Market conditions remain strong for equities, in my view, with stocks being held back only by the (likely transient) trade war uncertainty. The US economy appears to be hitting on all cylinders, with the new fiscal stimulus (tax reform, deregulation) providing the long-missing ingredient for a real economic “boom cycle” to finally get some traction. For too long, the US economy had to rely solely on Federal Reserve monetary stimulus (ZIRP and QE), which served mainly to create asset inflation to support the economy (aka “Ponzi financing”), while the bulk of our working population had to endure de facto recessions in corporate profits, capital investment, and hiring. But with fiscal stimulus, corporate earnings growth is on fire, underpinned by solid revenue growth and record levels of profitability.
So far, 2Q18 earnings reporting season has come in even better than expected, with year-over-year EPS growth for S&P 500 companies approaching 24%. Even when taking out the favorable impact of lower tax rates, organic earnings growth for full-year 2018 still looks as though it will come in around the low to mid-teens.
Cautious investors are seeing the fledgling trade war as a game of brinksmanship, with positions becoming ever more entrenched. But I actually see President Trump as a free-trade advocate who is only using tariffs to force our trading partners to the bargaining table, which they have long avoided doing (and given the advantages they enjoy, why wouldn’t they avoid it?). China is the biggest bogeyman in this game, and given the challenges it faces in deleveraging its enormous debt without upsetting growth targets, not to mention shoring up its bear market in stocks, its leaders are loath to address their rampant use of state ownership, subsidy, overcapacity, tariffs, forced technology transfer, and outright theft of intellectual property to give their own businesses an unfair advantage in the global marketplace. But a trade war couldn’t come at a worse time for China.
In this periodic update, I provide a 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 moderately bullish, while the sector rotation model retains its bullish posture. Read on....
Market Commentary:
I have a lot to talk about this month, so I’m breaking it up into sections. I will start with market performance, economic reports, and corporate earnings, then follow up with equity valuations and interest rates, then get a bit into the trade wars, and then finish up with some closing thoughts.
Performance, economic reports, and corporate earnings:
Year to date through Friday August 3, the S&P 500 large cap index is +6.3%, while the S&P 600 small cap index is +12.8% and the Russell 2000 is +9.1%. Stocks continue to be led by the Momentum factor. Looking at the iShares Edge MSCI USA single-factor ETFs, Momentum is far-and-away the leader at +9.6%, with Quality at +5.0%, Low-volatility at +4.7%, and Value at 3.5%. However, since the market swooned in early June (in response to tariff threats going into effect and rhetoric escalating), the Low-volatility factor has been the leader in a defensive rotation. Still, growth stocks have significantly outperformed value stocks year-to-date and over the past 12 months. The SPDR S&P 500 Growth (NYSE:SPYG) is +11.8% YTD through Friday, while SPDR S&P 500 Value (NYSE:SPYV) is essentially flat at 0.6%. Notably SPDR S&P 500 Growth (NYSE:SPYG) has its highest sector weighting in Technology at 37%, while SPDR S&P 500 Value (NYSE:SPYV) is heaviest in Financials at 24% (and has less than 7% in Technology) – and Technology Select Sector SPDR (NYSE:XLK) is +13.7% YTD while Financial Select Sector SPDR (NYSE:XLF) is +0.75%.
Goldman Sachs recently opined, “Unlike past episodes of narrow market breadth, the earnings environment today appears healthy and broad-based.” Indeed, I think market breadth in accumulation has been good, as evidenced by strength in small caps. Although I prefer to see the S&P 500 Equal-Weight index (+4.2% YTD) outperforming the cap-weighted version (+6.3%), the aforementioned Momentum factor and some high-flying mega-caps have made that race difficult to win for the equal-weight index. So, I would call the relative performance “close enough.” In addition, the Advance/Decline line remains in an uptrend, indicating a broad level of participation and points to a stock market that is consolidating within a secular uptrend. I also like to look at sector correlations to the benchmark, which are about 75% for the year so far, but for the past month they are around 50%, which means investors are picking their spots for investment – including suddenly avoiding the market segments and companies deemed most vulnerable to import tariffs. Some of these suddenly shunned companies are Sabrient GARP (growth at a reasonable price) favorites, but they are showing even better forward valuations for strong growth projections today than they did when we picked them – so we fully expect them to rise once again.
