekly Russell 2000 continues to show strong upward momentum from the February
lows. With momentum improving and the possibility of a 4Q breakout and rally, that
is good for stocks in our opinion.
Bottom Line: We
expect volatility through the end of the year but are confident that the market
can go higher from here. Political factors, monetary policy and economics,
earnings trends and technical analysis could be lining up to provide the much
anticipated 4Q rally. We are building positions in anticipation with stops in
place should our thesis prove incorrect.
Joseph S. Kalinowski, CFA
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