EC Ducks Continue To Line Up Positively For Equities

The market this year has been oscillating between fear and optimism, risk-off and risk-on. Until 8/27/19, risk-off defensive sentiment was winning, but since that date a risk-on sentiment has taken hold, and the historic divergence favoring secular growth, low-volatility and momentum factors, defensive sectors, and large caps (i.e., late-stage economic cycle behavior) over cyclical growth, value and high-beta factors, cyclical sectors, and small-mid caps (i.e., expansionary cycle behavior) continues to reverse, as fickle investors have become optimistic about at least a partial resolution to the trade war (including the lifting of tariffs), an improving outlook for 2020-21 corporate earnings, and resurgent capital investment. Investors have moved from displaying tepid and fleeting signs of a risk-on rotation to full-blown bullish enthusiasm and reluctance to sell in a fear of missing out (FOMO), even though the short-term technical picture has become overbought.

The late-August risk-on rotation came in the nick of time. Last year at that same time of the year, the S&P 500 was marching higher until peaking on 9/20/18, but it was doing so on the backs of defensive sectors along with secular-growth Tech mega-caps, and I was opining at the time that the rally would fizzle if there wasn’t some rotation into the risk-on cyclicals and small-mid caps – which as you know didn’t happen, leading to the Q4 selloff. But, happily, this year has played out quite differently.

Nevertheless, a lot of successful fundamentals-based strategies (including powerhouse quant firm AQR Capital, discussed below) really took it on the chin for the roughly 14-18 months preceding 8/27, ostensibly due to fear that a “late-cycle” economy was on the verge of recession. And indeed it was becoming a self-fulfilling prophesy, as the dominos seemed to be falling one by one:  escalating trade wars creating uncertainty leading to a global manufacturing slowdown, a hold-off in corporate capital spending, and negative interest rates overseas, which pushed global capital into US debt, which temporarily inverted the yield curve, which brought out the doomsaying pundits – all of which was beginning to negatively impact the previously-bulletproof consumer sentiment that had been carrying US GDP growth.

But it was all based on false pretenses, in my view, and investors now seem to be convinced that the bottom is in for the industrial cycle and the corporate earnings recession, and particularly for prices of value/cyclical stocks with solid fundamentals. Results haven’t been as bad as feared, and some of the macro clouds are parting. Ultimately, stock prices are driven by earnings expectations and interest rates (for discounted cash flow valuation), and as the external obstacles hindering the free market are lessened or removed, the outlook brightens. And when investors focus on the fundamentals rather than the latest tweet, CNN headline, or single economic number taken out of context, it bodes well for Sabrient’s value-tilted GARP (growth at a reasonable price) portfolios, which of course includes our flagship Baker’s Dozen.

In this periodic update, I provide a detailed market commentary, offer my technical analysis of the S&P 500, review Sabrient’s latest fundamentals-based SectorCast rankings of the ten US business sectors, and serve up some actionable ETF trading ideas. In summary, our sector rankings still look neutral to me, while the longer-term technical picture remains bullish, and our sector rotation model retains a solidly bullish posture.

Market Commentary:

Capital is rotating out of bonds and into equities. Institutional demand (the “smart money”) has surged. And the rally has been broad-based, as the Invesco S&P 500 Equal Weight (RSP) has been slightly outperforming the cap-weighted SPDR S&P 500 (SPY), while the Invesco S&P SmallCap 600 Equal Weight (EWSC) is outperforming the cap-weighted SPDR S&P SmallCap 600 (SLY) as well as both the SPY and RSP. But performing better than all of them is the SPDR S&P 600 Value (SLYV), which is quite bullish. So, it isn’t just Technology attracting capital.