Because a broad expectation for 20+% year-over-year EPS growth rate for the S&P 500 was largely baked into expectations, investor focus has been on forward guidance and how much the trade war rhetoric would impact plans for new capital investment. As expected, corporations have been using much of their huge stores of cash and new cash generation for share buybacks, dividend increases, and M&A, but capital spending (on new factories, onshoring operations, equipment upgrades, and capital goods) is the best indicator of corporate optimism in the future. Recall the extended period of anemic capex before the 2016 elections, as businesses were reluctant to invest given all the uncertainty. But for Q1, capital spending by S&P 500 companies totaled about $167 billion, representing a year-over-year growth rate of 32.7%. For Q2, year-over-year growth was still a solid 15.7%. This is good stuff. Notably, the CBOE Market Volatility Index (VIX), aka “fear gauge,” has fallen precipitously to close Monday at 11.27, as volatility has subsided.
As for recent economic reports, unemployment fell back below the 4% level to 3.9%, with wage growth at +2.7% year-over-year. The U6 unemployment rate (including discouraged workers and those settling for part-time jobs) fell to an ultra-low 7.5%. Chicago PMI was described as “torrid.” Railcar utilization (Warren Buffett’s favorite indicator) has risen to a robust 86%. Redbook same-store retail sales numbers were stronger, and the PCE Index rose nicely, with analysts noting an easing in inflationary pressure and a healthy consumer. Although New, Existing, and Pending Home Sales were slightly down year-over-year, the S&P Corelogic Case-Shiller Home Price Index was up. Both Consumer Confidence and the State Street Investor Confidence Index rose. These suggest both a healthy consumer and accumulation of equities by global institutional investors.
For US real GDP growth in 2Q18, domestic economists’ consensus estimate was for annualized growth to be at least 4%, and they were right, with the BEA’s advance estimate coming in at an annualized rate of 4.1%, the fastest since 2014 (note: the second estimate will be out on 8/29/18). In addition, Q1 GDP growth was revised upward to 2.2%. Of course, there were those analysts who tried to put a wet blanket on it, noting a spike in Q2 exports likely intended to skirt the imminent tariffs, which essentially borrowed from Q3 growth. But the reality is that inventories are also included in the GDP computation, so most of those extra exports came out of inventories (in fact, it was the largest drop in inventories since 2009). So, it was basically a wash, with increased exports adding 1.06 to GDP and decreased inventories subtracting 1.0. In other words, the GDP growth was for real.
Looking ahead, the Atlanta Fed’s GDPNow model as of August 3 forecasts 3Q18 GDP annualized growth of 4.4%, while the New York Fed’s Nowcast model forecasts 2.6%. Both the IMF and the OECD have lifted their estimates for full-year 2018 global growth to 3.9%, which would represent the highest pace since 2011 if it comes to fruition. The IMF also upgraded US expectations from 2.7% to 2.9% and China from 6.5% to 6.6%. For full-year 2018, forecasting firm IHS Markit is predicting real US GDP growth of 3.0%, then falling to 2.7% in 2019 and 1.7% in 2020 as unresolved trade wars, tightening of monetary stimulus, high oil prices, and geopolitical risks persist and take a toll. However, I believe trade wars will subside, as discussed below.
I keep hearing commentators lament that the economic cycle and bull market are getting long in the tooth, but I just don’t see it, other than on the calendar. But you have often heard that bull markets don’t die of old age, nor do economic cycles. With annual GDP growth over the past nine years barely averaging 2%, this post-Financial Crisis recovery has barely caught any traction compared to the recoveries in the 1980’s and 1990’s that averaged in the 3.9% to 4.5% range. As such, I continue to believe there is plenty of fuel in the tank from tax reform, deregulation, and new corporate and government spending plans, providing potential for strong growth for at least the next few years. Notably, Reuters’ monthly asset allocation poll of 50 global wealth managers and CEOs showed an increase in their US equity allocations to roughly 42%, which is the highest since June 2015.
Moreover, the quality of earnings appears to be improving, which of course is the area of expertise of Sabrient’s wholly-owned subsidiary Gradient Analytics. First and foremost, “cash is king,” and whereas prior years have seen earnings growth driven more by cost-cutting and creative accounting, today we are seeing earnings growth driven by revenue growth. For 2Q18, S&P 500 companies are on course to hit 9% revenue growth, which would be the highest since 2011. Furthermore, corporate profitability is stronger than ever – and importantly, it encompasses all sectors (yet another indicator of market breadth). For Q1, net profit margin for S&P 500 companies hit a record high of 11.4%, and the 12-month forward profit margin at that time was estimated to be 12.3%. Such strong profitability serves to magnify top-line growth as it flows down to the bottom line, allowing earnings to grow at much faster rate than revenues, which is favorable for equity prices. So far in Q2, with 81% of the S&P 500 companies having reported, FactSet says that 74% of the reporting companies have beaten consensus revenue estimates and 80% have beaten EPS estimates, and the overall year-over-year earnings growth rate is expected to be 24%, with a net profit margin of 11.8% (another record).
