Fundamentals Suggest Impressive Risk-On Recovery Will Continue

The first two months of 2019 have treated Sabrient’s portfolios quite well. After a disconcerting 3Q2018, in which small-cap and cyclicals-heavy portfolios badly trailed the broad market amid a fear-driven defensive rotation, followed by a dismal Q4 for all stocks, the dramatic V-bottom recovery has been led by those same forsaken small-mid caps and cyclical sectors. All of our 12 monthly all-cap Baker’s Dozen portfolios from 2018 have handily outperformed the S&P 500 benchmark since then, as fundamentals seem to matter once again to investors. Indeed, although valuations can become disconnected from fundamentals for a given stretch of time (whether too exuberant or too pessimistic), share prices eventually do reflect fundamentals. Indeed, it appears that institutional fund managers and corporate insiders alike have been scooping up shares of attractive-but-neglected companies from cyclical sectors and small-mid caps in what they evidently saw as a buying opportunity.

And why wouldn’t they? It seems clear that Q4 was unnecessarily weak, with the ugliest December since the Great Depression, selling off to valuations that seem more reflective of an imminent global recession and Treasury yields of 5%. But when you combine earnings beats and stable forward guidance with price declines – and supported by a de-escalation in the trade war with China and a more “patient and flexible” Federal Reserve – it appears that the worst might be behind us, as investors recognize the opportunity before them and pay less attention to the provocative news headlines and fear mongering commentators. Moreover, I expect to see a renewed appreciation for the art of active selection (rather than passive pure-beta vehicles). However, we must remain cognizant of 2018’s lesson that volatility is not dead, so let’s not be alarmed if and when we encounter bouts of it over the course of the year.

Looking ahead, economic conditions appear favorable for stocks, with low unemployment, rising wages, strong consumer sentiment, and solid GDP growth. Moreover, Q4 corporate earnings are still strong overall, with rising dividends, share buybacks at record levels, and rejuvenated capital investment. So, with the Fed on the sidelines and China desperately needing an end to the trade war, I would expect that any positive announcement in the trade negotiations will recharge the economy in supply-side fashion, as US companies further ramp up capital spending and restate guidance higher, enticing risk capital back into stocks (but again, not without bouts of volatility). This should then encourage investors to redouble their current risk-on rotation into high-quality stocks from cyclical sectors and small-mid caps that typically flourish in a growing economy – which bodes well for Sabrient’s growth-at-a-reasonable-price (GARP) portfolios.

In this periodic update, I provide 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 remain bullish, while the sector rotation model has returned to a bullish posture. Read on…

Market Commentary:

Year-to-date through Friday’s close (3/1), the S&P 500 large caps (SPY) reflect a total return of +11.8%, Nasdaq 100 (QQQ) +13.0%, S&P 400 mid-caps (MDY) +15.9%, and S&P 600 small caps (SLY) +16.0%. If we look at performance from the close on Christmas Eve (“capitulation day”) through Friday, the SPY is +19.7%, QQQ is +21.5%, MDY is +22.6%, and SLY is +23.5%. Leading sectors have been risk-on cyclicals like Industrials, Technology (including the semiconductor segment), Energy, and Consumer Discretionary (including the homebuilding segment). And looking ahead, according to S&P Dow Jones Indices based on data starting in 1938, when both January and February have been positive, the S&P 500 finished the year in positive territory 29 of 30 times with an average return of more than 20%. And small caps seem to me to be even better poised for further gains. As DataTrek pointed out, small caps are heavily levered to high-yield corporate spreads due to external financing, and those spreads have tightened (reflecting lower credit risk) quite a bit this year, given the expectation of continued US economic growth, a supportive Fed, ongoing deregulation, and the fact that small caps are more US-focused and so are less impacted by dollar strength.

China stocks are up +23% in US dollars, as government stimulus and optimism about a trade deal improve investor confidence. In addition, its weighting in the MSCI Emerging Markets index was tripled to 2.82%, which suggests roughly $125 billion in new capital will passively flow into Chinese equities this year. But with China's manufacturing sector in contraction and its lowest growth target in 30 years, an end to the trade war with the US is imperative. Indeed, the news on this front has been quite positive and the recovery rally in global equity markets reflects this expectation.

The federal government shutdown resulted in the BEA releasing a combined first-and-second estimate of Q4 US real GDP growth. The results showed that the U.S. economy grew at an annualized rate of 2.6% during Q4, which was lower than Q2 and Q3. However, total 4Q2018 GDP was actually 3.1% higher than total 4Q2017 GDP, so we need to keep in perspective short-term fluctuations in annualized growth rates. Moreover, it will be interesting to see the Q4 reading on real Gross Output (GO), which is gaining traction as a key metric among economists since it measures total economic activity including transactions within the supply chain and not just final products. For Q3, when GDP measured 3.4%, GO came in at 3.9%, and historically, when GO grows faster than GDP, it foreshadows continued strong growth. Moreover, business investment grew 7.2% during 2018, which First Trust Advisors pointed out was the fastest growth for any year since 2011. And Consumer Confidence recently came in at 131.4, which is back to its lofty levels, and consumer credit default rates continue to drop. Nevertheless, looking ahead to 1Q2019, the Atlanta Fed’s GDPNow model (as of March 4) is forecasting only 0.3% GDP growth for 1Q2019, while the New York Fed’s Nowcast model (as of March 1) forecasts 0.88%.

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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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