Equities
For the month of May, the model underperformed both global equities and the S&P 500. For the month of June, the model is further paring back its risk exposure.
Consumer goods stocks enjoyed a spirited run at the end of 2015 and into 2016, but have largely consolidated that outperformance this year. However, the S&P packaged food (PF) index has bucked the trend, recently setting a new all-time relative performance high. Despite our preference for defensive groups, we are surprised by the resilience of the PF industry, and wary of its sustainability. To be sure, a surge in net earnings revisions suggests that analysts were behind the curve. However, positive profit revisions are not necessarily a sign of operating vitality, as they appear to be entirely driven by cost reductions rather than top-line strength: packaged food sales growth is contracting. PF ROE has deteriorated on the back of revenue contraction, diverging negatively from the relative valuation expansion. Typically, a sustained multiple increase can only occur within the context of a rising ROE, given the latter's direct impact on profit growth. Relative valuations may reflect an M&A premium rather than superior operating performance. Both the value and volume of deals accelerated aggressively in 2015. But 2016 has seen a sharp drop in the value of announced deals, warning that valuations may get squeezed unless growth prospects improve. We are underweight this group. The ticker symbols for the stocks in this index are: BLBG: S5PACK - MDLZ, KHC, GIS, CAG, TSN, K, MJN, SJM, HSY, MKC, CPB, HRL.VAR.
The housing market remains a bright spot within the U.S. economy, which is not yet fully reflected in relative share performance. For instance, the NAHB survey has massively outperformed the ISM composite, signaling that relative profit conditions are more favorable for housing (top panel). The latest data showed that new home sales have surged, and that homes purchased but not yet under construction are at their highest level since 2007. Importantly, while banks are tightening standards on C&I loans, they remain willing to make mortgage loans, and consumers are increasingly willing to take on residential-related debt. This is bullish from a cyclical perspective, particularly since housing starts and household formation have considerable room to run before hitting a saturation point. Stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5HOME - DHI, LEN, PHM.
Stocks have breathed a sigh of relief following earnings season. Nevertheless, cracks are spreading beneath the surface. The chart shows a compilation of non-conventional indicators that are waving a yellow flag. Breadth is thinning, as evidenced by the downtrend in the NYSE A/D line (top panel). Sentiment is also poor, with bullish investors throwing in the towel at an accelerating pace (third panel). Rather than view this contrarily, it can often be a sign that selling may accelerate. Moreover, once vibrant M&A activity is cooling rapidly, and the news has been recently dominated not by deal making, but by deal break ups. This may reflect increased trepidation about further adding debt to already bloated corporate sector balance sheets (bottom panel). Bottom Line: Resist the temptation to deplete cash balances, and continue to favor defensives over deep cyclicals. A capital preservation mindset is still warranted.
This month's <i>Special Report</i> reviews the literature on equity market timing, and identifies the key indicators that historically have had the best track record. We then aggregate the indicators into an overall scorecard that should prove to be valuable for investors in these volatile times.
This month's <i>Special Report</i> reviews the literature on equity market timing, and identifies the key indicators that historically have had the best track record. We then aggregate the indicators into an overall scorecard that should prove to be valuable for investors in these volatile times.
Our upgrade of the S&P electrical components & equipment (ECE) index to overweight earlier this year was based on both market and industry factors. The group had undershot on technical, valuation and sentiment basis. Moreover, it was being unfairly lumped in with more resource-dependent industrial sector groups, particularly given that the index is comprised of large, diversified manufacturing businesses with exposure to a variety of end markets. However, market extremes have been unwound and headwinds to a fundamental earnings recovery have surfaced. Shipment contraction is rife, and unlikely to improve given that new orders have tumbled. Factories are likely to become underutilized. Utilization rates had stayed remarkably high during the overall economic downturn, owing to capacity shrinkage. This resilience is at risk now that leading revenue indicators are sinking. Productivity growth has dipped, and has more downside risk, given that wage inflation is outpacing deflationary pricing power growth. Adding it up, the power to sustain the advance in ECE stocks is diminishing, and we recommend moving to the sidelines. Please see yesterday's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5ELCO - EMR, ETN, ROK, AME, AYI.
The S&P industrials sector has led the deep cyclical sector recovery this year, validating our upgrade to neutral to protect against a countertrend move spurred by U.S. dollar softness. However, the industrial sector share price ratio is now near the top end of a 15-year range, suggesting major resistance. An exhaustive examination of our Indicators highlights that this year's rally has been based on portfolio repositioning and reversion from oversold conditions rather than expectations of a sustainable earnings recovery. Valuations have gone from cheap to neutral, implying that further gains require earnings outperformance. The objective message from our industrials Cyclical Macro Indicator is that relative forward earnings estimates will continue to fall. The underlying bearish force is top-line malaise. Hopes for an industrial sector revival appear to be misplaced. Once credit conditions tighten and banks become less willing to extend C&I loans, the ISM manufacturing index generally weakens. Core durable goods orders are already contracting, despite the boom in auto production over the past few years. Importantly, the corporate sector is not in a position to ramp up investment, as highlighted in last Monday's Weekly Report. That is particularly true of resource companies, where the most intense leverage pressures reside. Consequently, it is premature to bet on an industrial profit recovery and we recommend returning to an underweight stance. Please see yesterday's Weekly Report for more details.
Industrial machinery stocks have surged as if China is headed back to double-digit GDP growth and the U.S. dollar is going to reverse all of its recent year's gains. That combined scenario would produce a rebound in sales growth, and allow investors to bet on increased operating leverage. But that is wildly optimistic, especially given that the sales outlook remains murky. Our global machinery new order proxy is contracting. Global machinery exports have also gone ex-growth. Importantly, leading indicators of new orders are bearish. For instance, BCA's Global CapEx Indicator is heralding a contraction in developed country capital formation. That does not bode well for global output growth, and by extension, machinery consumption. Coal and other commodities also provide a good read for future industrial machinery demand. Clearly, coal is warning that machinery new orders will stay punk. Whiffs of reflation in China have supported other commodity prices, but it is premature to extrapolate this liquidity-driven bounce into a demand-driven upturn. Loan demand is still anemic, and machinery stocks have front run any improvement in China's cyclical outlook (bottom panel). Use the rally in the SP& industrial machinery index to downshift to an underweight position.The ticker symbols for the stocks in this index are: BLBG: S5INDM - ITW, SWK, IR, PH, PNR, DOV, SNA, XYL, FLS.
Fed hawkishness reinforces the need for an imminent profit recovery to justify current valuations. Our Indicators do not signal such an outcome. Stay defensive, and return to an underweight stance in the industrials sector.