As for the lofty levels of non-financial corporate debt, which is now at 45% of GDP, I have read commentaries expressing grave concern that defaults will be rising as interest rates creep up. But I think this a situation in which you must look at other key variables relevant to today’s economy to put this in the proper context. The real question is whether this level of debt is as burdensome today as it might have been in the past. So, you should consider the cash positions of corporate borrowers by netting out cash and cash equivalents from the debt. Given the tax cuts and strong corporate earnings and cash flows that have led to high levels of cash in the corporate coffers, net corporate debt to GDP is about 33%, which is right in-line with historical averages for net debt levels – and it is even less concerning than other times in history given today’s superior profitability and low interest rates.
Equity valuations:
Some gloomy commentators are lamenting the 2.02% 3-month T-bill yield having eclipsed the 1.82% dividend yield of the S&P 500, calling it a warning sign of impending recession. But this is another case of taking a situation out of context. Shareholders are enjoying record levels of share buybacks, which reduces public float and improves valuations. When you add in the yield from buybacks, the composite yield to an investor actually might be around 5.2%, based on BofA’s estimate that S&P 500 companies will execute buybacks totaling $850 billion this year (3.4% of the S&P 500 market cap of about $25 trillion).
Moreover, the S&P 500’s dividend growth over the last five years has averaged 13.4%, and with the tax cuts putting more cash into corporate coffers, I would expect that growth rate to rise. Increases in dividends are a signal from corporate leadership that the future is bright such that higher dividends are sustainable, as opposed to share buyback programs that are often ad hoc. In addition, Thomson Reuters has reported that global M&A activity totaled $2.5 trillion during 1Q18, which was 64% higher than 1Q17.
Let’s talk a bit about stock valuations. The S&P 500 has a forward P/E of about 16.4x, implying an earnings yield of 6.1%. The S&P 600 small cap index has a forward P/E of about 17.6x (5.7% earnings yield). In addition, S&P 500 Growth (SPYG) is at 20.1x (5.0% earnings yield) and S&P 500 Value (SPYV) is at 14.2x (7.0% earnings yield). Using the “Fed Model” to compare these to a 10-year Treasury yield under 3%, stocks still look pretty good to me.
Moreover, Sabrient continues to find intriguing stocks with low forward P/E and forward PEG (forward P/E to next 12 months year-over-year estimated EPS growth). Our July Baker’s Dozen portfolio displayed upon launch an average forward P/E of 13.2x for over 100% average EPS growth, or a forward PEG of 0.13, which is extraordinarily low.
Regarding growth stocks in general, the Technology sector represents nearly 40% of them by market cap, so let’s examine some of the big players. Following recent disappointing reports from FANG stalwarts Facebook (NASDAQ:FB) and Netflix (NASDAQ:NFLX), last week Apple (NASDAQ:AAPL) bolstered the Tech sector with a strong earnings report and became the first company ever to hit $1 trillion in market cap – and Alphabet (NASDAQ:GOOGL) (GOOG), Amazon (NASDAQ:AMZN), and Microsoft (NASDAQ:MSFT) are all inching closer to that mark, as well. So Tech is overvalued, right? This has become another Tech bubble like in 2000, right? Well, not so fast. The reality is that these market leaders can be considered relatively cheap today compared to 2000. Most of the Tech juggernauts not only dominate their space but are also cash machines with superb profitability and cash flow generation. Also, the cost of capital is much lower today. Thus, Tech sector profitability, cash flow generation, and cash balances are much higher while the cost of capital is much lower, all of which bolster valuations. So, making simple comparisons of P/E and P/S today versus in 2000 is yet another example of comparing numbers out of context.
Sell-side analysts continue to raise consensus revenue and earnings estimates for 2019. As of July 19, economist Ed Yardeni calculates the consensus year-over-year EPS growth for 2018 to be 21.3%, with earnings rising so fast, he thinks the market deserves a P/E ratio in the high teens (e.g., 17-18x). So, with the S&P 500 reflecting 2019 earnings expectations of $177.34 per share, and assuming a forward P/E of 17x at year-end, the S&P 500 would close the 2018 at 3,015. This view aligns with what I have been forecasting all year.