Prior to 8/27, year-to-date sector leadership comprised Utilities, Consumer Staples, and Real Estate, but since then, laggards like Materials, Financials, Industrials, and Transports have become the leaders. Even Healthcare, which has been struggling under the weight of political rhetoric (e.g., “Medicare for All” and drug pricing) has been making a comeback. Banks, homebuilders, building supply, oil refining, trucking, and semiconductors have been leaders, and “deep cyclicals” like steel, mining, chemicals, railroads, heavy equipment, and machinery companies are attracting capital, as well – which is not suggestive of an impending recession. And on the chart below, take a look at the iShares MSCI Europe Financials (EUFN), which is up nearly +16% since 8/27. It also shows outperformance in Financial Select Sector SPDR (XLF) and the aforementioned SLYV, EWSC, and SLY versus RSP, SPY, and (defensive) Utilities Select Sector SPDR (XLU).

(Click on image to enlarge)

Performance comparison of market segments

But as you might expect, Tech (except for the software segment) is not being left behind. In particular, the cyclical semiconductor industry is trading at new all-time highs, reflecting the secular growth expectations of 5G, AI, Internet of Things, Big Data, robotics, autonomous vehicles, augmented reality (AR), etc. Only the Energy sector (except for the consumer-oriented refining & marketing segment, which is looking strong) continues to struggle among the cyclical sectors.

My friends at DataTrek observed a few weeks ago (on 10/22) that while the S&P 500 was handily outperforming the Russell 2000 this year, it was completely attributable to secular growth “large-cap disruptive technology,” and primarily driven by six mega-caps: Apple (AAPL), Microsoft (MSFT), Visa (V), Mastercard (MA), and Oracle (ORCL) – which make up 50% of the Technology sector by market cap – plus Facebook (FB), which is now in the Communications Services sector. Without these juggernauts, DataTrek determined that the S&P 500 actually would be lagging the Russell 2000 small caps. Moreover, this handful of mega-caps was suppressing overall market volatility, whereas the vast majority of stocks actually have been much more volatile. Of course, “deep cyclicals” like Industrials, Energy, and Materials have been heavily impacted by the unending trade war, and the small-cap universe is dominated by value/cyclical sectors like Financials and Industrials that have been buffeted by uncertainty, in contrast to the large-cap universe that is dominated by secular growth Technology (which by the way, makes the S&P 500 a difficult benchmark to compete within anomalous times like these).

FactSet observed last Friday that, after 89% of S&P 500 companies have reported Q3 results, aggregate year-over-year earnings are showing a decline of -2.4%, which marks the first time the index has reported three straight quarters of year-over-year declines in earnings since 4Q2015-2Q2016. Moreover, net profit margin for the S&P 500 appears to be around 11.3%, which would mark the first time the index has reported three straight quarters of year-over-year declines in net profit margin since 2009. It all seems to be driven by difficult year-over-year comparisons (which were historically high last year, including record profitability of 12%) as well as higher costs like wages and raw materials. The latest BLS data showed productivity declined 0.3% last quarter while unit labor costs rose 3.6% over last year. But make no mistake, this is still solid profitability. Note that many corporations warned of lower earnings and profitability due to the difficult comps versus last year’s sudden boost from the tax cuts. So, investors were expecting this and are now focused on the horizon ahead, with earnings and profitability expected to increase (and benefit from this year’s lower comps). Indeed, that will have to be the reality if stocks are to continue to rise since further multiple expansion is unlikely, especially given the gradual steepening of the yield curve (which increases the discount rate on future earnings).

Of note, UBS lead strategist Francois Trahan wrote a gloomy update to clients, saying, “Every bear market of the past 50 years has witnessed an actual decline in S&P 500 forward earnings…Ultimately, the most vulnerable macro backdrop for equities occurs when forward earnings growth turns negative as LEIs are trending downward (pushing P/E lower)”. True enough. But here’s the rub from my perspective. The underlying weakness in manufacturing and incorporate capital spending has been driven by uncertainty from the escalating trade war, not from overproduction, rising inflation, or central bank tightening. Already, investors are anticipating a positive turn in the trade war, particularly given the urgency created by both economic weakness in China and the impending US election – and given that the prevailing view is that there is little likelihood of the Senate removing Trump from office, a resurgent economy and rising corporate earnings in 2020-21 seems more and more likely to investors.

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Disclaimer: This newsletter is published solely for informational purposes and is not to be construed as advice or a recommendation to specific individuals. Individuals should take into account ...

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